Shareholder Yield - the New, Improved version of Dividend Investing

We've previously noted the income and return attractions of high dividend stocks and ETFs concentrated in such stocks. After all, producing cash for shareholders is ultimately what investors want from companies. But dividend investing is evolving. Instead of only considering the dividend cash payout, some adjustments and refinements have been found by researchers to be worthwhile.

The new refined measure is called Shareholder Yield. It equals three pieces summed together: Dividend Yield + Net Share Buyback Yield + Net Debt Paydown Yield

1) Dividend Yield = The latest quarterly dividend per share multiplied by four to get a projected yearly total and then showing that as a percentage of the current stock price.

This is the long-recognized traditional measure used by dividend investors to find attractive companies and it does still work, just not as well as Shareholder Yield.

2) Net Share Buyback Yield = The net amount of shares bought back by the company in the previous year, after subtracting shares issued.

Although the most accurate calculation would be in dollar terms, expressed as a percentage of current company market capitalization, an accurate enough simplification is simply to take the percentage change in common shares outstanding (as Mebane Faber points out in his excellent mini-book Shareholder Yield; the book's website also contains links to various research articles on the topic).

The reason it is important to consider share buybacks and issuance is that some years ago companies, especially in the USA, began returning cash to shareholders by buying back their shares in the open market. Changes in relative tax rates that favoured capital gains, or stopped favouring dividends, are often cited as a key reason stimulating the shift to buybacks. In any case, the chart below from index providers Standard & Poors, detailing the rise of buybacks from negligible amounts in 1980 to as much or more than actual dividends today in the USA, shows it is essential to consider repurchases.

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In Canada, the relative tax attractiveness to investors of dividends versus the capital gains that buybacks engender for the investor, has remained much more muted than in the USA (see Table 2 in Taxation, Dividends and Share Repurchases: Taking Evidence Global by Marcus and Martin Jacob for the tax penalty on dividends through the years in Canada, the USA and 23 other major countries). There is not such a large incentive for Canadian companies to send cash back to shareholders by buybacks instead of dividends. But there are still many companies in Canada, as we see below in our comparison table of some Canadian dividend stocks, where net repurchases or issuance, dwarf the effects of cash dividends.

The important point to note is that when companies have fewer shares after net repurchases, the buyback yield is positive and more shares after net issuance means a negative yield.

3) Net Debt Paydown Yield = The year over year difference in the debt load of a company as a percentage of market capitalization.

This metric is not measuring return of cash to shareholders. Rather, it measures the judicious use of cash by company executives in a way that ultimately benefits shareholders. Instead of wasting cash inflows / profits in empire-building like poor acquisitions or low-return projects, the executives avoid temptation by paying down debt. Shareholders benefit since less cash inflow goes to paying interest on debt and more to profits and potentially higher dividends down the road. In their research paper Enhancing the Investment Performance of Yield-Based Strategies Wesley Gray and Jack Vogel discovered that incorporating debt paydown in picking better stocks resulted in higher returns ... not without fail in every case, it should be noted, but as a strong average.

The Return Difference - Example of the S&P 500 from 1982 to 2011
Gray and Vogel found that selecting stocks with the highest yield for the three components of Shareholder Yield, taking each component by itself, produced significantly higher returns than the S&P 500 index average, repeating the findings of many other studies. But they also found that picking stocks with the highest yield combination of all three, Shareholder Yield, produced the best return of all.

Yearly Return 1982-2011
S&P 500: 10.96%
Dividend Yield (highest yield quartile): 13.40%
Net Buyback Yield (highest yield quartile): 13.19%
Net Debt Paydown (highest yield quartile): 13.25%
Shareholder Yield (highest yield quartile): 15.04%

Huge Shareholder Yield variation amongst stocks in a Canadian Dividend ETF
To see how different a picture Shareholder Yield might paint of stocks in a dividend-stock focussed ETF we compiled the Shareholder Yield for the holdings of the iShares S&P/TSX Canadian Dividend Aristocrats Index ETF (TSX symbol: CDZ), which selects stocks that have increased dividends for at least five consecutive years.

Unfortunately, there does not seem to be a free website that provides Shareholder Yield already calculated for Canadian stocks. We had to do our own calculations, which is not too complicated though it takes a while for many stocks. In our table below, dividend yield, dividend growth and total 5-year return came straight out of GlobeInvestor WatchList. Google Finance Canada provides quarterly Balance Sheet numbers for total debt and number of common shares (e.g. for Enbridge here) that, along with the market cap from GlobeWatchList, allowed us to work out the change over the most recent four quarters to come up with net buyback yield and net debt paydown yield.

We've taken the top/best and bottom/worst parts of CDZ's companies sorted by Shareholder Yield in the light blue column.

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The results are surprising. There is little relation between Dividend Yield and Shareholder Yield. At the top of the table, some companies with modest dividends like Home Capital Group and SNC-Lavalin have extremely high Shareholder Yield by virtue of significant debt reduction. A handful, like Jean Coutu and Tim Hortons have instead relied on big share buybacks to deliver high Shareholder Yield. Several companies like AGF, Bird Construction and Thomson Reuters have good-looking Shareholder Yield numbers yet their dividend payouts (cf the Payout Ratio column) far exceed net income and may thus not be sustainable. Yet others - Transcontinental and Major Drilling - have net losses, raising the same question even more urgently.

At the bottom of the table are many companies that have been counter-acting their sometimes elevated dividends with share and/or debt issuance to reduce Shareholder Yield to a negative number. In the case of Exchange Income Corp (EIF) both debt and share issuance are allied with a payout ratio of dividends more than six times recent net income. No wonder bad news articles like this one in the Globe are appearing about EIF. In the case of Empire, which last year swallowed a huge acquisition in Safeway, the piling on of new debt and shares to finance the acquisition may make good business sense. Empire's Payout ratio still looks sustainable at 55% though it used to be below 20% before the Safeway acquisition. It is worth looking at Shareholder Yield in combination with Payout ratio - Gray and Vogel found that among low Yield companies, those with the highest Payout ratios tended to under-perform.

Bottom Line: Shareholder Yield appears to offer an additional angle, though not a complete definitive answer, to the assessment of individual stocks. It suggest further useful questions to ask, such as reasons for share or debt issuance and the sustainability of dividends and repurchases.

ETFs based on these factors
The ETF providers have observed the importance of share buybacks, especially in the USA, and have stepped forward with funds that select holdings on more than high dividends.

• PowerShares Buyback Achievers ETF (NYSE: PKW), MER 0.71% - Selects holdings based on dividends plus buybacks. Very successful since 2006 inception, with $2.5 billion in assets and 2.4% better performance than the S&P 500. MER seems to be high for a simple mechanical stock selection process. This Seeking Alpha article compares it to an ordinary dividend fund.
• PowerShares International Buyback Achievers (NASDAQ: IPKW) MER 0.55% - Same selection criteria as PKW on international stocks. Inception Feb 2014, $18 million in assets. Includes some Canadian companies like Tim Hortons and Magna.
• Cambria Shareholder Yield ETF (NYSE: SYLD), MER 0.59% - Selects based on all three elements of Shareholder Yield. Co-managed by the same Mebane Faber who wrote the above-linked book on Shareholder Yield. Inception May 2013. Assets of $223 million
• AdvisorShares TrimTabs Float Shrink ETF (NYSE: TTFS), MER 0.99% (that's high!), Selects companies that are repurchasing stock. Inception 2011. $151 million in assets. This article from Sizemore Capital compares the three US-stock ETFs

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.

Socially Responsible Canadian Large-Cap Companies - Who's the fairest of them all?

Last week's post on the latest in Socially Responsible Investing talked only of various funds, not individual companies. Some investors might want to assemble their own portfolio of such companies, or at least take the Environmental, Social and Governance (ESG) rating into account when assessing the stock. It's also sensible to expect that not all companies will have equally good ratings. Finally, the various funds and indices use slightly different selection or exclusion factors and weighting schemes of the factors' importance. Different results can easily arise. Yet, we would expect the best of the ESG performers to rate highly no matter what the scheme. It's a bit like judging beauty. Different people might have different opinions but some individuals everyone agrees are gorgeous. So, let's hold up the mirror against the largest Canadian public companies (those in the TSX 60 index) to find the ones everyone agrees are the fairest of them all.

The Indexes and the Funds
All of the funds and indexes focus on larger companies. It may well be that smaller companies could score equally well but they have not been assessed or rated.

• Thomson Reuters Developed Markets (ex-US) ESG Index 
• TSX 60 ESG Index, based on RobecoSAM Corporate Sustainability Assessment
• Stoxx Global ESG Leaders Index
• iShares Jantzi Social Index ETF (XEN) - Canada's sole SRI-focussed ETF
• NEI Ethical Canadian Equity Fund - a mutual fund, the largest SRI fund in Canada; holdings as of 31 Mar 2014 obtained from SEDAR in the fund's interim financial statement
• Desjardins Environment Fund - mutual fund, holdings also as of 31 Mar 2014, from SEDAR
• PH&N Community Values Canadian Equity Fund - mutual fund, holdings as of 31 Dec 2013, from SEDAR
• HowToInvestOnline - though we did not use this to rank the companies, we've included our own ESG assessment results from various past posts listed in our Guide post under Socially Responsible Investing  

The Belles of Canadian Companies

The comparison table below shows that five companies are in every single index and fund; they are the veritable beauty queens of SRI:

• Bank of Nova Scotia (TSX symbol: BNS)
• Canadian National Railway (CNR)
• Rogers Communications Class B (RCI.B)
• Suncor Energy (SU)
• Toronto Dominion Bank (TD)

Following on are a group of four "princesses", appearing in six out of seven lists, and another eight companies amongst our still very attractive "debutantes", featuring in five out of seven. In every case where we had actually rated these companies in our own posts, we had found them to be very acceptable from a Sustainability (yet another term that is used more or less inter-changeably with SRI and ESG) perspective.

Surprise - Every company in the ordinary TSX 60 index made it into at least one SRI / ESG fund or index list. In our analysis we discovered that every company in the regular TSX 60 index, based on market cap to represent leading sectors and companies from a financial point of view, also shows up in a SRI/ESG list. An ETF based on the TSX 60 index, such as iShares' XIU, might thus be considered a lowest common denominator SRI fund. Beauty is in the eye of the beholder and it seems everyone is indeed beautiful in someone's eye.

The Belles and Stock Performance

Our second comparison table below shows that the top-rated beauty queens did indeed turn out out very attractive numbers for total stock return (capital gains plus dividends), return on equity and beta (a measure of volatility relative to the market, where 1.0 is the market average, in this case the TSX 60 ordinary market cap index, while below 1.0 is more stable, less volatile, less risky stock price). 

The princesses also did very well but performance has not been nearly as good amongst the debutantes.

Bottom line:  For those concerned only about financial performance, consistently high ESG ratings can be a useful extra dimension to add to a stock evaluation since the very top of the list seems to be occupied by very successful, safe and profitable companies. For those concerned about ethics, companies with consistent high ratings probably will meet most people's approval. At the very least, the list of the top companies can be a useful starting point for drilling into the details of a company to examine its behaviour on the dimensions of particular interest to the individual investor.

Disclosure: This blogger directly owns shares of BNS, CNR, SU, BMO,RY, BCE and TCK.B as well as all the companies listed through ETFs.

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.

Socially Responsible (Environmental, Social, Governance) Investing - What difference does it make?

Back in 2009 we first wrote about Socially Responsible Investing (SRI), also commonly known as investing based on Environmental, Social and Governance factors (ESG).  The chart below from one of the ESG ratings providers, Thomson Reuters, shows what the process considers.

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The question of whether an investor can expect to get better, or worse, results than simply buying an index fund that owns a piece of every public company regardless of SRI/ESG factors matters. SRI/ESG is a topic of continuing interest to us, with enough past posts to merit its own category in our guide to online investing. Let's see what recent research has found and examine the latest return results of the actual available funds.

SRI screening makes a small but significant contribution to the variability of performance
In the January 2014 paper Do Social Responsibility Screens Really Matter? A Comparison with Conventional Sources of Performance authors Marie Brière, Jonathan Peillex and Loredana Ureche decompose the sources of performance variability of SRI equity funds worldwide between 2006 and 2012. Unsurprisingly, overall market movements determined the bulk - 70% - of return variability. Most of the remaining 30% was down to asset allocation and active management (stock picking) about in equal measures in a range of 10-14% for each source. But SRI screening itself, either screening in stocks with good ESG ratings or screening out "bad" tobacco, alcohol, weapons or nuclear stocks, accounted for 6% of the return variability. As the authors conclude, "SR screens matter but, like active portfolio choices, they have a limited impact on total equity fund performance, heavily dominated by market movements".

High ESG scoring companies have better risk-adjusted returns
Indrani De and Michelle Clayman tell us in The Benefits of Socially Responsible Investing: An Active Manager's Perspective that high ESG scoring stocks tend to exhibit lower volatility, giving them a more favourable return to volatility (standard deviation of price movements) ratio i.e. risk-adjusted return. Better yet, this lower volatility was more accentuated when markets were most volatile in their study period of 2007 to 2012, which covered the horrors of the financial crisis. Protection in the worst times sounds pretty good. The catch is that the difference in volatility is not that huge as we can see in the chart from their study below. The stocks in the bottom 10% of ESG scores, the red bars, had a lower standard deviation of returns, in 2008-2009 at the worst of the financial crisis, compared to the top 90% ESG scoring companies in the blue bars. Di and Clayman conclude that ESG ratings are more useful as risk indicators than as predictors of return out-performance - " while ESG ratings may not have predictive alpha capability, they do predict the stock risk".

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Material vs non-Material factors
The research on ESG was refined in a March 2015 working paper by Harvard Business School professors Mozaffar Khan, George Serafeim, and Aaron Yoon. Corporate Sustainability: First Evidence on Materiality found that it was important to distinguish ESG factors that are material, i.e. that make a difference to financial and stock market performance, from those that do not. Each sector and industry has different material factors. No single factor is material across the board. The enticing results are depicted in this chart from the study. Companies that do something about highly material factors and ignore insignificant factors perform the best - see the box at the upper left.

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The Sustainability Accounting Standards Board in the USA has published a detailed Materiality Map of what matters for which sector and industry amongst five ESG main factor groupings (Environment, Social Capital, Human Capital, Business Model and Innovation, Leadership and Governance) subdivided into 30 specific factors with measurable performance metrics. The Map shows, for instance, that fair marketing and advertizing is material for asset managers while employee health safety and well-being are non-material but for a railway company the opposite holds.

Stock returns for SRI/ESG investing strategies seem to track the market quite closely
The total returns performance of ESG-selected stocks does not seem to differ much from that of mainstream capitalization weighted indices, as the following recent chart from Thomson Reuters shows. The lines of the cap-weight vs the ESG index are hardly distinguishable.

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In the case of Canada the one and only SRI/ESG oriented ETF, the iShares Jantzi Social Index ETF (TSX symbol: XEN), delivered a five-year total return (price appreciation plus distributions) of 10.32%, slightly ahead of the large cap iShares S&P / TSX 60 Index ETF (XIU) at 9.44%, which it is most comparable to, and slightly behind the broad market iShares Capped Composite Index ETF (XIC) at 10.71%. The latest returns table from index provider Jantzi going back to 2000, which notable excludes the return-reducing effect of XEN's 0.4 to 0.5% higher MER fee over those of XIU and XIC, suggest the same -  in Canada it is also a close race.

It may well be that the market has recognized the superior accounting performance of high ESG companies and factored that into their market price, much reducing or eliminating the possible stock return advantage. De and Clayman cite research suggesting so. A 2013 news item that one in five institutional investors in the USA consider ESG factors can be seen as a glass half-empty or half-full argument, but 20% is enough to have influence on market prices. Certainly company CEOs are paying attention, as major consulting outfit McKinsey's July 2014 Global Survey attests. De and Clayman relate that "the share of S&P 500 companies filing sustainability reports has increased from 20% in 2011 to 72% in 2013".

Investor fund choices still mainly mutual funds and a handful of ETFs
Maybe it's the close alignment of returns with mainstream cap-weight funds or that, if one takes the trouble to look inside, the holdings of the  SRI/ESG funds have a high degree of overlap with cap-weight funds. But the reality is that ordinary retail investors have not flocked to buy such funds. As we noted above, there is still only the one ETF in Canada devoted to an SRI/ESG strategy - XEN - and it has attracted puny assets of $25 million since 2007 inception. Canadian mutual funds have been more successful in attracting investors but the size of assets is still not impressive. The latest June 2014 quarterly table from the Responsible Investment Association lists 26 Canadian equity mutual funds with $1.8 billion in total assets, not much considering there are fifteen individual ordinary Canadian equity funds with the same or more in assets according to GlobeInvestor.

Canadian investors can also buy a handful of SRI/ESG ETFs on US markets. The two serious contenders are well established:
- iShares MSCI KLD 400 Social ETF (NYSE: DSI) - 2006 inception, $372 million USD in assets, tracking 400 US companies, MER 0.5%, 5-year return 17.9%
- iShares MSCI USA ESG Select ETF (NYSE: KLD) - 2005 inception, $267 million USD assets, 100 stocks only and excludes tobacco companies), MER 0.5%, 5-year return 17.36%
In the USA, five-year returns of the cap-weight benchmark have been better than the above ESG funds. The iShares Core S&P 500 ETF (NYSE: IVV) compound annualized return of 18.74% outstrips that of both KLD and DSI.

Finding individual companies that meet the SRI/ESG criteria:
1) Holdings listings of ETFs or mutual funds on the provider websites
2) Constituent listings of various indexes -
... Thomson Reuters' Developed Markets ex-US, which includes Canada, or Large Cap US
... S&P/TSX index on TMX Money, the 60 ESG
... Sustainalytics' Global Compact 100 and STOXX Global ESG Leaders, which include Canadian and US companies
... Calvert Social Index of large and mid-cap US companies

Bottom line: Investing by SRI/ESG principles may make you a bit better off financially, or maybe not, but it probably won't make you much worse off either.

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.

Low Volatility ETF Update - Are they performing as advertized?

In 2012 we introduced the newly launched category of low volatility equity ETFs that promised more stability and equal or better returns in comparison to standard index funds with holdings selected and weighted by market capitalization. A couple of years have passed, so let's see how they are performing.

Comparison Table - Low Vol ETFs vs Cap-Weight Benchmarks

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Low Vol performance mostly lags Cap-Weight ...
The green cells in our comparison table above show where the Cap-Weight ETFs have done better than their Low Vol counterparts. The green cells outnumber the yellow cells showing Low Vol superiority. It is interesting how consistent is the pattern of returns. In every single equity market around the world, Cap-Weight has higher returns for the year ending June 30th. But the tide seems to have turned since the beginning of 2014 - most of the Low Vol ETFs have pulled ahead Year-To-Date (YTD).

... and the reason is that Cap-Weight should win in a strong bull market
As we noted in the original post (and as reiterated in this excellent National Bank Financial January 2013 analysis of Low Vol ETFs), the main drawback of Low Vol strategies is likely performance lag in strong upward markets. That is what has been happening - returns in every world market have been wonderful recently - 14% to 28% 1-year total returns in the various global equity markets. The Low Vol returns have been very good too, just not quite as good.

More evidence of how good things have been recently shows in the columns for Reward to Volatility (Sharpe) Ratio and Volatility (standard deviation of returns). Sharpe ratios are very high - compare the 1-year numbers ranging from 0.6 up to 4.6 versus the 10-year averages of 0.4 and 0.5. Historical long term Sharpe ratio figures across many equity markets cited in the 2012 Credit Suisse Global Investment Returns Yearbook (see Fig.4 on page 19) range from 0.1 to 0.7. We have been living in unusually good and stable times for the last few years. Volatility itself is also very low compared to past longer term averages. Equity volatility below 10 is well below the usual high-teen or greater long term average (see Tables 1 and 2 on page 22 of Credit Suisse). The result is that in several cases, the Cap-Weight ETF benchmarks actually display lower volatility than the Low Vol ETFs which are specifically designed to be lower volatility.

When markets go sour again, that will be the real test of Low Vol ETFs
It is perhaps obvious to say it but the current equity party will end - market volatility will return and large market drops will happen. There's no reason to think the history of markets will not be repeated and equities will not exhibit considerable volatility in future. The only thing we don't know is exactly when that will happen. That is when we will see how much the Low Vol ETFs limit the downside drop and the volatility, perhaps proving their worth with better risk-adjusted (higher Sharpe ratio) and total returns.

We investors must decide whether to wait another five or ten years for definitive proof to emerge to substantiate the benefits of actual ETFs that attempt to capture results shown in academic research and backtests. Waiting means possibly missing out on Low Vol benefits ... or missing out on Low Vol disappointment if they really do not pan out.

As far as what other investors are doing, so far, the net asset figures of the various ETFs in our table show that Low Vol has caught on mainly in the USA. In Canada, only BMO's low vol version has attracted substantial investor money.

Disclosure: This blogger owns shares of the BMO Low Volatility Canadian Equity ETF (TSX symbol: ZLB).

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.

Inflation Protection's Big Trade-off - Protection vs Returns

Friday the latest CPI inflation indicator for Canada showed a 2.4% rise. Inflation has been fairly low and quite stable for more than a decade now but the wary investor keeps the more distant past in mind when inflation ran amok and therefore factors an amount of "just-in-case" protection against any resurgence and surprise spikes of inflation.

As with many situations there is a trade-off - what works very well as protection often has low returns. Let's therefore have a look at the major asset classes to see how they respond to unexpected inflation.

Expected vs Unexpected Inflation - First, it's necessary to clarify that what's expected won't hurt so much, it's the unexpected that matters. With inflation running at around 2%, the expected returns and yields of various investments have that amount (as we noted in this recent post) incorporated into prices. It's the shock and surprise increases that take away real value which hurt investors.

Macro-Economic Volatility and Supply Shock Inflation vs "Great Moderation" Inflation - It probably has not seemed so to those suffering through rising prices, but the nature of inflation has differed in the 1990s and 2000s from the decades of the 1970s and 80s. The less volatile business cycles of more recent times, termed the Great Moderation, have entailed a different kind of inflation. In the 1970s, inflation arose more from supply shocks, in the form of big oil price increases, and at times when the economy struggled, while in the more recent period inflation has risen in tandem with good economic growth. That, according to the research paper Inflation-Hedging Portfolios: Economic Regimes Matter (on SSRN) by Marie Grière and Ombretta Signori, has meant that the best protection against inflation has changed, as we note below.

Short-term vs Long Term - The final key distinction is that the type of investment that responds well and quickly to a surprise inflation leap may not do as well as another over many years.

Asset Classes - How they respond to inflation

a) Cash - Except for a short few months of typical lag before rates adjust, cash investments like T-Bills and money-market funds will rise with inflation, no matter what the economic regime. The bad news is the trade-off that returns on cash short- and long-term are low and, as Brière and Signori point out, the return on a long-term investment in cash stands a fair risk of falling shy of full inflation-matching. BlackRock's review Are Hedging Properties Inflated? notes how central bank policies like ones in place at present may mean negative overall real returns for cash.

b) Nominal Bonds (Government 10+ year) - Bonds do not usually offer inflation protection. On the contrary, in the short term bonds suffer losses through price reductions. However, with longer holding periods extending out more and more years, bonds progressively recover. During the years of the Great Moderation, Grière and Sognori even found nominal bonds to be a good long-run inflation hedge, whereas in the earlier opposite economic environment, nominal bonds were a bad choice for inflation compensation. This brings to the fore a key issue for investors - will the Bank of Canada (and other central banks) continue to maintain their credibility and the belief of investors that inflation will not be allowed to run rampant? If inflation is consistently contained, nominal bonds will do fine as inflation protection. The advantage of nominal bonds over inflation-indexed bonds of similar duration is slightly higher yields.

c) Inflation-Indexed (Real Return) Bonds - Such bonds, called Real Return Bonds in Canada and TIPS in the USA, offer explicit inflation hedging by the built-in mechanism to increase interest and principal in lockstep with a measure of inflation, in Canada that being the CPI. Any and every inflation rise, whether expected or unexpected, feeds automatically into the bonds' returns three months after the actual CPI results. The downside is that net real returns after taking away the inflation-matching portion are very low.

d) Equities (Broad market cap-weight index) - Equities are hurt by unexpected inflation in the short term and especially so when inflation is of the supply shock variety, as the 1970s oil price shocks so well demonstrated when stocks had negative total returns while CPI rose significantly (e.g. see this chart of the USA's S&P 500 index). In the long term, the ability of businesses to cope with inflation by passing through price increases to make up for inflation has enabled gradual, though sometimes not full recovery depending on the period as BlackRock show. The Credit Suisse Global Investment Returns Yearbook for 2012, which examined the inflation-fighting performance of various asset classes, summarized equities as "not particularly good inflation hedges". On the other hand, equities offer the best long-term historical returns record.

e) Real Estate - This asset class is a very poor short-term inflation hedge but an effective long term hedge (see all our reference studies linked in this post), with returns similar to equities.

f) Gold and Precious Metals - In the short-term, gold has been found to be a very good hedge for unexpected inflation but only erratically in certain periods, and is a weak hedge for overall inflation in the long term. It is an asset that produces no income and its long term return from capital appreciation only is very low as the Credit Suisse Yearbook data shows. It's hedging value is probably more related to financial and currency collapse than inflation.

g) Commodities - There appears to be consensus that commodities offer excellent short-run inflation hedging according to an IMF paper of 2011 Inflation Hedging for Long Term Investors by Alexander Attié and Shaun Roache. BlackRock ranks commodities as the best short-term inflation hedge of all the asset types. This conclusion applies to broad commodity indices as individual commodities are not effective. The protection offered by commodities erodes over time till at more than five years, there is no benefit. Worst for the long term, commodities have exhibited negative real returns far short of inflation as the graph below copied from the Attié and Roache paper shows where the dark black line of commodities lies below CPI inflation.

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Take-aways
Given 1) the variable hedging performance of the various asset classes, 2) the difficulties in knowing when inflation surprises are set to arrive (no kidding!) and what type of economic regime and inflation drivers there will be and 3) the need to gain higher returns than simply keep up with inflation, the sensible thing to do for the investor with a long time horizon would seem to us to include some of each asset, to maintain a diversified portfolio that will cope with all the eventualities. Rebalancing to the target asset allocation will take into account the effects of inflation reactions as well as the many other effects affecting asset values such as real interest rates, changing perceptions of riskiness and foreign currency swings.

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.

Dogs of the Dow and the TSX - Are they nasty or nice investing pets?

It's now the dog days of summer, so it's a good time to write about an investing theory referring to dogs that seems to have worked pretty well since it was first put forward by Michael O'Higgins in his 1991 book Beating the Dow.

The theory is called the Dogs of the Dow. The method is ultra-simple: once a year, take the list of the 30 stocks in the Dow Jones Industrial Average, sort them by dividend yield, and buy an equal amount of the ten highest yielding stocks. Hold them for a year and then the following year, sell the stocks no longer in the top ten and buy the replacements. By convention the buying and selling is done on January 1st, though there is nothing to prevent anyone from starting at any time during the year.

The popularity of the strategy has even led to the creation of a dedicated Dogs of the Dow website, where the 2014 January 1st list of Dogs is shown in blue. For someone buying today, a stock screener such as Finviz.com with the DJIA index selected, will list all its components, which can then be sorted by yield.

The logic and rationale of the Dogs method is that the dividend yield indicates stocks which are out of favour, usually only temporarily. Dividend yield is defined as dividends over current stock price so the yield of a stock rises when price declines i.e. the stock falls out of favour. Thus, the Dogs strategy is often described as a simple, crude strategy for identifying Value stocks.

Performance - Up-to-date total return data seems difficult to find, but up to 2011 the Dogs strategy performed the same as the overall DJIA with a 10.8% average over the preceding 20 years according to Dogs of the Dow. Since then, the Dogs have edged ahead, judging by the price in blue in the chart below of the sole ETN that tracks the Dogs, the Deutsche Bank AG ELEMENTS Dogs of the Dow Total Return Index Note (NYSE: DOD, MER 0.75%) compared to the red line of the DJIA.

(click image to enlarge)

Criticisms and caveats:

• Equal weighting of selected Dogs while the DJIA is price-weighted gives the Dogs an unfair advantage (see Wikipedia write-up and Forbes article) i.e. the performance comes from the weighting not the stock selection
• Dividends alone are no longer a good test of fundamental value (e.g. this article in Barron's magazine) due to a rising rate of share buybacks; instead something like shareholder yield (net of share buybacks minus issuance plus dividends) would be more appropriate
• Lack of diversification of the Dogs as a portfolio due to the small number of stocks and accidental sector concentrations

Dogs of the TSX
The same idea has been applied in Canada on stocks in the TSX 60 Index, though with some modifications by the originator of the Canadian version Dave Stanley, like the exclusion of deliberately high-yielding income trusts and former trusts (as described in the Beating the TSX Finiki article and as discussed in this thread on the Financial Wisdom Forum), to ensure a similar focus on blue chip, large cap stocks.

Up to 2011, the Dogs of the TSX did even better than the Dow original, beating the TSX 60 Index by more than 2% per year on average between 1987 and 2011 (according to Finiki, citing a 2012 Canadian MoneySaver article).

Current List of TSX Dogs:
Using the superb Stock Rover screener, we extracted all the high yielding larger cap stocks on the TSX, then filtered out all stocks that are not included (rows highlighted in pale yellow) in the TSX 60 Index, as well as any income trusts and former income trusts (rows in tan) not already excluded to come up with the table below. The white rows are the TSX Dogs as of July 11.

(click to enlarge)

The rules of selecting the Dogs are not set in stone. It's an active strategy, not a passive one and we investors can change what we want.  Some of the companies may be in the doghouse for good reason. Norm Rothery of Stingy Investor has just published in MoneySense his list of Top Dogs of the TSX, filtering out stocks where the dividend may be in danger, as indicated by dividends that exceed earnings. Notice how TransAlta (TSX: TA), top of the list above with highest yield, got dropped, no surprise given its negative earnings. Some investors might consider TransAlta a good buy as a turnaround candidate but others, who want only to buy high quality blue chip companies and their dividends, may well want to exclude TA, which is not even a very large cap company.

Other differences between our list above and Rothery's probably arise because his list came from data as of June 30th. Two on his list - Telus (TSX: T) and Power Corporation (TSX: POW) - are 11th and 12th in line in the Stock Rover screen. Market prices are always changing.

The resulting Dogs looks less like ones that will bite you and more like faithful companions. Most of the current Dogs have shown up in our previous posts of centenarian companies (National Bank, CIBC, BCE and Bank of Montreal and blue chips (as well as the centenarians, Potash Corp, Rogers, Shaw) or dependable utilities (Fortis).

Other variations of the Dogs selection method are also possible e.g.:

• Relax the exclusion of (former) income trusts, especially now that it has been several years since the 2011 trust conversion deadline and excessive payouts would most likely have had to be reigned in. For example, Canada's largest REIT Riocan (TSX: REI.UN) has a high yield which is still well under its earnings, as our table above shows. Global Securities writes about such an apparently successful implementation of this Dogs variation.
• Allow in large caps that the TSX 60 excludes, like Power Financial (TSX: PWF), Great West Life (TSX: GWO) and IGM Financial (TSX: IGM)

Due to the lack of diversification / the high sector concentration (4 out of 10, or 40% on an equal investment basis, are in Communication Services, with none in Industrials or Consumer stocks and only 10% each in Energy and Materials), we would not think it advisable to put all a Canadian equity allocation into this strategy. However it does offer a way to identify stocks that currently offer higher dividends at a reasonable price and to establish long term positions in high quality 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.

Long Term Return Expectations for USA and Rest of World - the Current Outlook

Last week we laid out what by historical standards are the modest future long term returns investors can expect from Canadian stocks and bonds. Since most Canadian investors also include an allocation to equities of the USA and other countries, this week we'll review the indicators of their likely future returns over the next 10+ years.

US Equities

Method 1 - Current Dividend Yield + Dividend Growth
The idea is the same as that in our post about Canadian stocks but since US companies make heavy use of stock buybacks (see this Credit Suisse article) to return money to shareholders instead of dividends, we'll adopt the modification that takes account of buybacks and new share issuance to derive Shareholder Yield. Patrick O'Shaughnessy at Millenial Invest recently explained Shareholder Yield and graphed its historical actual values for the US equity market, which currently looks to be just under 4% - we'll use 3.9%.

Then we add potential dividend growth based on growth of the overall US economy. Forecasts of long term US GDP growth vary from the Conference Board's Global Outlook of about 2% as an average of the two periods from 2014-19 and 2020-25, to the US Federal Reserve's 2.2 to 2.4% cited by Rick Ferri back in January. We multiply those GDP forecasts by the 0.6 proportion that flows through on average to shareholders (as we reported in our original post on future return expectations, research shows that GDP growth gets diluted and does not translate into as much shareholder return) to get a range of 1.2% to 1.4% annual dividend growth.

Result: A reasonably attractive, at least compared to what CAPE tells us below, total US real annual equity return estimate of 3.9 + 1.2/1.4 = 5.1 to 5.3%

Method 2 - Shiller's Cyclically-Adjusted Price Earnings (CAPE) Ratio
Yale professor Robert Shiller found that a P/E that adjusts earnings for inflation and averages over the past ten years smooths out economic cycles in calculating a Price/Earnings ratio for the US stock market. The adjusted P/E or CAPE gives a good indicator of probable future long term stock returns. The higher the CAPE the lower the future returns. Clifford Asness of AQR Capital explains the ratio in more detail and defends its usefulness in An Old Friend: The Stock Market’s Shiller P/E.

The CAPE is now over 26, which is very high by historical standards, as this chart from Guru Focus shows. Note the tiny implied future annual return, a mere +0.6%!

(click to enlarge image)

The following chart from a post at the Blakeley Group shows what happened to subsequent S&P 500 returns at various CAPE levels through the past 114 years.

However, the relationship between CAPE and US equity returns has a fair degree of variability - all is not deterministically and rigidly fore-ordained. Asness includes a table showing that for CAPE over 25, subsequent annualized 10-years have ranged over a worst case of -6.1% to a best of +6.3%.

Method 3 - Ratio of Total Market Cap to GDP
This is apparently Warren Buffett's method of assessing whether the US market is over- or under-valued. As calculated by Guru Focus, it currently shows the US market to be significantly over-valued. Consequently the expected future return for US equities is a paltry 1%.

We would have hoped for closer agreement between the three methods but that's the situation. US equity real returns will be muted but there seems to be a high degree of uncertainty with a plausible range from 0.6% to 5.3%.

For those who wish to look at nominal returns including US inflation, simply add the Federal Reserve Bank of Cleveland's current 10-year inflation forecast of 1.8% to the real return figures above.

Developed and Emerging Market Country Equities
CAPE works about as well for other developed country markets as for the US, but less reliably for Emerging market countries, according to this 2012 paper by Joachim Klement. The Shiller P/E for Europe has been rising but is still low in relative historical terms as seen in the charts on MrMarket.EU and in this presentation by Henderson Global Investors. The latter two papers do not translate the low CAPE numbers into projected returns but Klement does and his projections, though two years old, may still be useful, especially for emerging markets which have gone sideways since 2012. His projections are for five years only. The annual compound real return for emerging markets he projects at 5.8%. For developed markets the projection in 2012 was 5.7% annual real growth, but we have seen gains of over 23% in the last year alone so a current projection will not be as high.

Guru Focus uses a method similar to the dividends plus dividend growth formula we have used above, but it explicitly adjusts for reversion to the mean of the ratio of market cap to GDP. By this method, of the 19 major countries in the table of CAPE-based return expectations on Guru Focus, every single country, both developed and emerging market, is estimated to have future returns significantly above the USA's (see chart below). Emerging markets have very high projected returns. Incidentally, we note that the Guru Focus estimate for Canada is 3.9%, which fits within the bound of other estimates we wrote about last week.

Takeaway:
A Canadian investor should look to maintain, or establish if not already there, an allocation in the portfolio to developed country and emerging market equities. The USA offers less promise of reward than those markets.

Caveat: A Canadian investor's return on foreign assets will be affected by moves of the Canadian dollar versus the currency of the foreign country equities. Though such moves tend to even out in the very long run for investors who maintain and regularly rebalance their asset allocation, as we discuss here and here, over longer periods such as ten years or more, returns may raised or reduced by foreign exchange moves. Forecasting foreign exchange shifts is too uncertain to be worth trying.

Addendum April 2016: McKinsey & Company's Global Institute is forecasting much lower returns for the USA and Europe than those experienced over the last 30 years - 1.5 to 4.0% per year lower on equities and 3 to 5% on bonds. Research Affiliates provides monthly updated forecasts of long term future returns for many asset classes, including Canadian equities, which as of the 31 March 2016 update pegged the 10-year expected real return at 3.4%.

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.