Readers of last week's post might wonder why an investor might want to do anything else than buy one of the all-inclusive portfolio funds we examined. The simplicity, convenience and effectiveness of those funds notwithstanding, there are a number of reasons that an investor could want to build a more complex portfolio and do the required extra work.
1) Additional Asset Classes for Extra Diversification - We noted that some of the funds had no holdings in REITs, emerging market equities, real return bonds, commodities and/or gold, preferred shares and US / other foreign bonds. Including such other types of less correlated (i.e. tending to move out of sync with each other other) assets will lower the portfolio's variability and increase returns slightly (see this post at CanadianFinancialDIY). The ability to pick asset classes gives the investor the opportunity to deliberately exclude some - like commodities - that are in the more complex all-in-one portfolios but which do not garner universal support as a mainstream portfolio holding (see this post on the pros and cons). Or it allows the inclusion of some that certain investors desire for matching their circumstances, such as retirees wanting real return bonds (see this post for more).
2) Ability to Tailor Percentage Allocations to Each Asset Class - With the all-in-one portfolios, you must take the fund as it is. That is most likely not optimal for every individual. A person's spending goals and risk tolerance should have matching characteristics in the portfolio. For example, as you get closer to the time when the money will be spent, be that retirement or something other, and when the saving goal is closer to being reached, a rising proportion of more and more stable investments (equities > bonds > T-bills) should be in the portfolio. Our post on Asset Allocation has links to tools that can guide you for your own circumstances.
3) More Selectivity in Funds for Each Asset Class - It is not possible to pick which specific funds are held in the all-in-one portfolio to represent each asset class. The internal funds may not be the best in class for each category. As our various reviews of ETFs for such categories as Canadian Bonds, Canadian Large Cap Equity, US Large Cap (S&P 500 or similar), Commodities, and Emerging Market Equity (Canadian- or US-traded) show, there are many choices and differences.
Some equity markets may be better represented by a total market fund instead of only a large cap fund like those based on the S&P 500 (see discussion here) or the TSX 60.
It may be better to buy real return bonds directly and not in a fund, or even individual bonds in a ladder (ladder pluses, fund pluses).
There are arguments for and against funds based on alternative weighting and selection criteria such as equal and fundamental weighting.
Some foreign funds are hedged and others not, another choice which has pros and cons. The investor has many possibilities for making a better portfolio.
4) Rebalancing - All the all-in-one funds rebalance the portfolio quarterly to maintain risk at a constant level. It is possible and perhaps desirable to rebalance less frequently such as once a year, or even less often (as we discussed here) to gain slightly higher returns.
5) Tax Benefits by Splitting Holdings Between Registered and Non-Registered Accounts - When there is no room left in tax-deferred registered accounts, investments generating interest income, such as bonds, should go into the registered accounts while those generating dividends and capital gains, such as equities, belong in a non-registered account (see TaxTips.ca guidelines for which investments in which account). Splitting types of investments up for tax savings is obviously not possible when one fund contains all types of investments.
All these refinements require extra work of course, but the payoff should be a portfolio with better returns (try a compound interest calculator to see how much difference a small extra return can make when compounded over many years e.g. 3.5% vs 3.0% for 35 years gives you 18% more at the end) and less variability that is better adapted to your individual circumstances.
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, 15 February 2011
Tuesday, 8 February 2011
One-Stop-Investing for Your RRSP Contribution(s)
Contributing money to your RRSP is only the first step that gets you the tax refund. It will be a waste of time, since you have to pay the tax back upon withdrawal, unless the funds are invested so that they grow over the years (see our previous post comparing RRSPs with TFSAs, RESPS and non-registered taxable accounts for comments on what makes RRSPs worthwhile). The multitude of investment choices available, uncertainties about the economy, the mechanics of making the investment purchase, all can prove daunting, even too overwhelming, leading to no action and no investment, as we noted in Investing Success: More is Less, Less is More. That's bad, so we offer some solutions - ultra-simple, all-in-one, low-cost, auto-pilot, do-it-once-and forever, well-diversified and, of course(!), online.
First, and very importantly, we assume that the investor will be holding these funds in an RRSP i.e. with the goal of retirement and no selling out for at least next ten years (see our post on Setting Investment Objectives for discussion on how goals should shape the choice of investment) . That allows us to include a healthy dose of highly-variable-in-the-short-term-but-faster-growing-in-the-long-term equities amongst the assets. That also means we do not need to consider tax consequences of equities vs bonds vs foreign income as there are no taxes to pay (even US withholding taxes) while the money is within the RRSP.
The solution we propose is portfolio funds, ETFs and mutual funds, bought through a single purchase, that contain a whole gamut of types of assets and thousands of securities within.
Our Five Portfolio Funds
We have chosen five candidate funds (acknowledgements to Bylo Selhi for his list of low-cost index funds where the mutual fund choices were located) - two ETFs and three mutual funds. Our comparison table got too large for one screen and we had to split the ETFs from the mutual funds into two tables below, but we will do our comparisons of all five together.
1) ETFs - CBN and XGR
2) Mutual Funds - TDB965, INI230 and CIB901
Other Funds - There are other low-fee broadly diversified mutual funds that could fit into our criteria e.g. Mawer Canadian Balanced RSP, Mawer Canadian Diversified Investment Fund and RBC Monthly Income. We have focused on funds with an indexing strategy. To compare other funds, do a search in the Tools on Morningstar Canada's Funds page.
Diversification, Volatility and Returns - Diversification means having, a) many under-lying securities from different governments and companies inside the portfolio, to reduce the bad effects of trouble in any one organization, b) many different types of securities, or asset classes, to gain the stability and possibly higher returns, from having investments that do not all move in the same direction, especially when it is downwards, at the same time (see previous posts here and here).
All our funds have literally thousands of holdings within, mostly by holding other funds with lots of holdings, so all do a good job of reducing individual organization risk. All our funds also perform all the internal portfolio management for the investor, buying and selling individual stocks and rebalancing on a quarterly basis to keep within target allocations.
A big caution, since we cannot be sure what kind of long term results it will produce, is that iShares actively manages XGR - it varies its percentage allocation among the asset classes quite a bit instead of the passive indexing of all the other funds.
Asset Classes: CBN and XGR are appreciably superior to the three mutual funds by incorporating a number of important asset classes that are completely absent from the mutual funds - real estate, commodities, emerging market equities (China, Russia, Brazil etc that are not in EAFE) and some distinct sub-groups of fixed income like preferred shares, high-yield bonds, real return bonds and foreign market bonds (all excluded from the DEX Universe bond index definition).
Currency Hedging: The large foreign bond holdings in XGR explain its high percentage of foreign currency hedging - in order to protect the higher foreign bond returns from being eaten up by possible rises in the Canadian dollar, that portion of the portfolio gets hedged. CBN hedges its foreign bonds too while the mutual funds contain no foreign bonds to hedge. On the other hand, none of the funds hedges the foreign equities, which we tend to agree with (see post here). Hedging is thus a neutral factor in comparing the funds in our view.
Equity - Fixed Income Split: This is the most significant factor differentiating the five funds, though it isn't necessarily good or bad if one recognizes and is prepared to live with the volatility effect. The fund with the most equity, CBN, is also the most volatile, overcoming, it is interesting to note, even the stabilizing effect of having more asset classes during the extreme stress period of the 2008 financial crisis, as the chart below vividly shows (we had to omit XGR to do a fair comparison since it only started up in November 2008 after the worst of the crisis). CBN is the blue line and it followed the purple line of the TSX Composite down.
However, on the rebound, it is rising faster than the other funds, as the next chart below of the recovery period since January 2009, shows. The one year returns (see Comparison table) to December 31st, 2010 reflect that as well, with CBN in the lead.
Over the long term of ten years or more, the success of TDB965 and CIB901 will depend much more on the strength of the Canadian stock market due to the much heavier weighting of Canadian equities. INI230 places investor money evenly across its Canadian, US and EAFE equity holdings. CBN and XGR have very little in Canadian equity by contrast; the investor's success depends on how foreign holdings do.
TDB965's track record since its 1998 inception has been solid if not spectacular - 4.7% per year. Founded in the same year, CIB901 lags that at only 3.9% per year. CBN only goes back to mid 2007. That was just before the financial crisis, so it is no surprise that the return since inception is a loss of 3.8% per year.
Costs and Convenience
XGR is the low-cost leader at a Management Expense Ratio of only 0.62% with CBN and TDB965 0.2% higher and INI230 and CIB901 another 0.2% or so above that.
However, XGR lacks all the features to ease the on-going investment work for the investor. In contrast, CBN, TDB965, INI230 and CIB901 all have automatic no fee dividend reinvestment mechanism and automatic pre-authorized no extra fee fund purchase plans for regular small amounts. (Note that not all brokers have opted in to the auto purchase plan for CBN - check this table from Claymore). Reinvested dividends make up a very significant part of the total long term return of equities, as we discussed here, so having it done automatically, instead of the dividends sitting in cash which is too easily neglected and forgotten, is a big plus. The three mutual funds have the additional feature that all the tracking of Adjusted Cost Base is done by the mutual fund company, whereas with CBN and XGR, the investor must do that once a year for him/herself, as we described here.
Bottom Line - We find XGR to be less attractive than the others due to the active management and the lack of automatic features. All four of the other four funds are an effective choice in our opinion (and that is our opinion only, you should always think for yourself and possibly consult others to get alternate views), we like CBN and TDB965 for their low fees. CBN is more for those prepared for the bigger swings from a higher equity content, i.e. those in it truly for the long term who will not get too nervous when markets experience big declines. TDB965 suits the slow and steady crowd who are willing to sacrifice a possible, though not assured, higher end result for interim greater stability.
The most important thing is to invest in something. Comic Woody Allen spoke truly when he said "Eighty percent of success is showing up."
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.
First, and very importantly, we assume that the investor will be holding these funds in an RRSP i.e. with the goal of retirement and no selling out for at least next ten years (see our post on Setting Investment Objectives for discussion on how goals should shape the choice of investment) . That allows us to include a healthy dose of highly-variable-in-the-short-term-but-faster-growing-in-the-long-term equities amongst the assets. That also means we do not need to consider tax consequences of equities vs bonds vs foreign income as there are no taxes to pay (even US withholding taxes) while the money is within the RRSP.
The solution we propose is portfolio funds, ETFs and mutual funds, bought through a single purchase, that contain a whole gamut of types of assets and thousands of securities within.
Our Five Portfolio Funds
We have chosen five candidate funds (acknowledgements to Bylo Selhi for his list of low-cost index funds where the mutual fund choices were located) - two ETFs and three mutual funds. Our comparison table got too large for one screen and we had to split the ETFs from the mutual funds into two tables below, but we will do our comparisons of all five together.
- Claymore Balanced Growth CorePortfolio ETF (Trading Symbol: CBN)
- iShares Growth Core Portfolio Builder Fund ETF (XGR)
- TD Balanced Index Mutual Fund (TDB965)
- ING Direct Streetwise Balanced Growth Fund (INI230)
- CIBC Balanced Index Fund (CIB901)
1) ETFs - CBN and XGR
2) Mutual Funds - TDB965, INI230 and CIB901
Other Funds - There are other low-fee broadly diversified mutual funds that could fit into our criteria e.g. Mawer Canadian Balanced RSP, Mawer Canadian Diversified Investment Fund and RBC Monthly Income. We have focused on funds with an indexing strategy. To compare other funds, do a search in the Tools on Morningstar Canada's Funds page.
Diversification, Volatility and Returns - Diversification means having, a) many under-lying securities from different governments and companies inside the portfolio, to reduce the bad effects of trouble in any one organization, b) many different types of securities, or asset classes, to gain the stability and possibly higher returns, from having investments that do not all move in the same direction, especially when it is downwards, at the same time (see previous posts here and here).
All our funds have literally thousands of holdings within, mostly by holding other funds with lots of holdings, so all do a good job of reducing individual organization risk. All our funds also perform all the internal portfolio management for the investor, buying and selling individual stocks and rebalancing on a quarterly basis to keep within target allocations.
A big caution, since we cannot be sure what kind of long term results it will produce, is that iShares actively manages XGR - it varies its percentage allocation among the asset classes quite a bit instead of the passive indexing of all the other funds.
Asset Classes: CBN and XGR are appreciably superior to the three mutual funds by incorporating a number of important asset classes that are completely absent from the mutual funds - real estate, commodities, emerging market equities (China, Russia, Brazil etc that are not in EAFE) and some distinct sub-groups of fixed income like preferred shares, high-yield bonds, real return bonds and foreign market bonds (all excluded from the DEX Universe bond index definition).
Currency Hedging: The large foreign bond holdings in XGR explain its high percentage of foreign currency hedging - in order to protect the higher foreign bond returns from being eaten up by possible rises in the Canadian dollar, that portion of the portfolio gets hedged. CBN hedges its foreign bonds too while the mutual funds contain no foreign bonds to hedge. On the other hand, none of the funds hedges the foreign equities, which we tend to agree with (see post here). Hedging is thus a neutral factor in comparing the funds in our view.
Equity - Fixed Income Split: This is the most significant factor differentiating the five funds, though it isn't necessarily good or bad if one recognizes and is prepared to live with the volatility effect. The fund with the most equity, CBN, is also the most volatile, overcoming, it is interesting to note, even the stabilizing effect of having more asset classes during the extreme stress period of the 2008 financial crisis, as the chart below vividly shows (we had to omit XGR to do a fair comparison since it only started up in November 2008 after the worst of the crisis). CBN is the blue line and it followed the purple line of the TSX Composite down.
However, on the rebound, it is rising faster than the other funds, as the next chart below of the recovery period since January 2009, shows. The one year returns (see Comparison table) to December 31st, 2010 reflect that as well, with CBN in the lead.
Over the long term of ten years or more, the success of TDB965 and CIB901 will depend much more on the strength of the Canadian stock market due to the much heavier weighting of Canadian equities. INI230 places investor money evenly across its Canadian, US and EAFE equity holdings. CBN and XGR have very little in Canadian equity by contrast; the investor's success depends on how foreign holdings do.
TDB965's track record since its 1998 inception has been solid if not spectacular - 4.7% per year. Founded in the same year, CIB901 lags that at only 3.9% per year. CBN only goes back to mid 2007. That was just before the financial crisis, so it is no surprise that the return since inception is a loss of 3.8% per year.
Costs and Convenience
XGR is the low-cost leader at a Management Expense Ratio of only 0.62% with CBN and TDB965 0.2% higher and INI230 and CIB901 another 0.2% or so above that.
However, XGR lacks all the features to ease the on-going investment work for the investor. In contrast, CBN, TDB965, INI230 and CIB901 all have automatic no fee dividend reinvestment mechanism and automatic pre-authorized no extra fee fund purchase plans for regular small amounts. (Note that not all brokers have opted in to the auto purchase plan for CBN - check this table from Claymore). Reinvested dividends make up a very significant part of the total long term return of equities, as we discussed here, so having it done automatically, instead of the dividends sitting in cash which is too easily neglected and forgotten, is a big plus. The three mutual funds have the additional feature that all the tracking of Adjusted Cost Base is done by the mutual fund company, whereas with CBN and XGR, the investor must do that once a year for him/herself, as we described here.
Bottom Line - We find XGR to be less attractive than the others due to the active management and the lack of automatic features. All four of the other four funds are an effective choice in our opinion (and that is our opinion only, you should always think for yourself and possibly consult others to get alternate views), we like CBN and TDB965 for their low fees. CBN is more for those prepared for the bigger swings from a higher equity content, i.e. those in it truly for the long term who will not get too nervous when markets experience big declines. TDB965 suits the slow and steady crowd who are willing to sacrifice a possible, though not assured, higher end result for interim greater stability.
The most important thing is to invest in something. Comic Woody Allen spoke truly when he said "Eighty percent of success is showing up."
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, 1 February 2011
Share Repurchases vs Cash Dividends - Ins and Outs
Cash dividends and share repurchases are described as ways of returning money to shareholders (e.g. Still Waiting for the Payout in the Financial Post) but they differ substantially as to mechanics and the potential effect on stock value.
Trend - More Repurchasing Compared to Dividends
Decades ago, company spending on repurchases amounted to very little compared to dividends but there has been a steady, almost un-interrupted rise over the years. NYU professor Aswath Damodaran's Musings on Markets blog post Stock Buybacks: What is happening and why? has a great chart that plots dividends and repurchases from 1988 to 2009 in the bellwether US stock index, the S&P 500. After the exceptional reversal in 2009 due to the financial crisis, 2010 has seen a rebound in the dominance of buybacks according to the S&P report covering up to the 3rd quarter. In Canada, the sources in the Financial Post article say it is much the same (unfortunately, there is no parallel report by S&P for the TSX). No one expects the trend to reverse, so investors must understand and deal with buybacks substituting for dividends.
Cash dividends are familiar to most investors and easy enough to understand. Some of the key features:
Share repurchases, also known as stock buybacks, differ in a number of ways:
As the above implies, every repurchase is different. Sometimes it is good for the shareholder investor and sometimes not. The different factors that come into play and ideas for ways to assess them include:
Bottom Line
Each repurchase by each company must be assessed individually for what factors are at play and how they will work out. Uncertainty of analysis and eventual outcome will always exist but the effort is worthwhile since something notable is being revealed about the company that regular cash dividends do not impart.
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.
Trend - More Repurchasing Compared to Dividends
Decades ago, company spending on repurchases amounted to very little compared to dividends but there has been a steady, almost un-interrupted rise over the years. NYU professor Aswath Damodaran's Musings on Markets blog post Stock Buybacks: What is happening and why? has a great chart that plots dividends and repurchases from 1988 to 2009 in the bellwether US stock index, the S&P 500. After the exceptional reversal in 2009 due to the financial crisis, 2010 has seen a rebound in the dominance of buybacks according to the S&P report covering up to the 3rd quarter. In Canada, the sources in the Financial Post article say it is much the same (unfortunately, there is no parallel report by S&P for the TSX). No one expects the trend to reverse, so investors must understand and deal with buybacks substituting for dividends.
Cash dividends are familiar to most investors and easy enough to understand. Some of the key features:
- A company pays out cash to all shareholders, usually out of its earnings
- Regular payments, most often on a quarterly basis.
- On-going expectations - Once a quarterly amount has been set, shareholders and company management expect that the dividend will continue to be paid regularly quarter after quarter and increase as profits increase. Often companies set a formal policy for the percentage of earnings to be paid out. Cuts in dividends usually signal a bad turn in company fortunes.
- Analysis is mostly about the cash flows and profitability of the business - whether a company's dividend is too high or too low and whether it is sustainable.
- Dividend data is readily available as any stock quote will show the amount of the current dividend and the dividend yield, which is the current annual dividend as a percentage of the share price. There is even a weighted average dividend yield readily available for the overall stock market - for instance, according to the official Toronto stock market website TMX.com as of January 28th, 2010 the S&P/TSX Composite Index dividend yield was 2.44%.
Share repurchases, also known as stock buybacks, differ in a number of ways:
- Repurchase cash goes to a limited number of shareholders, the ones from whom the company buys the shares. The normal method for buying the shares is on the stock market at the going price in a Normal Course Issuer Bid (NCIB). Since this occurs on the stock market, the sellers do not know that they are taking company cash as opposed to another investor's but the effect is still that all shareholders do not directly receive the company cash.
- Repurchased shares are then cancelled (almost always this is the case, though the company could hold them on the books as Treasury shares), which reduces the number of shares in circulation. Fewer shares and the same earnings increases earnings per share, normally a good thing that would increase share price but the reality is more complicated than that, as we explain below.
- Each buyback is different - dollar and percent of share targets vary and actual purchases may not match announced intentions. There is a constraint in Canada that NCIB purchases may not exceed 5% of outstanding shares within any 12 month period (see law firm Davies, Ward, Phillips and Vineberg's Revised Canadian Take-over Bid and Issuer Bid Regime). Repurchases, even announced, are voluntary and flexible. A direct issuer bid may also be made direct to shareholders at a fixed price, which may be above market price. After announcing an intention to buy back stock, the company is not obliged to do so and may buy only a portion or no stock at all.
- Analysis considers multiple factors simultaneously - share price over- or under-valuation, company leverage/debt levels (some buyouts are done with borrowed money), capital gains vs dividend tax rates, management/employee options, company waste or productive use of cash
- Data is only available piecemeal - a company intending to buy back stock is obliged to announce the amount and timing in advance through a news release, and that seems to be the only way to get data - company by company through a news release source.
As the above implies, every repurchase is different. Sometimes it is good for the shareholder investor and sometimes not. The different factors that come into play and ideas for ways to assess them include:
- Management / Employee Stock Options - Some companies, the worst culprits being in high technology (see S&P report above), routinely issue large numbers of stock options as compensation. The buyback then mops up the excess in shares created when the options are exercised. That may be fine if the compensation occurs in a high-growth company whose earnings rise fast enough to reward the public shareholders as well. Or it may be bad if it only amounts to diversion of profits away from shareholders towards the managers/employees. Checking the company financial statements will reveal the presence of options issuance and then assessment can move to other factors.
- Leverage or Debt / Equity - Sometimes companies borrow money to fund repurchases (e.g. Potash Corporation recently issued $1 billion in new debt to pay for half the $2 billion repurchase program announced in November). As Prof. Damodaran points out in another post Buybacks and Stock Prices: Good or Bad News? whether that is good or bad depends on the company having too much or too little debt to begin with. Adding debt to the point of too-much raises risk of default and will lower stock price while adding when there is too-little promises to increase profits for shareholders and thus the stock price.
- Shares Under-Priced or Over-Priced - A good reason for buying back stock is if management thinks shares are under-priced and it is true. The purchase is a way of saying it to investors in the market. If not believed immediately by the market, existing shareholders will benefit from higher profits later, which presumably would be followed by higher actual dividends and/or share price. If believed immediately, share prices will rise right away to reflect the true valuation of the company to the benefit of existing shareholders. If insiders are buying while a share repurchase is underway, it is a confirming signal that management believes the under-priced story.
- Uncertainty about Earnings - The flexibility of buybacks to match volatile earnings instead of the more locked-in nature of cash dividends may better suit businesses in cyclical sectors or those where deregulation has reduced predictability. To that extent it may be perfectly ok.
- Taxes on Dividends vs Capital Gains - This is the argument that some types of investors like hedge funds prefer to receive profits as capital gains over dividends. There is more skepticism than belief about this factor as a driving force in the trend. Its impact depends on one's own tax circumstances.
- Cash Being, or Likely to be, Wasted by Management - The current situation where large amounts of cash are apparently sitting on corporate balance sheets raises the question of how profitably it will be deployed. Ironically, if management decides that it cannot do better than give the money back to shareholders through buybacks and investors agree, there may well be a positive boost to the stock price. Prof. Damodaran suggests a good place to start looking for cash efficiency - large, established, mature companies with poor returns on assets and little debt may benefit from repurchases. High-growth companies with strong returns on assets and little debt capacity may suffer a stock decline if cash is returned through a buyback since that may be a signal that the future will not be as rosy as the past.
- Canada - Enter the word "repurchase" as the search term in the news release site CNW; then look through the resulting list which appears with recent announcements first. That's how we compiled the list below.
- USA - The Online Investor maintains a handy list, though of course its completeness and accuracy must be checked
- Individual Companies - check the Investor section of the company website for the complete details in press releases and financial statements
Bottom Line
Each repurchase by each company must be assessed individually for what factors are at play and how they will work out. Uncertainty of analysis and eventual outcome will always exist but the effort is worthwhile since something notable is being revealed about the company that regular cash dividends do not impart.
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, 25 January 2011
Investing in Utilities - Individual Stocks vs Funds
Our recent post on Electric Power Utility Stocks for the Income Investor? drew the comment from reader Richard that ETFs or other funds offer a diversified alternative to someone interested in the sector. Fair comment, interesting idea! We've therefore decided to compare those stocks against the Canadian fund choices.
Finding the Funds
This required some rooting around since the range of possible fund structures could include mutual funds, ETFs, closed-end funds and split capital shares. We had to check various filters and research tools like GlobeInvestor's Funds page, FundLibrary.com and TMX Money, whose down-loadable list on the Structured Products page turned out to be the most useful, as it included all our candidates below. It seems that there is not a single Canadian mutual fund specialized in Utilities stocks at the moment. The comparison is still something of a challenge, comparing not just apples and oranges but grapes and bananas too. That's the messy reality we investors face!
1) Utility Split Trust - This is a split capital corporation, with the same structure, features, pros and cons as described in two recent posts on split preferreds and on capital shares. We list both the Capital shares and the Preferred Shares below as possibilities since an income oriented investor might want either. One concern is that the corporation is due to close down in December 2011, with holdings liquidated and Net Asset Value returned to shareholders at that time. If the managers First Asset Funds Inc think investors still want it, there could be a proposal to extend its life beyond the intended five-year lifespan.
3) Canadian Utilities and Telecom Income Fund (UTE.UN) - It's a brand spanking new closed-end fund, just out of the Initial Public Offering December 17, 2011. There is no track record, so the only comparisons we can make are based on the prospectus.
4) BMO Equal Weight Utilities Index (ZUT) - This ETF has the best-sounding stock symbol but that isn't necessarily a reason to invest. It is only one year old, so again we must infer from available information.
Dividend / Distribution Yield and Value (click to enlarge table)
The current payout of the funds, per the Dividend Yield and Value table above, exceeds that of the individual companies rated top quality in our previous blog post individual company analysis (green highlighted rows), except for that of TransAlta. That would be fine except that dividends are only part of the return, especially for the long term hold investor.
Past Returns - Individual Stocks Outshine Funds
The five year share price graph below, taken from TMX.com, shows how much UST.UN fell behind the TSX Composite. UTC.C more or less kept pace with the TSX while our top three stocks - EMA, CU and FTS - to make a bad pun, "powered" ahead of the TSX and UST.UN. The management fees (MER) of the various funds drag down net returns for the investor. Individual stocks do not have any on-going management fees. There is a price to pay for the diversification gained by a portfolio and the MER is it. UTC.C and UST.UN both have MERs over 1%. A key stated objective of UTC.C's warrant issue is to reduce the MER by spreading costs over a larger asset base. Doubling the UTC.C asset base probably will not reduce the MER by half but it should help a lot.
In the past year UST.UN has done much better, second behind EMA, and UTC.C has fallen well behind the others since its warrant announcement in September. Which will do better in future? That is ever the unknown factor.
The UST.PR.A preferred shares look to be a poor investment at the moment. The yield to maturity in December this year, is a paltry 0.1%. As opposed to the current dividend yield of 5.7% (dividend /stock price), the yield to maturity calculation takes account of the fact that the stock price at $10.59 is above the December redemption price of $10, i.e. a capital loss will occur.
DRIP - For investors who wish to plow back their dividends into shares, the best individual stocks, with both a free DRIP program and a discount on such new purchases, such as EMA, FTS and TA, are clearly better the funds. BMO's ZUT at least offers a free DRIP.
Distribution Tax Types - There is little to mark funds or individual stocks as better for an investor's taxable account since the distributions are mostly all dividends, though for the moment UST.UN is handing out only Return of Capital (ROC). The funds, especially the active funds - UST.UN and UTE.UN - may distribute capital gains in future. In contrast, with individual stocks, it is the investor him/herself who decides when to sell stock and realize capital gains. Within a registered account, none of this matters of course, as tax is only applicable when funds are withdrawn from the account.
Liquidity - The funds are weaker than the individual stocks in terms of trading costs, as measured by wider bid-ask (sell-buy) quote spreads, and trading volumes, which determine how easy it is to set up a holding or sell out as needed. ZUT is best of the funds with a low bid-ask spread. UTC.C's bigger capital base should help it after all the warrants are exercised in the next few months. For a long term hold investor, this factor is not a major consideration.
Safety and Stability - On what is probably the most important dimension to the income investor, the individual stocks, especially the top companies in our previous ratings, look much better than three of the funds, though UTC.C comes out looking reasonably good.
Three of the four company stocks - EMA, FTS and CU and one fund, UTC.C, survived the 2008 crash with much less of a price decline than the TSX Composite as the graph below from Google Finance shows. That's the stability we seek. UST.UN fared even worse than the TSX Composite.
The situation is the same on dividends. Whereas all four of the top stocks have had at least one dividend increase, and no decreases, UST.UN went through two significant chops in 2008 and 2009 before an increase in 2010. UTC.C did what one would hope. It increased dividends in all three of the most recent years.
Another measure of stability is how closely the funds sell for what they are worth, in other words the Net Asset Value of the holdings within the fund. As is typical of Closed-end funds and Split shares, these funds are all trading at a considerable discount - UST.UN (-9.6%), UTC.C (-5.3%) - or premium - UTE.UN (+11.4%) - to NAV. The ETF ZUT is working as intended and typical for ETFs, trading very close to its NAV. Some might consider this a trading opportunity to buy a fund for less than it is worth, but suppose the fund is at a discount when you want to sell, is that helpful?
UST.UN adds risk through the use of leverage (borrowed money, through its split share structure), while UTE.UN's prospectus says it may borrow. UTC.C is totally passive and never trades, not even to rebalance, which is contrary to the usual fund risk management principle of rebalancing regularly.
The preferred share UST.PR.A is quite safe according to the investment grade DBRS rating of Pfd-2 (low).
Holdings - Three of the Funds Look More Speculative (click on table to enlarge)
When we look inside the funds at their holdings, we discover that in addition to the top companies, ZUT contains most of the companies we judged to be of middle and lower quality. If you agree with our assessment then perhaps unstable income will be mixed with possible big capital gains, or losses, in ZUT. UTC.C in contrast, holds only the top electric power companies and a broader mix of large well-known firms in other utility sub-sectors. Though we have not assessed these other holdings, they are more reassuring than worrisome for UTC.C.
UST.UN and UTE.UN both lack transparency. We cannot really tell what is inside since neither reveals the entire portfolio. Both appear to contain companies in our middle quality group and other smaller cap companies. In addition, both are actively managed so we must put our faith in the managers.
Bottom Line
From an income investor's viewpoint, despite the lack of diversification gained from multiple holdings, the best company stocks, even held individually, seem to have done as well as the best fund currently available in Canada - UTC.C - in terms of reliable increasing income and stable safe capital value. The other funds appear more suited to those who seek a combination of fairly reliable income and possible though not assured capital gains with greater volatility along the way.
Maybe we are discovering the meaning of legendary investor Warren Buffett's words (from Wikipedia):
A possible course of action, for the investor who has sufficient capital to buy large enough holdings, would be to buy and hold all the top four electric power utilities - FTS, EMA, CU and TA. However, this is not the end of the story or necessarily the moment to buy in. We have not delved that deeply into the companies to pretend that we know the business in the way Buffett means.
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.
Finding the Funds
This required some rooting around since the range of possible fund structures could include mutual funds, ETFs, closed-end funds and split capital shares. We had to check various filters and research tools like GlobeInvestor's Funds page, FundLibrary.com and TMX Money, whose down-loadable list on the Structured Products page turned out to be the most useful, as it included all our candidates below. It seems that there is not a single Canadian mutual fund specialized in Utilities stocks at the moment. The comparison is still something of a challenge, comparing not just apples and oranges but grapes and bananas too. That's the messy reality we investors face!
1) Utility Split Trust - This is a split capital corporation, with the same structure, features, pros and cons as described in two recent posts on split preferreds and on capital shares. We list both the Capital shares and the Preferred Shares below as possibilities since an income oriented investor might want either. One concern is that the corporation is due to close down in December 2011, with holdings liquidated and Net Asset Value returned to shareholders at that time. If the managers First Asset Funds Inc think investors still want it, there could be a proposal to extend its life beyond the intended five-year lifespan.
- Capital Shares (TSX quote: UST.UN)2) Utility Corp (UTC.C) - This is a closed-end fund (see our previous post on CEFs) due to mature and wrap up in May 2013, though this looks unlikely as the managers Scotia Capital issued warrants in September 2010 to double the size of the fund.
- Preferred Shares (UST.PR.A)
3) Canadian Utilities and Telecom Income Fund (UTE.UN) - It's a brand spanking new closed-end fund, just out of the Initial Public Offering December 17, 2011. There is no track record, so the only comparisons we can make are based on the prospectus.
4) BMO Equal Weight Utilities Index (ZUT) - This ETF has the best-sounding stock symbol but that isn't necessarily a reason to invest. It is only one year old, so again we must infer from available information.
Dividend / Distribution Yield and Value (click to enlarge table)
The current payout of the funds, per the Dividend Yield and Value table above, exceeds that of the individual companies rated top quality in our previous blog post individual company analysis (green highlighted rows), except for that of TransAlta. That would be fine except that dividends are only part of the return, especially for the long term hold investor.
Past Returns - Individual Stocks Outshine Funds
The five year share price graph below, taken from TMX.com, shows how much UST.UN fell behind the TSX Composite. UTC.C more or less kept pace with the TSX while our top three stocks - EMA, CU and FTS - to make a bad pun, "powered" ahead of the TSX and UST.UN. The management fees (MER) of the various funds drag down net returns for the investor. Individual stocks do not have any on-going management fees. There is a price to pay for the diversification gained by a portfolio and the MER is it. UTC.C and UST.UN both have MERs over 1%. A key stated objective of UTC.C's warrant issue is to reduce the MER by spreading costs over a larger asset base. Doubling the UTC.C asset base probably will not reduce the MER by half but it should help a lot.
In the past year UST.UN has done much better, second behind EMA, and UTC.C has fallen well behind the others since its warrant announcement in September. Which will do better in future? That is ever the unknown factor.
The UST.PR.A preferred shares look to be a poor investment at the moment. The yield to maturity in December this year, is a paltry 0.1%. As opposed to the current dividend yield of 5.7% (dividend /stock price), the yield to maturity calculation takes account of the fact that the stock price at $10.59 is above the December redemption price of $10, i.e. a capital loss will occur.
DRIP - For investors who wish to plow back their dividends into shares, the best individual stocks, with both a free DRIP program and a discount on such new purchases, such as EMA, FTS and TA, are clearly better the funds. BMO's ZUT at least offers a free DRIP.
Distribution Tax Types - There is little to mark funds or individual stocks as better for an investor's taxable account since the distributions are mostly all dividends, though for the moment UST.UN is handing out only Return of Capital (ROC). The funds, especially the active funds - UST.UN and UTE.UN - may distribute capital gains in future. In contrast, with individual stocks, it is the investor him/herself who decides when to sell stock and realize capital gains. Within a registered account, none of this matters of course, as tax is only applicable when funds are withdrawn from the account.
Liquidity - The funds are weaker than the individual stocks in terms of trading costs, as measured by wider bid-ask (sell-buy) quote spreads, and trading volumes, which determine how easy it is to set up a holding or sell out as needed. ZUT is best of the funds with a low bid-ask spread. UTC.C's bigger capital base should help it after all the warrants are exercised in the next few months. For a long term hold investor, this factor is not a major consideration.
Safety and Stability - On what is probably the most important dimension to the income investor, the individual stocks, especially the top companies in our previous ratings, look much better than three of the funds, though UTC.C comes out looking reasonably good.
Three of the four company stocks - EMA, FTS and CU and one fund, UTC.C, survived the 2008 crash with much less of a price decline than the TSX Composite as the graph below from Google Finance shows. That's the stability we seek. UST.UN fared even worse than the TSX Composite.
The situation is the same on dividends. Whereas all four of the top stocks have had at least one dividend increase, and no decreases, UST.UN went through two significant chops in 2008 and 2009 before an increase in 2010. UTC.C did what one would hope. It increased dividends in all three of the most recent years.
Another measure of stability is how closely the funds sell for what they are worth, in other words the Net Asset Value of the holdings within the fund. As is typical of Closed-end funds and Split shares, these funds are all trading at a considerable discount - UST.UN (-9.6%), UTC.C (-5.3%) - or premium - UTE.UN (+11.4%) - to NAV. The ETF ZUT is working as intended and typical for ETFs, trading very close to its NAV. Some might consider this a trading opportunity to buy a fund for less than it is worth, but suppose the fund is at a discount when you want to sell, is that helpful?
UST.UN adds risk through the use of leverage (borrowed money, through its split share structure), while UTE.UN's prospectus says it may borrow. UTC.C is totally passive and never trades, not even to rebalance, which is contrary to the usual fund risk management principle of rebalancing regularly.
The preferred share UST.PR.A is quite safe according to the investment grade DBRS rating of Pfd-2 (low).
Holdings - Three of the Funds Look More Speculative (click on table to enlarge)
When we look inside the funds at their holdings, we discover that in addition to the top companies, ZUT contains most of the companies we judged to be of middle and lower quality. If you agree with our assessment then perhaps unstable income will be mixed with possible big capital gains, or losses, in ZUT. UTC.C in contrast, holds only the top electric power companies and a broader mix of large well-known firms in other utility sub-sectors. Though we have not assessed these other holdings, they are more reassuring than worrisome for UTC.C.
UST.UN and UTE.UN both lack transparency. We cannot really tell what is inside since neither reveals the entire portfolio. Both appear to contain companies in our middle quality group and other smaller cap companies. In addition, both are actively managed so we must put our faith in the managers.
Bottom Line
From an income investor's viewpoint, despite the lack of diversification gained from multiple holdings, the best company stocks, even held individually, seem to have done as well as the best fund currently available in Canada - UTC.C - in terms of reliable increasing income and stable safe capital value. The other funds appear more suited to those who seek a combination of fairly reliable income and possible though not assured capital gains with greater volatility along the way.
Maybe we are discovering the meaning of legendary investor Warren Buffett's words (from Wikipedia):
"The strategy we've adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it."
A possible course of action, for the investor who has sufficient capital to buy large enough holdings, would be to buy and hold all the top four electric power utilities - FTS, EMA, CU and TA. However, this is not the end of the story or necessarily the moment to buy in. We have not delved that deeply into the companies to pretend that we know the business in the way Buffett means.
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 January 2011
2011 Calendar Checklist for the Canadian Investor
Most everyone starts a new year by buying a wall calendar or a personal agenda to mark key dates and appointments throughout the year. We are all organized by time and the investor is no different. To help readers we therefore offer an annual calendar with key dates that will affect most investors, along with a set of links to previous posts or other Internet resources where how-to help is available on the various topics in the calendar.
The 2011 Canadian Investor Calendar
Links to Topic Resources
Our goal in presenting this calendar is to enhance your efficiency as an investor, so that things are done promptly at the right time. Or, in the words of a man who succeeded in many spheres of life (see this Wikipedia bio),
Disclaimer: this post is my opinion for information only and should not be construed as investment advice. Readers should be aware that while every effort has been made to ensure accuracy, the above dates and information may contain errors and as such, the article's accuracy is not guaranteed. Do your homework before making any decisions and consider consulting a professional advisor.
The 2011 Canadian Investor Calendar
| January | Tactical Stock Trading – exploit January effect |
| TFSA additional $5000 contribution room for new year starts Jan.1 | |
| ETFs/Mutual Funds – year-end distributions paid in during first few days of month; consider reinvestment of cash | |
| Planning – 1) review portfolio goals, performance and rebalance as required; 2) plan tax strategy | |
| February | ETFs - calculate adjusted cost base for ROC, reinvested dividends; data from ETF providers available by approx. mid-February |
| RRSP contribution deadline March 1st | |
| March | Tax Preparation – gather tax slips, capital gains data; pick best software |
| April | ETFs/Mutual Funds – quarterly distributions paid in during first few days of month; consider reinvestment of cash |
| Income Tax – deadline April 30 for filing and paying tax owed | |
| May | RRSP tax refund to reinvest or pay down loan |
| June | Real Return Bonds – interest payment June 1 |
| July | ETFs/Mutual Funds – semi-annual distributions paid in during first few days of month; consider reinvestment of cash |
| August | |
| September | |
| October | ETFs/Mutual Funds – quarterly distributions paid in during first few days of month; consider reinvestment of cash |
| Canada Savings Bonds – sale begins early October | |
| November | |
| December | Canada Savings Bonds – deadline for purchase Dec.1 |
| Real Return Bonds – interest payment Dec.1 | |
| RESP contribution deadline Dec.31 | |
| RRSP – deadline of Dec.31st in the year you turn 71 years of age is the last day you can contribute to your own RRSP | |
| RRSP/RRIF – deadline of Dec.31st the year you turn 71 years of age for RRSP closure (RRIF conversion, annuity, withdrawal options) | |
| RRIF/LIF/LRIF – deadline of Dec.31st to withdraw annual minimum amount | |
| Trading deadline of Dec.23 (Canada) / Dec.27 (US) to settle in 2011 | |
| Tax Optimization – tax loss selling | |
| TFSA – deadline of Dec.31st to withdraw funds and get the corresponding contribution in 2012 | |
| Monthly | Income ETFs/Mutual Funds |
| Variable | Bonds – semi-annual interest payment date unique to each bond e.g. TERASEN 5.56%15SEP14 pays twice yearly on Sept.15 and 6 months later on March 15 till it matures and the face value principal is paid back on Sept.15, 2014. |
| Stock & Preferred Share Dividends – payment after quarterly financial results, i.e. one of 3 cycles – J(anuary) A(pril) J(uly) O(ctober), FMAN, MJSD. Most companies are on January cycle. Check company website Investor section for exact dates of past payments and future schedule | |
| Note | Deadline date is the day on or before which something can or must be done e.g. income taxes filed May 1st are late |
Links to Topic Resources
Our goal in presenting this calendar is to enhance your efficiency as an investor, so that things are done promptly at the right time. Or, in the words of a man who succeeded in many spheres of life (see this Wikipedia bio),
"Dost thou love life? Then do not squander time, for that is the stuff life is made of."
--Benjamin Franklin (quotation from theotherpages.org)
Disclaimer: this post is my opinion for information only and should not be construed as investment advice. Readers should be aware that while every effort has been made to ensure accuracy, the above dates and information may contain errors and as such, the article's accuracy is not guaranteed. Do your homework before making any decisions and consider consulting a professional advisor.
Wednesday, 12 January 2011
Electric Power Utility Stocks for the Income Investor?
Income-seeking investors are in a bind with bonds. Low interest rates have reduced bond yields to minuscule levels. Furthermore, the possibility that interest rates could start to rise would hit the capital value of bonds. It is natural for an investor seeking steady income to look around at other options.
Could electric power generating utilities offer an option? After all, everyone needs power so it should be a stable business. Perhaps attractive reliable dividends are on offer and hopefully the stock price would be less volatile than that of most stocks too. Unlike bonds, if interest rates rise, the companies can adjust power rates to compensate, though perhaps slowly through a regulatory process. Finally, when the stock is held in a taxable account, the fact that dividends are taxed at a lower rate than interest increases the attraction. So let's have a look at the main contenders in Canada and see how these ideas pan out.
1) Finding Steady Profit Makers
The first step is to find strong reliable performers and to weed out weaker companies that cannot make profits year after year who will not be able to sustain and grow dividends. Merely assuming that electric utilities will automatically be profitable is a too-risky leap. We identify the companies within the industry sector by going to GlobeInvestor's Stock Filter and selecting Electrical Utilities in the Industry scroll box. The resulting list contains a number of preferred share issues and companies with operations mainly outside Canada so we put them aside. There are sixteen companies left, which are all listed on the spreadsheet table below.
Next we hop over to the Toronto Stock Exchange's TMX Money website to do the manual and repetitious (since the automated stock filters don't provide this information) but revealing task of checking the profit record of the sixteen initial candidates. Some electric utilities seem to generate more losses than power, so we've highlighted them in red and remove them from further consideration. (click on comparison table for details)
2) Separating the Really Good from the Middling
When we then look at a series of financial indicators to form an overall assessment, the field divides into a set of strong companies (highlighted in green in the comparison table) and another set of middling stocks.
Stocks That Don't Quite Make It
The middling stocks all have several significant deficiencies that make us cautious despite what is an enticingly high dividend yield in several cases. The dangers include past dividend cuts, declining earnings, unsustainably high dividend payout rates, a significant net loss within the last five years, no dividend at all, too high stock price relative to earnings (P/E ratio) and high stock price volatility as reflected in the high stress 2008 period. Many are relatively small companies - as reflected by the quarterly revenue column - which would mean greater impact from any problems in a less diversified operational base.
Algonquin Power & Utilities Corp (TSX quote: AQN) almost makes it to the top category. Its significant loss and dividend cut in 2008 may now be merely history and its recent indicators like payout ratio, interest coverage, debt to equity level, quarterly profits, per share profit growth and P/E ratio appear to show dividend stability and potential stock value. Certainly one of our top companies - Emera Inc - seems to think so as it has just increased its stake in Algonquin.
The Cream of the Crop
Four companies fit the desirable stable image we want through such characteristics as: profits year in and year out, rising profits (though to much varying degrees), dividends that not only are sustained but rising over time, stock prices that survived the 2008 crash much better than the TSX, conservative financial ratios for debt levels and interest coverage. Three of four have the welcome and useful bonus of offering DRIP (dividend reinvestment) programs that allow purchase of more shares at a discount.
Canadian Utilities Ltd (quote: CU) - This stock demonstrates the error of judging a stock only by its current dividend yield. It has the lowest dividend yield at only 2.8% but it has raised it twice in the last two years. The low dividend payout ratio and healthy recent profit growth (3-year EPS) suggest room for more dividend rises. Its P/E at 15.8 is still well below that of the TSX Composite's 19.7 and within the range of 15 or less that professional analysts use to judge fair value for utilities.
Emera Inc (quote: EMA) - This company, and its stock, has been on a tear recently. Very strong profit growth and dividend increases in each of the last three years have pushed stock price appreciation far ahead of the TSX. The DRIP discount of 5% is at the high end of any offered. Its dividend is still a relatively high 4.1%. From the looks of the company news its expansion plans continue. The key question is whether it will be successful in doing that profitably.
Fortis Inc (quote: FTS) - The biggest of the utilities, it personifies the image of a conservative, solid performer - steady unrelenting rising profits, stock price that blipped downwards very little during 2008, regular dividend increases but a modest dividend yield. If there is still such a thing as a widows and orphans stock, this is probably it.
TransAlta Corporation (quote: TA) - There might justifiably be doubts about this company's dividend stability. Its payout is currently significantly more than its profits. The market seems to think so as the stock price has actually declined in the past year (see chart below) while the overall market has gone up. As a result its dividend yield is the highest of the top group at 5.5%. An investor is well advised to start reading the company financial reports to figure out what is going on before buying in.
The overall impression the data leaves with this blogger is that currently one gets what one pays for amongst electric power stocks.
What About the Future?
One big question is whether these companies' stock prices are liable to languish since three of the four have far outstripped the one-year price rise of the TSX Composite Index (blue line in chart) as shown in the chart below from TMX Money.
The professional analysts seem to think that's the case as only Canadian Utilities is rated a BUY while the others are given a Hold recommendation in our Returns Market Sentiment table (click on chart image below for details).
The other key issue is whether - as for any stock and company - past performance is likely to be sustained and whether we investors are about to purchase a piece of a business on the upswing or the downswing. The usual essential step of due diligence imposes itself: reading company reports, analyst commentary and investigating other news to form an opinion about those prospects.
Other Resources:
TMX Stock Screener - also has a Utilities selector to cross-check lists of potential companies
DRIP blog list - Canadian companies' dividend reinvestment program details with links
Wikipedia list of Canadian electricity companies
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.
Could electric power generating utilities offer an option? After all, everyone needs power so it should be a stable business. Perhaps attractive reliable dividends are on offer and hopefully the stock price would be less volatile than that of most stocks too. Unlike bonds, if interest rates rise, the companies can adjust power rates to compensate, though perhaps slowly through a regulatory process. Finally, when the stock is held in a taxable account, the fact that dividends are taxed at a lower rate than interest increases the attraction. So let's have a look at the main contenders in Canada and see how these ideas pan out.
1) Finding Steady Profit Makers
The first step is to find strong reliable performers and to weed out weaker companies that cannot make profits year after year who will not be able to sustain and grow dividends. Merely assuming that electric utilities will automatically be profitable is a too-risky leap. We identify the companies within the industry sector by going to GlobeInvestor's Stock Filter and selecting Electrical Utilities in the Industry scroll box. The resulting list contains a number of preferred share issues and companies with operations mainly outside Canada so we put them aside. There are sixteen companies left, which are all listed on the spreadsheet table below.
Next we hop over to the Toronto Stock Exchange's TMX Money website to do the manual and repetitious (since the automated stock filters don't provide this information) but revealing task of checking the profit record of the sixteen initial candidates. Some electric utilities seem to generate more losses than power, so we've highlighted them in red and remove them from further consideration. (click on comparison table for details)
2) Separating the Really Good from the Middling
When we then look at a series of financial indicators to form an overall assessment, the field divides into a set of strong companies (highlighted in green in the comparison table) and another set of middling stocks.
Stocks That Don't Quite Make It
The middling stocks all have several significant deficiencies that make us cautious despite what is an enticingly high dividend yield in several cases. The dangers include past dividend cuts, declining earnings, unsustainably high dividend payout rates, a significant net loss within the last five years, no dividend at all, too high stock price relative to earnings (P/E ratio) and high stock price volatility as reflected in the high stress 2008 period. Many are relatively small companies - as reflected by the quarterly revenue column - which would mean greater impact from any problems in a less diversified operational base.
Algonquin Power & Utilities Corp (TSX quote: AQN) almost makes it to the top category. Its significant loss and dividend cut in 2008 may now be merely history and its recent indicators like payout ratio, interest coverage, debt to equity level, quarterly profits, per share profit growth and P/E ratio appear to show dividend stability and potential stock value. Certainly one of our top companies - Emera Inc - seems to think so as it has just increased its stake in Algonquin.
The Cream of the Crop
Four companies fit the desirable stable image we want through such characteristics as: profits year in and year out, rising profits (though to much varying degrees), dividends that not only are sustained but rising over time, stock prices that survived the 2008 crash much better than the TSX, conservative financial ratios for debt levels and interest coverage. Three of four have the welcome and useful bonus of offering DRIP (dividend reinvestment) programs that allow purchase of more shares at a discount.
Canadian Utilities Ltd (quote: CU) - This stock demonstrates the error of judging a stock only by its current dividend yield. It has the lowest dividend yield at only 2.8% but it has raised it twice in the last two years. The low dividend payout ratio and healthy recent profit growth (3-year EPS) suggest room for more dividend rises. Its P/E at 15.8 is still well below that of the TSX Composite's 19.7 and within the range of 15 or less that professional analysts use to judge fair value for utilities.
Emera Inc (quote: EMA) - This company, and its stock, has been on a tear recently. Very strong profit growth and dividend increases in each of the last three years have pushed stock price appreciation far ahead of the TSX. The DRIP discount of 5% is at the high end of any offered. Its dividend is still a relatively high 4.1%. From the looks of the company news its expansion plans continue. The key question is whether it will be successful in doing that profitably.
Fortis Inc (quote: FTS) - The biggest of the utilities, it personifies the image of a conservative, solid performer - steady unrelenting rising profits, stock price that blipped downwards very little during 2008, regular dividend increases but a modest dividend yield. If there is still such a thing as a widows and orphans stock, this is probably it.
TransAlta Corporation (quote: TA) - There might justifiably be doubts about this company's dividend stability. Its payout is currently significantly more than its profits. The market seems to think so as the stock price has actually declined in the past year (see chart below) while the overall market has gone up. As a result its dividend yield is the highest of the top group at 5.5%. An investor is well advised to start reading the company financial reports to figure out what is going on before buying in.
The overall impression the data leaves with this blogger is that currently one gets what one pays for amongst electric power stocks.
What About the Future?
One big question is whether these companies' stock prices are liable to languish since three of the four have far outstripped the one-year price rise of the TSX Composite Index (blue line in chart) as shown in the chart below from TMX Money.
The professional analysts seem to think that's the case as only Canadian Utilities is rated a BUY while the others are given a Hold recommendation in our Returns Market Sentiment table (click on chart image below for details).
The other key issue is whether - as for any stock and company - past performance is likely to be sustained and whether we investors are about to purchase a piece of a business on the upswing or the downswing. The usual essential step of due diligence imposes itself: reading company reports, analyst commentary and investigating other news to form an opinion about those prospects.
Other Resources:
TMX Stock Screener - also has a Utilities selector to cross-check lists of potential companies
DRIP blog list - Canadian companies' dividend reinvestment program details with links
Wikipedia list of Canadian electricity companies
Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.
Thursday, 6 January 2011
Investing Success: More is Less, Less is More
Do you have nagging doubts whether you've made the right investing choices? Do you feel over-whelmed and confused by the huge number and variety of investment options? The reason for these feelings may not be anything you have done or failed to do at all.
The Tyranny of Choice: You Choose published in the December 18th edition of The Economist magazine, describes many ways in which the proliferation of choice in modern society can go too far. Whether it is a decision facing a person to buy a shampoo or an ETF, the benefit of a wider range of products to suit the circumstances and desires of individuals eventually reaches the point of diminishing returns and value. To understand the potential for investor over-load, consider that the main Toronto Stock Exchange lists 1498 securities according to Wikipedia and GlobeInvestor Fund Filter tells us that there are 13069 ETFs, mutual funds and closed-end funds in Canada alone.
Too wide a choice manifests its negative effect two ways. First, more choices often means less and less technical difference between products so that expending a lot of effort to see the differences may not be worth it.
But there are also a harmful effects on the consumer through psychological influences. A multitude of choices often causes people to avoid making any choice at all, an effect explained in such studies as When Choice is Demotivating: Can One Desire Too Much of a Good Thing? by Sheena Iyengar and Mark Lepper. With investments, a pertinent example is that people do not start saving if they cannot figure out the right way to invest, or if they do make a contribution to a TFSA or RRSP, the money simply sits as cash gathering dust. As has been shown and discussed many times, the sooner one starts saving for retirement, the less one needs to contribute in total to achieve goals as the effect of compounding has more time to work.
Another harmful effect is that people faced with too many choices will simply pick the first one at hand instead of taking time to choose using proper criteria. The potential time and effort required to weed through so many choices is so daunting that spinning the wheel or picking a nice sounding name becomes the decision method. Despite professional management, funds are not all the same! A variant of this effect is that people pick the fund that did best in the past on the erroneous supposition that fund success will be repeated, despite even the mandatory warnings imposed by regulatory authorities that past performance is no guide to future performance.
What to do - A (Very) Few Ways to Reduce Investing Choice Problems
We'll try to avoid the fault by keeping our list ultra-short.
Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comments 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.
The Tyranny of Choice: You Choose published in the December 18th edition of The Economist magazine, describes many ways in which the proliferation of choice in modern society can go too far. Whether it is a decision facing a person to buy a shampoo or an ETF, the benefit of a wider range of products to suit the circumstances and desires of individuals eventually reaches the point of diminishing returns and value. To understand the potential for investor over-load, consider that the main Toronto Stock Exchange lists 1498 securities according to Wikipedia and GlobeInvestor Fund Filter tells us that there are 13069 ETFs, mutual funds and closed-end funds in Canada alone.
Too wide a choice manifests its negative effect two ways. First, more choices often means less and less technical difference between products so that expending a lot of effort to see the differences may not be worth it.
But there are also a harmful effects on the consumer through psychological influences. A multitude of choices often causes people to avoid making any choice at all, an effect explained in such studies as When Choice is Demotivating: Can One Desire Too Much of a Good Thing? by Sheena Iyengar and Mark Lepper. With investments, a pertinent example is that people do not start saving if they cannot figure out the right way to invest, or if they do make a contribution to a TFSA or RRSP, the money simply sits as cash gathering dust. As has been shown and discussed many times, the sooner one starts saving for retirement, the less one needs to contribute in total to achieve goals as the effect of compounding has more time to work.
Another harmful effect is that people faced with too many choices will simply pick the first one at hand instead of taking time to choose using proper criteria. The potential time and effort required to weed through so many choices is so daunting that spinning the wheel or picking a nice sounding name becomes the decision method. Despite professional management, funds are not all the same! A variant of this effect is that people pick the fund that did best in the past on the erroneous supposition that fund success will be repeated, despite even the mandatory warnings imposed by regulatory authorities that past performance is no guide to future performance.
What to do - A (Very) Few Ways to Reduce Investing Choice Problems
We'll try to avoid the fault by keeping our list ultra-short.
- Keep your portfolio small, no more than 10 holdings - In our previous post Simple Portfolios Compared we looked at eight (that's still a manageable number to choose from, right?) portfolios with a balance and mix of types of assets. None of these portfolios contain more than five holdings. As we noted in the post, they perform quite acceptably.
- Look for low fees amongst funds and ETFs - Funnily enough, low fees reliably equal good performance for the investor. As recounted by McMaster University finance professor Richard Deaves in his book What Kind of Investor Are You? (see review here by CanadianFinancialDIY) and recently again re-confirmed in a Morningstar report various studies concluded that investors get the best net results from mutual funds with low fees, even amongst actively managed funds where the portfolio managers supposedly aim to justify higher fees with better results.
- Seek out a trustworthy advisor - When the investing world gets to be too much consider going to a professional who can guide and narrow choices by having worked through it before. Of course, you need to choose the advisor too! The key is to be able to satisfactorily answer this question - "Is this potential advisor worth listening to?" In other words, does he or she know what they are talking about and will he/she be guiding me for my benefit, not his or hers to my detriment? Your head / logic and your heart / instinctive feeling should both be saying the same thing to make a good decision. See this Globe and Mail article or Blue Collar Financial Planning for more detail on how to choose an advisor. Though not on a personal, formal basis, the aim of this blog is to offer impartial information and trustworthy practical analysis to individual Canadian investors.
Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comments 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.
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