HowtoInvestOnline

Canadian Equity Market Darlings and Dogs: January 2012 Edition

2012-01-26T11:19:00.016-05:00

Once again we look at sectors and companies that the TSX market favours (darlings, highlighted in green in our comparison table below) or dislikes (dogs, in red) to see how the situation has evolved from our previous reviews in June 2011 and March 2010. As before we do this by comparing the holdings of two ETFs - the iShares S&P/TSX 60 Index Fund (TSX: XIU), which selects and weights stocks by their market value and thus represents market opinion, and the Claymore Canadian Fundamental Index ETF (TSX: CRQ), which picks and weights holdings by accounting factors of actual dividends, cash flow, sales and book value.

Market Darlings
Almost two years after our first review, it is remarkable how persistent are some of the favoured sectors and companies.

Energy and Materials still receive the market's love, far outweighing what their tangible accounting factors would suggest. The market is looking forward to results that are even better than they are now for companies like Suncor (SU), Barrick Gold (ABX), Canadian Natural Resources (CNQ), Potash Corp (POT) and Goldcorp (G), the very same companies we listed in 2010. The promise is mostly yet to be fulfilled as these stocks' accounting results have not carried them much higher in the CRQ holdings. Potash Corp's latest just-released quarterly results show strong growth and a doubled dividend but analysts were described as disappointed in the Globe and Mail. Is this a case of over-optimism that will eventually be dashed? On the other hand, Encana (ECA) remains an unusual energy outlier, being far less valued in the market than its fundamentals indicate. Is this over-pessimism that will eventually be corrected? ECA recently attracted mention in the Globe and Mail as a stock meeting value investor criteria.
Telecommunications companies BCE Inc (BCE) and Telus Corp (T) have been darlings on our list all along as well. They have crept ahead somewhat in the CRQ weightings but what is it that attracts investors so much? Perhaps the high dividend yield, the growth in dividends, the relative price stability of the stocks, lowish P/E of around 14? Time has yet to tell.

Dogs
Again, it is largely a familiar continuing story.

Financials continue to be vastly under-weighted, partly because of exclusion of major firms like Power Corp (POW), Fairfax Financial Holdings (FFH), Onex (OCX), Great West Lifeco (GWO) and partly because of troubled companies Manulife (MFC) and Sun Life (SLF). One thing that has changed is that big banks, with the one exception of Bank of Montreal (BMO), are now close in terms of market opinion and fundamental factors. BMO's market weight is still far below its fundamental weight - is that indicating a trading opportunity as it has started to move back into line with the other banks? Looking back, the market pessimism about Manulife seems to have been justified to a good degree, as the company's struggles have dragged it down on accounting measures reflected by CRQ. Looking forward, the question is whether those negatives have been overdone, since MFC's fundamentals still indicate a far stronger entity than the market estimates.
Consumer Discretionary & Staples, as well as Utilities stocks still find no market favour as they receive much smaller market weighting. It is a surprise since Utilities like Emera (EMA), Fortis (FTS) and Canadian Utilities (CU) have gained good returns over the past year while the TSX has declined.

These differences between holdings and weightings in XIU and CRQ provide a good starting point to investigate and possibly then invest in companies whose fundamental and market values are at odds. The answer could go either way, either that the market has mis-estimated, or that it has properly assessed the future, in a way that is not reflected in CRQ's fundamental factors.

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.

Low Volatility Equity ETFs - Promising Safety and Reward

2012-01-19T04:27:00.030-05:00

Safe stocks?
Is there any simple way to invest in equities while protecting against downside risk like the huge dip of the 2008 credit crisis? Take a look at the Google Finance chart below. Suppose you had invested in a combination of the three stocks in the chart - Fairfax Financial Holdings (TSX: FFH), Metro Inc (TSX: MRU.A) and Shoppers Drug Mart (TSX: SC) - which happen to be three of the top holdings in the BMO ETF we discuss below. The crash would have been a minor blip at most.

The idea of stable safe stocks, so-called blue chips or perhaps defensive stocks, has long been put in terms of certain sectors like utilities and er, banks. But try adding banks, such as Canada's two largest - Royal Bank of Canada (TSX: RY) and Toronto Dominion (TSX: TD) - e.g. in this Google chart. The banks went down right along with the TSX, in fact leading the way since banks comprise such a big chunk of the TSX. In 2001-02, the previous major market crash, banks would have been fine holdings while Fairfax tanked like tech stocks and the TSX. What to do?

Pick stocks with recent low volatility - By going directly to the challenge and gauging stocks by their recent (past 12-36 months) daily price volatility, it turns out that it is possible to assemble stock portfolios which provide considerable downside protection. Various research studies (cited and summarized in Why Low Volatility Wins on the Pension and Investments page for the recent Low Volatility Summit conference) going back to the 1970s and using data going as far back as 1968, show that taking the least volatile individual stocks produces the amazing dual result of, 1) lower overall variability and lesser drops during market crashes and; 2) higher, a lot higher - 2 to 4% per year - long term annualized returns. Meanwhile the most volatile stocks significantly under-perform. This spectacular anomaly to market theory that says risk and return should be related has been found to exist not only where it was first detected in the USA but in many other countries, notably including Canada, as the slide image below copied from the presentation shows for developed countries.

Sounds too good to be true, huh? - The cautious investor is always well advised to look closely when such a surprising result is presented. Yet the academic researchers, who are the most impartial and rigorously critical people around, spend their time trying to explain why the anomaly is there, and not denying its existence e.g. Harvard finance professor Malcolm Baker and two others in this recent paper, or the presenters of the slides linked to above. Among the multiple explanations for the anomaly offered:

investor behavioural biases / mistakes like lottery mentality (a bet on a high risk stock might pay off hugely while a low risk stock is always expected to have a low payoff), representativeness (people fixate on the famous big winners like Google and Apple and forget the many losers) and overconfidence (optimists tend to set prices too high, only to be disappointed later)
assessment against cap-weighted passive benchmarks by institutional investors, who dominate the market and would be the ones most capable of eliminating the anomaly through arbitrage. Baker et al say, and in traditional academic fashion provide a math proof, that institutional investors actually are incentivized to lower the amount invested in low volatility stocks. A variation on this idea is that money managers are attracted to volatile stocks since bonus payoffs and career advancement come much easier if they win big sonner rather than later.

Possible ETF implementation issues
The difference between research findings, in which taxes, management fees and transaction costs for rebalancing and reconstitution are ignored, and ETFs based on the findings that have to face these issues, may make or break the practical viability of low volatility ETFs. Since all low volatility ETFs are very new - less than a year since inception - there is no track record to prove how they will actually perform net overall.

The actual ETFs vary somewhat from the models that produced the research results. Variations include: restricting rebalancing to quarterly or semi-annually instead of monthly to contain turnover transaction costs; limiting candidate stocks to liquid, large cap stocks; using "recent" volatility to mean the past 12 or 36 months; picking component stocks based on price volatility for each stock independently, or volatility relative to the overall index i.e. beta, or as a volatility relative to each other in the whole portfolio. These ETF variations do not appear, from reading the testing done in the finance research, likely to change the pre-tax performance results much. Tax effects from probable more frequent distributions have not been examined but may lower net results for taxable investors somewhat.

Of course, the lower the expense ratio, the less net return loss for the investor. At 0.25% to 0.35%, the ETF expenses are reasonable, though not near the lowest of benchmark market ETFs, which hover around 0.1 - 0.2%

What do low volatility ETFs look like and how will they probably perform?
Here are some common features of the few existing low-vol ETFs:

large cap, liquid stocks
stocks are a portion / subset of a major market index - TSX Composite in Canada, S&P 500 in USA
not cap-weighted but low volatility-weighted
sector weightings and concentrations are quite different from the overall market and vary considerably from year to year, though utilities seem to be heavily weighted in past modeling and would likely remain so e.g. in BMO's low-vol ETF, utilities make up 11% of the fund and only 2% in the TSX Composite
higher than market average dividend yield

Likely (intended) performance features:

capital protection - much lower total decline of the ETF in the short term during big market meltdowns e.g. in 2008 S&P 500 Index fell 37% while the S&P Low Vol Index (ETF did not exist and would have been less due to differences discussed above) fell 21%
lower volatility all along the way
lower gains than the market index during strong bull markets (such as the tech bubble) - this is the big trade-off ... in periods lasting several years
higher gains in the long term as the advantage of not losing during downturns more than makes up for the gain shortfall during strong bull markets

Available ETFs
Likely to change fast, as several have been added in the past few weeks, following on the huge success of the original Powershares ETF, which garnered over $1 billion in assets since its May 2011 inception.

Canada

BMO Low Volatility Canadian Equity ETF (TSX: ZLB) - MER 0.35%, tiny $6 million in assets since October 2011 startup, 40 lowest beta stocks in Canada, div yield 3.05%

USA

PowerShares S&P 500 Low Volatility Portfolio (NYSE: SPLV) - MER 0.25%, $1009 million in assets, May 2011 startup, 100 lowest volatility stocks from the S&P 500, div yield 3.11%
iShares MSCI USA Minimum Volatility Index Fund (NYSE: USMV) - MER 0.15%, inception October 2011, $8 million assets, 127 stocks in lowest volatility portfolio, div yield 2.35%

International Developed

PowerShares S&P International Developed Low Volatility Portfolio (NYSE: IDLV) - MER 0.25% (reduction in fees from 0.35% till 2013), inception January 13, 2012, $2.5 million assets, 200 lowest volatility stocks (20% of which are Canadian), div yield 2.26%
iShares MSCI EAFE Minimum Volatility Index Fund (NYSE: EFAV) - MER 0.20% (reduction in fees from 0.35% till 2015), inception October 2011, $10 million assets, 175 stocks in lowest volatility portfolio, div yield 1.4%

Emerging Markets

PowerShares S&P Emerging Markets Low Volatility Portfolio (NYSE: EELV) - MER 0.29% (reduction in fees from 0.45% till 2013), inception January 13, 2012, $2.5 million assets, 200 lowest volatility stocks, div yield n.a.
iShares MSCI Emerging Markets Minimum Volatility Index Fund (NYSE: EEMV) - MER 0.25% (reduction in fees from 0.69% till 2015), inception October 2011, $41 million assets, 200 stocks in lowest volatility portfolio, div yield 2.2%

World

iShares MSCI All Country World Minimum Volatility Index Fund (NYSE: ACWV) - MER 0.35%, inception October 2011, $10 million assets, 281 stocks in lowest volatility portfolio, div yield 2.26%

To date, the low-vol ETFs' performance seems to be enticing. ZLB is well ahead of the TSX, while SPLV is a bit behind the S&P 500 despite experiencing a much smaller decline in the November dip - see the Google chart below where SPY represents the S&P 500.

In Aesop's fable of the Tortoise and the Hare, the slow steady progress of the Tortoise wins out over the much faster but erratic Hare. So it is with investing, or was. Will history repeat itself, or is this one of those cases where, as those disclaimers always say, "past performance is not indicative of future results"?

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.

Top-100 Pay CEOs: Who Earned their Rewards?

2012-01-12T09:51:00.014-05:00

Last week's post pinned donkey ears on those CEOs with the largest gap between what they earned in 2010 and large losses investors experienced. This week, let's take the same list of best paid CEOs to see which ones provided excellent returns for shareholders and thus earned their pay.

Stocks with big investor bang for CEO bucks
Several ways are possible to rate CEO compensation against investor returns. We have used 5-year total returns (which includes both dividends and stock price appreciation) to avoid short-term year to year variations. Then we took that return and divided by CEO pay, as reported in Canada's CEO Elite 100 to give us the pale yellow column in our Bang for Bucks table below. The higher the number the better, i.e. more return "bang" for CEO "bucks". It is important to note that 5-year returns were as of November 2011 per the Globe and Mail's 2011 Board Games Governance rankings of Canadian companies on the TSX. Even five year results can change quickly, as we explore below.

We also used as a secondary measure the relative position (rank) in the CEO pay table against the position in the returns table, as shown in the pale blue column. When a company is way down at 95th in the pay column but high up at 2nd in the returns results, as our top company Osisko Mining Corp (TSX: OSK) is, that's really good. A negative number, such as minus 18 at Gabriel Resources shows a situation where the CEO was higher up relatively than the investor. At least Gabriel's returns were strongly positive for the investor.

Bang for bucks not great compared to all TSX companies
What about the companies whose CEOs were below the Top-100 pay level? That would mean less bucks and possibly more bang. Since we do not have the pay data for everyone, we have kludged a relative ranking evaluation (same as the second method above) by arbitrarily assigning 101st position to all the other TSX companies. Comparing thereby against all TSX-traded companies we find that only a few companies - three amongst the top 30 as highlighted in blue - manage to stay in the upper reaches of great investor results for CEO pay: Osisko Mining, Westport Innovations (TSX: WPT) and Alamos Gold (TSX: AGI). A strong caution about the limits of using only CEO pay to judge a company is the appearance of investor disaster Sino-Forest amongst the top TSX list.

Success may be fleeting
Even in the short space of a few months, the results can go topsy-turvy. We took the best 30 companies in our first table and quickly created a Watchlist in GlobeInvestor (it's as easy as entering the stock symbols or company name) and find in the snapshot table image below that many of our previous stars have lost much luster. Research in Motion (TSX: RIM) now has a significantly negative five year cumulative return of minus 21%. HudBay Minerals (TSX: HBM) is also into investor pain territory at minus 13%. Even our top performer Osisko has gone backwards to a modest 14% five-year return.

The Watchlist table contains some of the many other user-selectable data items available in that tool, of which we have picked a few, such as recent earnings, return on equity, profit growth, P/E ratio and dividend growth, that either reassure or caution about these companies. The moral of the story for the investor is that reasonable CEO pay is one indicator but certainly not the only one to consider in deciding whether the company is well run and a good investment.

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.

Top-100 Canadian CEOs: Who is The Most Over-paid?

2012-01-05T14:15:00.003-05:00

The recent release of Canada's CEO Elite 100 , an examination of Canadian CEO pay in 2010 by Hugh Mackenzie of the Canadian Centre for Policy Alternatives, attracted much media coverage and comment from a public policy and societal fairness perspective - e.g. in the Vancouver Sun, the Toronto Star and the CBC. From the investor perspective, the question of who is over-paid is different. The question is whether company profits and shareholder stock and dividend returns match the high pay.

We've sifted through the Elite 100 list to identify the CEOs who in our opinion do not seem to merit their rewards and those who do to give us a clue for bad or good potential investments. This week we first address the under-performers, then next week the good performers.

The Unlucky (for Investors) 13
The table below that we built from GlobeInvestor's Watchlist shows many red negative numbers for investors in contrast to the large CEO compensation packages reported in the Elite 100.

Top, or bottom of the list, depending how you like to view it, the worst shareholder reward for the highest CEO pay, clearly is Yellow Media (TSX: YLO). How CEO Marc Tellier merited $8.9 million, 35th spot in the top 100, in the face of continually declining profits and stock price (see TMX Money chart image below), is a mystery. No wonder analysts have rated the company a Sell.

Next in line would have to be Magna International Inc (TSX: MG), a stock with negative total returns over the past 1-year and 5-year periods. Meanwhile its CEO Frank Stronach pulled down an amazing $61.8 million in 2010, top pay in Canada by several orders of magnitude. Two other Magna executives occupied second and third spots in the pay table. The stock chart below from Google Finance for Magna is interesting. At the end of 2010, the stock price was sky high perhaps leading some to think the pay was possibly justified. But then the price plummeted in 2011, probably prompting investors to think the executives "took the money and ran". Now, analysts have a Buy rating on the company. Caveat emptor would appear to be a pertinent comment.

Air Canada (TSX: AC.B) CEO Calvin Rovinescu got very well paid, number 88 at $4.5 million, for producing occasional small profits and more frequent large losses in recent years. Negative investor returns have been commensurate. Air Canada has given investors the worst five-year return amongst the Elite CEO list at a horrible -43.5%.

It is a mystery why Nordion (TSX: NDN) CEO at the time (he has since been replaced) Stephen DeFalco merited pay of $13.1 million - good for 8th position! The small company under his leadership made large losses and shrunk considerably taking investors on a steep downhill ride.

The Niko Resources Ltd (TSX: NKO) stock chart from Google Finance looks like a roller coaster over the past five years and is currently at a low. Profits have been similarly volatile. The big investor question is whether this is a cyclical bottom or a continuing low. CEO Sampson's gigantic (4th overall in the list), mainly stock option, compensation of $13.1 million fell to March financial year-end 2011 and no doubt would have gone down yet more since, but investors have incurred net losses over five years, not just variations in income.

Other companies and stocks in our table of disappointments have similar stories - generous CEO compensation and investor negative returns over both one and five years. The past results are clear - these CEOs have not earned their pay. Others too which we have not listed have fallen short.

Such divergence of CEO pay and stock returns is certainly a warning sign to the investor to exercise extra caution. A key question for investors is the future outlook. Which of these CEOs are truly over-paid because the company earnings, which in many cases have been depressed, will recover from merely cyclical economic conditions? Or will earnings be revived from structural industry changes through the efforts and leadership of the high-paid CEOs, in which case their high pay could be justified?

In which of the two categories fall the remainder of our list - Nexen Inc (TSX: NXT), Sherritt International (TSX: S), Sun Life Financial (TSX: SLF), Rona Inc (TSX: RON), Cameco Corp (TSX: CCO), Cott Corp (TSX: BCB), Manulife Financial (TSX: MFC) and Uranium One (TSX: UUU)? We do not attempt an answer here but the investor's task is two-fold: first, to get angry and lobby for more reasonable pay, but also second, to get even by making investments according to the true worth of the stocks, which requires the usual due diligence investigation of company basics. High CEO pay without results is certainly a negative factor worth noting.

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.

Stock Market Outlook - The Insider View

2011-12-28T13:03:00.001-05:00

Insiders - company executives and board members - know better than anyone else what the prospects are for their own company. Investors are wise to take account of their views, as we have previously written about in relation to individual companies in Insider Trading: Using It to Get an Edge. There is no better indication of what insiders really think than when they put their own cash on the line by buying shares when good prospects loom, or selling when things look dicey.

The same idea can be extended to overall market prospects by totalling up insider buying and selling and comparing the two. Fortunately, we don't have to dig the data out ourselves as the Canadian Insider publishes on its home page what it calls Insider Sentiment versus TSX. The screenshot below of that chart is how things look today.

Insiders appear to be mildly but not wildly optimistic right now, based on the sentiment ratio somewhere around 125% (i.e. a bit more buying than selling). That's nothing like the huge insider buying that occurred in late 2008 after the crash, shown on this CI page, when the sentiment indicator reached about 550%.

This cautious view seems to be in rough accord with mainstream media reports on professional forecaster outlooks such as this one in the Financial Post on a BMO presentation, or this collection of 2012 outlook articles at the Globe and Mail.

Naturally, the situation varies by individual company as insiders at some are big net buyers and while others are big net sellers, as also shown at CI for the past seven days total on the homepage. For those readers interested in individual company insider trading, we note in passing that the CEO of Canadian Insider Ted Dixon publishes a regular commentary on individual companies in the Globe and Mail's Who is Buying and Selling.

Among what might be called the pessimists are three of the big banks - Bank of Nova Scotia (TSX: BNS), National Bank (NA) and CIBC (CM). Could the insiders be worried about their bank stock being sideswiped by the "tough outlook" ahead as reported in the Financial Post? Also amongst the nabobs of negativity is TransCanada Corp (TRP) - is the selling a reaction to the Keystone XL fiasco?

On the optimistic side, insider buyers seem to be most prevalent amongst very small companies. One bigger company with an upsurge in buying is Canfor (CFP). Lumber companies have had a hard time for years but might the insiders be thinking that prospects are as good as this Financial Post article says 2012 will be? Another company with keen insiders is CCL Industries (CCL.B). In this case, the company's own outlook paints a modest growth story, so could it just be that it is under-valued, as the current P/E of 12.6 suggests. The sole stock analyst rating the company at TMX Money likes it too, recommending the stock as a "Strong Buy".

There's nothing like putting your money where your mouth is and the insiders are speaking. Of course insiders do not have infallible foresight but their opinion matters.

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.

Investing Book Gift Ideas

2011-12-20T08:56:00.029-05:00

Still need a few gifts and don't know what to get for that investor on your list, or are you an investor looking for something good to read during the holidays? Here are some suggestions.

The Intelligent Investor - by Benjamin Graham, updated by Jason Zweig

This classic should be on every investor's reading list. It teaches us how not to lose money in the market, both from the technical standpoint of assessing accounting and business factors to the psychological discipline required. If we can absorb and adhere to the lessons within, we can aspire to doing as well as Graham's most famous disciple, the multi-billionaire Warren Buffett.

Stock Market Superstars by Bob Thompson

A dozen of Canada's most successful stock-picking fund managers say how they do it in a series of rollicking free-form interviews which entertain and educate about how to succeed by being different from the herd. Not many investment books can make you laugh but this one does with the irreverent, no-punches pulled comments by the superstars.

Financial Statement Analysis (4th edition) by Martin Fridson and Fernando Alvarez

For the more advanced investor, once you want to get into the ins and outs of financial statements and the tricks of the accounting trade in order to assess companies and stocks yourself, this book will help enormously. It assumes you know the basics of income statements and balance sheets but you don't have to be a chartered accountant to follow along. Highly readable for the layman despite the subject matter, it tells us how to protect ourselves and spot trouble by taking account of the motivations of company managers.

Understanding Wall Street (5th ed) by Jeffrey Little and Lucien Rhodes

If you need something simpler to get started, whether it is to understand accounting statements or how markets and investments work in general, this is the book to buy. Very practical and intuitive with many simple examples, it can be read through or used merely as reference.

No Hype - The Straight Goods on Investing Your Money, 2nd edition by Gail Bebee

Here's another book that covers basics, but this one is aimed specifically at Canadians. It includes a brief rundown on everything from the types of investments out there (stocks, bonds, GICs, mutual funds, ETFs etc), the various accounts (RRSP, TFSA, RESP, taxable and so on), taxes on investments, annuities, advisors, the list goes on. There is little missing the average investor could want to know about. The book even includes sample portfolios, ranging from the ultra-simple starter to complex with individual stocks and with differing levels of conservatism.

Behavioural Technical Analysis by Paul Azzopardi

We've all heard that our own worst enemy in investing is not the market or some outside agency but our very own selves. We buy when we should sell and sell when it it time to buy. Lots of research has been done into the errors we make and there are some quite well-known books about how and why our behavioural errors happen. But no book does as good a job at explaining them and fitting them together coherently as does this one. The value for the investor is obvious - understanding can lead to fewer costly errors.

What Kind of an Investor Are You? by Richard Deaves

Those who take pleasure in their investing and are good at it may find it hard to believe that many people don't have the interest, time or skills to do respectably at it. If you are among those "many", here is a book that will guide you to figure out whether to simply rely on an advisor (and if so, how to pick a good one, since a bad one could wreck your financial future) or to do-it-yourself. If you are a DIYer there is guidance on how to build a sensible strategy based on Canadian ETFs or mutual funds. The book's advice is brief, simple and practical.

Unconventional Success by David Swensen

David Swensen's long and successful experience managing the gigantic Yale University endowment fund gives him deep knowledge of how the investment industry works and how various types of assets perform, knowledge that he passes along to the reader in this book. He recommends using only certain asset classes and passive index funds for most investors, and explains why in a cogent, persuasive fashion backed by logic and data. Who knows, in a few years the investment strategy he advocates could become the mainstream conventional approach.

All About Asset Allocation by Richard Ferri

This blog has emphasized the importance of asset allocation as a means to lower investment risk and achieve steadier returns. Ferri's book walks us through in more detail from the ground up why asset allocation works and how to do it properly using ETFs or mutual funds.

The New Investment Frontier III by Howard Atkinson

It's still the best book about ETFs in Canada, despite getting out of date due to the multiplication of new ETFs on the market. The explanation of how ETFs function in comparison to mutual funds, the discussion of indices, the run-through on income tax implications, all are as true today as when the book was last revised.

Uncontrolled Risk by Mark T. Williams

Interested to know who to blame for the 2008 credit crisis? Read this book to find out who else there is besides the obvious culprits in investment banking. Through the story of the collapse of central player Lehman Brothers, Williams shows how 2008 was the culmination of decades of build-up among many players. Along the way we learn what acronyms like CDS and MBS mean ... without our brain hurting too much. The scary thing is the author's conclusion that the risk of systemic financial collapse still remains.

Happy holidays to all and good reading!

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.

Gulp! Asset Allocation & Rebalancing Theory Meet a Scary Real World

2011-12-16T10:09:00.001-05:00

Have you set up your portfolio structure according to a defined asset allocation with explicit rebalancing rules, as many experts suggest and as we advocate in this blog? Are you coming up to an annual review date to rebalance holdings in the new year after the 2011 results are in? Or perhaps the percentages allocated to each asset class have gone beyond the limits set to trigger rebalancing.

If you have noticed the large performance divergence of various asset classes this year, then the difficult reality of current economic and market conditions will surely test your resolve to go ahead with rebalancing.

Example portfolio - Complete Couch Potato
Let's take one of the model portfolios composed of common ETFs - the Complete Couch Potato - from the popular Canadian Couch Potato blog to illustrate the kind of anxiety-laden situations facing the investor trying to practise disciplined portfolio management. CCP also publishes up-to-date performance figures for the various portfolios and its ETF components, which is very handy since the value of distributions and the effect of currency swings on the US-denominated ETFs is taken into account. Below is a table of the portfolio and how it has performed since the start of the year.

Psychological barriers to rebalancing
The arithmetic about how to rebalance by buying some ETFs and selling others, as shown in the performance table above, is not the issue. The challenge is actually convincing yourself that it makes sense. Consider the situation:

Canadian Equity - The TSX has been in a downward trend for months now. It doesn't look as though things are likely to get much better anytime soon. The temptation is to wait.
US Equity - Thanks to the fall of the Canadian dollar against that of the USA along with the receipt of dividends, VTI has managed a slight gain. One might be tempted to put more money into VTI since it looks as though the economic situation in the USA may be stabilizing but our rebalancing calculation tells us to do nothing.
International Equity - Here is the scariest situation. Our policy says to buy more VXUS when all it has done during the year is slide downwards to a 10% loss. Not only that, the underlying problems in Europe could well get a lot worse, Japan still struggles and now China is said to be slowing down. Poor decisions by authorities might lead to disaster, or perhaps we are already inevitably heading that way. The urge to hold off buying, if not to sell and run for safety, is understandably strong.
Real Estate, Real Return Bonds and Canadian Bonds - These have been the bright spots, providing the biggest positive returns that have enabled the overall portfolio to eke out a small gain for the year. Rebalancing tells us to sell some of each yet it is hard not to consider that the underlying conditions that produced such returns seem still to be in place. Why not stick with the winners which, after all, are the safest of the holdings in these dangerous times?

Such is the dilemma facing the investor trying to follow the standard advice about diversification, asset allocation and rebalancing. It is much easier to rebalance when everything is going up and it is only a reallocation from a big winner to a small winner. Taking from winners to give to the losers is much tougher. Who knows it might not even be the correct choice.

Long term faith in outcomes is required
The dilemma today highlights that the main challenge we face as investors is ourselves in following our plans despite doubts and uncertainties. Should we adopt the same blind faith as one of the most successful investors ever, Warren Buffett, who said this?

"In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497" (source BrainyQuote)

Was the original portfolio allocation appropriate?

A reluctance to rebalance also raises the question of whether the original allocation percentages were appropriate for our individual circumstances. Is the 50% allocation to stocks necessary or reasonable if our savings goals have been reached? Is our time horizon for staying invested and not spending the money allocated to equity at least ten years, since that amount of time could easily be required before stocks again begin to pull ahead of bonds? The credit crisis and debt deleveraging troubles are very severe so it should not be a surprise that recovery takes a long time.

Diversification has worked again
The other thing to remind ourselves is that the diversified portfolio has produced a small but positive gain overall (2.2% in this case). That should help encourage us to continue following the basic strategy predicated on the idea that different asset classes will perform differently from year to year but will usually produce positive returns.

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.

High Income Foreign Bond ETFs

2011-12-09T03:05:00.019-05:00

With interest rates being so low these days, many investors are casting their eyes further afield in the search for better returns. The benchmark Canadian bond ETF iShares DEX Universe Bond Index Fund (TSX symbol: XBB) offers a paltry 2.3% yield to maturity. Even its current cash distribution yield is only 3.5% (per the TMX Money XBB quote). Let's therefore have a look at some foreign bond ETFs available from Canadian fund providers Claymore, BMO Financial and BlackRock / iShares (new entrant Vanguard doesn't seem to offer any) to see the pros and cons of what they offer.

The ETFs fall into two groups: US corporate bonds and government bonds from Emerging Market countries. Interestingly, no fund seems to offer developed country bonds (so there aren't any opportunities to take a flier on Greek or Italian debt!).

Emerging Markets

BMO Emerging Markets Hedged to CAD Bond Index ETF (ZEF)
iShares J.P. Morgan USD Emerging Markets Bond Index Fund (CAD-Hedged) (XEB)

US Corporate

BMO High Yield US Corporate Bond Hedged to CAD Index ETF (ZHY)
iShares U.S. High Yield Bond CAD-Hedged Index Fund (XHY)
iShares U.S. IG Corporate Bond CAD-Hedged Index Fund (XIG)
Claymore Advantaged High-Yield Bond ETF (Hedged) (CHB)

Currency hedging is a worthwhile common feature - All of the funds use futures contracts to hedge the swings of the Canadian dollar against the US dollar. Since currency swings can easily overwhelm the basic bond returns from interest and capital appreciation, we consider currency hedging to be a desirable feature in general. However, the hedging operation is not free or perfect and that usually causes a reduction in the net return and under-performance compared to each ETF's index. Not all the ETF managers do an equally successful job. In our comparison table below, we see that ZHY has done worst with a -1.3% performance drag against its index. In contrast, the best result over the past year has come from XIG which has achieved the unusual result of a performance boost over the index of 0.9%! Most probably XIG's boost comes from unintended profits from the futures hedging contracts, as suggested by the fact that XIG is one of the iShares ETFs with capital gains to distribute in 2011. For more on how tracking error comes about, see Rob Carrick's MoneyShow article Watch Out for Tracking Error When Buying ETFs.

There are a number of US-traded bond ETFs (see list here), both for US bonds and international bonds, but none are Canadian dollar-hedged. A Canadian investor would face both bond and currency risk. In our view currency exposure is best achieved, and sufficiently so, through foreign equity holdings. That's a big reason why we've left them out of this review.

XIG comes out best on MER - Its 0.3% MER is about half that of the other ETFs.

Return vs default risk profile is the key differentiator - Whether we compare by cash distribution yield or more properly by the yield to maturity figures, we first note that all the ETFs offer superior returns varying from 1% to 6% over XBB. However, there's a catch - risk. There is a marked difference amongst the ETFs with respect to default risk, as measured by credit ratings from Standard & Poors (see Wikipedia's table that explains the ratings). Our comparison table shows with a big red line the key cut-off between ratings of investment grade and those riskier ratings underneath. XIG is clearly the safest and it correspondingly has the lowest returns to offer. ZEF and XEB on the S&P ratings measure rank next safest but the high concentration of assets in the top ten countries (such as Mexico, Russia, Korea, Brazil, Venezuela and the Philippines) makes us raise that risk estimate somewhat. ZHY, XHY and CHB are all quite diversified in the sense of having many holdings and low concentration but if a recession hits, it is likely many of these weaker companies will hit the skids at the same time. Peaks of default also happen with governments as we are seeing in the European contagion scenario and as we discussed a few months back in this post on Default Risk. All this is reflected in the year to date evolution of market price of the various ETFs , shown in the Google Finance chart below. XIG is up nicely, XEB and ZEF up a bit and the other three are down. XIG has also been more stable through the year.

Bottom line
XIG works best for investors who want stability with steady cash income.

The others work best when an investor wants cash income, is able to accept higher risk and wants to have another asset type that will help diversify the portfolio since the ETFs will not move in tandem with other equity or Canadian bond holdings.

All but one of these ETFs are best held in registered retirement accounts rather than a taxable account (since the cash distributions are foreign income). The exception is CHB which can be held in taxable account since it doles out Return of Capital and Capital Gains through its clever (and legitimate) use of forward agreements.

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.

Avoiding an Unpleasant Year End Tax Surprise on ETFs

2011-12-02T10:18:00.025-05:00

A few years back we delved into the Mystery of Fund Capital Gains in 2008, explaining how it came to pass that investors holding ETFs or mutual funds in taxable accounts (i.e NOT in registered accounts such as RRSP, TFSA, RESP etc) could be liable for tax on capital gains when 2008 was such a horrible down year in markets. Investors received no cash yet there was income tax payable!

Estimated 2011 ETF Capital Gains Distributions
It's time to pay attention again this year, though the problem is not so widespread or severe as 2008. The main Canadian ETF providers have recently published their estimates in the links below of capital gains distributions for 2011 in their funds (final figures are to be published between December 15 and 19):

ETFs with a Potential Tax Surprise
We have culled the lists and picked out the half dozen ETFs that will occasion significant capital gains tax to pay in taxable accounts despite what has been in most cases a year of declining market price of the ETF. Here are the ETFs to watch out for and their estimated capital gains distribution per share:

Claymore S&P TSX Canadian Dividend ETF (TSX: CDZ) - $0.8446 capital gains per share
iShares S&P TSX Small Cap Index Fund (TSX: XCS) - $0.7841
iShares S&P 500 Index Fund (CAD-hedged) (TSX: XSP) - $0.4748
BMO Junior Gold Index ETF (TSX:ZJG) - $1.2510
BMO Junior Gas Index ETF (TSX: ZJN) - $ 0.9936
BMO Equal Weight Global Base Metals Hedged to CAD Index ETF (TSX: ZMT) - $1.5467

Why Pay Attention
These ETFs all have, relative to the ETF price, a high amount of capital gains to allocate to investors but that are not actually paid out as cash since the gains stay within the fund. For example, if you own 1000 shares of XCS at the end of 2011 when the tally of shareholders to whom the gains will be attributed is taken, there would be 1000 x $0.7841 = $784.10 of capital gains to report on a 2011 tax return. A top bracket Ontario taxpayer paying about a 23% marginal rate on capital gains would owe $180 extra for gains that he/she would not see in cash.

The only consolation is that the capital gain gets added to Adjusted Cost Base of the investor's ETF holding, which means less tax to pay down the road if the shares are later sold for a gain, or if sold for an eventual loss, it would create a larger capital loss to offset other gains. But that goes against the basic principle of tax minimization, which is to defer payment of taxes.

The investor can well feel aggrieved paying taxes up front on gains that he/she has not seen. The situation feels worse when we look at the price performance in the Google Finance chart image below of these ETFs over the past year.

Only two of our list - ZJN and CDZ - are in positive territory and the others are all down significantly during 2011 up to December 2.

What Can be Done?
For an existing shareholder of these ETFs it is possible to avoid receiving the unwanted capital gains distribution by selling the ETFs on or before December 22nd (from December 23rd onwards, the shares trade ex-dividend, which means that if you sold the shares on December 23rd, you would still receive the year end distributions as the trade settlement would not occur till after the new year and you would still be on the books as the shareowner till then).

The value of doing this depends on the price you bought the shares. In a taxable account, you would need to do the usual capital gain/loss calculation (here is our post explaining how that works). If you bought ZJG at its inception in January 2010 you would be sitting on a sizeable capital gain. Triggering the big gain's realization to avoid the much smaller 2011 distribution does not make sense. However, if you had bought ZJG in January 2011 there would be a big paper loss so the sale before year end makes a lot of tax sense. This would be tax loss selling at its best. For the ins and outs of tax loss selling see this post.

For those investors who do not yet own but want to buy any of these ETFs, they are better off waiting till December 23rd.

Possible Short-Term Substitute ETFs
One tricky issue when an existing investor wants to continue owning the ETF for the long term is to properly comply with the superficial loss rule, by which the Canada Revenue Agency will deny the loss if the ETF is repurchased within 30 days e.g. by selling ZJG December 22 and buying it back on the 23rd.

One option is to wait for a month before buying back the ETF but that takes the chance that the price might rise significantly in the interim.

Another option is to substitute/buy similar, but not identical, ETFs while the 30 day period elapses. ETFs that use the identical index are a no-no but many ETFs using dissimilar indices within a sector follow a similar price price pattern, especially for a short period. That is all one really needs. Here are some matchups for our ETFs that we found using Google Finance charts to give us an eyeball validation.

CDZ > substitute in BMO Canadian Dividend ETF (TSX: ZDV)
XCS > iShares S&P TSX Capped Composite Index ETF (TSX: XIC)
XSP > BMO Dow Jones Industrial Average Hedged to CAD Index (TSX: ZDJ)
ZJG > Claymore Gold Bullion ETF (TSX: CGL), a so-so fit but it's our best shot
ZJN > iShares S& P TSX Capped Energy Index Fund (TSX: XEG), also a so-so fit
ZMT > iShares S&P TSX Global Base Metals Index Fund (TSX: XBM)

In mid-March, the fund companies publish the complete final tax breakdown of all types of fund income (dividends, interest, return of capital, capital gains) to help investors prepare their taxes and track their cost base. Meantime, this advance information helps investors make decisions and take action to defer capital gains.

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.

ETF Asset Allocation across RRSP, TFSA and Taxable Accounts

2011-11-24T05:07:00.018-05:00

Many investors, including this blogger, whether by intent or happenstance, have their investments spread across multiple account types, such as RRSP (or a LIRA), TFSA and Taxable/Non-registered. As we advocate in this blog, the wise investor diversifies across different types of investments to maintain a portfolio asset allocation with the percentage breakdown specified to meet investment objectives - see example in our post on investment policy. A fundamental principle is that though the portfolio may span many accounts it should be managed as a whole, not as independent pieces. The next question then is - What is the best way to divide up the investments across the two dimensions of account type and asset type?

Key Portfolio Issues - Let's work through an example to see how it could look in practice, considering these factors:

Canadian taxes - See our posts on the general principles to apply for income level and province, choice of RRSP vs TFSA vs Taxable account and RRSP vs TFSA critical differences,
US and International withholding taxes - How this affects investments is explained in Pros and Cons of Cross-Border Shopping for ETFs; there is a worked-out example together with a link to a free downloadable spreadsheet to test other ETFs in the Cross-Border ETF Free Tool post
RRSP, TFSA account limits - $5,000 per year for TFSA, which three years after startup, amounts to a total possible of only $15,000 and 18% of earned income for the RRSP (see TaxTips.ca here for details). Come January 1, 2012, the TFSA contribution limit will rise another $5,000.
Rebalancing in future on a regular basis to keep the portfolio in line with the intended allocation

Our example portfolio contains $100,000, a nice round number that makes it easy to match up percentage breakdown and dollar amounts. Our portfolio uses the ETFs and breakdown in the Balanced Portfolio suggested in the just-released update edition of Gail Bebee's book No Hype: The Straight Goods on Investing Your Money.

1) RSSP and TFSA are the major accounts for the portfolio - The tax-free growth in both the TFSA and RRSP produces the best long run returns and that's where everything should go if possible. However, we assume for illustration purposes that the investor has run out of RRSP room and must also maintain a taxable account, which allows us to show what should go in there. We also assume that the person wants to use both a RRSP and a TFSA but of course the TFSA has a $15k contribution limit. A person in the highest tax bracket might want to concentrate everything in the RRSP.

2) Cash is split amongst all three account types to facilitate rebalancing. Possibly the cash may be handy for emergency needs and it can be put back into the account when it is in a TFSA (in the following calendar year) or a taxable account (anytime). Note that the Manulife Financial Investment Savings Account (MIP510), may face higher minimum purchase amounts from certain brokers though Manulife itself does not impose a minimum.

3) Highest tax rate interest bearing bond ETFs go in the RRSP or the TFSA where there is tax protection.

4) TFSA gets some bonds and some equity to facilitate rebalancing, since those are the assets most likely to move in different directions. Equities worldwide tend more to move in sync. It is far easier to do rebalancing trades within an account. Indeed, it is not permitted to transfer money into a TFSA to rebalance if the TFSA's contribution limit has been maxed out. Taking money out of the RRSP to rebalance to a Taxable account loses the tax advantage so that doesn't make sense. The Claymore 1-5 Year Government Bond ETF (CLF) is split between RRSP and TFSA since it has a bigger allocation and will be cheaper to rebalance considering trading costs. Similarly it is the larger iShares S&P/TSX Capped Composite Index Fund (XIC) that is split between the RRSP and the TFSA.

5) Taxable account gets ETFs with US and international holdings due to foreign withholding taxes that cannot be recovered.

The same principles would apply to other ETFs that can be used to construct the same or other portfolios. The percentage allocations may vary towards more or less fixed income or equities but the asset classes and the tax characteristics will be the same.

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.

Dividend Initiators as a Stock Selection Concept

2011-11-18T04:11:00.016-05:00

In his first feature article for the recently acquired Canadian MoneySaver, new owner Peter Hodson, formerly hedge fund manager at Sprott Asset Management, provides an intriguing idea for finding stocks that will pay off well in future. He goes so far as to state that this is the single best investing theme he has to offer after 25 years in the business. His principle: take a serious look at companies that declare their first ever dividend.

Why dividend initiation is significant
Hodson believes that initiating a dividend tells us the company: a) is doing well; b) has excess cash; c) is managed by a Board that respects shareholders and likely owns lots of shares itself; d) is likely to pay out a steady stream of stable or rising dividends for many years. That sounds sensible but how can we take the idea forward?

Finding first-time dividend payers
His article mentions two companies that have have recently declared their first dividends: Primary Corp (TSX: PYC) and DSW Inc (NYSE: DSW). To find others, we cannot unfortunately rely on that standard investor tool, the stock screener. We could find no screener with a first-dividend filter or even some proxy that would cleverly achieve that end. Instead our list below relied on the basic Internet tool that everyone knows, the Google search, where we searched for words such as "dividend, stock, initiate, first, Board".

Tracking and investigating the candidate stocks
Compiling a list is a start but not the end of the story. No doubt some of these companies and stocks look better than the rest and some may not look good at all.

Watchlist - A simple starting point is to set up a watchlist of the potential stocks, for example by using the GlobeInvestor My Watchlist (see screenshot below of the above list with a few of the customizations that the tool allows). It can contain both Canadian and US stocks and shows many of the financial indicators and ratios on profitability, growth rates, valuation and safety that give a good preliminary view of the attractiveness of the stock.

Company financial reports - Each company's website will contain the quarterly and annual financial reports that are replete with data and management comment on the company. Before buying stock, one should have read through a number of them.

Stock data websites - As well as the basic financial data in the company reports, several go much deeper in calculating a multitude of ratios and barometers of financial health of companies.

ADVFN - most extensive free set of data and ratios around
InvestorPoint - includes insider trading info
Google Finance - includes data on similar companies, though the degree of similarity varies (see example below of screenshot for WJA)

Stock discussion forums and boards - Though one should always be wary of the motives and expertise of the commentary, there may be nuggets of useful information in such online sites.

StockChase
Financial Webring's forum on Stocks, Bonds, ETFs, Funds, REITs and More

Whether this method really helps zero in on stocks worth buying, we don't know for sure as Hodson doesn't offer any systematic or rigorous data to back up his claim. However, it is always interesting to experiment with and entertain a new angle to stock selection.

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.

Borrowing to Invest: Examples of Potential Profits

2011-11-09T13:28:00.026-05:00

In our post last week we explored the factors that contribute to success in using borrowed money to invest. Today we work out the numbers for two current possible investments that look reasonable according to our criteria.

The Calculation Tools
Many kudos go to TaxTips.ca's free Borrow to Invest Calculator that takes account of different tax rates in the various provinces (and shows how the bottom line can vary a lot across the country). We have used the calculator for our examples.

The yield to redemption on the preferred share example has been figured out using Shakespeare's yield to call calculator.

Example 1 - Leveraging a Canadian Equity ETF
Our first example uses the most popular Canadian equity ETF, the iShares S&P TSX 60 Index Fund (TSX: XIU), which features several desirable qualities:

Diversification: This ETF holds shares of the 60 biggest companies in Canada, as determined by their market capitalization. Default risk is more or less nil, though of course there can be severe market dips of up to 40% as investors well know having passed through the 2008 crash.
Passive Index Tracking: XIU only occasionally trades when the index itself changes. That meets our goal of trade minimization to defer paying capital gains. We note that despite its passive investing strategy, even XIU has unavoidably not been perfect in this regard in the past, as can be seen in the hefty capital gains distributions in some recent years, like 2006 (see the Distributions for XIU here).
Canadian Equities: The Canadian-only holdings mean that dividends distributed to the investor are eligible for the enhanced dividend tax credit, another tax advantage.
Healthy Dividend Yield: XIU's dividend yield is currently around 2.3%. This cash income to the investor will help meet a substantial part of the cash outflow for interest on the loan taken out to invest, thus lessening the potential for strain and stress on the investor.

The scenario we examine makes the following assumptions:

Investment in Taxable Account: this is to take advantage of the deductibility of loan interest, the favourable tax treatment of capital gains and the tax credit for dividends.
Investor Taxable Income: $60,000 or $120,000. The investor's job earnings provide the stable base to support the leveraged investing. We compare what happens with either middle income or a high income investor.
Amount Borrowed: $50,000. We use the same amount for comparing the middle vs higher earning investor, though the latter could probably easily manage a bigger loan.
Loan Interest Rate: 4%, based on secured loan rates commonly available now per Fiscal Agents Consumer Loans.
Investment Time Horizon: 15 years, to allow for market swings up and down and increase the chances that the net market return over that period will be positive and reasonably close to our expected return.
Expected Return: 6%, a total of the current 2.3% dividend rate plus capital gains to make up the rest. As we wrote about in our previous post, that seems a reasonably conservative and achievable figure given the current TSX market level.

Results:
A) TaxTips calculator screenshot below for an Ontario investor earning $60,000 of other taxable income.

Despite loan interest payments of $2000 per year (4% of $50k) the disposable income difference after tax only requires a net cash outlay of $264 at most in year 2, which declines and becomes positive - the investor receives cash in pocket - from year nine onwards.
After 15 tears, the investor is better off by a total cumulative amount of $34,665, i.e. net of the loan. That's a very nice gain, providing of course all goes according to the assumptions.

B) Summary Table By Province and Taxable Income Level

Income level makes little difference overall within each province. The net gain is very close to the same whether income is $60,000 or $120,000.
Provincial tax rates make a substantial difference in the net gain, almost a 20% difference between the highest / best in Quebec (over $40,000) and the lowest / worst gain in Nova Scotia ( about $34,000).

Example 2 - Leveraging a Canadian Split Share Preferred
Our second example uses Big Bank Big Oil Split Corp (TSX: BBO.PR.A) as the investment. Its features:

Redemption Date & Exact Return: On 30 December 2016, the investor is promised the $10 redemption value, which means the current $10.25 market price will converge by that date to the $10 amount. The fixed duration of the investment allows us to compute the exact return, or yield, that our investment will achieve, using the above calculator from Shakespeare, in this case 4.58%. In addition, the investment held to maturity will produce only dividend income for tax reporting each year. There will be a small capital loss ($10.25 - $10) to report, only at maturity.
Dividend Yield: Note that the current dividend payout is 5.12%, which exceeds the total yield due to the capital loss.
Investment Grade: Backed by the value of the corresponding Split Capital shares (see our discussion of how Split Preferreds work here), which are invested in a portfolio of shares of six Canadian banks and ten oil and gas producers, DBRS rates BBO.PR.A as P2-low, which is investment grade and thus well protected against default.

Results:

An Alberta investor with $60,000 taxable income would be $3,340 richer after 5 years. (The total gains are less in total than for Example 1 since the investment only lasts 5 years.)

Net after tax cash flow is positive every year (we do not show the TaxTips screenshot of this result). The investment should sustain the loan on a cash basis.
Provincial differences are even more pronounced, with Quebec, still at the top of the list, gaining twice (!) as much as the perennial heavy tax bottom feeder, Nova Scotia.

Caveats and Cautions:
The results depend on the assumptions. That the loan interest rate will stay at 4% is unlikely. Plugging in different numbers to the calculator, for example to see what a 5% interest rate might do to the net result, or a much smaller capital gain on XIU, could show how much leeway there is for a profitable outcome. Another variation would be to make the loan amortize, which would progressively reduce the loan and the leverage and thus the risk, over the investment horizon. An amortizing loan could enable you the investor to lock in a fixed loan interest rate. It would also indicate the cash flow required and give you an idea whether it would be supportable. Finally, to be sure of what you are doing, it may be wise to consult a professional.

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.

Borrowing to Invest: When & How to Do It

2011-11-03T07:35:00.023-04:00

The basic idea and attraction of borrowing money to invest is simple - if the cost of the loan is less than the return on the investment then there is a profit. You have used money you don't own to earn. That's why the operation is also called leverage - you use the borrowed money as a lever to gain a profit. However, as usual, there is a downside, since it is possible to lose money too. If things go awry, the leverage makes you lose faster, which is why there are many dark warnings e.g. What are the dangers of borrowing to invest? on the GetSmarterAboutMoney.ca site sponsored by the Ontario Securities Commission, or Wealthy Boomer Jonathan Chevreau's Financial Post column When does it pay to borrow to invest?

A few months ago, we looked at various ways to carry out leveraged investing. Today we will drill down to see under what circumstances it can work, to examine the risks, to look at tax and book-keeping implementation do's and don'ts. That should give you a better idea if borrowing to invest is worthwhile for you.

Favourable Conditions
A beneficial combination of factors specific to you and of conditions in markets and the economy will increase the chance of success.

Investor's Personal Situation:

Able to sustain the loan payments - Whether it be an interest-only or an interest plus principal repayment, you must be able to keep up payments, otherwise you may be forced to liquidate the investments, which as bad luck could have it, might be at a time when the investments have declined in value. There should be some leeway for higher payments since some forms of loans have floating interest rates that will rise with general interest rates. In addition, when the investing is within a non-registered taxable account, there is income tax to pay each year on the investing income. Thus, the following conditions give you an advantage.
Stable job with a steady reliable income,
Little or no other debt
Long term horizon - If you can invest the money for a longer time, such as ten years or more, and not need or expect to spend it for urgent needs, that allows you to wait out inevitable difficult market periods. Having other resources for near-term needs or wants helps a lot.

Markets & Economy:

Low interest rates to borrow - This is one of the best factors in the current situation, with loans available at 4%, perhaps even a bit less. When the cost of borrowing is low, it sets a lower bar for earnings from interest, dividends or capital gains to beat in order to make a profit.
High yields on dividend stocks - There are many solid companies paying dividends over 3%, and some even in the 4-5% range,. Against current borrowing rates that offers the promise of cash in- vs out-flow that can sustain payments on interest-only loans. Added to the benefit is that most dividends from Canadian companies are eligible for the enhanced dividend tax credit, which effectively means a very low marginal tax rate on that type of income. This improves the investor's chances of making a net profit in a non-registered taxable account.
Reasonable stock market valuation level - The indicators we discussed in Is the Stock Market Over- or Under-Valued? suggest that US and Canadian stock markets are at a level that promise modest returns of 4 - 8% over the next ten years.

Risks & Counter-Measures
Some of the major things that could go wrong include:

Psychological stress and panic - No one wants the anxiety of a very large debt hanging overhead when facing a large market decline that could get worse. That leads those with experience in leveraged investing to suggest: 1) only going ahead when you have at least several years of investing under your belt, which gets you mentally and emotionally familiar with the frequent falls in the market; 2) starting out with a small loan and investment; 3) buying the investments progressively so that if the market goes down after the first purchase you feel less regret (a line of credit is well suited to this tactic since you borrow as you go).
Job loss - For most people, employment income is the source of cash flow that protects the ability to pay back the loan. The danger is that the layoff might occur at just the wrong time - the economy is bad, you lose your job and the markets / your investment goes south simultaneously. Opting out and repaying the loan to limit the damage may not be possible ... unless you have included that safety margin in planning as we suggested above.
Interest rate increases - A rise in borrowing costs when the loan is on a variable rate basis may make the whole scheme unprofitable. If fixed income investments like bonds or preferred shares were bought, these would decline in value so an attempt to opt out and collapse the scheme could incur a big capital loss. There would then be a large lump sum to find to make up the total owing to the lender.
Family home subjected to collateral call - In what could be termed a disastrous case of "collateral damage", the necessity to sell a home that had been used to guarantee a home equity loan or a mortgage might result after a big loss on an investment. Apart from the above-discussed preparations to avoid such an eventuality, before proceeding with borrowing to invest the investor should contemplate whether the potential investment gain is worth the potential pain of having to sell his/her home, alongside the probability of that event occurring.
Investments fall in value - The most basic risk as inferred above is that the investment has lost value when you sell. The defenses against this: a long holding period for equities to ride out market slumps; a personal situation that allows you to sell only when you decide and; diversification and solid investments to avoid total default loss. (point inserted after first posting following blogger Michael James on Money's mention, which highlighted that this obvious point might not be obvious enough!)

Investment Candidates
First, we note that the maximum value from leveraged investing comes when the tax advantages are utilized, in particular the deductibility of interest expense and the lower tax rates on dividends and capital gains. The implication is that investing is best done within a non-registered taxable account. It also means that Canadian equity should make up the investment holdings.

Our take on the best combination at the moment includes:

Passively managed index ETFs - The passive index management results in low turnover, which minimizes annual capital gains distributions and tax to pay. It also ensures diversification through multiple holdings, which eliminates the possibility of complete loss of capital through default and reduces the year-in-year-out volatility.
Equity ETFs - Equity provides its return in the form of the desired dividends and capital gains. Over the long haul, equity has outperformed fixed income. We do not like some of the specialty dividend ETFs despite their enticing high distributions because often a sizable chunk of their distributions consists of Return of Capital, which causes problems with the deductibility of the loan interest (see MillionDollarJourney's Key Tax Considerations on an Investment Loan).

Some reasonable though less attractive possibilities:

Pipeline and utility stocks - These are amongst the most stable in a business sense and as a result are so on the stock market too. All offer much better than average dividends (see our January 2011 post on these stocks)
Split Share Preferreds - Unlike most preferred shares, this type of preferred has a redemption date and price. The price and yield you buy at today is locked in to the redemption date if you hold till then. If interest rates rise in the meantime, the market price of such shares may decline temporarily but by the redemption date the market price must converge to the redemption price. The catches are that such shares still have some default risk and that redemption dates may be within only a few years so you would need to be renewing and reinvesting the holdings with capital gains taxes to settle up earlier than desired. See our detailed post on assessing Split Preferreds.

Interest Deductibility Tax and Book-keeping
The general principle is that interest on the investment loan may be deducted against the investor's income (and not just investment income but against other income such employment earnings). However, the rules for carrying out the borrowing to the Canada Revenue Agency's satisfaction to ensure the deduction is not denied can be quite tricky. Consider getting the guidance of an accountant! Amongst the tricky bits:

Investment must be capable of earning income, though it may not actually do so. If it can only ever achieve capital gains, that will not qualify.
Book-keeping is much easier if the investments purchased with the loan are in a separate account.
Similarly for book-keeping ease, once income is received, take that money out of the account to keep the cost basis of the debt the same as the investment.
Watch out when withdrawing funds from the account since the amount of eligible debt may change.

Helpful info on these matters: TaxTips.ca's series of pages on Borrowing to Invest, MillionDollarJourney's article link mentioned above, Tim Cestnick's Borrowing to Invest article on Fiscal Agents website and his It's in your interest to know the deduction rules for borrowing in the Globe and Mail.

Next post, we will work through an example with the help of available online tools to see how the numbers work out and give a feel for how big the benefits could be.

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.

RRSP vs TFSA? Critical Differences and Imponderables

2011-10-21T06:58:00.023-04:00

Our last post compared the RRSP with the TFSA strictly on the basis of numbers - which generates the most after-tax income during retirement - and concluded that the TFSA is best for people earning below $37,000 during their working years while the RRSP is best for higher earners. Today we look at other features of these plans to see why that conclusion might not hold up.

Tax Rate Changes - Contribution vs Withdrawal
The RRSP gains a monetary bonus if the tax rate in retirement is lower than when contributions were made and it incurs a penalty if it is higher. The TFSA is completely unaffected by such a tax rate difference (since all contributions are made with after-tax funds and withdrawals are not taxable). In the section titled What happens when rates change? on his lengthy page on RRSPs RetailInvestor works through an example and concludes that "This effect (of a change in tax rates) is the major difference between the TFSA and the RRSP".

Most probably, figuring out whether your retirement tax rate will be higher or lower is well-nigh impossible for most people. On the same page under What are the unknowns that will determine a rate change? RetailInvestor lists many factors that can cause a change, such as: a large RRSP/RRIF (or LIRA/LRIF/LIF) balance at death that all becomes taxable income through deemed disposition tax rules and pushes RRSP income into higher brackets; big lump sum withdrawals for illness, long term care, round-the-world cruises that push RRSP withdrawals into higher brackets; non-registered investment income that might get boosted from inheritances or profitable sale of a home; government decisions to raise or lower taxes. As a result:

for top bracket earners ($120,000+) who stand a good chance of taking money out at lower tax rates, the RRSP solidifies its advantage
lowest bracket earners will almost certainly experience a rise in tax rates in retirement and thus should forget the RRSP and focus on the TFSA

Savings Discipline
Simply getting around to making contributions is a big psychological challenge for both the TFSA and the RRSP. It isn't the only one however. Each has its own pitfalls and each investor must figure out which ones he/she is most prone to fall prey to. This could be the key factor - obvious though such a comment might be, if you don't save and keep the money in the plan, it cannot grow.

RRSP - The Tax Refund Temptation
The first issue is that in order to get the full value of contributing, compared to a TFSA, the tax refund portion must, in effect, be invested as well. In one example from the TaxTips comparison calculator we used in our previous post, a $5000 RRSP (pre-tax) contribution was, for instance, only equivalent to a $3550 TFSA (post-tax) contribution (the actual equivalent amount varies according to your tax bracket). Put another way, if you have $5000 cash to contribute either to a TFSA or a RRSP but spend the RRSP contribution tax refund you will be far short of your retirement spending goal when the RRSP's deferred taxes have to be paid (see a detailed explanation in the TFSA vs RRSP comparison on Million Dollar Journey). TFSAs don't offer the temptation of the seemingly found money refund, which all too many Canadians succumb to. Score one for TFSAs.

TFSA - The Cookie Jar Temptation
In a recent GlobeInvestor article about TFSAs and RRSPs, Wealthy Barber author David Chilton said he feels the ease of TFSA withdrawal, greased by the thought that the money can be replaced the following year, which is not allowed with RRSP withdrawals, makes it more prone to the withdrawal temptation than the RRSP. Will Canadians delve into their TFSAs for luxury spending more than they have into RRSPs? That remains to be seen. Score a minor plus for the RRSP.

Tax Management
The TFSA has several significant post-retirement tax advantages:

TFSA withdrawals do not count for income-restricted benefits such as OAS and GIS.

When you need a bigger lump sum of cash in a particular year e.g. for that cruise, home renovations, health costs, gifts, new car etc, a bigger RRSP/RRIF withdrawal can push you into a higher tax bracket and reduce or eliminate GIS or OAS.

TFSA allows contributions up to any age

In contrast, the RRSP must be converted to a RRIF or an annuity i.e. be progressively withdrawn starting by age 71 at the latest. This TFSA feature is very useful to gain tax-free earnings from investing surplus funds, such as on-going cash not needed for current living expenses or perhaps an unexpected lump sum like an inheritance. The cumulative, non-expiring annual $5000 contribution room of a TFSA enhances this advantage. You cannot put inheritances received into a RRIF.

Example - Putting these factors together, suppose you withdrew $30,000 extra during retirement from a RRIF, pushing you from $36,000 taxable income to $66,000 that year. That would cost about $10,000 more in taxes for an Ontario resident. Suppose a year later, you received a $30,000 inheritance, you could not put it back into the RRIF. Your choice would be to invest it in a regular taxable account, subject to tax every year, or into a TFSA if you had the contribution room. With the TFSA, the money would come out with zero effect on taxes and the withdrawal would create $30k in contribution room, permitting you to return the inheritance money to tax-free gains.

TFSA simplifies income splitting between couples to lower overall tax

Income splitting is easier with the TFSA since both spouses automatically get $5000 in annual contribution room and one spouse can contribute up to that limit to the other's account. With the RRSP, the receiving spouse must have available contribution room built up through earnings, a problem when one spouse is a low- or no-income earner.

TFSA is simpler to manage and figure out.

With a RRIF you must content with: having to pay attention to forced RRIF minimum annual withdrawal amounts; and figuring out the net cash available immediately upon withdrawal after witholding tax (from TaxTips) or after tax filing, which amounts will probably differ, for withdrawals above the minimum from a RRIF. With the TFSA, to use the hoary phrase "what you see is what you get". There's no confusion or uncertainty. The amount you withdraw is what shows up in your bank account to spend. There are no tax implications to figure out, things to file in a tax return or later amounts due or refunds. Life is simple, as it should be.

RRSP/RRIF qualifies for Pension Amount

One plus of the RRSP is that withdrawals from a RRIF qualify, if you are 65 or older, for the $2000 pension income tax credit (see Canadian Tax Resource's What is Eligible Pension Income? for details). TFSA withdrawals do not qualify.

RRSP/RRIF Witholding Tax superiority

Since the US government recognizes only the RRSP/RRIF and not the TFSA as a bona fide retirement account, 15% US-government levied witholding taxes eat away at returns on US-listed ETFs, as we wrote about in Pros and Cons of Cross-Border Shopping in the USA for ETFs. That penalty for TFSAs applies pre- and post-retirement and across all income levels and would also apply to US-listed equities paying dividends or bonds paying interest. That can make a significant difference to returns on such holdings in the long term, as we noted here.

Bottom Line

Highest income earners of $120,000+. Focus on the RRSP first due to the likelihood of a drop in your tax rate. If the RRSP contribution room isn't sufficient for savings goals, put any extra in the TFSA. After retirement the TFSA makes a fine parking spot for surplus funds.
Income earners below $37,000. Focus exclusively on the TFSA. If you are frugal enough to save more than the $5000 contribution limit, then look to the RRSP.
In between $37k and $120k. Save through both TFSA and RRSP to gain the advantages of each and the flexibility of having both.

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.

RRSP vs TFSA? First, the Numbers

2011-10-21T04:49:00.017-04:00

Trying to save for retirement but unable to figure out if putting money into an RRSP is better than a TFSA? Welcome to the party, you are not alone.

Our previous blog post RRSP vs TFSA vs RESP vs Non-Registered Taxable Account took a general look and gave rules of thumb. Now we get more specific in comparing the RRSP against the TFSA.

The Calculator
TaxTips.ca offers a free and quite complete tax TFSA vs RRSP Calculator (see screen shot below) that can compare the two in terms of after-tax cash flows from the working and saving years right through retirement. The customization to one's own circumstances includes all the key factors - province of residence to reflect different provincial tax rates, current age, intended age to convert RRSP to RRIF or to begin receiving CPP, how much CPP and OAS entitlement one will have, pension income other than the RRSP or TFSA, amount of contribution to the RRSP, or TFSA (the latter which the calculator adjusts to make it exactly equivalent after-tax to the RRSP contribution) and estimated future portfolio rate of return within the RRSP/TFSA. Behind the scenes the calculator uses the appropriate tax rates, tax clawbacks and credits to show year by year how much spending after-tax money you end with.

After you select all the variables and click "Calculate" the big blue text line tells you whether the TFSA or the RRSP is best overall. Wonderful!

The Results
We tested across a range of income levels from $35,000 to $120,000 for a hypothetical single 30 year old in the various provinces. The bottom line number we look for is what percent of after-tax disposable income the RRSP/TFSA replaces, the higher the better.

TFSA Always Wins for the $35,000 Wage Earner - that's in every province; the result is mainly due to not losing out on benefits like OAS and GIS
RRSP Always Wins for All Higher Pre-Retirement Income Levels - MillionDollar Journey's post TFSA vs RRSP - Best Retirement Vehicle? puts the cut-off more precisely at $37,000
The Margin of Advantage is Always Quite Small, No More than About 1.5% - that's right, across all income levels and the scenarios discussed below, whether the TFSA or the RRSP wins, the total lifetime cash flows, as expressed in their Net Present Value, and shown at the bottom of the Calculator's Results table, is never very greatly different!
TFSA Alone is Not Adequate for High Income Earners - the $5000 annual contribution limit on the TFSA makes it impossible for those at $120,000 to save enough to achieve even minimal 60% income replacement. Thus, in practical terms, the RRSP is a required element for retirement saving for high earners.

Key Scenarios
Next we looked at a couple of scenarios for the assumptions that matter the most: a) portfolio return - instead of our base 3%, we tried 5%, which we dub the "Excellent Market Returns" scenario, and b) savings to be depleted over 20 years (by age 85) instead of our base 30 years, which we call the "Die per Average Life Expectancy" scenario.

Higher Portfolio Rates of Return Matter More than How Long the Savings Must Last - Effective investing matters. The results of our scenarios show a much greater effect in retirement disposable income from a change in returns to 5% than shortening the retirement period from 30 to 20 years. A low-cost portfolio that includes a good portion of higher-return, though riskier equities, makes a big difference, as we blogged about in our previous post.

Those are the numbers. Overall, it looks as though the TFSA should be the automatic choice for low earners - those earning $37,000 or less - and the RRSP the preferred vehicle for those in the highest income category. In between, it doesn't seem to matter much.

However, there are other considerations that can change the picture and in our view affect the best strategy, as we will explain in our next post.

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.

What is a Viable Mix for Retirement Savings Success?

2011-10-17T12:05:00.003-04:00

Are you on track for building a financially sustainable retirement? How can you know if you are making progress whether you are 35 or 55?

Saving and investing enough depends on several factors that inter-twine and affect one another:
- what age you stop working and retire,
- how many years you save,
- your savings rate,
- your desired retirement spending,
- how long you will live,
- the returns from the portfolio where your savings are invested.
In addition, there is the make-up of the portfolio between stocks, bonds and other asset classes to decide.

It is easy to see that deciding on a viable mix can seem dauntingly complex. Obviously, the longer you work and save, delaying retirement, the lower the required savings rate needs to be. The more stocks in the portfolio as opposed to bonds, the higher the return should be, but there is more chance of stocks doing one of their familiar nose-dives at the wrong time, just at the start of retirement. The question everyone faces: what are the numbers to use?

The Past as a Guide
One way to get a good idea, if not a definitive answer, since we can never be sure the future will be exactly the same, is to look at what happened and what worked in the past. Using a long enough period that includes recessions, inflationary periods, depressions, booms, wars, financial crises, bubbles and crashes, we can gain some confidence that the numbers might be worth considering.

Enter researcher professor Wade Pfau of the National Graduate Institute for Policy Studies in Tokyo, Japan, who has done some interesting number-crunching in his paper Getting on Track for a Sustainable Retirement: A Reality Check on Saving and Work. He has figured out what various combinations of retirement age, income replacement level and asset allocation would have ensured that a person would never have run out of money up to age 100 (few of us get to live as long as Jack Rabbit Johannsen) assuming that the person had already saved a certain amount to date. In other words, he has looked at the worst case scenario for anyone retiring anytime during most of the 20th century (though he cannot go beyond anyone who would be less than 100 in 2010 e.g. a 55 year old retiree of 1965, who would have 45 years of retirement by 2010, or a 65 year old retiree of 1975, who would have 35 years).

The Example of a 55 Year Old
Pfau uses as his base case the example of a 55 year old making decisions about what to do. This is what Pfau determined.

To maintain a spending rate of 50% of final salary, a person could have retired at 67 if he/she had already accumulated savings of six times his/her annual salary and was prepared to save 15% of their annual salary continually till retirement using a mix of 60% stock (S&P Composite Index) and 40% fixed income (six-month commercial paper) - see the blue-circled cell in the top panel of the table below copied from the paper. For instance, a person earning $60,000 per year would need to have $360,000 in retirement savings already and to set aside $9,000 per year till age 67.
If the person lowered the stock allocation to 40%, retirement age would rise to 70 - per the middle panel blue-circled cell
If the person wanted a higher 60% of final salary replacement spending level, retirement age would rise to 69 - per the lower panel blue-circled cell
If the person had only saved up four times their annual salary so far and could only manage to save 10% of earnings per year, retirement age would rise to 72 - per the upper panel red-circled cell.

Ages 35, 40, 45, 50 or 60
Prof. Pfau has used the same assumptions and methods to calculate the path forward for individuals 35, 45, 50 and 60 in his blog post Getting on Track for Retirement. The table for 40-year olds is here in another post.

Taking one example from these tables, we see that a 35 year old with zero retirement savings today could still retire at 66 (blue-circled cell in the table below) at the 50% spending rate by saving 15% per year.

Stock Allocation Sweet Spot 40 to 60%
One fascinating fact coming out of the middle panel of all the tables, whatever the age at which the look forward starts, is that an optimal allocation percentage to stocks looks to lie between 40% and 60%. A higher allocation to stocks lowers possible retirement age little if at all. Below 40%, the safety of fixed income comes with a significantly increasing higher retirement age, due no doubt to the much lower returns historically achieved by fixed income.

Lower Income Replacement Gives Earlier Retirement
A 10% cut in income replacement rate from 50% to 40% has as much effect in lowering viable retirement age - three years, from 67 to 64 - as having saved eight times your salary by age 55 instead of only six times (see the green circled cells in the first table above). In the example of the $60,000 earner, is it easier or more worthwhile to save $480,000 instead of $360,000 by age 55, or cut annual retirement spending from $30,000 to $24,000.

Caveats and Cautions
We believe that though very useful, the tables should be used to ballpark and to judge rough trade-offs, not to set precise expectations.

Data is for the USA and though similar, Canadian investment returns have not been identical and will not be in future either. Whether this means higher or lower, we cannot be sure since Prof. Pfau has not run any numbers for Canada.
Investment management fees have not been deducted as the study uses index data. That would lower returns and raise potential retirement age and required savings rates to obtain the same income replacement rate.
A constant spending rate throughout retirement probably over-estimates what usually happens as people slow down as age advances. People also can cut back if returns are poor. Similarly, setting 100 as the age to which income is required overdoes it since life expectancy, while it continues to creep up constantly, is still only just over 80. Applying those factors would all enable a lower retirement age or lower savings rate.

The test that the portfolio should never have run out of money is very stringent. The high required savings rates are necessary in a minority of all the years considered, as Pfau's figure 4 shows. Taking a chance that the retirement years will be blessed with reasonable investment returns may suffice. Which part of the past will the future be like? No one knows. Pfau lays out an ultra-cautious approach. It may not even suffice if the future brings something worse than any period yet recorded. We sincerely hope, and expect, not.

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.

Investor Forecast: Stormy Weather, Not Falling Sky

2011-10-06T07:38:00.024-04:00

Since early this year, it feels as though there have constant steep drops in stock markets with every upward recovery being smaller and then followed by an even bigger decline. Indeed, the numbers confirm the impression: S&P TSX Composite Index's 1-year price return is -7.3%, the year-to-date price return is -14.8%, the price change since 2011 peak on April 5 -19.4%. The Google Finance chart of this period really doesn't look pretty.

Is the "Sky Falling"? - The feeling that things can and quite possibly might get even worse is quite understandable. Major country economies are weak, possibly heading into recession. On top of that, if a default by Greece could provoke a chain reaction to other European countries, what might be the result of country defaults considering that a mere investment bank's (Lehman) downfall in 2008 led to that horrendous market crash?

Answer: No, though there are definite menacing clouds, we believe the Sky is Not Falling. As we blogged about a few months back in Investing Risk: Defaults, or how often do investments go belly up?, country defaults happen, the last peak episode being around 1990 according to the chart in that post. The world weathered that period. Whether various authorities manage to prevent the seemingly inevitable default of Greece, the world economy is likely to survive and then revive after such an occurrence. Also instructive is the history of the recurrence of significant market losing periods, which we blogged about in Investing Risk: Historical Worst Volatility, Business Cycles, Crashes and Crises. The lesson of history is that it may take many years to recover but recovery does ensue, even in the very worst episodes of the past.

What therefore should we as investors do?

Action item 1 - Set Expectation to Long Holding Period for Equities: Our allocation of money to stocks must go along with an expectation of a holding period of at least ten years before we intend to cash in and start spending the money. The knowledge that we will not be needing the funds for many years will allow us to weather the financial storm and its aftermath. Setting our expectations appropriately helps us sleep better and avoid panic selling.

Action item 2 - Rebalance the Portfolio: A portfolio should contain target percentages of cash, fixed income and equities in proportions which we suggest should be explicitly set out, as we explained in the post on Investment Policy. Since equities have declined quite a bit while fixed income has stayed constant or gone up (e.g. the iShares DEX Universe Bond Index ETF - TSX: XBB - is up 2.6% over the past year), it is quite likely the equity vs fixed income percentages have gone out of whack. If the proportions have gone far enough askew, then now is an opportune time to take the cash or sell fixed income to buy equities. For more see our post on Rebalancing - What, Why and How.

Current stock market valuations are encouraging in that sense as they are at levels low enough to promise reasonable future returns for equities. Using the sources we blogged about in February 2010 in Is the Stock Market Over- or Under-Valued?, the signs are more promising or at least not worse now than back then.

InvestorsFriend.com's Shawn Allen figured as of September 28th that the TSX Composite Index fair value is somewhere around 11,838, implying an investor could get an 8% return over a ten-year holding period. With the TSX gyrating around that level as of Oct.13th, the prospects are quite reasonable.
Ben Stein and Phil DeMuth's Yes, You Can Time the Market indicators (Price, P/E Ratio, Dividend Yield, Earnings Yield vs AAA Bonds) for the S&P 500 bellwether US market index as of September 30th were all flashing Green for Buy.
The CAPE vs q Ratio calculated by Smithers & Co. on September 16th showed the S&P 500 to be still over-priced at a price level of 1216, not much different from February 2010, but today the S&P 500 is lower at about 1200 so it would be less over-priced.
In the same vein, the Schiller CAPE ratio is the same at 19.8 as it was in February 2010, and thus still exceeds the long-term average of 16.

The most fearful situation for most is having to face the unknown. It is easier to face adversity when it is defined. We hope that with the above facts in mind, our investor readers can be more confident and less anxious for the long term.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above commentary is not an investment recommendation. It rests 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.

And Now for Some Good News - Low & Stable Inflation Expected

2011-09-30T07:50:00.001-04:00

Amongst all the big market swings and dire news of countries at risk of defaulting on debt, there's one key economic variable whose outlook is relatively benign that is of crucial interest to investors - future inflation rates.

Big unexpected leaps in inflation that hurt both stocks and bonds do not seem to be in the cards at the moment, despite the latest CPI figures from Stats Can for August which showed a still-high rate of 3.1%.

The future according to:
Economists

BMO Capital Markets: forecasts 2.0% in 2012
TD Economics: forecasts 1.7% in 2012 and 1.9% in 2013
RBC Economics Research: forecasts 1.9% in 2012
International Monetary Fund: 2.0% 2012 through 2016 as shown in the chart below from Google's Public Data Explorer.

Bank of Canada - The organization responsible for monitoring and controlling inflation in Canada states that its

official Inflation Control Target is still 2% with an allowable band of 1-3%

The Market - By subtracting what investors are willing to pay (accept as a return) for inflation-indexed Real Return Bonds from ordinary non-inflation indexed Canadian government bonds of similar maturity, we can infer the market expectation of inflation. Reuters thankfully has been doing the tracking for us in the Canada Breakeven 20 Year chart, the update as of September 29, 2011 shown below. Note how expectations have varied quite a bit in the last five years, though never going above about 2.8%.

current expectation 2.08%

Best future inflation estimate: 2%

How likely is it the forecasts will be correct?
We all know how prone to error forecasts can be. CanadianFinancialDIY blogged about a Credit Suisse report that surprisingly found central bankers to be the most accurate though they too erred by more than 1% above and below the eventual real rate.

What does it mean for the investor? Low and, especially, stable inflation would remove a major troubling element for investors as inflation is a potentially very nasty risk (see our recent post on how how bad inflation and its effects have been in the past). Despite the good forecasts it may still be wise to be cautious and hedge bets by building inflation protection into a portfolio, as we discussed in Investments to Protect against Inflation and in Investing Risk: What is there to Lose?

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.

Twelve Tricks in Financial Statements and How to Detect Them

2011-09-21T10:10:00.027-04:00

Last post we listed a dozen general warning signs that company management may be up to no good and be trying to conceal outright illegal fraud or painting a rosier-than-justified but still legal picture of the financial condition of the company. This week we look at some of tricks of the managers and a few ways to detect the manipulation.

Deceptions on the Balance Sheet

1) Liability provision for Product Warranties in excess of what's needed to cover actual costs. This reduces current earnings and creates a "cookie jar", as Al and Mark Rosen describe in their book Swindlers, that can be used later on to boost earnings by simply reversing the excess provision. The obvious sign: the provision rises significantly and out of line with sales.

2) Excessive restructuring charges upon a reorganization or cutbacks, often after poor results. Erring on the high side gives management the opportunity to look good by using this form of the cookie jar to boost earnings in subsequent quarters and try to deceive investors that a quick turn-around has taken place.

3) Resource companies can use, and often have used, asset writedowns to lower earnings initially and then raise them later by reversing the writedown. Similarly reserves for claims are a key variable in life insurance companies, or loan loss provisions in banks and it is very difficult for an investor to figure out what such values should be, even at times company management is trying its best to be forthright.

4) Expenses booked as an increase to Assets - capitalized expenses - instead of including the amounts in operating expenses. This results in higher immediate earnings. One way to uncover this subterfuge is to to compare the choice of methods used to capitalize expenses in other similar companies, as explained in notes to financial statements. It also helps to compare the depreciation and amortization expense amounts with the average asset balance. If either depreciation expense as a percentage of fixed assets or amortization expense as a percentage of intangible assets is much lower than in prior years, this might indicate the fraudulent classification of operating expenditures as capital expenditures. (from What's Your Fraud IQ? in the Journal of Accountancy)

5) Hidden asset impairments that should trigger a reduction in earnings through writedowns but don't because hidden. Such impairments might consist of obsolete equipment and facilities in industries like manufacturing, technology, media and communications. At an extreme of impact, we note the example of toxic mortgage and related derivatives assets on bank balance sheets which played a central role in the credit crisis. Often the problem is hidden in a manner that is quite within accounting accounting rules but which effectively masks economic reality by choosing a favourable valuation technique. The way to discover the ruse is to read the notes to financial statements regarding accounting assumptions and then to compare with other companies in the same sector.

6) Significant liabilities off the balance sheet. Items such as leases and contractual obligations and pension liabilities can hide a weak financial situation. Tracking them down involves going through various sections of quarterly and annual reports such as the notes and the management's discussion and analysis, the company's annual information form and the proxy circular.

7) Omitted or down-played contingent liabilities. The best example is the possible impact of lawsuits, which companies are wont to under-emphasize, if only to not publicly admit culpability before a case is settled. There may not be a hard and fast answer until actual resolution of a lawsuit but the investor may be able to develop a sense of where things are heading by reading up on what is said in the media, for which Internet search tools are a wonderful help.

Trickery in the Income Statement

8) Lower credit standards, allowing more people or firms to buy products, who otherwise would not be accepted. This raises sales in the near term but results in higher future write-offs for uncollectible bills.

9) Premature recognition of revenue in multi-year contracts, such as construction and projects, through overstating progress towards completion, again in order to enhance immediate earnings.

10) Fictitious sales are outright illegal fraud. In one variation, a company ships product to an outside warehouse, books the revenue to meet a year-end goal, and then returns the goods to its own inventory. A clue is that a large proportion of reported revenue is uncollected - the Swindlers book warns that when accounts receivable represent 80%+ of a quarter's sales, danger lurks. Another indicator is a reversal to accounts receivable in later periods. A third sign is a big sudden increase in the Quick Ratio, of which receivables is a key part.

11) Big discounts or extended payment terms to customers to bring forward sales into the current period to boost earnings. One sign is that the Gross Margin (Sales - Cost of Goods Sold) will decline.

Cash Flow Manipulation

12) Operating cash flow juiced up by a whole menu of possible tactics such as: sale of receivables, separate sales companies, stock option compensation instead of pay, prepaid maintenance, substituting property ownership for leasing, buying R&D instead of doing it in-house, paying consulting fees to related parties with shares and other techniques, as described by RetailInvestor.org in Cash Truths that Aren't.

The Beneish M Score - A good way to start investigating a particular company would be to apply the system of financial ratio tests developed by Indiana University professor Messod Beneish to detect earnings manipulation. The test uses eight different financial ratios and produces a single number that in Beneish's testing successfully identified about three quarters of manipulators, though it also wrongly labelled 18% of non-manipulators (see David Bricknell's short and readable summary on iStockAnalyst of the various ratios and what they mean).

That kind of result reminds us too that detection of fraud or manipulation is not always possible. Therefore we might not be sure about what a company is doing and how much that should affect the value of its stock. However, investigation directed at typical trouble spots can be a real boon for the investor contemplating purchasing a particular company's stock.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comments 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.

Financial Statement Manipulation and Fraud: A Dirty Dozen Warning Signs

2011-09-14T08:16:00.012-04:00

Controversy again erupted on the stock market recently with first Sino-Forest Corp (TSX: TRE) being accused of illegal deceptive financial reporting and then Silvercorp (TSX: SVM) too being accused of falsifying data. Though the verdict on the accusations is not in for these two companies, it reminds us that financial misrepresentation does happen, ranging from dubious but often legal earnings management through to outright falsification and fraud.

Whether dishonest perpetrators eventually get caught or not, in the meantime investors can lose a lot of money since the inevitable result of the malfeasance is big losses in stock value and often total loss. It's better to detect problems in the first place and either avoid the stock altogether, or for those brave enough, such as those first raising the stink about Sino-Forest and Silvercorp, short-sell the stock.

To that end, we offer a list of warning signs that something may be amiss in a company. Most of these signs are culled from two books: Financial Statement Analysis (4th edition) by Martin Fridson and Fernando Alvarez and; Swindlers by Al Rosen and Mark Rosen (reviewed by CanadianFinancialDIY, by Jonathan Chevreau in the Financial Post and by CorporateKnights)

Unexpected turnover of senior management - e.g. the sudden resignation of the Chief Financial Officer or the CEO
Late financial statements - companies must publish results within a certain time after quarter and year-end dates; e.g. the Ontario Securities Commission sets out deadlines here
Incomplete quarterly statements - e.g. missing the Balance Sheet or Cash Flow Statement
Professional financial analysts state they cannot understand the company's financial statements - Fridson and Alvarez note that such was often said about Enron before it went up in smoke. They cite Warren Buffett's trenchant comment - "... if you cannot understand the footnotes [in financial statements], it is because management does not want you to."
Board members not sufficiently independent of management or not very experienced or with little ownership stake or simply a Board that is too small - this forms part of overall corporate governance, which we reviewed in our post Stocks and Corporate Governance: Do the Good Guys Finish First or Last?
Infrequent meetings of the Board audit committee - on the other hand, it is a good sign when the independent (i.e. not family or business relations of senior managers) committee members meet more than twice a year (see study in next bullet)
Members of the audit committee had short term stock options - see Corporate Governance and Earnings Management (download here from SSRN) by researchers Sonda Marrakchi Chtourou, Jean Bédard and Lucie Courteau
Management untrustworthy on other grounds - Fridson and Alvarez give the example of insider trading by Richard Scrushy at HealthSouth before it imploded
Related party non-arm's length transactions and private companies set up by executives to do business with the public company - these situations present opportunities for the executives to enrich themselves at the expense of the public company and its shareholders
Corporate restructurings - where there is the danger that excessive costs are written off, creating a cookie jar account reserve that management can use later to boost earnings as the high costs do not come to pass.
Industries that are more susceptible include non-manufacturing, non-retail sectors like finance, credit unions, banks, insurance, real estate and not surprisingly, resources
Weasel words in earnings conference calls - we can listen carefully to those post-earnings conference calls where management explains results to professional analysts (which the Internet now makes possible for individual investors to listen in on - get links from the company investor relations website area or a news website like CNW's webcast listing). According to David Larcker and Anastasia Zakolyukina's paper Detecting Deceptive Discussions in Conference Calls, the question and answer time at the end is where "... the answers of deceptive executives have more references to general knowledge, fewer non-extreme positive emotions, and fewer references to shareholder value. In addition, deceptive CEOs use significantly more extreme positive emotion and fewer anxiety words."

None of these warning signs is necessarily sufficient to conclude that hanky-panky is going on. Combinations of factors along with actual digging through the accounting statements is required to arrive at a determination. Nor is it 100% sure that even with the utmost expert due diligence - that was the depressing take-away from the Enron situation where pretty well everyone was oblivious to the fraud - will it be possible to detect every fraud. Nevertheless, paying attention to warnings signs and checking out the situation can help avoid investing grief.

Getting Started in Value Investing

2011-09-07T07:00:00.004-04:00

Our last post reviewed past blog post lists of stocks picked by industry or by certain characteristics. Now is an opportune time to bring up the grand-daddy method of stock selection that is the basis used by most active investors - Value Investing. As Wikipedia explains in more detail here, Value Investors attempt to find bargain-priced stocks through so-called fundamental analysis of accounting data. Often this starts with the ratio of current stock Price to company Earnings, the P/E ratio, with lower P/E being better, i.e. the lower the Price paid for the company's yearly profits the better off the investor is.

Analysis then usually proceeds through a series of other ratios considered to be indicative of a "good buy", like low Price to Book Value, low Price to Assets, high Dividend Yield (dividend over Price) and of safety margin, like low Debt / Equity and high Interest Coverage (by how much the company's earnings exceed required interest payments to avoid a disastrous default). Within the general concept there are many variations in the practical specifics. To get you started, here are a few Value investor examples and some useful tools.

First, let us acknowledge Benjamin Graham, the practical and philosophical inspiration of Value investing. His book The Intelligent Investor, as updated by Jason Zweig, is still an essential read for any Value investor.

Ben Graham Center for Value Investing - headed by Dr. George Athanassakos
The website contains papers, audio downloads, links to data sources, book references. Athanassakos writes a regular column for the Globe and Mail, the most recent of which, The Contrarian Case for Active Investing, tells of his success in picking stocks that have outperformed. In A Faster Way to Identify Value Stocks, found at the Canadian Investment Review he gives more detail on his method, which includes these factors to derive the best combined SCORE to pick the stocks:

Low P/E stocks, excluding negative numbers (i.e. companies with negative earnings / losses)
Price > $1
Smallest Market Cap stocks (small companies)
Least liquid stocks (small trading volumes)
Highest Asset Turnover stocks (ratio of Sales over Balance Sheet Assets)
Highest Revenue growth stocks
Highest Earnings Per Share (EPS) growth stocks
Highest Earnings Before Interest and Taxes (EBIT) stocks

Mutual Funds - Amongst the resources listed by the Ben Graham Center are several fund management companies offering services to Canadian investors, who are said to espouse value investing methods, such as Burgundy Asset Management, Chou Associates, I.A. Michael Investment Council / ABC Funds (its principles for stock selection shown here on the Globe and Mail site), SteadyHand and others.

ETFs - Unsurprisingly, there are many Value-based ETFs. Sporting the word "value" in the fund's name, they vary in which factors are used to select the stocks, some using only historical P/E and P/B data, others using analyst forecasts as well. Stock-Encyclopedia.com has a list of Value Stock ETFs here. CanadianFinancialDIY commented on the "slippery" meaning of Value in ETFs and Yahoo Finance describes the different ETF definitions of Value.

Tweedy, Browne Company LLC - The 91 year-old portfolio management company subscribes to Value investing principles, which it explains in its free booklet What Has Worked in Investing. The factors Tweedy looks for:

Low P/E
Low P/B
High Dividend Yield combined with a low Dividend Payout (ratio of dividends to earnings)
Insider purchasing - executives and Board members buying shares themselves
Small market cap
Significant Price declines from highs

StingyInvestor - Investment advisor Norman Rothery lists his current and past stock picks using what he interprets to be Ben Graham's Value principles (e.g. in table 2 of 7 Graham Stocks for 2011). He provides informative comments on the practicalities and on the success of his picks.

Screening and Data Tools - To do your own searches and then assessments for Value stocks, here are some online resources.

ADVFN.com (free registration required) - This is by far the most complete and flexible source to screen stocks with numerous and varied criteria. One unique and very helpful feature is that for any metric chosen ADVFN shows the range of values and where the median and average values lie. This tells us what is a high or a low PE value at the moment; for instance, in the screenshot below we see that of all the TSX stocks with a positive P/E ratio (to do that we entered a constraint of PE greater than 0.1), the average P/E is 33 and the median is 12. We might thus set the constraint that a potential Value stock must have a P/E under 12. Adding other criteria results in a shorter and shorter list of candidate stocks. After winnowing the list down to a manageable number the real work of individually assessing each company begins and ADVFN includes a large number of financial ratios going back five years, along with graphs of many key numbers to enable quicker trend spotting and understanding what is driving each company.
InvestorPoint.com - This site contains perhaps the one thing missing from ADVFN that Value investors often monitor - Insider Trading e.g. Bank Of Montreal.
GlobeInvestor's My Watchlist - Quickly construct a portfolio of candidate stocks, with a selection of the key fundamental data in a variety of standard views plus the capability to build your own view with only data of interest to you. It's handy because the Watchlist is part of the GlobeInvestor website of business and investing news.

Methods of Corporate Valuation - The late Prof Ian Giddy of New York University wrote this short readable introduction to the methods of valuing a stock.

RetailInvestor.org - The anonymous investor author gets to the gist of many stock valuation issues with a very practical perspective. He notes many of the potential trip-ups and mistakes that can subvert an investor's evaluations in the sections on Stock Picking and the Cash Flow Debate.

The essence of Value investing is smart detective work. That's what will distinguish the companies and stocks that deserve their low price, as most do, from those that are truly under-valued. As a corollary we also need to keep in mind that sometimes we will be wrong - the detective work, even when done with great care, may give the wrong answer. The idea is that there may well be more losers than winners but the winners' gains will more than compensate for the losses on the losers. It is necessary to keep at it, keep track of new information and not put everything on the line in one stock.

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.

Assessing Our Stock Picks - Mostly Good Results, The Remainder Average

2011-08-31T08:01:00.001-04:00

It is impossible to learn from our mistakes unless we know what they were, or to learn what investment strategies work and which do not unless we look at actual performance. Let's take a simple look back at the performance of some specific individual stocks we thought looked good in past blog posts.

The Benchmarks: S&P/TSX Composite Total Return and CPI Inflation
Assessing performance needs to be done from several angles. First, there is the absolute performance - did we make money or lose money after inflation (if we don't beat inflation, we have lost purchasing power, so we have lost money in real terms)? Second, we need to compare in relative terms - have we beat the overall average return of similar assets. In this case, our picks were all Canadian stocks so we benchmark against the Toronto Stock Exchange's basic index, the S&P/TSX Composite Total Return.

CPI Inflation - 2.7% in the latest available figures covering up to the end of July 2011, published by Statistics Canada on August 19th
S&P/TSX Composite Total Return - 9.5% gain in the one year up to August 24th. Note that Total Return includes both the stock price gain plus dividends. If we buy a stock, we receive dividends so we must compare with the index that includes them. Unfortunately, almost every chart available on the Internet and in news reports uses only the price gain index, excluding dividends, which are running at about 2.7% per year currently. As we wrote about in TSX Composite and S&P 500 Total Market Return, dividends are a significant part of investing profits. Our source for the TSX Composite Total Return Index is GlobeInvestor's Stock price report using the ticker symbol TSXT-I. (Pull up the chart and graph the price-only index TSX-I and see the difference even in one year)

Stock Performance
We've used GlobeInvestor's My Watchlist to create the series of mini portfolios. The ones we created are not publicly visible, being under our personal id, but you can easily reproduce them simply by creating a new watchlist of your own and typing in the stock symbols. Apart from being so quick and easy to use, My Watchlist most importantly can show the one-year total returns (again, so many price quote sites only show the price movement of stocks excluding dividends).

The Twelve Ultimate Buy and Hold Stocks - original post of June 2010 here

Inflation-beaters: 67% (8/12)
Index-beaters: 50% (6/12)

That's not great results over one year but hey, maybe we should think longer term as these companies have all been around for over a century. e.g. look at the bottom of our list:

George Weston (TSX: WN) - continues to be profitable every quarter; though its profits are up and down, it keeps paying its dividend
CP Rail (TSX: CP) - continues to be profitable every quarter; though its profits were down the last two quarters, it increased its dividend in the most recent quarter
Great-West Lifeco (TSX: GWO) - continues to be profitable every quarter; though its profits are up and down, it keeps paying its dividend

In short, things could be a lot worse than the situation of these companies.

Food Companies - original post of September 2010 here

Inflation-beaters: 75% (3/4)
Index-beaters: 75% (3/4)

These results look good. Our only loser is Canada Bread Company (TSX: CBY), which had a loss in the March 2011 quarter but rebounded in June and more than tripled its dividend at that time.

Electric Power Utilities - original post of January 2011 here

Inflation-beaters: 100% (4/4)
Index-beaters: 100% (4/4)

What's not to like about such results? Steady profits and dividends have found market approval in price gains.

Split Share Capital Shares - original post of December 2010 here

Inflation-beaters: 100% (3/3)
Index-beaters: 67% (2/3)

The only stock that has not beat the market benchmark is NewGrowth Corp (TSX: NEW.A). Its bank holdings have been holding it back. Is that a problem or a buying opportunity, given NEW.A's use of leverage? It all depends where one feels Canadian banks are heading.

Dividend Growers - original posts of April 2011 on High-Yielders here and of May 2011 on Low-Yielders here

Inflation-beaters: 84% (16/19)
Index-beaters: 53% (10/19)

It is pushing matters to do a performance assessment so soon after the original posts, so we will leave our comments at saying the results so far look reasonably positive.

Overall, the performance results support the idea that looking at the numbers for stocks and companies is worthwhile to help find good investments. We must temper our enthusiasm and consider that it is to some degree by chance that our very short term success rate is so high since even professionals do not on average achieve much above 50% success. Our blog post assessments did not delve very deeply into each company so we should be wary. Still, those dull-looking numbers merit our attention!

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.

Stocks to Drown Your Sorrows or Lift Your Spirits

2011-08-26T10:13:00.001-04:00

Let's face it, the stock market has not been very strong lately, what with European and USA debt troubles and other assorted ills of the world threatening another recession or another Lehman crash. It's enough to drive an investor to drink! Instead of drinking maybe the thing to do is invest in distillers, wineries and breweries.

Why Booze Stocks?
That this is more than joking possibility, do a Google search with words like sin stocks (among which booze is counted) and recession. There will be a raft of articles, many of them saying that such stocks do well in bad times, e.g. The Virtues of Vice Stocks at Kiplinger.com and Living with Sin Stocks at Forbes.com. There is even an academic study Sin Stock Returns over the Business Cycle that found " ... the abnormal return on the sin portfolio is higher during recessions than during expansions ..."

The following chart from Google Finance for the Alcoholic Beverages sector appears to add support for the idea as it shows it outperforming the S&P 500 through the last recession, though most of the gains seemed to occur once recovery was underway.

Finding the Stocks and their Data
The first step to look at the sector is to find the booze companies listed in Canada and the USA. There is not one source or tool that contains everything. This blog's data is an amalgam of these sources:

TMX Money's Stock Screener - set the Sub-industry choice to Beverages - Brewers or Wineries and Distilleries under Consumer Goods
Yahoo Finance's Industry Center under the Investing tab - pick Beverages - Brewers or Wineries and Distilleries
Google Finance - pull up a quote for a company in the sector such as Diageo (NYSE: DEO) and the result will show other stocks in the sector with their key financial ratios.
GlobeInvestor's My Watchlist - enter the stock symbols to create a portfolio to get most of the financial data we present below. Export the data to your own spreadsheet and then you can enter missing data using the other sources. N.B. Every investor must acknowledge that all data sources are subject to incompleteness and error - yes, sometimes the published numbers are wrong. Anything that looks unusual bears double checking with other sources, or with the company's own annual or quarterly reports.

Profitability and Growth
Most of these companies have been steady performers through the last five years, earning profits every year, even through 2008 and 2009. The number of good performers shrinks when other measures of company quality, such as Operating Profit Margin and Return on Shareholder Equity. Less than half managed to grow profits in the latest year. Only one company looks very weak - Craft Brewers Alliance (Nasdaq: HOOK) with profits in only 3 of the past 5 years, low operating margin and low return on equity.
Best Stocks on these measures:

Brown-Forman (NYSE: BF.B) - Earnings every year including growth last year, high operating margin and return on equity, dividend growth. Provides Southern Comfort, literally and metaphorically.
Companhia de Bebidas das Americas ADS (NYSE: ABV) - Giant company that has been growing profits and dividends at an astonishing pace given its humongous size. Outstanding operating margin and return on equity.
Molson Coors Brewing (NYSE: TAP) - Solid numbers across the board, better than the similar Canadian company.

Value - Which are Cheaply Priced Right Now?
There are a number of companies cheaply priced relative the industry average Price / Earnings (P/E) ratio and where Price to Book Value is near or below 1.0 or where the Price to Sales ratio is very low. Amongst the previous set of solidly profitable companies only one, Molson Coors, seems cheap. The other highly profitable companies, especially ABV, look to be getting a high market valuation.

Returns and Market Sentiment
Reading this table, we are lead to question whether the future may not be like the past. A different set of companies has experienced strong positive returns and enthusiastic Strong Buy recommendations from professional stock analysts. The one exception is ABV, which seems to be favoured by a Strong Buy despite its already phenomenal growth (No, the target price is not an error being below current market, that's what the data source shows, a reminder that numbers are not always correct. I double-checked the Strong Buy from My Watchlist against the one in TMX under the stock quotes research tab for ABV and it shows the same analyst recommendation so the target price must be wrong.)

Safety - How Risky is the Company and How Sure is the Dividend?
Debt is the principal danger to companies trying to weather economic storms so the amount of debt relative to various company metrics gives us a quick view of which companies look solid or dodgy. Constellation Brands (NYSE: STZ) and Diageo (NYSE: DEO)both have a lot of debt compared to the equity in the company, while Andrew Peller (TSX: ADW.A) has a high level of debt compared to cash flow, as does Constellation.

Four companies already pay out a high percentage of earnings as dividends (see table below), indicating a lesser likelihood of increases in the near future, though none is so high that dividend cuts would seem likely. Companies with 30% or less payout ration, highlighted in green numbers on the table, may be inclined to increase it, while those paying out nothing at the moment have the potential to start doing so if they have been consistently profitable. An example of the latter is Magnotta Winery (TSX: MGN).

Overall

Best Prospect - Molson Coors for its combination of consistent profitability, record of rising dividends and good valuation metrics

Fully-Valued but Solid Companies - Diageo, Brown-Forman, Companhia de Bebidas and Compania Cervecerias Unidas (NYSE: CCU)

Turn-around Prospect - Constellation Brands Inc. (NYSE: STZ) which has hit a rough patch but claims it is fixing things

Note that the above is based only on this preliminary assessment using the numbers in the tables. Further investigation of each company's prospects and conditions will be needed to confirm good and bad situations suggested by the numbers. Otherwise an investing hangover may result!

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.

Bank Stocks: Alternative Ways to Invest

2011-08-22T00:25:00.000-04:00

Many investors these days are casting their eyes towards the Canadian banks for any number of reasons: generally they are in good shape; they are amongst a raft of stocks offering attractive looking valuation numbers as we remarked in last week's Summer Stock Sale post; and finally, they have above market average dividend yields, which even have the potential to go up further according to this GlobeInvestor article looking ahead to their quarterly earnings reports of the next few weeks.

For those interested, there are three main ways to invest in bank stocks:

Common shares - Very straightforward, what you see is what you get. There are no extra management fees or expenses and they currently offer higher dividend yields than Split Capitals, as our comparison table below shows. There is no leverage either in common shares (of course, banks themselves use leverage internally and that is one of the risk factors for the common shares but we are referring to leverage applied by the investor in making the investment).

ETFs and Mutual funds - Among ETFs, the most concentrated is BMO's S&P/TSX Equal Weight Banks Index ETF TSX: ZEB, which only holds the big six banks in equal proportions. The iShares S&P/TSX Capped Financials Index Fund (TSX: XFN) contains healthy doses of bank shares but in the interests of diversification, it holds a much wider mix of stocks than just bank stocks, such as insurers and investment companies. Neither of these ETFs apply any leverage. There is an ETF with leverage, the Horizons BetaPro S&P/TSX Capped Financials Bull+ ETF (TSX: HFU) but it is quite a different animal, a tool only for the day trader since its returns equal 200% of the daily performance of the index.

Split Capital corporations - These are companies with the sole function of investing in stocks. The split share corporations issue preferred shares paying a fixed dividend rate, which in effect is borrowed money from the perspective of the capital share owners (see our previous posts on Split Capital Shares and Split Preferreds for more explanation how each works). Through this, Split Capital shares have the unique property of leverage, which amplifies gains - and losses too, raising their riskiness. The Split's leverage may thus be of special interest now if the banks are now back on a growth path. Dividend growth by the banks will also accrue only to the benefit of Split Capital owners since Split preferred share dividends are fixed.

Split shares currently a mixed bag of attractive and scary -

Scary - Original Commerce Split (TSX: YCM.X) and New Commerce Split (TSX: YCM.A), both based on CIBC, look destined to produce large losses for an investor today - a negative Net Asset Value (NAV) and a price far above it. The Split corporation is not even able to pay the Preferreds' dividends. A little less scary but still quite worrisome is TDb Split Corp. (TSX: XTD), trading at a value almost 75% above its NAV.
Attractive - Again, based on the view that bank shares and dividends are on the upswing, two of our list look best to us - Allbanc Split Corp. II (TSX: ALB) which holds more or less equal proportions of the top six banks and 5Banc Split Inc. (TSX: FPS), which holds only the big five and not National. Both have higher leverage, promising a bigger boost if the banks do well. Both have a fairly good discount of market price to NAV of about 7%, which provides some downside protection and the extra upside potential that the price may move closer to NAV. Both are also healthy enough to pay a decent dividend rate to the Capital shareholders as well as the required dividends to the Preferred shares. Though FPS is due to be redeemed and go out of existence December 15th this year, its managers TD Securities earlier this year announced an intention to examine the extension of the corporation's life. Amongst the single underlying stock Splits, the Royal Bank based R Split III Corp. (TSX: RBS) looks reasonably good - 7.8% discount to NAV and wrap-up scheduled for May 2012 which means that discount must be eliminated by then; decent dividend of 2.7%; and lots of leverage 2.5x though in this case the nearby wrap-up date means the stock price has to move up by then for the benefit to be gained. RBS is a play on short-term expectations.

Canadian Bank Share Alternatives Comparison

With bank stocks down along with the market these days, it takes fortitude to go ahead and invest. The investor must make the fundamental choice between the risk and possible reward of equity investment versus the stability of GICs and such. But for those who want to take the plunge, the alternatives are there.

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.

Summer Sale Event! 15% Off on Stocks

2011-08-11T12:28:00.001-04:00

Every shopper knows and likes sales. It is an opportunity to buy the same item for less. So it is in the stock market. The same companies are now selling for less. The market declines over the last few months and especially in the last few weeks have cut 15% off the TSX index price since year highs in early April as seen in this chart copied from Google Finance.

Storewide Sale - To continue our analogy, the decline has affected every sector from financials, through energy, mining, telecommunications, consumer staples and consumer discretionary. It has not been quite to the same degree everywhere, with energy being hit harder and telecomms less so. Nevertheless the effect is that there are companies selling at much-reduced and potentially attractive prices.

Featured Companies on Sale - To find where the biggest bargains might lie, we have searched through equities within the TSX Composite using the TMX Money.com Stock Screener. We will define a stock to be attractive when it is cheaper than the overall TSX market average and pays more in dividends as well. At close of market on August 9th, a rare day of an upward market (though we see from our chart above it has not made much of a dent in countering the cumulative decline) the TSX Composite Price/Earnings (P/E) ratio, our measure of "cheaper", was 16.89 and the average dividend yield, our measure of "pays more", was 2.76%. (These figures are updated every day on TMX Money's page here). Using Stock Screener, the stocks we selected meet these criteria:

P/E under 15 (this number is also the approximate long term average P/E for the TSX). These companies necessarily are profitable - in order for P/E to be a positive number, E must be above zero.
Dividend Yield between 3 and 10% (we set an upper limit of 10% to start weeding out companies which are paying out unrealistically high amounts and may be forced to reduce dividends, a result we don't want)

Our search uncovered over 100 stocks (TMX limits results to 100), many of them amongst the biggest and most solid companies in the country, starting with all the banks. There are also utilities, life insurers, energy companies, telecomms providers, real estate investment trusts, in short a smattering of all sectors. The table below takes only the 30 largest companies, which means all have a market cap over $2 billion and ranks them top to bottom by amount of price fall since their respective 52 week high. There are many big discounts on offer for high quality companies these days. Re-run the search to get the rest of the list, which of course will change somewhat as stock prices continue to gyrate.

All Sales are Final - If you buy any of these stocks, there is no money back guarantee. They could fall more in price or get into financial trouble and go out of business. There is a lot of talk of a possible coming recession and some companies may suffer. Shareholders of such companies will suffer too. That's why more than blind buying is required.

Make Sure It's a Real Bargain - Sometimes shoddy merchandise goes on sale. That's not a bargain. As additional indication of the checking to do on the safety and staying power of these apparent stock bargains, we used the Stock Screener to extract data that can help. If recession strikes or credit freezes up again, companies with low debt and strong cash flow are likely to escape better and perhaps even grow at the expense of weaker rivals. Our comparison table thus includes three extra indicators (from the Stock Screener's extra columns selector) - Net Profit Margin (the higher the better), Total Debt/Equity ratio (the lower the better) and Price / Cash Flow (the lower the better). Note that safe levels of these indicators can and should vary by sector - for instance utilities can sustain much higher levels of debt than other companies because of the stability of that business and profit margins will be lower due to control of rates by regulators.

To find out more about the companies and their financial indicators, a handy free tool is GlobeInvestor's My Watchlist. By entering the trading symbols, we can build the portfolio of our stocks and obtain other data such as debt to cash flow, dividend or profit growth, price to sales and many others, as well as links to news, quotes, charts, analyst recommendations.

Caveat emptor but happy stock shopping. Who knows how long the bargains will last.

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.

Investing Risk: The Harmful Effect of Rising Required Rate of Return

2011-08-09T08:20:00.001-04:00

In this last post of our series on the most important investment risks, we examine how much the required rates of return on investments varied in the past. It may seem odd to call the rate of return a risk since return is the reward for investors. The problem is that if required return rises, the price of the investment asset will fall. For example, in order for a bond that has a fixed interest coupon rate to provide a new higher return, the price of the bond must be lower so that the bond provides a capital gain in addition to the fixed interest received. The existing bondholder experiences a capital loss. Similarly, stocks with given earnings and dividends must fall in price to provide capital gains to reach the higher required return.

The Rise and Fall of Required Returns - Required returns do not stay constant. Through the years there has been much variation. In the chart below from Retail Investor, we see that yields of all maturities of fixed income have fallen steadily since the early 1980s. That trend continued through the mid 1990s to today, despite the fact that inflation has remained consistently in the Bank of Canada's 1-3% target range throughout. This illustrates the important point that required returns in the form of interest rates can vary independent of inflation.

What has come down once went up. From the 1930s to 1982, interest rates and yields followed a general upward trend, as illustrated by this chart of US Treasury Bill rates since 1920 from the Gold versus Paper blog. Within that trend however, there was significant variation through the decades.

To those who may think that the current ultra low interest rates are due to rise soon, this chart shows us that near-zero-rates persisted for about a decade during the 1930s.

Similar Canadian historical rates for Federal Government T-Bills and Long-Term bonds can be found at the Bank of Canada here.

Several lessons stand out for the investor:

rates have varied from virtually zero to over 20%
upward and downward trends have persisted for several decades
spikes and dips of 5% or more within a couple of years have often occurred within the longer term trend; those spikes will hurt!

The Current Situation of Required Returns

1) Bonds and Fixed Income - In the case of bonds or other fixed income investments like Treasury Bills and GICs, the current required return is easily visible. It is the current yield found on websites where current market fixed income quotes are available - such as GlobeInvestor, CanadianFixedIncome.ca, or any online broker. For example, the Canadian Federal Government bond maturing 1 June 2037 with a coupon rate of 5.0% yields only 3.31% as of August 2nd according to GlobeInvestor. T-Bills are now yielding around 0.9%.

Such rates are at historically low levels. The risk seems to be at its greatest as interest rates can seemingly only rise. The question is how soon; as history shows, that might be years away.

The Duration metric tells us how sensitive a fixed income investment is to a change in interest rate e.g. a duration of 5 means a bond price will fall by about 5% if interest rates rise 1%. Our example Federal Government 2037 bond has a duration of 15.79 according to the GlobeInvestor listing. A 2% rise in required return / yield would see its value drop almost a third. Thus, we can see that long term bonds are very exposed to severe capital losses from rising interest rates.

2) Equities / Stocks - It is not quite as easy to figure out what return investors currently require since the calculations incorporate assumptions about the evolution of company earnings, dividends and the economy. The proper more complicated method involves taking the current dividend yield and adding an estimate of the future dividend growth rate (see explanation on Tipster). A simpler first approximation is to turn the Price/Earnings (P/E) ratio upside down, i.e. E/P equals company profits over the stock price. As of close of market July 29th, the TSX Composite Index P/E stood at 18.46 according to TMX Money; thus E/P is 5.4%.

The historical range of market P/E ratios gives us a realistic idea of possible changes in required return and the corresponding implication for stock prices. According to the chart in Wikipedia entry on the P/E Ratio, the US S&P 500 Index has fallen to a P/E as low as 4.78 in 1920, or an E/P of 21%. If the all-time low were to happen again, it would mean prices falling a stupendous 78% from the current 21.64 S&P 500 P/E. The average P/E since 1880 is about 16.4. Markets have been going down lately but clearly they could credibly go much lower.

While a rise in required return causes stock prices to drop, companies that have pricing power and are able to raise earnings, thereby restoring the arithmetic that allows a higher price - as E(arnings) rises, so can P(rice) in our E/P formula. Thus the risk impact of rising required return may not be the same for all companies as some, utilities for example, may be more affected in the short term and take longer to recover due to regulatory controls on profits. Industry sectors may also go out of favour, with higher required returns being required to entice investment, which of course means their stock prices will fall. Or the opposite may happen, sectors become favourites - required return falls and stock prices rise.

It must be said again that the above maximum downward numbers look scary. But they are no means inevitable or imminent and the countermeasures outlined in the first blog post in this risk series should go a long way to reduce the negative effects.

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.

Investing Risk: The Ouch from Management Costs and Taxes

2011-07-27T16:14:00.001-04:00

Next in our rundown putting numbers to the magnitude of investing risks comes the combined effect of the management fees (MER), salaries, trading costs, administrative costs, commissions, trading spreads, price premiums over fund Net Asset Value and taxes. Unlike the more sudden and dramatic single events of most other risks, this type of risk mainly happens slowly and often obscurely but the cumulative effects can cause losses that are severe and permanent too.

Recurring Fees and Costs - Annual recurring charges can significantly damage the value of mutual fund, closed-end fund or ETF investments. Whether it be a fund's MER, trading costs or advisor wrap fees, seemingly modest annual costs of even 2% add up over time.

How bad can the effects be? The chart below from Bylo Selhi displays how much an investor is left with after deduction of annual fees. In order to isolate and reveal the fee effect, the chart is before investment returns, i.e. assuming 0% market returns. Market returns must overcome the constant drag of fees if the investor is to make any headway.

Are fees really as high as the worst numbers on the chart? Unfortunately, in many cases the answer is yes. A search in the Globe Investor Fund listing tool selecting funds where the MER, which is usually the main component of total annual costs, is 3% or more, brings up 2621 funds. Morningstar's report Global Fund Investor Experience 2011, linked to by Canadian Capitalist in his blog post Morningstar Grades Canada an F calculates that the median Canadian equity mutual fund charged 2.31%, while median fixed income fund expenses were 1.31% and money market funds were 0.8%. Note that the MER is charged against a fund's total assets, not against profits / returns, so it takes away a chunk of the investment whether or not the fund has made money.

Michael James on Money in MER Drag on Returns in Pictures took the actual returns of the S&P 500 over a 50 year investment period and calculated that a 2.5% annual expense ratio "decimated returns" leaving less than one third the end value of what it would have been with an expense ratio of 0.17% (an expense ratio available amongst the lowest cost index ETFs such as iShares S&P TSX 60 Index Fund, symbol: XIU).

Independent Investor's Cost of Investing (free registration required) shows other examples and studies of the negative impact of too-high fund fees.

Stocks and Salaries - A company's internal cost for management salaries is the individual stock counter-part to fund MER. Just as fund fees can vary, so can the salary burden of a company. It doesn't always follow, despite the oversight role of a company Board in controlling management, that the shareholder owner gets good value for salary. Some companies overpay and all the profit in effect ends up in management hands. At worst, management can bleed a company and leave the shareholder with a bankrupt worthless shell. That risk of loss is one reason for research into a company, including its management's behaviour, before investing.

Taxes - Fees are not the only thorny all-too-present recurring problem. Taxes can drastically reduce returns too. It is quite difficult to generalize about how dire the effects can be since taxes depend heavily on combinations of factors that vary considerably from one investor to another:

tax bracket of the investor
tax rates on interest, dividends and capital gains that vary according to the investor's tax bracket
the proportions of interest, dividends and capital gains created by the investment mix
account type holding the investment - tax-deferred, such as RRSP, LIF, LIRA etc; tax-free TFSA; annually taxable regular account

An example taken from the cited Morningstar report gives an idea of the impact: the effective taxes in Canada consumed 26% (vs only 20% in the USA) of a mutual fund's gains over a 5-year holding period for a couple with $100k income and a $100k initial portfolio composed of 40% fixed income and 60% equities in a taxable account.

Planning and deliberate structuring of investments is the primary way to achieve lower taxes. That can be quite involved and investors may be wise to turn to a professional tax advisor to do it effectively. Amongst those going it alone, a popular planning software is RRIFmetic, which shows how to optimize retirement income flows, factoring in taxes, from different types of accounts during retirement. The Finiki page on Tax-Efficient Investing contains a rundown of practical basic principles to follow.

Some may quibble that costs and taxes are not really a risk at all since there is no uncertainty about them - they always occur. We prefer to include them because, a) their negative effect is considerable and, b) there is great variability in their level. Fortunately, the investor can reduce this risk a lot through advance research by looking at published information on fees and costs and picking investments with lower costs. Costs are a much bigger risk for the unwary, the heedless and the careless.

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.

Investing Risk: Default or, How often do investments go belly up?

2011-07-19T12:07:00.002-04:00

Greece has been much in the news lately, scaring investors and governments around the world at the prospect that it will default on its debt. The fright is no surprise as default - not paying money back as promised - is perhaps the most serious and devastating risk an investor can face. But what are the facts? Often fear of the unknown is worse than the real threat itself. This week we therefore try to reduce the unknown and pose the question: what are the chances of default for bonds and stocks, and does default necessarily mean complete loss of funds or has there been some money recovered afterwards?

Bonds
Governments - Greece's predicament is not an isolated incident. Governments around the world have a habit of issuing more debt than they can pay back. University professors Carmen Reinhart and Kenneth Rogoff have looked at records going back hundreds of years. They tell us in Eight Hundred Years of Financial Folly, from which comes the chart below, that there are periods of high financial stress when 40% or more of countries are in default or restructuring their debt.

A Canadian investor mulling over such statistics is no doubt grateful that the most likely destination for their investments, the debt of the federal and various Canadian provincial governments, has not yet seen a default, though the provinces do not enjoy the very highest triple A / lowest likelihood of default rating enjoyed by the federal government. For those interested, a search of ratings agency DBRS for each province will reveal the ratings for each province.

Corporate Bonds - Periodic peaks of defaults also bedevil corporate bonds, especially amongst bonds rated speculative or below investment grade. The chart below from the Credit Suisse Global Investment Returns Yearbook 2011 shows spikes in default rates nearing 6% at times in recent decades.

Speculative grades of corporate bonds show highly variable default cycles. In some years, like 2005, there have been no defaults. In other years, like 1989 and 1990, defaults have spiked upwards to extreme levels - up to 50% default rates, as bond rater Moody's shows in Default and Recovery Rates of Canadian Corporate Bond Issuers 1989 - 2005. Investment grade bonds on the other hand, have been quite stable and have stayed at very low default rates. Of course, that can be deceiving. Buying only investment grade bonds does not necessarily ensure safety, as the rating agencies quickly change their ratings downwards as problems mount at companies so that by the time of default the bonds are no longer investment grade.

Recovery Rates - The same Moody's document mentions the significant fact that all is not automatically lost when a default occurs. Recovery rates vary by the bond's priority of claim. As one would expect, bonds with higher priority have higher recovery rates on average. Senior secured bondholders got 54% of their money back over the 1989 to 2005 period, while senior unsecured bondholders only managed to recover 36.5% (see Exhibit 9 for all the rates by categories). Moody's also states that US and Canadian recovery rates are roughly similar.

Equities - Stockholders are residual owners, having a claim to assets upon default only after all other claimholders have been satisfied. It is seldom that anything is left over for stockholders when a company goes bankrupt. What is more, life for the vast majority businesses is short, much shorter than that of humans. According to the Business Week article The Lifespan of a Company, the average Fortune 500 company only lasts 40 to 50 years. Moreover, the Fortune 500 consists of large successful corporations and thus represents more winners than losers. United Capital Funding's post Small Business Survival Rates in the United States, cites various US government sources that indicate only about a quarter of small businesses last even 15 years.

The situation in Canada is much the same. Though statistics and studies are hard to find, consider the following. In our comparison of the top 25 stocks in the TSX index between 1995 and 2009, we found that about half had disappeared. In the entire TSX index, only about a quarter of the companies from 1995 still appear in 2011. Not all were eliminated in spectacular bankruptcies like Air Canada, Nortel and Canwest that completely wiped out stock value, but a number did. When a company weakens over time and is eventually acquired by another, often the stock will have declined considerably to a tiny fraction of the peak value. This latter kind of "default" loss of capital takes place over months or years.

In short, default risk has been and continues to be a critical risk, requiring the investor's close attention and indicating a serious need for countering action.

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.

Investing Risk: How Badly did Inflation and Currency Hurt Past Returns?

2011-07-11T14:16:00.002-04:00

We have been dissecting the impact of various types of risk, seeing what historically has been the worst result for the Canadian investor, starting first with the list of all the main risks, the nature of their effect and counter-measures and then last week with the historical numbers on past market crashes. This week we factor in historical inflation and currency shifts to see what were the net combined worst effects.

Inflation
When Canadian inflation goes up unexpectedly, that is bad for an investor. Though rates have generally been quite stable within the Bank of Canada's target 1-3% range for the last 20 years, data back to the early 1950s shows periods of big jumps and high inflation, such as the chart below from Global-Rates.com. RetailInvestor.org has another chart going back to the 1870s in his discussion of inflation risk. It show huge swings between high inflation and deflation.

Rampant, totally out-of-control inflation can have the same effect as outright default. The chart below from the Credit Suisse Global Investment Returns Yearbook 2011 shows the devastating impact of hyper-inflation on bonds amongst major European countries of France, Italy, Germany and the UK during the 20th century.

Currency Swings
It wasn't just inflation that experienced large swings in the past. An investor in US securities would also have been affected by the shifting value of of the US dollar against the Canadian dollar. Investments in non-US foreign securities, which have become ever more popular and accessible through funds and ETFs in the last quarter century, would also have been strongly affected by the movement of the Canadian dollar against many foreign currencies.

The Oanda website, from which the chart below is copied, shows Historical Exchange rates for major foreign currencies going back to the early 1950s. Retail Investor.org has a chart on this page for the US vs Canadian dollar back to 1925. These charts show major shifts and upward /downward movements lasting decades, which might, at first glance, be thought to depress returns for the Canadian investor caught on the wrong side of the long term trends.

In a summary of the renowned book Triumph of the Optimists by the same authors as the Credit Suisse Yearbook, the CXO Advisory blog notes that once exchange rates and local country inflation are netted out the real equity return is what counted most and "local exchange rate fluctuations have not presented a significant disincentive to diversifying internationally in equities over the long term".

Including both Inflation and Currency, what were the worst returns for a Canadian investor?
The best available free online resource for seeing the combined effect of inflation and currency for the Canadian investor appears to be Stingy Investor's Asset Mixer. By filling in 100% allocations to each asset class in turn, it is possible to see how each fared over the maximum period of available data. Results are in real-after inflation Canadian dollars and assume no fund fees, which we will look at separately in a future post.

Canadian T-Bills

Worst drop 1971 -11.6%, recovery 11 years
Total down years 9 / 41 or 22%

This is quite a contrast with the finding in our previous post that T-Bills, in nominal terms, had never had a down year. Inflation can be a harsh risk. It undercuts T-Bills' oft-cited safety. T-Bills may be safe but they are still risky!

Canadian Bonds 1970 to 2010

Worst drop 1980 -10.9%, recovery 2 years
Total down years 5 / 41 years or 12%

Canadian Stocks TSX Composite 1970 to 2010

Worst drop 1973 -39.6%, recovery time 6 years
Total down years 13 / 41 or 32%

US Bonds 1971 to 2010 - corporate and government bonds together

Worst drop 2003 - 26.9%, still recovering; next worst 1972 -25.5% recovery time 12 years
Total down years 17 / 40 or42%

US Stocks S&P 500 1970 to 2010

Worst drop 2000 -49.7%, still recovering 11 years later, next worst 1973 -49.1%, recovery time 10 years
Total down years 13 / 41 or 32%

The 2008 drop only amounted to -23.5% in Canadian dollars. The S&P 500's enormous drop of -40.3% in US dollars was significantly cushioned by a simultaneously falling Canadian dollar as we discussed at the time in this post. However, the opposite happened in 2000. The 39.7% drop of the S&P 500 in US dollar terms was made much worse - down 49.7% per the above figure - by the currency movement at that time. Currency is a double-edged sword.

Developed World Stocks EAFE 1970 to 2010

Worst drop in 1973 -45.8%, recovery time 5 years, next worst 2000 -42.1%, still recovering
Total down years 14 / 41 or 34%

Emerging Market Stocks 1988 to 2010

Worst drop in 2008 -43.1%, still recovering, next worst 2000 -35.6%, recovery time 5 years
Total down years 8 / 23 years or 35%

Currency has accentuated the downward extremes of foreign stocks for the Canadian investor. The good news is that it exaggerated the upside too. We previously showed how this has worked within a portfolio combining multiple asset classes in Historical Effect of Currency and Inflation.

Bottom Line: Currency and inflation contribute to return downside over periods of up to a decade. The investor must be able to exercise patience.

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.

Investing Risk: Historical Worst Volatility, Business Cycles, Crashes and Crises

2011-07-04T22:10:00.003-04:00

Last week, we explained how the various investing risks come about but only gave a general idea of their extent and magnitude. It's time to rectify that by attaching some numbers to the risks. History will be our guide. We'll cover the risks in several posts. This first post will deal with downward market moves.

Rather than try to split hairs about what distinguishes short-term volatility from business cycle moves, crashes or crises we have lumped all these market events together. The important thing to know is: how far down can down be and how long does it take to recover losses?

Stocks
S&P 500 USA 1928 to 2010 in US dollars, i.e. not converted into the Canadian dollars that a Canadian investor would experience

Worst one-year drop: -43.8% (1931) then -36.6% (2008)
Max peak to bottom drop (drawdown): -79% real/inflation-adjusted (1929-32) shown as blue area in the chart below; Recovery period to 1929 peak - 1945 / 16 years
Tech Bubble Crash: -52% real drawdown 2000 to 2002, Recovery not complete
Financial Crisis: -48% real drawdown 2007 to 2009, Recovery not complete

TSX Composite Canada 1958 to 2010 -

Worst one-year drop: -33.0% (2008), then -25.9% (1974)
Worst drawdown real/inflation-adjusted: -39.6% (1973-4), Recovery period 6 years
Total down years nominal dollars (1958 to 2010): 14 years / 26%
Total down years real/inflation-adjusted (1970 to 2010): 13 years / 32%

T-Bills -
Worst year USA (1928 to 2010): 0.03% return (1940)
Worst year Canada (1970 to 2010): 0.5% return (both 2009 and 2010)

Treasury Long Term Bonds -
Worst one-year drop USA (1928 to 2010): -11.1% (2009)
Worst one-year drop Canada (1970 to 2010): -7.4% (1994)
Maximum real drawdown USA (1900 to 2010): -67% (1940 to 1981) shown as red area in the chart above, Recovery period to 1991 - 51 years!
Maximum real drawdown Canada (1970 to 2010): -37.9% (1973), Recovery period 12 years

Some of the above numbers look quite scary indeed, especially the effect of drawdowns and extended recovery periods. One might be tempted to invest only in Treasury Bills. They are low risk in terms of annual nominal returns ... but there is also inflation to consider, which creates losses in real value in many years. Inflation is another risk we will quantify in a another future post.

It's also good to remember that the above are the worst historical results. Averages over extended periods of years are positive and many years or periods offer large upward moves.

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.

Sources:
USA Returns: Aswath Damodaran, Professor of Finance, NY University, Historical Returns on Stocks, Bonds and Bills - United States
USA Drawdowns: Credit Suisse Global Investment Returns Yearbook 2011, compiled by Elroy Dimson, Paul Marsh and Mike Staunton
Canada Returns: Libra Investment Management, Spreadsheet of Annual Returns
Canada Drawdowns: Stingy Investor, Asset Mixer

Investing Risk: What is there to lose?

2011-06-27T14:12:00.001-04:00

For most investors, risk means the chance of loss of part or all of their investment. In some imaginary world, we could all become rich with no risk in our investments. But, as the expression goes, "no risk, no reward". In order to reach future goals, whether it be retirement, education, a house, most people need to do more than merely save. They need to have their savings grow through investment. The ability to understand and control investing risk, taking appropriate risks in the context of those goals and one's personal circumstances, is essential for investing success. To that end, we break down investing risk into its main components and explore ways to counter each one by interpreting our deliberately ambiguous title What is there to lose? in three ways.

1) What do I have to lose?
The significance of risk depends in part on the impact on the investor. Circumstances unique to the investor heavily affect the decision on how to deal with the risks - to accept, mitigate or transfer the risk to someone else (for a price, of course).

Time Horizon - How long before you will, or might, need the money strongly influences whether certain types of investment and their inherent risk characteristics are acceptable at all, and what counter-measures make sense. Many people will have multiple time horizons, for example, retirement and a house or a legacy. Retirement itself will involve spending year by year, from the immediate to the, hopefully(!), far distant. Some of the external risks we discuss below can effectively be dealt with if a person has a long term horizon and can simply ride out what may be very severe but passing non-permanent losses.
Wealth - The richer you are, the more you can afford to take some losses or wait out short-term market volatility. A $10,000 or even a 10%, loss for a multi-millionaire hurts him/her a lot less than the same loss for an average wage earner.

2) How can various types of investments lose?
Bad things can happen in the financial world. Some happen steadily and predictably every year, others suddenly and violently. Some are quite visible, others much less so. Some cause irreparable damage, others only temporarily. Some are unavoidable, others resulting from investor panic reaction.

Volatility - Daily, weekly and monthly price movements downwards can look worrisome on account statements e.g. as we write, the TSX is in a "correction" - down more than 10% from the previous high. Most people do not panic and sell in reaction to such a decline, but doing so will lock in losses if they end up buying back in at higher level once the correction ends. As David Parkinson tells us in Correction: Signs of doom have been greatly exaggerated in the Globe and Mail, corrections happen more years than not and the recovery is normally quick. Counter-measures: Short-term - buy put options on your holdings, which perfectly counter-balances any decline, but why bother if you can simply do the following. Long-term - continue to hold. Diversification - holding many types of asset classes in a portfolio will dampen swings. The S&P 500 index is down much less than the TSX and bonds are up so a portfolio with all three would not be down much.
Default / No Repayment - The chance that you may not get your money back despite explicit promises to do so by companies and governments applies mainly to fixed income investments. Such promises are only as good as the organization making them and times can change. If the promising organization runs into financial trouble, it may not be able or willing to repay all or part of the principal. Some people think US Treasury Bonds are not as safe as they have been up to now. Twenty years ago, the Canadian government's ability to pay prompted derisory descriptions of it as the northern peso but now Canada's finances are among the strongest in the world. In the case of common equity, there is not even a promise to repay, only residual rights to whatever is left after all other claims have been paid off (mainly bondholders, taxes, employees). Sometimes governments simply expropriate companies for political motives and do not offer fair compensation. Counter-measures: Diversification - multiple holdings in a particular asset class spreads the risk and lessens the impact of any one holding going bad. ETFs and mutual funds offer this quality to investors. Bond ladders can help somewhat but it takes a sizable portfolio with many holdings to reduce the impact of any single holding enough. Due diligence - Credit rating agencies publish their opinion on the likelihood of fixed income corporate and government securities being able to meet their promises as we discussed in Seeking Safety. Credit raters do get things wrong. For individual securities, the investor would be advised to develop skills in reading financial statements and keep abreast of developments in the subject organization to get his/her own idea of evolving safety.
Business Cycles - Economies and business go through constant though irregular cycles of expansion and booming times followed by recessions and retrenchment. Investments respond and follow suit, or more exactly, anticipate such cycles, which can stay for several years in upward or downward movement. Counter-measures: Diversification - Holdings across different sectors and countries even out and dampen the effects since business cycles are not in perfect sync or severity across such boundaries. Continue to hold - As with shorter term volatility, stay invested and the drop will be recovered, especially when one holds broad-based passive funds that more or less cover the whole market. Trying to time the cycles - selling before the drop to buy in again at the bottom - is so difficult, most professionals don't try it as the consensus is that you cannot win consistently.
Asset Crashes and Financial Crises - These are severe negative events for investors. They frighten by their speed and sudden onset and depress by their duration, whose after-effects can extend to a decade or more. In the case of the 2008 financial crisis, we are still living with the consequences three years later. The systemic and structural defects await to be fixed and government debt loads from bailouts or the property crash remain extremely high or are climbing to unsustainable levels. As we saw when we reviewed the situation in Tech Stocks Revisited, tech stocks still had not recovered as a whole ten years after the Internet mania. Contrary to what some hope or mistakenly believe, such crashes are not once-in-a-hundred-years occurrences - more like every ten years since the 1970s. Counter-measures: Diversification - That includes holding a certain amount of cash and the safest government T-bills available, which these days for a Canadian means those issued by the federal government. See our post The 2008 Crash - Case Study in Diversification on what worked during the most recent episode of an extreme market downturn. Though the cash and short-term government debt should always be in a portfolio, the next crash will no doubt be somewhat different such that another asset mix will hold up better than what worked in the past. Thus, holding a variety of asset classes adds protection. Rebalance - When there are drastic drops in some or many asset classes, the ultra-safe ones will hold their value as the 2008 experience demonstrates. That is the time to re-establish the portfolio proportions according to the intended asset allocation.
Unexpected Inflation - The current expected medium to long term inflation of around 2%, which is the Bank of Canada's explicit target rate for the country, is already incorporated into rates. If inflation were to jump upwards to 5%, whether due to sustained increases in commodity prices, as currently seems to be the main source of such concerns, or something else, the value of fixed income holdings in particular would fall drastically. Equities would too, at least for a time while companies adjusted their pricing to recover lost profits. Counter-measures: Real Return Bonds - These federal government bonds (and some provinces offer them too) continuously ratchet up the interest paid and the principal value in line with CPI. No need to guess about future CPI, though they will pay a bit less as a result. Equities - Though they suffer in the short term, the ability of companies to increase prices to maintain profit margins means they will cope with unexpected inflation in the longer term.
Fees & Agent Costs - The management fees charged by mutual funds or ETFs and the salaries/bonuses paid to company management & employees reduce the returns going to the investor. The risk is that such costs will be excessive - that the profits go to these agents instead of the investor. Fees are too often hidden or difficult to see. A 2% annual fee seems small, which is the reason most investors don't get alarmed. But such seemingly small annual fees can add up significantly over the years as Independent Investor shows. The effect after 20 years can reduce a portfolio's value as much as the most severe market crash. It is just in slow motion not fast. Counter-measures: Shop-around for low fees - There are low cost funds around and efficient companies. Do some research. This blog attempts to contribute to this process by taking fees into account when assessing ETFs or other investments. The playing field is not level so it can really pay off to take steps to keep fees low. Very few high fee funds outperform and justify their high fees. High fees mean a high risk of significant portfolio loss for the long term investor.
Required Return - The return expected or demanded by investors as a whole, i.e. the market, varies up or down. The same company's shares or bonds with the same continuing business outlook may be valued less and fall if the market demands a higher return. This may happen independently of both inflation and official Bank of Canada interest rates. The cause may be higher risk aversion or risk perception but the effect is that prices drop. RetailInvestor.org explains this factor, which he calls Interest Rate Risk, in detail. Counter-measures: Floating rate debt, Rate reset preferred shares - These securities include automatic or investor-choice adjustment to higher rates as market rates change. Short-term debt - The frequent rolling over of such debt allows the investments to be reinvested at higher rates as they change, though that also means the possibility of going down too and the rates will be lower than longer term options. Equities with pricing power - When required returns go up, companies with pricing power can increase prices to offset their rising financing costs and boost returns.
Foreign Currency Shifts - When the Canadian dollar (CAD) is rising against the US dollar or other currencies, the net return on foreign investments after translation back into Canadian dollars is reduced. A strong CAD may even turn a foreign profit into a loss. Counter-measures: Hedge - Many ETFs and mutual funds invested in foreign securities takes measures to eliminate the effect of currency movements. Recently, we took a close look at two such ETFs that track the US S&P 500 Index. Retail Investor's How to Hedge Foreign Currency describes several other methods an investor with the time and interest can use to do so him/herself. We discussed the pros and cons of hedging in To Hedge or Not to Hedge.

3) Why should I bother worrying about it?
The carefree and careless attitude typified by this last form of the question is a sure-fire way to turn the above uncertain risks into certain losses. One cannot be fatalistic. Counter-measures: Plan and review - Set up a portfolio and an investment plan adapted to life goals, as we wrote about in the very first posts of this blog here, here and here. Follow that with a regular but not too-frequent review (otherwise it becomes obsessive and creates un-necessary worry in the day-to-day noise), such as we discussed in Annual Investment Review. The philosophy to adopt is to seek continual improvement. Scenarios and Too-small-to-fail - Taking a look at market history gives an idea of the possible extreme downside results that various asset classes and securities might produce. Consideration of the impact of the ultimate downside where an investment is wiped out helps inject a proper degree of caution. No single investment should be large enough to cause catastrophe for the investor.

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.

Dual Class Shares - Are they Ok or to be Avoided?

2011-06-21T04:06:00.001-04:00

One person, one vote is a fundamental principle of democracy. Presumably it should also apply in stocks as one share, one vote. After all, if one takes the risk of owning common stock, it is only right that there should be an equal say in the affairs of a company. Yet that is not the case amongst many companies listed on the Toronto stock exchange which have two classes of common stock, one with lesser or no voting rights and the other with multiple or all voting rights. As of February 2011, there were 83 such companies, or about 6% of TSX listings, according to papers posted on the website of the University of Toronto's Capital Markets Institute. Very often the reason invoked to create dual shares is to allow continued founder control over a company to keep it growing and to maintain a long-term outlook while injecting new equity capital instead of debt financing.

Dual Class - Not Automatically Bad!
It is not necessary for the individual investor to automatically bypass such shares. The most recent substantial - and impartial - research on the subject by Ben Amoako-Adu, Brian F. Smith, Vishaal Baulkaran of Wilfrid Laurier University (paper available here from the CMI) notes that "Investors in dual class companies do not earn a lower risk-adjusted return than those in single class companies with concentrated ownership". Their recommendation upon studying thirty-two companies that unified (eliminated) dual class shares in Canada from 1989 to 2010 is that they nevertheless serve a useful role: "Dual class shares should continue to be issued to finance growth without the fear of losing control until the firm is matured".

Caveats - The Devil in the Details
Dual class share structures are not always good however, and the researchers' additional recommendations tell us key features to watch out for since, unsurprisingly, rights and privileges of the "lower class" shares can and do vary considerably, as we show below.

Coattail protection - These rights allow holders of non‑voting or restricted-voting shares to participate equally with the holders of the superior‑voting shares in a formal company takeover bid for superior-voting shares i.e they get the same deal. The TSX made this condition a requirement for new listings as of 1987 but older companies got a grandfather clause exemption. Some of the exempt companies are Rogers Communications Inc., Astral Media Inc. and Shaw Communications Inc.
Maximum 10:1 Voting Ratio - The superior shares should not have more than 10 times the vote per share of each subordinate share.
No Non-voting Shares - Each share should have some voting rights, though limited.
Sunset Clause Upon Founder Retirement - Since dual class shares often come about in companies with a founder-owner, it is a good idea to set an end to the dual class shares at a time when the structure should no longer be useful or necessary for company progress. Moreover, the terms and conditions for special compensation of the founder should be written down. This condition might be called the Frank Stronach test for the outrageously high payout ($983 million or 2063% return according to the authors) the Magna founder and controlling shareholder extracted from the company upon its conversion to a single common share class in 2010.

Conversion Bonus - Speculative Opportunity
Researchers have also found that amongst the actual conversions from dual class structure to single common class, subordinate shareholders benefited by an average 8% increase in stock price upon conversion. Ironically, "... the worse the job that the controller does, the greater the buyout premium!" according to Prof. Jeffrey MacIntosh of the University of Toronto in this presentation. Those who wish to engage in stock speculation can buy shares in badly run companies in anticipation of a conversion to single class since elimination of the dual classes will cause improved management and higher profits.

Example: Dual Class Shares Amongst Dividend Growers
We came across a number of dual shares in our recent postings on stocks with the attractive feature of growing dividends - the Low-Yielders and the High-Yielders. That gives us ten companies to compare in terms of the voting privileges, controlling shareholder, rights of subordinate shareholders, governance rating (from the Clarkson Centre for Business Ethics and Corporate Governance), 5-year dividend growth and 5-year total stock appreciation and dividend return. As a rough benchmark for returns, we include the performance of the popular iShares S&P TSX60 ETF (symbol: XIU).

Observations:

Best Returns Have Worst Protection - Rogers and Shaw look to have the most ominous rights for the subordinate shareholders yet the returns for both are the best in our table and exceed XIU's by a good margin. Go figure.
Best Rights Have Excellent Returns - Metro has the best minority rights, in fact the subordinate MRU.A shareholders, control almost all the votes. Metro also exhibits excellent performance, beating XIU in both dividend growth and total returns.
Occasional Extra Dividends for Subordinate Status - Some companies - CCL, Corus, Shaw and ShawCor - offer more dividends to subordinate shares than to the controlling shares.
Take Your Pick of Voting or Non-Voting - Many of the companies have both classes of shares available for public purchase on the TSX, though the dominant / multiple voting shares trade in much smaller volumes. What is not feasible for institutions who need high volume liquidity may be accessible and possible for an individual.

Finding Info on Dual Class Shares

Companies - There seems to be no ready-made source list of the afore-mentioned 83 dual share companies in Canada. Such shares can however be identified by a suffix - .A or .B or .X - attached to a ticker symbol. There is no convention for whether the subordinate shares should have .A or .B. As we saw in the sample stocks, it is easy to find both.
Share Structure and Rights - To find out the rights for each class of shares, go to Sedar Search Database and pull up the Annual Information Form for the company, then within it go to the part on Share Capital Structure.

Bottom Line
The biggest lesson is that subordinate rights vary a lot from company to company. When considering a company's shares, along with the prospects and position of the business itself, proper due diligence must consider the share structure and the rights of each class.

Further Reading:

Primer - Dual-Class Share Structures and Best Practice in Corporate Governance by Tara Gry from the Canadian Library of Parliament
Pros and Cons - Dual Class Shares - Not the Enemy by lawyer Barry J. Reiter

S&P 500 Currency Hedged ETFs - How Well do They Work and Which is the Best?

2011-06-14T18:27:00.002-04:00

The ordinary investor's goal for including an ETF that hedges currency while investing in an S&P 500 index tracker is to gain exposure to diversification and the returns of the US equity market while removing the possible damaging effects of a climbing Canadian dollar. There are such two ETFs available in Canada, both traded in Canadian dollars on the TSX:

iShares S&P 500 Index Fund (CAD-Hedged) (symbol: XSP) - the giant leader, launched in May 2001, with $1505 million in assets
Horizons S&P 500 Index (C$ Hedged) ETF (HXS) - only $21 million in assets, just launched in November 2010

The inner workings have some similarities and some marked differences, some good and some bad for the investor and some surprising characteristics that reduce their effectiveness exactly at the wrong time while enhancing returns at other times. Our chart below provides details of these key points.

MER, including the new in 2010 HST - each fund has a management fee, HXS' a bit lower than XSP's, but that is just the beginning as MER is a minor drag on returns compared to other factors

Swap Fee - 0.30% for HXS only, none for XSP. HXS obtains the returns of the S&P 500 through an agreement with the National Bank in which the Bank swaps the return of the S&P 500 index in exchange for the swap fee and interest on cash held by HXS. Canadian Capitalist described this ingenious method of tracking an index, much practiced in Europe, in this post.

Residual Currency Effect - Here is the first zinger. The constant movement of both currencies and the stock market means that it is impossible to hedge perfectly at every moment. Find out how and why in An Imperfect Hedge: The Limitations of Currency Hedging by Philip Falls and Dino Bourdos in the April 2010 Pension & Benefits Monitor and Currency Hedged S&P 500 Funds: The Unsuspected Challenges by Raymond Kerzérho of PWL Capital. The bottom line is that hedging works least well precisely when investors want it most - at periods of extreme stock and currency volatility, such as during the 2008 and 2009 financial crisis. The crisis period gave the worst tracking results vs the benchmark index. There is some debate whether the right benchmark is the native US dollar percentage returns of the S&P 500, which is the simple objective of an ordinary investor, or the percentage returns of the hedged S&P 500 index, which both iShares and Horizons insist is the right way to track. Using either index the results are bad, it just looks far worse when the Canadian investor's hedged percentage returns in CAD are compared to the "native" S&P 500 percentage US dollar results such as a US investor would have obtained - see Canadian Capitalist here for some of the ugly numbers. Ironically, when both the USD and the S&P 500 are dropping simultaneously, the hedged tracks the native results very closely! Big sudden moves in opposite directions are what hurt most. At present the environment looks quite tame and both HXS and XSP in the last six months (see table below) have been only 0.1 - 0.25% below both the S&P 500 hedged index and the native index.

US Withholding Tax - XSP owns US shares through its holding of the US iShares S&P 500 ETF (IVV) and the US government deducts the standard 15% withholding tax on distributions. In a registered account (see our dissection of this issue here) XSP shareholders cannot get this amount back, neither as a tax credit, nor by preventing it being deducted. At the current S&P 500 dividend yield of 1.73% that means there is a 0.26% return reduction on XSP in registered accounts compared to HXS, which receives no distributions per se (they are implicitly included in the swap return) and certainly not from the US, only from the National Bank (whether the Bank suffers the 15% tax has no effect on HXS shareholders since the swap provides HXS the index return, which calculates no deduction for tax). In taxable accounts HXS and XSP are equal. HXS has not paid any tax while XSP shareholders can deduct it as a credit against other taxes.

Canadian Income Tax - Here is another big return-reducing area, with significant potential advantages of HXS over XSP in taxable accounts. In registered accounts, neither has a problem since there is no tax levied against any type of gains or income, as is usual.

In taxable accounts, HXS' swap structure means that all returns, both price advances of the S&P and its dividends, a) become capital gains and b) become realized and taxable only when the investor finally sells the HXS shares. In contrast, XSP receives dividends and makes distributions every year, which are a) taxable each year upon receipt and b) taxed at the same rate as ordinary income, which is double the capital gains rate. There is a significant net return reduction to both funds but it is up to double or more for XSP compared to HXS. Our comparison table shows that the advantage of HXS is more pronounced when the S&P 500 dividend yield is higher, the gains are deferred longer and the taxpayer is in a higher tax bracket.

Interest Rate Spread - The use of forward contracts by both funds to implement the hedging creates a net benefit, or cost, to the fund as a result of differences in short term interest rates between Canada (as represented by something called CDOR) and the USA (LIBOR). At the moment, Canadian rates are about 1% higher than US rates, which means HXS and XSP are making money from the forward contracts themselves. That extra return, especially with the difference being quite high right now, could cause the funds to outperform the index! While it lasts, it will at least drastically reduce the historical under-performance of hedge funds noted above.

Of course, in taxable accounts, the extra income gets taxed. In 2010, XSP shareholders had to pay taxes on substantial capital gains generated by forward hedging contracts. HXS will not have this negative since the National Bank does the hedging and although the hedging profit accrues to the fund through returns of the hedged index, the gain is not distributed annually to HXS shareholders and there is not tax to pay immediately. The HXS website and Prospectus has announced the intention not to make any distributions at all.

Investor's Trading Costs - There are several other factors that an investor faces when buying and selling ETF shares which can either boost or reduce returns:

Bid-Ask Price Spread - Pull up a quote from a website such as TMX.com and it will show the lowest price at which someone is willing to sell - the Ask price - and the highest price someone at that moment is offering to buy - the Bid price. The lowest possible spread between the two is the best - one cent. A big spread represents a cost to the investor. XSP comes out much better than HXS with a much smaller spread on average. The end of trading bid-ask quote on June 10th is significant not so much for the positive or negative sign, since that can and does switch back and forth between positive and negative regularly for each fund. It is more the size of the spread that matters. XSP should almost always have a much smaller spread and that is a benefit to the investor. Its asset size and trading volume ensure a more efficient market than for HXS. It is hard to quantify the impact of the higher spread since it will depend on how much trading an investor does (more trades = more cost) and holding period (longer = less cost because the cost is averaged over more years).
Price vs Net Asset Value (NAV) Premium or Discount - The ETF size and trading volume also drives this return/cost factor. The market price of XSP or HXS may deviate from the actual fair value of the stocks within the S&P 500 index. It may be higher, which is called trading at a Premium. In this case, the investor who buys at the market price pays more than the stock is worth. Or it may be lower, at a Discount, which means paying less than it is worth. Horizons publishes HXS' updated (every 15 seconds) Intra-day NAV here such that one can compare it with market price in a real-time quote from a broker website (as opposed to the 15-20 minute delayed quotes in TMX, Yahoo Finance, GlobeInvestor and other free public sites), but unfortunately iShares does not publish this data for its ETFs. There are constant fluctuations of price above and below NAV as arbitrage by market players keeps the Premium or Discount down but it will be a lot closer on average for higher volume XSP than for HXS. The lower the deviation, the better for investors so XSP is much better on this factor.
Dividend Reinvestment Commission - Since HXS incorporates implicit automatic dividend reinvestment as a result of the swap for the total return of the S&P 500 (capital gains plus dividends), it has zero cost for this operation. The XSP investor must remember to reinvest the cash dividends received twice a year, as well as pay the broker commission. HXS is thus superior to XSP on this cost factor.

Risk Factors of HXS - The structure of HXS based on swap derivatives presents several special risks unique to HXS that XSP does not have.

Counterparty risk - Up to 10% of the value of the positive returns of the S&P 500 could be lost to XSP shareholders in the event of default of the National Bank. It is the returns only, not the principal value of HXS, that is possibly at risk, and only up to 10% of returns, since the Bank must provide collateral beyond that amount, and it is only positive returns, since in the event of losses, it is HXS that must pay the Bank money (the swap tracks the gains and the losses of the S&P 500). How serious a risk this factor represents is a matter of judgment, since the National Bank would have to fail at a time when the market is going up. During the financial crisis, when many banks did fail, the market was going down a lot, not up.
Swap expiry risk - If Horizons decided to terminate HXS and thus the swap, the embedded capital gains would be realized involuntarily by shareholders. Assuming the market goes up over the long term, that would create a sudden potential tax hit for HXS holdings in taxable accounts. The current swap with National Bank is due to expire in 2015 but Horizons says it intends to renew and roll it over indefinitely so that the tax hit does come about, but the possibility exists. In this blogger's opinion, the small current asset size of HXS makes this risk a concern at the moment.

Bottom Line

XSP and HXS both will be much more efficient hedging tools and will track the S&P 500 percentage returns much more closely (within 0.3% per year) as long as lower market and currency volatility and higher Canadian vs US interest rates continue.
HXS has appreciable cost advantages over XSP for holdings in registered accounts and especially for holdings in taxable accounts of high marginal rate investors. However,
HXS has some extra risk over XSP which counterbalances to some degree the return advantage.

Additional Reading:

Canadian Capitalist reviews recent actual Performance of Currency-Neutral S&P 500 Index Funds and debates Why Currency Hedging is Necessary
Canadian Couch Potato's Understanding Swap-Based ETFs and Swap-Based ETFs: What are the Risks?
Dan Hallett of the Wealth Steward discusses the swap structure risks in A Closer Look at BetaPro's Dirt Cheap ETF

Canadian Market Darlings & Dogs Update - Looking for Over- and Under-Priced Stocks

2011-06-07T09:40:00.001-04:00

A little over a year ago, we wrote about the market darlings and dogs of the day, the stocks whose market prices implied either optimism or pessimism by the mass of investors. Let's see what has happened since and identify stocks that might be the victim of undue pessimism at the moment and therefore possibly under-valued, or the opposite, the beneficiaries of undue favour.

As before, we compare two large-cap Canadian equity ETFs with similar holdings but different weighting schemes to identify where the market is either pricing above (optimism aka Darlings) or below (pessimism aka Dogs) actual historical results - iShares' S&P TSX 60 Index Fund (symbol: XIU), which is the price-weighted ETF, and Claymore's Canadian Fundamental Index (CRQ), the historical fundamental accounting data-based ETF. The table below shows the companies and the sectors colour-coded - Darlings in Green and the Dogs in Red with the really big differences between XIU and CRQ highlighted in Yellow. The table also shows the change in internal weighting over the past year for each ETF, which tells us stocks and sectors that have been on the up- or down-swing, either in terms of price (XIU) or fundamentals (CRQ).

Financials - Dogs

As a sector, Financials were Dogs a year ago and are even more so today with a dropping share of both funds, though the pessimism of the market with a faster drop in market cap has outstripped what is justified on the basis of CRQ's adjustments due to fundamentals
Bank of Montreal (BMO), Manulife (MFC), CIBC (CM) and Sun Life (SLF) are all going in the same downward direction in both CRQ and XIU, indicating that actual trailing results in CRQ back up the direction of the market's forward looking price opinion as seen in XIU. However, is the market pessimism overdone as the drop in XIU much exceeds that in CRQ?
Royal Bank (RY) on the other hand may be the victim of unwarranted market pessimism as it is going in the opposite directions in CRQ and XIU, rising in CRQ while dropping in XIU. Royal has just raised its dividend for the first time in years but its stock has dropped fairly significantly in the last few weeks and analysts have it rated as 'Hold'. Why?

Energy - Darlings

The sector was a Darling a year ago, is still a Darling today and is growing even more so
Some validation comes from the increasing proportion of CRQ for such companies due to elements like rising sales and profits but the optimism in prices outstrips the reality confirmed so far
One unusual contrary company is EnCana (ECA). It suffers from pessimism in the market - a much lower place in XIU last year that has got worse while its place in CRQ due to better fundamentals has gone up. What does the market know that the accounting results do not show is the critical question.

Telecomms - Darlings

The sector was a Darling last year and is getting more price affection from the market, contrary to the direction in CRQ
BCE Inc (BCE) and Telus (T) are the main beneficiaries of this positive market opinion. Again, why so?

Consumer Staples and Consumer Discretionary - Dogs

They were Dogs a year ago and are Dogs today. Some of the imbalance is due to XIU not including companies like Empire Company (EMP.A) and Alimentation Couche-Tard (ATD.B). There is not much change on the price side but the decline of this sector within CRQ indicates that the market opinion is being proven right by results.

Information Technology - from Darlings to Dogs

From Darling sector of last year, it is now a slight Dog, XIU having dropped its seemingly undue optimism to the level of reality in CRQ.
Research in Motion (RIM) is the explanation, its fall from lofty heights being widely observed.

Utilities - Dogs

Dog status is little changed. The market / XIU seems to have little respect for the well-mannered Dogs of this sector as companies that are substantial in accounting terms do not achieve the market cap to be included in XIU but gain entry to CRQ. The list of absentees from XIU includes Canadian Utilities (CU), Emera (EMA) and Atco (ACO.X), the first two of which looked rather attractive in our recent review Electric Power Utility Stocks for the Income Investor?

Are the Darlings worthy of our love and the Dogs of our scorn? The above cursory review suggests a mix of yes and no answers. One can never be absolutely sure and certainly more looking into the circumstances and prospects of the companies would be necessary but our comparison offers a starting point for further investigation and potential investment action. To be really sure of the answers, we would need to wait a year, or two, or ten, but then any opportunities to make a profitable investment would be gone too!

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.

Disclosure: the blogger owns shares of RY and CRQ.

Stocks & Board Governance - Do the Good Guys Finish First or Last?

2011-05-31T10:02:00.002-04:00

Many investors take a keen interest in the ethics and business practices of the companies in which they invest. Leading institutional investors think that taking into consideration so-called Environmental, Social and Governance factors and even active involvement with companies to further such goals can enhance long-term investment returns. For example, the Canada Pension Plan Investment Board's pursuit of Responsible Investing evidently takes up much time and effort because it believes that "... responsible behaviour regarding environmental, social and governance factors by these companies can have a positive influence on their long-term financial performance and therefore, to our investment return". Internationally, many major pension funds subscribe to the United Nations Principles on Responsible Investing, as is evident in the reports on the PRI website.

All investors object to being taken unfair advantage of by crooked or avaricious company insiders. To prevent that happening, shareholders rely upon a company's Board of Directors, in other words the Governance part of ESG. In Canada, the Clarkson Centre for Business Ethics and Board Effectiveness within the Rotman School of Management at the University of Toronto publishes annual ratings for Board Shareholder Confidence that assess various aspects of Board best practice and give an indication of how likely it is that a company Board will serve shareholder interests well. There are two sets of ratings: 1) Companies in the TSX Composite Index for 2003 to 2010; 2) Small and Medium companies for 2009 and 2010.

The big question is how well do the rankings correspond to investment results? Does governance best practice earn the best returns, or at least good returns? To get an idea, we've compiled a few tables below. Note that it is by no means a definitive scientific answer. A Board that is good today may not have been so five years ago; future results are really what we would need to compare, while we compare with past investment performance. Our unproven assumption is that the best Boards today would generally have been better in past years too as improvement happens gradually.

Investment Performance of Top-Rated 2010 Boards - Mixed Results
Taking all 19 companies in the top two ratings CCBE governance categories of AAA and AA shows us that excellent ratings have not guaranteed success. Four top-rated companies have not even managed a positive total return over the past five years. Manulife (symbol: MFC) has had particular trouble. On the other hand, eight companies of the companies on the list have regularly and steadily increased their dividend payouts, as further detailed below. Almost are solidly profitable and the worst rating by professional analysts is Hold, no Sells at all.

Investment Results of TSX Companies vs Board Ratings Overall - Advantage to the Good Guys
When the latest ratings came out in the autumn, the Globe and Mail's Report on Business published Board Games 2010, a series of articles on the ratings which are well worth reading. The material published includes a different version of the TSX table that includes 5-year returns for each company. Filtering through the list, we find that amongst the top 25 scoring companies, 16%, or four, had negative 5-year returns. However, in the entire list of 187 companies, a greater proportion - 26% or forty-eight companies - had negative returns. The well-governed-Board stocks have done better overall.

Dividend Growers & Board Governance - No Discernible Effect
Since we recently reviewed stocks that have been steadily increasing their dividends - here for low-yielders and here for high-yielders - we decided to look at them too. We added the CCBE rating against this select group of potentially attractive stocks to see if they all have high Board ratings. Result: not so at all, as there are just as many dividend growers with the terrible lowest "C" Board rating as with the high AA and AAA ratings. Nevertheless, all the companies with high rated Boards showed quite healthy five-year returns and none had negative returns while none of the losing negative return stocks had high ratings.

Bottom Line
Good governance seems to have had a mild positive effect so far on stock returns but it is not a guarantee of success. It is a useful addition to the mix of factors for a stock investor to assess. Perhaps its best role is to provide a measure of risk to investors on the chances that bad things may or may not come from within the company, either from management or dominating majority shareholders, at the expense of the average individual investor.

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.

Cross-Border ETFs - Here's a Free Tool to Compare Costs

2011-05-24T04:23:00.001-04:00

Our last post ended by suggesting that investors should compare the total costs of investing in US-listed ETFs vs Canadian-listed versions. We've taken up our own challenge and offer a spreadsheet (click here for download) to help readers assess their candidate foreign ETFs. Here is a screenshot of the spreadsheet.

What the spreadsheet does
Our approach is to start with assumptions about growth of an index that two ETFs aim to track and adjust returns taking into account the various factors explained below. The spreadsheet takes into account these factors by allowing you to enter the data for pairs of ETFs and applying costs, taxes, rates and fees that influence net returns.

US holdings and International holdings - Each type has its own sheet since a) each would be a separate asset class within a portfolio - thus we want to compare within an asset class - and b) the tax consequences are different.
RRSP (& other registered retirement accounts like RRIF, LIRA, LIF), TFSA, Taxable account choice - Tax consequences differ for each type of account.
Direct or Indirect ETF holdings - Instead of holding foreign stocks directly, some Canadian ETFs hold US ETFs inside, which we call Indirect ETFs. Again, there are different tax effects.
Capital gains and Distribution/Dividend yield - The amount and proportion of each source of return affects the net return due to the interplay of the other factors. A usual starting point for picking numbers to enter is historical data. For example, the current distribution yield for the SPDR S&P500 ETF (symbol: SPY) is 1.74%. Estimating Capital gains can be a lot more problematic - are we looking forward to years of low 2-3% growth or higher 5-6% gains? The usefulness of the spreadsheet is that we can quickly plug in different numbers to see if the best choice of ETF and account varies and by how much.
Tracking error - This is the amount by which the ETF performance differs from its index. Although a very few ETFs may actually outperform the index in the occasional year, the typical and expected result is under-performance over the long term, which is what interests us. A key element of Tracking error is the ETF's Management Expense Ratio (MER) and that figure should be the minimum value to enter. However, it is not the only one and especially with International ETFs or currency-hedged ETFs, not necessarily the biggest component. Other Tracking error sources include: Sampling/optimization or Replication strategy, Rebalancing and Reconstitution efficiency, Cash dividend reinvestment drag, Trading costs, HST (Canada only), Currency hedging costs, Concentration limits on holdings and Securities lending (a source of revenue for many ETFs). Larry MacDonald's Investopedia article ETF Tracking Errors: Is Your Fund Falling Short? explains this topic well. As Tracking error rises to the 1% or more range it starts to heavily influence net results, as playing with our spreadsheet will quickly show. Canadian Couch Potato's tally of Tracking Errors on US and International ETFs listed in Canada shows widely varying errors amongst funds for 2010. Keep in mind that errors can vary, sometimes a lot, year to year. Some ETFs seem to be quite stable, others not. Tracking error very often turns out to be the key factor in differentiating ETF performance.
International withholding tax - The actual amount paid to foreign non-USA governments varies within various ETFs - often 8 or 9%, but up to the 15% maximum of international tax treaties. In only one combination of circumstances, a Canadian listed ETF that directly holds international securities in a taxable account e.g. Claymore's International Fundamental Index (CIE), can a Canadian investor recover that tax through a tax credit.
US withholding tax - Though not a variable you need to estimate or change in the spreadsheet as it is always applied at the 15% rate specified in the Canada-USA tax treaty, US withholding tax can have a big influence on performance at times, especially when the ETF distribution yield gets to 2% or more and account type is brought into play.
DRIP brokerage commission and auto-DRIP - Many brokers now charge $10 per trade so we have set that as the amount in the input cell. If you want to see how reinvesting more often e.g. twice a year or quarterly when the ETFs make distributions, simply enter the total brokerage trading commissions you will incur per year. The same input adjustment can be made if you unfortunately are paying higher brokerage commission rates. Two ETF providers in Canada - BMO and Claymore - will automatically reinvest distributions for free, so our spreadsheet will adjust for that savings too. Some discount brokers even offer a so-called synthetic DRIP for ETFs (call your broker to find out if it offers that service; see also this article from CanadianFinancialDIY), absorbing the cost of distribution reinvestment.
Transaction fees on foreign exchange - The amount charged by discount brokers to convert Canadian into US dollars or vice versa varies from broker to broker, ranging from 0.5% up to 1.5% - see MillionDollarJourney's broker comparison. Forex can have a significant influence, mainly when Tracking errors of ETFs are close and where Withholding taxes do not differ.
Annual contribution - See how rich you might get! Just for the fun and as a reference point, since it does not affect which ETF is a better choice, the annual contribution you invest in the ETFs can be varied.

What the spreadsheet does NOT do

Compare different indices - It is assumed the ETFs compared track the same index. Different ETFs, even within the same asset class, such as US equity, can produce markedly different returns and portfolio growth. Look at the variability of fund returns in 2010 in Couch Potato's Tracking error article we cited above. If you compare ETFs with different indices, remember that you are only comparing costs, not total returns.
Exchange rate variability - There is no attempt to incorporate effects of changes over time in the value of the Canadian dollar against the US dollar or international currencies. Year to year and over multiple years, the evolution of currencies strongly affects foreign investment net returns. Whether to hedge or not is a fundamental choice for the investor and comes before the choice of a specific ETF.

Examples (numbers in the download spreadsheet)

US Holdings

US-listed = PowerShares FTSE RAFI US 1000 Portfolio (PRF)
Canadian-listed = Claymore US Fundamental Index (non-hedged) (CLU.C)
Forex fee = 1.0%, rate applied at big bank brokers
Distribution yield = 1.5%, current rate per PowerShares; could also try 1.99% cited on Claymore (rate as of end of March)
Account type = 1 RRSP
ETF type = 4 Direct i.e. CLU.C directly holds shares of companies, not a US ETF
Auto DRIP = 1 since CLU.C is a Claymore fund
Tracking error US ETF (PRF) = -0.48%, estimated using historical results on page 11 of the 2010 Annual Report here on the PowerShares website
Tracking error Canadian ETF (CLU.C) = -1.5%, estimated future error. The 2010 error was a horrible -2.3% from page 12 of the Annual Report here on Claymore's website, but in future it should be much lower as the ETF switched to full replication in September 2010, holding all 1000 stocks in the index, instead of the partial replication by 400 or so stocks it had previously carried.
Bottom Line = Under the above assumptions, PRF gets ever further ahead till it is up more than 20% over its competitor after 30 years due to the harmful effects of CLU.C's high tracking error.

International Holdings

US-listed = PowerShares FTSE RAFI Developed Markets ex-US 1000 Portfolio (PXF)
Canadian-listed = Claymore International Fundamental Index (CIE)
Forex fee = 1.0%, rate applied at big bank brokers
Distribution yield = 3.2%, current index rate per Claymore; could also try 2.3% cited on PowerShares though that is net of international non-USA withholding taxes already deducted
Account type = 2 Taxable
ETF type = 4 Direct i.e. CIE directly holds shares of companies, not a US ETF
Auto DRIP = 1 since CIE is a Claymore fund
Tracking error US ETF (PXF) = -1.2%, estimated using historical results on page 11 of the 2010 Annual Report here on the PowerShares website
Tracking error Canadian ETF (CIE) = -1.5%, estimated future error. The 2010 error was a terrible -2.1% from page 9 of the Annual Report here on Claymore's website, but in future it should be much lower as the ETF switched to full replication in September 2010, holding all 1000 stocks in the index, instead of the partial replication by 300 or so stocks it had previously carried.
International withholding tax = 9%, estimate from Foreign Tax Paid actuals on page 123 of the Annual Report
Bottom Line = Under the above assumptions, CIE comes out a constant 3% or so better than PXF. Put the CIE into a TFSA, however, and its advantage grows over the years, reaching over 10% after 25 years. Beware of withholding taxes!

There you have it. Use the spreadsheet to see which costs matter and which don't under reasonable assumptions, or to check how far things would have to change to make a difference in choosing ETFs and which account to put them in.

Disclaimer: This post is my opinion only and should not be construed as investment advice. Calculations and formulas are believed to be accurate but are not guaranteed to be so. Use at your own risk. 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.

Pros and Cons of Cross-Border Shopping in the USA for ETFs

2011-05-17T10:17:00.004-04:00

Cross-border shopping in the USA has long been a favorite activity of Canadians when the exchange rate vs the US dollar has swung in our favour. Investors looking for ETFs can shop cross-border too, as online brokers all provide seamless access to US stock markets with a click of the mouse on a drop down menu. What are the possible advantages and drawbacks of buying ETFs on US markets instead of the TSX in Canada?

The high Canadian dollar is not a reason to buy in the USA - The rise in the Canadian dollar does not create the same bargains in ETFs as it can in shoes. Buying the same thing in the USA and in Canada will not present the same bargains in ETFs because the much greater speed, volume and ease of moving money brings about a high degree of stock market efficiency – the same thing will at every instant cost the same amount, factoring in the exchange rate, on both sides of the border.

Pros – Reasons that favour buying ETFs in the USA

1) Management expense ratios – The lowest MER for an asset category is most often found in a US-based ETF. A good example is a fund that tracks the flagship large cap equity S&P 500 Index or something very similar. In Canada the lowest MER is Claymore's CLU.C with an MER of 0.71%, while in the US, the SPDR S&P 500 tracker (SPY) has a 0.09% MER.

2) Range of choice – US financial markets are many times larger than Canada's and that results in a much greater selection of ETFs. Whether it is US equity, international equity, emerging market equity or bond funds, there are more ETFs available. Sometimes there isn't even a comparable ETF in Canada for a key category, e.g. a whole of market US equity fund. Other worthwhile categories where there is a dearth of ETFs available in Canada include: Value stocks, Small cap stocks, foreign bonds.

3) High liquidity, reduced bid-ask spreads and lower tracking error – The size of the US market is reflected in the size of ETFs sold in its markets. Often the net asset value of a US fund is many times greater than that of a Canadian alternative. Trading volumes are consequently much higher and that tends to keep these sources of cost down and allow the investor to achieve returns that are higher and closer to the index they aim to track. For instance, the tracking error of Claymore's International Fundamental Index ETF (CIE) came out to 2.1% below its index in 2010 according to this Couch Potato blog post while the parallel US ETF, PowerShares' FTSE RAFI Developed Markets ex-US fund (PXF) has been tracking only about 1.1% below the same index. That amounts to a 1% extra “cost” of using CIE instead of PXF. It's worth checking several years of tracking error to see if it has varied a lot or if the pattern is consistent.

4) Unhedged versions of US and international funds – Due to anxiety amongst Canadian investors that our dollar will keep rising, it seems that almost all foreign equity ETFs sold in Canada come only in versions that hedge against currency shifts. Whether that is the best approach or even necessary is not cut and dried (see our post here on the pros and cons). Also, Canadian Capitalist has discovered that hedged ETFs are prone to especially bad tracking error.

5) US 15% withholding tax charged in registered accounts (RRSP, TFSA, RRIF, LIRA etc) – For Canadian-listed ETFs with foreign holdings consisting of US ETFs, such as iShares' MSCI Emerging Markets Fund (XEM) which holds only the US-listed EEM, the US government levies a 15% withholding tax on distributions that cannot be recovered. The constant reduction in net return is the 15% withholding tax times the fund dividend/distribution rate – e.g. 0.15 x 2% = 0.3% less. Other ETFs with this return-reducing problem include: Claymore's Emerging Markets (CWO), iShares Canada's S&P 500 (XSP), Russell 200 Index (XSU), MSCI EAFE Index (XIN), China Index (XCH), World Index (XWD). Our table below shows the various situations that can arise in ETFs regarding withholding tax. Green boxes show the minimal tax situation, red is bad with two layers of (US and international) withholding taxes that cannot be avoided or claimed as a credit against Canadian taxes and the clear boxes are where one withholding tax applies.

Cons – Reasons against buying ETFs in the USA

1) Currency exchange costs – Buying a US-listed ETF means having to pay in US dollars. The swap of Canadian dollars to buy the US currency can cost the individual investor up to 1.5% commission depending on the broker. Within a Canadian-listed ETF, the fund does the buying at lower institutional rates, which are usually so low as to be not worth worrying about. The problem is worst for registered accounts since selling the US ETF will result in conversion back to Canadian dollars at most brokers, a second big hit. The same hit happens to distributions by the ETF. An investor who wants to rebalance his/her portfolio by buying and selling might incur several round-trip currency conversions, each time with a return-reducing fee incurred. The problem is alleviated to a degree in several ways: by the fact that some brokers now allow US dollars to be held in a registered account after a sale; by many brokers allowing wash trades or by a fancy trading manoeuvre called Norbert's gambit (see Couch Potato's suggestions for reducing Forex fees)

2) Hedged ETFs not available – Despite the costs, some investors, such as those who are convinced the Canadian dollar will continue to rise or whose time horizon is too short for perhaps decades-long cycles to even things out, may still wish to diversify into foreign markets but with hedging against currency swings. In that case, US-listed ETFs are not the place to look – the only hedged US ETF hedges the US dollar against the rest of the world for the benefit of US investors.

3) Possible exposure to US Estate taxes – Only those whose worldwide assets exceed $5 million need to be concerned, but owning US ETFs makes one subject to US laws on estate taxes as we explained last December.

4) Automatic free dividend reinvestment, pre-authorized chequing purchases and systematic withdrawals – These extra services, available only in Canada from the likes of Claymore Canada and BMO Financial for their ETFs, avoid the costs of commissions on smaller purchases or sales and avoid having cash sitting around uninvested. Saving a $10 commission on a $200 purchase (a $10,000 holding with a 2% distribution gives off $200 a year) is a $10 / $10,000 = 0.1% saving on the holding's total expenses.

5) Withholding tax in a TFSA or RESP account – The US government levies a 15% withholding tax on distributions from US-listed ETFs to TFSAs, RESPs or non-registered taxable accounts i.e. anything other than accounts it recognizes as legitimate retirement accounts, such as RRSPs, RIFs, LRIFs, LIRAs, LIFs. That's on top of what the foreign countries already deducted in withholding tax. A Canadian-based ETF with direct international holdings such as BMO's International Equity Hedged to CAD ETF (ZDM), since it has nothing to do with the US, in contrast pays only the original foreign withholding tax and that tax shows up on T slips issued by the Canadian ETF provider as a foreign tax paid credit that can be used for taxable accounts. The RESP and TFSA still lose that amount but at least there is only one layer of taxation. How much can that reduce returns? Using for example a 2% distribution rate from the ETF holdings, the first level of withholding tax reduces it to 2% - (2% x 0.15) = 1.7% and the second level to 1.7% - (1.7% x 0.15) = 1.4%.

Bottom Line
Ask yourself whether you really want or need currency hedging. If yes, then Canadian-listed ETFs are the only option.

Otherwise, when there are directly parallel Canadian- and US-listed ETFs, add up the hard plus and minus costs associated with MER, Foreign exchange fees, Withholding tax, DRIP commission and Tracking error.

Happy cross-border comparison shopping from the comfort of your own computer!

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.

How to Invest for Retirement Like a Pension Fund by Using ETFs

2011-05-10T08:26:00.002-04:00

Pension funds, by definition, have the goal of providing retirement income for their members. Maybe there are some ideas to be gleaned from their operations for us individual investors to apply in our RRSPs. After all, the pension funds are the pros and we are the amateurs. Therefore, this week we look at the three largest pension funds in Canada (see Benefits Canada article and pdf of the top 100) who lead not only in net assets but in methods that are being copied by many other pension plans:

#1 Canada Pension Plan Investment Board: $140 billion in net assets - This is the investment arm of the CPP, from which all working Canadians receive payments in retirement. The CPPIB plans two portfolios. One is the reference benchmark portfolio, consisting of standard asset classes. The other is the actual portfolio, which deviates from the benchmark in specific investments in an attempt to outperform the benchmark, but which the managers still aim to keep within the same risk parameters.
#2 Ontario Teachers' Pension Plan Board: $105 billion in net assets
#3 Ontario Municipal Employees Retirement System: $53 billion in net assets

Pre- and Post-Retirement Equity vs Fixed Income Allocation
The CPPIB is still in savings mode, with about ten years till it will need to begin drawing on its investment portfolio to partially fund CPP payments. Meantime there is a net inflow of funds as CPP collection from paycheques exceeds payments out. We'll call this analogous for an individual as "retiring in ten years".

The OTTP and OMERS, in contrast, already have substantial numbers of retired members and outflow surpasses inflows. This situation we'll call "retired with a part-time job".

The key result to note (see comparison chart below) is that the CPPIB has a much higher allocation to equities - about 2/3rds in its benchmark - than OMERS and OTTP, which each have about a 50% allocation. As a pattern, the big three follow the familiar advice - when in retirement, the equity allocation goes down. There is also the fact that, even in retirement, the equity allocation remains substantial.

Inflation Protection through Specific Asset Classes
All three pension plans make protection against inflation an explicit key investment objective and they target various types of assets that they obviously feel will help achieve that. For that reason Real Return Bonds, Infrastructure (utilities, pipelines, water systems, airports, seaports, toll-roads) and Real Estate are in all their portfolios. The OTTP adds investments in general Commodities and in Timberland to the inflation-protection category.

We note as well that the allocations to inflation protection assets are: a) substantial and; b) higher for OMERS and OTTP which as we noted are in retirement mode already. This reflects the fact that one of the main retirement risks to income is inflation, even at the steady 2% rate we have been experiencing for the last fifteen years and which all three assume will continue. One of the important and valuable promises of all three plans is CPI-indexed income. As life expectancies have gone up (and retired teachers live longer than the general population according to the OTTP), the cumulative long-term effects of inflation on standard of living can be extremely debilitating. Isn't protection against inflation what all of us would desire too?

Foreign Investments and Hedging
There is a divergence of thinking amongst the three pension funds as to whether it is worthwhile to hedge exposure to foreign currency fluctuations through foreign investments, which all three have in considerable amounts. The CPPIB and OTTP hedge only minor portions relating to certain parts of their portfolios - CPPIB's foreign government bonds and some of OTTP's foreign real estate. The OMERS, on the other hand, hedges a lot - about 40% of its foreign equity portfolio. Readers may recall from our previous post Foreign Investments: to Hedge or Not to Hedge Currency that there are pros and cons to each strategy.

Non-Mainstream Investment Strategies
These funds employ some investment strategies that are not open to the average individual investor, the two chief ones being absolute return strategies and private equity. The OTPP provides this information in its 2010 annual report: "Absolute return strategies (which are managed internally) generally look to capitalize on market inefficiencies and also include external hedge fund assets that are managed to earn consistent, market- neutral returns ..." Private equity simply means that the funds invest money directly, mostly in equity though a bit also as lending, through direct private placements. Unlike absolute return, which is an entirely different animal and for which there are no ETFs available, private equity stills falls within equity or fixed income, so although there are no such ETFs, the individual investor can imitate the effect within ETFs that invest in public market securities.

Investment Returns and Expectations
The diversified and risk-controlled portfolios of CPPIB, OTTP and OMERS can serve as a guide and a benchmark for our own returns. The table below shows some recent results and what they aim for in future. One-year returns in 2010 ranged from 12 to 14%, an exceptional good year after the heavy declines of the financial crisis. Their expectations for future long term average returns are only 6 to 7% including an inflation component of around 2%, i.e. 4 to 5% future real returns.

The ETFs that Best Mimic the Pension Funds' Asset Allocation
Keeping as much as possible to ETFs sold in Canada, an individual investor can construct a portfolio, except for Absolute Return strategy as noted above, that models each of the pension funds. In our detail table, we have colour-coded across to show how one or more ETFs line up with the funds (in certain cases, like Emerging Markets equity where BMO's ZEM and Claymore's CMO can both fill the bill, there a couple of ETFs for an asset class). Only two asset classes - Foreign Government Bonds and Timberland - would require ETFs traded in the USA.

The perhaps surprising bottom line is that it is not complicated to come quite close to building a portfolio that mimics the pension funds' approach. Only six to eight ETFs in all are required.

To find details of the ETFs:

BMO Financial Group ETFs
Claymore Canada ETFs
iShares Canada
US-traded ETFs listed and linked to providers by Stock Encylcopedia

One must note that the massive scale of these pension funds gives them certain advantages (there are disadvantages too in being an investing elephant - see for example, CPPIB CEO David Denison's speech The Challenge of Managing CPP's Assets) that an individual cannot replicate with ETFs. For instance, the broadest Canadian equity ETF, iShares' XIC, contains 248 companies within it, while the CPPIB's portfolio (listed here) as of March 31st this year held over 400 different Canadian companies. Another difference is that their unit costs for investment management are much lower than ETF management expense ratios.

Nevertheless, it is encouraging to know that the small investor can construct a solid portfolio without much complication or trouble simply by imitating what some of our leading pension funds do.

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.

Which Canadian Stocks with Growing Dividends? - The Low Yielders

2011-05-03T06:49:00.002-04:00

Last week we looked at Canadian stocks that have consistently increased their dividends for several years and whose dividend yield of 3% or more exceeds the TSX Composite average. This week, we turn to the other batch of dividend growers, 20 in all, whose yield is below that of the TSX.

Is the lower yield a good or a bad sign? If these companies have been progressively increasing their dividends, how might it be that their dividend still does not come up to the broad market average? Several possibilities exist: the stock price has more than kept pace with the dividend rises so that the yield formula of Div/Stock Price produces a smaller number; the dividend started at such a low payout level or the amount of increase has been so small that the yield still has not risen much. A scan of our comparison tables below reveals that both explanations apply to different companies and in most cases that looks like good news. (Note that our tables this week have more columns and are based primarily on the superb recently beefed-up My Watchlist customizable tool available free on GlobeInvestor.)

Dividend Past Performance, Safety and Further Growth Potential
(click on image to enlarge)

Great Dividend Performance: Dividend growth rates, whether measured over the past year or five years, has been outstanding. The 5-year compounded annual growth of the bottom performer, Atco Ltd (ACO.X), at 6.8% is very satisfactory while that of the top performer, Tim Hortons (THI), at 35.3% is phenomenal. The high-yielders of last week showed much more modest growth rates as a group.
Strong Dividend Growth Potential: Dividend payouts as a ratio of earnings is low (under 30%) for almost every company indicating considerable leeway to give further increases despite very healthy - the lowest is 6.8% per year - compounded dividend increases over the last five years. This is in sharp contrast to last week's high-yielders which almost all have high payout ratios.
Strong Dividend Safety: Interest coverage is high enough at every company, except at Finning (symbol: FTT), that there appears little danger of an actual dividend cut in the short term and in the longer term, debt levels as seen in the various debt ratios, seems low enough to protect dividends of almost all the companies.

Stock Price Attractiveness - Are there potential good buys?

Many of the stocks exhibit attractive green indicators amongst the series of different value metrics, but five of them look to be good across the board with no negatives and lots of positives - rising sales and profits, healthy return on equity, low current stock price compared to past or analyst forecast future earnings, low stock price compared to sales, cash flow and book value, even analyst ratings:
Tim Hortons (THI)
Home Capital Group (HCG)
SNC-Lavalin Group (SNC)
Empire Company (EMP.A)
Atco Ltd (ACO.X)

The overall conclusion is that a good number of the low-yield dividend growing stocks appear to have good potential for further dividend rises and probably stock price gains too. Numbers are not the final answer, however, and the investor is still wise to look into each company's prospects through reading annual reports, news articles and whatever commentary can be found. It is not what has happened in the past, as reflected in the above numbers, but what will happen in the future, that matters.

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.

Which Canadian Stocks with Growing Dividends? - The High Yielders

2011-04-29T06:33:00.010-04:00

Income-seeking investors are naturally keen on stocks that pay dividends, especially ones that combine a history of consistently rising dividend with high dividend yield (dividend as a percent of stock price). Such stocks are often termed dividend achievers or aristocrats. Some might think those stocks to be automatic winners. Today we look at Canadian stocks that currently fit that bill to see how true that might be.

Finding the Current Canadian Dividend Achievers
In doing our search we first came across blogger Passive Income Earner's list from January 2011. To find a current list at any time, a convenient source is the holdings of Claymore Canada's S&P TSX Canadian Dividend ETF (symbol CDZ , MER 0.66%) which selects only companies that have increased dividends for at least five consecutive years. Then we sorted the list to select the "high" dividend payers, which we define simply as anything more that the TSX Composite average yield of 2.4%, a figure obtained on the TMX Money Indices page. That left less than half the original number of stocks, whose yields were all 3.0% or more. (Next week, we'll look at and compare the remainder of the stocks in the list, whose yields fall below 3%.) The resulting list is below.

Lesson #1 - Dividend achievers exist in a variety of sectors, everything from the expected utilities and pipelines to retailers, oil companies, financial companies, telecoms, media and transportation.

Is the Dividend a) Safe and b) Likely to Continue Rising?
As we all should know, the future may not repeat the success of the past. Our table of comparison above shows that for several of the companies, various factors may threaten the dividend, such as:

large debt load and weak coverage of interest on that debt, which must be paid before dividends
dividend payouts that exceed the earnings of the company
falling earnings that may not generate enough cash to fund dividend increases

Lesson #2 - Some companies may not be able to sustain further dividend rises

Two companies look vulnerable to an end to dividend increases, if not outright dividend cuts - Enbridge Income Fund Holdings (symbol ENF, not to be confused with Enbridge Inc, symbol ENB, which looks quite solid) and Thomson Reuters Corp (TRI).

Based on the combinations of the factors (green numbers in the table), several companies look to be well capable of continued increases in their dividends:

Canadian Real Estate Investment Trust (REF.UN)
Corus Entertainment Inc B (CJR.B)
Canadian Utilities Inc (CU)
Rogers Communications Inc B (RCI.B)
Intact Financial Corporation (IFC)
Transcontinental A Subvtng (TCL.A)
Canadian National Railways (CNR)
Imperial Oil Ltd (IMO)

Are the Stocks Too High Priced?
The dividend may be safe and even likely to rise further, but perhaps the stock is over-priced and its price risks falling, leading to capital loss for the investor. This factor is the hardest to assess and could benefit from more detailed examination of the company than is done here but we can draw tentative indications.

Lesson # 3 - The price of some of these stocks appears attractive and others not at all.

Some of the indicators that suggest stocks which may be worth a detailed look include: stock price to earnings ratio that is lower than the TSX Composite average of 19.7; price to company cash flow that is low; healthy return on equity and on assets; and growing earnings per share. Stocks that look good on this preliminary basis of value include:

North West Company Inc (NWC as of May 2nd - before that NWF)
Telus Corp (T)
Canadian Real Estate Investment Trust (REF.UN)
Rogers Communications Inc B (RCI.B)
Corus Entertainment Inc B (CJR.B)
Shaw Communications Inc B (SJR.B)
Canadian Utilties Inc (CU)
Transcontinental A Subvtng (TCL.A)
Intact Financial Corporation (IFC)

The not-so-attractively priced stocks:

Enbridge Income Fund (ENF)
Thomson Reuters Corp (TRI)

Have the Same Companies been the Top Canadian Dividend Achievers Year After Year?
If there was any doubt of the need to be cautious in assuming that the current companies with consistent records of dividend increases will keep doing so, it is only necessary to see how past lists compare. We managed to find similar lists from 2007 (from the Globe and Mail here and here) and 2009 (from the Million Dollar Journey blog here)and only four companies have managed to qualify in all three years' lists. In the comparison table below, we highlight in green cells the stocks that appear in every list, in pale yellow the stocks in the 2009 and 2011 lists and in pale blue those in the 2007 and 2009 lists.

Here are the current dividend longevity champions:

AGF Management Ltd B (AGF.B)
Enbridge Inc (ENB)
Canadian National Railways (CNR)
Imperial Oil Ltd (IMO)

CNR and IMO both have modest dividend yields, though the accumulated increases over the decade or so (the total time straddled by all the lists) that they have been raising dividends would have produced a handsome income for shareholders of long duration.

Perhaps the most interesting feature of the 2007 to 2011 evolution is the falling away of the banks and insurance companies after the financial crisis. The big question - will any or all come back to qualify again for the dividend achiever list? A few banks have announced dividend increases recently. Perhaps the future won't be like the recent past, only the distant past?

Lesson # 4 - The present is very little like the past and the future may be quite unlike the present as well. Such lists as Canadian Dividend Achievers can be a good starting point to find promising dividend-generating income stocks but are not a foolproof method of picking them.

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.

Borrowing to Invest (Leverage) - Choosing Amongst Loan, Margin, Leveraged Fund, Capital Split Shares

2011-04-26T03:45:00.002-04:00

Interest rates are low these days so some investors might be considering borrowing money to invest. The first step is to carefully consider the rewards and risks of borrowing money to invest, also referred to as using leverage. Doing a Google search for the words "borrowing to invest" along with "leverage" will bring up many articles. It's highly advisable to read several before jumping in.

Once the decision has been taken, the next step is choosing a method. Let's explore the pros and cons of three common ways to use leverage for buying stocks in Canada - 1) Bank loan, secured or unsecured, 2) Broker Margin, 3) Leveraged ETFs - and one less known method - 4) Capital Split Shares.

1) Bank Loan / Line of Credit

Loan interest must be paid regularly on a fixed schedule, and perhaps principal payments too, unless the loan is interest-only
Payments do not vary with value of the investments, whether they go up or down, unlike margin with its possible margin calls. Close monitoring of the investments is not required.
Full amount of the investment can be covered by the loan
Loan collateral may be none, if unsecured, provided by the securities, or by other assets, like a home. That can have drastic consequences if the investments go bad and you cannot pay the loan. A key pre-requisite to choosing this method of leverage would have to be the investor's capacity to keep paying the loan despite stock market dips.
Investment choices are unlimited.
Current unsecured loan interest rates are in the 5-6% range according to Fiscal Agents. One should then net out the tax deduction of interest in a taxable account - at 46% top marginal rate in Ontario, that works out to 5% - 0.46*5% = 2.7%. Secured (against a home or the investments) rates would be about 1% less, around 4%. These are floating rates that will rise when interest rates do. Fixed rate term loans are available but the cost will be much higher. One major bank is quoting 8.55% for a two-year term loan.

2) Broker Margin

Interest rate fluctuates up or down with prime rate. Borrowing cost is not fixed or predictable
Investor must put in some equity money, calculated as a percentage of the total investment e.g. 30%. That percentage must be maintained at all times. If the market goes up, there's no problem but a market decline may push the value of the investments too low compared to the loan and the investor will then receive a margin call to add cash to the account or be forced to sell some of the securities
Loan collateral is provided by the securities
Amount of margin or equity that the investor must provide varies by stock price e.g. for stocks priced at $5 or more, the investor must put up a stake of 30% of the total investment while it is 50% for stocks $2 to $5 and under $2, it is not possible to buy on margin at all. Beyond that, investment choices are unlimited.
Margin accounts are normally only available for taxable accounts, not TFSAs, RRSPs or other registered accounts. In any case, losing the tax deductability of the interest expense, which happens when funds are borrowed for investment within registered accounts, knocks off a big part of the value of borrowing to invest.
Interest is paid through monthly posting by the broker of the charge in the account (see BMO's FAQ). If the account has a cash balance, the interest will be deducted against the cash, otherwise it is cumulated and compounded monthly with the rest of the margin loan and figures into the margin maintenance calculation.
Cost of borrowing - A typical current broker margin rate is 4.25% such as at BMO Investorline, though it may be less for larger accounts One should then net out the tax deduction of interest in a taxable account - at 46% top marginal rate in Ontario, that works out to 4.25 - 0.46*4.25 = 2.38%.

3) Leveraged ETFs (see primers such as ETFdb's and GetSmarterAboutMoney's)

Fund applies the leverage, not the investor. The ETF determines the amount of leveraging, not the investor. Most ETFs are 2x leveraged to get double the underlying stock return though some US ETFs apply 3x leverage.
Due to leveraging techniques used, such as options and futures, the investor gets no tax deductible interest charge. Investors will generally experience only capital gains or losses from buying or selling the ETF shares.
Daily performance tracking of such ETFs - it is the daily return only that the ETF enhances - means that they are suitable only for short term trading and not for long term investing.
Broad range of index and sector tracking funds is available.
Eligible to be bought in any type of account
Costs are difficult to determine or predict due to the mix of management fees (the only Canadian leveraged ETF provider Horizons BetaPro funds charge 1.15%) and on-going leveraging costs. Price performance of the ETF shares will almost always overwhelm such costs in determining investment returns.

4) Capital Split Shares (see our recent post looking at their overall investment potential)

Borrowing is carried out by the split share corporation, not the investor. Thus, amount of leverage is not controlled by the investor. Most split shares employ less than 2x leverage, many much less than that. To find out exactly how much, one must go to the split share's website and either get it from the corporation's profile or from the annual report. For instance, Newgrowth Corp (TSX symbol: NEW.A) sports leverage of 1.52x (52 cents of debt for each equity dollar invested)
Investor faces no loan repayments or margin calls. The collective "loan" consisting of the preferred shares in the split share corporation is only paid back at its wind-up maturity date (June 26, 2014 for NEW.A). As an investor, you merely hold the shares and experience up or down movements in stocks as paper gains or losses until they are realized upon sale. The Capital share will merely(!) decline a lot faster than the market but you won't be required to come up with extra cash.
No tax-deductible interest arises from owning split shares. Distributions are in the form of dividends or return of capital.
A limited range of investment opportunities through split shares exists in Canada - mainly large banks, insurance companies, utilities, REITs, telecomms, pipelines. The majority have multiple holdings, a few are fairly diversified and some hold the shares of only one company. The 50 or so Canadian split share corporations are listed within the GlobeInvestor Closed-End Fund report.
Total cost of borrowing is the sum of the preferred share interest rate plus other corporate expenses. For example, for NEW.A, we estimate costs at 6.45% - the sum of preferred dividends receiving 6.0% plus other fund costs 0.45%. The cost remains quite static. The main component, the preferred share dividends, remains fixed through out the life of split share corporation and the other expenses should not vary a great deal. Interest rates these days are quite low but if, or should we say when, they start to rise the fixed borrowing rate costs of existing Split Shares will become increasingly beneficial to Capital shareholders.

This quick review of the options for leveraged investing suggests that the best method might vary amongst investors depending on many factors, such as type of account, tax situation, financial flexibility, target securities, time horizon and risk capacity. Hopefully, this post helps you to be aware of the alternatives and some of their key characteristics.

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.

Five Last Minute Tax Reducers for Investors

2011-04-14T11:01:00.003-04:00

2010 is long gone and the April 30th income tax filing deadline looms close, so investors might ask themselves what last minute tax actions they might be able to take to reduce taxes or get a larger refund on this year's return. Here are some suggestions.

1) Swap between spouses to offset unrealized capital gains of one against losses of the other
This operation could save taxes of the current year or of the past three years for couples with investments in non-registered taxable accounts. A person with unrealized capital gains makes a swap with his/her spouse who has unrealized capital losses. The somewhat tricky procedure requires several steps to effect the gain-loss transfer. Two good step-by-step descriptions can be found in financial planner and author Alexandra Macqueen's Canada:Transfer Capital Losses and in accountant Tim Cestnick's Globe and Mail article Share with your spouse and erase a cash drain.

2) Carryback 2010 (or older) realized capital losses to offset previously reported realized capital gains and recover past taxes paid
If you have capital losses from 2010, they can be used to offset gains in the three previous tax years (2007, 2008 and 2009). That is allowed after 2010 losses have been applied to any 2010 gains and there is still a loss. The form to use is the Canada Revenue Agency's T1A Request for Loss Carryback, which is included/filed with the 2010 return.

3) Apply net realized capital losses of prior years to reduce realized 2010 capital gains or past capital gains
The same idea of offsetting capital losses in one year against gains in another year can work as well by bringing forward past losses to the present. You will see on your 2009 Notice of Assessment from the CRA the total of past capital losses you have claimed. The claim is made on line 253 of your income tax return.

If you messed up and missed doing this before, there is still some chance to do the offsetting of gains and losses further back. First, note that there is a time limit on changes to past returns. The CRA's How to change your return page says that you may only change returns of up to ten years ago, i.e. 2001 or later. If you neglected to report losses in 2002 (remember that year of big market declines?), you can do so now but cannot claim against any gains in 2000 (perhaps tech boom year profits?). The ten year limitation is a good reason to report capital losses promptly each year, even if there are no present gains to offset. Losses can be carried forward indefinitely against future gains. It is too easy to forget or lose documents needed to make a future claim, and the process is more cumbersome.

4) Make a declaration of deemed capital loss for companies gone bust
When a company like Nortel goes bankrupt or becomes insolvent and its shares become worthless with no hope of recovery, it is possible even without selling the shares to make a declaration to the CRA claiming a total capital loss under subsection 50(1) of the Income Tax Act. The claim is made through a letter to CRA (no form is available) stating: name of the company, number and class of shares, date shares were bought, adjusted cost base, proceeds of disposition (usually zero), any expenses for disposition, and amount of the loss. Accountant Robert Smith's Tax Deduction for Shares You Can't Sell and Million Dollar Journey's Claiming Capital Loss from a De-listed Stock provide more background.

Two important points are:

The declaration must be made in the return for the tax year the bankruptcy happens e.g. for a 2010 bankruptcy, it must be made this year.
De-listing of the stock is not enough - some companies may carry on doing business after de-listing. However, de-listing is a strong sign to pay attention (check the TSX Reviews and Suspensions list on TMX Money) if the drop to zero in your account hasn't caught your attention! The Office of the Superintendent of Bankruptcy Canada has a database that can be searched to provide a key detail required in the claim letter - the date of insolvency, bankruptcy or wind-up.

5) File a return and pay taxes owing on time
The easiest way for an investor to save money is to avoid paying a penalty for late filing, paying interest on any taxes owing or interest on the penalty! The CRA Interest and penalties page tells us exactly how much interest and penalties CRA will apply. Should it be necessary to report imprecise or incomplete data, it is still better to file a return, and estimate the amount owed. Even when that means over-paying taxes, there may be a silver lining since CRA's current rate of interest paid back to individuals on overpayments is a rather attractive, compared to that of bank accounts and term deposits, 3%.

Disclaimer: this post is my opinion only and should not be construed as investment or tax 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 or an accountant.

How Your Province, Income Level and Investment Choices Affect Your Income Tax

2011-04-05T10:48:00.001-04:00

Taxes matter to the investor. What is left to spend after paying income tax is what interests us as investors, not the nominal pre-tax return. There are key elements that an investor should be aware of in order to guide plans and shape investing strategy. As we show below the differences can be very large indeed.

The major tax differences arise from:

Type of income - employment, pension (including age 65+ RRIF withdrawals), interest (including RRSP withdrawals), capital gains, dividends, TFSA withdrawals
Province - each province has its own tax scale for each type of income, in addition to that of the federal government. Some Provinces have high taxes, some are low and some are in the middle (see the Ernst & Young 2011 Personal Tax Calculator to find where each Province falls in the spectrum). We've chosen three to do our comparisons - middle level Ontario, low tax BC and high tax Nova Scotia.
Income level - each type of income in each Province has its own tax scale according to income level (yes, it is reminiscent of the child's song "there's a hole in the bottom of the sea")

Tax Comparisons:
The Canadian 2010/2011 Tax Calculator from TaxTips.ca provides a quite sophisticated free tool (it includes exemptions, deductions, tax credits, adjustments for dependents, age and spouse income splitting) that we have used to gain insight into the bottom line effect of various combinations of the above factors. Our comparison tables are organized by income level. We've chosen three - a modest pre-tax income of $40,000, a middle income of $60,000 and a high income of $100,000. Then we try out different breakdowns of types of income sources to see total tax payable results.

Middle Income - $60k Table

High Income - $120k Table

Modest Income - $40k Table

What the numbers tell us:

Interest income always attracts the highest tax and by a lot, no matter what the Province or income level.
Healthy doses of capital gain and dividend income can significantly reduce an investor's total tax / average tax rate, especially for high income earners.
The mixture of income types makes the most tax difference. The mix of interest, capital gains, dividends etc has a huge impact that is far greater than any difference amongst Provinces. For example, a $60k income could have $10,000 to $11,000 less income tax to pay if instead of being all interest income, it is an even combination of interest, capital gains, dividends and TFSA withdrawals (which are tax-free).
The highest tax Province of Nova Scotia shows the most sensitivity to type of income. It has the greatest dollar difference between highest and lowest combination no matter what the income level.
The lower the income level, the more the type of income matters ie. the greater the relative difference between highest and lowest tax. In our tables, that shows up in the column "Within Province, Highest to Lowest Multiple". For example, in Ontario, someone with $40k income only in interest would have almost 11 times (10.9 is the exact figure) more tax to pay than if they had only dividend income. At $60k income the multiple is only 4.7 times and at $100k, only 2.9 times.
The difference between the Provinces matters less for modest income. At $40k the percent difference in between the highest and lowest Province varies from 1.5 to 4.7% while at $60k and and $120k the difference is generally 5+%.

Practical Implications and Considerations:

Use the Tax Calculator to examine how your individual situation works out in detail, then compare against alternatives. Keep in mind that registered accounts (like RRSPs, RRIFs, etc) allow tax deferral of any income, so if you do not need the money now to spend, it is likely better to contribute and keep the funds within such accounts (see our previous post RRSP vs TFSA vs RESP vs Non-Registered Taxable Account?). In any given year, when you have a choice of which combination of accounts and sources to use to withdraw funds, such as in retirement, the calculator may save you hundreds or thousands of dollars. Investors may also want to look at the long term planning software package RRIFMetic, which asserts it can optimize such withdrawal strategies over many future years.
Lower income investors should try to shape their income towards dividends and capital gains.
TFSAs could, down the road when they have grown enough to contain substantial assets, be a valuable source of supplementary tax-free income that keep total taxes down. During retirement, the TFSA has another nice feature in that withdrawals do not reduce eligibility for OAS and GIS.
Within taxable accounts, investors should acquire investments that generate dividends and capital gains. (Dividends and capital gains within registered accounts such as RRSPs, LIRAs RRIFs etc do not matter as there is no immediate tax to pay and the money when withdrawn will be either ordinary income or pension income.)
Some people might even wish to consider Provincial tax differences in deciding where to live, though that is quite a drastic measure!

Investing Lessons from a Golf Game

2011-03-29T10:45:00.002-04:00

The very first myth in Dan Bortolotti's excellent article on the MoneySense website Busting the Couch Potato Myths is that it is easy to stay the course in following an investing strategy. As Dan says, it is not at all easy! It never gets easy, though it can possibly get easier with the right actions. In fact, it actually never gets foolproof guaranteed that you will not deviate from your plan. Let's explore how this works using a golf game example.

The golf story: One day, a certain blog writer goes golfing with a buddy. The first hole is longish par 3 but with no great hazards or rough, just a nice grass slope gently uphill up to an open green that has a bunker on one side only. To get into real trouble, the tee shot has to go almost 45 degrees askew. [Translation in investing terms, the market looks quite stable and the economy is performing reasonably well, a great time to begin investing one would think]

Looks like an easy start! Except that there is a fallible human golfer [investor] involved. Now this golfer is a high-handicapper (i.e. not very good - an average investor) but he has played enough to know his own penchant for getting upset unlike the rank beginner [i.e. is not a total newbie investor and thus knows that markets can move down] who expects to play like the world number one [who expects markets to always rise], so he mentally prepares himself by thinking as follows "I've not warmed up and hit any practice shots, so if things go bad here, it's no big surprise or disaster and the best thing to do is stay calm and keep at it" [the market might go down some but we won't worry too much, we'll stick with the investing strategy].

That's good preparation [both #1 creating a plan, and #2 learning market history, are excellent first steps, as Dan has noted], but then reality begins to operate. The golf partner's tee shot is very nice and straight at the hole [a peer investor you know starts with a good gain], though just short of the green. The pressure rises to do as well. Unfortunately, our hero's tee shot isn't nearly as good, scuffed out left and only two-thirds of the way to the green. Oh well, that's disappointing but the possibility had been anticipated. No big deal. The next shot is an attempted chip from short rough onto the green, not that hard at all, no bunkers, mounds or other obstacles in the way. A complete duff! The ball moves only a foot. Geez, now that is annoying, the chipping had been so good lately [this latest investment seemed a sure thing but it is going down while the market is going up]. Meanwhile, golf partner makes a chip pretty close to the hole [own investment just sits there, while the friend's continues to move up very nicely].

The next shot is well hit but much too hard and rolls right off the far side of the green. Grr, when is there going to be a good shot [upward move]? The pros [e.g. Warren Buffett in the investing world] seem to stop it within inches every time. The blood pressure is definitely rising. Next shot - needs to be a delicate little chip to the edge of the green since the hole is close to the edge. Another complete duff, the ball moves a few inches! [the investment takes another appreciable drop] At this point, the emotional system suddenly takes over and we will spare readers from an account of the careless, furious series of shots [sell the darn stock!] that followed before a horrible score of 10 finally ended the pain. The partner missed the first put but sunk the next one to record a very respectable, for a high handicapper, single bogey 4 on the hole. It seems that the chance of a good score [profitable investment] has been destroyed on the very first hole [investment month or year]. Were it not for the golfing partner, whose presence made it easier to maintain a certain decorum, the putter might have flown further than the tee shot [#3 it's a good idea to have a neutral investment buddy to talk things over with to avoid the too-rash action we may regret later, like selling everything out at a loss; simply talking about an investment to someone else will assist in restoring calm so that rational thought can supplant emotional reactions; it helps externalize and objectify the problem to move on to sensible decisions].

It is not just the average person who is susceptible to such moments. Those who watch pro golf on TV can observe the occasional similar blow-up, both in shot-making and in self-control, even by the very best golfers. The difference is only that it happens less often and is usually much less severe for the pros. The world number one golfer Martin Kaymer, though already recognized for his calm demeanour, actively works on controlling his emotions. But no one is ever totally immune from bad things happening or from getting unduly emotional, even when the possibility is anticipated. Our own reaction can worsen the results and it is as hard to control our reactions as to make good shots. So it is also with investing.

There are longer term actions, outside the stress moment of a golf or an investment crisis, that bring about improvement: #4 build a feedback loop - go over the incidents afterwards while they are still fresh and ask yourself what you did wrong, what you will change. Part of the revised improved action likely will be: #5 technical practice on shots [collecting more data or doing more analysis]. Another part can be: #6 mental preparation - our golfer partly did that right by anticipating a possible bad outcome and deciding in advance what to do about it, but maybe not enough - only one or two bad shots seemed to be mentally forgivable. We also need to remind ourselves that just as technical practice brings about improvement in fits and starts and it takes time, so does it on the mental side.

Fortunately in golf, as in investing, the first hole is not the end of the round, the final result. At least in golf, it is quite difficult to walk off the course and refuse to play the rest of the round after the first hole, or worse, stop playing the sport entirely [quit investing and retreat into the low return safety of Canada Savings Bonds or GICs].

Following the disastrous first hole, the golfer, more by accident than by design, ignored the score, letting the playing partner keep track, and merely played each hole as it came. [#7 check returns and performance infrequently only when you need to and at a moment you have planned in advance - if you don't know how well or poorly you are doing in the interim, you will be unable to react and deviate from the plan! This presumes you have built a proper plan beforehand - see our post on creating an Investment Policy, part of which specifies how often you will review and make changes to investments] The result was that the shotmaking settled down to what eventually overall compensated for bad first hole and the total score turned out even a bit lower than average [investment returns tend to even out over the long term too, but we must be patient]. A successful day!

May our readers' golf games, or other sporting endeavours, enjoy success ... and may their investing be so too.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comments are not an investment recommendation. Do your homework before making any decisions and consider consulting a professional advisor.