Wednesday, 29 September 2010

Canadian Large Cap Equity ETFs: BetaPro's HXT Joins the Fray

A significant new player - Horizons BetaPro S&P/TSX 60 Index ETF (TSX symbol: HXT)- has come onto to the scene of Canadian Large Cap Equity ETFs since our review of last December. How does the new entrant, which started trading on September 15th, stack up against the others - BMO Dow Jones Canada Titans 60 Index ETF (ZCN), iShares S&P/TSX 60 Index Fund (XIU) and Claymore Canadian Fundamental Index ETF (CRQ) - and how have the others changed since December?

HXT's Unique Product Design
Instead of buying and holding the companies in its index like the other ETF providers, the Horizons manager of HXT has set up a contract, called a Total Return Swap, with the National Bank under which the the bank agrees to provide HXT with the exact return on daily basis of the S&P/TSX 60 Index, including the value of any distributions the constituent companies pay out. This has a number of implications and consequences when HXT is compared to the other ETFs:

1) Counter-party Risk - What Happens if National Bank Cannot Pay?
This has generated a lot of controversy (e.g. this Financial Webring forum thread) and misunderstanding about whether HXT is inherently much more risky due to its structure. Blogger WhereDoesAllMyMoneyGo provides an excellent summary and explanation of exactly how HXT works, the bottom line of which is that HXT does not have appreciably more counter-party credit risk due to the Swap form of construction. See also Horizon's clarification posted on the Canadian Capitalist blog.

2) Dividends/Distributions get automatically reflected in the asset value of HXT as if they were being reinvested completely and instantaneously. This can be good or bad for the investor, depending on his/her needs and circumstances. Whereas ZCN and CRQ offer an optional Dividend Reinvestment Program (DRIP), there is no choice but to reinvest with HXT. The Total Return index tracking makes this happen in effect as part of the design. That's good if the investor is building a portfolio and wishes to reinvest but not so if you wish to receive the cash. XIU is inferior on this factor since iShares offers no DRIP.

3) Deferred Capital Gains vs Immediate Dividends - HXT does not, as noted above, actually receive dividends. Instead their value is incorporated within the share price and is only realized when the investor sells the shares, which means capital gains are deferred. Nor does HXT pay out any dividends. There will be no annual tax slips issued. In a registered account, it doesn't matter since there is no annual tax liability, only income tax to pay when a withdrawal is made from the account. Within a taxable account the absence of annual taxable distributions can make a very large positive difference in the end total after taxes since the dividends can grow and compound on a tax-deferred basis. But there is a caveat - it does not help low income investors (up to about $40,000 taxable income in Ontario - see this table in since they do not pay any income tax on eligible dividends (and that's what constitutes 90% or more of distributions from the S&P/TSX60) - see our previous post Three Reasons to Love Dividends for more on how this works.

4) Income Tax Liability Risk - Though HXT is designed and expected by Horizons to continue indefinitely, in which case the only tax liability of the investor is upon selling the HXT shares for a capital gain, the termination of the Swap would cause the gains, both the price rise and the dividends, accumulated within HXT to be distributed for tax purposes as ordinary income to HXT shareholders at the time. After many years that could be a very large amount. A shareholder who had bought in much later would become liable for tax on TSX60 capital gains and dividends generated in all the years before he or she bought in. In contrast, the other ETFs distribute cash received on a quarterly basis, so any tax liability is dealt with each year and there is no overhanging risk of potential future liability beyond a quarter.

5) Management Expense Ratio - HXT is the new low cost leader with an outstanding 0.07% MER, less than half its closest rivals ZCN and XIU. Horizons claims that there are no other expenses other than 13% HST tax on the MER, which will add another 0.01% to the total.

6) Assets, Liquidity, Tracking Error and Premium/Discount to NAV - The bigger and more actively traded an ETF, the better for the investor to get efficient pricing versus the Net Asset Value (NAV) of the underlying holdings and tight bid-ask spreads that lower the difference between buying and selling prices. ZCN has made the greatest progress into a very competitive second place in terms of asset size (increasing its asset size more than ten times its size from our first review, to a hefty $526 million in total assets). ZCN is still far behind the market leader XIU, which gained more than $1.9 billion in asset size and which has maintained the smallest bid-ask spread. CRQ more than doubled in asset size. New entrant HXT has started with a small initial stake of $50 million but its trading volumes have been amazingly high at several million shares per day, indicating the heavy presence of day traders and institutional investors. Such large increases across the board reflect the growing popularity of index ETFs. Asset size growth from the gain in value of the TSX 60 would only account for about 8.7%. ZCN and CRQ are very similar with bid-ask spreads higher than XIU's, but they are still quite low. HXT's trading volume would suggest its bid-ask spread will be similar too.

Interestingly, HXT breaks the mold on tracking error and it almost surely will be the best on that dimension. Since its value is mathematically calculated to follow the S&P/TSX 60 Index, it should have only the under-performance caused by its MER fee cost, which is the lowest. XIU has its higher 0.17% MER plus reduction to due to transaction costs, re-balancing costs and portfolio optimization costs, together which amounted to 0.02% annually over the past decade, or a total under-performance of 0.19% per year. It may not seem like much difference but it all adds up as XIU returned 81.02% in the last ten years while the Index gained 84.52%.

7) Fund Diversification - ZCN, XIU and HXT share a very similar allocation amongst economic sectors. CRQ's looks very lopsided with a much higher concentration in Financial Services (45% of total assets) and much less in Materials and Energy. Offsetting this is the fact that it has a lower concentration in individual companies - the top ten holdings are only 42% in CRQ vs 45-46% for the others and in the top twenty-five, there is also a much lower concentration. Whether CRQ's portfolio is considered better or worse boils down to a judgement of its fundamental indexing approach compared to the cap-weighted approach, as we discussed in Different and Better (?) Ways to Invest in the Broad US Equity Market.

CRQ has slightly out-performed the other ETFs over the past year as the chart below from Google Finance shows. CRQ's approximate 0.8% higher price gain on the chart does not include the fact that XIU and ZCN had about a 0.4-0.7% higher dividend yield, so the net difference is only 0.1 to 0.3%.

Summary Comparison Table (click on it for larger image)

Bottom Line - a Best Fund?
It's a tough call. All these ETFs are solid choices, none is clearly bad, nor is any a winner across all factors.
  • XIU offers the cheapest trading and best liquidity, but there is no DRIP and its fees are beaten by both ZCN and HXT.
  • ZCN offers second lowest fees and an optional DRIP but unknown tracking error.
  • HXT offers offers outstandingly low fees, automatic reinvestment for those who want it and tax-deferral in taxable accounts but there is the niggling worry about the Swap and potential future bad consequences.
  • CRQ has given better returns and claims it can continue to do so, along with offering the best account features like the DRIP, Systematic Withdrawal Plan and Pre-authorized chequing contributions, but it has a much higher MER and a portfolio very concentrated in Financials.
You choose!

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, 21 September 2010

Food Companies to Satisfy Investment Hunger

BMO Capital Markets recently put out the report It's Not Just About Flavour, It's Good Business Too (download pdf here) in which it says the Canadian food and beverage manufacturing industry "has lots going for it" in economic and business terms. Since everyone has to eat and drink, perhaps in these uncertain times there are steady performers in that industry. How does the food and beverage industry (which excludes beer, wine and hard alcohol companies) translate into investment opportunity? Let's take a look.

1) Finding the Candidate Stocks
Our first stop is a stock screening tool such as GlobeInvestor's, which includes the option to select an industry sector, in this case Food Processing. Your discount broker website will have a stock screening tool too; in BMO InvestorLine's case, it is the enhanced version of the Globe tool. The search pulls up 21 securities, of which five are preferred shares (symbols with .PR) or debentures (symbols with .DB) and one, Menu Foods (MEW.UN), produces pet food, so we eliminate them, leaving us with 15 common stocks.

2) Companies with Consistent Profitability
Our next step is to find the companies that are consistently profitable. To do that, we go to the Toronto Stock Exchange's investor website TMX Money and:
  • type in the stock symbol for each of the 15 candidates, then
  • click on the Financials tab and
  • pick the Income Statement and Annual View from the drop down menus
TMX shows the most recent five years of results. We select only those companies where there has been a profit i.e. whose Net Income has been positive, for at least the last four years. That leaves us with six companies. One of them - High Liner Foods - has two classes of shares, the HLF.A being non-voting equity shares, so we will consider them together:
  • Rogers Sugar Income Fund (RSI.UN) - refines, processes and distributes sugar in Canada
  • High Liner Foods (HLF and HLF.A) - processes and markets prepared frozen seafood
  • Lassonde Industries (LAS.A) - processes and markets fruit juices, drinks, wine, sauces, soups and beans, and specialty food products such as canned corn-on-the-cob, fondue broths, bruschetta toppings and tapenades
  • Premium Brands Holdings Corp (PBH) - manufactures, markets and distributes branded consumer food products across Canada and the Western United States
  • Canada Bread Company Limited (CBY) - manufactures and markets flour-based products in various markets, including fresh bread in Canada, frozen par-baked bread in the U.S. and Canada, specialty bakery products including pasta and sauces in Canada and bagels in the U.K.
  • Saputo Inc (SAP) - produces and distributes dairy and grocery products, including cheddars, specialty and fine cheeses, as well as mozzarella, dairy products, such as fluid milk, flavoured milk, cream, yogurt, butter and sour cream
3) Profitability, Growth and Value
A quick initial indicator of potential value is a stock's Price to Earnings (P/E) ratio. All of our profitable companies exhibit a much lower P/E than the 20.4 average of the TSX Composite (as of Sept.17th close of business). That is encouraging for our candidates.

There are other promising indicators as well, such as the rapid profit, revenue and Earnings Per Share (EPS) growth of all but Rogers Sugar. The 1-year Return on Equity (ROE) and Return on Assets all look reasonable, though Lassonde and Saputo shine brightest.

4) Safety
There is a bit more differentiation between the companies on these measures as Rogers Sugar and Premium Brands look much weaker on the amount of debt they carry, as expressed in the higher debt/equity ratio, and the consequent much lower coverage for their interest costs.

Similarly, the very high dividend payout percentage (as a % of Earnings) of these two companies is much less reassuring than the situation of the other companies. Perhaps this is a factor in the Financial Post report on a BMO Capital Markets prediction that Rogers Sugar Income Trust will reduce distributions upon conversion to a corporation.

5) Returns and Market Sentiment
It appears that it is not only BMO Capital Markets and this blog paying attention to the best of the Food Producers. The market loves these stocks. 1-year price returns on five of our six stocks (CBY being the odd one out) have outstripped the TSX Composite by a huge margin as the graph from Google Finance (link to live chart) shows.

For all except CBY, that 1-year return is far above that of their peers in the industry (see the 1 Yr O/U Median Industry Rtn column). A couple of them (RSI.UN and HLF) even provide a higher dividend yield than the TSX's 2.7%.

Analysts love most of these stocks too - three have the best five-star rating (HLF, LAS.A and SAP) - and two garner four stars (RSI.UN and PBH).

6) Past vs Future Returns
Past performance is impressive but what really matters is whether the good performance will continue. Have these stocks played out their rise?

The low P/E ratios suggest more catch-up to the market average is possible. And the professional analysts seem to feel there is still upward potential for several of our candidates, as seen in the Strong Buy rating for HLF and PBH and the Buy rating for CBY and SAP, and in the higher projected 12 month stock prices. (Note however, that analysts can be wrong, as we wrote about in Stock Market Analysts: add Salt and Pepper.)

The Food sector appears to hold potential. But the investigation process isn't complete. To get a view of the future and make a decision as to whether to invest would require delving into the companies' financial and management reports on their websites, reading the news about them, examining insider trading (see Insider Trading: Using It to Get and Edge, Legally of Course) and getting a sense of what could propel further growth in revenues and earnings, since that is what will eventually determine stock price and the ability to pay increasing dividends.

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, 14 September 2010

CleanTech & Profitable Investment - Yes, the Two Can Go Together

Clean, green technology may be the way of the future but is it possible for an investor to find solid profitable companies in the burgeoning sector? For many, the debacle of the dot com era, where start-up companies galore without profits (or sometimes even revenues) achieved stratospheric stock prices, only to have it all crash and burn into cinders, is an all-too-painful reminder that an emerging sector can pose great danger.

Let's take a look at the 19 members of the S&P/TSX Clean Technology Index (see link on this page)"... whose activities provide value-added solutions to environmental problems". The Index members are not tiny start-ups - S&P selects only companies with C$100 million or more in market cap with enough stock trading volume and shares outstanding available for trading to be reasonably liquid.

Eliminating The Unprofitable Companies
By clicking on the stock symbols in the Constituent Companies list and then the Financials tab for each company on the TMX Money website, we are able to quickly see that these companies have chronic and/or repeated big losses:

These companies may eventually be highly profitable and for many hope springs eternal (which some of the stock price charts for these companies suggest!), but for now, we say, no thanks and move on to the proven performers.

Nine Profitable Clean Tech Companies
More than half the profitable (i.e. positive Net Income) group consists of renewable hydro and wind power generation firms:
  • Algonquin Power & Utilities Corp (TSX symbol AQN)
  • Macquarie Power & Infrastructure (MPT.UN)
  • Boralex Inc (BLX)
  • Northland Power Income Fund (NPI.UN)
  • Brookfield Renewable Power Fund (BRC.UN)
These companies are characterized in most cases by long-term electricity sale agreements. Barring major weather or equipment problems, they should continue to generate as much profit as power. The healthy dividends most already pay confirms that capability.

Two of the power companies - Macquarie and Brookfield - have yet to convert from the income trust structure to corporations, as they are being in effect forced to do by the federal tax change (see previous posts on this topic here and here) to take effect January 1st, 2011, but both Brookfield and Macquarie have announced the intention to convert. When that happens they will likely reduce cash distributions by about a third.

One power company - Boralex - is an interesting case. Boralex Inc has been in the throes of a takeover attempt (apparently likely to be successful under revised terms) on the similarly-named but separate income trust Boralex Power Income Fund, which has its own listing under BPT.UN and has not not been profitable.

The other four present a range of CleanTech sectors:
  • ATS Automation Tooling Systems Inc (ATA) - Designs, manufactures and installs factory automation solutions for various industries including telecommunications, semiconductor, fibre optics, automotive, computers, healthcare, electronics, solar energy and consumer products. It has not had a long track record of profits. It was not profitable until 2008 but has maintained it through the recession in 2009. No dividends yet.
  • Newalta Corporation (NAL) - Delivers industrial waste management and environmental services to customers across Canada. After a big dip in Net Income in 2009, it increased its dividend in August.
  • RuggedCom Inc (RCM) - Designs and manufactures ruggedized communications equipment for harsh electrical and climatic environments. Its high P/E ratio of 39.6 says the market price anticipates strong rises in profits but it is not yet paying a dividend.
  • WaterFurnace Renewable Energy Inc (WFI) - Designs, manufactures and distributes geothermal and water-source HVAC systems for residential, commercial and institutional applications. Profits have dipped in 2009, not much of a surprise for a company heavily dependent on the US housing sector but it did increase its dividend in the first quarter of 2010.
Summary of Key Financial Ratios (source

Market Action
None of the profitable CleanTech stocks has exactly been a market darling powering to lofty heights over the past five years as all but one stock - WaterFurnace - has done no better and in most cases much worse than the TSX Composite. However, over the past year the chart below shows that four of the power companies have done considerably better than the TSX Composite. WaterFurnace itself made all its gains in 2006; in 2009 -2010 it has seriously under-performed, falling while the TSX has risen. It seems that there is no GreenTech bubble so far.

Several of these stocks, notably Macquarie, Algonquin, Waterfurnace and perhaps Newalta, exhibit reasonably attractive combinations of low P/E, low P/B and growing dividends, enough perhaps to make them candidates for a potential buy. The final judgment as to whether any of these stocks is worth an investment needs to rely on much more than simple past profitability or ratios and a thorough examination of financial reports and each company's prospects would be the next step for the investor.

However, it is encouraging to know that clean technology companies can be considered more than a politically correct fad. Some do indeed appear to have credible investment potential.

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, 7 September 2010

ETF Comparison: Three New China ETFs for Canadian Investors

The economies of the USA, Europe and even Canada may be struggling to avoid a double dip recession but that of China is powering forward with recent annualized growth of over 10%. The case for investing in China as a separate individual country holding becomes more compelling every day. It is now acknowledged to be the world's second largest economy (see Wikipedia article on China's economy) and there is a school of thought e.g. this academic paper that it will eventually eclipse even that of the USA. The investment view is generally bullish as is seen in a couple of other backgrounders on China: Investment Strategies for the China Century from Claymore Canada and Will China, India and Gold Lead the Recovery? from BMO ETFs in February 2010.

As investor interest in China grows, so do the ETFs available. Last year we posted on US-traded China ETFs - Investing in China: Four ETFs Compared. Since the start of 2010, three new ETFs trading in Canada on the TSX have appeared so let's review them.

iShares China Index Fund (symbol: XCH)
XCH is the Canadian version of the iShares China ETF sold in the USA under the symbol FXI. In fact, XCH holds only FXI. XCH's management fee (MER) is a bit higher at 0.85% vs 0.74% for FXI. XCH has the highest MER of the three new ETFs.

To repeat the previous review of FXI, a key characteristic and drawback of XCH is the relative lack of diversification - few holdings in total with only 25 stocks in the portfolio. For more, read the excellent Morningstar Analyst Report by John Gabriel (free registration required) of July 27, 2010.

Claymore China ETF (Symbol: CHI)
The newest ETF kid on the block, CHI is barely a month old. Like XCH, it is a Canadian clone of a US-traded ETF, in this case Claymore's fund under the symbol YAO. As opposed to XCH/FXI, Claymore charges the same MER of 0.70% in Canada on CHI as it does in the US.

CHI is a well-diversified fund with a good number of holdings - 150, the most of any China ETF including all the previously reviewed US ETFs. CHI also deliberately spreads out its allocation across sectors and individual companies through its policy limit of a maximum 35% in any industry sector and 5% in any company. For more on CHI/YAO, read the Seeking Alpha article YAO: Eight Reasons to Watch New Claymore China ETF.

As with all its funds, Claymore offers automatic no-commission dividend reinvestment (DRIP), pre-authorized chequing contributions (PACC) and systematic withdrawal e.g. for retirees (SWP). These features save commission costs.

BMO China Equity Hedged to CAD Index ETF (symbol: ZCH)
ZCH's unique characteristic is the hedging of the Chinese currency against the Canadian dollar to remove the effects of currency swings on the investment performance of the ETF. However, hedging costs money and the fund, not the manager, pays the cost. Though it remains to be seen with ZCH, hedging cost typically manifests itself in under-performance against the index. It is too early to tell how well the ETF managers will do the job and how much return loss there may be in exchange for the currency protection. Currency is a double-edged sword for investors. It can accentuate or overwhelm the actual foreign market return, either to the investor's benefit or detriment, as we have discussed previously in The Historical Effect of Inflation and Currency on a Canadian Investor's International Portfolio and Foreign Investments: to Hedge or Not to Hedge Foreign Currency.

ZCH's management expense ratio is the lowest of three funds at 0.65%. Its diversification lies between XCH and CHI - it holds 42 stocks, spread across all sectors. As one of the BMO ETF family it also offers an optional DRIP for investors.

Key Differences Between the ETFs
1) Sector and Stock Weightings, Not Holdings: Despite using different indices, the main holdings of the three funds overlap to a significant degree. For example, in the top ten holdings XCH and CHI have 6 stocks in common, XCH and ZCH share 5 stocks and ZCH and CHI share 6 stocks. It is the stock and sector weightings that will be more important to eventual differences in investment performance of the three ETFs.
  • XCH has a high percentage (60%) of the total portfolio represented by the top ten stocks, heavy concentration in financial sector stocks and no holdings at all in the Technology sector
  • The top ten holdings make up only 43% of CHI, which is the lowest concentration of any China ETF. CHI has an appreciable allocation of 11% to Technology stocks.
  • ZCH has by far the highest weighting (22%) of any of the funds in the Technology sector and the lowest in Financials (only 9% vs 32% in CHI and 47% in XCH).
2) Currency Exposure vs Hedging: ZCH's policy to hedge exposure to the Chinese currency (note that it is the Chinese Yuan exposure that is at issue not the US dollar, even when the holdings of XCH and CHI consists of US-traded securities - see CanadianFinancialDIY's Clarification of Foreign Exchange Risk on International ETFs) may end up being good or bad but it will surely cause ZCH's returns to differ, probably markedly from those of XCH and CHI. In the month of August alone, the price path of ZCH has differed markedly from that of XCH and CHI as the Google Finance chart below shows.

There has been much pressure on China to let the yuan rise in value (see NuWire Investor's How China's Currency Policy Change Could Impact the US Economy) and if that comes to pass, it will increase returns on Chinese stocks for Canadian investors. On the other hand, in the past year, the Yuan has depreciated 5% against the Canadian dollar (according to the RatesFX Visualization chart for Yuan), which has reduced net returns for Canadian investors.

Detailed Comparison Table of ETF Features and Characteristics

The Canadian-Traded vs the US China ETFs - Factors to Consider
  • Currency Conversion: For the Canadian investor, ETFs traded in Canada offer the convenience of dealing only in Canadian dollars. Most online brokers still do not offer the possibility to hold US dollar cash in registered accounts so trading in Canada avoids the necessity to incur currency conversion costs (which average around 1% per conversion of the amount converted). The frequency of buying or selling accentuates this factor. For non-registered accounts, tax reporting will be easier for the Canadian funds as the conversion results will show up on T-slips and capital gains ACB calculations will be simpler.
  • Trading Spreads and Liquidity: Being new, all three Canadian-traded ETFs are tiny in terms of net assets, which adds cost through higher bid-ask spreads (i.e. you buy at a higher price and sell at a lower price). For those wishing to trade thousands of shares that will be a bigger problem as the market making ETF sponsor may be obliged to step into the market at a bigger spread.
Which ETF is Best?
The choice is really between Claymore's CHI and BMO's ZCH. For those too worried about currency effects, ZCH hedges the currency exposure and it also has the lowest MER by a fraction over CHI. For investors with a long term investment intention who feel currency effects will wash out, CHI offers the best diversification, a reasonable management fee and convenient account features.

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.