Friday 21 February 2014

Convertible Debentures: the Certs mint of investments

Many years ago a famous TV commercial for Certs featured a debate as to whether it is a candy mint or a breath mint.
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The answer was that it is both at the same time - "two, two, two mints in one". 

Step forward the investing equivalent, the convertible debenture, a hybrid security that has features of both debt and equity. It is a debenture debt which promises to make fixed regular payments and has a defined maturity date. But it also is convertible into equity of the company under certain conditions. When it works well, it provides the steady income of debt repayment with the potential for capital appreciation if the common stock rises in the market.

Our simple description above inadequately describes the many details and variations possible with convertible debentures. To ease into the subject, we suggest reading:
1) A Primer on Convertible Debentures - by Hank Cunningham, author of the book In Your Best Interest: The Ultimate Guide to the Canadian Bond Market; includes a brief intro to assessing convertibles
2) Convertible Debentures for Income & Growth - on the Income Research website, which charges a subscription for access to its ratings and ratio calculations for the various issues on the market  
3) Convertible Debenture Overview - by ScotiaMcLeod
4) Convertible Bonds: Combining the Advantages of Stocks and Bonds in One ETF - by Barrry Gordon of ETF provider XTF in

List of Canadian Convertible Debentures
The Financial Post publishes a freely available list under Market Data. The screenshot below shows part of the list of almost 190 issues on the market.
(click image to enlarge)

The detailed conditions for each issue may be found on the company website, though the authoritative comprehensive source is the relevant Prospectus that issuers must file on Click on Search Database then Public Company Documents, then enter the Company name in the search box and Prospectus in the drop down box.

USA Convertibles
An easy way to get a list of convertibles of US companies is to download the holdings of an ETF focussed on that segment, such as the SPDR Barclays Convertible Securities ETF (NYSE symbol: CWB), which holds 100 of the largest issues.

Canadian ETFs, Closed End Funds and Mutual Funds
A few examples of debenture price action
1) Far out of the money, a "busted convertible" - Debenture price behaves according to bond value
Advantage Energy's conversion price is far below the current stock so the convertible AAV.DB.H hardly budges , there's no reaction to stock price movements and its value to an investor is the yield to maturity of 4.30% as the TMX Money chart below shows.
(click image to enlarge)

2) At the money, where stock and conversion price are quite close - Algoma Central's common stock price is slightly above the conversion price. In the last few months especially as ALC has risen, the price of its debenture ALC.DB has moved a lot more in sync with ALC. 

3) Deep in the money, where the stock price is far above the conversion price - Just a few days ago Cargojet (CJT) announced a huge contract and the stock price skyrocketed. So did the debenture's price, as seen below, to the point that the yield to maturity on the debt is a big negative 8.09%. That doesn't matter since debenture holders are now making a large capital gain based on the stock price. From now on till conversion into equity, CJT.DB.A will bounce up and down in tandem with the stock price.

Bad things can happen
If a company begins to get into financial difficulty, the stock price will go down, not increase, eliminating any possibility of capital appreciation. If the difficulties get too bad, the risk of default may impair the value of the debenture. As the primers above point out, an investor needs to assess credit risk among other things. And as the type of companies that issue debentures are usually smaller and not rated by the credit rating agencies such as DBRS, the self-directed investor must do more work him/herself. The provisions of each issue can vary considerably so it's a very good idea to check the Prospectus on SEDAR.

Nevertheless, convertible debentures can offer a solid way to invest in a security that offers the dual properties of equities and fixed income. The analogy with CERTS isn't perfect however, since you cannot be sure in advance whether it will be a candy mint, a breath mint, a bit of both, or even at times a possible sour taste.

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 18 February 2014

Canadian Equity Market Darlings and Dogs: February 2014 Update

February 14th being Valentines Day, it's a good time time for our semi-annual look at the Canadian equities market to see which sectors and companies the market loves (the Darlings) or shuns (the Dogs). To do that we don't count flowers, champagne or chocolates, we compare the relative weightings of sectors and stocks in two ETFs:
  • the iShares S&P/TSX 60 Index Fund (TSX symbol: XIU), which selects its holdings and weights based on market capitalization and thus tracks market sentiment, against 
  • the iShares Canadian Fundamental Index Fund (CRQ), which chooses holdings based on past hard accounting results likes sales, dividends, cash flow and book equity value
We will also examine interesting changes in the Darlings and Dogs from previous comparisons in August 2013February 2013August 2012January 2012June 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. 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 Consumer Discretionary, Information Technology and Utilities sectors and two banks - TD and Scotiabank.

Financials - Continuing the trend we noted last August, the convergence of the market view and the fundamental view is almost complete on an individual stock basis. Today there are no real Darlings amongst Financials, and there are only two Dogs - Manulife (MFC) and Sun Life (SLF).  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 even though those companies are firmly within the top 60 largest market cap stocks on the TSX.

Energy - The situation is much like August. There has been no further convergence of market view with fundamentals. CRQ still has more weight in Energy than XIU, thus keeping the sector as a Dog. However, one big company - Enbridge (ENB) - is still a market Darling. Encana (ECA) meanwhile remains as the perpetual and the most extreme Dog, with the largest difference in weighting between XIU, where it is in 21st place at 1.28% and CRQ, where it is 7th at 3.67% adjusted weighting.

Materials - Not much has changed in this sector either. Perpetual Darlings Potash Corp (POT) and Goldcorp Inc (G) remain so with stock prices 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 - As the expression goes, plus ça change, plus c'est la même chose - the two DarlingBCE Inc (BCE) and Telus (T) continue to be the object of market desire, being vastly overweight in XIU compared to CRQ.

Industrials - Canadian Pacific Railway (CP) continues its resurgence as a Darling, which along with perpetual Darling - Canadian National Railway (CNR) - makes the whole sector so.

Consumer Discretionary - This sector has fallen out favour and is now a mild Dog. Despite having two extra sector companies in XIU that add 1.18% in weight, the sector has less weight than it does in CRQ. Magna International (MG) is the largest example of the unloved in this sector.

Consumer Staples - It's steady-as-she-goes in this neutral sector. Individual companies themselves remain in balance too.

Health Care - The market loves both companies in this sector - Valeant Pharmaceuticals (VRX) and Catamaran Corp (CCT). By fundamentals, Catamaran is too small even to be included in CRQ yet it is the 32nd largest holding in XIU.

Utilities - Though there is one extra utility in CRQ, it puts a lot more weight in this sector. The market thinks the sector and individual companies are Dogs.

Information Technology - Blackberry (BB) continues its fall. As the fundamentals are catching up with the market view, it is less of a Dog.

The Darling and Dog sectors and stocks since 2010
Most sectors and companies are still in the same position of being either Darlings - Materials (Potash Corp and Goldcorp), Healthcare (Valeant) and Telecommunications (BCE and Telus) - or Dogs - Financials (Manulife and Sun Life) and Encana. Utilities and Consumer Discretionary are back to being Dogs. The brief moment last August when Darling sectors outnumbered Dogs has ended and there are now five Dog sectors and only four Darling sectors.
(click on image to enlarge)

How do the Darlings and Dogs stocks' numbers look?
As before, we checked the stocks in a Globe&Mail WatchList to see recent stock and company financial performance. This time we have a bit of a surprise. The table screenshot below shows surprisingly that Dogs Manulife and and Sun Life both have performed well! Manulife in particular looks interesting. It has just reported good earnings, continuing its recovering financial performance. Yet it's Price/Earnings is reasonably low at 14. As we said last August, perhaps there is more value yet to be recognized.
(click on table image to enlarge)

Valeant is the other end of the spectrum. To use our Valentine's Day theme, it is like an exciting affair, losing money but on an aggressive acquisition strategy that seems to enthral. Will it turn out to be long term love or just a disappointing affair?

XIU and CRQ, or other broad market funds can also be used directly as 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 herehere 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.

Friday 7 February 2014

Dividend Stock Olympics - The 15 Canadian Medalists

Inspired by the upcoming start of the 22nd Olympic Winter Games in Sochi, we decided to look at what's inside the Canadian equity dividend ETFs that we reviewed last week to pick out the athletes (companies) who qualify for gold, silver and bronze medals. Our selection method is similar to many Olympic sports like figure skating and freestyle skiing - the judges decide, in this case the managers of the various ETFs. Who scores the most points, i.e. which stocks show up in the holdings of the most ETFs? These stocks can be good candidates for investors who want to directly build a portfolio of solid dividend payers.

The 15 Medalists are (please stand for the national anthem) ...
It's not who you might think, like the Royal Bank, Canada's largest company by market capitalization, or any of the other banks, though there are a bunch in the medals. The one and only gold medal, since it is the only stock that appears in every single dividend ETF, goes to IGM Financial Inc. (TSX symbol: IGM) manager and distributor of financial products, mainly mutual funds under banners such as Investors Group, Mackenzie and AGF.

There are nine stocks in this group (it must be other countries who won the gold) as all but one of the ETFs, or seven out of eight, hold them:
  • Corus Entertainment (CJR.B)
  • Shaw Communications (SJR.B)
  • Bank of Montreal (BMO)
  • Bank of Nova Scotia (BNS)
  • CIBC (CM)
  • Great-West Lifeco (GWO)
  • Power Financial Corp. (PWF)
  • Rogers Communications (RCI.B)
  • TELUS Corp. (T)
The competition is fierce and there are only five stocks that appear in six out of eight of the ETFs:
  • Canadian Oil Sands (COS)
  • Enbridge Income Fund Holdings (ERF)
  • Royal Bank of Canada (RY)
  • BCE Inc. (BCE)
  • Emera Inc. (EMA)
Our comparison table below shows which stocks appear in which ETFs. It confirms that most of the ETFs are quite alike for a good chunk of their holdings, the exception being iShares S&P/TSX Canadian Dividend Aristocrats Index Fund (CDZ) whose selection criteria based strictly on increasing dividend payers has excluded most of the big banks since the 2008 financial crisis.

To get an idea of what might make these stocks so attractive, we created a watchlist in Globe Investor's old WatchList tool, entered the stock symbols and manipulated the columns with the result in the screenshot below. All the stocks have healthy five-year returns and a higher than average (the TSX Composite is about 2.7% at the moment) dividend yields that look quite sustainable given payout ratios. Only two stocks - COS and GWO - are very volatile compared to the market, i.e. sport a beta much over the market average of 1.0.

We note in passing that we investors should always be aware that data errors can creep into any source - Bank of Nova Scotia does not have negative cash flow!! If some number looks odd, it is well worth digging into. We also found a bunch of companies that had actually increased their dividends over the past five years, unlike what the Globe WatchList says. In this and the honourable mention list below, this includes ticker symbols RCI.B, CPG, MIC, MTL and RUS. Raw basic data generally is ok, it is derived values like ratios and growth rates where things get messed up. Globe and other resources like online brokers rely on outside data gathering companies who have a difficult job to compile the huge amounts of data investors want so errors do occur regularly.

Close but no medal
There is also a group of strong competitors, the chasing pack one might say, who appear in at least half the ETFs. The list of twenty-five stocks looks as follows:

We finally see stocks in sectors not represented at all amongst the medal winners, such as real estate, materials and industrials.The ETF CDZ widens its difference with the other ETFs, with even less of its holdings over-lapping.

The data for these stocks looks generally positive too, though returns haven't been as uniformly good, there are more volatile stocks and some have very high Price to Earnings ratios.

When it comes to stocks held by a minority of the ETFs, there is much less agreement. The ETFs spread over 122 stocks for their remaining holdings. CDZ is very much the most unique - it has no less than 29 stocks, 45% of its total number, that no other ETF holds. The next closest, PDC, has only 11% of its stocks held by no other ETF. The most conforming is ZDV, which holds not a single stock that no other ETF holds.

Bottom line:
The above stocks are a pretty good starting list for assembling a dividend portfolio. But it's good to keep in mind what can happen in the Olympics, especially when judges are involved - the winner isn't necessarily the best, only the one they liked the best. There may be one-performance wonders too. Be your own judge, as we are sure everyone likes to do anyway when watching the excitement of Olympic competition.

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.