Sunday, 28 September 2014

Retirement Spending Rules and Forced RRIF Withdrawals

Last week's post left unexplored retirement portfolio withdrawal strategies that could serve as alternatives to our base case of a constant inflation-adjusted dollar amount. This week, we'll look at several such optional strategies, plus we'll discuss what to do about forced minimum withdrawal rates for registered retirement income funds.

The portfolio assumptions we'll use for our comparisons:
  • $100,000 in assets as of retirement date
  • 30-year expected duration of retirement
  • asset allocation 50% fixed income (Canadian government T-Bills/cash instead of the broad bonds in our previous so that we can use historical data going further back in the Stingy Investor Asset Mixer tool), plus 50% equity (in equal parts TSX Composite Canada, S&P 500 USA and MSCI EAFE Developed countries)

1) Base case: Constant Inflation-Adjusted Dollar Amount
Method: Calculate a dollar amount based on a sustainable withdrawal rate as a percentage of the portfolio at the start of retirement. Increase annually per the past year's inflation.

Example: using the 4.0% rate that worked in the past (though 3.5% is the going-forward sustainable withdrawal we estimated in our previous post to be reasonable nowadays), in Year 1, withdraw $4000, in Year 2, after a CPI rise of 2.0%, withdraw 4000 x 1.02 = $4080.

Key Characteristics:
  • Designed to maintain a steady lifestyle - while early on retirement perhaps more is spent on travel and activities, even if life slows down later on spending may rise on health care or gifts.
  • Usually ends up leaving a lot more legacy at death compared to the other alternatives due to conservative withdrawal rate based on worst case assumptions designed to avoid depletion of the portfolio.
  • Withdrawal amounts may look very low after a multi-year stock market bull run, making it tempting to abandon the strategy and increase withdrawals
2) Constant Percentage of Portfolio Balance
Method: Every year withdraw the same percentage amount of the current portfolio remaining balance, which may be up or down according to market swings and the effect of withdrawals

Example: Stingy Investor's tool shows us that applying a 4% withdrawal rule to historical results for our sample portfolio from 1970 to 2013 produced the following table of real (inflation-adjusted) dollar withdrawals.
(click on image to enlarge)

Key Characteristics:
  • Suited to luxury or discretionary spending - amounts from year to year are highly variable - see in the table above how the amount withdrawn fell about a third from 1972 to 1974 and took till 1986 to get back to near the initial $4000 mark.
  • Allows slightly higher percentage withdrawal rate than the initial percent set in the constant dollar method, but despite never incurring the risk of totally depleting, higher withdrawal rates can eat into the portfolio enough to reduce the balance to very low levels and much diminished dollar withdrawal amounts. Using Stingy Investor again, we see that a 9% withdrawal rate would have started with $8878 withdrawn in 1970 but that would have dropped to less than half that by 1980 and to only about $3000 twenty years later in 2000. The portfolio had under $11,000 left after 30 years. That's only one scenario. In his classic book Conserving Client Portfolios During Retirement, William Bengen found that a constant percentage strategy for a US investor using data going back to 1926 would on average still have incurred a 15% drop from starting amounts, even using a 4.43% withdrawal rate.
3) Higher Withdrawals in Early Years
Method: Calculate a set dollar amount higher than the constant dollars of method 1 above, adjusting it annually for inflation as before too, for the first X years of retirement, then reduce the amount in later years, perhaps by cutting part or all of the inflation adjustment.

Example: There is no set way to decide on the parameters, many combinations are possible. Bengen gives an example of a 1955 retiree who takes a 4.78% withdrawal rate for the first ten years of retirement, i.e. a $4777 real annual withdrawal, then takes an adjustment of inflation less 3% for the next ten years and at inflation for the ten years following that. It's a combination that ensures the portfolio would not have run out after 30 years. He compares that to a fixed dollar withdrawal retiree who have been able to withdraw only $4433. In exchange for $343 more for ten years (7.8% more), the higher early withdrawal retiree would have suffered an income that eventually became 19% less.

Key Characteristics:
  • Suited to those who don't mind a big drop in spending in later years - the income penalty of the later drop is much greater the reward of the early permissible boost, according to multiple scenarios Bengen constructed. More than half of the 30 years during retirement experienced lower spending than the constant dollar amount.
  • Maximum workable non-depleting withdrawal rates are not much more than the maximum sustainable rate of the constant dollar approach. Eyeballing Bengen's results show the early boost possible in his formulations to be about 0.25-0.3% more.
4) Floor and Ceiling
Method: Calculate a first-year dollar amount then each year withdraw a percentage of the current portfolio value, within a lower "floor" limit and upper "ceiling" limit compared in real dollars to the initial amount (or in a variation proposed by Vanguard, in this review of the alternatives, compared to the previous year amount).

Example: A 5.0% initial withdrawal, or $5000 in our $100k portfolio is bounded to not fall less than 5%, i.e. below $4750 in real dollars, or go above 10% ($5500, which would mean the portfolio had risen to $110k - 5% of 110,000 is 5500 - or more).

Key Characteristics:
  • Provides some flexibility in spending according to market performance, with reward in good times and restriction in bad times, yet quite a bit of stability in funds available for spending. It's a solution in between fixed dollar and percent of portfolio.
  • Allows an appreciably higher initial spending rate. The downside restriction in particular is key in protecting the portfolio. The upside limits make no difference! Bengen's figures show that the larger the allowable downside reduction, the greater the safe initial withdrawal amount. a 5% reduction floor allows approximately a 0.8% higher initial percentage - instead of the 3.5% we calculated, that would allow 4.3%. A 10% floor gives a 1.2% initial boost and a 15% floor permits a 1.5% boost. The big question is whether the investor can and will carry out the actual spending reduction after markets have gone sour.
RRIF or LIF withdrawal rates complicate life - The requirement imposed by the federal government to withdraw a rising minimum percentage of money ( based on outdated longevity assumptions) from RRIFs and other registered retirement accounts is completely out of sync with any of the above strategies.  For the required withdrawals, see this table from TD Canada Trust. Being obliged at age 71, when all registered retirement accounts must begin withdrawing money, to take out 7.38% far exceeds the safe rates to avoid portfolio depletion. There have been complaints in the media, like this article in the Financial Post and this one in the Globe and Mail, about the unfairness and the danger to savings depletion.

What can an investor do: avoid spending the forced withdrawal amount in excess of the sustainable minimums we have discussed, and in particular,
  • Delay conversion of RRSPs to RRIFs and forced withdrawals as long as possible (age 71), keeping in mind that partial conversion is worthwhile to take advantage of the pension income tax credit (consult this page at for details). This step, and the next, allow tax-free accumulation to continue as long as possible, which is a significant benefit.
  • Contribute to a TFSA as much excess as possible. The yearly contribution limit is currently $5500 and there is no age restriction, nor any forced withdrawals. Like any registered account, all income and gains in a TFSA are tax-exempt.
  • Re-invest the remaining excess amount in a taxable account. There is on-going tax paid on income in such an account but the judicious use of efficient investments can defer the payment of tax, which helps.
Bottom Line: The Floor and Ceiling method offers an appealing compromise between income stability and higher sustainable withdrawal rates for those who have the discipline to reduce withdrawals after market downturn years.

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Monday, 22 September 2014

Refining the 4% Retirement Withdrawal Rate Rule: Pay Attention to Stock Market Valuation

How much can be withdrawn each year to spend on retirement expenses without depleting an investment portfolio can be a daunting decision considering the money has to last 25, 30 years or more. In 2009 we introduced the widely-recognized rule-of-thumb solution called the 4% rule, which entails taking out 4% of the capital in the first year of retirement and then continuing to take out the same amount year after year after increasing the amount for the previous year's inflation. (Note that the 4% rule is not withdrawing 4% of the remaining capital every year - obviously you will never run out no matter how small your balance gets.)

Actuary Fred Vettese wrote about the 4% rule in the Financial Post in July, saying that it might be too low, since at least a couple of recent historical scenarios applying an 8% withdrawal rate did not run out after 25 years. However, he does advocate caution and recommends sticking with the lower 4% rate. He cites as the key reason that rates of return on investments are likely to be much lower in future - in the order of 3% real (after-inflation) return in a diversified portfolio. That's compared to the Credit Suisse Global Investment Returns Yearbook 2014 reported historical average for Canada of 5.7% for equities and 2.1% for bonds from 1900 to 2013, or 3.9% in a portfolio containing half of each.

A world of 1% lower returns - Our own recent look at prospective future returns for Canada and for the USA (especially!) and other foreign countries found much the same probable return as Vettese proposes. Using the ranges of future return estimates in our posts, which end up straddling Vettese's 3% real return, we figure a portfolio of 50% equity (1/3 each of Canada, USA and other Developed plus Emerging Markets together) and 50% Canadian bonds, will likely produce 2.8 to 3.1% annual compound real return.

Effects of 1% less on the Maximum Safe Withdrawal Rate - Vettese does not demonstrate in the newspaper article the exact impact on the maximum sustainable withdrawal rate retirees can adopt. But other researchers in the USA have done so and included a longer 30 year retirement period (is even that enough for people retiring early and living longer?). The results suggest some caution is in order for the 4% rate.

In a newly-published paper Retirement Risk, Rising Equity Glidepaths, and Valuation-Based Asset Allocation, Michael Kitces and Wade Pfau find that in the past when stock markets were over-valued, such as is the case right now, the maximum safe / sustainable withdrawal rate for a US stocks and (10 year government) bonds portfolio fell short of the 4% rate, no matter which of various asset allocation investment strategies they tested.

A table of their key results is shown below. Note the majority of values under 4.0% for SAFEMAX (the maximum withdrawal rate that doesn't run out of money) in the right hand "Overvalued" column, which we have highlighted by a blue rectangle. Such results based on index values do not take account of fund MERs that further reduce returns by 0.1 or 0.2% even for the lowest fee funds.
(click on image to enlarge)
As a result, we believe a safer withdrawal rate for a 30-year retirement is closer to 3.5% nowadays for a traditional portfolio made up of stocks and bonds.

This and other research points out several other useful ideas for investors contemplating their retirement investment strategy:
  • Fixed 60% stocks, 40% bonds or T-Bills (aka cash or short-term bonds up to a couple of years maturity) does quite acceptably - Kitces and Pfau: "... an annually rebalanced static 60% equity exposure is still remarkably effective as a retirement asset allocation". For the investor wishing to keep retirement investing simple, this is a comforting thought. Another conclusion from other research (like William Bengen's seminal book Conserving Client Portfolios During Retirement, is that equity allocations in a range of 45 to 65% do about equally well, especially as retirement duration lasts 20 years and longer. Conversely, very low equity allocations, like 10% stand more chance of running out at withdrawal rates of 4%, or to put it another way, they can sustain only much lower withdrawal rates. The reason is that bonds provide a much lower return than equities.
  • Successful retirement income portfolios include at least 30%, up to 70% equity. A fairly even mix of equities, which produce higher returns, and bonds (or T-Bills/cash) which reduce volatility, gives the best chance of success through all types of market environments.
  • A rising equity glidepath, where the equity allocation starts low (30% in their testing) and is increased 2% per year over the first 15 years of retirement to reach an eventual 60%, or a strategy that switches amongst 30-45-60% equity allocation according to market valuation, are best suited to the present high-valuation market environment. 
  • "... declining equity glidepaths [from 60% equity at retirement steadily down to 30% after 30 years] provide the worst outcomes"! The idea that you should progressively reduce the equity allocation during retirement is unhelpful in an over-valued market environment. Nevertheless, such a strategy is not disastrous as there is always a substantial allocation to equity.
  • Cash / T-Bills / Short term bonds (< 2 year) work better in providing safety than bonds (10 year government) as can be seen in the table above. Sacrificing lower return from cash is more than compensated by the much lower volatility. This is particularly so in today's environment where bond returns are already low.
Flexible withdrawal rate rules - 4% growing by inflation is used as the base case to test portfolio resilience but there is no obligation to take and spend 4% or any fixed amount out of the portfolio every year. Next week we'll review various retirement withdrawal alternatives and discuss how the forced withdrawals from registered retirement accounts fit into the picture.

Bottom line - Meantime, investors need to keep in mind that returns are likely to be lower than past historical averages and that spending from retirement portfolios needs to be reduced in consequence.
Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Thursday, 18 September 2014

Fixed Income - best rates in Canada for 1 to 20+ year maturities

A year ago we compared the best available rates for safe fixed income investments with a variety of maturities from on-demand savings accounts to terms expiring in 20+ years. Rates keep changing and it's time to do an update.

As before we have restricted our search to investment grade bonds (BBB or higher) and preferred shares (Pfd2-low or higher), those securities having "substantial protection of interest / dividend payment and principal", either from individual issuers, ETFs or closed-end funds. We've primarily selected investments with hard maturity dates when money will definitely be paid back to the investor. We've thus excluded the many preferred shares with either no fixed maturity date or a date at the discretion of the issuer. Some of these excluded preferreds currently offer much higher rates than anything in our comparisons below - see for example the weekly list of top-yielding preferreds at the Libra Investment Management Quick Pick Prefs page - but such investments bear that crucial difference. Despite focusing on hard maturities, for comparison we have included some of the main Canadian bond ETFs, which of course do not have a definite maturity date as they incessantly keep buying new bonds to replace maturing bonds.

The Investment Options:
  • High interest savings account - BMO's version (symbol: AAT770)
  • Guaranteed Investment Certificates (GIC) - our biggest constraint here is to select only from GICs available from online brokers, ignoring some (see Cannex's complete listing of rates and providers) that might have higher rates but which require going direct to the provider; different brokers have different sets of GIC offerings, especially at the higher-yielding end
  • Corporate, federal and provincial government bonds as individual bonds and in target maturity ETFs, or traditional ever-renewing ETFs - see this previous post comparing the ins and outs of fixed income alternatives)
  • Preferred shares of individual companies (previous post here)
  • Preferred shares of split share corporations (see posts here and here), with under-lying holdings of either a single company or multiple companies

Pre- or No-Tax Accounts: TFSA, RRSP - Green text shows the best rate trade-off between credit risk rating and return. Red text shows rates that fall below the most recent July 2014 CPI inflation rate for Canada of 2.1%. There are quite a few choices that fall short of compensating for inflation even in tax-sheltered accounts so picking the best ones really matters.
(click on image to enlarge)

Comparing this table to the one for September 2013, we notice that interest and dividend rates on offer are lower. Many people, including this blogger(!), have for years expected rates to rise but it has not been happening yet.

The chart below takes the best choices for each maturity range. All investments except the 1-year GIC beats inflation in a tax-protected account.
(click to enlarge)

Taxable Account - There is a lot more red in the table below, indicating investments that do not beat inflation. The higher tax rate on interest income from bonds makes many of the bonds unattractive. The split share preferreds from CGI and Partners Value look especially attractive in contrast.
(click to enlarge)

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Friday, 5 September 2014

The #1 Canadian Dividend ETF according to the Shareholder Yield Test

In the past month we have written several posts on using Shareholder Yield as a broader measure of dividend performance, first introducing the concept, then looking at which individual Canadian stocks rate best according to this measure. Today we'll compare the main Canadian dividend ETFs against the measure (see our January post comparing these ETFs on a range of other factors). For a benchmark, we'll also look at the stats for the ETF formed of the 60 largest and most liquid Canadian companies, the iShares S&P/TSX 60 Index ETF (TSX symbol: XIU). After all, if the dividend ETFs don't look any better than the benchmark, why bother with them?

The Comparison Method
First, we had to calculate the Shareholder Yield for all the stocks held by all the dividend ETFs. There are 161 different stocks held by at least one ETF. Then we counted how many of the stocks in each ETF had a positive or a negative Shareholder Yield. As a supplement, we have included the stats for Total Payout Yield, formed as the sum of straight dividend yield and net share purchase/buybacks yield, which is used as the basis for several ETFs in the USA (see our first post for details) though none yet in Canada. Payout Yield gives a better representation of dividend performance than only dividends (to understand this, see the various articles and research papers linked to by Mebane Faber). We did this to see whether there was any consistency in results. Fortunately, we would say yes, both Shareholder Yield and Payout Yield paint the same picture of the ETFs.

The Results
Our comparison table below shows Shareholder Yield in the light blue cells and Payout Yield in the yellow cells, with the total ETF stats at the bottom. Green text is positive and/or good numbers while red text is negative / bad. Within the table, the detailed stats are shown for all the 30 individual stocks held by the ETF that has impressed us the most, the iShares Canadian Select Dividend Index ETF (XDV).

XDV looks significantly better than any other ETF

  • It is the only ETF holding a much greater proportion (67%) of companies with positive Shareholder Yield vs the benchmark XIU (57%), or the gamut of all the 161 companies across all the dividend ETFs (also 57%). Even the stocks with negative numbers held by XDV are not extreme - the worst is -7.7% while the bottom stocks of the overall table (not shown) are in the high negative 90 percents and worse.
  • XDV's 90% proportion of holdings with positive Payout Yield is also well above both XIU's 82% and the "gamut" range's 78%
  • XDV holds all but one (missing only Potash Corp) of the Shareholder Yield superstars (see post on the individual stocks) shown in green text
In sharp contrast, none of the other dividend ETFs looks any better on Shareholder Yield than either XIU or the overall dividend stock average. Only one - CDZ - manages to exceed XIU's Payout Yield.

Somehow, XDV's vaguely defined "rules-based methodology including an analysis of dividend growth, yield and average payout ratio" seems to achieve the closest alignment with Shareholder Yield. XDV's cumulative five-year total return to the end of August 2014 of 79.05% far outstrips XIU's 57.11%. The big question - will it continue? We believe there is a good chance, though perhaps not to the same degree, based on the research, but there are no guarantees.

Cherry-pick high Shareholder Yield stocks - Investors willing and able (i.e. with sufficient funds to properly diversify by buying 20 or so companies) to invest in individual stocks may wish to select stocks with attractive Shareholder Yields and ally that to other stock evaluation methods such as ratio analysis to make a final choice. To that end, below is more of our working table sorted by Shareholder Yield. Stocks not previously shown above, i.e. not held by XDV, have paler blue cells.

Update 30 September: We had no inkling this was coming but S&P Dow Jones Indices and TMX Group have teamed up to create a Canadian stock shareholder yield index, whose constituents are listed here on the TMX website. Horizons ETFs is apparently planning to launch an ETF based on the index according to this Financial Post article.

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Friday, 29 August 2014

Shareholder Yield - How do the popular dividend stocks measure up?

Recently we introduced  the idea of using Shareholder Yield as broader measure of dividend stocks that are likely (according to historical experience and some academic research) to provide better returns for the investor. We took the holdings of one dividend-oriented ETF to get a feel for how its stocks stack up but found little link between the holdings and Shareholder Yield. This week we'll take another stab at the idea by taking the most popular dividend stocks - those held by all, or most of the eight Canadian dividend ETFs (reviewed in our post this past January) - and see how they come out in terms of Shareholder Yield. We've updated the list of most popular dividend stocks that we had compiled in this post in February.

Shareholder Yield - To recap, this measure is the sum of Dividend Yield plus net Share Buyback Yield (% change in number of common shares resulting from issuance and repurchases over the past 12 months with a rise in outstanding shares considered to be a bad thing and thus termed negative yield) plus net Debt Paydown Yield (% change in total debt, with a reduction being considered good for shareholders and thus positive yield).

The Comparison Table
The basic data on dividend yield and other columns comes from GlobeInvestor's Watchlist, except that we have had to calculate ourselves (using the raw debt and share numbers in Google Finance Canada) the Share Buyback Yield and Debt Paydown Yield since no free source seems to publish that data. Our table shows all the stocks - 31 in total - currently held by at least five out of eight dividend ETFs
(click to enlarge table image)

The most popular dividend stocks generally also look positive from a Shareholder Yield viewpoint

  • 18 of 31 (58%) have positive Shareholder Yield
  • The average of all the top stocks has a slightly positive Shareholder Yield - 1.04%
but ...
  • Dividend yield, which of course is positive for every stock by design in these ETFs, compensates for an average negative yield of both stock buyback and debt reduction.
  • Increases in debt cause most of the cases of negative Shareholder Yield, although the stock with worst result, Northland Power's minus 46%, saw large increases in both net share issuance and additional debt
Some companies shine across the board - the dividend and shareholder yield superstars
Eleven companies have fine looking numbers across every metric with a solid cash dividend backed by low or negligible stock and debt issuance. Along with that there have been good dividend increases over the past five years and double digit return on equity.
  • Shaw Communications (TSX symbol: SJR.B)
  • Bank of Montreal (BMO)
  • CIBC (CM)
  • Corus Entertainment (CJR.B)
  • Royal Bank of Canada (RY)
  • Bank of Nova Scotia (BNS)
  • Canadian Oil Sands (COS)
  • Potash Corp. of Saskatchewan (POT)
  • Husky Energy (HSE)
  • Laurentian Bank of Canada (LB)
  • TD Bank (TD)
Potential opportunity stocks to buy or to avoid
A handful of stocks in our list exhibit contradictory indications that suggest extra digging into the situation may reveal interesting prospects. Canadian Oil Sands has a healthy Shareholder Yield of 8.6% where there has been no extra debt and no share issuance, plus a strong return on equity of 16.5% and a 5-year record of strongly increasing dividends. Yet its total return for the past five years is a disappointing 1.6% annually. Potash Corp presents a fairly similar picture. Sun Life (SLF) has been reporting stronger results so perhaps its stock, which has started to revive, might further catch up with much higher returns that the rest of the stocks in the dividend superstars have been achieving. Maybe it will also escape being a Market Dog, as we described the other day.

On the other hand, Northland Power Inc seems like a much riskier investment. The very large negative Shareholder Yield of 45.9% has been accompanied by no dividend increases. Yet the stock has seen strong annual total returns of 17.9% compounded. In looking at company news releases, the latest quarterly financial statements (not yet reflected in the Globe WatchList data in our table which shows positive net income) show a large net loss with the company paying out all its free cash flow in dividends. Success seems to hinge on stick-handling the various expansion projects, whose need for funds explains the large share issuance and debt addition.

Disclosure: This blogger directly owns shares of SJR.B, BMO, RY, BNS, POT

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Wednesday, 27 August 2014

Canadian Equity Market Darlings and Dogs: August 2014 Update

The days and weeks have been flying by in a very upbeat Canadian stock market this year. It's time for our semi-annual look at the Canadian equities market to see which sectors and companies the market loves (the Darlings) or shuns (the Dogs). Is it even possible to have Dogs in such a strong market? The answer is yes, based on the relative weightings of sectors and stocks in two ETFs:
  • the iShares S&P/TSX 60 Index Fund (TSX symbol: XIU), which selects its holdings and weights based on market capitalization and thus tracks market sentiment, against 
  • the iShares Canadian Fundamental Index Fund (CRQ), which chooses holdings based on past hard accounting results likes sales, dividends, cash flow and book equity value
We will also examine interesting changes in the Darlings and Dogs from previous comparisons in February 2014August 2013February 2013August 2012January 2012June 2011 and the original post in April 2010.

The Numbers
The table below shows the companies and the sectors colour-coded - Darlings in Green and the Dogs in Red. The table also shows the change in internal weighting over the past six months for each ETF, which tells us stocks and sectors that have been moving up or down, either in terms of price (XIU) or fundamentals (CRQ). The bigger shifts are highlighted in Bold.
(click on table image to enlarge)

Adjustment for differing numbers of total holdings in XIU and CRQ - As a cross-check to be sure the sector differences are not due to the fact that CRQ has 29 more holdings than XIU's 60 (which might tend to result in XIU being more concentrated and have higher individual percentages than CRQ) we've re-calculated weights for CRQ using only its top 60 holdings.

Adjustment for differing numbers of holdings in sectors by XIU and CRQ - A second adjustment takes account of the fact that XIU and CRQ hold a different number of stocks in almost every sector (see table for details) and thus the weight of the sector in the ETF may be tilted upward or downward. e.g. XIU holds 10 Financials stocks but CRQ has 14. We've therefore adjusted XIU's weightings to account for the extra or missing stocks, as one of the columns shows.

Adjustment for relative size of holdings in XIU and CRQ - In this edition we've added a further refinement to take account of the fact that sectors and stocks vary a lot in their size within each ETF. For instance, the second largest stock, the Toronto Dominion Bank makes up 7.49% of XIU, while the 20th largest stock, Sun Life Financial is much smaller at only 1.76% of the ETF. Sun Life's 0.41% difference in weight between XIU's 1.76% and CRQ's top 60 stock adjusted 2.17% is much more significant relative to its size than TD's 0.48% difference. We have thus created two new columns outlined in double-blue lines to show differences in sectors and stocks relative to their size. In several cases this adjustment changes the picture dramatically - for the Financials, Energy, Materials and Information Technology sectors and three banks - TD, Bank of Montreal and Scotiabank, plus Brookfield Asset Management and Goldcorp.

Financials - Continuing the trend we noted a year ago, the alignment of the market view and the fundamental view is quite close. Today there are no Darlings amongst Financials, and the Dogs - Bank of Montreal (TSX symbol: BMO), CIBC (CM), Manulife (MFC) and Sun Life (SLF) are not nearly so negatively considered as other sectors and companies are loved.  That CRQ continues to have a much heavier weighting in our table in the Financials seems to be a quirk of XIU's construction.  Several Financial companies that are in CRQ such as Intact Financial, Great West Life, Power Financial, Fairfax Financial Holdings don't even figure in the XIU portfolio even though those companies are firmly within the top 60 largest market cap stocks on the TSX.

Energy - There has been further convergence of market view with fundamentals to the point that the sector overall within XIU is so slightly less weighted - only 12%. less -in relative terms that we cannot really call it a Dog. CRQ still has more weight in Energy than XIU, but it is not so much as to make it a Dog. One big company - Enbridge (ENB) - is still a market Darling, while Canadian Natural Resources rejoins the Darling ranks after a few years absence. Cenovus (CVE) has emerged as a new Dog, replacing Encana, which has now shrunk so much in both XIU and CRQ that it dropped out of the top 20 stocks in both.

Materials - This sector has moved from being a Darling to a neutral position. Perpetual Darling Potash Corp (POT) remains so with a stock price at a level significantly higher than accounting fundamentals justify. Former Darling Goldcorp Inc (G) is now neutral. Apart from those two stocks, the difference in weight between XIU and CRQ is due to the fact that XIU includes several miners excluded from CRQ.

Telecommunications - The two DarlingBCE Inc (BCE) and Telus (T) continue to be the object of market desire, being vastly overweight in XIU compared to CRQ, though Telus has been displaced in XIU's top 20 by even faster growing stocks.

Industrials - Our comments of February still apply exactly - Canadian Pacific Railway (CP) continues its resurgence as a Darling which, along with perpetual Darling Canadian National Railway (CNR), makes the whole sector so.

Consumer Discretionary - This sector is now completely neutral. Even the former Dog Magna International (MG) is now valued the same in both XIU and CRQ.

Consumer Staples - Not much is going on here either. The sector remains neutral as in February. Individual companies themselves remain in balance too.

Health Care - Darling ! The market is still over the moon in love with both companies in this sector - Valeant Pharmaceuticals (VRX) and Catamaran Corp (CCT). By fundamentals, Catamaran is too small even to be included in CRQ's top 60 yet it is the 40th largest holding in XIU. The passion may be starting to ebb though. Valeant's weight in XIU dropped the most of any stock since February and Catamaran also fell eight places in the ranking from 32nd.

Utilities - CRQ puts a lot more weight in this sector. The market thinks the sector and individual companies Fortis (FTS) and TransAlta (TA) are Dogs, despite all the adjustments we make. Is there investment opportunity here?

Information Technology - Blackberry (BB) is an interesting case. It continues to become more of a Dog as its market cap in XIU has continued to drop but its fundamental weight in CRQ has recovered somewhat.

The Darling and Dog sectors and stocks since 2010
Using the same benchmark as February, most sectors and companies are still in the same position of being either Darlings - Materials (Potash Corp and Goldcorp), Industrials (CN Rail and CP Rail), Healthcare (Valeant) and Telecommunications (BCE and Telus) - or Dogs - Financials (Manulife and Sun Life)Utilities and Consumer Discretionary

However, using our new relative benchmark, Financials, Energy and Consumer Discretionary are no longer seen as Dogs, nor would they have been in February. Consumer Staples and Materials would have been Darlings in February but are not now. All those sectors we now label as neutral.

Telecomms and Industrials are consistent Darlings while Utilities and Information Technology are consistent Dogs.

Our table shows the classification based on both the old method and the new relative revised method of distinguishing the Darlings and the Dogs.
(click on image to enlarge)

How do the Darlings and Dogs stocks' numbers look?
We entered the thirteen stocks from the top 20 biggest in XIU that are either Darlings of Dogs in a Globe&Mail WatchList to see recent stock and company financial performance. We got a shock. The table screenshot below shows that the one-year total return (stock price plus dividends) for all the companies, Darlings and Dogs both, was positive. Counter-intuitively, several Darlings, like Potash Corp, BCE and Valeant did worse than the XIU average, while only one Dog did - Cenovus. The only company with net losses is one of the Darlings and the most extreme Darling at that - Valeant!

Meanwhile, Dogs Manulife, BMO and CIBC, apart from being solidly profitable, sport reasonable dividend yields and attractively low Price to Earnings ratios. They appear to be worth a look for individual stock investors.
(click on table image to enlarge)

XIU and CRQ, or other broad market funds can also be used directly as diversified investments for those investors who do not feel confident, or who don't have the time, to investigate individual stocks. The differences in weightings and holdings are only a couple of aspects in comparing the two ETFs. See our previous posts reviewing Canadian equity ETFs herehere and here.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Saturday, 23 August 2014

Shareholder Yield - the New, Improved version of Dividend Investing

We've previously noted the income and return attractions of high dividend stocks and ETFs concentrated in such stocks. After all, producing cash for shareholders is ultimately what investors want from companies. But dividend investing is evolving. Instead of only considering the dividend cash payout, some adjustments and refinements have been found by researchers to be worthwhile.

The new refined measure is called Shareholder Yield. It equals three pieces summed together: Dividend Yield + Net Share Buyback Yield + Net Debt Paydown Yield

1) Dividend Yield = The latest quarterly dividend per share multiplied by four to get a projected yearly total and then showing that as a percentage of the current stock price.

This is the long-recognized traditional measure used by dividend investors to find attractive companies and it does still work, just not as well as Shareholder Yield.

2) Net Share Buyback Yield = The net amount of shares bought back by the company in the previous year, after subtracting shares issued.

Although the most accurate calculation would be in dollar terms, expressed as a percentage of current company market capitalization, an accurate enough simplification is simply to take the percentage change in common shares outstanding (as Mebane Faber points out in his excellent mini-book Shareholder Yield; the book's website also contains links to various research articles on the topic).

The reason it is important to consider share buybacks and issuance is that some years ago companies, especially in the USA, began returning cash to shareholders by buying back their shares in the open market. Changes in relative tax rates that favoured capital gains, or stopped favouring dividends, are often cited as a key reason stimulating the shift to buybacks. In any case, the chart below from index providers Standard & Poors, detailing the rise of buybacks from negligible amounts in 1980 to as much or more than actual dividends today in the USA, shows it is essential to consider repurchases.
(click to enlarge Image)

In Canada, the relative tax attractiveness to investors of dividends versus the capital gains that buybacks engender for the investor, has remained much more muted than in the USA (see Table 2 in Taxation, Dividends and Share Repurchases: Taking Evidence Global by Marcus and Martin Jacob for the tax penalty on dividends through the years in Canada, the USA and 23 other major countries). There is not such a large incentive for Canadian companies to send cash back to shareholders by buybacks instead of dividends. But there are still many companies in Canada, as we see below in our comparison table of some Canadian dividend stocks, where net repurchases or issuance, dwarf the effects of cash dividends.

The important point to note is that when companies have fewer shares after net repurchases, the buyback yield is positive and more shares after net issuance means a negative yield.

3) Net Debt Paydown Yield = The year over year difference in the debt load of a company as a percentage of market capitalization.

This metric is not measuring return of cash to shareholders. Rather, it measures the judicious use of cash by company executives in a way that ultimately benefits shareholders. Instead of wasting cash inflows / profits in empire-building like poor acquisitions or low-return projects, the executives avoid temptation by paying down debt. Shareholders benefit since less cash inflow goes to paying interest on debt and more to profits and potentially higher dividends down the road. In their research paper Enhancing the Investment Performance of Yield-Based Strategies Wesley Gray and Jack Vogel discovered that incorporating debt paydown in picking better stocks resulted in higher returns ... not without fail in every case, it should be noted, but as a strong average.

The Return Difference - Example of the S&P 500 from 1982 to 2011
Gray and Vogel found that selecting stocks with the highest yield for the three components of Shareholder Yield, taking each component by itself, produced significantly higher returns than the S&P 500 index average, repeating the findings of many other studies. But they also found that picking stocks with the highest yield combination of all three, Shareholder Yield, produced the best return of all.

Yearly Return 1982-2011
S&P 500: 10.96%
Dividend Yield (highest yield quartile): 13.40%
Net Buyback Yield (highest yield quartile): 13.19%
Net Debt Paydown (highest yield quartile): 13.25%
Shareholder Yield (highest yield quartile): 15.04%

Huge Shareholder Yield variation amongst stocks in a Canadian Dividend ETF
To see how different a picture Shareholder Yield might paint of stocks in a dividend-stock focussed ETF we compiled the Shareholder Yield for the holdings of the iShares S&P/TSX Canadian Dividend Aristocrats Index ETF (TSX symbol: CDZ), which selects stocks that have increased dividends for at least five consecutive years.

Unfortunately, there does not seem to be a free website that provides Shareholder Yield already calculated for Canadian stocks. We had to do our own calculations, which is not too complicated though it takes a while for many stocks. In our table below, dividend yield, dividend growth and total 5-year return came straight out of GlobeInvestor WatchList. Google Finance Canada provides quarterly Balance Sheet numbers for total debt and number of common shares (e.g. for Enbridge here) that, along with the market cap from GlobeWatchList, allowed us to work out the change over the most recent four quarters to come up with net buyback yield and net debt paydown yield.

We've taken the top/best and bottom/worst parts of CDZ's companies sorted by Shareholder Yield in the light blue column.
(click on image to enlarge)

The results are surprising. There is little relation between Dividend Yield and Shareholder Yield. At the top of the table, some companies with modest dividends like Home Capital Group and SNC-Lavalin have extremely high Shareholder Yield by virtue of significant debt reduction. A handful, like Jean Coutu and Tim Hortons have instead relied on big share buybacks to deliver high Shareholder Yield. Several companies like AGF, Bird Construction and Thomson Reuters have good-looking Shareholder Yield numbers yet their dividend payouts (cf the Payout Ratio column) far exceed net income and may thus not be sustainable. Yet others - Transcontinental and Major Drilling - have net losses, raising the same question even more urgently.

At the bottom of the table are many companies that have been counter-acting their sometimes elevated dividends with share and/or debt issuance to reduce Shareholder Yield to a negative number. In the case of Exchange Income Corp (EIF) both debt and share issuance are allied with a payout ratio of dividends more than six times recent net income. No wonder bad news articles like this one in the Globe are appearing about EIF. In the case of Empire, which last year swallowed a huge acquisition in Safeway, the piling on of new debt and shares to finance the acquisition may make good business sense. Empire's Payout ratio still looks sustainable at 55% though it used to be below 20% before the Safeway acquisition. It is worth looking at Shareholder Yield in combination with Payout ratio - Gray and Vogel found that among low Yield companies, those with the highest Payout ratios tended to under-perform.

Bottom Line: Shareholder Yield appears to offer an additional angle, though not a complete definitive answer, to the assessment of individual stocks. It suggest further useful questions to ask, such as reasons for share or debt issuance and the sustainability of dividends and repurchases.

ETFs based on these factors
The ETF providers have observed the importance of share buybacks, especially in the USA, and have stepped forward with funds that select holdings on more than high dividends.
  • PowerShares Buyback Achievers ETF (NYSE: PKW), MER 0.71% - Selects holdings based on dividends plus buybacks. Very successful since 2006 inception, with $2.5 billion in assets and 2.4% better performance than the S&P 500. MER seems to be high for a simple mechanical stock selection process. This Seeking Alpha article compares it to an ordinary dividend fund.
  • PowerShares International Buyback Achievers (NASDAQ: IPKW) MER 0.55% - Same selection criteria as PKW on international stocks. Inception Feb 2014, $18 million in assets. Includes some Canadian companies like Tim Hortons and Magna.
  • Cambria Shareholder Yield ETF (NYSE: SYLD), MER 0.59% - Selects based on all three elements of Shareholder Yield. Co-managed by the same Mebane Faber who wrote the above-linked book on Shareholder Yield. Inception May 2013. Assets of $223 million
  • AdvisorShares TrimTabs Float Shrink ETF (NYSE: TTFS), MER 0.99% (that's high!), Selects companies that are repurchasing stock. Inception 2011. $151 million in assets. This article from Sizemore Capital compares the three US-stock ETFs
Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.