Saturday 28 June 2014

Long Term Stock and Bond Return Expectations for Canada - the Current Outlook

A view of probable future returns is essential for individuals to develop realistic planning assumptions for retirement savings growth. Two years ago we wrote about the prospects for long term returns (10 years or more) of the Canadian stock market, the S&P/TSX Composite Index. Our estimate then was an average compound real after-inflation return of 4.2% per year.

The last two years have seen undeniably outstanding stock market growth - almost 32% in price gains alone (leaving aside another yearly 2.5% or so of dividends) as the Yahoo Finance chart below shows. It's time for an update look forward, which we'll also expand by looking at probable bond market returns and inflation.

Stock Returns

Method #1 - First, we'll apply the same method as we did two years ago:

Future Return = Current Dividend Yield + Estimated Growth Rate of Dividends

Current Dividend Yield - The current S&P/TSX Composite dividend yield (the current annualized sum of dividends being paid by the 245 stocks in the index divided by the current stock prices in proportion to the market cap size of the companies) is not easily found. It is not unfortunately not published by the index providers so the individual investor must use an approximation, as Globe columnist John Heinzl described in How to find index yields. The answer is to use the yield on an ETF that tracks the index, such as the iShares S&P/TSX Capped Composite Index ETF (TSX symbol: XIC). Both the Trailing Yield and the Distribution Yield round out to the same 2.4% and the recently lowered MER is now down to a paltry 0.05% so we'll use a Current Dividend Yield of 2.4%.

Estimated Growth Rate of Dividends - A declining working age population and slower population growth in Canada cause forecasters to predict markedly lower economic long term growth rates, as in the chart below from BMO Capital Markets recent publication Long Term Outlook: Destiny Dictated by Demography? (and similarly elsewhere e.g. this report from the OECD where table 4.1 estimates a likely 1.2% per capita GDP annual growth rate)

Taking the OECD figure of 1.2% times the 0.6 proportion that actually flows through to the shareholder (see our previous post and its links as to why all the growth isn't gained by the investor) gives us 1.2% x 0.6 = 0.7% in real future growth rate of dividends.

Thus our total is 2.4% + 0.7% = 3.1% future estimated real long term Canadian stock returns

It is perhaps not surprising that the estimate would be much lower today than two years ago, given the large gains since then, far above the projected average at that time and the long run historic averages.

Method #2 - For comparison, we'll add another method, described in Jay Ritters' paper Economic growth and equity returns, namely the earnings yield, or Earnings / Price.

According to the data for XIC on the iShares website, its P/E is currently 17.6. Turing that upside down gives us E/P, or 1/17.6 = 5.7%. But the ratio should use the past 10-year average of earnings according to Ritter, to smooth out economic booms and busts, not just the current earnings number embodied in the 17.6. Again the data for Canada is hard to to obtain for the individual investor. A rough estimation can be obtained using the TSX earnings figures taken at various points over the last twelve years by in his evaluation of whether the TSX is fairly valued. The average Earnings since 2005 over the current TSX Price (Index Value) of 15,000 gives an E/P of 4.7%. That number is still too high since the Earnings for each year have not been adjusted downwards for inflation but it gives an upper bound on the probable value.

Another comparison is the projection in the BMO Capital Markets paper, which is 7.0 (before inflation). Taking away 2% for inflation, for example using the figure derived below and which BMO also estimates, that would give a net return of 5.0%. Finally, using yet another method (and higher growth assumptions), InvestorsFriend estimated at the beginning of June based on a lower TSX index value of 14,375, that the TSX Composite would return about 7% annually, which gives the same 5% after inflation.

Our conclusion: over the next ten years, it is reasonable to assume that Canadian stocks are poised to deliver from 3% up to 5% real total return.

Bond Returns
The future return for bonds is simpler to estimate and much more certain. As we have written about previously here and here, bond duration tells us how long we need to stay invested in order to attain, within fairly narrow variation, the yield to maturity of the bond or a bond ETF at the time of purchase. Thus, if we take a bond ETF with long duration of 10 years or more, we know almost exactly what the total return, before inflation, will  be.

Take an average with a third each of the BMO Long Federal Bond Index ETF (TSX: ZFL) with a 14.84 years duration and a yield to maturity of 2.79%, the BMO Long Corporate Bond Index ETF (TSX: ZLC) of 12.85 years duration and 4.34% yield to maturity and BMO Long Provincial Bond Index ETF (TSX: ZPL) of 14.21 duration and 3.69% yield to maturity. That gives a future bond return of 3.6% before inflation, or 1.6% after inflation of 2%.

BMO's estimate for bond returns over the next ten years is 4%, or 2% net of inflation.

The best forecast of inflation is the difference between the yield on long term Government of Canada ordinary bonds (2.82% as of June 25) and long term real return bonds (0.78%), which automatically adjust for inflation. These figures from the Bank of Canada webpage with daily updated values for both types show almost exactly a 2.0% (2.82 - 0.78 = 2.04) difference between the two. 2% also happens to be the policy target rate for inflation set by the Bank of Canada. The market rates set by supply and demand obviously believe the Bank of Canada can and will achieve 2% on average. Thus our estimate of 2.0% inflation for the long term.

Wishes, and estimates, don't always come true
It is necessary to keep in mind, as we noted two years ago, that for stock returns, and for inflation, the relationships driving forecasts are not deterministic and there can be considerable variability in actual outcome. It might be a lot more, or a lot less.

A future below historical averages
A 50-50 portfolio of Canadian stocks and bonds would thus produce a blended annual nominal total return of 4.3% to 5.3% and a real return of 2.3% to 3.3%.  That's less than the averages from 1900 to 2013 reported in the Credit Suisse Global Investment Returns Yearbook 2014 for Canada of 5.7% real stock return and 2.1% bond return, or 3.9% in a 50-50 mix. Over a long period that 0.6 to 1.6% gap would make a significant difference. The implication is that investors need to save more to build the same size retirement fund, or take longer to do it and then, in retirement, can withdraw at a lower rate than the 4% rule which worked in the past.

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 23 June 2014

Canadian Preferred Share ETF Comparison - Attractive Income but Some Caveats

Why consider preferred shares?
Preferred shares offer the Canadian investor steady income in the form of tax-advantaged (when held within a taxable non-registered account) eligible dividends. The dividends are usually greater than interest income even before taxes for debt of comparable credit rating and term. With interest rates being so chronically low these days, that can be appealing.

Preferred dividends have claim to company profits after bonds, so there is extra credit risk. On the other hand, compared to common share dividends, preferred dividends have prior claim, though the offsetting downside is that preferred shares do not have the opportunity for capital growth like common shares. Preferred shares stand in the middle between common shares and debt and are generally considered an income investment (see Blackmont Capital's primer on preferred shares, linked to by's preferred share page, which delves into some of the pros and cons in more detail).

Why an ETF?
ETFs devoted to preferred shares offer a convenient way to invest. One purchase can create a permanent low maintenance holding that contains a widely diversified assortment of individual securities, lowering risk of exposure to individual companies. There's no need to rebalance or reinvest when securities are called, no need to figure out which individual securities to buy or sell, it is all done within the ETF by the managers.

There are currently five ETFs focused on Canadian preferreds. We leave aside US-based offerings since foreign preferred dividends are treated as ordinary income on Canadian taxes and lose their tax advantage. All offer fairly similar expense ratios around 0.5% per year. There are however some fairly marked differences between the funds in their mix of types of preferred share holdings and consequently sensitivity to interest rate changes.

The ETFs
  • Horizons Active Floating Rate Preferred Share ETF (TSX: HFP) - an actively managed ETF where managers apply their judgement, targeting short-term income while keeping value stable despite interest rate change effects; still tiny at $22 million in assets since October 2013 start-up; MER 0.62%
  • iShares S&P/TSX Canadian Preferred Share Index ETF (TSX symbol: CPD) - oldest (2007 inception) and largest in assets at $1.3 billion; strategy is to passively track the overall preferred share market; MER 0.50%
  • BMO S&P/TSX Laddered Preferred Share Index ETF (TSX: ZPR) - second largest fund at $1.0 billion assets, has been catching up quickly to CPD since 2012 inception; invests in a 5-year ladder of preferreds that reset rates. Lowest MER at 0.45%
  • Horizons Active Preferred Share ETF (TSX: HPR) - another actively managed fund "to provide dividend income while preserving capital"; highest MER at 0.64%
  • PowerShares Canadian Preferred Share Index (TSX: PPS) - founded in 2011 but changed its index in May this year to target lower recent volatility and higher dividends whereas before it screened only on liquidity, resulting in a huge shift to a heavy weight in fixed rate perpetual preferreds; MER 0.51%

Diversification and credit risk - trading off sector concentration vs credit rating
As our comparison table above shows, all funds have a substantial chunk (20% or more)  of holdings in in credit rating Pfd-3, which is below investment grade of Pfd-1 or Pfd-2. The fund with the most holdings below investment grade - ZPR at 32% - makes up for it by having a more even spread across sectors and a low concentration in the top 10. Another fund that is highly concentrated in banks and insurance companies - PPS, at 71% - makes up for that by the highest proportion of holdings in the top Pfd-1 credit rating at 11%. HFP has the most concentrated top 10 at 29% but a wide sector spread. There doesn't seem to be any ETF that is clearly superior to the others.

We note also that there has been a significant decline in the overall credit quality of CPD over the last six years as the comparison with statistics by James Hymas in a 2008 Canadian MoneySaver article shows. The proportion of the highest rated Pfd-1 holdings was 65% in October 2008 vs only 9% today. Many major bank issues got cut from Pfd-1 to Pfd-2. Pfd-3 holdings have also risen substantially. Many new issuers offering preferred shares, such as industrial companies, are below investment grade. Lower credit quality raises credit / default risk.

Interest rate risk exposure - the biggest differentiator
Four funds appear to be most exposed to changes in interest rates - CPD, PPS, ZPR and HPR - though it is hard to tell which is most exposed. The weighted average duration (which is a measure of sensitivity to interest rate change, the higher the number the greater the sensitivity) of their holdings at 5.2  for CPD and 6.3 for HPR are one indication. In comparison, the broad benchmark bond ETF from iShares (TSX:XBB) has a duration of 7.09 while a short-term bond fund - iShares' XSB -  has a duration of 2.87. Though Invesco does not provide a duration figure for PPS, we estimate that it will have a similar interest sensitivity by virtue of its large 45% component in perpetuals, which are by far the most sensitive type, as seen in the following chart from Scotia McLeod's Guide to Preferred Shares.

Horizons' HFP is the least sensitive to interest rates, with a duration of only 0.9, a reflection its policy to keep holdings in short-term resets and floating rate preferreds. BMO's ZPR theoretically should fit in between HFP and the others, with its strategy of holding preferreds that will reset rates in five or less years. But the price action of the various ETFs seen in the chart below contrasting ZLB vs the other preferred ETFs and XBB suggests that it behaves much like CPD. And HPR has been less volatile than CPD and ZPR - it looks as though the active management strategy of HPR "to preserve capital" has been effective.

Despite the higher duration of XBB, CPD and ZPR dropped more in 2013 when interest rates took their upward spike.

Attractive payouts and reasonable but volatile returns
An important lesson for investors is that preferred share ETFs can be quite volatile compared to bonds. In 2008-2009 during the credit crisis and the recovery, CPD took a big drop in 2008 with a 17.2% negative return and in 2009 with a 26.2% positive return while XBB toddled along smoothly at +6.1% and +5.0% respectively.

Our second comparison table below shows recent cash payout rates. Four of the ETFs are paying out 4.1 to 4.9% depending on which payout measure is used, while HFP is paying 2.1 (trailing 12 months) or 3.4% (current yield). That's attractive income compared to XBB's 3.2% distribution yield and 2.4% yield to maturity, especially when tax rates are taken into account (it can take $1.30 of pre-tax interest to equal the net after-tax of $1 of dividends in a taxable account, though this varies depending on the investor's tax bracket and province) and the fact that a good chunk of the preferred ETF payouts has been non-taxed Return of Capital.

However, not all is sweetness and light. Returns - which includes both dividends and capital gains/losses - have not been nearly so attractive in the short term. Three of the four (CPD, ZPR and PPS) that have been around long enough (at least a full year) to officially report returns show negative 1-year returns. The 2013 interest rate rise hurt capital values. In addition, the capital losses seen in the above price chart have caused the ETFs to have bad Return of Capital, merely giving investors their own money back. As a recent Raymond James Canadian Preferred Shares Report points out (see pages 2-3) many of the Reset preferreds are being and will be called in 2014 by the issuers and new issues will have lower dividend rates. The reality of the low interest rate environment is being absorbed and cash payouts have been falling.

It is very hard to predict exactly how an investment in these preferred ETFs will fare. There is such a mix of inter-acting factors that can affect eventual returns and future income / cash payouts - interest rates, most obviously, but also credit risk, call risk (likelihood of issues being redeemed prematurely, when it advantages the issuing company and not the investor), the required return differential between government debt and corporate preferreds, the variable mix of types of holdings within each ETF and the wide variety of special redemption or retraction features attached to the types of preferred shares. Finally, and ironically, to some extent the tail is wagging the dog - flows into or out of the ETFs themselves are so large that they affect the market for underlying preferred shares according to Scotia McLeod's annual Guide to Preferred Shares 2014 edition. Unlike bond index funds whose future possibilities under rising interest rates we examined last year, we would hesitate to forecast the probable evolution of any of these ETFs in detail. Certainly, if interest rates rise, the capital value / market price of the ETFs will fall in response, but by how much and for how long is too hard to tell.

Bottom line - Though it is not possible to predict exactly what will happen, the ETFs would slot into a fixed income portion of a portfolio as follows:

  • Horizons' HFP fits as a reasonably stable short-term holding that generates better after-tax income than a short-term bond fund
  • The others are best considered for longer term or indefinite time holdings to generate fairly steady income superior in varying degrees over the years to bond funds but with volatility in capital value.

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 16 June 2014

Centenarian Companies in Canada - Surviving and Thriving, Mostly

We'd all like to live to be 100 years old. But more than that, we'd like to be healthy and vigorous. It's not easy to achieve for people and just as difficult for companies. We decided to have a look at Canadian publicly traded companies that have existed for at least a century to see how they are doing, whether they are merely surviving or doing well.

No casualties amongst 2010 centenarians - The first pleasing thing to note is that all twelve of the companies in our 2010 post Twelve Ultimate Buy and Hold Canadian Stocks are still around and doing quite well, thank you.

Dominant players on the TSX - Three of the centenarians, led by the Royal Bank (TSX: RY), followed by TD Bank (TSX: TD) and Scotiabank (TSX: BNS), are the three largest companies, measured by total market value of stock, in Canada.

Beyond the original twelve, we did more digging (in University of Western Ontario's Canadian Centennial Companies and the Globe's Report on Business Top 1000) and uncovered another dozen companies that have a continuous 100-year history, though at times quite eventful (we are thinking especially of the oldest one of all, the Hudson Bay Company, which went private for several years recently and has undergone plenty of restructuring).
(click on table to enlarge image)

The two dozen companies together are massive - they constitute only 10% of the number of companies but they make up 33% of the total value of the TSX Composite Index. As our comparison table shows, the centenarians' market cap almost all far exceed the average of $1.6 billion (based on the stats from the iShares ETF (TSX: XIC) that invests in the TSX Composite).

Banks and insurance companies in the majority - Almost half (11) of the companies are financial companies, including all of Canada's largest banks. There is only one or two representatives from other sectors - mining (Teck), forestry (Domtar, though it evolved from an industrial company), industrials (CPR and Russel Metals), energy (Imperial Oil and Enbridge, which was originally Consumers Gas), booze (Corby and Molson), telecommunications (BCE), consumer (HBC, North West Company and George Weston) and publishing (McGraw-Hill Ryerson).

Stock price stability - The majority of the centenarians' stock prices are quite stable, as the Beta (a measure of a stock's price volatility compared to the market average) figures below the market average of 1.0  in our table demonstrate. Of course, when the stock market experiences extreme stress, as during the 2008 financial crisis, then the stock price stability can change dramatically. The nature of the crisis will influence individual stock reactions too - during the financial crisis, bank stocks in Canada, despite the strength of Canada's banks unlike those of the USA, Europe and the UK, suffered a sharper drop than the overall TSX. The bank stocks' price recovery was faster than the TSX too, pushing up the Beta, as the chart from TMX Money below shows. Upward high volatility / Beta can be good - current CPR shareholders will attest to that.

Prosperous and healthy at the moment - The centenarian companies are still as blue chip as they come (cf  Earnings, Dividends and Return on Equity in our comparison table above) with solid consistent profits, healthy and rising dividends. Only HBC is losing money and only Manulife has a negative stock return over the past five years and only three companies have 5-year compound returns less than the TSX Composite/XIC.

All the companies pay dividends but the growth of dividends is one relatively weaker spot of the centenarians. One company - MFC - has had to cut dividends. Several others have not increased theirs at all over the past five years while others have not increased their distributions by as much as XIC's 6.4% annual rate.

One other apparent anomaly on dividends, North West Company's (TSX symbol: NWC) 2% drop in dividends is a result of its conversion from income trust to corporation in 2012, which forced it to change from distributing pre-tax income to after-tax dividends (and which would leave an investment in a taxable account no worse off due to the dividend tax credit). The corporate NWC has increased its dividend in 2013 and again in 2014, up a total of 17% over 2012.

Swings and roundabouts of company and shareholder returns - Extending the view of these companies' histories shows that some have done considerably better than others.

The chart below using BMO InvestorLine's graphing tools shows the price-only (i.e. excluding dividends) performance since 1984 of four of the centenarians - Royal Bank, BMO, Russel and Imperial Oil - against the TSX. The dark blue line of RY is way above the others, though at one point in 2007, IMO briefly topped it. Meanwhile Russel has doddered along, more or less returning nothing but dividends to shareholders who may have bought 30 years ago.

That doesn't look at all good for Russel ... but then consider the last ten years alone. Suddenly, Russel is the best performer of all, exceeding even Royal Bank. Stay in the game long enough and good things may happen. We might adapt the Star Trek motto, "Live long and prosper" to "Live long enough and you will prosper".

The mix of positive and negative analyst recommendations in our table suggests however that success is not assured. Indeed our list of centenarians is biased in that it includes only survivors and excludes those many companies that have fallen by the wayside.

Yogi Berra's delightful quote, "it ain't over till it's over", sums it up. Unlike people, whose bodies and minds eventually deteriorate but cannot be repaired or replaced, companies have the potential to bring in new people, hopefully to absorb and continue the best elements of the past while adapting to inevitable changes. A report in the Economist magazine suggests that longevity and prosperity are not accidentally associated. The centenarians provide an interesting starting list of companies to consider for a long term portfolio.

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 6 June 2014

The Reluctant Investor's Lifelong Portfolio - a Portfolio Inspired by, and for, Albert Einstein

"Everything should be made as simple as possible, but not simpler." Albert Einstein
Last week we defined what a portfolio for a reluctant investor should do, and reviewed several alternatives that don't quite do the best job. Now, let's reveal our winner.
This is what we propose, the Reluctant Investor's Lifelong Portfolio and Investing Plan

1) Portfolio structure: The portfolio will consist of two funds -
2) Account setup: Start with a TFSA. Open a TFSA account at a discount broker. If there is less in total to invest than $31,000, which is the cumulative maximum contribution limit up to and including to 2014 that can be invested in a TFSA, put it all in the TFSA. When there is more than $31k to invest put the excess into an RRSP (another account that will need to be opened at a discount broker), up to the cumualtive unused contribution limit shown on tax assessment letter from the Canada Revenue Agency that it sends out after you have filed your taxes every year. It there is more than the total limits of TFSA plus RRSP to invest, open a taxable account.

3) Initial allocation to target: Within each account, buy equal amounts of both XQB and XIC.

4) Automate investing: Set up automatic transfers to contribute to the TFSA/RRSP/taxable account if in savings mode. XQB has the wonderful feature of being part of the Pre-authorized cash contribution plan at iShares, which is free and automatic, so sign up for the amount going into XQB.  Unfortunately, XIC is not part of the PACC so purchases of XIC you will have to do yourself. Leave the money going into XIC in cash until there is at least $1000 to invest. Less than a $1000 for a trade and the commissions start to add up too much and hurt investment returns.

Similarly, during retirement withdrawal when regular amounts are to come out, sign up for the Systematic withdrawal plan for XQB (also not available for XIC). You will have to sell the appropriate amount to leave approximately half each in XIC and XQB.

Note: Not all brokers participate in the PACC and SWP. Check out here the in/out listing of brokers, along with details and forms for all the plans, including the DRIP. If the broker does not do the PACC and SWP, you must carry out buy and sell transactions yourself.

Sign up for the Dividend reinvestment plan (DRIP) for both XIC and XQB. That way, the regular cash distributions will not sit idle and will get reinvested automatically and for free in XIC and XQB.

5) Rebalance: Once a year, perhaps on a birthday to remember more easily, check the latest monthly market values of XIC and XQB holdings totalled across all accounts. If either is more than 5% away from the target 50%, sell the excess amount of the greater value ETF and buy that amount of the lesser. If less than $1000 is at stake to be re-allocated, don't bother, the cost of trading commissions is not worth it.

In the same manner, any large lump sum contributions or withdrawals can be used to even up the 50% allocation to each ETF.
Historical Performance - To see what kind of performance the Reluctant Investor Portfolio would have provided, we again turn to the Stingy Investor Asset Mixer tool. XIC's performance matches exactly with the tool's TSX Composite, while XQB lines reasonably well with All Canadian Bonds. (Note: Stingy Investor has a model portfolio it calls the Simply Canadian ETF Portfolio which has the same composition as our Reluctant Investor, i.e. we did not invent the idea but we are promoting it with a different name to emphasize its potential usefulness.)

From 1961 to 2013 inclusive, our portfolio performed quite well. Compared to more complicated and sophisticated alternatives, the portfolio trades off some performance and some volatility to gain simplicity and convenience.

For a retiree withdrawing 4% a year the worst down year was 2008, when it incurred a 17% loss. The portfolio had fully recovered its loss within two years. Over the whole 53 year time span, despite constant yearly withdrawals, the portfolio gained an average of 4.6% compounded per year and it never dropped below its retirement start date value despite a number of down years (15 out of 53).

For a saver, the fact of making no withdrawals reduces the worst 2008 down to only 13% and there were only 10 down years in total. Recovery from down years never took longer than two years. The compound return was a healthy 9% a year.

Unfortunately the Stingy Investor tool does include inflation data before 1980, so the period of high inflation, and its effects on real after-inflation returns, which is what really matters, cannot be examined. From 1980 to 2013, the real return of the Reluctant Investor Portfolio was 6.1% compounded during the savings no-withdrawal phase, with only 7 years out of 34 showing a decline that never took longer than two years till recovery from a decline. When the added stress on the portfolio of a 4% annual withdrawal was included, the portfolio still managed an average gain of 1.9% annually, but had 11 down years, and a decline of 17.7% starting in 2008 that still has not been recaptured.

Thus, though there is no absolute assurance of never taking a loss by selling out at any time we believe the Reluctant Investor's Lifelong Portfolio is a pretty good balance of the objectives. Overall, we believe the solution works pretty well, delivering 80% or more of the benefits of more time-consuming and complicated investing.

Such a portfolio has value. Not everyone can, or should be, an investor who spends time and effort on investing. That's why our post's title says the portfolio is both inspired by, and intended for, someone like Albert Einstein. After all, could anyone think that Einstein, or the world, would have been better off, if he had applied his time to investing at the expense of physics?

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.