Friday, 25 January 2013

The Crucial Difference between Price and Income Stability of Equities

Stock markets are volatile, there's no denying it, the latest gut-wrenching downward episode being the credit and financial crisis of 2008, which saw the TSX Composite plunge 48% between June 2008 and March 2009. Bonds, on the other hand, have been quite stable, steady performers. This classic widely-known view is well illustrated by the annual returns in the chart below of three of the most popular ETFs in Canada - the flagship equity iShares S&P/TSX 60 Index Fund (TSX: XIU), the dividend focussed equity iShares Dow Jones Canada Select Dividend Index Fund (XDV) and the broad bond iShares DEX Universe Bond Index Fund (XBB).
(click on image to enlarge)

Apart from the wild ups and downs of the two equity ETFs, they have both turned in poorer total performance than XBB.

Is that it, case closed, bonds are clearly superior, especially for an investor interested in steady income, like a retiree? Let's consider a bit more history and where we might be headed in future.

Income volatility of stocks and bonds looks quite similar
Total returns and income do not follow the same pattern. Unlike the price volatility noted above, the actual hard cash paid to investors by the ETFs - the income - has not varied much year to year. That probably isn't surprising about the bond ETF XBB but look at the chart below, which we compiled from the data in the Distributions tab for each ETF on the iShares website. The two equity ETFs are as steady in paying out cash as XBB! XDV, built as a dividend fund, has paid out more than XIU.
(click to enlarge)

Bond income has trended down while equity income is on the way up
The yellow line of XBB's cash payouts has declined considerably while that of XIU and XDV have gone up. We note especially that the severe recession of 2009 - one of the worst in the past century - put hardly a dent in the equity fund payouts. The slow (XIU) or fast (XDV) upward rise in their distributions has resumed since then.

It is little surprise that XBB's payouts have steadily declined. As interest rates have fallen, lower coupon paying bonds have gradually replaced higher paying bonds in the holdings. What does the future hold? For now, and perhaps the next few years, central banks seem intent on keeping rates at the current rock bottom level to encourage economic growth. Based on XBB's average coupon rate of 3.86%, which drives the cash distribution rate pre-expenses (XBB's MER is 0.33%), the 2012 distribution payout rate of 3.6% is likely to stay about the same. If / when interest rates start to rise, then gradually existing low coupon bonds will be replaced by new higher coupon bonds and the payout yield will start to gradually rise again. At the same time of course, the rise in interest rates will cause the principal value of the existing bonds to fall and XBB may well see negative total returns.

Rising income for equity is a typical pattern
It is also no surprise that both equity funds have increased payouts over the years. This is typical for equities and has been sustained over many years in other countries. Moreover, the rise in dividends more than keeps pace with inflation over the long run. Look at this chart for the USA's S&P 500 index from the presentation Assessing the Relative Value of Stocks, Bonds,and Other Asset Classes by Wharton School professor and author Jeremy J. Siegel.
(click to enlarge)
The same pattern - equity income rising and at a faster rate than inflation - can be seen in Canada. To illustrate, we pretended to invest $100,000 in each of our example ETFs at the end of December 2006. If we simply bought and held the original share units, not reinvesting any distributions, the chart below shows the actual cash amount we would have received. The cash from XIU and XDV goes up nicely over the five years and at a faster clip than inflation (using Total CPI figures from the Bank of Canada). (Though distributions do not strictly equate to dividends - some years there are other types of income, the annual tax type breakdown on the iShares website shows the exact composition - XDV and XIU distribute as cash mostly dividends received from the companies in their holdings.)
(click to enlarge)
Notice how XDV's distributions now exceed those of XBB by 2012 after starting from a much lower base. That's impressive and enticing!

Equity income is attractive in a non-registered taxable account
The lower tax rates (see Ernst & Young tax calculator for rates by province) on dividends (or occasional capital gains) in XDV and XIU versus interest income in XBB can make a big difference to net after-tax cash. Due to the preponderance of dividend income, XDV was a bronze medalist in our evaluation last year of the 2011 ETF tax champions.

Potential to use equity as part of a retirement income strategy
The idea of using dividend paying equities as an integrated part of a plan to continually generate income during retirement is expanded in Thornburg Investment Management's Investing in Retirement Using a Global Dividend Income Strategy. US and international equities, which exhibit the same long term rising dividends, are combined with shorter term fixed income and cash to produce dependable and increasing income. The example they present using data from the supposedly "lost decade" of the years from 2000 to 2011 makes for thought-provoking reading. Thornburg's balanced approach addresses the obvious danger of an equity-only portfolio: being subject to wild short-term volatility of the equity principal, unexpected spending needs above the regular income stream could require cashing in shares at the worst possible time during a market plunge. Such forced sales can permanently damage the portfolio.

Regular equity income can diminish panic selling urges
When we see that cash distributions from equity are, in fact, quite stable, we can be reassured and be less prone to selling out at market lows. Having cash around for near-term spending, as Thornburg suggests, also reduces these self-destructive urges.

Bottom line
Dividends have always been a steady and important part of total returns, as we discussed here. Now that we see how stable this income from equity is, equity ETFs look quite attractive for their long term income-generating potential.

N.B. XDV is not the only choice amongst Canadian equity dividend ETFs. We reviewed XDV and its Canadian dividend rivals in this 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.

Friday, 18 January 2013

Cash in a TFSA or RRSP - What are the best choices?

2013 has arrived and it is TFSA and RRSP season.

Cash going in - how much can you contribute?
The arrival of 2013 brings with it new contribution room for TFSA accounts. There is an increased limit of $5500 this year, up from the $5000 per year for the four years TFSAs have existed. For someone who has never made any contributions, the previous year contribution room is not lost, so there is $25,500 in total contribution room.

This is also the time to consider making an RRSP contribution applicable to the 2012 tax year before the March 1st deadline. The maximum contribution room (aka deduction limit) for 2012 is $22,970 but previous years' unused room may also be used to push the year limit higher. Those who have already contributed for 2012 may take advantage of the 2013 limit of $23,820.

Cash is in - now what?
Getting the cash into a TFSA/RRSP investment account is an important first step. But suppose you have not done your annual investment review (see our posts Goals, Performance and Rebalancing and Tax Matters) and have not decided exactly how to invest the funds. In the meantime, the parked cash is earning nothing since most if not all mainstream online brokers pay 0% interest on cash balances at the moment. Or, suppose you want to keep the money in some highly secure form as near to cash as possible but still earning something e.g. when a TFSA is used as a just-in-case of emergency fund. Let's look at the main options.

Cash-like alternatives
We limit the options to those where a) the initial minimum investment is reasonably near the amounts for the annual contribution limits of TFSAs and RRSPs i.e. we exclude securities like bankers acceptances and commercial paper which typically require a purchase of $50,000 and;.b) the securities mature within a year or less.

We find the following choices:
  • Cash in broker account - the straw man that pays nothing (0%) though it is always and instantaneously available
  • High Interest Savings account - equivalent to bank accounts in terms of security (backed by Canada Deposit Insurance Corporation), paying up to 1.25%;
  • GICs, Cashable and Non-cashable - the standard safe investment we all know and trust, with cashables paying 1.25% and non-cashables 1.70%
  • Government Bonds - we compare the Government of Canada bond, whose triple AAA credit rating is the highest possible and just as good or better than any other government rating, including the USA (only AA+); now paying about 0.8%
  • Corporate Bonds - we consider only those of investment grade BBB or better, paying 1.0 to 1.4% depending on the issuer
  • Money Market Mutual Funds - the funds invest in various types of investment grade securities with a maturity of one year or less; there isn't a future expected rate actually published, so we had to presume that if interest rates remain stable, past returns will be about the same too - that's how we estimated that the best in class (see Morningstar's rating for our example Beutel Goodman Money Market Class D here) should return about 1%
Comparison factors - it's not just the interest rate
Yes, the interest rate earned does matter a lot. We think as a minimum that the rate of return should meet or exceed the CPI inflation rate, which in the latest release by Stats Can in December stood at 0.8%. That's one reason for not leaving the cash sitting un-invested in the broker account - in real terms there is a gradual loss of purchasing power. It matters especially if the funds are intended to stay indefinitely in secure cash-like investments. Fortunately, all our choices meet or beat inflation when held in a tax-protected TFSA or RRSP.

The other factors that may be important or not, depending on the use or potential need for the money -
  • liquidity / how fast can you get the money into cash; 
  • interest payout frequency
  • what happens to the rate of return for the investment if interest rates start rising or falling in case you sell early or hold for a year (some follow the trend up or down, others go in the opposite direction, others don't change); 
  • what is the minimum initial purchase/deposit; 
  • how auto-pilot is the investment - do interest payments get put back into the investment to keep accumulating or do they get paid out as cash that then sits in your 0% broker account till you do something; does the investment continue indefinitely or require action at maturity; 
  • default security - who exactly backs up the investment to ensure you don't lose your capital, though that doesn't mean some of the choices like the bonds won't change value if interest rates go up or down.
Comparison table - the details
click image to enlarge it

Is there a best choice?
In general, no, we do not think so, since each alternative has some limiting characteristics. For example, the one-year GIC pays the most at 1.7% and that's the return you get no matter what interest rates do, but the money is locked up and inaccessible for a year. High interest savings accounts offer quick access to the money and interest is reinvested automatically as long as you hold the account but the minimum amount is substantial. The value of bonds can fall if interest rates rise (which is more likely these days?) so there may even be a negative return.

We should also mention that higher interest rates are available on TFSA savings accounts, such as shown on TFSA Best Rates, by going direct to smaller institutions. But that means opening a separate account (will you open a new one very year depending who has the highest rates at the time or try to transfer from one to the other if the rate is changed later etc) and losing the flexibility of having the other investment options available at the online broker.  Is it worth the extra 1% or so ($55 on a $5500 contribution)?

The choices, the pros and cons, are dissimilar enough in matching against the likely range of individual investor circumstances that we don't think there is one best answer for everyone. We hope our comparison provides readers a good leg up on where to find their own best option.

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, 11 January 2013

Using Weak Currencies to Find Foreign Equity Investment Opportunity

Investors might be forgiven for thinking that countries doing well economically, whose businesses are necessarily thriving, should also see strongly rising stock markets and therefore that is where they should direct their investments. It turns out in fact to be the other way round - those countries which have been experiencing currency weakness i.e. a currency declining against most others, tend to do better in the future.

The findings come from three London Business School professors Elroy Dimson, Paul Marsh and Mike Staunton in the Credit Suisse Global Investment Returns Yearbook 2012. Probably it's that weak currency allows exporting companies to sell more or to attain higher profit margins, with subsequent profitability and stock prices; the professors don't say with certainty. But they do say quite confidently based on up to 112 years of data (depending on the country) for 83 countries that "... equities in particular perform best after periods of currency weakness". The effect is quite pronounced (especially since 1972 when the modern era of floating exchange rates began), as can be seen in the image below copied from the document, where the much taller dark bars show the stock market outperformance in the countries with weakest currencies. The effect is also stronger after 5 years of weakness than only one year.
click on the chart to enlarge it

Which countries now have had extended weak currencies?
To explore the possibility of using this phenomenon for investing, we first need to find countries whose currencies have been depreciating. To do this we turn to the RatesFX website, whose Visualizations allow us to see in a glance when a currency has been depreciating against major world currencies. We copied one of the charts for one such depreciating currency country, India. Notice how the 3-years tab we selected is all bright red - the maximum end of the depreciation scale.
Unfortunately, RatesFX does not cover every country's currency, one notable absence being Russia, but the 30 currencies comprise most major economies. It is easy and quick to click through the 30 countries and look for the bright red pattern of currency weakness. Here are the 8 countries/currencies that have experienced broad weakness over the past 3 years: the Euro i.e. most but not all European countries; India; Brazil; Indonesia; Poland; South Africa; Turkey and; Denmark. The Canadian dollar and the US dollar, incidentally, are in the middle, with a mix of mostly mild appreciation or depreciation. Some countries whose currencies have been appreciating include China, Australia, Taiwan, Chile, Switzerland, Singapore, Thailand and Malaysia.

A feasible investing approach using ETFs
Selecting individual stocks across such a wide range of countries would be unwieldy and impractical for the individual investor. However, ETFs traded in Canada and the USA offer the Canadian online investor a good choice of securities to focus on these countries. Such ETFs hold a basket of stocks, usually the local country index of each individual country, at a reasonable expense ratio. To find the Canadian-traded ETFs, we used several of the screeners reviewed in our ETF Screeners Compared post in September. The easiest one to use for finding the US-traded ETFs is ETFdb, which has a tool to display a list of individual countries. Here are the results:

1) The Euro area
Most European ETFs include the UK, a non-Euro country so we avoid them to select strictly ETFs that cover the whole Euro area. There are also individual country ETFs for each major Euro country but we also avoid them to keep things simpler.
We find it interesting that our recent post, coming at the issue from a fundamental valuation perspective, found attractive valuation of European equities. The post briefly compared some European ETFs, including FEZ. 
2) India

3) Brazil
4) Indonesia
5) Poland
6) South Africa
7) Turkey
8) Denmark
Balancing the risk in a portfolio
Keeping firmly in mind that the researchers' results apply to the average of many countries over many years, it is wise to spread the odds over all the countries and buy an ETF for each one above. Some will not pay off, while hopefully the winners will more than compensate. We should expect the payoff to come gradually over the course of several years. Dimson et al saw strong returns for up to ten years after the weakness.

A second measure to keep risk within reasonable bounds is to limit the total invested on this basis within a small proportion of our total portfolio, perhaps 10% or less. The allocation could, for instance, come out of the overall allocation to foreign developed or emerging market equities.

A third risk limiter is to review the situation regularly, at least once a year. This active investment strategy would best suit investors who watch their portfolio constantly.  Currencies can shift rapidly and so can markets. Sometimes, extremely rapidly depreciating currency is a sign a country is going down the tubes and the stock market is headed for total wipe out.

Selling the ETFs of countries with strong stock market gains and suddenly appreciating currencies, which will show up in our investment portfolio as a double whammy gain (see our post on the Historical Effect of Currency and Inflation on a Canadian Investor's International Portfolio), and buying those of the new weak ones, keeps the tactic everfresh.

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

Monday, 7 January 2013

Stocks that Analysts Love, and a Few that They Hate

The end of a year and the beginning of another always brings out articles about trends for the coming year and favorite stocks that are believed to be primed for success. This time around has been no exception and we can peruse such articles in the mainstream press on the Globe and Mail site, the Financial Post, Yahoo!Finance, and even on chat forums such as Financial Webring's 2012 and 2013 threads. Inspired by the idea, we decided to cast a wider net and check all the stocks in the TSX Composite Index to see which are universally loved i.e. rated a Strong Buy, and which are hated, the ones with Sell ratings.

Finding the ratings
As clients of online brokerages, we now usually, at least among the best of the brokerages, have at our disposal two main kinds of analyst ratings. First, there are those of the human analysts working at investment bankers. Then there are various automated tools that filter and rate stocks using mainly accounting data but often including some price momentum data.

In addition, we all can use for free the TMX Money site maintained by the TMX Group that runs the Toronto Stock Exchange. Pulling up a quote for a company reveals several tabs, one of which is titled Research, e.g. this one for Royal Bank of Canada (TSX: RY). The tab shows the range of investment banker Analyst ratings, anywhere between Strong Buy and Strong Sell, and it also gives a overall combined average between 1.0 at the top Buy end to 5.0 at the lowest Sell end. There is unfortunately not a stock filter choice that can extract a list of Strong Buy/Sell stocks, so we have laboriously, for the benefit of us all, looked up the 250 TSX Composite stocks one at a time and compiled a list of the Analyst ratings. We found that the vast bulk of stocks are rated somewhere between mild Buy and Hold. We ignore these stocks today.

Stocks the human analysts love
At the top of the list are the companies that have an overall combined Strong Buy rating. No less than 41 stocks currently have a composite average Strong Buy score of 1.5 or less according to TMX Money. However, when we used two automated ratings reports available on BMO Investorline - the Value Analyzer from Recognia and the Ford Equity Research Report - the results were surprising. In most cases the automated rating diverged sharply from those of the human analysts, as can be seen in our comparison tables below. Human analysts and automated ratings tools often disagree! For only a minority of ten companies did the stock rating agree or not actually disagree. And only for two companies - Goldcorp Inc (TSX: G) and Intact Financial (IFC) - did all three sources agree and point to BUY!
click on table image to enlarge

Stocks the human analysts hate (i.e. condemn with faint praise)
At the other end of the spectrum, there are far fewer stocks, only 11 in total, that receive from human analysts any kind of overall Sell rating, which we have set at a score below the mid-range 3.0 of the Hold category. Human analysts give Sell ratings far less than the automated reports! The absolute worst rating of any stock is Atlantic Power Corp's (ATP) 3.71, which places it as a Moderate Sell in the TMX schema. Surprisingly, since the automated reports appear to be "harder markers", in two cases - Bank of Montreal (BMO) and National Bank (NA) - the human analysts are pessimistic while the automated reports indicate the very opposite, a Buy situation! To compound our shock, we note that these two stocks were amongst the good looking Buys in our recent post that took a closer look into Low EPS Dispersion Stocks. Westport Innovations (WPT) has the dubious distinction of being the only company with across the board negative opinion.
click on image to enlarge

Making effective use of the ratings
As we noted before in this post, it is best to take analysts forecasts and assessments with a large grain of salt. There is undoubtedly too much optimism in most of the forecasts. Some will be correct and most will be wrong. However, we need to remind ourselves that even when the consensus is negative as it is with Westport, there is someone with a positive view (one analyst has a Strong Buy rating on the stock). Or, conversely, for a stock rated strongly positive, there is someone with a much less sanguine view (e.g. a Hold rating).

In all cases it is all about future prospects. Human analysts tend to forecast change in the future while the automated reports basically extrapolate the past. Which will be correct? By looking at fundamental ratios such price/earnings, return on equity, profit and dividend growth, debt ratios and so on, the ratings can point us to key issues about each stock. If results have been bad but there is a Strong Buy rating, such as for Wi-Lan (WIN), obviously Analysts expect a turn-around so we should look to assess how likely or believable that story is. If results have been good but there is a Sell rating, as for BMO and National Bank, then the Analyst expectation is for a slowdown or decline so we should focus on that as a key issue.

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.