Friday, 30 August 2013

Savvy Investor Quizzes - Beware the Tricky Questions and Answers

The Globe and Mail's recent article Are you a savvy investor? Take this quiz to find out caught our attention. Would we get the right answers? Is there something we could learn since no one can know everything? But we quickly found that most questions had several possible answers, or "none of the above", as several commenters also noted. Let's go through the questions and add what else we think needs to be considered.

Q1 An investment pays 5-per-cent annual interest. If you put in $1,000 today, how much money will you have two years from now?

The correct answer is said to be more than $1100 but less than $1200. There is an implicit assumption that the investment will pay compounding interest to arrive at $1102.50 (1000 x 1.05 x 1.05). But as we saw a few weeks ago in a post on finding the highest rate GICs, the compounding assumption is not always the case and some investments pay only simple non-compounding interest. The investment could then pay $50 per year (1000 x 0.05) for two years giving a total of $1100. Furthermore, almost every investor with $1000 to spare to invest must surely have enough income to pay at least some tax. Even at a minuscule 10% tax rate, the $102.50 interest would be reduced by $10.25 after-tax. The correct answer would thus more probably be a) "$1100 or less". The truly savvy investor will ask beforehand how interest will be calculated on an investment.

Q2 If you earn $1,000 on the money in your RRSP, when will this income be taxable?

The supposed correct answer is "when you take the money out of your RRSP". In a purely mechanical and superficial sense, that's true. Any and all money withdrawn from an RRSP, whether it's contributions, gains or earnings, must be reported on your tax return for that year and has tax applied to it at the ordinary income rate. But the economic reality, the one that matters for understanding how an RRSP works and what makes it valuable, is quite different.

As shows in step by step detail in Nitty-Gritty of the RRSP Model, the essence of what happens is that earnings from your money put into an RRSP are not taxed, period - not while inside and not when withdrawn either. That is also what makes an RRSP and a TFSA equivalent, except that the investor in the RRSP is allowed to defer payment of the original tax that was due in the year when the original contribution was made, i.e. the RRSP refund is the government deferring receipt of, and lending you, the tax. The tax refund is not your money it's government money.

The government wants it tax money back, plus interest. Plus interest? Yes, indeed. The key sentence in the article is "The taxes paid by the RRSP on withdrawal are not taxes on the portfolio's profits. They are the Future Value of the unpaid tax on the original employment income." The interest rate charged - the number that generates the future value in the calculation - is whatever rate of return your investments have managed to achieve while inside the RRSP. Thus, we believe a savvy investor would more likely answer choice d) "The earnings are never taxed".

Q3 If you know you will need all of your savings to pay for expenses two years from now, stocks are a safe place to park your money until you need it.

On this question we agree, the savvy investor knows that the enormous possible variation in the short term, most critically on the downside - remember 2008 when the TSX Composite Index fell by 33% - makes stocks a very bad place to put money. As we argued in a couple of our early posts on Setting Investment Objectives and Risk: What Can You Afford and What Can You Put Up With? the type of investment chosen must suit the objective in terms of risk for the time horizon.

Q4 Over the next 20 years, the stock market will probably earn more money than a savings account.

For this question as well, we think the Globe's correct answer - highly agree - is the best choice. It all hinges on the word "probably". Has there actually ever been any 20 year period over which stocks have not earned more than a savings account? We cannot tell as the data for bank accounts does not seem to be readily available online. There is suggestive data out there - e.g. charts like the one below from that show the TSX Composite Index always generating a healthy positive return over any rolling 20 year period from 1935 to 2007,
and others like the Credit Suisse Global Investment Returns Yearbook 2013 that show Canadian equities handily outpacing T-Bills, whose return would be similar to that of a savings account, since 1900.

Finally, of course, the future may not be like the past so the cautionary note in the use of the word probably adds the necessary realism about the unknown future. The savvy investor knows the difference between a probable outcome and a sure thing.

Q5 Over an average 20-year period, what annual rate (what per cent a year) would you reasonably expect to earn by owning a typical basket of Canadian stocks?

The Globe's correct answer is 6-8 percent. Let's do our own calculation to see on what basis this may be true. The summary chart below shows the enormous impact on returns of the following factors.

Critical Factor #1 - Fund fees & costs cause under- or out-performance
We'll have to assume that the typical basket refers to the TSX Composite. Since this index represents well over 200 stocks (the number has varied between just over 200 to 300 stocks over the years), the only way we retail investors can own such a basket is through a mutual fund or an ETF. That's important because the index return does not account for the return reduction resulting from fund fees and costs. A passive index-tracking ETF such as the iShares S&P/TSX Capped Composite Index Fund (TSX symbol: XIC) currently has an expense ratio of 0.27%. That figure is about the amount by which XIC will under-perform the index. Our data source - StingyInvestor's Asset Mixer - uses 0.3% annual under-performance for an ETF.  Stingy Investor assigns annual performance vs the index - what it calls a Global Alpha Assumption - as follows: Index mutual fund minus 1.0%; Average mutual fund minus 1.7%; Bad mutual fund minus 4.1%; Good mutual fund plus 1.8% i.e. out-performance. The numbers come from research into the spread of historical mutual fund results.

Critical Factor #2 - Inflation cause a difference between nominal returns and real "what is your dollar worth" returns
Inflation is an ever-present menace that constantly reduces the net return to an investor. A high nominal return is of little benefit if inflation is even higher such as during the 1970s. That's why we believe the investor should focus on real after-inflation returns. We cannot tell which type of return the Globe quiz is referring to but our own calculation based on real returns is much closer to the Globe answer than one using nominal returns. Our chart shows that nominal returns have always exceeded real returns by a big margin. The blue and orange lines show nominal returns. The yellow line shows the real return, which is what we believe to be the important relevant line.

Critical Factor #3 - Compound aka geometric rate of return is lower than average aka arithmetic return
We believe the long term investor putting his or her money in for 20 years will be interested in the end result, the growth over the period, not the average of the yearly ups and downs. If the TSX is up 10% one year and down 10% the next year, the arithmetic average is 0% but that's not what the investor who held the TSX for two years would have at the end. The compounding method works like this - $100 invested goes up 10% to $110 after year 1; then a 10% market drop would take away $11 and the end result is $99. The result in total is minus 1% or about minus 0.5% per year compounded, which would be the geometric rate of return. The geometric return will always be less than the arithmetic and the wilder the TSX swings the more the difference. Our chart shows the difference between the historical nominal arithmetic and geometric rates. It's about 1% per year. For real returns the difference is about the same 1%. The yellow line in our chart shows the net return adjusted for both inflation and the compounding method of calculating return but not fees.

Critical Factor #4 - The Average ignores the range of possible outcomes
The yellow line shows the compound returns from the TSX index over various 20 year periods ending December 31st of the years on the horizontal axis. The variation was anything from 2.4% ending in 1992 to more than triple that - 8.2% ending in 1997 - just five years later. As the bad joke goes, if you stick your head in the oven and your feet in a freezer, on average you will be comfortable. It so happens that an investment in T-Bills for the same time period would have produced a compound annual real return of 3.3%. As we noted regarding Question 4, probably means usually stocks out-perform, not always.

The fee-adjusted real compound returns for the various actual investment fund options would run parallel to the yellow line. To keep the chart tidier, we have inserted only the points for all the funds where the real return was highest, lowest and one in-between. For example, in the lowest year 1992, a bad-performing mutual fund would have suffered negative returns 4.1% per year lower than the index so the net positive index return of 2.4% would have become a negative 2.7% (2.4 - 4.1) per year compound loss. Ouch!

Bottom Line - Through most but not all of recent market history an investor holding a low cost efficient index ETF would have made anywhere from 2.1 to 7.9% before tax. Taking away taxes if held in a non-registered account at marginal rates somewhere around 30% for a mix of capital gains and dividend returns (see's marginal rates by province), the highest tax bracket investor might have achieved a net return of only1.5% or so at the low end. It's not the reasonable expectation but it could happen again. The savvy investor is cautious and conservative in forming expectations.

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, 26 August 2013

Update on High-Yielding Canadian Mortgage Companies: New Entrants & Rising Interest Rate Effects

Our May review of Canadian high-yielding mortgage companies listed seven publicly-traded choices facing the investor. We missed a few very new offerings, as we found out when reading MoneySense magazine's MICs: Make money on debt article. The article provides only some basic info on the various options so let's take a closer look to help readers possibly interested in adding this type of holding to their portfolio. In addition, we'll see how the on-set of rising interest rates is affecting mortgage companies.

I) The New Entrants
There are six companies that are new on the market since the beginning of 2012. An over-riding challenge is thus that there is little track record to help our assessment.

Hold in registered accounts for some, in non-registered for the others
In our comparison table above the first thing we notice, a critical factor for appropriate choice of account in which to hold these funds, is that there is a mix of tax status - ERM, TZZ and TZS are true MICs that are tax-exempt themselves if they pass all income, which is 100% ordinary interest, through to investors for taxation in investor hands. The ROI funds are all taxable closed-end funds that distribute, for the moment at least, lesser-taxed capital gains or non-taxed return of income.

ERM, TZZ and TZS thus go best in a registered account.

The ROI funds are excellent for non-registered taxable accounts, until the complicated forward agreement that transforms interest into capital gains runs out. The March 2013 federal budget announced that this tax loophole would henceforth be closed and these three funds have been caught in the net. Perhaps that is the reason these funds all trade at a considerable discount to their Net Asset Value (NAV), or maybe it is the discount often observed on closed-end funds. Certainly the unitholder's right to redemption at NAV once a year doesn't work very well to let arbitrageurs trade away the discount as no more than 15% of outstanding units may be redeemed per year. Another possible reason for a fairly big discount to NAV may be lingering doubt following a temporary suspension of redemptions in 2012, an action that caused internal review and the eventual launch of ROI funds later in 2012 onto the TSX public market. After the forward agreements expire, the ordinary interest income that will be distributed henceforth means that holdings of ROI funds would then also work best in a registered account.

Distribution re-investment good for some, bad for others
The DRIP plans of the ROI funds, which re-invest at NAV, are useless for the investor as long as NAV is below market price. Better are Trez Capital's plan which re-invests at the lower of market price or NAV within limits.

Ability to maintain payouts difficult to judge

With such new funds and no track record, we are faced with a difficult job to try judging whether these companies can maintain, let alone increase, their cash payouts over time. Our second table below presents some pertinent information. Unfortunately, as we show, Eclipse and ROI do not even reveal the average yield of their holdings. Trez's monthly portfolio summaries show a pie chart with the spread of mortgage holdings' interest rates that suggest the bulk garner a rate above what the MICs pay out, so that is a positive sign.

Two of the ROI funds - RIH.un and RIR.UN - have experienced steadily declining NAV in their short lives, a sign that they have been paying out more cash than the holdings have been generating.

Beyond interest revenue, the other key to sustainable distributions is the level of expenses, which reduce cash available to distribute. The published management expense ratio is not the whole story. Service / trailer fees paid out to financial advisors or brokers whose investor clients hold the securities, must be added in, as well as operating expenses and performance fees. Performance fees (paid for returns that exceed a benchmark like a 2-year Government of Canada bond rate plus either 4 or 4.5%) in particular must make the investor wary since they appear destined to push up total fund expenses considerably. Two of our previous batch of mortgage companies that carry such a performance fee - First National Mortgage Investment Fund (FNM.UN) and Timbercreek MIC ((TMC) - have had higher actual total expense ratios. It will not be surprising to see the companies in our new batch with performance fees - RIH.UN, RIR.UN and TZZ - generate high total expenses when they come to publish their first annual reports (which is where this information can be found).

The funds with performance fees also hold more aggressive, riskier mortgage portfolios, with higher percentages of junior first (see explanation of differences in precedence in the Eclipse Prospectus on page 14) and second mortgages and higher ratios of mortgage loan to property value. As a consequence, the interest rates charged and the payouts to investors are higher.

The ROI funds have a final source of uncertainty that could be good or bad for returns and ultimately, payouts. Unlike MICs, which are not permitted to do so, the ROI funds all develop and own property with other partners.

Concentration of mortgage assets
ERM and TZZ have the most diversified assets in terms of geographic spread and limits per borrower.

Investment focus, term duration, loan-to-value ratio and 1st vs 2nd proportions
The safest offering appears to be TZS. It is the only one to hold 100% first mortgages, the least in junior tranches and the lowest loan to value actual ratio and policy limit.

Management skin in the game is either none or significant
Only in the case of RIR.UN, where managers and directors own about 21% of the units, does management hold any significant stake in the success of the stock.

Amount of leverage employed
TZZ has the lowest limit on the use of leverage and TZS the highest. The thinking appears to be that it is ok to put more leverage on a safer portfolio. It does lessen TZS' safety back towards the other stocks though.

II) Effect of rising interest rates
Since early May interest rates have started rising. The effect on all our mortgage companies, both the present and the previous group, has been to lower stock price. It makes sense since they all offer stable relatively fixed income and as is the usual case for fixed income, rising interest rates, aka required return, means a falling price. The charts below from Yahoo Finance show the almost universal effect.

New group

Older group from previous post

The same effect can be seen in the table below of the change in cash yield (current payout as a percentage of stock price) from May to today. These changes are mostly roughly in line with the 0.3% or so rise in 2 to 3 year Government of Canada bond rates.

Two companies have had much bigger price declines / yield rises. MCAN Mortgage has just released poor financial results with earnings per share down 27% and taxable income down 64%, the latter figure which the company warned may well cause a reduction in the cash distribution. It is perhaps little wonder the CFO was replaced in June. Firm Capital's (FC) fall is harder to explain with tangible news - its latest quarterly results showed only a small 1.8% decline in profits. The figures do not threaten a distribution cut. FC looks like a reasonable value at the moment.

Bottom Line
Of the new offerings, TZS offers the best choice of safety and probable stability of distributions along with a low expense ratio. However, a very similar offering from the May post list, Timbercreek Senior MIC (MTG) is even more attractive. First, it provides a 0.8% higher yield. The company has also announced a conversion plan (still to be approved by shareholders) that would amongst other effects, eliminate the 0.5% trailer fee and thus appreciably reduce expenses.

The recent disappointment of MCAN, which looked good back in May, illustrates well how even the amount of digging we have done is not necessarily sufficient to avoid trouble and obtain the steady high income we seek. Heavy insider selling in late May and early June would have been a warning sign, as would have been the resignation of the CFO. Now that the price has dropped a lot the insiders are buying.

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 August 2013

Canadian Equity Market Darlings and Dogs: August 2013 Update

As we have been doing every six months or so, we are again taking a look at the Canadian equities market to see which sectors and companies are currently in hot demand (the Darlings) or out of favour (the Dogs). To do that we compare the relative weightings of sectors and stocks in two ETFs:
We will also examine interesting changes in the Darlings and Dogs from previous comparisons in February 2013, August 2012, January 2012, June 2011 and the original post in April 2010.

The Numbers
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 six months for each ETF, which tells us stocks and sectors that have been moving up or down, either in terms of price (XIU) or fundamentals (CRQ). The bigger shifts are highlighted in Bold.
(click on table image to enlarge)

As a cross-check to be sure the sector differences are not due to the fact that CRQ has 28 more holdings than XIU's 60 (which might tend to result in XIU being more concentrated and have higher individual percentages than CRQ) we've re-calculated weights for CRQ using only its top 60 holdings like XIU. This adjustment for the most part makes little difference to the results but it does matter a lot for the Utilities sector and a couple of banks.

Financials - This is a sector where the market view and the fundamental view have been converging. Market value has been rising while the fundamental value has been dropping. As a result, today there are no real Darlings, and the Dogs - Manulife (MFC) and Sun Life (SLF) - are much less pronounced than previously.  That CRQ continues to have a much heavier weighting in our table in the Financials seems to be a quirk of XIU's construction.  Several Financial companies that are in CRQ such as Great West Life, Power Financial, Fairfax Financial Holdings (see the list of the main stocks not held by the other fund at the bottom of the table) don't even figure in the XIU portfolio. And those companies are firmly within the top 60 largest market cap stocks on the TSX.

Energy - In this sector, there has been a convergence of market view, which in this case has been falling in total weight from the February update, while the fundamentals have been rising in weight in CRQ. Now CRQ has more weight in Energy than XIU. This is a dramatic reversal of situation from a few years ago. Only one big company - Enbridge (ENB) - remains as a market Darling.

Encana (ECA) meanwhile remains as the perpetual Dog. It has been sliding down the cap-weight table since it dropped out of the top 20 a year ago.

Materials - The recent battering of miners has definitely reduced the love factor but our previous description as perpetual Darlings still seems apt. Potash Corp (POT) and Goldcorp Inc (G) still are priced at levels significantly higher than accounting fundamentals justify. Apart from those two stocks, the difference in weight between XIU and CRQ is due to the fact that XIU includes several miners excluded from CRQ, and whose cap weight is not in the top 60 anyway.

Telecommunications - The story is exactly the same as in February - the two Darlings BCE Inc (BCE) and Telus (T) continue to be the object of market desire, being vastly overweight in XIU compared to CRQ.

Industrials - Neutral no longer, the rebirth of Canadian Pacific Railway (CP) has made it a Darling, which along with a continuing Darling - Canadian National Railway (CNR) - makes the whole sector so.

Consumer Discretionary - Steady as she goes is the byword, this sector remains neutral. Market views and fundamentals are closely in balance.

Consumer Staples - This sector has made resurgence since February and is no longer a Dog. It is now neutral. The individual companies themselves look pretty much in balance too.

Health Care - There is one big love in this sector - Valeant Pharmaceuticals (VRX) is the sole health care company in both XIU and CRQ. The market must be anticipating very good times ahead for VRX.

Utilities - If we adjust for the fact that there are more utilities in CRQ and take only the top 60 holdings in CRQ, then the smaller utilities fall away and XIU is reasonably closely in balance with CRQ. The sector and individual companies are neutral.

Information Technology - Research in Motion (RIM)'s name change to Blackberry (BB) has not made much difference. The weight based on fundamentals is slowly falling but not nearly as fast as the weight set by the market view. So the company and the sector as a result remain a firm Dog.

The Darling and Dog sectors and stocks since 2010
Some sectors and companies are still in the same rut of being either Darlings - Materials (Potash Corp and Goldcorp) and Telecommunications (BCE and Telus) - or Dogs - Financials (Manulife and Sun Life) and Encana. The other sectors and stocks have shifted into or out of favour. For the first time since 2010, when we started this series of posts, there are more Darling (4) than Dog (3) sectors.
(click on image to enlarge)

How do the Darlings and Dogs stocks' numbers look?
Again, we checked the stocks in a Globe&Mail WatchList to see if the stock evaluation data it contains could suggest whether they really have been good or bad. The tale is quite similar to February. The table screenshot below shows that ranking the stocks by Return on Equity puts two of the Dogs at the bottom. The most notable change is that Manulife has been making a resurgence in its financial and market returns performance. Perhaps there is more value yet to be recognized.
(click on table image to enlarge)

The stocks with the most extreme divergence between the market view and the fundamentals are the best candidates to offer the greatest future surprise. That's probably good hunting ground for the investor looking for under-valued stocks.

XIU and CRQ can also be used directly as nicely-diversified investments for those investors who do not feel confident, or who don't have the time, to investigate individual stocks. The differences in weightings and holdings are only a couple of aspects in comparing the two ETFs. See our previous posts reviewing Canadian equity ETFs here, here and here.

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, 12 August 2013

Tools and Tips for Picking the Highest Rate GIC

Guaranteed Investment Certificates are probably the simplest to understand investment security. A couple of good overviews of the basics are the primer on GICs and BalanceJunkie's GIC Frequently Asked Questions. Yet they still offer a few challenges and tricky bits for the investor trying to find the best return.

Finding the available GICs and key data
CANNEX is the most complete and up-to-date source of current GICs with data on rates by length of term, minimum deposit, redeemability and registered vs non-registered account eligibility for 53 banks, trust companies and credit unions that offer GICs. Unfortunately, the free information does not include important columns for compounding frequency or payment frequency. Nor are tables sortable to quickly enable finding the highest rate on offer. That's important because rates and competitive conditions change so the company offering the best rate today won't necessarily be the same next week or even tomorrow. 

Most important in a practical sense is that only a much-reduced selection is available from the typical self-directed discount brokerage. Discount brokers do not usually offer the highest rate GICs. Chasing the highest rates outside your main brokerage account might involve creating a spaghetti of accounts over time, which will get cumbersome and unwieldy to manage, for example when reinvesting matured funds. Thus it will be necessary to decide whether the convenience of having all investments together at the broker, with instantaneous online account management, offsets what will not be the highest rate in the market.

Your broker's GIC offerings will be found in the fixed income section. Online broker investment minimums are often higher at $5000 than the $1000 minimum many GIC providers offer when investors deal directly with them, as shown in the CANNEX tables.

Calculators to compare rates
In order to decide if the payoff of a higher rate elsewhere is worth the extra effort, it helps to know the bottom line difference in dollars of interest earned. In addition, the databases and tables above do not show the different end dollar results of several choices and trade-offs - how much does annual vs semi-annual vs monthly compounding affect things, or does a higher annual rate with no compounding work out better than compounding, or does locking in for a year have a big enough payoff compared to a lower rate redeemable GIC?

This calculator will help you do the numbers:

  • Compound Interest Calculator from - pop in four numbers investment amount, interest rate, times compounded per year (i.e. annual = 1, semi-annual = 2 etc), number of years invested. The calculator shows the arithmetic detail step by step of how this works out which really helps to avoid entering the data incorrectly.
Non-Compounding GICs - These are simple enough that no fancy calculator is required. Do this: Published Interest Rate x Principal Amount x Number of Years Term e.g. Home Trust's 5-year GIC - 2.67% x $5000 x 5 years = $667.50 in total interest. It doesn't matter whether the payout is monthly, semi-annually or annually, the total interest paid out by the end is calculated the same way. Note however, that the interest rates offered on GICs that pay more often are lower than for annual pay GICs.

Let's look for a GIC to hold in an RRSP in a self-directed discount brokerage available to someone living in Ontario.

According to, ICICI Bank offers a 5 year GIC with 1.75% compounded annually with a minimum investment of $1000. Looks attractive relative to what big banks are offering per the CANNEX list. Meanwhile, a GIC inventory search at brokerage BMO InvestorLine for a 5-year investment turns up a best rate of only 1.53% compounded annually from Homequity Bank while the ICICI Bank offering is only 1.50%. At the ICICI website itself the best 5-year rate is only 1.55%. 

Lesson number 1 - Rates vary, even from the same provider for the same GIC.

Note also that BMO's minimum investment is $5000, while it is only $1000 when buying direct from ICICI. 

Lesson number 2 - Rates on cashable or redeemable GICs are significantly lower than on the non-redeemable locked-in version. In ICICI's case the 5 year cashable pays only 1.15% interest. In addition, if the redeemable ICICI is redeemed early there will only be interest paid at an annual rate of 0.50% and that's after being invested a minimum of six months. Up to six months, principal is returned without any interest. That's quite a severe penalty.

Another item of note is that there are a lot of odd and unknown names in the CANNEX list of GIC providers e.g. how many people have heard of ICICI Bank and Homequity Bank? The important fact to observe is that both provide GICs backed by the Canada Deposit Insurance Corporation, behind which stands the Government of Canada. Up to $100,000 of principal and interest in GIC money per institution is guaranteed by CDIC. As far as this blogger is concerned an ICICI GIC is therefore just as safe as a Royal Bank GIC, though the chances of actually needing to invoke the guarantee is not the same.

Returns - Using the WebMath calculator, the total interest on a 5 year $5000 investment would be:

  • ICICI 1.50% Annual Compound Non-redeem from BMO InvestorLine - $386.42
  • ICICI 1.55% Annual Compound Non-redeem direct from ICICI - $399.70
  • Homequity Bank 1.53% Annual Compound BMO InvestorLine - $394.39
  • Homequity Bank 1.53% Annual Pay BMO InvestorLine - $382.50
  • Homequity Bank 1.49% Semi-Annual Pay BMO InvestorLine - $372.50 
  • Homequity Bank 1.44% Monthly Pay BMO InvestorLine - $360.00
  • Sun Life Financial 0.40% Annual Compound BMO InvestorLine - $100.80
  • AcceleRate Financial 2.1% Annual Compound direct from AcceleRate - $547.52

The next to last example of Sun Life is the lowest paying 5 year GIC in BMO's list. Clearly, the choice of provider makes the most difference to the investor's return. 

The last example of AcceleRate, the highest in the CANNEX list, indicates a fairly substantial higher return. But there's a catch, the deposit is not CDIC insured; it is backed only by the Deposit Guarantee Corporation of Manitoba a far less solid guarantor.

Bottom Line: Are the above differences worth it? It's up to each investor to decide but clearly it pays to compare alternatives. Rates are so low these days that the differences matter even more.

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, 2 August 2013

Canadian Oil & Gas Stocks - Does better Corporate Sustainability & ESG mean better performance?

There's no doubt about it, oil and gas companies attract more than their share of attention, much if not most of it critical. Whether it's disastrous spills, carbon emissions, native land rights, water quality, air quality, ecological effects on flora and fauna, land reclamation, extractive technologies like fracing, the companies are in the thick of serious highly-visible issues. Yet their many products are essential to our way of life and the stocks of the companies form a substantial part of any broad equity mutual fund or ETF and of every Canadian's pension whether it is private plans or the Canada Pension Plan's Investment Board. The investor faces the question not of whether to participate but on what basis.

Going beyond broad funds that pay no attention to Environmental, Social and Governance (ESG) factors, the investor with a goal to do Socially Responsible Investing (SRI) in Canada will find some mutual funds (see 2012 list from NEI Investments) and one ETF - iShares Jantzi Social Index® Fund (TSX symbol XEN) - that do select only companies following a "higher standard of environmental and social performance", as XEN's profile puts it. However, such funds may be constrained to a certain size and exclude worthy companies in a sector. An investor thinking of buying individual stocks may also want to know more about the details which explain inclusion or exclusion since the fund companies publish nothing of their actual assessments for competitive or proprietary reasons. Finally, the paper The Impact of Corporate Sustainability on Organizational Processes and Performance by Harvard Business School researchers, cited in our recent review of corporate sustainability of Canadian consumer stocks, found that accounting and stock performance by resource extraction companies was also particularly influenced by ESG factors.

We therefore decided to examine ESG at the 15 largest (by market cap) oil & gas producers with significant operations in Canada.

The ESG corporate sustainability factors
As with the consumer stocks, we included three key factors that the Harvard paper found to influence performance:
1) Board of Directors committee with a sustainability mandate
2) Executive compensation tied to ESG performance
3) Formal stakeholder engagement processes
Our research method for these items was the same too - reading the annual Management Proxy Circular from Sedar or on the company website and looking for the company's Corporate Sustainability report, either on its website or from the Global Reporting Initiative database, which has been spearheading standardized comprehensive reporting on a worldwide basis for ESG.

We also gathered other evidence that a company has been taking sustainability seriously:
4) Published, annual, up to date corporate sustainability reports, preferably audited and submitted to GRI
5) Recognition by ESG assessment organizations such as Corporate Knights Global 100 for 2013,or the Dow Jones Social Index (whose holdings are not publicly disclosed by the index provider, so the information comes from companies themselves touting their selection)
6) Membership in voluntary environmental reporting organizations like CDP and Extractive Industries Transparency Initiative (EITI)
7) Constituent of XEN and thus approved by the Jantzi methodology
8) High rating in the Board Shareholder Confidence Index published by the Clarkson Centre for Business Ethics and Board Effectiveness - The governance dimension does not seem to be part of the Jantzi methodology for XEN and we discovered that a couple of XEN holdings - Penn West Petroleum and MEG Energy Corp - have poor scores. For the investor, good governance by a company is a prime matter of concern. It helps ensure that management, the Board and major shareholders treat all shareholders fairly and behave honestly.

Corporate performance factors
To see to what extent good or bad ESG has been associated with accounting and investor success for these companies, we gathered profitability ratios -
a) Return on Equity (ROE), from the Globe and Mail's WatchList, and
b) Return on Assets (ROA) from Morningstar Canada.

We also gathered from the WatchList a single metric that any investor would care about -
c) Total Return (i.e. capital gains plus dividends) for the last five years - for each stock and for several benchmarks, including the Canadian energy sector ETF iShares S&P / TSX Capped Energy Index Fund (XEG).

Our comparison table below reveals some interesting and surprising results. As is perhaps appropriate, green text in cells means good.

Most oil and gas companies are doing a pretty good job on ESG
Eleven of fifteen companies have multiple green entries. Only four companies don't seem to be paying much if any attention to ESG - Baytex (BTE), Tourmaline (TOU), Crescent Point (CPG) and MEG Energy (MEG). It is a puzzle to us how MEG could be justified as a holding for iShares' XEN. Other companies, like Husky and Canadian Natural Resources, look to be stronger candidates.

The oil and gas stars of ESG are Cenovus (CVE), Suncor (SU) and Encana (ECA), with green across the table. Talisman (TLM) and Imperial Oil (IMO) are not far behind.

But looking at the performance figures gives us a shock.

Performance seems unrelated to ESG!
The bottom of the performance table, whether sorted by ROE as it is, or by ROA or Total Return, is occupied by ESG-star Encana. Conversely, right near the top is ESG bad-boy Baytex. Maybe our time frame isn't long enough and good ESG practices will prove themselves eventually. Maybe even Encana will turn itself around. The latest quarterly results announced a small net profit.

Using the results
Depending on your viewpoint, you could either say that attempting to pick oil and gas stocks based on ESG ratings is a waste of time or, that picking successful companies that are also highly rated for ESG is quite feasible.

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.

Postscript: TD Economics' Special Report The Greening of the Canadian Economy reviews the environmental performance of the Canadian unconventional oil industry and finds it generally good.