Tuesday 27 July 2010

Stock Market Analyst Forecasts: add Salt and Pepper

The Salt
"Prediction is very difficult, especially if it's about the future."
-Nils Bohr, Nobel laureate in Physics, quote from University of Exeter

Analysts try to divine what the future will bring for companies or markets and then tell us whether to buy or sell. That it is exceedingly difficult to forecast accurately there is no doubt at all - people have checked by tracking and assessing analyst predictions. Analyst accuracy on average has been, and continues to be, very poor as discovered in such studies as, Forecast Accuracy of Individual Analysts: a Nine-Industry Study (MIT, 1987), The Bias of Wall Street Analysts (Harvard Business School, 2004), Equity Analysts: Still too Bullish (McKinsey Company, 2010). There is even a website - CXO Advisory Gurus - that continually tracks the accuracy of US analysts who have made publicly-available predictions. The top analyst manages only a 68% accuracy rate and two thirds of analysts failed to exceed 50% right, which isn't any better than random selection. Thus, the Salt advice - take analyst predictions about future market direction, individual stock prices, interest rates or any other financial data with a skeptical eye and a proverbial large grain of salt. They are most likely wrong. (It is well to remember that if you yourself start making predictions, then you become an analyst too!)

The Pepper
"It is far better to foresee even without certainty than not to foresee at all. "
Henri Poincaré in The Foundations of Science

Should one then simply ignore anything said or written by analysts? As the above quote suggests, there are reasons to consider analyst prognostications despite the high failure rate. Rather than trying to find the one or two "best" analysts who get it right, a fruitless task since success in one period more often than not becomes failure later on, here are some suggestions for a better approach to extract value:
  • Consider analyst predictions as scenarios, or possible future outcomes. Particularly if there is disagreement between analysts, their discussion and explanation can bring out different factors to help form your own expectations of a high-low range and probabilities. A current example of divergent views is Jonathan Chevreau's Wealthy Boomer blog post Battling stock gurus on video: a bull, bear and superbear. If you cannot tell or don't want to chance which scenario will pan out, structure your portfolio to fare reasonably well regardless of which scenario comes to pass. Diversification through a variety of types of holdings (domestic and foreign equities, real return, government and corporate bonds, real estate, commodities including gold, cash) is the standard method to manage this challenge.
  • Most analyst reports contain a very useful synopsis of key company business operations, financial ratios, comparative results and year-by-year trends, which saves the investor a lot of wading through quarterly / annual financial reports and number-crunching, enabling more time to be spent on the qualitative aspects of a company.
Our Pepper advice is thus to add flavour and taste to the plain investment fare of the raw numbers with a dash of opinion and judgement "pepper".

As with the culinary ingredients, one should be aware that there is always a limit to how much salt and pepper to add to produce a good meal and it is sometimes difficult to know how much is just the right amount.

Where to find analyst reports and opinions
Individual companies: A good place to start is the research section of the discount broker website where entering the company name or stock symbol will bring up links to one or more formal reports by research companies contracted by the broker.

Markets as a whole: Mainstream online media such as the Financial Post, GlobeInvestor, CNN Money, BNN, Yahoo Finance, Google Finance, Wall Street Journal, Bloomberg and Canoe Money also regularly feature less structured articles and video interviews of analysts and market gurus.

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.

Tuesday 20 July 2010

Return of Capital: Separating the Good from the Bad

Investors in mutual funds, ETFs, REITs and Income Trusts often see on their tax slips amongst the different types of income the curiously titled Return of Capital (ROC). It is natural for the investor to wonder if he or she is simply being given his or her money back as a kind of false income. Let us see how ROC comes about to decide if it is good or bad.

Return of Capital consists of distribution amounts in excess of net income. Sometimes that's good, sometimes it's bad. Part of the answer depends on taxation.

ROC Tax Rules: ROC, as identified on T3 slips in box 42, is not taxable. Instead of reporting the ROC as income on a tax return, investors receiving a distribution containing ROC must reduce the fund's Adjusted Cost Base by the amount of the ROC. When the fund holding is later sold, the difference between selling price and the Adjusted Cost Base becomes a capital gain on the investor's tax return. Two good things are accomplished for the investor - deferral of tax on the ROC portion of the distribution till sale of units and receipt of that ROC distribution income as a capital gain. However, it is possible that years of ROC distributions will reduce the ACB to zero. Any ROC received after ACB reaches zero must be reported in the tax return for the year of receipt as a capital gain, as TaxTips.ca notes in Tax treatment of income from investments in income trusts.

Part of the good vs bad ROC answer also depends on Where ROC comes from:
1) Depreciation in REITs: The primary source of ROC in REITs is Capital Cost Allowance, the amount that the Canada Revenue Agency permits the REIT to deduct for depreciation. According to the Deloitte REIT Guide the REIT generally includes in the distribution an amount labelled as ROC equal to the CCA. Page 9 of the Guide pdf shows how the accounting works.

In terms of being good or bad for the investor, the key point noted by Deloitte is that "Although a REIT claims a deduction for CCA, this is in no way representative of the actual deterioration of its assets; it is simply the prescribed rate at which the taxing authorities will allow real estate owners to amortize their acquisition cost." If the REIT maintains its facilities, there is no reason the economic value of its building assets should decline, nor should the REIT's stock market price decline as a result.

Due to tax deferral and receipt distribution income as a capital gain, ROC in REITs is beneficial when its source is depreciation and when the real estate property maintains its value.

2) Index Mimicking in ETFs: There are two sources of ROC in ETFs. One source is simply that some ETFs may contain REITs. When ROC income is received by the ETF it passes such income along in its original form to shareholders within the ETF distributions, so refer to the explanation for REITs as to how and why ROC occurs in this case.

The other source of ROC in ETFs arises when large institutional investors pay in funds to the ETF managers like iShares' BlackRock, Claymore and BMO to create new ETF units, which are blocks of shares in the underlying companies of the ETF. (We individual retail investors do not create or redeem units when we buy or sell shares on the stock market; we merely buy or sell shares from other investors.) In order to maintain payout rates as close as possible to the index the ETF aims to track (e.g. iShares' S&P TSX 60 (symbol XIU) should distribute about 2.7% annually according to its Index quoted on TMX.com), the ETF will distribute some of the new cash to all - both new and existing, institutional and individual - ETF shareholders. Effectively, some of what would have been dividend income for existing shareholders is transformed into ROC. That's good ROC. John Heinzl's recent GlobeInvestor article Explaining the ABCs of dividend-paying ETFs gives more explanation and shows an example.

3) Unrealized Capital Gains in Mutual Funds - As accountant Jamie Golombek explains in Return of Capital, an equity mutual fund with sufficient cash on hand and with an unrealized capital gain at the end of a year, may decide to pay out some or all of that gain. Since no sale of the underlying share holdings occurs, the distribution is not a capital gain and since the distribution also exceeds income, it is treated as ROC. Assuming the investor wants the cash, this kind of ROC is good.

4) Bad ROC aka Giving the Investor's Capital Back - At other times, funds may actually distribute some of the original capital of the fund to shareholders without having any gains or income to justify the distribution. That's bad. The fund may do this to maintain a promised distribution schedule. Often this occurs under the disguise label of "tax-efficient fund" according to Jamie Golombek. The only way to really tell apart good from bad is the investor's usual obligation - to look at the financial statements to find the source of the ROC.

How to track ROC for your taxes
A previous post on this blog ETFs and Mutual Funds - Calculating Capital Gains works through how to track ROC and ACB for tax reporting. See also the Canada Revenue Agency publication Tax Treatment of Mutual Funds for Investors.

ROC Samples - Below are a few 2009 ROC distributions. Note that:
  • ROC can vary tremendously year to year - e.g. RioCan's have varied between 30% and 63% over the years
  • ROC can vary tremendously from one fund to another - in 2009 some REITs had close to no ROC at all while other REITs had high ROC

The bottom line for differentiating good from bad ROC is to determine whether it results from accounting treatment or from economic reality, i.e. whether it is a superficial or a real return of capital since both are possible.

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

Friday 16 July 2010

Green Investing - Doing Right and Doing it Right

Want to put your money to work actively improving the environment? There is a wide and growing choice of public companies whose products and services provide the tools to clean up, to conserve, to improve efficiency and to reduce consumption without sacrificing performance. And, of course, as an investor you want to make money while providing that support.

What does Green investing include?
Often called Clean Technology or Environmental Sustainability, the range of Green sectors includes:
  • Renewable Energy & Fuels - generation or equipment for wind, solar, geothermal, tidal, small-scale hydro, biofuels
  • Energy Conservation - green buildings, transportation efficiency, industrial efficiency, power management, smart grid
  • Water Conservation & Purification - recovery, re-use, treatment, recycling
  • Waste Management - pollution prevention and control, re-use, recycling, energy recovery, remediation
  • Low Impact Materials and Products
For more detail on these categories, see TMX Money's S&P TSX Clean Technology Index description

Where to find companies and funds
  • S&P TSX Clean Tech Profile lists all the 127 publicly-traded Canadian companies whose business is primarily Green
  • S&P TSX Clean Tech Index narrows down the list to 20 larger companies of more than $100 million capitalization
  • US and International companies - Look at the holdings of clean tech ETFs and mutual funds
  • ETFs - There are no Canadian-traded Green ETFs unless one counts Claymore's S&P Global Water ETF. There are numerous US-traded ETFs, with a variety of companies from around the world - see Stock Encyclopedia's Ethical ETF list.
  • Mutual Funds - Try downloading the latest SRI Fund Performance table from the Social Investment Organization website. Within this general list of funds that espouse Socially Responsible Investing principles are the Green funds.
Assessing the investment
It goes without saying ... ok, let's say it, Green environmentally does not automatically mean Green financially. Investor research is required to improve chances of making money on Clean tech investments. The same bottom-up analysis of companies is required, and in the case of funds, looking at their costs and the manager's stock-picking skills. Here are some sources that may help:
Does Green investing entail lower overall stock returns?
It is difficult and perhaps too soon to tell whether this relatively new sector provides returns that are better, worse or about the same as market averages. Companies in the sector don't have long histories and are relatively small, which can mean both fast growth and greater volatility. To the extent that such firms are here to stay due to the permanence of the environmental challenge and not a fad like bowling in the 1950s and 60s, then one would expect profitability to follow the path of any other business and the stock market to value them fairly in comparison to the overall market. However, many do rely on government policies and incentives so revenue streams may be more fragile. Furthermore, the tech sector bubble taught us that an emerging, permanent, gigantic new industry like the Internet could mean speculative over-pricing.

Returns from one product, the Elements linked to the Credit Suisse Global Warming Index (symbol GWO) have considerably lagged the S&P 500 in the USA since inception in 2008 and over the past five years as simulated. The Yahoo! Finance chart below shows how the Powershares Cleantech ETF (NYSE: PZD) initially leaped ahead of the SPDR ETF tracking the S&P 500 Index (SPY) after start-up in 2006 but fell back to the same level for a time during the 2008 crisis. Another chart, not shown, would reveal that PZD has considerably lagged SPY in the past year period.

The S&P TSX Clean Tech Index has a solid dividend yield of 3.3%, which generally indicates steady profits, due to the presence of a number of profitable power generation firms like Algonquin (AQN), Boralex (BLX), Innergex (INE) and Northland (NPI.UN). The investor's usual caution and discriminating judgment will be required to separate the good stocks from the bad.

May your investing be Green in every way, perhaps even to make your friends green with envy.

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.