Thursday 26 January 2012

Canadian Equity Market Darlings and Dogs: January 2012 Edition

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.
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.

Thursday 19 January 2012

Low Volatility Equity ETFs - Promising Safety and Reward

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 (updated 3 May 2012)
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.

International Developed
Emerging Markets

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.

Thursday 12 January 2012

Top-100 Pay CEOs: Who Earned their Rewards?

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.

Thursday 5 January 2012

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

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.