Canada’s new First Home Savings Plan

Brand new for Canadians this year is the First Home Savings Account (FHSA). If you or perhaps your adult child will be a first time home buyer in the foreseeable future, then this new plan should be of interest to you.

For first-time home buyers it allows a maximum contribution of $8000 this year and that contribution is tax deductible.

The FHSA allows for a maximum contribution of $40,000 over 5 to 15 years. If the money (including the growth of the money) is ultimately used to purchase a first home then the withdrawal is not taxed.

I wanted to draw your attention to this new account at this time because the end of the year is approaching. It turns out that if a future first-time home buyer does not contribute anything or the does not contribute the maximum $8000 by December 31, they CAN carry forward the unused contribution to 2024. But they would lose the chance to make a maximum income tax deduction in 2023. Correction: You can only carry forward the unused room from 2023 if you actually open a FHSA by December 31. (And note that if they again do not contribute in 2024 the maximum carry forward to 2025 would be $8,000 and not $16,000). Edit: For potential first-time home buyers there is NOTHING to lose by opening a First Home Savings Account by December 31 and you can contribute just a few dollars or up to $8000. If you can only contribute a few dollars you will at least create unused contribution room to carry forward.

My message is that potential first-time home buyers should probably take action and open a FHSA account before the end of this year and consider contributing up to $8,000. This is especially relevant and important for those with high enough incomes to benefit from the the income tax deduction.

In Ontario, the income tax savings will range from 20.05% of the FHSA contribution to as high as 53.35% of the contribution for those with taxable incomes over $236,000. For those with taxable incomes between $53,000 and $87,000 the tax savings will be 29.65% or $2,372 for an $8,000 contribution. This if basically “free money” and those to which it is applicable should take advantage of it.

Why the Stock Markets are down

The Toronto Stock Exchange is down 3.3% year to date and it’s down 16% from the high for this year reached at the beginning of February. And the S&P 500 is down 11% from its peak level reached this past summer.

Higher interest rates have pushed stocks lower in four ways.

First, even if companies continue to earn and to grow at the same level as previously, those earnings and the associated dividends are simply less valuable as interest rates increase. For example a dollar that is guaranteed to be received in 10 years has a theoretical value of 82 cents when interest  rates are 2% but only 56 cents when interest rates are 6%. Stated another way, stocks have to offer a higher expected return as interest rates rise. And if the expected future earnings and cash flows have not changed then the only way a stock can offer a higher expected return is to decrease in price.

Second, compounding the above is the fact that many companies can expect to have lower future earnings as interest rates rise because of the higher interest they must pay on debt. This impact varies greatly by company depending on their debt level and how much, if any, of their debt is locked in with fixed interest rates for several or more years.

Third, in the most extreme cases the higher interest payments can threaten the financial viability of a company and in that case its share price can drop precipitously.

Fourth, higher interest rates tend to slow the overall economy. In fact Central Banks increased interest rates with a goal of slowing the economy and therefore inflation. A slower economy tends to lower the expected earnings of most companies even those with no debt.

How to Get Started Investing Now.

This month, I updated my article on how to get started investing in a prudent balanced and diversified way. Both stock and bond prices have declined on average in recent months. While this could continue, the fact is that the lower prices are presenting an opportunity for new investors. And anyone getting started investing now is not likely doing a “once-and-done” form of investing. Younger investors in particular can invest funds each month or year. A scenario of lower stock and bond prices, if that does continue, will be an advantage. Investing will almost certainly provide a better future as compared to never getting started investing.

Preferred Shares

My updated article on preferred shares explains why they have fallen in value and why they are now offering attractive returns.

END

InvestorsFriend Inc.
Shawn Allen
October 29, 2023

Bank Shareholders – Beware of Bank Bailouts!

Mythology has it that banks and their shareholders got “bailed out” in the 2008 financial crisis. And yes, some of them did, but not all of them.

Washington Mutual was the sixth largest bank in the U.S. and it was taken over by the Federal Deposit Insurance Corporation and the company went broke with zero recovery to shareholders. A complete wipeout! Certainly no bailout for shareholders. As for its executives, yeah they probably fared very well considering the circumstances. I believe the depositors were all made whole, even the uninsured deposits. So it was the depositors who were bailed out, not the shareholders. And that’s how it should be.

Other shareholders that were wiped out during the financial crisis included the shareholders of Lehman Brothers who were completely wiped out. And the shareholders of Bear Sterns received $2 a share for their shares that had peaked a year or so earlier at $171. Approximately a 99% wipeout.

There were other fairly large lenders and many small ones where shareholders were completely wiped out in 2008. Any notion that bank shareholders were all bailed out is simply wrong.

But it is true that  the shareholders of most banks did benefit from the 2008 bailouts and assistance to banks. That was was somewhat inadvertent as I will explain below.

Who or what is bank regulation meant to protect?

First and foremost, bank regulation is meant to protect bank depositors. Not bank management, not holders of bonds issued by banks and not bank shareholders. The economy would suffer greatly if people and corporations did not think their money was safe in banks. 

So why did many large bank shareholders also get bailed out in 2008?

It was because taking actions that would have protected only the depositors of the large banks while letting their shares go to zero would have been too disruptive to the financial markets and the economy. As is often said, some banks were to to big to (allow to) fail.

What happened with Silicon Valley Bank?

At December 31, 2022 it reported $212 billion in assets and $16 billion in equity. That’s leverage of 13 times but that’s not at all unusual for a bank. It had $91 billion of its assets or 43% invested in securities and the great majority of these securities were mortgage-related securities. It’s very normal for banks to invest in securities in addition to making loans. But having 43% in securities is a very high level. While these were very safe investments 95% of the $91 billion would not mature until at least 10 years. And these securities were yielding or earning an average of just 1.63%. This was a huge problem as interest rates jumped. The biggest chunk here was $57 billion in “Agency-issued Mortgage Backed Securities” with at least 10 years until maturity and earning an average of 1.54%. Mortgage rates never got that low but once bundled up and sold as agency-backed securities, the yield on these investments was down close to the yield on actual long-term U.S. treasuries which got very low. This bank was implicitly betting that interest rates would not rise.

This $91 billion was not required to be marked-to-market under accounting rules because the intention was to hold until maturity and collect the full amount. But that would become very problematic if they had to start paying far more than this 1.63% on deposits.

Looking at this, the whistle blowers who claimed that this bank was “technically insolvent” certainly had a good point. A the very least it looks like SVB was going to suffer years of low or negative profits because the rates it paid on deposits were now up very sharply and it was stuck with massive amounts of securities earning low rates that would not mature for at least 10 years.  The catalyst for the bank failure was the run on deposits that arose when SVB was said to be “technically insolvent” and word of that spread.

How did the takeover by the Federal Deposit Insurance Corporation (FDIC) proceed?

The FDIC seized the bank on Friday March 10 after the bank suffered a massive loss of deposits based on rumors that it was “technically insolvent”.

On March 26, 2023, the FDIC announced that it had sold all of Silicon Valley’s loans and all of its deposits to First-Citizens Bank. This was apparently at a Fire Sale price. It did not include SVB’s problematic securities assets (those long-maturity mortgage-backed securities). First-Citizens got $72 billion in loans at a $16.5 billion discount or 77 cents on the dollar. If First-Citizens can ultimately collect the $72 billion in loans there will be a $16.5 billion dollar gain but some of that gain (or any losses) will be shared with the FDIC. First-Citizens is also taking over $119 billion in deposits. Since the deposit liabilities of $119 exceed the discounted value of the loans ($55.5 billion) by $63.5 billion, it would appear that the FDIC will also be sending $63.5 billion in cash to First-Citizens. FDIC will next sell the problematic $90 billion in other SVB securities and assets. Those are not worth anything close to $90 billion because they are mostly long term mortgage-linked securities at far below today’s market interest rates. FDIC may sell these these at a discount even to the already discounted market value. Warren Buffett may be thinking of throwing in a low-ball bid at this very moment. And he is likely the only person in the world who could commit instantly to buying many billions of these securities with no need to check with his Board.

Conclusions and lessons:

The main lesson of the above paragraph for bank shareholders is that if a bank you own shares in suffers a run on the bank for any reason and gets seized by the FDIC (In Canada the CDIC) they will sell the loan assets of your bank at an absolute fire sale price and your shares will almost certainly be worthless. If your bank has issued preferred shares and bonds (usually bonds are issued to institutional investors), those will also almost certainly be worthless because the FDIC will sell off the loans at such a big loss. 

The lesson for the public is that yes depositors mostly get bailed out here. (Uninsured deposits above the insurance limit may or may not get fully paid.) And bank management loses their jobs but likely collects all their salary and bonus. Management loses the value of their stock options and shares. But share owners and bond investors in the bank typically get wiped out. No bail out for bank shareholders. 

The only time bank shareholders get bailed out is when there is a systematic threat to the banking system (such as happened in 2008) and the banks get rescue packages without being thrown into receivership. Receivership it seems is death to bank shareholder value. 

I suppose bank shareholders losing 100% of their investment in the event of a bank failure is fair. But I just wonder if a more orderly and slower receivership process would preserve at least some value for bank shareholders or at least for the bond investors (who rank higher in priority). One thing is for sure: It is absolutely right that the main focus be on protecting depositors. The interests of bank bond investors and bank shareholders rightly rank far below the interests of depositors.

END

Shawn Allen, CFA, CPA, MBA, P.Eng.
InvestorsFriend Inc.

April 2, 2023

The Investment Outlook for 2023

2023 began with stocks and longer-term bonds ripping higher in January as long-term interest rates backed off somewhat from earlier peaks. Then in February, stocks and long-term bonds gave back some of those gains. Still, the S&P 500 remains up 3.3% and the Toronto stock exchange remains up 4.3% for the year to date.

The outlook is always uncertain and so most investors should probably hedge their bets by holding not only equities but also fixed income and cash.

The great news is that cash in investment accounts is now earning just over 4%. And you can easily get over 4% in short-term GICs. The yield available on all forms of fixed income has risen. In 2022, most fixed-income investors suffered capital losses as longer-term interest rates rose. (Investors learned or re-learned that fixed income does not mean fixed value.) But that’s far less likely to be a concern in the rest of 2023 since long-term interest rates have already risen very significantly and may be more likely to decline modestly by the end of this year rather than increase much. So, an allocation to fixed income should do reasonably well this year.

Equities are always a tough call in any given year. They rise in the long term and so it’s wise to have a fairly heavy allocation to equities. But current stock valuations on average are not cheap and could be driven down as many investors may tend to sell shares in favor of fixed income. Other investors will buy those shares but the share prices would be “bid down”.

In addition to a lot of free information, InvestorsFriend has a paid Stock Picks service which includes a good selection of stocks as well as fixed income. This also includes short daily comments on the market each weekday. The cost is a modest $15 per month or $150 per year. Click here or on the Stock Picks link at the top of every page on this web site to see the page where you can subscribe to that service if you wish. [Notice my “hard sell” approach here.] And you can see full details of our past track record by clicking the “Performance” link above.

Not everyone is interested in owning individual stocks and so we also provide (for free) information on building a portfolio using Exchange Traded Funds.

These Higher Interest Rates are a Massive Game Changer

Higher interest rates have already cooled off the Canadian housing markets significantly. Single-family home prices in the highest priced areas like Toronto and Vancouver have apparently declined over 20%.

Let’s take a look at some of the rather shocking math here.

Just 14 months ago on January 1, 2022 the interest rate (or yield) on a 30-year U.S. treasury bond was 2.01%. Today it’s 3.88%. The value of a $1000 U.S. treasury bond purchased 14 months ago has plummeted to $678. That’s a 32% capital loss on a so-called risk-free bond! This investor is locked into to getting $20.10 per year in interest while newer 30 year bonds issued today are paying $38.80. So, the value of that lower interest rate bond had to plummet.

And let’s look at how the payment on a $400,000 mortgage changes as a 5 year mortgage rate has jumped from about 2.0% to about 5.0% in the space of about 14 months.

The monthly payment at 2.0% is (was) $1694. Furthermore, and very importantly, $1,030 or 61% of the first payment was going to pay down principle and only $664 or 29% of the payment was going towards interest. And after 10 years, 34% of the mortgage was paid off.

But at a 5.0% interest rate the payment increases by 37% to $2,326. And there’s more bad news. Now only 29% or $677 of the first payment is going to pay down principle. 71% or $1650 is going just to pay interest. So your payment is 37% higher and yet you are paying far less towards the principle. After 10 years this mortgage is only 26% paid off.

To run the numbers for a different mortgage amount or interest rate, use this handy link.

So mortgage payments for home buyers have just shot up by about 37%. And not only that but the amount going to principle in the first payments drops by 34% despite the higher payment. So, it becomes harder to pay off the mortgage earlier.

This is a game changer and all else equal has to lead to lower home prices and this has already occurred especially in Toronto and Vancouver. But, all else is never equal and there may be other factors such as immigration that could offset some of the decline.

Next, consider that just 14 months ago, cash bank account products in self-directed investing accounts were paying just 0.05% (not a typo!). Now these same accounts are paying 4.0 to 4.35%. That’s another game changer.

Many fixed income investments that might have looked reasonable 14 months ago at 5% suddenly do not look attractive in comparison to getting 4% in a daily interest account. The prices of most preferred shares fell hard in 2022 as their prices came down to “compete” with the higher interest rates and yields suddenly available on other fixed income investment options.

Equity valuations also came under pressure due to higher interest rates. a A P/E of 20 that seemed reasonable when cash was paying 0% suddenly is less attractive when cash is paying 4% and when there are suddenly many options to earn 6% or more in dividends.

Higher interest rates also lead to higher expenses for corporate debt. And that can push stock prices down. But the bigger impact is that the required higher “discount” rate on future cashflows pulls down the P/E ratios that stocks trade at – meaning stock prices decline, all else equal.

Yep, it’s a game changer!

Marginal Income Tax Rates

With a few days left in RRSP season and with tax filing season upon us, it’s a good time to take a look at marginal tax rates.

I’ll look at Ontario because it is the largest province but I also have a handy link where you can find the marginal tax rates for all the other provinces.

For the 2022 tax year, the marginal tax rate on regular income such as wages and interest in Ontario is 20.05% up to a taxable income of $49,231. People in that tax bracket should probably not make an RRSP contribution since the marginal tax rate at withdrawal time could easily be higher. It’s interesting and shocking to see that in that first tax bracket the marginal tax rate on eligible dividends is negative 6.86% Eligible dividends are dividends from almost any Canadian company on the stock exchange including their preferred shares. These dividends are “eligible” for the dividend tax credit. For this tax bracket, it seems that the dividend credit in Ontario is higher than 20.05%.

Of course, the vast majority of people, especially those with lower taxable incomes have no eligible dividend income, or very little at most. But a small percentage of people are in a position to take big advantage of the low tax rate on eligible dividends.

Investors should be aware of their tax bracket and the marginal tax rate that they face on regular income (including wages, interest, non-Canadian dividends, pensions and RRSP withdrawals), capital gains (half the tax rate on regular income), eligible dividends, and Non-eligible dividends (which are dividends from Canadian small businesses).

Here’s a link to a great web site that gives the marginal tax rates for all the different tax brackets with a page for every province and territory in Canada.

More useful links

Click the “links” button at the top of every page on this web site. There are links there to a lot of sites that are very useful for investors.

END

Shawn Allen

InvestorsFriend Inc.
February 25, 2023

Will 2023 be a good year in the markets?

No guarantees, but I think 2023 is shaping up to probably be a decent year in the markets despite certainly some risks associated with recession and inflation and more people unable to make their monthly payments due to higher interest rates and inflation – not to mention anyone that loses their job.

Why do I think 2023 could be a good year:

1: With the S&P 500 down 19% in 2022 we are starting from a much lower level from which it will be easier to make gains (but again, that’s absolutely not guaranteed). 

2. Most importantly, it was the significant increase in interest rates that acted as a strong “gravitational force” on stocks and especially on medium and long term bonds in 2022. Now, even if interest rates stay at about current levels the stock and bond prices have already moved down to reflect the stronger “gravity”. 

3. For the first time in years, we can now easily earn close to 4 to 5% on very short-term cash and near-cash investments. That will be helpful no matter what stock prices do. (Yes, inflation is running higher than that but that’s a topic for perhaps my next newsletter.)

In my last newsletter dated December 5, I wrote that it was probably a good time to invest. See that newsletter again for more reasons why I believe that and exactly how to instantly achieve a diversified and balanced  investment for some or all of your portfolio.

AMBITION IS THE MOTHER OF SUCCESS

(I very recently wrote the following for another publication that I contribute to, so a few of you may have already seen it.)

Think about the role that ambition plays in the greatest success stories both in life and in business.

 For example, Tiger Woods was groomed and strived for greatness in golf from literally the age of two. Donald Trump has his detractors, but no one would accuse him of lacking ambition. When you think about the most successful CEOs in recent or past decades (Steve Jobs, Jeff Bezos, Elon Musk, Bill Gates, Sam Walton, Warren Buffett and the other greats), they all obviously had great ambitions.

 In my analysis of public companies, I have often been struck by the raw ambition of certain CEOs. For example Shopify was started by a then 23 year old Tobias (Toby) Lutke in Canada in 2004. It would not have become today’s enormous world-wide company without his enormous ambition. And Chip Wilson of Vancouver would not have grown lululemon into an international giant without being extremely ambitious.

 I have marveled at CEOs that were already multi-millionaires, even billionaires and yet they keep striving for growth. Alain Bouchard at Couche-Tard comes to mind as does Alain Bedard at TFI International.  

 Some companies seem to have growth and ambition embedded in their DNA. For example, Canadian Tire and CN Rail have both cycled through a handful of different CEOs in the past couple of decades. Yet their approach and thirst for continued improvement and growth and their success has remained consistent.

 On the other hand, I have recently been frustrated to see that some companies with mediocre results seem to be complacent. They excuse poor performance and blame it on outside circumstances or even on their own “legacy” operations. Often, they refuse to set out profitability goals and generally exhibit a lack of ambition.

 Great Ambition is not a sufficient trait to ensure great success but it’s almost always a necessary trait. Great success will rarely, if ever, be found where there is no great ambition. Success in all areas of life tends to come from setting ambitious goals and striving to meet those goals.

 But goals alone are not enough. I’ve often been skeptical of grand plans for growth. I was more interested in companies that could tell me about actual past success. “Don’t tell me, show me”. But if a company appears to be unambitious and complacent then I will certainly not expect much growth

INVESTMENT VALUATIONS AND INTEREST RATES

(In May 2022 I wrote the following for another publications that I contribute to, so a few of you may have already seen it. My newsletter to you dated March 26, 2022 also covered this interest rate math although not in this detail.)

Higher interest rates and rising inflation are now top of mind for investors. And for good reason.

It’s worth reviewing just how powerful is the force of higher interest rates on investment valuations. The impact of higher interest rates is most direct and easiest to see on bonds and any fixed income investments.

Consider the following: The market yield on a US 30-year bond hit the incredible low of 1% on March 9, 2020, as markets panicked about the pandemic. I guess the buyers that day did not stop to consider that this was literally a 100 year pay-back period! Today [today here refers to May 30, 2022 when I wrote this but the math still applies], the market yield on that same bond is 3% and the value of a $1,000 US Treasury bond purchased on March 9, 2020, and with 28 years left to maturity is down to $625. That’s a massive 37.5% loss on a so-called risk-free bond! And if the market yield on that bond hits 5% in a year’s time, that bond with 27 years left will be worth just $414. The impact of higher interest rates on long-term bonds is absolutely dramatic. And it’s an iron-clad rule. It’s like gravity.

Even more dramatically, consider what happens to the value of a perpetual fixed income stream as interest rates rise. The formula for the value of a perpetual is simply the annual amount to be received divided by the interest rate. Therefore a risk-free $1 annual interest income to be received in perpetuity is worth precisely $50 if the market yield on such perpetuals is 2%. The value then falls by precisely half every time the market required interest rates double. So, it’s worth $25 at 4%, $12.50 at 8%, and $6.25 if the market perpetual interest rate went to 16%. This is so brutal and ugly that it’s almost comical. But it’s true.

The same powerful gravitational force works on equity investments as interest rates rise. But it’s not as easy to see or usually as dramatic for several reasons: The market required yield on equities is never precisely known but it is higher than for bonds and does not increase as fast as interest rates. And the dividends and earnings on equities can be expected to increase to offset some of the impacts of the higher market required return.

As an example, consider a company that currently earns $1 per share and pays out 50% of earnings as a cash dividend. Let’s assume a 20-year holding period and that the earnings will grow at 5% per year. In 20 years, the earnings will be $2.65, and the dividend will be $1.33. Let’s also assume the stock can be sold at 20 times earnings after 20 years and that the market required return on this equity investment is 7%. The math indicates that this stock is worth $21.96 today under those assumptions. But if the market required return on equities jumps to 10% then the value of this share should immediately plunge to $14.25 for a capital loss of 35%.

The above math explains why stock prices have fallen as interest rates have risen and as the market turned its attention to the probability that interest rates will continue to rise.

END

Shawn Allen, CFA, CMA, MBA, P. Eng.

InvestorsFriend Inc.

InvestorsFriend Newsletter December 5, 2022

Is NOW a good time to invest?

Those thinking about putting money into stocks and bonds are always wondering whether now is a good time to invest. And those with money invested are often wondering if they should pull some or all of their money out of the markets.

And this is particularly the case today when the direction of the stock market seems so uncertain due to talk of recession, the impact of inflation and higher interest rates and even the possibility of the war in Ukraine turning into a much larger conflict, possibly even a nuclear conflict. Scary stuff!

But the reality is that there is seldom a time when investors and potential investors don’t face major uncertainties and fears. The future is never clear. It’s only in hindsight that past markets seem far less risky.  Various market crashes and plunges that seemed to last forever when we lived through them eventually start to look like short-term blips after enough time passes.

So, it’s never really clear which way the market will head in the short-term. A more realistic goal is to at least analyse whether or not the market seems over-valued or undervalued in relation to its earnings and the longer term growth trend for earnings/ 

A few days ago, I competed a detailed analysis of the valuation of the S&P 500 when it was at level of 4026 and trading at trailing price to earnings (P/E) level of 21.5 and a forward P/E ratio of 20.1. I concluded that the market at that level was probably about fairly valued. Based on that, I would say that now is a reasonable time to invest in stocks and there was no indication that it is a time to aggressively pull money out of the market. The key, as always is to be balanced and keep some funds in cash and fixed income in order to not become overly exposed to the market. And that’s especially true for those with larger portfolios.

Last year on November 12, 2021 with the S&P 500 then sitting at 4,641 and trading at a lofty P/E ratio of 26.4 times trailing year earnings, I concluded that the S&P 500 was over-valued and that its fair value as a point estimate was 3788 at that time. During 2022 the S&P 500 dropped as low as 3,492 (that was on October 13, only seven weeks ago). It’s now recovered to 3990. But it appears that I was correct that the market was over-valued last November.

What to Invest in Now?

The theoretical best investment portfolio is always “a little bit of everything”. A portfolio that is well “balanced” across the various asset classes (primarily fixed income and equity stocks) and well diversified among industries and regions of the world, in theory, has the best expected return versus risk profile in the face of uncertainty.

Such a balanced and diversified portfolio will always give an average result. The very definition of average should be based on such a portfolio. About half of investors using any other approach will outperform the average and about half will underperform. Nevertheless, the fully balanced and diversified portfolio is theoretically the best unless you have good reason to think you can outperform the average.

And indeed many of us do think that we can do better than average through analysis and by following certain advisers and approaches.

But most investors should consider putting some, most, or all of their investments into a balanced and diversified portfolio. And the good news is that these days you can do that by simply purchasing just one low-fee Exchange Traded Fund on the Toronto Stock Exchange such as Vanguard Canada’s VBAL or iShares XBAL. Some have described investing only in such funds as “VBAL and chill”.  

You can rest easy with such an investment because you will get an average return. The investment could certainly decline (probably temporarily). But any losses will be in spite of the fact that you made a theoretically good and prudent investment. You can honestly tell your spouse that any decline is not your fault. And any losses are almost certain to be temporary in any case. 

For more detail on this approach see my article here. The article also covers versions of  these EFTs that are somewhat more conservative or more aggressive.

For those interested in investing in individual stocks with at least some portion of their funds, InvestorsFriend does offer advice on that as well. Click the “Stock Picks” link at the top of this page for more information. 

Loss of Trust in Our Economic System

I think it’s fair to say that the most Canadians today have lost trust in our economic system. Most people do not trust competition to keep prices at a fair level (witness the current accusations that he grocery industry is using inflation as an excuse to price gouge). And most people do not seem to think that the economy is providing fair wages and a fair opportunity especially for younger people.

Sadly, I think these people have good reasons to think that way.

Consider how our the retail landscape has become more and more dominated by fewer and fewer national-chain competitors. Back in the 1960’s and 1970’s Canadian towns had main streets lined with independent locally owned grocery stores, clothing stores, insurance brokers, hardware stores, shoe stores and other businesses.  The owners were local people who in most cases were not extremely wealthy. There were some national chains like Canadian Tire and the car dealers and gas stations (which were also car repair shops) and of course the big banks. But I don’t think either these dealers or the bank managers were head and shoulders wealthier than most of the local people. Money was tight all around and with multiple competitors people tended to trust that competition worked to keep any particular store from gouging them. Everyday pricing was the norm. Telephone and electricity rates were regulated. Fast-food chains and casual dining chains were rare and just coming into existence.

Today, the great majority of our spending is with national or even international chains and corporations. Truly independent businesses are a far smaller part of the economic landscape. That has both pluses and minuses. These huge chains and corporations operate with economies of scale and lower costs. In a well functioning competitive economy (try not to laugh) most of their lower costs would get passed along to consumers with lower prices. 

But it’s a fact that there are far fewer of these national chains to choose from compared to the old days of numerous independent businesses. Consumers are well-founded in their suspicion that there is insufficient competition.

For example, today in Canada we have just 3 major national grocery chains (Loblaws, Sobeys / Empire, and Metro – although each of these operates under several brand names). Costco and Walmart are also major national grocery sellers. So, that’s just five choices in total and Costco and Walmart are not always conveniently nearby.

There is a recent huge  example that I believe proves that the largest corporations are not competing aggressively on price. In late 2017, Donald Trump reduced U.S. corporate income taxes massively from 35% to 21%. The financial press and analysts, seemingly without exception, predicted that stock prices would rise with substantially higher profits due to the lower income tax.  But I thought that competition would force companies to pass along most of the savings in lower prices. They would not want to, but I thought that, for example, if one grocery store did pass on the savings and one major fast food chain did then the others would be forced to follow. I was completely wrong.

Stock prices and profits soared and (except briefly during the pandemic) have never looked back In fact, profits on the S&P 500 in 2022 are just about precisely double what they were in 2016. And lower income taxes that were never passed along in lower prices are a good part of the reason (along with normal growth in the economy). This is strong evidence that these huge companies in the S&P 500 do not face much competition on the basis of price. And take a look at who these companies are. Among the top 6 companies in the S&P 500 are: Apple, MicroSoft, Amazon, Alphabet (Google), and Tesla. It’s not hard to imagine that by their nature these companies are not competing much on price. There are other reasons for their dominance. Some large companies including Costco and Walmart do compete heavily on price. But they are the exception rather than the rule.

The bottom line is that there is good evidence that corporate concentration and other factors have led to a situation where competition is not as effective in protecting consumers.

So, people are right to have a lower trust in the economy and that is a very bad thing. Well, I guess for us investors it’s a good thing. This may be a good case of “If you can’t beat ’em, join ’em”. (Become an investor.)  Critics take the opposite approach of “if you can’t join ’em, beat ’em” (up). Perhaps the best logical and moral choice is to do a bit of both.

END

InvestorsFriend Inc.
Shawn Allen
December 5, 2022

Investors – Prepare for Higher Interest Rates 

We have liftoff!

It now seems clear that the four decade period of declining interest rates is finally over. Central Banks in Canada, the United Kingdom and the United States have all started to raise interest rates and have signaled that fairly significant increases are coming over the next year or two. That should worry stock investors.

Interest rates as set in the bond market have already moved up significantly. Since January 1 the yield on the ten year U.S. Treasury bond has increased from 1.72% to 2.48%. And the yield on a five year government of Canada bond has doubled from 1.25% to 2.51%.

Financial theory and math is crystal clear that higher interest rates act as a gravitational force on stock prices. It’s possible that higher profits will offset that and stock prices will continue to rise. But investors should not be surprised if stock indexes such as the S&P 500 decline as interest rates rise. In fact, it’s to be expected.

A reasonable defense against this possibility is to hold a higher proportion of cash and short-term fixed income investments. This will provide funds to invest in equities if their prices drop due to higher interest rates.

Investors that agree that interest rates will move materially higher should reduce their holdings of long-term bonds if they hold any. 

It may also be possible to select stocks or sectors that will do better than most in a rising interest rate environment.

In short, higher interest rates may become the story of the markets in 2022 and investors should prepare accordingly.

An Instant Balanced and Globally Diversified Portfolio

A great portfolio for anyone getting started investing and arguably even for experienced investors is to set up a balanced globally diversified portfolio using low-fee Exchange Traded Funds. In fact there are some Exchange Traded Funds that offer this in a single fund. I recently updated my article that provides the stock symbols to accomplish this. I included a suggested approach to specifically deal with expected higher interest rates. I also include more sophisticated approaches that use several Exchange Traded Funds. In all cases these portfolios can be purchased in minutes and thereafter require very little attention.

Warren Buffett’s latest Annual Letter

Literally millions of investors eagerly wait for and then devour Warren Buffett’s annual letter to shareholders. Why? Because it is always full of the finest pearls of investment wisdom to be found. It’s also always an easy read .

So let’s take a tour thorough this year’s letter which was dated February 26, 2022.

You see the full letter at www.berkshire.com or click this link directly to the letter.

First up is the table that compares the rise in Berkshire Hathaway’s share price with the performance of the S&P 500 index with dividends on the index reinvested.  The comparison period is for the 58 years ended September 30, 1965 (the year Warren Buffett took control of the company and ousted the former management) through to the end of 2021.

The table shows that Berkshire’s share price has compounded up at 20.1% per year while the S&P 500 including reinvested dividends has compounded up at 10.5%. Berkshire has not paid any dividends during that entire time except, strangely enough, one thin dime per share in 1967 which is ignored in the comparison.

Okay, so with Buffett at the helm, Berkshire has compounded up at a percentage return 91% higher or close to double that of the S&P 500. That sounds impressive but perhaps not earth shattering.

But the bottom line in the table shows us the amazing power of compounding a higher return over 58 years. The S&P 500 has gained an impressive 30,209% over those years but Berkshire’s stock price has risen a staggering 3,641,613%. So Berkshire has outperformed by 121 times! Stated differently $1000 invested in the S&P 500 on September 30, 1964 is now worth $303 thousand dollars while the same $1000 invested in Berkshire on the same date is now worth $36.4 million dollars.

Some of you will be thinking, okay but what about inflation? Indeed, inflation during those 58 years has eroded the purchasing power of a U.S. dollar by a withering 87%. So, in real terms, after inflation, $1000 invested in the S&P 500 on September 30, 1964 is worth $39 thousand dollars while the same amount invested in Berkshire shares on the same date is worth $4.7 million dollars. 

Anyway you look at it, the rise in Berkshire’s share price under Warren Buffett’s management has been spectacular and dwarfs that of the S&P 500 which itself was already an exceptionally strong investment.

Treating all shareholders equally

“Charlie Munger, my long-time partner, and I have the job of managing a portion of your savings. We are honored by your trust.

Our position carries with it the responsibility to report to you what we would like to know if we were the absentee owner and you were the manager. We enjoy communicating directly with you through this annual letter, and through the annual meeting as well.

Our policy is to treat all shareholders equally. Therefore, we do not hold discussions with analysts nor large institutions.”

So, Buffett treats all shareholders equally. Virtually every other publicly traded company treats large institutional owners and stock analysts far more favorably. They hold meetings for those people. They take questions from them. Top management spends countless hours dealing with only the biggest owners and the stock analysts. Buffett has always refused to do that.

Berkshire picks businesses, not stocks

“…our goal is to have meaningful investments in businesses with both durable
economic advantages and a first-class CEO. Please note particularly that we own stocks based upon our expectations about their long-term business performance and not because we view them as vehicles for timely market moves. That point is crucial: Charlie and I are not stock-pickers; we are business-pickers.”

This is an important mindset. Buffett never invests by looking at the history of a stock’s price changes. He looks as the earnings history and future potential. There is a huge difference in mindset when we see ourselves as owners of businesses as opposed to stocks (mere squiggles on a screen).

Berkshire’s success has been good for America and vice versa

“Berkshire owns and operates more U.S.-based “infrastructure” assets – classified on our balance sheet as property, plant and equipment – than are owned and operated by any other American corporation. That supremacy has never been our goal. It has, however, become a fact. … Berkshire always will be building.”

That’s an interesting fact. Much of the infrastructure Berkshire owns would have existed and been owned by others if Berkshire did not buy the railroad and utility companies that it owns. But, remember, Berkshire does not pay a dividend and instead has plowed billions into needed new infrastructure that the previous owners of those businesses may never have done. That’s been good for Berkshire and for America.

Buffett details how Berkshire Hathaway was formed by the merger of the Berkshire and Hathaway companies in 1955 and how poorly it performed in the following ten years prior to Buffett taking it over. This led to not much income tax being paid to finance the government.

“All told, the company paid the government only $337,359 in income tax during that period – a pathetic $100 per day.” And now? “Now, Berkshire pays roughly $9,000,000 daily to the Treasury.” (That’s 90,000 times more per day!).  “Absent our American home,
however, Berkshire would never have come close to becoming what it is today. When you see the flag, say thanks.”

Buffett never complains about paying income tax and always gives ample credit to the nature of the American economic system that makes his success possible..

InvestorsFriend Newsletter February 10, 2021

Even More Sunshine and Roses

Our December 8th newsletter said that as the end of 2020 approached “all is sunshine and roses in the stock market market”.  The S&P 500 finished the year up 16.2%. The Toronto stock index was up only 2.2% in 2020 but that put it more than 50% above its March lows. Markets have continued to roar ahead so far in 2021. The S&P 500 is up another 4.1% this new year to date and Toronto is up 5.8%. 

Investors should be careful not to be lulled into a false sense of security. It’s ironic that markets feel like a safer bet now than they did back in March. In reality, we now know that last March was a fantastic time to invest.

I recently updated a detailed analysis of the valuation of the S&P 500. This analysis has tended to suggest that the market is over-valued – but it keeps on rising.

Long Term Bonds?

Traditional asset allocation practices and portfolio management advice suggests that most investors should have an allocation to fixed income and that this should include an allocation to long-term bonds. But long-term bonds have had puny yields for years now. Yet they have somehow managed to provide investors with good returns through capital gains for years now. They promise low returns and yet their results have given those that hold them a warm and fussy feeling.

I’ve just updated my in-depth long-term bond article that takes a deep dive into how long-term bonds have managed to outperform their own yields and which explains why that almost certainly cannot continue much longer.

The GameStop Debacle (Predictably) Harmed Retail Investors

In January a huge group of online retail investors were urged to gang-up and cause huge losses to (evil) institutional short sellers by acting together to push the share price of GameStop dramatically higher. This would cause the short sellers to have to buy shares at big losses to “cover” their positions and that buying would help push the stock price even higher. This plan was absolutely destined to cause huge losses to many thousands of retail traders. In fact, the higher they were able to push the price to impose big losses on the short-sellers, the more losses that were destined to be incurred by retail traders. Let’s explore why.

GameStop entered 2021 at a price of about $20 with 65 million shares outstanding. The number of shares sold short actually exceeded 65 million (which can happen) but for my analysis I will assume 65 million shares were sold short.

With 65 million shares sold short, this actually means that there were 130 million shares owned in total offset by 65 million sold short. It’s interesting to contemplate this. It means that, in effect, 65 million shares were conjured out of thin air by the short sellers. Those that bought the shares that were sold by the short sellers would not have been aware that their shares were sort of “phantom”. This also explains why short sellers have to cover any dividends on shares they sell short. The company itself is only going to pay the dividend on the actual number of shares, not on shares artificially created by short selling. I am not suggesting that this is nefarious in any way. It’s just how it works and is interesting to contemplate.

At $20 dollars, and a total of 130 million shares, this would mean a total value of $2.6 billion dollars in investor accounts offset by the short sellers obligation to buy back $1.3 billion worth so that the wealth held by all the shareholders minus the short position was $1.3 billion. And let’s imagine that the the true value of these shares was $40 and many of those holding shares believed that it was the (evil) short sellers that had pushed the price down to $20. (But the short sellers presumably believed the shares were worth less than $20 or at least were headed well under $20.)

The idea was that the massive retail group would act together and buy shares and bid the price up forcing the short sellers (who were deemed evil) to buy back shares at huge losses.

Imagine the situation as the share price got pushed up to say $200. By then most or all of the short sellers would have thrown in the towel and reluctantly bought back shares to close their positions at huge losses. Mission accomplished! 

Assuming the short position was now down to zero, there remained 65 million shares outstanding at $200 per share totaling $13 billion.  So who owned these shares? Well, the trading volume on the peak days ranged from 33 million shares to as high as 198 million shares. There were nine days when the number of shares traded exceeded the total 65 million shares issued and four days when the volume exceeded even the initial 130 million of shares that counts the actual shares plus all those sold short. So, on multiple days each share traded hands on average more than once. Much of the buying must have been retail investors selling to other retail investors. It’s likely that most of the owners of the total 130 million shares owned in early January would have sold for various gains. And many retail investors would have bought in January and then sold. By the time the share price got to $200 and then ultimately peaked at $483 the 65 million shares must have been owned largely by recent purchasers and most likely mostly retail investors. 

Many retail investors would have managed to buy low and sell much higher and made big gains. Some of those gains would have come at the expense of the short sellers. So mission accomplished. But given that the buying volume on the peak days (total trading was 1,206 million shares from January 13 to the end of January) was way beyond the 65 million the short sellers presumably bought back, the owners at and near the peak must have been largely brand new owners who had bought near the highs and who were likely mostly retail investors. Institutional investors would largely have known better than to pay hugely inflated prices. 

So, near the highs the 65 million shares must have been owned to a large extent by retail investors. And that was absolutely destined to happen given that it was the retail investors who got together to buy and push the price way up. The short sellers also bought but that was to cover their short positions and in effect those shares simply disappeared into the thin air from whence they were conjured (see above). 

So retail investors at the peak ended up being the proud owners of much or most of the 65 million shares at $483 for a total of $31.4 billion. But those shares which had traded for $20 in early January were likely to be actually worth at most $40 and certainly no where near $400 or $200 or even $100. 

The share price was then absolutely destined to decline. You can keep anything aloft by blowing on it hard enough, but eventually gravity prevails. In this case, as the share price went back to $50 that was a decline in value of $28 billion dollars compared to the peak value. Some retail investors who bought low but failed to sell would have suffered mostly only paper losses. But it would be extremely distressing to have seen huge gains in their brokerages accounts and then have that disappear. The regret at not selling at high prices would be immense. And many retail investors would have bought near the highs. After all, the trading volume on the day before it peaked was 93 million shares at a range from $249 to $380. A huge portion of the share owners as of the peak must have been recent purchasers at prices above $250. The pain of having bought shares at $250, or $300 or more only to seem them quickly plunge to about $50 would be immense.  Some of these investors would have quickly sold and limited their losses. But on Reddit, investors were encouraged to “hold the line”. Some people must have incurred massive losses. Imagine the regret! I really think it’s safe to assume that there will be divorces and even suicides over this.

Some will blame Robinhood for suspending buying of shares. It appears that Robinhood actually had to do that because it got a $3 billion margin call from the clearing house. In any case, once the shares were artificially driven up to over ten times their rational value, a decline, fast or slow, was absolutely inevitable.

In summary, when retail investors collaborated to push share prices way up in order to punish short sellers, it was absolutely inevitable that many of these retail investors would then end up owning most of the vastly inflated shares and the subsequent losses were inevitable. And given the trading volume that was necessary to drive the price up it was inevitable that the the particular retail investors left owning the shares (holding the bag)  at the peak would mostly have purchased those shares at very high prices. 

END

Shawn Allen

InvestorsFriend Inc.

February 10, 2021 

To view all previous editions of this newsletter, click here.

Investing using Exchange Traded Funds

All self-directed investors should be making use of Exchange Traded Funds at least to some extent. This is most especially true for newer self-directed investors.

The simplest way to invest is to buy a single ETF that is diversified across countries and which contains a mix of fixed income and equity stocks and where the equities are well diversified across the various industry segments. For Canadians, Vanguard provides four such diversified ETFs with the fixed income component set at 60% (VCNS), 40% (VBAL), 20% (VGRO) or 0% (VEQT). iShares has has a very similar set of funds XCNS, XBAL, XGRO and XEQT. The Vanguard products hedge away the currency risk (or reward) on all the investments outside of Canada while the iShares products expose the investor to the currency risk (or potential currency reward). Correction: Neither iShares nor Vanguard hedges the currency risk on the equities portion. That is appropriate as currency fluctuations adds to the desired diversification. Vanguard hedged the currency risk on the fixed income portion perhaps to make that portion even more “Fixed” – though it is still subject to fluctuations related to interest rates and credit risk. iShares does not hedge any of the currency risk (or possible reward).

For newer investors as well as any investor with a relatively modest portfolio, a very reasonable strategy would be to choose just one of the above funds and invest the entire portfolio in that one ETF. These funds are widely diversified and so additional diversification is not strictly necessary. Due to the size of Vanguard and iShares and due to regulations and the manner in which these investments are held, there is likely virtually no risk that these giant fund companies would fail AND that this would lead to (other than modest and temporary) losses for the ETF investors.  

Financial theory suggests that holding a broadly diversified portfolio such as the above funds provides the best expected return for a given level of risk.

However, many investors would want to to use multiple ETFs to construct a more customized but still balanced and diversified portfolio. For example, for those with taxable as well as non-taxable accounts, the single ETF approach would be less tax efficient. Such an investor might want to include a preferred share ETF in the taxable account. And some investors would prefer a different geographic allocation and/or different weightings to various industry segments.

Our updated ETF Portfolio article provides more detail on the single ETF approach and provides a short list of low-fee ETFs that can be used to create a more customized balanced and diversified portfolio. It also has some suggestions on appropriate allocations to each ETF, but that would vary greatly based on individual circumstances.

Of course, many of us prefer to invest largely in individual companies. But in that case ETFs can be used to get exposure to particular segments and geographies and to help to make the portfolio more balanced. Our Canadian ETF article has just been updated and contains details on many ETFs including even some for commodities (Gold, Silver, Oil and Natural Gas).

INDICATORS POINT TO A SOFTENING ECONOMY

In addition to this web site, I am also a contributing editor to Gordon Pape’s The Internet Wealth Builder. The following is an article that I recently wrote for that publication:

There are many indicators that can provide clues as to the state of and direction of the economy. The following are a few of the key ones that I follow.

GDP growth. Real Gross Domestic Product growth is the broadest measure of economic growth. In the United States, real GDP (before inflation) grew at an annual rate of 3.1% in the first quarter of this year but then slowed to 2% in the second quarter. The slower growth in the second quarter was attributed to “downturns in inventory investment, exports, and nonresidential fixed investment”. This data suggests that the U.S. economy has been relatively strong, but that growth is slowing.

In Canada, real GDP for the first quarter grew at an annual rate of 0.5% but this rose to 3.7% in the second quarter, driven by higher energy exports.

Railcar loadings. Warren Buffett has often pointed to railcar loadings as one of the very best and most current indicators of how the economy is doing. Conveniently, the Association of American Railroads provides a timely chart that shows railcar loadings for the U.S. and Canada on a weekly basis with a comparison to the three prior years. The latest data is for the week ended Sept. 14.

For the United States, the chart shows that total weekly railcar loadings have been running noticeably below the corresponding week in 2018 virtually every week this year. For the past fifteen weeks the levels have also slipped below the corresponding 2017 levels. And in the latest two weeks, the 2019 level even slipped down to the 2016 level. This weakness was fairly consistent across all commodities with the exception of petroleum car loadings. They were materially higher virtually every week in 2019 but then slipped back to or below the 2018 level in the latest three weeks. This data strongly suggests the U.S. economy has softened broadly in 2019 and that it is getting softer as the year progresses.

For Canada, the chart shows that railcar loadings have been running at similar levels to 2018. Forest product shipments were the weakest category and have been running noticeably below the levels of any of the past three years. Non-metallic mineral volumes have been running below the 2018 and 2017 levels but above the 2016 levels. Petroleum and petroleum product volumes have exhibited, by far, the most growth in 2018. The remaining categories were relatively similar to the 2018 levels. This data presents a mixed picture but overall suggests a relatively flat Canadian economy compared to 2018.

Manufacturing sales. U.S. manufacturing sales for July rose 0.3% versus June on a seasonally adjusted basis and 1.3% versus July 2018.

Canadian manufacturing sales decreased 1.3% in July which followed a 1.4% decline in June. The declines were broad based, with lower sales in 11 industries that represent two-thirds of total manufacturing sales.

FedEx. FedEx is often considered to be a bellwether indicator for the economy. This week it announced poor results for its latest quarter, highlighting weakening global economic conditions driven by increased trade tensions and policy uncertainty.

Buffett businesses. Warren Buffett has often said that Berkshire Hathaway’s vast array of operating businesses provides him with an excellent window into the health of the American economy. In the first half of 2019, volume at many of its operations was down. Its railroad car loadings were down 4.5% in the first half of 2019. Same-store volume at its residential real estate brokerage operation was down 8% year to date. Industrial manufacturing revenues were up 0.6%.  The number of manufactured homes it sold at retail declined 6%. Revenues at its travel trailer division fell 13%.

Revenues at its service businesses (primarily related to aviation) were up 4.6%. New auto sales were down 3%. Home furniture revenues were down 3%. Berkshire also owns 25% of Kraft Heinz, which has experienced lower revenues in 2019. While revenues were up modestly in its railroad and utilities operations and at some of its other businesses, the overall picture indicates a slower economy in the first half of 2019.

Overall, the above indicators suggest that the U.S. economy is clearly softening, and that Canada’s economy is relatively flat compared to 2018. Investors can prepare for a softer economy by reviewing their asset allocations and by lowering their exposure to the most economically sensitive companies. An increased emphasis on more stable investments including short-term cash deposits may be warranted.

STOCK MARKET VOLATILITY

With the economy softening, and given trade tensions, it is a good time to think about potential declines in the stock market. 

“Volatility” – that’s the euphemism that the financial markets use to refer to market value losses. Technically, market gains are also “volatility”, but gains are never referred to in that way. Equity investors are always aware that volatility and losses are a possibility at any time. But it’s typically only after a material amount of loss has happened that we start to focus a lot more attention on volatility and how to avoid it.

At the end of the day there are two broad choices when it comes to volatility:

1. Minimise it with action before the fact. This can be done by constructing a safer portfolio, which includes a material allocation of assets to non-volatile assets including cash, GICs, and shorter-term bonds. And with equity investments that are well diversified and perhaps mostly concentrated in lower volatility stocks.

2. Accept the risk of volatility. This means accepting that a higher level of exposure to equities is extremely likely to result in higher long term returns but at the probably unavoidable cost of higher volatility and periodic losses over shorter periods of time.

END

Shawn Allen
InvestorsFriend Inc.

September 29,2019

Buying too high and/or failing to sell as earnings deteriorate

Selling exceptional companies because they seemed too pricey

At times I have sold shares in companies that I knew were extremely excellent businesses that were very likely to continue to grow their profits per share over time. The reason for selling was that the shares looked very expensive with price to earnings ratios that seemed very high, for example, over 30. Examples of this include Visa, Costco, and Berkshire Hathaway. I have gone on to regret those sales. Each of those three have had occasional declines but for the most part they continue to rise over time. Warren Buffett has long suggested that once you have identified and bought shares in an exceptional business the wisest course is usually to avoid selling. Instead, accumulate more on dips.

Regression to the Mean in P/E ratios

Stocks with significantly above average earnings per share growth rates can justify and do deserve to trade at higher than average P/E ratios. But buying stocks with high P/E ratios does mean that we are effectively paying up in advance for the expected future growth. I’ve considered it to be prudent to assume that a stock with a high P/E such as 30 will tend to regress down towards the market average of say 18 over a five or certainly a ten year assumed holding period. But recent experience has been that many of the higher P/E stocks have remained much higher than average. This certainly applies to Visa and MasterCard.

Conversely, there are some apparently good companies that tend to trade at lower thahan average P/E ratios. At times an assumption that their P/E ratios will rise providing an attractive gain has paid off. But in some cases the laggards to contine to lag.

Winners win and losers lose?

The momentum strategy of investing tends to assume that stocks that are going up will continue to do so. And those going down will continue to do so. When stocks continue to rise because earnings continue to rise, this can certainly be a winning strategy. For the past several years momentum or growth strategies have out-performed strategies based on fundamental value. But that is certainly not always the case.