Newsletter

Recent Stock Market Performance

Stock markets have surged higher since the start of this year.  As of April 24, the U.S. market (the S&P 500 index) is up 11% and that’s on top of a huge surge of 16% in 2020 (despite the pandemic). In Toronto the stock market is up 9.5% this year to date but it was up only 2.2% in 2020.

In 2021, the stocks that InvestorsFriend rated in the Buy or strong Buy range are up an average of 21% and only two of the 21 are down in price. I would hasten to add that this is well beyond what we expected. It’s definitely not typical.

Where to Invest?

If you are new to investing, take a look at our article that shows how Canadians can instantly set up a diversified portfolio.

Try our stock picks.

For those interested, we have a paid service that provides our individual stock picks and analysis. In addition to the stock picks, I provide a short daily comment on the market five days a week. We don’t make any guarantees on performance but we do guarantee to be honest and transparent and to show you the detailed logic behind every stock pick.

Buying Physical Gold including Gold Coins

I happened to notice recently that the choices TD Bank has under “Investment Products” are: GICs, Mutual funds, and Precious Metals.

I was surprised to see precious metals (gold and silver) listed alongside such unsophisticated products as GICs and mutual funds. It strikes me as a bit dangerous.

Upon investigation I see that under gold, TD is selling gold coins and gold wafers/bars.

Most of the coins are one ounce although some are as small as 1/10th ounce. Prices for 1 ounce coins range from Canadian $2402 to as high as $2566. This is noticeably higher than the Canadian dollar value of one ounce of gold which is $2232 at the time of writing. Investors buying gold coins need to be aware that they are paying  a premium over and above the value of the actual gold.

Prices for 1 ounce gold bars ranged from $2358 to $2403 which is 6% to 8% above the quoted spot value of gold per ounce.

I would consider these coins and small gold bars to be collectibles as opposed to financial investments.

Checking online I see that Canadagold has 10 retail locations across Canada and it appears that their prices are lower. For example, 7% lower for a Maple Leaf gold coin.

I would not recommend gold coins or bars as an investment due to the risk of loss or theft and due to the fact that the cost is higher than the gold content and there would be a fairly large buy/sell spread. And it appears that a retail gold store will have better prices than TD.

For the serious physical gold bug TD offers a 1 kilogram gold bar currently quoted at $74,100. At 32.15 troy ounces per kilogram, that’s about 3% higher than the spot gold value.

My conclusion is that what TD offers is more for collectibles and might be bought as a gift. For actual gold investments, I would go with an exchange Traded fund that holds physical gold.  Examples are CGL on the Toronto stock exchange which is an iShares gold trust hedged to Canadian dollars. Or MNT on Toronto which is offered by the Royal Canadian Mint and is not hedged to the Canadian dollar.

Buying Life Insurance?

In 20 years online, I have never gotten involved in promoting any product or service. I am often asked to promote various financial products such as foreign exchange trading sites. But I never do it.

However, I recently came across a new company that is selling life insurance online and it seemed like an intriguing idea. After investigation and after speaking at some length to the leaders of this company I am satisfied that it is a good outfit and that it could save most people money on a life insurance purchase. Although it is an online service, they have licensed agents that will help you select the right product for your needs. Be very sure to take your time to get the right product if you are buying life insurance.

Here’s how they describe what they offer: Dundas Life makes life insurance easier, more accessible, and personalized. Compare rates and get coverage from Canada’s top providers. You can be insured for up to $1,000,000+ in coverage. Get started today in 5 minutes or less.

You can check out what they offer at this link. Note: They are currently licensed to sell to customers only in Ontario, B.C. and Alberta.

Money and Banking

The nature of money and how it is created in the economy is not easy to understand.

Part of the reason that money at the national level is hard to understand is that the total quantity of money at the national level works very differently than how it works in our own individual bank accounts.

Money that is spent, still exists 

When individuals or businesses spend money it of course disappears from their bank accounts. Our money is a wasting asset in that sense. When it is spent it is “gone”.  We can say that our money went “into” a bicycle  or we put it “into” the stock market. We need to replenish our money as we spend it or we will run out of money.

But think about money at the level of the whole country. Money that is “spent” ends up in someone else’s pocket, cash register or bank account. Spending money does not deplete the total amount of money in circulation. We hear talk of investors as a group putting more money “into” the stock market. But in reality, one investor buying stocks from another simply transfers money from the buyers account to the sellers account. At the level of a country, money is a transfer mechanism.

If an individual or business could “print” legitimate money they would become vastly wealthy. But it’s pretty clear that a country cannot become wealthier by simply printing money. A certain amount of money needs to be created in a country and there may be times where government money printing is beneficial. But ultimately unlimited money printing cannot possibly be the “road to riches” at the national level.

At the individual level, money is wealth. At the national level money is not really wealth. The real wealth of a nation and it citizens is things like the physical houses and factories and buildings of all types and roads and (importantly) knowledge and also computer systems and communications systems.

Money creation

Strangely but truly money is created in most or perhaps all cases by borrowing. Borrowing by governments, individuals and corporations literally creates money. Paradoxically, paying back loans decreases the total amount of money in circulation and borrowing increases the total money supply.

There is nothing evil or nefarious about this. It’s just the way it works. Claims that this is evil stem from the persistent but incorrect image of money as consisting of a limited number of paper bills printed by government. Or from the even more archaic notion that money should consist of a limited number of gold and silver coins.

Excess savings? People and businesses sitting on excess cash?

Currently the financial press has many stories about consumers and businesses “sitting on” excess cash and savings. Canadians are said have some $90 billion of “excess” savings. And business are said to be “sitting on” $120 billion of excess cash.

The hope and assumption is that post-COVID this excess money will be “spent” and/or “invested” which will boost the economy. I don’t disagree with that but I take some issue with how things have worked and will work.

First, given that money is created when governments (and anyone else) borrow, and given the massive government borrowing of late and also significant corporate borrowing, that created money had to show up as someone’s cash.

There seems to be an assumption that if consumers had spent all of their government assistance money and if businesses had invested or spent all their assistance money then we would not have this “excess” cash. But for the country, money spent by one individual or business simply ends up in the account of another individual or business. The money was created by the “excess” borrowing and so it seems wrong to call it excess cash or excess savings. The only way for this money to be reduced or disappear is for it to be used to repay loans. But on average, the people and businesses with the excess debt are not the ones with the excess cash and so loans are not being paid down to any great extent.

We always seem to have this erroneous picture of cash as paper money. Corporations do not have $120 billion of excess cash in the office safe. That  money is in their bank accounts. And on a bank balance sheet it is funding loans. And no matter where it is ultimately spent it is going to end up simply being transferred to another bank account – unless it is used to repay a loan.

Pundits say they want cash to move out of banks and “into” the economy. In reality the best that can happen is that it will move “through” the economy from one bank account to another. To grow the economy, money needs to move at an accelerated pace.

Central Bank Digital Currency?

I read where central banks might issue a digital currency to compete with Bitcoin. This confuses me because in fact our money is already almost entirely digital. We keep having this picture in our heads of money as being bits of paper. It’s mostly not. I guess the digital currency that the central banks have in mind would include anonymity like paper cash. That’s already easily done with reloadable pre-paid credit and debt cards. We just need banks to issue more of those. These could be loaded with small amounts and there would be no record of where it was spent – like paper cash.

Bank reserve ratios and capital ratios

The following will be better understood if you understand how banks work and can picture what the balance sheet of a savings and loan bank looks like. We have a short article that shows it.

Banks, by nature and by regulation, are subject to two main balance sheet constraints. The two are vastly different. They actually sit on opposite sides of the balance sheet and yet are often confused with one another.

First, a bank must for both practical and regulatory reasons keep a certain amount of cash on hand to allow for withdrawals. Cash must be kept at a certain minimum percentage of its total assets. This is called the cash reserve ratio.

In practice, the amount and percentage of cash that a bank needs to keep on hand has gone down dramatically for several reasons.

Historically, especially in the U.S., banks were small and had very few branches and sometimes served only one City. Historically, also, there were no debit cards and no credit cards. There were cheques, but but most people took their wages out largely in paper cash for spending purposes.  A small bank like that had to keep substantial cash on hand for unexpected withdrawals. And any rumor that the bank was financially shaky would cause a huge exodus of cash. There was no deposit insurance in the early days. So, early banks needed to keep a large percentage of their assets in cash.

As banks got larger they also developed procedures to almost instantly borrow cash from one another. Larger, more solid banks and deposit insurance meant that there would almost never be any fearful “run on the bank”.  (But it can still happen, in Canada Home Capital suffered a massive run on the bank in the spring of 2017. Its high interest savings deposits “fled” due to news and fears that it was facing mortgage fraud problems. It was rescued by Warren Buffett).

The situation in Canada today is that most of the banks are huge. They can instantly borrow cash from other banks when needed. In extreme cases they can borrow from the Bank of Canada. Deposit insurance and the stability of Canada’s banks makes a “run” on the larger banks extremely unlikely. And, with paper cash cash largely going out of style, cash is rarely taken out of banks in paper form. Rather, it is simply transferred to another bank, where the first bank can borrow it back if needed. Due to all of these factors, Canada’s large banks today can and do operate with very low levels of “cash”.  That includes not just paper cash, but also their cash deposits at other banks and at the central bank. They simply have very little cash of their own. Ironically, almost all cash or money consists of bank deposits and yet banks have extremely little cash. Did I mention that money and banking is not easy to understand?

In Canada there is no regulated minimum cash reserve that banks must keep on hand. They keep just a small amount that they need in their operations and they are safe in the knowledge that they can instantly borrow any needed cash.

The second balance sheet constraint on banks is on the other side of the balance sheet. Their owner’s equity has to be kept at certain minimum levels compared to their assets. Banks are highly leveraged by nature. Their assets (mostly loans) can be as much as 30 times larger than their owner’s equity in some cases. The more leveraged they are, the higher return on owner’s equity they can make. But leverage is also dangerous in the case of loan losses. Regulators require minimum equity (or capital) ratios in order to insure banks remain solvent. Apparently, without regulations, some banks would basically leverage themselves to extreme and risky levels.

Conclusion

Money and banking are complex to understand. But perhaps all that most people really need to know is that it is better to have more money and more wealth. They need to know that money is usually hard to come by and easily disbursed and they should act accordingly. For example, by investing their money for growth. It is far more useful to understand how to get more money in your own bank account than to understand how money is created in the economy.

END

InvestorsFriend Inc.

April 24, 2021

Newsletter December 6, 2020

This has been an extremely volatile year in the stock market.  At the depths of the virus-driven market panic on March 23, the S&P 500 was down a gut-wrenching 32% for the year. Similarly, the Toronto stock index was down 35%! And many individual stocks fell by over 50%.

Those kind of declines were more than enough to scare almost all stock investors. In particular those who had invested the great majority of their funds in stocks and who had little cash or fixed income investments were hard pressed not to feel some panic.

Even the Vanguard Balanced Exchange Traded Fund Portfolio (VBAL) which is only 60% invested in stocks and which has global diversification was down fully 20% at the low point in March. Even most fixed income investments traded down significantly due to the fear.

Only cash, and cash equivalents held rock steady which is always the case by definition. And the strongest longer-term government bonds rose significantly in value as investors paid higher prices in a quest for safety.

But now, as the end of 2020 approaches, all is sunshine and roses in the stock market. The S&P 500 is now up 14.5% this year which, incredibly, is 69% higher than its low point. The Toronto stock index is up 2.7% year to date which puts it 57% above its March low. VBAL is up 7.3% for the year and sits 35% above its low point.

An ideal but unrealistic scenario for 2020 would have been to have sold stocks at the highs in January and so to have entered the panicky month of March with a very large allocation to cash and then bravely bought back into stocks as others panicked in March. 

A more realistic scenario would have been to have been holding a balanced portfolio with a reasonable allocation to cash and fixed income and then to have done basically nothing. except ride the storm out. That strategy would have been stressful in March but has worked out well as the year draws to a close. It might also have allowed at least some buying near the lows simply due to rebalancing to keep the cash and equity percentages relatively constant. For example, the VBAL fund is automatically and frequently rebalanced on that basis. 

The worst scenario would have been to have panicked and sold a significant portion of a portfolio near the lows in March and then to have “sat in cash”. That scenario has locked in the losses.

With the markets now at record highs it might be tempting to move to a sharply lower equity allocation and higher cash allocation. Or, others might be tempted to have a very heavy allocation to stocks to ride the current trend. Only one of those strategies will look wise in a year’s time. If 2020 has taught us nothing else it is that markets are unpredictable. History has shown time and again that markets rise over the longer term. A reasonable strategy for most investors is to have some balance in their portfolios and to stick with that allocation.

Long-term historical annual returns from stocks, bonds, cash and gold

I recently updated my article on the annual returns from the main asset classes of investment which are stocks, bonds and cash. I also included Gold although it is usually considered a more niche investment. The data covers 1926 through 2019. One thing to note, it is annual data  and does hide some of the within-year volatility that we have just seen can occur.

I also updated an article on whether stocks are really riskier than bonds. They certainly are in the short term but arguably not in the long term.

This is Not Your Father’s Mortgage

HSBC Bank was in the news this week because it is offering a mortgage below 1% for Canadians. Their current offer is 0.99% for a 5 year variable rate mortgage! I’ll round that off and call it 1%.

A 1% mortgage rate is intriguing and got me thinking.  At 1%, the interest on a one million dollar mortgage is just $10,000 per year or $833 per month.

I’m old enough to have paid over 10% on a mortgage. At 10%, a million dollar mortgage would have cost $100,000 per year in interest or $8,333 per month! But not coincidently, ordinary houses did not cost anything close to $1 million back then.

Don’t worry, I am not here to suggest that it’s easier to buy a house now because interest rates are so low. Home prices have vastly increased since the days of 10% or even 6% mortgage rates. 

What I wanted to explore today, is the way in which mortgage math has been just about turned on its head.

In the “old days” with say a 10% interest rate most of the payment for quite a few years had to go to paying interest and the amount owing on the mortgage came down very slowly indeed. Amazingly, with a 25 year mortgage, it took over 19 years before the mortgage was half paid off. After 10 years the mortgage was only 16% paid off with 84% remaining. The good news however was that it was feasible to pay off the mortgage years early by making extra payments over and above the required payment. For example a $5,000 bonus cheque would knock a meaningful chunk off of a $100,000 mortgage.

Now, with a 1% mortgage most of the payment even in the first year goes to paying down the principal. For a 25 year mortgage at a 1% interest rate the amount paid off after 10 years is 37% and the mortgage is half paid off in a little over 13 years – which is not much longer than half of the full 25 year period. My figures are from Dominion Lending’s mortgage payment calculator web page.

It’s difficult to know how large of a mortgage families are taking out these days. But given that a single family home in, for example, Hamilton averages about $725,000 it’s probably fair to say that a $600,000 mortgage for a young two-income professional couple is not particularly unusual. 

At a 1% interest rate the payment on that $600,000 mortgage would be $2,261 per month. At a 10% interest rate the same payment would support a far lower mortgage of $252,800. The table below compares these two mortgages. They are vastly different in that the 1% mortgage allows most of the payment to go to paying down the mortgage right from the start. 

Mortgage Comparison Assuming the same Monthly Payment
Interest Rate	1%	10%
Starting Mortgage	$600,000	$252,800
Monthly Payment for 25 years	$2,261	2,261
Initial amount going to interest	$499	$2,064
Initial percentage of payment going to interest	22%	91%
Initial amount going to pay down principal	$1,762	$197
Percent paid off after 1 year	3.5%	1.0%
Amount owing after 10 years	378,000	$212,871
Percent paid off after ten years	37%	16%

In the days of 10% mortgages, most of the payment went to interest for many years. At 1% that’s not the case but the mortgages are now typically far larger.

Taking out and then paying down a mortgage can be thought of as “renting” the money from the bank and then paying it down over time.

In the days of 10% interest rates the “rent” was high and it was good advice to pay off the mortgage as quickly as possible.  And given the far lower mortgage amounts in those days it was often feasible to pay it off early. Some over-time hours, a bonus or any kind of savings could fairly quickly make a noticeable dent in the amount owed. 

With a 2% or certainly a 1% mortgage, the annual “rent” per dollar owed is vastly lower. But typically the mortgage starts out vastly higher. It’s now far harder to pay off today’s mortgages early. A typical bonus cheque or a savings of a couple hundred dollars per month simply will not make a noticeable dent in today’s mortgages. 

And perhaps these mortgages should not typically be paid off early. The savings in interest at 1% or 2% may simply not be worth the effort. There may be far better uses for the cash than paying down these low-interest mortgages. There may even be good arguments that these mortgages should be paid off over an even longer period such as 35 years.

These are not your father’s mortgages (or those of your own younger days as the case may be) and the stern rules of your father’s generation about paying down debt may simply not be applicable.

Home buyers today are more or less trusting that home prices will rise or be stable or at worse will fall very little. They are also trusting that interest rates will remain low or at least not rise very much. 

There are certainly risks and stresses in taking on these very large mortgages.

No one can guarantee the future but my guess is that with the existence of 1% or even 2% mortgages, house prices are not about to drop.

Taking on a huge mortgage like $600,000 is not a comfortable idea for me. But the math suggests that it may be reasonable to do so in order to buy a home – and also necessary. And the old adage that paying a mortgage builds equity has never been truer – as long as house prices hold their value that is.

END

Shawn Allen

InvestorsFriend Inc.

December 6, 2020 (with minor edits on December 8, 2020)

 

 

The State of the Markets

The S&P 500 crashed hard due to the coronavirus fears and the growing economic shutdown. After bottoming on March 23 it then staged a very large rally based on truly massive government financial aid to both consumers and businesses including massive central bank support for the banking sector. The rally was also helped and extended by indications that the peak of the virus situation may be at hand and assurances from some (Including President Trump) that the economic shutdown will soon begin to be lifted.

As of Easter weekend, the S&P 500 is down  14% and the Toronto stock exchange index is down 17%.

In my view the 14% decline in the S&P 500 seems almost modest compared to the situation we are in. Even in a best case scenario, the North American economy at the end of 2020 is almost certain to be operating a lower level than it entered 2020. Unemployment seems certain to be materially higher. Caution about the direction of stock markets therefore seems in order.

Oil Markets – Bad news 

The world was recently consuming about 100 million barrels of oil per day. With the economic shutdown consumption has apparently dropped by something in the order of 30 percent or 30 million barrels per day.

Quite naturally, the laws of supply and demand kicked in and sent the price of oil plummeting.

On top of that the OPEC price-fixing cartel which normally uses production quotas to keep some of the lowest cost barrels of oil off the market and therefore artificially boost prices which benefits all oil producers world wide has largely collapsed as Saudi Arabia has increased production in some kind of a market share battle with Russia. There is also a theory that OPEC has purposely increased production at this time of low oil prices in order to drive western world producers permanently out of business. Whatever the reason for it, the collapse of the OPEC quota system has pushed oil prices even lower.

If demand for oil has indeed fallen by some 30 million barrels and if at the same time Saudi Arabia and other OPEC members with its low-cost oil have actually boosted production then it follows that the rest of the world must have cut production by even more than the amount of the demand reduction. (Well, for a short time the cut may not be quite that deep with the excess going into storage but the storage would soon be filled to capacity which soon forces the production cuts).

Over the Easter Weekend OPEC is trying to reach an agreement to curtail production by 10 million barrels per day. The oil producers in the rest of the world represented by the G20 countries would dearly love to see OPEC make that cut. If they did it then the rest of the world would only have to cut by an estimated 20 million barrels rather than 30 million barrels per day. Apparently OPEC would like the G20 to agree to also make some oil productions cuts.

I find it rather strange indeed to suggest than the G20 countries agree to oil production cuts. First, if demand is down some 30 million barrels per day then huge cuts must already be automatically occurring outside of OPEC – either that or the storage facilities must be filling up fast and about to over flow. Second the great majority of oil production outside of OPEC is not owned by governments but by private corporations. Admittedly, Alberta has mandated production cuts by private corporations since the start of 2019, but that was a rare intrusion. 

If I understand the situation correctly then OPEC as the low cost producer would normally not have to cut production in response to lower world demand. The simple and sometimes brutal laws of supply and demand work to automatically force the higher cost producers in the rest of the world to reduce production by the full amount of the drop in world demand (setting aside a short delay until all storage capacity is filled). An OPEC cut by 10 million barrels would be greatly welcomed by oil producers in the rest of the world and would push prices up somewhat. Any agreed cuts by the G20 would seem to be purely symbolic in that those cuts must automatically be made under the rules of supply and demand. If world demand is down by 30 million barrels per day then world production must fall by that amount and whatever does not occur in OPEC must occur in the rest of the world.

My conclusion is that as long as oil demand is down by some 30% or 30 million barrels per day then oil prices will continue to be very low. A 10 million barrel per day cut by the low cost producers in OPEC would push the price somewhat higher but nowhere close to pre-economic-shutdown levels.

Furthermore the laws of supply and demand dictate that it is the highest marginal cost producers that must bear the brunt of production cuts. Unfortunately that probably includes the Alberta oil sands especially when the cost of transportation to markets is factored in.

And, unfortunately for oil producers and all who profit from the industry, when the economic shutdown ends, oil demand cannot be expected to return to 100 million barrels per day. Cruise lines and Airlines will certainly not return to the old consumption levels anytime soon. Higher unemployment and perhaps the newly discovered ability to work from home will reduce gasoline demand. Western oil producers, although they don’t like to admit it, will continue to be reliant on the OPEC cartel operating to push world oil prices higher. But with lower demand for oil, prices are unlikely to recover nearly as much as the industry would hope.

Comments on Asset Allocation

Individual investors have different asset allocations across the major asset classes which are equities, fixed income and cash. They also have different allocations across geographies. And the equity and fixed income asset classes can both be divided into many segments and ultimately into individual stocks, bonds and other securities. 

Historical data confirm that over longer periods of time such as 30 years a 100% allocation to equities has provided the highest returns but also features periods of truly gut-wrenching declines. The most conventional advice is for most people to take a balanced approach featuring about 60% equities and 40% fixed income. This has historically produced returns somewhat lower than an all-equity approach but has also greatly reduced the depth of the declines in bear markets.

It turns out that a balanced and well diversified portfolio would have been a very good strategy entering 2020. For example the Vanguard balanced portfolio VBAL is down a comparatively modest 7.4% in 2020 to date. 

My analysis has focused heavily on individual equity stocks. And those stock picks have beaten the market over the long term. But that has not been the case recently. In my October 15, 2017 newsletter as well as in other articles on this site I have been very upfront about the difficulty of beating the market index through investing in individual stocks.

My most recent previous newsletter dated September 29, 2019 explained exactly how to invest in a balanced and well diversified manner by simply buying the likes of VBAL or VGRO or creating a balanced portfolio from a list of exchange traded funds.  It turns out that was timely advice if anyone took it. (I did not.)

At this time investing some or even all of a portfolio in something like VBAL or VGRO may continue to be a good approach. I think a heavier than normal allocation to simple cash could also be a good strategy at this time. If the market begins to forecast that the world will come of this situation with a 2021 GDP level several percentage points or more below that of 2019 and with significantly higher unemployment, not to mention the higher government debt levels, then certainly markets could fall from current levels. 

Should Contract Enforcement Be Suspended?

I am disturbed by any suggestion that individuals and even large corporations should be entitled to simply refuse to pay their rents and leases and mortgages during this crisis.

Apparently, Canada’s largest banks are financially in a position to allow six month personal mortgage deferrals. I am okay with that although concerned about the longer term impacts on both the banks and their customers.

But suggestions that people and, even large corporations, without an agreed deferral from their bank or landlord simply refuse to pay are disturbing. 

Our entire economic system relies on the trust that financial obligations will be met. Money circulates constantly. If you stop the flow of money to banks and certainly to building owners then those banks and certainly building owners will soon become unable to meet their own financial obligations. 

For many years now a relatively strong economy with relatively low unemployment combined with an easy ability to borrow, has meant that the great majority of financial obligations have been met. There are always some bankruptcies and delinquencies and bad debts, but these have been relatively minor. Businesses have been able to rely on other businesses and consumers to meet their obligations.

In the current situation many people are suddenly unemployed. And many businesses are suddenly closed. The government has greatly mitigated this with new emergency cash payments to individuals and businesses although much of this cash will take some weeks to start flowing. In my view, both businesses and individuals should be strongly encouraged to meet their obligations if at all possible. And if they don’t have the cash then they should tap any available borrowing sources to meet their obligations. They could also politely ask for, but not demand, some relief from their lenders and/or landlords.

The alternative of suggesting that businesses or individuals should simply temporarily renege on their obligations would be a huge affront to the idea of the enforcement of contracts and the trust that is absolutely central to our economic system. It will be much more difficult for the economy to ever return to normal if that trust is much diminished.

END

Shawn Allen
InvestorsFriend Inc. 

April 12, 2020

 

 

What Caused Stock Markets to Fall in 2018?

Basically, 2018 was the year that fear returned to the markets. While earnings mostly rose, investors grew fearful of a future recession caused by trade wars, higher interest rates, or simply the ebbs and flows and cycles of the economy.

This is illustrated dramatically by the performance of the S&P 500 index. Earnings for that index in 2018 rose a staggering  27% versus 2017. (Based on the actual reported results for the first nine months of 2018 plus the estimated earnings for the final three months.) This huge 27% earnings surge was driven primarily by the Trump income tax cuts but also by by continued growth in the total pre-tax profitability of the 500 companies in the index.

The index nevertheless fell 6% in 2018. Investors at the start of 2018 were valuing the index at 24.3 times the trailing year earnings. This high P/E ratio reflected optimism about future earnings growth including the impact of the Trump tax cuts.

In contrast, at the end of 2018, investors were valuing the S&P 500 index at a far lower 17.9 times trailing year earnings. The 26% decrease in the P/E ratio was enough to more than offset the big earnings increase. This 17.9 is the lowest end of year P/E ratio since 2012. Investors ended 2018 less optimistic and more fearful than they had been since 2012.

To some degree, the lower P/E multiple can be explained by higher interest rates which cause investors to “require” a higher expected return (that is, they “discount” expected future earnings using a higher interest rate). But the huge decline of 26% in the P/E ratio, to a level that is significantly lower than the average of 22 over the past 30 years,  is primarily explained by a fear of lower earnings (or at least low earnings growth) ahead due to fears of recession.

Even more fear however is apparent in the P/E ratios of certain individual stocks as the two examples in the following table illustrate.

Company	P/E	2018 Price	2018 Earnings	Comment
Canadian Western Bank	8.7	34% decline	15% growth	Fear of loan losses and/or lower loan growth
Toll Brothers	6.9	31% decline	63% growth	Significant fear of reduced U.S. home building starts and/or new home prices.

Here we have two companies with strong earnings growth in 2018 but which suffered big price declines. The very low P/E ratios here despite the recent earnings growth suggest real fear about the future earnings of these two companies.

Is There Any Silver Lining to The Storm Clouds of the Market Decline?

Well, for any retired investors faced with having to sell a portion of their stocks at the lower prices to fund living expenses, there is really no silver lining.

But for most investors there are two related silver linings.

Firstly, 2018 was also the year that value returned to the market. Most investors are not forced to sell stocks at the lower prices and instead are in a position to use their annual savings as well as cash distributions from their existing investments to buy stocks at these lower prices. Young investors may be distressed by the declines, but a temporarily lower market is in their long-term interest.

Secondly, 2018 was also the year that yield returned to the market. Interest rates on (so-called) high-interest savings accounts are sharply higher. Rates on GICs are up substantially. And dividends yields are up quite substantially due to the lower share prices as well as annual dividend increases. For the first time in years it is now possible to easily set up a simple balanced portfolio that will spit off a cash yield of about 4% using or even higher. It has often been estimated that, in retirement, 4% is the maximum safe withdrawal rate to prevent the portfolio from possibly hitting zero by about age 90. Well, now, one could withdraw cash dividends and interest of about 4%, without touching the principal invested in stocks and fixed income. And, the cash flow of dividends and interest would almost certainly grow over time.

Given the better valuations and higher yields, now, is a very opportune time to be setting up a balanced portfolio. That is not to say that stocks won’t continue to fall. They might. But it is a mathematical fact that buying stocks now is a more opportune time than at the start of last year. And, if history is any guide at all then stocks will continue to rise over the longer term as well as to provide dividends.

How to Set Up A Balanced Portfolio

See our updated article that describes how to set up a diversified portfolio using ETFs, or even just using one single ETF.  This article includes the specific ETF symbols that can be purchased. We also have an updated reference article that provides a list of selected Canadian ETFs covering equities, higher dividend equities , fixed income and commodities. Most of the ETFs appear to be significantly more attractive in terms of valuation than they were a year ago.

Are Investors Over-Fixated on The Market Value of Their Portfolios?

It is absolutely fair and right that investors focus heavily on the growth or decline in the market value of their portfolio. But the market value should not be the ONLY measure of performance.

It may be that investors need to be a bit less excited when the market index and their portfolios rise and a little less depressed by declines.

Stocks represent ownership shares in actual real businesses. The owner of the local Tim Hortons or Honda Dealership likely focuses a lot on earnings and cashflow and not much at all on what he could sell the business for.

If a stock portfolio has declined due to lower P/E multiples while the earnings and dividends have increased is it fair to judge the performance solely by the change in market value while ignoring the increase in actual earnings and dividends? A business owner perspective would not think so.

What Will Markets Do in 2019?

No one knows the answer. But it seems clear that economic growth will be at least somewhat slower. Interest rates will likely continue to rise but not soar. The situation of getting oil out of Alberta will likely see some progress by the end of 2019 which could boost optimism in that province. Given that the the near-term direction of stock markets is very difficult or impossible to predict, perhaps the best strategy is to invest gradually over time and especially at times when stocks appear to offer better bargains.

END

January 4, 2019

To view the list of older editions of this newsletter, click here.

Bank Fees that Annoy (and that make banks vulnerable to disruption)

One bank fee that has always annoyed me is the high charges for converting currency.

I’m not talking about the extra 2% or so that they charge, over and above the wholesale exchange rate, when we Canadians go into a branch to get $500 or $1000 American cash or whatever for a vacation. In that case, I can see that the bank faces real costs to provide that service. Each branch has to keep paper American currency on hand and there are obviously human labour and building-related costs to providing this in-branch service. In any case, Canadians do not need to carry much paper American cash when vacationing in the U.S. and so if the 2% only amounts to $10 or $20, and is paid infrequently it is really not a big deal. The same applies even more so the other foreign currencies. The banks face real costs to supply us with paper Australian dollars or Euros.

The currency exchange fees that really annoy me are those that are imposed on electronic self-serve transactions. Foreign currency credit card purchases, debit card purchases and account transfers usually include these fees.

Almost every Canadian Visa and MasterCard (coincidentally?) imposes an extra 2.5% fee, over and above the wholesale currency exchange rate. The existence of this fee is disclosed in the terms and conditions of each credit card. Conveniently, for the banks, this added 2.5% is rolled in with the wholesale exchange rate so that consumers never see this charge separately on their monthly statements. Given the all-electronic nature of credit card payments, I am sure that this fee is virtually 100% profit for the banks and/or Visa/MasterCard. And, just to be sure that they collect it, the banks charge a similar amount or more on debit card purchases. In 2018 TD Bank boldly raised their fee on foreign currency debit card purchases from 2.5% to a 3.5% adder over and above the wholesale rate.

Most Canadians have no real choice but to use their credit card or debit card while on vacation. It would be risky to carry enough foreign currency to avoid the use of cards and in any case the banks make sure to charge a relatively similar adder when we obtain paper money.

Canadians traveling abroad are basically captive customers and sitting ducks for this charge.

Another version of this fee that annoys me and costs me money is that the banks also impose added fees when transferring cash between Canadian and foreign currency accounts. The big Canadian banks allow a single RRSP account to have a Canadian dollar”side” and an American dollar “side”. When I looked into the cost of transferring $30,000 from Canadian dollars to U.S. dollars, even within the same RRSP account, the added fee was 1.0% to 1.25%. That’s $300 to $325. The percentage fee was lower at 0.39% to 0.60% for transferring $100,000. But the fee in dollars was higher at $390 to $600. These added foreign currency fees are being charged on self-serve fully electronic transactions where the bank faces no direct incremental costs. I am simply not convinced that the banks face any costs or risks that would come even remotely close to justifying these added fees.

Another bank fee that recently had my blood pressure shooting higher was a $5.00 fee to cancel an interac transfer. At my bank I get “free” interac transfers because I have an “All inclusive Account”.  I recently had to cancel an interac transaction because the recipient’s email address had changed. The cancellation could only be done on-line and is therefore a self-serve electronic transaction that imposes zero incremental cost on the bank. I found it to be outrageous to be charged $5.00 for this particularly given that I have a so-called All Inclusive Account. Upon complaining, the fee was promptly reversed.

My belief is that the banks charge these fees because we are basically captive customers. Customers don’t choose their bank or credit card based on which bank has the lowest foreign currency fees. In fact, they can’t given that all the banks tend to be similar. And we don’t choose our bank accounts on the basis of the cancellation fee for interac transfers.

Overall, I am firmly convinced that banks as well as Visa and MasterCard are very much taking advantage of customers when it comes to these added foreign currency transfer fees and other fees on electronic self-serve transactions. Someday soon this may come back to haunt the banks as online competitors come in to disrupt banking. As banking becomes more and more about electronic transactions, costs are dropping rapidly. So far, the traditional banks are turning the lower costs into higher profits. At some point banks are going to face a disruptive competitor. This could be like Sears meeting Amazon. Or Yellowcab meeting Uber. It might be fun to watch.

Meanwhile, as customers, I believe we should take every opportunity to complain loudly and bitterly and to the highest levels when we see fees that seem unjustified.

Quickly Investing in a Diversified Fashion

Investing a diversified fashion with allocations to cash, fixed income and equities as well as with wide geographic diversification is considered the safest approach in the long term.

Some new Vanguard Exchanged Traded Funds are designed to allow Canadian investors instantly to achieve that by buying just one fund. Conservative, Balanced and more aggressive options are available and trade on the Toronto Stock Exchange under the symbols VCNS, VBAL and VGRO. These funds feature very low management fees. They were described in our February 2018 newsletter.

For investors using exchange traded funds, I have recently updated our article that gives a selected list of global ETFs and comments on which ones look attractive. At this time many country ETFs are cheaper in relation to earnings than they were in previous updates going back several years. The China and South Korea ETFs look particularly attractive on a price to earnings ratio basis. Our Canadian ETF list will be updated in the next week or two.

How higher interest rates affect investment values:

It’s a mathematical fact that higher interest rates reduce the market prices of existing bonds, especially long-term bonds. And it is accepted wisdom that higher interest rates are also bad for stock prices. All else being equal, the higher that interest rates climb, the lower the price to earnings ratios on stocks. But why exactly is that? I’ll go through some of the math below. And, I’ll get into that “all else being equal” bit as well.

The most basic step in understanding how higher interest rates lower most investment values is to observe the simple mathematical fact that any sum of money that earns interest will grow faster if interest rates move higher. This then leads to the opposite mathematical fact that any given sum of cash to be received on a specific date in the future has a lower present value at higher interest rates. Higher interest rates are therefore a strong gravitational force on the value today of cash to be received in the future.

For example, if the applicable interest rate is 2.5% then the value today of $1000 to be received in ten years is (1000/1.025^{^10}) = $781. That’s because $781 deposited at 2.5% interest will grow to $1,000 in ten years. So, since $781 today can be reliably turned into $1000 in ten years with no risk in a bank account, then $1000 to be received in ten years is worth only $781 today. But if the applicable interest rate rises to 4%, then the value of this future $1,000 falls to $676, for a decline of 13%. And if the interest rate rose dramatically to 10% then the value would fall dramatically to just $386, for a loss of 51%.

Note that even though the same $1,000 is to be received in ten years in all three cases, the present value or market value of that future $1,000 declines with higher interest. The market value declines become even larger the further into the future the cash is to be received.

So, clearly, the value of bonds that pay out fixed amounts of cash on specific dates must fall as interest rates rise. And stocks are also expected to pay out or be sold for cash at some point in the future. Therefore, all else being equal, higher interest rates are negative for stocks as well as bonds.

Interest are expected to continue to rise

The Bank of Canada has indicated that its policy rate, which in the past sixteen months has increased in five steps from 0.5% to 1.75%, will need to rise by a further 0.75% to 1.75%. That would take it to a neutral rate, estimated to be about 2.5% to 3.5%.

Since most investments produce cash flows over the long term, it is longer-term interest rates rather than the overnight Bank of Canada policy rate that most investments are sensitive to. Currently, the interest rate on the government of Canada 10-year bond rate is at 2.3%, which is 0.55% higher than the policy rate. Therefore, investors should probably expect, or at least be prepared for, the 10-year government bond rate to increase to about 3.05% to 4.05%.

While some investments are less sensitive to interest rates than others, the fact is that, as explained above, higher interest rates exert a gravity-like force on essentially all investments other than cash and near-cash investments. However, in some cases there are offsetting forces.

How to Position yourself for higher interest rates

This is highly dependent on each investor’s time horizon and risk tolerance. In general, most investors should respect the fact that the future is never certain and they should therefore continue to hold a balance of different asset classes.

The following describes the interest rate sensitivity of the main types of investment assets and provides comments on how to adjust your portfolio in these circumstances.

Cash. In an investment account, cash has no correlation to or immediate sensitivity to interest rates. Of course if the cash earns interest, it can grow over the longer term but the effect is not immediate.

Action: Cash, including high-interest savings accounts, often gets little respect due to its very low returns. However, experience teaches that there is no substitute for cash. Only cash is guaranteed to be there and to not have declined in value or to be locked in if you need it at a moment’s notice, either for spending or to pounce on an investment opportunity. Given these advantages and the interest-rate sensitivity of the other choices, it would seem wise to consider increasing cash holdings at this time.

GICs. If guaranteed investment certificates were traded, they would have some sensitivity to interest rates. But, because they are relatively short term and especially because they are not normally tradable or marked to market on your broker statement, GICs are considered to have no correlation or immediate sensitivity to interest rates.

Action: GICs also don’t get a lot of respect. But their stability and safety earns them a place in many portfolios. This is particularly true for non-taxable retirement accounts. A laddered approach is appropriate so that new cash is available to take advantage as rates rise.

Bonds. The market value of government bonds always falls with higher interest rates. There is a perfect negative correlation between government bond prices and higher interest rates. Nothing else affects the market value of a government bond. Therefore, government bonds can be said to be 100% interest rate sensitive. The longer their term in years, the more they fall in value as interest rates rise. By government bond here I refer to central governments that issue the currency in which the bond is denominated.

In the case of corporate bonds, their market value also falls with higher interest rates. But they do not have quite a 100% negative correlation with rates because their market value is also affected by changes in the credit rating and/or the financial strength of the issuer. That said, corporate bonds are still very highly interest rate sensitive.

Action: Bonds have the highest sensitivity to interest rates. Given the strong expectations that rates will rise, longer term bonds are probably best avoided or minimized at this time. A laddered approach seems sensible for shorter-term bonds.

Perpetual preferred shares. These have interest rate sensitivity similar to a very long-term corporate bond.

Action: Perpetual preferred shares should also be avoided or minimized. However, if they are being used to generate income for spending purposes, and if a lower market value is not of primary concern, then these remain appropriate.

Rate reset preferred shares. They are somewhat sensitive to changes in interest rates but that sensitivity is muted by the resetting of interest rates every five years and by the right of the issuer to repurchase the shares at par on each five-year anniversary.

Action: Rate reset preferred shares are generally expected (although not guaranteed) to largely retain their values, as interest rates rise, or to return to par value at their reset dates. Therefore, an increased allocation to these might be appropriate. Issues that are trading below $25 but which have not suffered a deterioration in their credit rating and which will reset in the next twelve to twenty four months should do well. However, this is not guaranteed and these shares can fall in value due to changes in their perceived attractiveness unrelated to interest rate changes.

High dividend, low-growth stocks. These have cash flows that are reasonably predictable. Higher interest rates act to reduce the present market value of those expected future cash flows, just as they do any future cash flow. But their values are also affected by changes in the credit rating and/or financial strength of the issuer as well as, importantly, by changes in estimates of the future growth (or decline) of the dividend and earnings. As a result, these stocks are interest rate sensitive but the correlation and sensitivity is not as strong as that of bonds or perpetual preferred shares.

Action: These stocks are interest sensitive and therefore a somewhat reduced allocation seems appropriate unless they are held primarily to generate needed cash.

Non- or low-dividend high-growth stocks. Their value is primarily linked to changes in estimates of the growth in earnings per share. Future growth in earnings could be lowered by the effect of higher interest rates on company debt. However, conversely, higher interest rates could be associated with an improving economy, leading to higher earnings. The share value also depends on the credit rating and financial strength of the issuer. All else being equal, the value of these stocks is also negatively correlated with higher interest rates. However, because in these cases there are many factors that are not likely to remain equal as interest rates change, the negative correlation with interest rates can be very weak. Therefore, these stocks are generally not considered to be interest rate sensitive.

Action: These stocks are less interest rate sensitive. Nevertheless, they are not immune to the gravitational effect of higher interest rates. It might be appropriate to maintain but not increase the allocation to these. Exceptions would include stocks that are expected to have particularly strong earnings growth but where the price is not already fully reflecting the expected growth.

Conclusion

An ideal investment at this time, with interest rates expected to rise, would be one that is expected to increase in value with higher interest rates. One such possibility would be to “short” long-term bonds. But that would be pure speculation and is certainly not advisable for most people. Bank shares could benefit from higher interest rates as non-interest chequing account money is loaned out at higher rates. However, their mortgage business may slow and they could be hit with more bad loans in a higher rate environment.

Overall, with higher interest rates exerting an undeniable gravitational force on the value of all future cash flows, there are no investments (setting aside shorting strategies) that are guaranteed to increase in the short term if interest rates rise.

In the longer term, however, higher interest rates provide the opportunity to invest cash, including new contributions, maturing bonds, dividends, and interest coupons, at higher rates and lower price earnings ratios. This would lead to higher returns in the future. Perhaps the best available approach is to plan to have additional cash to invest if interest rates do in fact rise.

END

December 2, 2018

To view the list of older editions of this newsletter, click here.

 

 

A Big Excuse For Not Investing In Stocks Just Went Away

Vanguard Canada has introduced three brand new Exchange Traded Funds of Funds that should be of interest to most Canadian investors.

And they should be of particular great interest to the following investors:

1. Anyone with at least $15,000 in savings savings who would like it to be invested in a diversified manner that includes some exposure to the stock market but who has struggled with the complexity of how to do so. (Someone with as little as about $3,000 might also benefit as long as they are willing to commit to monthly additions to the savings).
2. Anyone invested in mutual funds AND who is concerned about the fees charged but has hesitated to become a self-directed investor because of the complexity and difficulty of choosing specific stocks or specific Exchange Traded Funds.

These new Vanguard Exchange Traded Funds offer Canadians, for the very first time, the ability to very simply “set up” an investment portfolio that is allocated between fixed income and equities and that offers significant geographic diversification while retaining a material allocation to Canada and to achieve all of this with just one security and to do so at a very low fee. While each Balanced ETF is traded as a single security each constitutes a diversified portfolio because each is a fund of seven underlying ETFs and each of those underlying ETFs contain multiple individuals stocks, bonds, or other securities.

Please note that I am not one to “bash” the mutual fund industry. There are many people who have built up sizable portfolios and who never would have done so without the encouragement of a mutual fund sales person / advisor. An article of mine from 2003 indicated that mutual funds were a good choice for some people. Today, I still believe that using mutual funds with some guidance from a bank employee or other mutual fund sales person is a reasonable way to get started investing. My four articles on How to Get Started Investing have a heavy focus on Exchange Traded Funds but also indicate that mutual funds have their place especially for smaller portfolios.

Exchange Traded Funds have long been a great alternative to mutual funds for many investors because of their much lower fees. They also offered diversification but only through a (sometimes daunting) process of choosing at least several different ETFs to achieve that diversification.

Investing through Exchange Traded Funds remains somewhat more complex than mutual funds because it requires that a self-directed account be set up. This can be easily done through any of the larger banks. I have  an article that addresses how to get started investing on a self-directed basis.

The large Canadian banks typically charge an annual fee of about $100 if the account or the total of all self-directed accounts in the same household is under a minimum of about $15,000. However that fee is typically waived if the investor sets up a monthly automated contribution of as little as $100 per month.

Vanguard’s new fund of funds have effectively removed the extra and often daunting step of having to choose a number of ETFs or other investments in order to achieve some level of asset balance and geographic diversification in the portfolio. This removes what may have been, for many, a huge barrier to going the self-directed route.

If you would like to get started investing on a low-fee self directed basis but have not taken that step because of the complexity or lack of knowledge then these new Vanguard ETFs may have eliminated your excuse.

These brand new ETFs now trade on the Toronto Stock Exchange. They began trading on February 1, 2018.

Each of the three funds are structured as a fund of funds and are invested in seven underlying Vanguard ETFs. All three funds have a total management fee of 0.22%. This includes the management fees of the underlying funds. In addition, I believe taxes, fees and expenses would add about 0.05% for total fees of just under 0.30%. These fees are approximately the same as an investor would face if they invested directly in the various funds that make up each of the three balanced portfolios. The total fees of 0.30% are far lower than the fees faced by most mutual fund investors which would typically be at least 1.50%.

Each of the three funds includes significant geographic diversification outside of Canada which does lead to currency risk (or reward) which is not hedged. Financial diversification theory would suggest that it is best not to hedge currency risk in the long-term but the lack of hedging can can add to volatility. Typically, hedging is expected to lower volatility at the expense of also lowering long-term returns somewhat.

Balanced ETF Portfolio. Symbol VBAL. 60% equity, 40% fixed income.

Conservative ETF Portfolio. Symbol VCNS. 40% equity, 60% fixed income.

Growth ETF Portfolio. Symbol VGRO. 80% equity, 20% fixed income.

Click the links for more information on each balanced ETF including to see the underlying constituent ETFs and the proportion invested in each.

Investors in these funds would typically choose just one of the three funds based on their desired exposure to equities versus fixed income. I believe it would be quite legitimate and prudent for many investors to place their entire portfolio into just one of these three new diversified ETFs.

Some people would argue that a single security cannot provide proper diversification. My own belief is that given the regulations and given the financial strength of Vanguard there is no need to be concerned about Vanguard defaulting. And I believe the fund of funds nature of these three balanced ETFs provides excellent diversification. That is not to say that I think the particular asset and geographic diversification is ideal. It might not suit the needs of everyone. But I think these new ETFs are an excellent way to instantly get diversified exposure to the markets especially for modest portfolios and especially where simplicity is considered highly important.

Alternatively, these diversified ETFs could be used for a portion of a portfolio. For example, an investor might like to place half of their money into one of these ETFs while taking a much more active approach to the other half of their funds using individual securities.

Thoughts On Income Taxes for Small Businesses and Investors

The Canadian Finance Minister’s potential changes to the rules on income taxes for small businesses and investors has resulted in a huge amount of discussion around those topics.

Business owners and Investors mostly do face substantial income taxes. Therefore it is understandable that they almost universally reacted with stiff opposition and outrage towards any potential increases. But the fact is that business owners and investors benefit from many rules that reduce their taxes in comparison to the level of income tax applicable to higher levels of income from employment.

I find it disappointing and frankly somewhat scary that so many business owners and investors seemed to be so openly hostile to any discussion of any changes that would increase their income taxes. In fairness, that was partly because the finance minister implied that simply following the current rules was somehow cheating, abusive or immoral. Surely, people should at least be open to making a comparison between the taxes on regular employment income versus business and investment income and should be open to the idea that changes might be needed to make the system more fair.

None of us are without prejudices and conflicts of interest when the matter of how different forms of income should be taxed. But I like to think that I am capable of laying out facts honestly even if the facts might suggest that I personally should pay higher taxes on some of my income.

I am not a tax expert. But I have thought a good deal about these matters and offer the following thoughts and observations. If I become aware that anything I say here is in error then I will correct it when I learn of any such error.

Tax Advantages For Businesses

Taxation rules attempt to integrate business and personal income taxes such that if a business makes a profit and pays out a dividend, the total tax paid by the business and the shareholder is similar to what the shareholder would have paid by earning the same amount as employment income.

The goal is corporate tax plus personal tax on dividends approximately equals personal tax on a similar amount of employment income.

However, for a variety of reasons it is very often the case that the total tax paid is lower than would be paid on a similar amount of employment income.

Transformation of income from labour into income from capital: I believe that this is a HUGE benefit. And it is not one that is contemplated to change. This benefit is applicable to most small professional corporations and many small businesses where the main input to the business is the labour of the owner as opposed to machinery and equipment and property or labour of employees. Consider a skilled professional who earns $350,000 after expenses. If this is paid out as employment income then the marginal income tax rate in Ontario reaches 48% at $150,000, 52% at 206,000 and 53.5% at 220,000.

If the professional takes no salary then the income can be taxed at the small business rate totaling 14% in Ontario. If the $301,000 net after tax business income were then paid as a dividend to the business owner, the marginal tax rates would reach 40.4% at $150,000, 45% at $206,000 and 46.8% at $220,000. In that case even with quite low tax rates applicable on the first $89,000 of dividends, there would be little if any savings and the tax integration would have worked well. But often some of this business income would be paid to family members as earnings or dividends to achieve income splitting. And often some of the income would be retained and invested which is also beneficial as I will discuss next. Overall, the benefit of turning what in many cases was income from the owner’s personal labour into business income and paying it out to the owner and family members as dividends (income from capital) or retaining and investing some or all of it can be very beneficial in reducing taxes.

Deferral of taxes by retaining earnings: If a business earns income but retains some or all of the income then the portion of taxes that would be paid as personal tax on dividends is deferred.  If the earnings are retained and invested in securities within the corporation for many years then this deferral of taxes can be very beneficial. Some people earn part-time income through a small business in addition to their “day job”. In this case it might be possible to retain all of the the business income and to invest it and thereby defer substantial income tax for many years. Often, it might be possible to extract cash in years when the owner’s marginal income tax rate is lower. And, it is possible to remove half of any realized capital gains with no personal income tax payable.

Tax Advantages for Investors

Individual investors can invest in tax-sheltered plans including RRSP, RESP and Tax Free savings Accounts. In addition to that, dividends and capital gains are subject to lower tax rates than in income from emplyment.

Why is Investment Income Taxed at a Lower Rate than Income From Employment?

It is often argued that investment income should be taxed at lower rates in order to encourage people to invest because that is beneficial to the economy and also makes people less reliant on government assistance in retirement. This may very well be true but I think it remains a debatable point. How can we know what level of investment would have occurred in any case without the favorable tax treatment? How can we know precisely how favorably we should tax investment income? How can we know if this really benefits the wage earners who face higher taxes to make up for the lower income taxes on investment income?

The argument for favorable taxes on dividends relies on the argument that dividends are paid out of after-tax corporate earnings that have already been taxed. That argument seems quite valid in the case of small business dividends where the business owner would argue that she has already paid income taxes as the owner of the business. But I wonder how valid this argument is in the case of dividends from large corporations such as Royal Bank or CN Rail or Loblaws. First, many large corporations manage to pay cash tax rates that are far lower than the statutory rate. In such cases can the shareholders really claim that they have effectively already paid taxes at the statutory corporate rate which is what the dividend tax credit assumes? And, if those large corporations face stiff competition is it not the case that the customers of the businesses really paid the corporate tax? That is if corporate taxes were increased and all competitors faced that, would they not be able to increase prices such that the customers paid the increased taxes?

It has also been argued that investment and business income should be taxed at a lower rate because of the risk involved. That is not an argument that I had heard until recently. I don’t think this argument has any merit for several reasons. First, in theory, the reward for increased risk should be provided in the marketplace whereby riskier endeavors tend to face less competition and can achieve higher profits in the market. Second, we don’t tax income from employment differently based on risk. Not all jobs are equally safe in either sense of the meaning of that word. To my mind, this risk argument is self serving and amounts to grasping at straws.

Conclusion:

Business and investment income is taxed more favorably than income from employment. There are many different tax breaks and policies that create that situation. Mathematically, a tax break for one taxpayer has to be made up by higher taxes from others assuming a given level of total taxes are to be collected. It should certainly be fair game to re-examine the tax rules from time to time. But, no rational discussion can occur if everyone takes the position that no change should ever be detrimental to themselves.

END

Shawn Allen
InvestorsFriend Inc.
February 17, 2018

 

 

 

 

 

 

 

 

 

Stock Market Performance in 2017 to date

As of Friday, September 22, the S&P 500 is up about 13.1% including dividends and the Dow Jones Industrial Average is up about 14.8% including dividends. In Canada, the Toronto Stock Index is only up 1.1%. But that’s about 2.8% including dividends.

So, once again in 2017 investing in the major North America stock indexes has been rewarding for investors. The major stock market indexes do not provide positive returns every year, but they do most years.

At InvestorsFriend, we had three stocks rated Strong Buy at the start of 2017. These three have risen an average of 15.7%. In addition we had 18 stocks rated Buy and those are up an average of 6.7%, which would be about 8.7% with dividends included.

Those who have not been participating in these rewards, directly or indirectly, as an owner of stocks, might want to consider how they can participate in the future.

Why Do The Broad Stock Indexes Provide Positive Returns Most Years?

A stock index like the S&P 500 or the Toronto stock index represents an ownership share in the largest publicly traded companies in the United Sates or Canada. Almost every year the great majority, though not all, of these companies have positive earnings. These companies produce goods and services that are valued in the market and they do so on a profitable basis. A portion of these profits, averaging roughly 30 to 50%, is paid out as dividends to owners. This provides a cash return of about 2% per year to stock index investors. The remainder of the annual earnings (50 to 70%) is retained by the companies and reinvested for growth.

Due to the fact that roughly 50 to 70% of its annual earnings are retained by a typical company in the S&P 500 or Toronto stock index, most of these companies grow over time. Their assets and scope of operations and sales and earnings typically increase most years. In some cases this is accomplished partly by buying other companies. If these companies retain and reinvest 50 to 70% of their earnings for growth and if they can earn returns of about 10% on those investments then, assuming that earnings on the prior level of investments is unchanged, this should cause their earnings to grow by 5 to 7% annually. And earnings per share would grow by the same amount. If the price to earnings (P/E) ratio is unchanged then an earnings per share increase of 5 to 7% would cause stock prices to rise 5 to 7% per year.

So, the annual retention of earnings along with dividends can provide an average return of perhaps 7 to 9% per year. This is what drives stock index returns to be positive most years.

So, Why Are Stock Prices and Stock Returns So Volatile?

Even though the earnings of a major stock index like the S&P 500 grow relatively steadily, there are other factors that cause stock prices to be volatile such that instead of anything close to a steady 7 to 9% annual return from stocks we get volatile returns including some years with significant losses.

Even if annual earnings increase by an average of 5 to 7%, there can still be significant volatility around that and even on a broad index of stocks, earnings do decline some years.

In addition, other factors cause the P/E ratio of individual stocks and even broad stock market indexes to be volatile. This can easily cause stock prices to decline even as earnings are rising.

Investors push the P/E level up when their outlook for corporate earnings increases and they push the P/E level down when their outlook for corporate earnings growth declines, such as during a recession.

Investors also quite logically push the P/E level on stocks down when interest rates rise and up when interest rates decline.

The average P/E level can decline rapidly and this can cause a negative return on stocks even when earnings have increased.

Changes in the P/E level linked to changes in the outlook for growth (or retraction) and linked to changes in the outlook for interest rates are the biggest reasons for volatility in the return from the S&P 500. Volatility in actual achieved earnings growth on the S&P 500 usually contributes a smaller amount to stock price volatility. In the case of the Toronto Stock index, annual earnings are much more volatile due its concentrated nature and are responsible for a more significant portion of the volatility of that index.

How to Invest in the Canadian Stock Market

Imagine that a Canadian investor wishes to invest in Canadian stocks. How might they proceed?

This depends on the knowledge level of the investor and how they are going to invest.

Many such investors have very little knowledge of the markets and also are often not prepared to open self-directed accounts. In that case, they are going to need advice. The easiest path in that case is to seek advice at their bank branch or from an investment adviser.

The comments below are relevant to investors that have accounts enabling them to invest in individual stocks and Exchanges Traded Funds. Those without such accounts may be interested in our article on how to get started investing in individual stocks and ETFs.

Let’s assume that the investor has no particular special ability to forecast corporate earnings, interest rates or the general future of the economy. In that case, a very logical approach is to assume that current stock market prices are efficiently pricing in forecasts for future stock earnings and for interest rates. In this case the logical approach is to buy a low-cost index fund representing the stock market index.

Warren Buffett suggests that investors can participate in owning their share of “corporate America” by simply buying a low-cost S&P 500 index fund. Buffett has always expressed confidence that “corporate America” in aggregate will continue to be profitable and to increase earnings over the decades. Buying a low cost index fund that holds a broad section of “corporate America” will allow investors to participate in those gains over time. The same logic applies to investing in Canada or other countries.

What if an Investor Wants to Invest in Individual Stocks?

For a variety of reasons, many investors prefer to invest in individual companies in addition to or instead of broad index funds.

In selecting individual companies to invest in, it would seem logical to look for profitable publicly traded companies trading at attractive or at least fair prices.

In keeping with Buffett’s idea of investing in corporate America (or corporate Canada) investors can simply look around them.

Which publicly traded companies in your area and/or where you are spending money, appear to be profitable?

It is generally well known that the banks are highly profitable. What about the grocery stores in your area? Do they appear prosperous? What about Walmart, Home Depot, McDonalds, Tim Hortons, and Starbucks? Other profitable looking retailers that come to mind include Dollarama, lululemon, Canadian Tire, 7-Eleven, the big drug store chains, and certainly Costco and Ikea. Not all of these are publicly traded especially on a stand-alone basis but some of them are. You may own Apple phones and computers and you are likely spending material dollars each month on internet/ telephone and cable. Most investors are spending money on electricity and natural gas utilities. Are those publicly traded and do you suspect that they are reasonably profitable? There are some prosperous looking businesses that are usually not publicly traded including auto dealers and hotel chains. But some of these are publicly traded.

On the other hand most investors will be aware of some publicly traded companies that have been struggling. It is well known that newspaper subscriptions have been falling for years. Most of us could see for years that Sears stores were not prospering. (They were often the store that you simply walked through to get to the rest of the shopping mall.) Airlines have a notorious reputation for not being profitable most of the time due to brutal price competition.

The point is that it is probably not difficult for investors to look around them and identify many publicly traded companies that appear to be prosperous and likely profitable. The more you look around, the more you will see that there are many dozens of businesses all around you that appear to be prosperous. These can provide a good starting point in thinking about where to invest.

But What About the Stock Price?

It’s true that even the greatest of businesses will be a poor investment if the price you pay is too high. But most of the time the great businesses tend to grow enough to ultimately justify the price you pay if you are patient enough. The bigger mistake often comes from buying a really poor business at what appears to be a bargain price.

Those investors with little or no ability to judge if the stock price is reasonable might do well to invest fairly evenly in a dozen or more businesses that appear to be strong and prosperous. Those able (perhaps with some assistance) to evaluate the stock prices could be somewhat more discriminating and try to concentrate in those strong and prosperous businesses that appear to be selling at the more attractive prices. To a large degree, providing such assistance is the goal of InvestorsFriend’s paid subscription service.

Conclusion

There is little doubt that the publicly traded businesses that are all around us will, on average, be good investments if held for the long term. It therefore seems wise to be in a position to participate in this over the years.

END

Shawn Allen, InvestorsFriend Inc.

 

 

 

Is the Dow Jones Industrial Average Over-Valued?

In last month’s newsletter I calculated that the S&P 500 index appeared to be about 41% over-valued. That is, by a wide margin, the highest over-valuation that I have calculated since I began doing this calculation in 2004. Whether or not the current level of the S&P 500 can be maintained is likely to depend more on interest rates staying extremely low than on earnings growth.

This month I have calculated that the Dow Jones Industrial Average appears to be about 6% over-valued. Interestingly, the DOW always seems to look like better value than the S&P 500 based on my analysis. It rarely looks over-valued based on my analysis and in fact this 6% over-valuation is the highest I have calculated going back to 2002. The S&P 500 tends to look more richly valued because it typically trades at a higher price/earnings multiple.

First Quarter Earnings on the S&P 500

This month we will be hearing that the S&P 500 companies have increased their first quarter earnings significantly compared to last year. The current forecast is that the earnings will be 22% higher on a weighted average basis. That is impressive earnings growth indeed. However, the final figure usually comes in somewhat lower than the estimate. More importantly, the Q1 2017 earnings are being compared to a weak Q1 2016 level.

In Q1 2016, earnings had been about equal to the 2015 level which in turn had been 12% lower than the 2014 level. If the Q1 2017 earnings do in fact grow 22% over the 2016 level that will actually only be 9% higher than the 2013 level for a meager growth of 2.2% per year compounded over the past four years. On that basis, we should not get too excited about this 22% earnings growth in Q1 2017. Nevertheless, if earnings do grow as projected for the full year 2017 then the trailing P/E ratio of the S&P 500 will begin to decline from its current lofty level of close to 25. The S&P 500 P/E ratio is just under 20 based on forecast 2017 GAAP earnings. However, it is has been my experience that projected earnings tend to quite optimistic.

Is Competition Working for Consumers?

Almost every company claims that they “operate in a highly competitive environment”. In many cases, this is patently false. Some companies have monopolistic positions in the market. Our report on VISA Inc. notes that it operates as a duopoly with MasterCard when it comes to consumers. But it operates as more of a monopoly from the point of view of merchants. Almost every merchant is virtually forced to accept VISA as well as MasterCard. This monopoly position is the reason that some governments have stepped in to regulate the charges to merchants.

At the end of the day, the high returns on equity that many companies make are proof that they do not in fact operate in a highly competitive market. To be sure, some companies do face stiff competition in regards to the prices they can charge. But many do not.

When the market for a product is truly highly competitive in terms of the prices that can be charged then the profit or return on equity gets competed down to about the lowest level acceptable. In a world where investors can earn only about 2% on a ten year government bond, the lowest acceptable return on equity is surely in the single digits. Any company facing a highly price competitive market would be unlikely to earn more than about an 8% return on equity in this low interest rate environment. And there are entire industries where companies have historically struggled to make any return at all. Airlines and most commodity producers come to mind.

Yet, it turns out that the average ROE of the DOW 30 companies is about 17.5% and has been in that range for at least a decade. I have an article that explores the surprisingly high ROEs of large companies in more detail.

Unless a company has the lowest costs in an industry, it will usually avoid getting into a situation of competing primarily on price. Companies do this in many ways. Companies attempt to differentiate their products in the minds of their customers through branding. Starbucks can charge a higher price for its coffee partly because it has succeeded in convincing customers that its coffee is different than and superior to competing coffee offerings. Consumers have a great deal of loyalty to their favorite brands and this allows suppliers to avoid competing too aggressively on price.

Companies also attempt to eliminate competition by buying up their competitors.

The high ROEs achieved by most large companies is proof positive that they have succeeded in avoiding having to compete aggressively on price.

This has been to the advantage of investors and to the disadvantage of consumers.

The risk to investors is that governments will turn their attention to the lack of aggressive competition and take measures to increase competition.  To date, various competition regulators seem to approve most corporate acquisition proposals even when they have clearly lowered competition. And when companies have managed to monopolize an industry governments have largely not interfered.

As an investor, I try to focus on companies that do not operate in a highly price-competitive environment. There are many to choose from. In cases where the industry is highly price-competitive then it is best to look for companies that have the lowest costs. Costco is a case in point.

The Canadian Economy

Our reference article that looks at the makeup of the Canadian economy has been updated. It’s interesting to see which industries are the larger contributors to Canada’s GDP. And it is frightening to see how very little of Canada’s exports go to countries other than the United States.

Start Your Youngsters Investing Early

If there are young people in your family that are interested in investing in individual companies, they can get started with very little money. The trading fee to buy stocks in a self-directed account is $10 or less. For small accounts there is also usually an annual fee of about $100. But this fee usually does not apply if other members of the household have self-directed investment accounts that total about $50,000.

An 18 year old could open a Tax Free Savings Account  with as little as $500 or $1000 if they wanted to gain some experience in owning individual stocks. They could pick a few companies or even just one company and buy as little as one share. A $10 fee on buying say $250 worth of some stock is a bit hefty at 4%. But it is also only $10 which is a small price to pay for the education that getting started investing in individual companies could provide.

From the perspective of maximizing return and diversification it would make much more sense to stick with mutual funds and ETFs when first starting out. But from the perspective of making the process interesting and educational going with individual companies would be more beneficial in many cases.

For young people under the age of 18, the account would have to be set up in an adult’s name but can be in-trust for the child.

END

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

April 23, 2017

How Can I Help You Get Rich(er) Through Investing?

When I recently set up a twitter account for InvestorsFriend, I described the business this way: “InvestorsFriend Inc. exists to help investors grow rich through more intelligent investing.”

Let me review a bit of the history around how this came to be.

I started the InvestorsFriend web site back in June of 1999.

My original purpose was to share valuable advice and analysis on investing, and that has not changed. The original name was Investment-Picks.com based on the fact that the content included specific Stock Picks that visitors could investment in. For the first few years everything was free of charge.

I quickly realized that putting up a web site and having people visit it and read my work was pretty exciting. There is a certain inherent satisfaction – even a “high” – that comes from gaining an audience. Like every web site author, I craved more traffic. More or less the web site demanded to be “fed” with content which would attract and retain traffic. And so began the never-ending process of regularly creating new and valuable content for my readers.

By 2002 I concluded that having a hyphen in the web site name (www.investment-picks.com) was a mistake. In thinking about a new name I thought: “What can I offer that other investment sites are not offering?”. And I thought, well one thing I can offer is complete honesty and a devotion to being helpful to investors. To me, the name InvestorsFriend” best conveyed what the web site was about. The name itself is a constant reminder to me that the web site exists to serve the needs of investors.

It’s true that by early 2003, the Buy / Sell reports on individual stocks were restricted to paid subscribers. However most of the content on the site is still free of charge. And I have never relied on this site as my source of income. The absence of any real need for the income that the site generates helped me to avoid ever getting into aggressively advertising or “hyping” the service. I have turned down dozens of requests to advertise on this site because I did not trust the products and services being advertised and I did not need the money it would generate. I even refused almost all requests for reciprocal links to other sites. These links would have generated traffic and higher Google rankings for me. But I refuse to be a part of sending my visitors to dubious sites such as foreign exchange trading sites. I also refuse all offers to provide outside content for my site, since such articles are almost always just thinly-veiled advertisements.

While I don’t give away my Stock Picks free of charge, I think I can safely say that InvestorsFriend.com has lived up to its name and to the key values of honesty and transparency. And the performance of the Stock Picks (while never guaranteed) has more than lived up to the name as well.

And So, How Can I Help You?

If you are already a paid subscriber, then you already know that I will attempt to help you via the individual stock reports with buy/sell ratings and through my daily comments.

If you are a non-paid subscriber then the way in which I may be able to help depends on your current situation.

For many people, a first step would be to gain some knowledge of investing. Learning about investing is like learning most others things in life: It’s a never-ending process. If you want to learn a new language, or a new skill or even to to learn how to appreciate watching a new sport you have to start with gaining a little foothold or island of knowledge and then expand from there.

For those who need to or want to start by learning what investing and its rewards is and how it differs from saving, I have two articles at this link.

For those who are invested in mutual funds and are are thinking they might be interested in investing in individual stocks, I have two articles on how to get started. Not everyone is interested in or in a position to invest in individual stocks. Those who are can consider subscribing to InvestorsFriend’s stock rating service.

I have a group of nine articles which I group under the heading “Accumulating Wealth – Getting Rich”. Most or all of these articles are quite old but are still relevant.

In total I have written 96 original articles over a period of 16 years. Almost all of these are directly designed to assist investors in making money through investing. Often, they were written as I researched and analysed answers to my own questions about investing.

I also have a group of eight articles that are updated periodically that focus on whether the stock market offers good value at the point in time each article is updated. Included here are two additional special reports that show exactly how past investors have done in the past over various 30 year periods of investing or of drawing down a portfolio in retirement.

In addition to this, see the list of all of the past editions of my free newsletter. The list indicates the topics covered in each newsletter.

Conclusion

In conclusion, I have been growing my wealth quite successfully through investing for almost 30 years. My education and my intensive studies of investing have been the reason for my success (along with, no doubt, some good luck). For the past 17 years I have shared what I learned and what I am in invested in on this web site. The process of developing all of the articles and analysis on this site has greatly helped me to answer my own questions about investing. While there are absolutely no guarantees it seems to me that the information provided is meeting the goal of helping many investors grow rich through more intelligent investing.

Is the S&P 500 Index Over-Valued At This Time?

With the S&P 500 index trading at 25 times its achieved 2016 earnings level, it certainly appears over-valued on its face. I recently updated my comprehensive article on the valuation of this index and, to me, it does appear to be over-valued. But that does depend on various assumptions. Review the article to see why I think it is indeed over-valued. That does not mean that I am predicting that the S&P 500 index will soon decline.

END

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

March 4, 2017

 

InvestorsFriend 2016 Performance

2016 was a good year as our four Strong Buys rose an average of 26.1% and our 24 stocks rated (lower) Buy or higher rose an average of 17.0%. By comparison, the TSX rose 17.5% and the S&P 500 rose 9.5%. Click here for the details by individual stock.

Since the start of the year 2000 the average gain for the stocks that we rated as (lower) Buy or higher at the start of each year has been 12.4% compounded annually. That’s a total gain of  633%. And that excludes dividends.

The return on my own actual personal portfolio since the start of the year 2000 has been a compounded average return of 13.5% per year or a total of 755%. This includes dividends and deducts all trading costs.

These returns in the low double digits, if sustained, and if applied to even relatively modest annual savings, are more than enough to become quite wealthy over a period of several decades. These returns are also high enough to cause a retirement portfolio to grow rather than shrink despite withdrawals.

These returns were achieved based on investing in mature and relatively “blue chip” companies. No “grand slams” were required. These returns did not involve getting lucky in penny stocks or anything of that sort.

To illustrate the type of stocks involved I review  below each of the four stocks that we had rated Strong Buy at the start of 2016 and summarize the rationale as to why each was rated Strong Buy and how that turned out.

Canadian Western Bank – This stock rose 30% in 2016. It also paid a dividend yield of about 3.8%. At the start of 2016 it was trading at $23.38 which was down 46% from its all-time high of about $43 in the summer of 2014. Meanwhile its earnings were stable and had not declined. There were fears that its earnings were about to decline due to bad loans associated with the recession in Alberta. It appeared to us that the stock price had over-reacted to the probable earnings decline. And, we judged that this bank could safely be predicted to grow its earnings per share in the long term. Banks tend to be stable businesses with a “sticky” customer base. It had a strong history of growth. It was trading at only about a 10% premium to book value. Its trailing P/E ratio was very attractive at 9.0. The stock subsequently languished for most of 2016 but rose rapidly in November and December as oil prices rose sharply and with the generally strong markets. This was in spite of an earnings decline of about 12%.

Boston Pizza Royalties Income Fund – These units rose 27% in 2016. This was in addition to a dividend yield of 7.0%. We concluded that the dividend would rise with same-restaurant sales which we believed would rise perhaps 1 to 2% annually on average and that even in the face of the recession in Alberta were unlikely to decline more than a very modest amount. We believed that there was very little downside risk in terms of the cash distribution and that a 7% dividend that would likely grow slowly over time was highly attractive given the low level of interest rates. These units rose in price during the Summer of 2016 rewarding our faith in this investment.

TransForce Inc. – This stock rose 48% in 2016. This was in addition to a dividend yield of 3.1% of the start of the year price. We were attracted by the history of strong earnings per share growth.  The price to earnings ratio was attractive at about 11 and the return on equity was impressive at 23%.  We felt that the management quality was very good. Trucking is a relatively simple business and we felt that this company would continue to perform strongly as it had in the past. Despite the weak economy we concluded that this company offered good value. Our faith was amply rewarded as this stock rose steadily from February through October and then surged in the final two months of the year.

Melcor Developments – This stock ended the year at about the same price it started. But it did provide a dividend yield of 3.3%. This Alberta company is primarily in the business of developing raw land into residential home building lots and also develops and owns a stable of commercial rental buildings. We were attracted by the fact that the stock was trading at only about half of book value. And the assets were land and commercial buildings. While it was possible that land and commercial building values in Alberta would collapse, we were not seeing evidence that this was the case. We felt that the opportunity to effectively buy land and buildings at about 50 cents on the dollar would ultimately turn out well. This family-controlled business traces its roots back over 90 years and has been publicly traded since 1968.  It has weathered many recessions and we believed it would continue to prosper although in a volatile manner. This stock did not recover in 2016 and even dipped lower at times. But we expect that it will ultimately recover.

Get Our Latest Stock Picks

Those who are not already paid subscribers can click here to find out how to access our current stock picks. The cost is $15 per month or $150 per year.

Invest in Companies With “Good Economics”

As detailed in one of our articles , Warren Buffett, in 2008, said that he  “looks for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag.”

Buffett went on to state: “A truly great business must have an enduring “moat” that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns. Therefore a formidable barrier such as a company’s being the low cost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success.” … “Long-term competitive advantage in a stable industry is what we seek in a business”.

With this in mind, our InvestorsFriend stock reports always address the issue of the economics of the business and the competitive advantage (if any).

The following is how we view the economics and competitive advantage of several well-known Canadian companies:

Dollarama – You might think that a store selling items at a maximum price of $4.00 would not have wonderful economics. In fact Dollarama has wonderful economics as evidenced by its high return on equity. It is also evidenced by a stock price that is up 1037% since its Initial Public Offering in late 2009. Its profit as a percentage of sales is running at 14.5% which is very high for a retail business. While there may be nothing proprietary about their approach, the following appear to be competitive advantages: All sales are final resulting in lower costs as opposed to allowing returns. They are 4.5 times larger than their nearest Canadian dollar store competitor, (Dollar Tree) which provides economies of scale in purchasing. They have clean, modern, well located stores. About half of the merchandise is direct sourced from low-cost foreign jurisdictions such as China. Consistent products are carried as opposed to surplus or liquidation type items. They do not accept credit cards, so sales are cash and debit which avoids credit card fees. The company is very popular with consumers and has little or no need to advertise except when opening new locations. Lack of advertising is a cost advantage.

Dollarama definitely has wonderful economics. That doe NOT mean it is necessarily a good investment at its current share price. Our full report available to our paid subscribers delves into that issue.

Canadian National Railway – This company has wonderful economics as evidenced by CNR’s return on equity which has been relatively steady at about 23% for the past five years. Its share price is up 1018% since I first analysed it in August of 1999. Rail is more efficient than trucking. There is very limited rail competition in most of the territory it serves. Often only one competing rail service. It seems doubtful that it would be possible for any new competitor to move into Canada and lay down a third set of tracks to compete with CNR and CP. (I think any business owner would tell you that having only one major competitor would be a dream come true). So, CNR definitely has wonderful economics. That doe NOT mean it is necessarily a good investment at its current share price. Our full report available to our paid subscribers delves into that issue.

Bombardier – This is a company with absolutely terrible economics. The introduction of a new airplane model requires huge investments – often far larger than initially budgeted for. Your competitors may be subsidized by governments. You have to discount massively. You may need to help your airline customers finance the purchase which is risky given that airlines typically or often have terrible credit ratings. You have to guarantee the residual or resale value of the planes after the end of their service lives. The product liabilities are likely massive in the event of a technical problem causing a crash. The rail side of the business is not as bad but has also been a terrible business. Bombardier’s terrible economics are evidenced by its losses and the fact that its share price is down over 90% from its peak in September of 2000. And the share price is lower than it was in 1995 which is the earliest data shown in Yahoo Finance.

Bombardier makes excellent products and contributes greatly to the economy. But with its terrible economics and track record it is not a good candidate for a long term investment. Our report discusses its economics and its potential in more detail.

END

Shawn Allen
InvestorsFriend Inc.

January 8, 2017

 

 

InvestorsFriend Newsletter December 1, 2016

Growth Companies versus Growth Industries

I often hear companies explain, with great excitement, that they are in a very large industry or an industry that is growing rapidly. This leaves me unimpressed.

Being in a growth industry is neither a sufficient condition nor a required condition for being a growth company or, more importantly, a company that will provide high returns.

Of the companies that I follow, those with the largest compounded annual growth in their stock prices are not in high growth industries. These include:

Stantec Inc. – Its share price has grown 2,760% since I started monitoring it on September 3, 1999. That is a compounded annual growth rate of 21.5% for 17.3 years. Stantec provides engineering consulting services on an hourly fee-for-service basis. This industry segment has not grown any faster than the general economy. Stantec’s growth was achieved by relentlessly expanding its geographic reach through continuous acquisitions.

Canadian National Railway Company – Up 1018% since I started “tracking” it on August 27, 1999. That’s a compounded annual gain of 15.0% for 17.3 years in addition to its dividend. Rail traffic grows with the economy but it would not be considered a high growth industry. CN acquired most of its U.S. operations just prior to my start date. It has grown partly through some additional acquisitions. It has also bought back its own shares aggressively which added to growth. Earnings per share grew faster than revenues per share due to increased efficiency.

Alimentation Couche-Tard – Up 990% since I first looked at it on March 5, 2005. That’s a compounded gain of 22.7% for the past 11.7 years. Couche-Tard operates convenience stores, most of which include gasolines sales. This is not a fast-growing industry. Like Stantec, Couche-Tard grew by geographic expansion and a relentless and ambitious acquisition strategy.

Dollarama Inc. – Up 370% in the 4.9 years since I first looked at it on January 15, 2012. That’s a compounded annual gain of 37.1% per year. Discount retail is not a growth industry. Dollarama grew strictly organically by relentlessly adding new stores.

Constellation Software – Up 1123% in the 5.8 years since February 5, 2011. That’s a compounded annual gain of an astounding 53.9% per year. The type of software that Constellation provides has not been a high growth industry in those years. Constellation grew mostly by acquisition.

It turns out that of the companies on my list that have the highest share price growth, none are in particularly fast growing industries. All, however, are extremely well managed companies.

The Money Changers

My perception is that the fees that Canadian brokers charge for exchanging U.S. and Canadian currency are outrageously high. For registered accounts, customers are basically captive to their brokers who take advantage of this by charging high exchange fees.

I don’t complain when a bank branch charges an exchange fee of several percentage points to exchange paper money. In that case the bank has to keep an inventory of paper U.S. dollars and has staff and facility costs to cover. However, the bank-owned brokers are charging high fees even in cases where customers enter the transaction electronically and where larger sums are involved and where the broker is likely facing very little risk or costs of any kind. There are competitors willing to exchange currency electronically for fees that are tiny by comparison. The difficulty is that money in registered accounts can not be removed from the account and is captive to whatever fees the broker wishes to charge.

My two most recent experiences with exchanging currency ilustrate the problem and what I learned about possible solutions.

Last week, in an RESP account at TD Direct, I converted $2500 U.S. dollars that were in a U.S. dollar money market fund to Canadian dollars. The fee that I was charged on the conversion was 2.14% or $53.50 U.S. which was about $72 Canadian.  This was a hidden fee. My money was exchanged at a rate of $1.323 or 75.59 U.S. cents per Canadian dollar. However, TD Direct confirmed to me that the wholesale rate at time was $1.3444 (74.38 U.S. cents per Canadian dollar) for a difference of 2.14 or 214 basis points.

When I complained about the high fee, the TD Direct staff were sympathetic. They explained that I would have gotten a somewhat lower exchange fee by phoning in and having them do the exchange for me. That’s odd since it would have increased their cost.

Also, last week, I moved $14,945 U.S. cash from the U.S. dollar sub-account of my RRSP to the Canadian dollar sub-account or “side” of my RRSP. I did this using “Norbert’s Gambit” by buying the currency Exchange Traded Fund DLR.u which is effectively U.S. dollars on Toronto and then having this “journaled over” to the Canadian side of my RRSP and selling it as DLR. This resulted in $20,117 Canadian dollars. That was a good exchange rate equating to one Canadian dollar per 74.29 U.S. cents. I believe this was within a basis point or two of the wholesale exchange rate. I did incur fees of $53 from TD direct which amounts to 26 basis points. Had I just entered a currency transfer I believe the fee would have been about 2.14% or $431. Using Norbert’s Gambit saved me about $398 in this case. I believe I also could have faced added costs based on the bid/ask spread or the risk of a sudden move in the currency so keep that in mind if trying this method.

TD Direct inserted some confusion by sort of warning me that the trade would take 3 days to settle. But meanwhile I was still able to immediately buy stocks with the Canadian cash and so the 3 day settlement period did not seem to affect me at all.

The Post-Jobs Economy

There is a lot of fear lately about job losses due to automation. Experts tend to respond to this fear by comparing the fearful to the (misguided)  “luddites” who tried to stop the industrial revolution by smashing the new machines in textile mills in England in the early 1800’s. But I wonder if maybe the luddites are right this time. Also, we are hearing a lot about “the gig” economy where many young people hop between contracted “gigs” and can’t find a “permanent” job. The concept of the “gig economy” got me thinking about the extent to which our existing economy is mainly a “jobs economy” and whether that is destined to change and what some of the implications of such a change might be. See my article about the Post-Jobs Economy.

Toronto Stock Index Valuation

I updated my article that calculates the valuation of the Toronto Stock Index under different growth scenarios. Unfortunately, with the low current earnings on the TSX (due to lower energy prices), it is now more difficult to estimate the valuation of the TSX. In part, this is because the TSX index is not a diversified index.

END

Shawn Allen, InvestorsFriend Inc.

Is “Cash” becoming obsolete?

When we speak of “money” we often picture $20 and $50 dollar bills. Or at least we used to. However for most people, the majority of their day-to-day spending now takes place by using debit cards or credit cards. And “spending” on larger ticket items such as cars, furniture, and mortgage payments is rarely done in the form of paper cash.

Transferring money electronically has become the preferred method for both consumers and businesses.

And, we may soon get to the point where money in the form of paper cash dollars becomes obsolete.

The Alberta government no longer accepts cash in payment of income taxes at its payment window in downtown Edmonton. This refusal to accept cash would have been unthinkable 20 years ago. In fact, given the definition of cash as legal tender, I am not convinced that the Alberta government has the right to refuse paper cash in payment of income taxes owing. Nevertheless, this refusal to accept paper cash is part of a trend which is unlikely to be stopped.

If you need to exchange Canadian dollars for U.S. cash, most or all bank branches will no longer accept cash in payment. You must charge the purchase to a bank account and may not pay with cash or even a debit card from another bank. You can still buy U.S. currency with Canadian cash or a debit card at a speciality currency window like Thomas Cook, but not at your bank branch.

Given that electronic money leaves behind what we ironically refer to as a “paper trail” and paper cash does not, governments will be quick to embrace the idea of making paper cash more and more obsolete.

Wealth in Investment Accounts is Not Usually “Money” As Such

Most people will speak of having “money” in their RRSP account or Tax Free Savings Account. Often, that is not really true. Instead, we have investments in those accounts which are measured in terms of money. When you have a need to withdraw cash from those accounts it often becomes clear that the wealth is not “sitting in cash”. Instead you may need to sell shares or mutual funds to convert the investment to cash before you can make a withdrawal. But you may be reluctant to sell an investment that has declined in price.

I am not suggesting that people should hold more cash in their investment accounts. But I am pointing out that only cash is cash. This includes electronic cash. But investments that are not cash despite being worth so many dollars are not cash as such and are not money.

What Gets Measured (Often) Gets Manipulated

Those who seek to improve performance are fond of saying “What Gets Measured Gets Done”. And that is true. But it is also true that one must be careful not to let measurements get manipulated.

It’s dangerous to allow a person who is being rewarded based on a certain measurement to also be the one doing the measuring.

Wells Fargo is currently finding out what happens when you provide huge incentives for bank branch staff to “sell” more bank accounts to customers. And what happens when you provide punishments (such as job loss) to those who don’t sell more accounts. It turns out that a certain percentage of the staff will indeed sell more accounts “by hook or by crook”. With their bonus and perhaps even their job on the line, some branch staff resorted to opening accounts that the customer had not asked for or authorized and some staff even opened accounts for non-existent people.

As soon as any important performance indicator is measured there is a desirable tendency to influence and improve the measure. But there is usually some incentive to manipulate the measurement as well. Whenever rewards or punishments are tied to a measurement there should be safeguards put in place to prevent or at least detect manipulation of the measurement.

When public companies are expected to meet or exceed the earnings per share estimates of analysts I suspect there has to be at least some tendency, by some companies, to manipulate earnings to meet those expectations.

When banks have to report their 90-day delinquency figures I expect that there is pressure on staff to make various arrangements with customers such as officially allowing skipped payments which “coincidently” may mean that the loan is not officially delinquent.

When workers compensation insurance fees are tied to a company’s claims record you can be sure that the company will work harder to reduce lost-time injuries. That is of course a good thing. But you can also pretty much count on the company to begin manipulating its claims record by subtlety or not so subtlety encouraging workers not to report very minor injuries and/or by putting staff with minor injuries on desk duty rather than generating a claim for workers compensation insurance.

When car companies had to meet emissions standards, it turns out that the engineering staff of at least one car company cleverly designed software to trick the emissions testing process.

Investors looking at any kind of corporate performance measures should be on alert for signs of manipulation.

Rail Car Loadings

Rail car loadings provide a useful (and literal) indication of how fast the economy is moving.

The Association of American Railroads publishes a graph showing weekly rail car loadings with a comparison to each of the past three years. Data is separately available for the United States, Canada and Mexico. The data is also available for each of 13 different cargo types such as coal, grain and forest products. When the economy is growing the graph is likely to show a year-over-year increase in most or all of the different categories of freight.

Currently the graph is showing that rail car loadings for each week of 2016 in the United States are running consistently lower than in the corresponding week in each of the past three years. Freight categories that have declined substantially in most weeks include coal and petroleum products. Metallic ores and minerals as well as forest products are also down noticeably. Categories that are moderately down are non metallic minerals, and intermodal (consumer goods). Categories that are up modestly are grain, chemicals, and motor vehicles and parts.

In Canada, rail car loadings have also been running lower than in the past three years in most weeks of 2016. In general, the same categories of freight are up or down as in the United States.

It’s worth keeping an eye on these car loadings as an economic indicator and as an indicator of the economy. Those who own shares in rail companies should be particularly interested in this data.

END

To view all past editions of this free newsletter or to get off of our list, click here.

 

 

 

 

Why Interest Rates Are So Low

In a recent edition of this newsletter I suggested that low interest rates are explained by the laws of supply and demand and that there has been a high supply of money to be loaned in comparison to the demand for loans.

A large supply of lending comes down to a high degree of willingness of banks and other lenders to lend money.

Canadian banks have three main choices of where to invest their assets. They can i) place money on deposit at the Bank of Canada, ii) invest in safe government bonds and other very safe bonds and fixed income securities, or iii) loan out money to businesses and individuals.

Lending out money provides the highest rate of interest but also incurs higher administrative costs and involves the risk of loss if the loans are not repaid.

As we are all aware, interest rates are at historic lows. The lowest rates in Canada for a five-year fixed rate mortgage are in the range of only 2.3%. Banks can make attractive profits while lending money at 2.3% because they now pay little or nothing on deposits and because banks are highly leveraged. A typical bank may earn a net 1% on its loans but that can translate into a 15% return on owner’s equity due to leverage.

The Bank of Canada, like central banks around the world, has sharply lowered the rate of interest that it pays upon funds that the commercial banks keep on deposit at the central bank. I understand that this rate is currently 0.50%. If the central bank was paying banks 4.0% on money deposited at the central bank, then banks would certainly not be offering mortgage money at anything close to 2.3%.

Central banks have lowered the rate of interest they pay to banks in order to encourage banks to lend out money, which stimulates the economy, rather than keep it on deposit at the central bank.

However, banks have also chosen to invest heavily in government bonds as an alternative to lending out money and this has driven the interest rates on government bonds down to record lows as the banks and other bond buyers compete with each other and drive down the interest rate that they are willing to accept on government bond investments.

But banks have also been liberal in providing loans to customers and competition to obtain borrower customers has driven down lending rates. It is popular to suggest that Canadian banks form an uncompetitive oligopoly. That is simply not true and a 2.3% five-year mortgage rate is a testament to the fact that banks do compete aggressively on loan interest rates.

Banks will continue to be liberal in lending money and will continue to offer low rates until i) the central bank raises the rate it pays to banks making it more attractive to simply leave money on deposit at the central bank, ii) banking regulators reduce the capacity and profitability of lending by raising capital requirements which lowers leverage, or iii) the banks begin to fear higher default rates and loan losses causing them to increase interest rates to compensate for the higher risk.

The bank of Canada could increase its interest rate paid to banks if inflation rises and the Bank of Canada wishes to cool the economy by encouraging less lending.

Banking regulators could also cause an increase in loan interest rates if they decided lower the amount of leverage that banks are allowed to employ. For example, banks could be required to hold a higher percentage of equity capital as a percentage of their assets.

It is also entirely possible that loan default rates will rise due to a recession (higher unemployment rates) or due to a mayor decline in house prices. In that case, banks will raise interest rates on loans. If banks begin to reduce lending due to fears of higher default rates this could actually cause additional customers to default. Many businesses and consumers have been borrowing new money to pay old debts. Any reduction in lending could push such borrowers into defaulting causing more fear of defaults and a further lowering of lending. It is evident that this could turn into a nasty negative self reinforcing cycle.

The bottom line is that interest rates are low because central banks are encouraging commercial banks to lend and because commercial banks and other lenders are highly willing to lend even at low rates because loan default rates have been so low.

Low interest rates have been beneficial for investors. Wise investors should keep a close watch out for any material rise in interest rates since a material rise in interest rates would cool the economy and likely push down stock prices.

A Battle Brews Between Credit Card Companies and Merchants

There is a battle (rightly) brewing between credit card companies and the merchants who accept credit cards for payments. My belief is that credit card fees to merchants are far too high. Until recently it did not appear that any change was likely. But the system is ripe for change and it now appears more likely that change could indeed occur.

This has implications for investors in Visa Inc.,  MasterCard Incorporated and American Express Company. It also has major implications for all the retailers and merchants that accept these cards and their investors and may have implications for consumers as well.

Recently, Walmart Canada announced that it would no longer accept VISA cards citing the high fees charged by VISA.

When a merchant accepts a credit card payment they effectively receive somewhere between about 97 cents and 99 cents on the dollar. The credit card company receives about one to three cents for each dollar spent on a credit card. This one to three cents ends up flowing (directly or indirectly) in part to consumers in the form of rewards, and in part to the issuing bank (and perhaps to certain companies associated with the bank including “merchant acquirers”) and in part to VISA inc. or MasterCard incorporated or America Express. (In the case of America Express there is usually no issuing bank as they mostly issue cards directly rather than through banks.)

Credit card companies provide two main things for merchants and consumers. 1. They act as a payment mechanism. The merchant gets paid immediately (albeit an average of about 98 cents on the dollar) and the customer usually pays off the credit card bill at the end of the month. 2. The credit card offers long term credit to those consumers who don’t pay off the bill at the end of the month.

Some Rough History

Widely accepted credit cards did not exist until the 1960’s. Bank of America got things started in Fresno California in 1958 but it was not until the 1970’s that general purpose credit cards became relatively ubiquitous. Perhaps contrary to romantic notions of life in the 50’s and 60’s, many people did in fact use credit back then. It was extremely common practice for both large and small stores to allow their customers to buy now and pay later. Many people had “accounts” at the grocery store and the hardware store and even the corner store.

By the 1970’s and 1980’s credit cards became the retailer’s best friend. Credit cards eliminated the need for stores to offer credit and the associated losses and costs. As credit cards became ubiquitous the need to accept personal cheques was also eliminated. Credit cards also boosted sales. For a merchant, getting an immediate and largely risk free 97 or 98 cents on the dollar was better than having to offer credit or accept a personal cheque. And it was certainly better than failing to make the sale because the customer did not have sufficient cash.

Credit cards also facilitated the reserving and guaranteeing of Hotel rooms and airline seats. They were greatly useful for the mail order industry and later were essential for the development of online shopping.

Credit cards were a major boon to businesses and were highly convenient for customers.

By the 1980’s however and increasingly today, and especially in Canada, merchants found a new best friend – the debit card. In Canada the transaction fee for a merchant accepting a debit card payment is (usually) just a few pennies – no matter how large the transaction. There is also a monthly rental charge for the debit card reader but overall the costs that a merchant faces for debit card payments is far lower than for credit cards.

Merchants might be tempted to steer customers towards paying cash or using debit cards. But the credit card companies have strict rules against that.

Credit cards also became more expensive to merchants with the introduction and widespread adoption of various Gold and reward cards through the 1990’s and continuing through today. At some point the credit card companies started charging higher discount fees to merchants when these reward cards were used.

Nevertheless, credit cards remain a good friend of retailers even though the debit card is a better friend and is far less costly to the merchant.

The Current Situation and Problems

I have long said that VISA and MasterCard are not only a duopoly but for merchants are each monopolies. Most retailers have virtually no choice but to accept both VISA and MasterCard. They are captive to whatever fees are charged. Customers expect and even demand that retailers accept credit cards. Many customers seem to think they have a “right” to pay by credit card, failing to understand that this is tantamount to demanding a right to pay 97 cents on the dollar.

Monopolies are usually regulated as to the prices they can charge. But credit card fees have been largely unregulated in North America. It is certainly possible that legislators will move to regulate credit card fees as they have done in other parts of the world.

Reward cards have raised merchant discount fees. This results in higher prices for everyone. Those who pay by cash and debit card are basically subsidising those who pay with reward cards. Overall, I suspect that lower income consumers are subsidising higher income consumers. Reward cards result in a sort of alternate “currency” in the form points. These rewards are not subject to income tax. I view reward cards as having features of a kickback scheme. Overall, I think the government would be justified in banning reward cards. An indirect way to do that might be to simply limit the merchant discount fees. The reason we don’t see much in the way of rewards for using debit cards is that the low fees on debit cards cannot fund rewards.

The costs of processing a credit card transaction must have plummeted as the process became fully electronic and as the volume soared (economies of scale). Yet merchant discount fees have risen. The cost of proving a month’s worth of credit has also plummeted with today’s vastly lower interest rates. The notion that the credit card industry should charge anything close to 2% for simply providing a month’s credit and electronically paying the merchant and collecting from the customer beggars belief. Many customers are paying by credit card simply to collect points. It would be far more efficient (to the economy) for these customers to use debit cards. To the extent that credit card companies need to charge these kind of fees to offset the credit losses, they could tighten up the process of granting credit cards and credit limit increases. It is simply highly inefficient to have credit card companies standing between customers and merchants and collecting anything close to 2% on every dollar. As a matter of public policy, it would be preferable for credit cards to be used only when the customer needs credit for several months or more and for debit cards to be used when the customer does not require credit as such.

Credit card company profits are far higher than they need to be. For example, by my calculation VISA earned a return of 93% on tangible common equity in 2015. VISA came on the market trading at about $16 in 2008 and now trades at $75. This huge increase came in spite of cash flowing out for dividends and stock buy backs. American express earned about 33% on tangible common equity in the past year. Its stock has not done well presumably because investors had been pricing in even higher returns and/or growth. While it would hurt investors if the earnings were driven down through regulation of fees, the return on the actual assets invested in providing service would still be fair. Investors have bid up the share prices of credit card companies to very high multiples of tangible book value due to an expectation of very high returns on tangible equity. The public interest does not require that investors be protected from a share price decrease associated with more reasonable fees.

Investor Action Recommended:

Credit card companies remain extremely profitable. They may continue to be good investments based on growth and the current light-handed regulation. But there is some risk that a sort of retailer revolt, as seen with Walmart Canada, or regulation could lead to far lower profits. More nervous investors could consider getting out of these shares. More aggressive investors could continue to monitor the situation.

Go Trades, Young Man, Go Trades

150 years ago it was popular to advise a young man to “Go west” to seek opportunity. This has applied even in recent years as witnessed by the huge numbers of eastern-born folks living in Alberta.

In the 1960’s it certainly would have been popular to advise young men, and increasingly young women, to head to university. This advice  continues though with somewhat less enthusiasm as Starbucks probably has all the post-graduate-degree workers that it needs.

Trades have usually been somewhat less respected as a career choice even though well qualified trades people often out earned a large percentage of university graduates.

As of 2016, I would encourage young people to consider a career in the trades for several reasons:

1: There is often a glut of university graduated and finding employment in your field is often difficult.

2: University graduates often end up in jobs that really are not that intellectually stimulating at the end of the day. There tends to be limited autonomy.

3: Many university graduates will be at risk of being displaced by artificial intelligence and software. Accounting is increasingly automated. Engineering may no longer involve much in the way of original calculations when software can be programmed to do the math.

4: Many university graduates may be at risk of their job being off-shored. By its nature “brain work” can be done in other parts of the world and the results sent back over instant communication lines.

5: Trades can often be healthier as they involve physical work and yet also these days have a large component of intellectual aspects to stimulate the mind.

6: Many trades are far less susceptible to being “off-shored”. For example, plumbing, carpentry and electrical work, especially repairs and modifications, will need to be done on-site for the foreseeable future.

7: Trades also specifically train workers to do a useful job. In contrast what job specifically can a new science graduate actually do?

8: Trades often allow for far more autonomy and less micro management along with the satisfaction that comes from seeing the tangible results of the work performed.

9: Trades usually involve far fewer years of training and far less cost.

The bottom line is that young people would be well advised to consider the wide variety of trades. They may well find that there are better employment opportunities with better job security and better all around working conditions as compared to the university route.

END

Shawn Allen

InvestorsFriend Inc.

To view older editions of our free newsletter, click here.

 

 

 

 

 

The Implications of Job Losses to Automation And How to Prepare Yourself

Lately, the prospect of jobs being lost to software and automation seems to be a growing fear. McDonald’s has introduced automated ordering. Driverless vehicles could eventually eliminate the role of truck driver. The investment advice business is being automated for some clients with the introduction of “robo-advisors”. There is a fear that even higher level knowledge workers will be replaced by computers with artificial intelligence.

The same kind of fears have been around for at least several hundred years. And indeed many trades and millions of jobs were wiped out by technology. Nevertheless, people adjusted and retrained and the lives of the great majority (but not all) people have been greatly improved though automation.

But now, the fear is that there will be no jobs to retrain for. The fear is that automation will wipe out millions of jobs and there will simply be no jobs for many or most of the displaced workers.

History suggests that in fact new jobs will materialise. But it’s worth thinking about the implications of a world where good-paying jobs are far more scarce due to automation.

In such a world there will a far greater abundance of goods and services produced. That should lead to a higher standard of living, on average. The question will be how can people get their fair share of what is produced if they don’t have good jobs? Perhaps there will a good deal of redistribution of goods and services by government. There might be a guaranteed minimum income for every adult. But it also seems extremely likely that the owners of the automated machines and software will continue to receive an ample share of the output. In that world it will be more important than ever to be an owner of businesses. Therefore it will be more important than ever to invest in equities through the stock market. Those individuals and families that accumulate larger investment portfolios would be setting up themselves and their heirs for success in an increasingly automated  world

Thomas Piketty in his book Capital in the 21st Century decried that fact that wealth is becoming ever more concentrated in the hands of the owners of businesses. I’d suggest that a reasonable reaction to that is to set yourself up to be an owner of businesses. For most people that means investing in the equities through individual stocks, exchange traded funds or mutual funds.

The Surprisingly High ROEs of Large Companies

Economic theory suggests that abnormally high returns on equity or ROEs cannot be sustained in the face of competition. For example low interest rates make it easier for companies to invest in new assets which leads to increased competition and lower ROEs. Reality however, begs to disagree.

At the start of 2014, I demonstrated that the Dow Jones Industrial Average as well as a list of companies had high ROEs. In the two years since then, not much has changed.

Recent data from Dow Jones Industrial Average indicates that the average P/E ratio of the 30 companies in the Dow Jones Industrial Average was 17.01 as of March 31, 2016. And the Price to Book Value ratio was 2.99.

The average return on equity (ROE) of the DOW companies can be calculated from the above using the following formula. (This is return on ending equity, rather than the more familiar average equity over the year.)

ROE =earnings/equity = price/book equity divided by price/earnings.

Therefore the DOW ROE was 2.99/17.01 = 0.176 = 17.6%.

In a world where short term interest rates are about 0% and a 30-year US. government bond earns 2.6%, a 17.6% ROE is a staggeringly high return. And this is no anomaly, the ROE on the DOW has been at similar levels for many years.

Here are the recent ROEs, as well as P/B and P/E data, of some (mostly) large companies:

	ROE	P/B	P/E
Canadian National Railway Company (CNR, Toronto CNI, New York)	25.3%	4.32	18.2
Canadian Western Bank (CWB, Toronto)	12.9%	1.07	8.7
Stantec Inc. (STN, Toronto and New York)	14.4%	2.32	17.8
Canadian Tire (CTC.a, TO)	12.8%	2.03	16.4
MELCOR DEVELOPMENTS LTD. (MRD, Toronto)	5.4%	0.48	9.3
Alimentation Couche-Tard Inc., ATD.B	24.9%	5.39	23.0
Wal-Mart (WMT, New York)	19.0%	2.79	14.8
FedEx (FDX,NY)	18.1%	3.09	16.6
Berkshire Hathaway Inc. (BRKB, New York)	7.0%	1.39	20.4
Boston Pizza Royalties Income Fund (BPF.un, Toronto)	12.4%	1.49	13.7
Costco (COST, N)	21.8%	6.35	30.3
Wells Fargo (WFC, United States)	12.7%	1.47	11.8
Bombardier (BBD.B, Toronto)	negative equity
Toll Brothers Inc. (TOL, New York)	9.2%	1.30	14.6
RioCan Real Estate Investment Trust (REI.UN, Toronto)	6.4%	1.08	17.4
Bank of America Corporation (BAC, New York)	6.3%	0.65	10.6
Dollarama Inc. (DOL, Toronto)	63.8%	24.68	30.7
VISA (V)	21.5%	6.34	30.9
Constellation Software Inc. (CSU, Toronto)	124.7%	30.13	26.1
Liquor Stores N.A. Ltd. (LIQ, Toronto)	4.4%	0.61	14.6
Element Financial Corporation (EFN, Toronto)	5.4%	0.90	20.5
American Express Company (AXP, New York)	26.8%	2.98	11.4
Onex Corporation (OCX, Toronto)	-79.2%	39.21	negative earnings
Agrium Inc. (AGU, Toronto and U.S.)	17.0%	2.03	11.6
Amazon.com Inc.	3.0%	24.31	862.6
AutoCanada Inc.	9.6%	1.01	11.2
TransForce Inc. (TFI, Toronto)	18.2%	2.21	12.8
Royal Bank of Canada (RY, Toronto and U.S.)	17.0%	1.78	11.3

This table shows a few companies with low or even negative ROEs, however many of them are very high. Unfortunately the companies with high ROEs also tend to have prices that are high multiples of book value.

A high ROE does not guarantee that the company will be a good investment. It’s earnings could fall or the high ROE might be fully reflected in a very high price to book value ratio. Still, a high ROE company will often turn out to be a very a good investment. In fact, if the ROE remains high for many years, then the investment is sure to turn out well unless it was purchased at too large of a multiple to book value.

Why Interest Rates Are So Low

It’s popular to believe that interest rates are low simply because central banks pushed them down so low. And there is certainly some truth to that. But the central banks of most countries would raise interest rates if inflation exceeded about 2%. But slow growth in the economy and technological innoivations have kept inflation very low. This suggests that we could blame low interest rates on low growth.

And that brings up another theory for why interest rates are so low. This theory suggests that interest rates are set by the supply of savings versus the demand for loans. This theory can be used to explain the very high interest rates of the 1970’s. In those years the bulk of the baby boomers were forming households and borrowing to buy houses and cars. The pool of money to be loaned out came largely from older people. But the young people greatly outnumbered the older people due to the baby boom and to the earlier baby bust during the depression and perhaps even due to those lost in the war. In addition, retirees in the 1970’s often had little in the way of savings. Overall there was a huge demand for borrowing and small supply of savings available to be loaned out. Simple supply and demand and economics 101 would suggest this would lead to high interest rates which lowered the demand for borrowing and perhaps increased the supply of savings.

The supply and demand theory of interest rates also offers a possible explanation for today’s ultra low interest rates. Today, many (but certainly not all) baby boomers have accumulated large amounts of savings. Pension funds contain massive pools of savings. Meanwhile there is a smaller number of people forming households and borrowing to buy houses. Simple supply and demand suggests that interest rates had to drop in order to increase the demand for borrowing in order to sop up all of those savings.

The reality may be more complex, but it seems to me that the simple supply of savings and demand for borrowing does partially explain today’s ultra low interest rates.

How Corporate Directors Are Deferring Income Taxes

Corporate directors and executives often receive at least a portion of their compensation in the form of deferred stock units, stock options or restricted stock options. This part of their compensation does not require the payment of income taxes until some years later. However, there is usually a large cash component of compensation that does attract current income tax. This is much more the case for executives than for directors.

However, I recently saw that a number of companies are allowing their directors to be paid exclusively in the form of deffered stock units or restricted stock units or stock options. In one case that I looked at directors were receiving about $200,000 per year in deferred stock units as compensation and not paying a dime of income taxes on it until they would retire from the Board years later.

As an investor, this practice is not of much or any concern. However, as a tax paying citizen, I find this practice to be reprehensible. Why should these directors be allowed to defer all of their income tax on their director compensation for years? And why should corporations facilitate and even encourage this? I have contacted some newspaper columnists to see if some light can be shed on this tax deferral behavior.

END

Shawn Allen

InvestorsFriend Inc.

 

 

 

 

Why Stock Prices Can and Do (and actually should) Gyrate Rather Wildly

When the stock market declines by 10% or 20% or more in a short time period it is often claimed that there is no way that any change in fundamentals could have justified such a rapid change in valuation.

Actually, let’s look at the math:

Fundamentally, a stock’s intrinsic or true value is the present value of the cash that it can be expected to throw off to its owner(s) over its total future life (between now and doomsday).

To illustrate the valuation math we can use a hypothetical idealised case.

Consider a hypothetical stock (share) that currently pays a cash dividend of $1.00 and where that dividend is expected to grow in perpetuity at 4% per year as the company’s expected earnings per share also rise in perpetuity at 4% per year. At any given time there is a market expected or required return for an investment with a similar level of risk, for example 8%. This is the “competitive” return for an investment of a given level of perceived risk and it is set in the market and it varies over time. Cash to be received in the future is not as valuable as cash in hand today and must be “discounted” by the market required return level associated with the perceived risk, in this case 8%.

The theoretical value of this hypothetical stock is given by the formula: Value equals the initial dividend divided by (the required return rate minus the growth rate).

In the example above, the theoretical value of this share is $1.00/(0.08-0.04) = $1.00/0.04 = $25.00. In this case the share is worth $25.00 and the dividend yield, at that price, is 4%.

But what happens if the outlook for the company improves and analysts speak and write enthusiastically about the company and the expected growth rises to 6%? Now the theoretical value changes to $1.00/(.08-.06) = $1.00/.02 = $50.00 and the dividend yield, if the price rises to $50, is 2%.

Here the growth rate rose 2%, which may not seem like that much but is a 50% increase in the growth rate, and the theoretical value of the stock increased by 100%!

It is certainly not beyond the realm of possibility that the expected growth rate of a company could quickly change by 2% and cause this 100% increase in the theoretical intrinsic value of this stock.

For the stock market as a whole it would certainly be possible for the expected GDP growth rate (and/or the earnings growth rate of the average company) to change by 1%. If we assume that the theoretical stock above with an intrinsic value of $25 represents an average company then this change in the growth rate of just 1% could increase the value of the average company and therefore the entire stock market by 33% since $1.00/0.03 equals $33.33 or decrease it by 20% since $1.00/0.05 equals $20.

This math demonstrates that the value of a stock or even the entire stock market can legitimately change fairly dramatically and quickly if there is even a modest change in the expected growth rate.

Similarly, the competitive market level of the required return on an investment can change due to changes in interest rates or due to changes in the appetite for risk among investors or changes in the perception of the risk level of a particular company.

If the required return in the example above declined to 7% then at 4% growth the value changes to $1.00/(0.07-0.04) = $1.00/0.03 or $33.33 for a 33% increase in value.

When you consider how very sensitive the theoretical valuation is to the required return (which is related to interest rates, perceived risk levels, risk appetites and competing investments) and to the expected growth rate, both of which can change significantly and rapidly, then the wonder is perhaps not so much that stock markets sometimes change by 20% or more in a short time period, and that individual stocks can sometimes change by 50% in a day, but that it does not happen faster and more frequently.

The notion that fundamental values cannot change extremely rapidly is simply not correct.

To the extent that estimates of growth rates and estimates of the competitive level of returns change rapidly (and they do) then the fundamental value of individual stocks and the stock market as a whole do change rapidly and therefore stock prices should change and gyrate fairly wildly in response (and, in fact, they do).

Attracting Foreign Investment to Canada

I often hear in the news that Canada needs to attract more foreign investment. Often there are calls for the government to seek out such investments and also to insure that Canada has policies and regulations that are receptive to investment. The assumption seems to be that more foreign investment is always a good thing. But I am not convinced of this. I think the need for foreign investment depends on the type of investment and whether or not the economy “needs” that investment and whether or not there is a shortage of domestic investment money.

I would agree that government policies including taxation levels, royalty rates on crown resources and various regulations should not discourage either domestic or foreign investment. However each Country (and Province) is entitled to set reasonable levels of taxation, royalties and regulations for both domestic and foreign companies. Even where investment is desired, it is seldom to be desired at all cost.

Also, when it comes to infrastructure investments, governments need to insure that regulatory approvals can be obtained in a reasonable time frame and that opponents to development cannot unjustly hold up those projects that should be approved. There is no point attempting to attract investment if it is the approval process that is the barrier to development.

Once a government has set reasonable policies that are appropriately receptive to investment by both domestic and foreign firms then I am not sure that it is the role of government to actively encourage, much less subsidise, foreign investment. By experience, the world has learned that the free market does a very good job of attracting private investments in profitable undertakings. Few of us would argue that government actions are needed in order to attract investments in such things as, for example, retail stores, entertainment services, housing, office buildings, banks, utilities or communications systems. The central planning of the quantity of investments in these businesses has not had a general history of success.

Undue competition with existing businesses is also a concern. If a government attempts to attract private investments into any for-profit enterprise it may be rare indeed that there is not some existing domestic private business that would be harmed by the new competition. And it would probably never be the case that there is not some private company somewhere in the world that would not be harmed by any government-assisted competition though that may not be a matter of any concern to the government. Competition is a good thing, but having the government encourage or certainly subsidise competition against existing businesses may not be a good thing.

There are also several different types of foreign investment.

A physical type investment would be one where a foreign company comes in and spends money to create new assets in Canada. This could be tangible assets such as buildings, transportation systems, communication systems, mines, factories, refineries etc. as well as non-tangible assets like software. This could certainly be beneficial if it is providing goods and services that would not otherwise be produced in Canada and where it is not unduly competing with existing Canadian businesses and where the investment would not have occurred without foreign investment.

A monetary investment would be where a domestic company obtained debt (loans) or equity investments from foreign investors. This could be beneficial if there is a shortage of domestic investors. While such foreign investment should not be discouraged, it’s not clear to me what role government would have in encouraging it to take place.

A transfer of ownership type investment would be where a foreign company purchases existing assets and businesses from a Canadian holder. While this would free up cash for the former owner, this is not a true physical investment. To the extent that foreign investment is desired for the economy, I would view this transfer of ownership type investment to be far less desirable than a true physical investment that created new assets and new businesses in the country.

The following are some thoughts on the types of private sector foreign investment that Canada could attempt to attract:

Investments in new oil and gas development: At the present time, Canada and certainly Alberta appears to have already over-invested in this area. A world-wide glut of supply has pushed prices down to unprofitable levels. Encouraging more production would provide a short-term boost as the project is constructed but ultimately would harm existing players in the market. The same comments would seem to apply at this time to attracting investments in the production of most other commodities including metals and minerals and potash.

Investments in refineries and petrochemical plants to upgrade raw resources: It is often said that Canada could benefit from such investments. And if there are profitable opportunities for such upgraders that are not being funded domestically then attracting foreign investment would seem to be good thing. However, the actual barriers to the construction of such plants may be far more related to the ability to compete against existing foreign plants, the difficulty of obtaining approvals to construct in the face of opposition, and the lack of pipelines (for liquids) to bring the product to market especially if it is to exported.

Investments in pipelines: Similar to investments in refineries, such pipelines would be welcomed, but the barriers to their construction has not been lack of investment but lack of approvals to construct.

Investments in high-tech companies, especially those that will create products to sell outside of Canada: That would be beneficial. However, it’s not clear why governments need to play a role in this, or that there is a lack of domestic investment for viable projects.

Investments in auto and other manufacturing: There is probably a benefit and perhaps a large benefit in attracting auto production to Canada that would otherwise occur elsewhere. However, this usually comes only at the cost of heavy subsidies and gets into various governments competing as to which can most heavily subsidise an industry. It’s ultimately a bad idea. If other governments wish to subsidise auto production then perhaps Canada is better off to focus on other things and to simply import the subsidised autos for Canadians to buy.

Investments in housing, retail, office buildings, entertainment, restaurants, banks, utilities, or communication systems: As noted above, few would argue that Canada has any deficiency in most or all of these facilities and services much less that there is any need for government to intervene to attract additional investment.

The bottom line is that I don’t see the evidence that Canada is, at this time, in any particular need of added private sector investment and certainly not beyond what the free market is already providing (which has been excess investment in many sectors) and therefore I see no role at all for government to actively encourage much less subsidise an inflow of foreign investment. The role of government in the private sector portion of the economy is to provide the proper legal framework and then to basically stay out of the way of the private sector. Getting into subsidy bidding wars with other countries for things such as automobile assembly plants is likely not money well spent.

Government Investment to stimulate the economy

At this time there are a lot of calls for the Canadian government to make investments to offset a slowing economy.

I would certainly agree that there are certain things where government and not the private sector is the logical party to make investments. This includes things such as schools, hospitals, public mass transportation, highways, navigation facilities and defense-related needs.

I am also not against governments borrowing money to make such investments as long as the debt and deficits do not get too high. (And with the Canadian government’s level of debt and deficits being relatively low as a percentage of GDP compared to historical peaks and compared to other countries, I do not think the existing debt level is too high.)

There may also be a case for government investments in transfers of money to individuals in certain cases.

The following are my thoughts on various potential government investments that come to mind:

Highways: Canada has almost exclusively relied on governments to construct highways and has allowed both private and commercial vehicles to travel without toll charges. The costs are recovered to some degree by relatively high fuel taxes and to some extent from general tax revenues. A highway system is most certainly necessary to allow people and goods to circulate. And circulation is the essence of economic activity. To a good extent, “free” highways are a part of what allows more isolated towns and small cities in Canada to continue to exist and grow and most Canadians would support that notion. Highways also facilitate the extraction and production of resources including agricultural resources. I think there are areas in Canada where improved highways are needed including twinning of highways. As long as project costs are well-managed I think spending on highways would not be money wasted and that it would be a strong candidate for increased government investment especially in times of higher unemployment.

Mass Transit: Mass Transit systems are necessary to the circulation of people in large cities. They can enhance the value of both the city center and of the suburbs. They reduce vehicle congestion and pollution and they allow people to much more easily travel for work, shopping, recreation, social visits, and entertainment. However, any feasible level of fares charged tend to be insufficient to cover the full costs of these systems. Given that the economy of a city benefits from these systems it seems appropriate that governments invest to cover some of the costs.

Water and Sewer Infrastructure: There are certainly many smaller population centers where the population is not large enough to allow all needed water and sewer systems to be paid for through user fees. Unless the country wishes to see these small centers closed down it seems reasonable for governments to invest in improved water and sewer systems in such places. This type of work can create construction jobs.

Job Relocation Assistance: Canada has long suffered from a resistance of people to relocate to where the jobs are. The income tax moving expenses deduction already provides significant benefits to those who incur out of pocket costs to move and who are in a high tax bracket. Still, getting a tax benefit for say 40% of the direct out of pocket and eligible moving expenses still leaves the individual out of pocket for 60% of those costs and for 100% of various non-eligible costs. (Which could include, for example, a period of interruption of employment especially for a spouse, higher housing costs, and even the costs to travel back to visit family periodically). There are also large social and psychological “costs” and risks to moving. In many cases private companies are not willing to reimburse moving costs even in tight labor markets. To the extent that the entire economy can benefit from increased labour mobility it might be reasonable for government to increase its assistance. For example the tax deduction could become say a 75% tax credit. And the existence of this tax benefit could be better communicated.

Enhanced Employment Insurance Benefits: At a time of higher unemployment it may be appropriate to lengthen the period of eligibility for this benefit.

Reduced Income Taxes for Low Income Earners: Low income earners already pay lower income taxes. Still, the income tax rate on incomes between about $13,000 and about $42,000 is 20.05% in Ontario and 28.53% in Quebec. If the government wishes to invest in stimulating the economy then I would suggest a reduction to the marginal tax rates for low income earners.

END

Shawn Allen

InvestorsFriend Inc.

To view older editions of our free newsletter, click here.

 

 

 

 

InvestorsFriend Newsletter September 15, 2015

It’s been a Bad Year for Investors. Or Has It Really?

By some measures it has been a bad year for investors, especially for Canadian investors. The Toronto Stock Exchange index is down by 6.7% this year to date. And the S&P 500 index is down by 4.9%.

But really, those are not exactly devastating losses. Stock indexes don’t go up in straight lines and based on history a 7% decline is really pretty tame.

And given that the Canadian dollar is down 12.1% this year, Canadians who lost 4.9% by investing in the S&P 500 are actually up about 7.2% on that investment. And then there are dividends that add another 2% or so annually to the gains on stock indexes.

All in all, reports that the average Canadian investor has been mauled by a bear market this year are greatly exaggerated.

But yes, there have been some ugly losses on various individual company shares. Certainly energy stocks are generally down significantly and also the shares of most companies exposed to the western Canadian economy.

Among the companies that I follow (but don’t necessarily own) , some of the nastier losses include a Canadian bank that is down 28%, Walmart down 26%, Bombardier down 63%, and a number of “rate reset” preferred shares that are down about 25%.

But, among the bright spots are a large American bank that is up 9% (with the currency gain of about 12% for Canadians being on to of that), and Dollarama up 45%.

Even if it were such a bad year for stocks, that would really not be a totally bad thing for most investors. Investors who are still in the savings phase as opposed to the retirement/spending phase can always take advantage of lower prices as they save additional amounts each year. Also anyone with a high allocation to cash can move more funds into stocks at lower prices if they wish.

The Basics of Investing

With the seeming volatility of stock indexes and particularly of individual stock prices. it is always a good idea to remember some of the basics of investing.

Contrary to the opinion of non-investors, stock investing is not gambling and it is not a zero-sum game where some must lose in order for some to win.

While stock prices jump around in what at times seems to be a random manner, investors should always remember that underneath that bouncing stock price lies a real business. A business that in most cases is a money making operation and which usually has earnings that are FAR less volatile than the stock price.

To own stocks is to own a piece of corporate Canada or corporate America (or corporate the rest of the world). Most people as they go about their daily shopping, pay their monthly banking costs and monthly utilities are pretty sure that the companies that they are dealing with are making a profit. Yet these same people are often afraid that if they invest in the stock market, even on a widely diversified basis, they will lose money even if they hold for some years. Well, it would be pretty hard for both of these situations to be true. If corporations are regularly making money from you as a customer then it is pretty certain that if you become the part owner of a diversified group of companies then you will make money over the years (though not every year due to stock price gyrations).

If you are prepared to think about stocks as representing  ownership in real businesses rather than thinking of stocks as just a price that jumps around then there are opportunities today to find businesses for sale at discounted prices.

What about the World’s Economic Problems?

There will always be lots of warnings about the economy. Warnings about excessive government and personal debt. Warnings that money is not backed by gold. Warnings that this is no time to invest in stocks. There is no end of warnings. These kind of warnings have been around for literally hundreds of years. Occasionally what is warned of comes to pass, but usually not.

And the reality is that the most (but not all) companies in the Toronto Stock index and in the S&P 500 are making far more money per share today then they did ten years ago. And I suspect that they will be making even more in another ten years. And that their share prices will reflect the higher earnings.

So my strategy will be to continue to ignore the warnings and to continue to invest in stocks.

Valuation of the Toronto Stock Index

I updated my analysis of the valuation of the Toronto Stock Index and my conclusion is that the index is moderately under valued at this time. Most of the time in the past this analysis has indicated that the Toronto stock index is fairly valued or over valued. But right now it is indicating a modest under valuation.

END

 

 

 

InvestorsFriend Newsletter July 9, 2015

How to Invest in Uncertain Times

Actually, this is a trick topic. People almost always consider the times that they are living through to be uncertain. They are partly right, after all the future is always uncertain. But people tend to forget that almost all past times felt uncertain as well.

We now tend to view the early 1980’s as a wonderful time for investors. Interest rates on saving were spectacularly higher than today. And we now know that it was a great time to invest in stocks. But back in the early 1980’s people were living through extremely high inflation and also high unemployment. I could go on, but rest assured that every year in the past had its share of uncertainty and fear about where markets were headed.

Luckily, successful investing does not require any ability to predict the impact of various uncertain macro economic events or geopolitical events or anything of the sort.

Successful investing instead, involves accepting that markets will always be uncertain and volatile. It involves being in a position to live through the inevitable periods of market declines. This can be achieved partly by learning to be confident that the broad market averages do grow over the long term and do recover from set backs. It can be achieved through proper diversification. It can be achieved by being in a position (both emotionally and financially) to invest additional money at times of market declines in order to take advantage of bargains.

Why Oil Prices Are Lower

The generally accepted reason for the large decline in oil prices in the past year is that OPEC has decided to fight for market share. This explanation simply makes no sense to me.

Why would any rational supplier or group of suppliers cause a price decline in the order of 50% in order to gain just a few percentage points in market share? That is, why would any rational supplier purposefully cause their revenues to decline in the order of 40%? The purported reason is to drive out U.S. shale oil producers. That would make sense if the U.S. shale oil producers could be driven out relatively permanently. But how would that happen unless the oil price is to be lower on a relatively permanent basis? And again, how would that benefit OPEC? How does a few percentage points gain in market share offset a 40 or 50% drop in prices?

Another reason that has been put forward for OPEC’s actions is that it it was done to harm and put political pressure on certain countries including Russia and Iran. This makes more sense to me.

OPEC, the Organization of Petroleum Producing Counties consists of twelve countries. Based on figures from April 2014, Saudi Arabia accounts for 32% of OPEC’s production. Other important members are Iraq at 11%, Iran at 10%, Kuwait and the United Arab Emerates each at 9% and Venuzuela at 8%. It was by agreeing to limit production to certain quota levels in each country that OPEC kept oil prices relatively high for years. The basic purpose of a commodity cartel is to artificially raise prices by having each member curtail supply.

My understanding is that the smaller OPEC members have cheated on their quotas for years. It was often left to Saudi Arabia to curtail production to keep the overall oil supply low enough to keep the price up.

Today, OPEC no longer has production quotas for each county. My conclusion from that is that the OPEC cartel has basically fallen apart. Saudi Arabia may have turned on the oil taps in order to show the other members of OPEC what happens when production quotas are not adhered to. In this is correct, then oil prices are low because the OPEC cartel was no longer adhering to quotas and Saudi Arabia decided stop controlling the price on its own in order to attempt to restore discipline within OPEC.

Unless OPEC can reinstate quotas and member discipline then oil prices are unlikely to rise.

It may be that OPEC (especially Saudi Arabia) gave up because, with increased U.S. production it was simply no longer feasible for OPEC to curtail sufficiently to maintain the former prices.

In any case I simply do not buy the notion that OPEC willingly allowed prices to drop in the order of 50% just to gain a few percentages points of market share while losing perhaps 40% of its oil revenues.

The Canadian Trade Deficit

Statistics Canada reports that Canada’s trade deficit has widened considerably in the past eight months. In dollar terms (as opposed to volume), Canada’s imports have increased while Canada’s exports have decreased.

It was fully to be expected that imports would increase in Canadian dollar terms given that the Canadian dollar has weakened substantially and given that most imports are priced in U.S. dollars. I would have expected import volumes to decline due to the higher prices of imported goods. But import volumes have also risen.

I would have expected export volumes to rise because the cost of Canadian goods is now lower in U.S. dollars. But export volumes have fallen. It may be that Canadian exporters have not yet benefited much from the lower Canadian dollar. This would be the case if the prices were contracted in Canadian dollars.

I would expect some reversal in the trade deficit in the coming months as exporters benefit from the lower Canadian dollar and as importers curtail volume due to the higher prices.

Investing Globally

Investors can easily gain exposure to companies outside of Canada and the U.S. through various country- or region-specific Exchange Traded Funds (ETFs). This can provide diversification as well as exposure to higher growth areas.

I have recently updated my reference article that lists selected global exchange traded funds and which also provides some valuation data for each ETF. Unfortunately, there did not appear to be much in the way of obvious bargains.

Investing in Canada and the U.S.

For those interested in investing in individual stocks I offer,  through my company Investorsfriend Inc., a subscription-based web site that provides a listing of selected stocks rated as to their investment attractiveness, as I judge it, and backed up with a relatively short and yet comprehensive report outlining the profitability (per share) history of each stock and how the company fares on a host of standard items that I always consider in my ratings (growth, profitability, management quality, competitive advantage, balance sheet strength and many more).

This stock rating service has an excellent long-term track record

Those who are not already subscribing to this paid service and who are interested  can learn more at the following link:

http://www.investorsfriend.com/subscribe/

END

Shawn Allen

To see older editions of this newsletter, or to be removed from our list, click here.

 

 

 

 

 

 

 

InvestorsFriend Newsletter June 6, 2015

The Essense of Stock Investing

The essence of stock investing is to choose stocks of companies that are reasonably profitable and are growing their profits and that are available at reasonable prices and to then simply ride along and benefit from the increased profits.

The first criteria (profits) is often more important than the criteria of paying a reasonable price. You can’t get blood from a stone and buying the stone at a bargain price does not change that fact. In order to profit from stock investments it makes sense to focus on companies that are making good (or excellent) profits. In this case the rising profits will often cover up the “sin” of having paid a rich price for the stock.

The Intelligent Use of Profits by Corporations

The ultimate financial goal of companies on the stock exchange is (or should be) to earn attractive returns for their share owners.

Profitable companies typically generate cash which they can then use in three ways:
1. To pay out cash to owners as dividends or by buying back shares, or
2. To reinvest in the company for future growth, or
3. To pay down debt (This one is rare for growing companies)

Often, companies choose some combination of the three.

To illustrate, imagine that a certain company has $100 million in owner’s equity and that it earns an attractive return of 10% on equity. Imagine also that the company has 10 million shares outstanding which therefore have a book value of $10 each.

For the sake of simplicity, let’s assume that the earnings are realized in cash. Free cash flow  after accounting for any cash that needs to be expended to maintain the current size of the company is therefore also 10%. This company then has $10 million at the end of the year which it can distribute as dividends, use to buy back shares or use to invest in growing the size of the business or use to pay down debt.

What should the company do with the $10 million?

Some investors would argue that all of the money should be paid out as dividends. Others would argue that the best use of the cash would be to buy back shares in order to push up the value of the shares on the market. Still others might argue that the company should retain the $10 million and invest it for growth. The company could aslo use the cash to pay down debt. In the face of these competing uses for cash, companies often decide to do a little of each, (with the exception of paying down debt which is unusual for growing companies).

In reality the best course of action depends on the circumstances of each company.

If the above company that is making 10% on its $100 million of book value has no ability or opportunity to expand its existing business then it may not have any valid reason to retain any of of the $10 million.

If, on the other hand, the company has the ability and opportunity to invest in and expand its operations in a manner such that it will earn an attractive return on the incremental investment then it may be most logical for the company to retain all the earnings for reinvestments and not pay out any cash to owners at this time.

Debt should generally be paid down only if it is excessive.

If a company determines that it should pay out cash to owners then it can choose between dividends and stock buybacks. The two are not equivalent.

Dividends pay out cash to all owners proportionately.

Stock buybacks pay out cash only to departing owners who sell all or some of their shares. The continuing share owners have, in effect, collectively bought out the shares of the departing owners using the companies money (which they collectively own) to do so. Each continuing share now represents a slightly larger percentage of ownership of the company. However the company no longer possesses the cash that it used to buy back the shares.

From the perspective of the continuing share owners, a share buyback is a wise use of the company’s cash if and only if the shares are trading at something of a bargain price. A company that wishes to pay out cash should consider buying back shares if they are trading at what it considers to be a bargain price and should instead pay the cash as a dividend if its shares are not trading at a bargain price.

It is also the case that that “the market” expects dividends to be maintained or increased over the years. Therefore a company that pays a dividend should generally be prepared to maintain or increase its dividend. If a company wishes to pay out a dividend that it does not expect to be able to maintain it should consider declaring that as a special (one time) dividend.

How a company chooses to use or allocate its cash profits as between dividends, stock buybacks and reinvestment in the company can have a huge impact on the long-term returns enjoyed by its share owners. This decision is sometimes called the capital allocation decision.

Warren Buffett has sometimes been criticised because Berkshire Hathaway does not pay a dividend. But the record shows that Buffett had the ability and the opportunity to reinvest Berkshire’s cash profits on behalf of its owners at very attractive rates of return. The payment of dividends would have sharply reduced the long term returns for Berkshire’s owners.

On the other hand, there are companies like Bombardier which has historically used much of its cash profits to make acquisitions that have turned out to provide mediocre or negative returns. Nortel, in its hey-day used cash to make many dubious acquisitions. Had Nortel used cash to pay down debt it might still be in business.

Warren Buffett has pointed out that if a company is making a 10% ROE and if it retains all earnings and continues to make a 10% ROE then its book value of equity will double in less than eight years. How a company chooses to use its profits has a major impact on the long-term returns generated for its owners. If annual returns on equity of 10% can be reinvested in growing the business in a manner which maintains the 10% ROE, then the profits of the business will double in less than eight years. However, if the reinvestments are poured into investments that do not add to profits then profits will be unchanged after eight years despite the retention of years of profits. In that case it might have been far better to have paid ot the profits as dividends or perhaps through share buybacks.

Successful companies generate attractive returns for their owners through a combination of dividends, share buybacks or reasonably profitable reinvestments into the company.

Some companies simply do not have the opportunity and ability to reinvest profits at attractive returns. It is imperative that those companies pay out cash to owners. On the other hand, those companies that have the ability and the opportunity to reinvest profits at attractive returns should do rather than pay out money to owners.

When evaluating the track record of companies, investors should consider whether the company has been intelligent in regard to its policies around dividends, share buybacks and the retention of earnings for growth.

Stocks versus Bonds

There are many claims made about the performance of stocks versisu bonds and the wisdom of holding stocks versu bonds or some balanced combination of the two.

I have updated two reference articles that look at the returns from stocks versus bonds over various periods of time going back to 1926. Click the links to see these update articles:

Historic returns from stocks, bonds, treasury bills and gold.

Are Stocks Really Riskier than Bonds?

Is This A Good Time to Invest in Stocks?

Stock markets have historically risen more years than they have fallen and they have provided attractive returns over the long term. Given record-low interest rates, I believe the evidence is that stocks are not necessarily over-valued on average at this time. And, there are clearly some stocks which are at attractive valuations.

The following link shows our stock ratings at the start of 2014 and how they performed.

Performance 2014

Our current stock ratings are available on a subscription basis. Click this link for more information.

To see older editions of this newsletter, click here.

End

 

 

 

 

 

 

Stock Market Valuation

Investors often debate whether or not the stock market as a whole is over-valued. I recently updated my comprehensive reference article that analyses whether or not the U.S. stock market (the S&P 500) is over-valued. Click to see that article.

Thoughts on Income Taxes

This is the time of year when most Canadians “square up” our income taxes with the government. Most employees tend to receive a small refund because our system tends to deduct a little more taxes than needed to insure most people don’t end up with income taxes owed.

This is also the time of year when people look at their T4 and wonder why such a large amount of their gross pay is going for income taxes. Most Canadians recognize that income tax is a necessary thing, though they would, of course, like to pay less.

It’s certainly fair game to complain about wasteful government spending and to complain if government wages, pensions and other benefits seem too high. And it’s fair game to ask if others including high income earners and corporations are paying their fair share of taxes. Most Canadians would agree that there is room for improvement in all these areas.

But there is a lunatic fringe that believes that all taxes are evil. They believe that lowering taxes is always good in all cases. They believe that all wealth is created by the private sector and that government creates nothing. They believe that government workers don’t really pay any taxes because their wages come from private sector taxes. When taken to to this extreme, all of this is utter nonsense.

These government bashers fail to understand that our private sector companies could not exist without the government that creates and provides the rule of law, property rights, security, free health care, free roads, municipal water and sewer service and many other things. Yes, some (but not all) of these things could be provided by the private sector. But to suggest that ALL of these things are unnecessary, wasteful and unproductive, by definition simply because they are provided by government, is sheer nonsense.

Those government bashers who go so far as to resent paying even a dollar in taxes  conveniently forget that there is not a single person earning money that does not benefit from government services. Without some amount of government, society would be in chaos and private sector employers would not exist. Even those exceptionally few people who live off the grid growing their own food  and making their own cloths benefit from the government laws that prevent others from simply seizing their property and possessions by force.

We all owe our incomes largely to the broader economic system that very much includes government services in addition to private companies.

Again, that is not to say that we should not complain about government waste of any kind or about an unfair division of the tax burden.

But none of us should go so far as to resent paying any income tax at all. We should be thankful that we are in a position to have earned the money which is being taxed. We might wish to remember that one thing worse than having to pay a large amount of taxes, is not having to do so because of not having the kind of income or wealth that results in a large tax burden.

Flawed thinking about Gross Domestic Product (GDP)

Gross Domestic Product or GDP refers the total dollar value-added by recorded monetary-based economic activities within a country. GDP is often criticized because it does not include the value of unpaid work or of unreported economic activities such as the “underground economy”.

The criticism is valid in that far too many people seem to think that GDP is a precise measure of the total economy and of the well being of a country.  In fact, GDP never purported to measure the totality of all the goods and services produced in an economy. It has always been the case that economic activity and exchanges not based on financial transactions as well as financial transactions that take place but that are not officially recorded were not included in measures of GDP.

Economic activities certainly pre-dates the invention of the concept of GDP in 1934 (see Wikipedia). The related concept of Gross National Product was “invented” in the 1600s but economic activities also took place long before that.  If we define economic activity as the creation of and the value-added exchange of goods and services, that would also pre-date the use of money of any kind.

When we attempt to measure the economic activity within a country, it is difficult or impossible to include unrecorded financial exchanges and the production or exchange of goods and services that do not involve money. GDP,by its nature, should be thought of as a limited and imperfect measure of economic activity.

It is valid to criticize those who rely on GDP without remembering that it is only a limited and imperfect measure.

Policy makers err when they focus exclusively on increasing GDP.

Consider the service of caring for children. Let’s assume that 50% of mothers are stay-at home Moms. The work that they do goes unmeasured by GDP. Now, imagine that each of these mothers is encouraged to pair up with another Mother. Each Mother exchanges her kid(s) with those of another Mother each day. Each Mother incorporates as a mini-daycare operation. She hires herself and remits income taxes and payroll taxes. She deducts part of her food bill and utilities as a business expense. All these mothers pay each other $1000 per child per month. Voila, the workforce has been expanded greatly. The economy has been “expanded” because the work of looking after these children is now recorded in GDP.

If the goal was to increase GDP and increase the number of people in the labor force, it has been achieved. But the real economy has not been changed. The well being and living standards of the community have not increased. In fact, it’s pretty clear that the well being of most of the mothers and most of the children has been reduced.

This example illustrates that what really counts is the well being of people. The true economic activity within a country is usually increased when GDP rises. But not always. Policy makers need to be careful not to lose sight of the real goal which is certainly not to increase GDP for the sake of increasing GDP.

Another example is when people argue for the legalization of grow-ops to increase the size of the economy. I won’t get into that debate but to the extent that you simply make legal an activity that is already occurring, you have not increased the size of the economy but have rather just begun to measure what was already happening. It might increase income taxes but by itself starting to account for an activity that formerly existed but went unaccounted for, does not change the size of the economy.

Understanding Canada’s Economy

I have updated my article that shows how each sector contributes to Canada’s GDP. It also shows what Canada exports and imports and shows how various countries rank as Canada’s trading partners. This article reveals some things about Canada’s economy that will surprise most people.

END

Shawn C. Allen

President InvestorsFriend Inc.

April 11, 2015

Click to see all past editions of this newsletter or to get off the list.

 

 

 

Bank Fees and also Canadian Demographics

As an investor, and an owner of bank shares, I am not usually opposed to the fees banks charge. However, some bank fees are beyond the pale.

Credit Card Interest Rates

TD Visa customers that miss the minimum payment date by more than 30 days face higher interest rates. The interest rate on cash advances rises to 28% and on purchases to 25%. The normal rate is 21%.

They are making things even more onerous as of March this year. Upon being more than 30 days late with the minimum payment, the higher rates will now remain in place until the customer makes the minimum bill payment on time for 12 months in a row. It used to be 2 months before the rate would drop back to 21%.

This will not likely affect me because I almost always pay the full balance by the due date although once in a while I can forget to pay on time but I don’t think I have ever missed by a full 30 days.

To me, this is a disgusting change that hurts the most vulnerable people. I am all for making a profit but is 21% not a high enough rate?

I called TD at 1-855-384-9348 and they answered right away and I politely asked that they pass along to management that I thought that this was quite disgusting. Obviously it’s not the fault of those who answer the phone.

This sort of thing does illustrate how banks can make big money on interest rates and fees. It’s not likely that anyone choosing to have a TD credit card would make their choice based on what happens to the interest rate if they miss the minimum payment by over 30 days.

There are certain bank charges that most people encounter infrequently and for which the bank can charge almost anything they please.

Foreign exchange fees on Credit cards

TD Visa tacks on an extra 2.5% to the exchange fee “rate established by VISA” for purchases in U.S. dollars. Based on my recent transaction it appears that VISA inc. was charging 0.9% above the wholesale rate.

It appears I paid a total of 3.4% extra on the exchange.

I paid 1.22882 for a January 13, 2015 transaction whereas the Bank of Canada indicates that the wholesale exchange rate on that date at noon was 1.1948. And the rate the previous day was 1.1930 and the next day was 1.1958.

You can check historic wholesale exchange rates as of noon on any date in the past ten years at this link:

Now, I think it is perfectly okay for the bank to make a profit on the transaction. But in this case TD Visa would already have charged a merchant fee of probably 2.0%. The currency exchange part of this transaction was entirely electronic.

A currency exchange window at the airport faces real costs and risks in terms of staff time, exchange rate fluctuations on their inventory of cash in various currencies, and perhaps even counterfeit currency risk.

It seems to me that TD VISA and VISA Inc. faced no additional risks with this electronic currency exchange. The risks of me not paying the credit card bill do not increase when I purchase something in U.S. dollars. With everything being electronic they probably face no risk of the currency rate changing against them and no counterfeit money risk.

Again, they deserve and are perfectly entitled to make a profit. But in a situation like this is it right that they can charge a 3.4% profit over and above their merchant fee?

They can get away with it because I don’t do enough traveling to justify having a U.S. dollar credit card.

It seems to me that this is a system ripe for disruption whereby new electronic payment options could come in and reduce such a fee by probably 90% and still make a profit.

Exchange Rate Fees in Investment Accounts

When I checked just now, TD Direct Investments will allow me to transfer Canadian dollars to U.S. dollars at a rate of $1.2631. This is from the Canadian RRSP account to the U.S. dollar portion of the same RRSP. If I then go in the other direction transferring U.S. dollars to Canadian they will use a rate of $1.2267. That is a round trip fee of 3.34%. It appears that they are charging about 1.7% per transfer in each direction.

When I wrote about this in 2007 it appeared at that time that they were charging 1.8% round trip or 0.9% each way back then.

I consider a 1.7% fee for electronic transfers between TD investment accounts to be a rather obese fee. Banks should certainly make some fee on this transaction but I think 1.7% is beyond excessive.

There may be a may around this by buying a U.S. dollar fund called DLR-U and DLR on Toronto. DLR is U.S. dollars and trades in Canadian dollars while DLR-U is U.S. dollars and trades in U.S. dollars. Apparently one can buy DLR in a Canadian account and then phone the broker to have it “journaled over” to a U.S. dollar account as DLR-U where you can then sell it. I am told that due to settlement rues this would involve waiting three days and you face the exchange rate movement for three days. There is also a bid/ask spread and trading commission. So this doe not look like much of a solution.

Another possibility may be to buy a Canadian stock that also trades in New York in U.S. dollars and then have it journaled over to the U.S. dollar account and sell it there. Even if it is possible to do this without waiting three days there is still a bid /ask spread and trading commissions.

Once your money is invested with a certain broker you may be essentially captive to their high exchange rate fees. And they are not likely to compete on these fees since people rarely choose a broker based on these fees.

Demographics and the changing age profile of Canada

I recently came across an excellent graphical tool from Statistics Canada. It shows not only the age profile of Canada’s population in 2011 but how the profile has changed going all the way back to 1921.

http://www12.statcan.ca/census-recensement/2011/dp-pd/pyramid-pyramide/his/index-eng.cfm

As expected it shows the baby boom bulge in the population. The baby boom bulge in the population is the group of people now between about age 51 and about 69. The number of people over age 51 does drop off however due to deaths. Below about age 48 there is a sudden decrease of about 10% in the population. So we have about 10% fewer people in their 40’s today as we had only 10 or so years ago. That certainly must have some impact on the sales of various products and services catering to that age group.

There is no-doubt an awful lot that could be discerned from looking at the profile of the population and thinking about how it will change in the future.

I found it interesting to see that there appears to be about 10% fewer teenagers in 2011 as compared to those in their 20’s at that time. And probably 15% fewer that are under age 10. This is baked into the numbers. Immigration has been fairly stable and will not change this. I think we can reliably predict that there will be 10% fewer kids each year available to enter college starting right about now. We should also be hearing about some elementary schools closing down as there will 15% fewer kids than a decade ago. Of course in some areas we will be building schools. But it must be the case that there will be schools facing too few kids.

We can also reliably predict that there will be about 10% fewer “household formations”, 10% fewer first time home buyers. or first time renters. That effect may not show up until this “baby dearth” group starts hitting about age 25 starting in a year or two.

Statistics Canada also provides its graphic by province, with a comparison to Canada though only for 2011 and 2006.

End

Shawn Allen

Click here to see past editions of our free newsletter or to get off our list.

 

 

 

InvestorsFriend Inc. Newsletter October 23, 2014

Current Market Direction

Investors always want to know where the market is headed. They get worried when we have days when the market declines.

The reality is that no one can accurately predict where the market is headed in the short term. It’s safe to say that the long term direction is higher. But the short term is not something that can be predicted.

In the last five years we have had about half a dozen big scares in the market. There were at least two episodes of the debt limit crisis in the U.S. There have been several mild panics about the debt situation in Europe. I can’t remember all the reasons why but a look at the graph of the S&P 500 shows sizable declines in the Summer of 2010, the Summer of 2011 (that was a debt funding crisis), Spring 2012, Fall 2012 and most recently in the last two weeks of September to about the middle of this month.

If you got out of the market on any of those occasions it seems likely that you quickly lived to regret it.

Jumping in an out of the market based on short term outlooks is not likely to be financially rewarding. Instead, it is better to accept that markets will be volatile and simply try to take advantage of market movements. Use dips to buy high quality stocks and perhaps use rallies to trim positions or move into stocks that offer better value.

Investments that seem obvious in hindsight

Looking back over the past five years here is a list of stocks that have done very well and which really should not have taken anyone by much surprise:

Tim Hortons – Surely we all saw those massive line-ups and the added locations that kept popping up.

Starbucks – Expensive, located every where and busy. Hardly surprising that it has done well.

All the big Canadian Banks – The same banks that people complain act as an oligopoly and charge high fees. Turned out to be great investments. Go figure.

Dollarama – People bought the cheap goods, noticed all their new locations but mostly failed to notice the stock.

Costco – When they open a new store it can cause a traffic jam. Most of us have seen how busy they are. It’s been a great investment. Imagine that.

It’s always harder to identify the good investments looking forward. A great place to start is to look at companies that simply appear to be prosperous and busy and growing and which do not seem to compete too aggressively on price.

In Investing, as in life, be very careful who you take advice from

In today’s world the amount and sources of information and opinions available about investing and every other topic under the sun has exploded.

We have virtually unlimited information sources at our fingertips.

50 years ago there was certainly a LOT of information and opinions available about investing. Most of this would have been print sources including newspapers, books, financial magazines and investment newsletters. There would also have been the ability to attend investments courses and seminars. But the quantity of information available today is massively larger.

As for the typical quality of investment information today that is a different story.

Certainly the ability to access facts such as revenue and earnings reports of companies is improved and is infinitely faster.

When it comes to investment opinions I suspect the best sources of  opinions today are likely better than what existed 50 years ago.

But the average source of opinion is likely far inferior to those of 50 years ago.

Why would that be?; you might ask.

Well, 50 years ago getting material printed and distributed was still expensive. A proposed book for sale was closely reviewed and edited before it was ever published. Only a small percentage of proposed books ever reached readers’ eyes. Financial columnists in newspapers were also subject to editors. Crackpots were not welcome.

Today, anyone can easily distribute whatever opinion they want on the internet. One has only to browse the on-line comments on business and economic web sites to see that the lunatic fringe is well represented. Gloom and doom and end of the financial world web sites and books abound. The internet seems to have an over representation of bitter and extremely pessimistic individuals who like to spew vitriol, hatred and gloom all day long. No actual expertise or knowledge is required of those predicting such gloom. The more sensationalist their advice the more attention it may garner.

Anyone who follows the advice of doom and gloom financial sites does so at their peril. That is not to say that we should not all prepare for the occasional rainstorm. But many of these sites would suggest something more along the lines of quitting your day job to spend full time building an ARK. Or perhaps building and stocking a bunker to survive the predicted apocalypse.

Quality advice does exist. But it is often drowned out by the sea of uninformed yelping. Choose very carefully who you will take advice from.

Reasons to Like Investing in an RRSP

The feature that really makes RRSPs work for investing is a feature that is usually seen as a negative.

When we take money out of an RRSP it is taxed at our marginal tax tax rate which is often around 40%

This is understandably viewed as a big negative factor since no one enjoys paying tax.

However, it is this very tax consequence that causes most money that ever goes into an RRSP to remain there for use in retirement.

Money that is placed into RRSPs usually remains there for decades and compounds without tax for many years.

In contrast, Tax Free Saving Account investments can be withdrawn anytime with no tax consequence. The unfortunate consequence of that is that in many (and perhaps most) cases that money will not be left to compound for decades. It will just be too tempting to use that money to pay off debt or for a home renovation, a home down payment, a vacation, for education, to pay expenses while unemployed or a thousand other uses. It may be great to have that money to spend. But as far as saving money for retirement, money in Tax Free Savings Accounts is much less likely to be allowed to compound for decades as compared to RRSP investments.

In addition, I have discussed in a previous edition of this newsletter that the 40% or so tax on RRSP withdrawals can really be thought of as repayment of the government’s share of your RRSP. In effect the government subsidized your RRSP to the tune of about 40% through the tax refund when the contributions were first made and when you make a withdrawal it simply wants its 40% share of the RRSP back. Your net cost of the RRSP investment was about 60% and your 60% share grows tax free assuming that the marginal tax rate in unchanged from the time of investing to the time of withdrawal.

Corporate Takeover Bids

I have often watched corporate takeover bids with interest. Usually the buyer offers to pay a premium to the recent trading price of the company being “bought out”. Often the premium is in the range of about 30%.

The financial press usually focuses in on that premium. It’s the 30% (or whatever) “pop” in the share price that gets most of the attention.

Seldom does the financial press devote much (if any) ink to exploring whether the price to be paid reflects the true value of the company. Usually the recent trading price is taken to have been the former fair value of the company, as if the market price were always holy writ. If it is an unfriendly takeover, the company being bought will usually protest that the price, despite being say a 30% premium, still undervalues the company. But that protest usually receives little attention. If it is a friendly takeover then the the company being bought usually states that the price is fair.

The majority of the existing shareholders of the company being bought are usually happy enough to take the 30% (or whatever) gain and move on.

But these take-overs may often not be such a good thing for shareholders.

Consider Stantec which has risen from $2.50 to the $70 range in the last 15 years. As recently as June 2012 it was under $30. Had it been taken over for a 30% premium in any year prior to 2012 then investors would have traded away substantial long-term gains for their quick 30% pop.

There are many examples of stocks which have risen relentlessly at good rates for decades.

When it comes to our stocks getting taken over for such 30% premiums it may be a case where investors should be careful what they wish for.

The Pros and Cons of Share Buy Backs

Share buy backs are neither inherently good nor inherently bad for existing share owners nor for the economy at large.

One of the strange but well accepted fictions is that share buybacks return money to share holders just like dividends do. It may well be the same thing from the company’s perspective but it is definitely not the same from the perspective of share owners.

Share buy backs return money only to departing share owners. If the share price was where it should be the continuing owners own a larger share of a company with a bit less money than it had before the buy back. It’s a wash from the perspective of continuing shareholders unless the shares were bought back at a discount price. Often that is the case. Sometimes it is not.

To illustrate:

Imagine if five people owned 20% each of a local Boston Pizza restaurant owned through a corporation. One wants to sell out and the ownership corporation has the money to buy back the shares of the departing owner. It’s clear to see that the remaining four now own 25% each of a restaurant that no longer has the money that was just paid to the departing owner. Money has been returned to the departing owner and not to the four continuing owners. In contrast a dividend returns money to all owners. If the restaurant continues to do well the four remaining owners may well benefit by their increased ownership. But that is not a given. And the restaurant may need to borrow money now that its cash has been depleted by the buy-back. It is not necessarily the case that the earnings per share of the four remaining owners will increase. However that is likely the case if the cash used to buy back the shares of the departee had been sitting earning little return. But the point is that a corporation buying back shares certainly does not return money to the non-selling share holders by buying back shares. For whatever reason the fiction that this is the case seems widespread.

Theorists may point out that the share buy back is exactly like a dividend if all owners sell back the exact same proportion of shares. But no one would suggest that this ever happens in reality. Also the tax consequences would differ.

As far as share buy backs being bad for the economy, I do not agree. As an alternative to buying back shares a company could invest in more fixed assets. But if it has no economic need for those investments, why would that be better for the economy? And those who claim the buybacks are bad seem to forget that someone receives the cash paid out and can then spend it or buy other investments. The money does not disappear, it re-circulates in the economy. If you have read that share buy backs are always a bad thing, refer again to my thoughts above about being careful what you read and believe.

Weird Investments Foisted on Investors

Having signed up to receive notice of Initial Public Offerings from my discount brokerage (TD Direct) I have noticed that some of these are very complicated.

Here’s the latest example:

TD Bank Quarterly Pay Extendible Range Accrual Notes May 12, 2015 to November 12, 2021

A variable coupon accrues for any calendar day that the 3-month bankers’ acceptance rate is deemed to set within the following ranges, if any:
Year 1: 1.15% – 1.55%
Year 2: 1.15% – 1.75%
Year 3: 1.15% – 2.05%
Year 4: 1.15% – 2.25%
Year 5: 1.15% – 2.50%
Year 6: 1.15% – 3.00%
Year 7: 1.15% – 3.50%

No variable coupon will accrue for any calendar day that the 3-month bankers’ acceptance rate is deemed to set outside the above ranges.

Accrual Rate:
Year 1: 4.00%
Year 2: 4.30%
Year 3: 4.60%
Year 4: 5.00%
Year 5: 5.50%
Year 6: 6.00%
Year 7: 7.00%

The Notes are 6 month, quarterly pay, principal protected, Canadian-dollar denominated deposit notes issued by The Toronto-Dominion Bank extendible quarterly at TD’s option to a maximum term of 7 years. The Notes pay a quarterly variable coupon, if any, determined by reference to the 3-month bankers’ acceptances rate. A variable coupon accrues for any calendar day that the 3-month bankers’ acceptances rate is deemed to set within a range. No variable coupon will accrue for any calendar day that the 3-month bankers’ acceptances rate is deemed to set outside of the range. The accrual rate is initially 4.00% per annum and increases on predetermined dates, provided that the Note is extended, up to a maximum of 7.00% per annum in year 7. The range is initially greater than or equal to 1.15% and less than or equal to 1.55%. Provided that the Note is extended, the upper bound of the range will increase to 3.50% in year 7.

The maximum interest payable over the term of the Notes is 36.40% (provided that the 3-Month BA Rate is deemed to have set within the 3-Month BA Range on each Observation Day of each Accrual Period and the Note is extended to the Final Maturity Date). The minimum aggregate return on the Notes is 0%.

As far as I am concerned, this is bizarrely complicated and not suitable for any retail investor. The banks seem to “manufacture” these sorts of things frequently. I have no idea who is buying them. I would not touch this kind of thing. I presume this is being pushed out to investors through the banks in-house investment advisors.

Subscribe

In addition to this free newsletter and in addition to our substantial body of free investment educational articles, InvestorsFriend Inc. also offers a paid service that rates a selected number of stocks as Buy or Sell and which has a very good and documented track record since our inception 15 years ago. Those who are not already paid subscribers can learn more by clicking this link.

END

Shawn Allen, President
InvestorsFriend Inc.

InvestorsFriend Inc. Newsletter August 23, 2014

Some Long Term Winning Stocks, Identified in Advance

I have been tracking and analyzing certain stocks since 1999. The companies that I track come and go to a certain extent. But there are a few that I have tracked continuously since around 1999. And there are others that I have tracked continuously since whenever I first added them to this web site. The following stocks are all of the stocks on my list which were both rated in the Strong Buy range at some point and which I am still tracking.

In no way is this a random sample. In fact it is definitely biased toward better performing stocks. On the other hand these stocks were not picked after the fact, they were analyzed years ago and rated in the Strong Buy range.

The data here shows the gains from the date on which I first rated these stocks in the strong buy range until today.

Company	Date we first rated the company in the Strong Buy range	Specific rating	Total Price gain to date	Years	Gain per year
Stantec	3-Sep-99	Strong Buy	2708%	15.0	24.9%
Melcor Developments	20-Dec-02	Strong Buy	630%	11.7	18.6%
Canadian Western Bank	5-Aug-99	Strong Buy	733%	15.1	15.1%
CN	25-Jan-07	Strong Buy	180%	7.6	14.5%
Canadian Tire	4-Feb-00	Strong Buy	381%	14.6	11.4%
Wells Fargo	15-Feb-10	Speculative (lower) Strong Buy	87%	4.5	14.8%
Constellation Software	5-Feb-11	(lower) Strong Buy	355%	3.5	53.3%
Couche-Tard	31-Mar-05	(lower) Strong Buy	429%	9.4	19.4%
Visa	6-May-11	(lower) Strong Buy	165%	3.3	34.3%
Bank of America	5-Feb-11	Speculative Strong Buy	89%	3.5	19.7%
Boston Pizza Fund	13-Dec-08	Strong Buy	187%	5.7	20.3%

The biggest gainer is Stantec an Edmonton-headquartered engineering company that grew mostly by acquisitions. It was an obvious bargain in September 1999. It has gone on to gain 2708% in 15 years or a compounded 24.9% per year.

The largest gain per year is for Constellation Software, up 355% in 3.5 years or 53.3% per year.

The point is that this data shows that certain stocks can grow wealth at double digit rates for a period of years. They can be identified as strong buys in advance. And they can be relatively large and established companies. None of the companies above were particularly obscure at the time they were first rated on this site in the Strong Buy range.  Some were household names. Some of these stocks were already huge businesses at the time. Some were relatively small but none were micro caps. None of these were penny stocks. None of these companies are in exotic businesses. None are resource companies. None are heavily focused on research and development. These companies would not strike most people as a group of high-risk stocks. Many of them would be considered blue chip names.

Did I buy and hold any of these stocks over the entire period indicated? I did not, though it appears it would have been wise. I have held all of these stocks from time to time and in some cases held them for years. I tended to buy on dips and sell on rallies to a certain extent. A wiser strategy might have been to buy on the dips or buy regularly over the years but not sell on rallies.

Was the Strong Buy rating maintained for these stocks all these years? No it was not.

Do we rate these stocks as Strong Buy today? No, we do not.

Were these stocks free from volatility, even sickening losses? No, any that were rated Strong Buy prior to 2008 suffered big losses in 2008 and 2009. And in general they all had their ups and downs over the period.

But the point is that sticking with these companies would have worked out very well indeed. Our own performance is well document.

Investment and Business Wisdom of the ages

This summer I spent a good deal of time reading some old books.

Here is a selection of pearls of wisdom from that reading.

The Romance of Commerce – 1918, By Henry Gordon Selfridge founder of a huge department store in London England that still thrives.

Chapter I, Concerning Commerce:

“Ever since the moment when two individuals first lived upon this earth, one has had what the other wanted, and has been willing for a consideration to part with his possession. This is the principle underlying all trade…, and all men, except the idlers, are merchants.”

“…without Commerce there is no wealth. Commerce creates wealth , and is the foundation of the great state.”

“Honesty always pays.”

“It is desperately silly to hold wages down to the breaking point…”

“… the making of a fortune possess almost always in its formula a large quantity of risk.”

The Richest Man in Babylon – Fiction – 1926 by George S. Clason.

The key lesson of this tale is what is described these days as “pay yourself first”. Save at least 10% of all earnings regularly and, just as importantly, put your savings out as investments to grow.

“Willpower is but the unflinching purpose to carry a task you set for yourself to fulfillment…. When I set a task for myself, I complete it. Therefore, I am careful not to start difficult and impractical tasks, because I love leisure.”

“Counsel with wise men. Seek the advice of men whose daily work is handling money.”

“necessary expenses” will always grow to equal our incomes unless we protect the contrary.

Invest to build “an income that continueth to come whether thy work or travel”.

“Guard thy treasure from loss by investing only where thy principal is safe…”

“Own thy own home.”

“Provide in advance for the needs of thy growing age and the protection of thy family”.

“Increase thy capacity to earn” by perfecting yourself in your calling, by increased skill and by increased wisdom. Be in the front rank of progress and do not stand still, lest you be left behind.

Common Stocks and Uncommon Profits, 1957 by Philip A. Fisher

Philip Fisher is known as one of the great influences on Warren’s Buffett’s investment style. In 1957 Fisher has been a very successful investor for a very small group of clients. He started his investment firm in 1931 and focused on “a few growth companies”. He served in the war for three and a half years during which his spare time was used to think about and define the most successful investment principles that he had observed in himself and others. After the war he returned to his investment practice. He wrote his book as a way of communicating his unconventional approach to a wider audience.

In Chapter 1 of his book he wrote:

In the 1800’s and in the early part of the 1900’s it was possible to invest very successfully by betting on the business cycle. This was in an era of an unstable banking system which caused recurring booms and busts. One could could buy stocks in the bad times and sell in the good times. But, he said, this started to end with the creation of the FED in 1913 and came to an end with securities legislation passed in the early days of the Roosevelt Administration.

He said that the most significant fact to be realized was that even in 1800’s and early 1900’s, “those who used a different method made far more money and took far less risk”.

“Even in those earlier times, finding the really outstanding companies and staying with them through all the fluctuations of a gyrating market proved far more profitable to far more people than did the more colorful practice of trying buy them cheap and sell them dear.”

“What is required is the ability to distinguish those relatively few companies with outstanding investment possibilities from the much greater number whose future will vary all the way from the moderately successful to the complete failure.”

Fisher felt that the opportunity to find such companies was even greater, in 1957, than it had been in the past due to a new emphasis on research and development and the resulting newer products  and due to more professional management more focused on shareholder interests. But, he said, research and development spending could also be a crushing burden if not managed properly.

Fisher noted that since 1932 both political parties had accepted the need for deficit spending to combat recessions. This would lead to a situation where for financially strong growth companies, declines in market values during recessions would prove far more temporary than had been the case previously where the very existence of the company might have been threatened.

Fisher noted that due to periodic deficit spending, there was an inflationary bias in the economy. He (correctly, as it turned out) foresaw that this meant that long-term bonds were undesirable investments in 1957. And this was despite that yields on bonds were abnormally higher than stock dividend yields. He aid that viewing long-term bonds as undesirable “seems to run directly counter to all normally accepted thinking on this subject”.

He predicted inflation due to deficit spending and said: “it becomes clear that major inflationary spurts arise our of wholesale expansions of credit, which in turn result from large government deficits greatly enlarging the monetary base of the credit system”.

Fisher said that the evidence showed that “the greatest investment reward comes to those who by good luck or good sense find the occasional company that over the years can grow in sales and profits far more than industry as a whole. …when we believe we have found such a company we had better stick with it for a long period of time. …such companies need not necessarily be young and small. …what really counts is a management with the determination and ability to attain important growth and a vigilance in performing the day-to-day tasks of ordinary business outstandingly well.

Conclusions regarding lessons from the past

Philip Fisher’s comment on the undesirable ness of long-term bonds for long term investors seems even more appropriate in 2014. As in 1957 there is a fear today of inflation due to government deficit spending. Unlike 1957, the yields on bonds are not higher than many available dividend yields. I have explained this in my article comparing bond investing to stock investing.

Fisher’s comments that we should look for excellent companies with good management and then buy and hold these seems as true today as it ever was. It proved to be the case for the examples I identified above.

The advice from The Richest Man in Babylon to save and invest at least 10% of income is certainly still true.

Gordon Selfridge’s argument that all wealth stems from Commerce is just as valid today as it was a hundred years. (Even natural resources don’t create much wealth until trade and commercial business gets involved.) Investors should feel good about owning shares in the businesses of the world.

Subscribe

In addition to this free newsletter and in addition to our substantial body of free
investment educational articles, InvestorsFriend Inc. also offers a paid service that rates a selected number of stocks as Buy or Sell and which has a very good and documented track record since our inception 15 years ago. Those who are not already paid subscribers can learn more by clicking this link.

END

Shawn Allen, President
InvestorsFriend Inc.

To see older editions of this newsletter, or to get off of this email list, click here.

InvestorsFriend Inc. Newsletter June 8, 2014

The $100,000 (per kid) RESP

Back in 2007 I said that it was quite reasonable to expect that if an RESP was started soon after the birth of a child, and funded at $2000 per year, this could grow to $100,000 or more by the time the child is in university.

At the end of 2007 my two children were ages 11 and 12. And their (joint) RESP was sitting at $36,387 each. So, I was a long way from $100,000 each. The money was invested mostly in equities (with some cash for stability and opportunities) and I added to it each year.

This week, amazingly enough, the account did hit  $100,299 per kid. This includes $10,000 that had been withdrawn for the eldest of the two.

In total from 1998 to 2012, I contributed $34,142 per child. The government grants amounted to $6,412. The remaining $59,745 per child has come from stock market gains. Basically, I contributed enough to get approximately the maximum 20% grant each year.

So, in my experience it was possible to get to $100,000 per child. I did not invest a penny in “safe” bonds or interest-bearing accounts. I was invested in a handful of stocks that I had confidence in, along with usually a modest amount of cash.

The particular stocks owned, at particular points in time, were as follows :

mid 2008 – Tim Hortons, Western Financial Group, Wilan, TSX Group, and Melcor

mid 2009 – Western Financial Group, Wilan, Melcor, AeroPlan, First Service Preferred, and Dalsa

mid 2010 – Melcor, Shaw Communications, Walmart, Berkshire Hathaway and Visa

mid 2011 – Melcor, Walmart, Berkshire Hathaway, and Canadian Tire

mid 2012 – Melcor, Walmart, Berkshire Hathaway, Canadian Tire and Toll Brothers

mid 2013 – Melcor, Canadian Tire and Toll Brothers, Canadian Western Bank, and Bombardier

Today – Melcor, Toll Brothers, Wells Fargo, and Enbridge Preferred Shares.

The cash position is unusually high at this time, at 42%.

It can be seen that the portfolio was concentrated in just a few stocks. There were no penny stocks and no energy or resource stocks and no “tech” stocks. The stocks held tended to be relatively boring companies. There was some trading but certainly the trading was not done at a frenzied pace at all.

Valuation of the Toronto Stock Exchange Index

Our reference article that attempts to determine if the Toronto Stock Exchange Index is an attractive investment at a point in time has been updated.

Canadian Exchange Traded Funds

Our reference article that provides a list of Canadian Exchange Traded Funds along with fundamental data such as the P/E ratio, the dividend yield and the price to book value ratio has been updated.

Subscribe

InvestorsFriend Inc. offers a service that rates a selected number of stocks as Buy or Sell and which has a very good and documented track record since inception 15 years ago. Those who are not already subscribers can learn more by clicking this link.

END

Shawn Allen, President
InvestorsFriend Inc.

To see older editions of this newsletter, or to get off of this email list , click here.

InvestorsFriend Inc. Newsletter May 3, 2014

The Ten-Bagger RRSP Account

The larger of the two Registered Retirement Savings Plan (RRSP) accounts that I manage just reached a rather impressive milestone. This RRSP is now worth ten times the amount of money that was ever contributed to it.

As of yesterday, every $1.00 contributed to it has now grown to $10. More to the point, every $10,000 contributed has now grown to $100,000.

Peter Lynch in his very popular 1989 classic book One Up On Wall Street,  talked about how he loved ten-baggers — stocks in which you’ve made ten times your money. He talked about his passion for ten-baggers and how appealing they can be.

He was perhaps too modest to mention that he had actually achieved more than a ten-bagger on the entire amount of the investment fund that he was managing. He achieved a 19 bagger in ten years.

I mentioned this same portfolio back in our June 2009 newsletter, at which time it was merely a four bagger. This portfolio was started in 1991. The weighted average length of time that the money has been invested is 14.0 years.  The compounded average return has been 17.9% per year.

How did my RRSP grow ten times?

The following describes how this RRSP did so well. I am not arguing that the approach used should be used by others. In fact most advisors would consider my approach to have been excessively risky.

This RRSP was always invested in accordance with the stock picks and thinking that I have been sharing here at www.investorsfriend.com since mid 1999. (Those of you that are not already customers can learn more about subscribing to our stock picks and investment analysis at this link.)

No portion of this RRSP was ever invested in bonds.

This RRSP was invested 100% in either stocks or cash at all times. The cash component was usually not large but did get as high as about 35% at times when I preferred to hold cash while waiting to identify an investment opportunity. The cash percentage tended to be higher at times when the market seemed over-valued.

A concentrated portfolio approach was used. Many times a single stock represented 10% or even sometimes 20% of this portfolio. (One cannot beat the market index by holding the market index.)

Stocks were always selected on the basis of fundamental value and never on the basis of momentum or any type of technical analysis. Stop loss orders were never used.

I never engaged in aggressive market timing in terms of getting completely out of stocks (or anything close to that) at any time.

The stocks invested in only rarely included very small cap stocks or penny stocks. They were mostly medium to larger cap companies.

Dividends were never a requirement but most of the stocks, being well established companies, did pay dividends.

Commodity stocks (oil and gas, mining, forestry) were virtually never included.

Companies that were not yet at a profitable stage (which often happens with internet and bio-technology companies) were seldom if ever included.

The performance was not because I found and bought and held individual ten-bagger stocks. I did find a few ten-baggers. I am not an active trader but I have not held many (if any) stocks continuously while they rose 10 fold.

All of this is not to suggest that there were no mistakes. A $3,354 investment, made in about 2005, in Mount Real of Montreal, which turned out to be a scam company, went to zero. A $776 investment, made in about 1999, in a tiny soft drink maker went to zero. There was an unfortunate investment in ENRON made after it had already fallen substantially. There were certainly a few other stocks that were purchased and then sold at a loss. In terms of trading it is never possible to optimize that and many times stocks were sold, or the position reduced, that should have been retained. Overall the performance of this RRSP has been extremely satisfactory despite the mistakes that were made.

I should also mention that my other investment accounts have not done quite as well although they have also done very well.

How to Think About the Cost of Stock Options to Companies

The most usual type of stock options work as follows. Executives are given the option (but not the obligation) to purchase shares for a given period of time such as five or ten years at a fixed price which is usually the price when the options are issued.

For example, imagine that an executive is awarded options to purchase 100,000 of  his company’s shares. And imagine that those shares are trading at $10.00 at the time the options are issued and that the options have a life of ten years.

The question arises as to what expense, if any, the company should book.

For many years there was no requirement to book an expense when options were issued, nor when they were exercised. In part this was due to the fact that at the issue date, the options usually had no intrinsic value. (They had no value if exercised although they would have had a market value.) And it was also due to the fact that the ultimate value to the executive could not be known in advance.

The value of the stock options to the executive depends upon the future share price. If the options were exercised in the future at a time when the share price had risen to $16, then the executive would have the right to purchase 100,000 shares for $10.00 each or $1 million. These shares would have a value of $16 each or $1.6 million. Therefore the pre-tax gain to the executive would be $600,000.

If the share price never rose above $10 even in ten years, or otherwise expired unexercised, then it could be argued that the options turned out to be of no value to the executive.

I would argue that the ultimate cost (or expense) to the company of providing the stock options cannot be known until they are exercised and that the cost is exactly the same as the value that the executive realizes upon the exercise of the options.

In the example above, the company was obliged to issue 100,000 shares for $1 million when it could have sold those same shares to someone else for $1.6 million. I would therefore argue that the cost to the company was $600,000. Or if the options had ultimately expired without being exercised then I would say that the cost was zero.

For the past number of years companies have been required to book an expense at the time that options are issued. This expense is necessarily only an approximation of what the issuance of the options will ultimately cost the company. The amount that is booked is based on the estimated market value of the options and is usually calculated using the “Black-Scholes” formula. While the expense that must be booked is only an estimate of the “true” expense, it has been said that it is better to be approximately right (book an estimate) than precisely wrong (book no expense).

Many companies are still trying to implicitly argue that there is no cost to the issuance of options because it is a non-cash expense. Many companies urge investors to “add back” this non-cash expense and any other stock-based compensation. These arguments are wrong, self-serving and ultimately irrational. Investors should be leery of managements that argue that options are not a real expense.

As an illustration, imagine that you were the sole owner of a newer and growing company that was worth $100,000. And imagine that you hired a manager for a modest salary of $50,000 and that as an incentive you granted the manger the option to purchase half of your company at any time in the next five years for $50,000. (Half the company for half its current value). And imagine that you and your manager worked very hard and that in five years your company was worth $1 million. You would now be obliged to sell half of your $1 million company for just $50,000. Clearly there would have been a cost to your issuance of the option. You were now obliged to sell something worth $500,000 for just $50,000.

Options may be a very legitimate form of compensation and incentive pay. But like other forms of compensation they do represent an expense.

It can be argued that the expense of options is borne by the other shareholders. The company never has to pay out cash when options are exercised. But the ownership position of the other shareholders is diminished when options are exercised. And not only is the ownership diminished but the company, on behalf of the other shareholders, does not receive the current market value of the new shares to be issued.

In summary, stock options most assuredly do have a cost and this cost should not be ignored in calculating the expenses of a company.

Berkshire Hathaway’s Investment Portfolio

Berkshire held its huge annual meeting today and released its Q1 earnings yesterday. It’s always useful to take a look at what Warren Buffett is invested in.

The following is the breakdown of Berkshire’s huge investment portfolio as of March 31, 2014.

Asset Class	Market Value ($ billions)	Percentage
Cash	$50	23%
Fixed Income	$29	13%
Equities	$137	63%
Total	$216	100%

Berkshire has a total of $495 billion in assets. Most of the assets are invested in the many businesses that it owns. $216 billion or 44% of the assets are invested in the marketable securities and cash indicated above. Of those investments, 63% are equities, 23% is cash and 13% is in fixed income. It therefore seems fair to say that Buffett is not a big fan of fixed income investments at this time. He does not view cash as an investment but rather as a parking place for funds that may be needed on short notice in the event of any huge losses in the insurance business or to buy additional businesses or stocks on short notice.

I understand that much of the cash is invested in very short term U.S. Treasury bills and not, for example, deposited in banks. It’s probably not feasible to keep anything close to $50 billion in any one bank and it is somewhat safer in Treasury bills.

Regarding equities, Buffett runs a highly concentrated portfolio.

Here is how the equity portfolio breakout looked at the end of 2013: (In the interest of quick readability, I have rounded to the nearest billion, the percentages are based on the more precise figures.)

Company	Market Value ($billions)	Percentage of total
Wells Fargo	$22	17%
Coke	$17	13%
American Express	$14	11%
IBM	$13	10%
Bank of America Warrants	$11	8%
Wal-Mart	$4	3%
Munich Re	$4	3%
Proctor & Gamble	$4	3%
Exxon	$4	3%
U.S. Bancorp	$4	3%
Sanofi	$2	2%
Goldman Sachs	$2	2%
Moody’s	$2	2%
Tesco plc	$2	1%
Phillips 66	$2	1%
All Others	$20	16%
Total	$128	100%

This is a concentrated equity portfolio. The top five positions account for 59% of the equity portfolio. In past years Berkshire’s equity portfolio was even more concentrated. Buffett’s two new investment managers likely account for the bulk, though not all, of the “all other” category.

The Fixed Income portion of the investments is broken out as follows:

Bond Category	Market Value ($ billions)	Percentage
U.S. Treasury (includes U.S. corporations and agencies)	$3	10%
State and municipal	$2	7%
Foreign governments	$12	42%
Corporate	$10	34%
Mortgage-backed securities	$2	7%
Total	$29	100%

Berkshire’s fixed income investments are concentrated in foreign bonds and corporate bonds.

Overall, Buffett does not follow conventional portfolio diversification practices. His results are also unconventional.

In a future edition of this newsletter I will take a look at the different types of insurance companies that Berkshire owns.

END

Shawn Allen, President
InvestorsFriend Inc.

To see older editions of this newsletter, or to get off of this email list , click here.

InvestorsFriend Inc. Newsletter April 6, 2014

A Raison d’être

The theme of this edition of the newsletter is that the way for most people to beome relatively wealthy is to invest in profitable corporations through the stock market.

InvestorsFriend.com started out almost 15 years ago as web site devoted to sharing my knowledge of investing. Quite a few years ago I set out the Mission as being to help investors grow rich through more intelligent (more business-like) investing. This weekend I decided to state that a bit more directly. InvestorsFriend.com exists to help people grow rich(er) through more intelligent (more business-like) investing. Or,  more succinctly, InvestorsFriend.com exists to help people get rich.

Now some might view that as a rather audacious claim. Some would view it as distasteful. Others as perhaps somewhat preposterous.

Nevertheless, I think helping people get rich, or at least richer, is the reason that this web site exists and finds an audience. There are certainly some people who find the idea of getting rich through investing to be a compelling idea, and who appreciate some help in how to do it.

Lately, I have been thinking about how people can get rich or accumulate wealth. For most people getting rich is going to involve saving and investing money over decades.

The following are a couple of new articles that I wrote on this theme.

Who Gets the Spoils of the Economy?

A modern economy produces an amazing abundance of products and services. Modern grocery stores are filled with a mind-boggling abundance. A Costco store contains a stunning array of high quality goods. Car dealerships are filled with enticing products. Modern homes are comfortable and often have as many washrooms as people. Entertainment is abundant. Communications services are instant, reliable and ubiquitous.

But all of this great abundance is neither created equally nor shared equally.

Click to continue reading the article

How to Get Rich

One could argue endlessly about what it means to be rich in financial terms. But most definitions would indicate that being rich means the ability to spend a large amount of money annually and to sustain that for many years, ideally for life. I would argue that while all rich people do not necessarily actually spend a lot each year, having the ability to do so, for many years or indefinitely, if desired is a necessary prerequisite to being rich. What constitutes a large amount of spending per year depends on your perspective and frame  of reference and is not a set amount. Most people might agree that those who make say five times more than they do are rich. So a minimum wage earner might consider everyone making $100,000 per year to be rich, while those making $100,000 per year consider that it takes $500,000 per year to be rich. Whatever your definition of what it means to be rich, this article discusses how it might be achieved.

Click to continue reading the article.

Understanding the Canadian Economy

Every year at this time I update my article that describes the contribution of each sector of the economy to GDP and who consumes that GDP. It also describes what goods Canada exports and imports and which countries are our main trading partners. This year I added which services Canada imports and exports. This article draws a lot of traffic from Google searches, presumably because this information is not that easy to find in one place.

Click to see this article

Is the Stock Market Over-Valued?

There is lots of speculation that the stock market may now be over-valued. I have updated two analysis articles that take a look at the evidence. Click the links to see these articles

Is the S&P 500 Index Over-Valued?

Is the Dow Jones Industrial Average Over-Valued?

Next Newsletter

In the next edition of this newsletter I hope to take a look at the valuation of the Toronto Stock Exchange. Also I plan to explore some thoughts on how wealth is created in the economy and how wealth creation is measured.

Subscribe

InvestorsFriend Inc. offers a stock rating service that has a very good track record. Those who are not already subscribers can learn more by clicking this link.

END

Shawn Allen, President
InvestorsFriend Inc.

To see older editions of this newsletter, or to get off of this email list , click here.

InvestorsFriend Inc. Newsletter February 8, 2014

At Last, $10 Trades for Everyone

There is good news for those just getting started investing in individual stocks.

For quite a few years Canadian investors with larger portfolios have been able to trade through self-directed discount brokers for about $10 per trade or even less. All of the large banks have offered such accounts.

Unfortunately those with the smallest accounts were charged about $30 per trade.

The $30 trades meant that realistically the minimum trade size that made sense was roughly $3000. (Since $30 is 1% of $3000). This, in turn meant that it was hard to even get started investing in individual stocks with less than perhaps $30,000. (Since $30,000 would be needed to have ten stocks which many would argue would be a minimum for diversification purposes). The need to have $30,000 to get started and the need to pay $30 per trade was a significant barrier to getting started investing in individual stocks even for people who wanted to do so.

Now a couple of the major banks are offering $10 trades for all accounts. TD and RBC have introduced the $10 trades for everyone and the other bank brokers may soon follow.

Unfortunately, I understand that TD still imposes a $100 annual fee on smaller RSP accounts and charges $25 per quarter as an inactivity fee. RBC does not charge the maintenance fee if you have at least $15,000 across all of your brokerage accounts with them.

With $10 trades investors can consider investing amounts as small as $1000 in individual stocks.

The 2008 Stock Market Crash – Was it Such a Bad Thing?

The stock market crash of 2008 / 2009 was a horrible thing for investors to live through. Many investors lost (at least temporarily) 50% or more of their stock investments. Bonds got crushed as well.

Many venerable and well-know companies went broke with investors losing their entire investment. This included General Motors, Lehman Brothers, Washington Mutual, Wachovia Bank and many others.

The crash bottomed out on March 9, 2009. And, five years later that stock crash is looking like just a temporary dip for the broader stock market indexes.

Investors who simply held on to their stocks have, on average, recovered all of their losses and went on to make good returns.

And it turns out that there were some absolutely incredible bargains available at that time. Investors who bravely bought near the lows have been richly rewarded.

Here are some figures (split-adjusted where appropriate)

Company	Dec. 31, 2007	March 9, 2009	Loss	8-Feb-14	Recovery	Gain per year since the low	Gain per year since end 2007
Dow Average	13,265	6,547	-51%	15,794	141%	19%	3%
S&P 500	1468	677	-54%	1797	165%	22%	3%
Toronto Index	13,833	7567	-45%	13,786	82%	13%	0%
Starbucks	$20.47	$8.27	-60%	$74.04	795%	55%	24%
American Express	$52.02	$10.64	-80%	$87.00	718%	52%	9%
Canadian Tire	$74.20	$39.82	-46%	$95.17	139%	19%	4%
Canadian National Railway	$23.33	$19.37	-17%	$60.66	213%	26%	17%
FedEx	$89.17	$34.28	-62%	$131.76	284%	31%	7%

The last column shows that those who simply rode out the stock market crash have made positive returns. In the case of the stock market indexes the returns were relatively small but still positive. In the case of Canadian National and Starbucks, the returns were exceptionally good.

The second last column shows that anyone who was brave and smart enough to buy at or near the lows has made spectacular returns on those purchases in the five years since the lows.

PREDICTING THE MARKETS

Time and again it has been proven that most investors have no hope of predicting where stock markets are headed. It’s basically a waste of time. People may have some limited ability to predict whether the economy is getting bettor or worse, or if interest rates will rise or fall. But the stock market has a habit of being out of step with these things.

What investors can do is react to stock market levels. If stocks seem very expensive then positions can be trimmed. This is not the same as predicting a market correction. This is simply saying that if stocks are expensive then on average it will be a wise move to trim equity exposures.  And if stocks seem very cheap or if they have fallen a lot then it would seem logical to buy stocks. Most investors should buy stocks steadily over their working lives and such a program will tend to work out quite well. It is simply not necessary to predict stock market moves to do well in stocks. As often has been said, the important thing is time in the market, not timing the market.

Subscribe

InvestorsFriend Inc. offers a stock rating service that has a very good track record. Those who are not already subscribers can learn more by clicking this link.

END

Shawn Allen, President
InvestorsFriend Inc.

To see older editions of this newsletter, or to get off of this email list , click here.

InvestorsFriend Inc. Newsletter January 19, 2014

Getting Started in Investing

Some of you reading this are seasoned investors. But at some point everyone was a beginner. The following are links to two articles that address how to get started in investing and how to get started investing in individual stocks (as opposed to mutual funds).

How to get started in investing

How to get started in investing in individual stocks (as opposed to mutual funds)

How Much Money Will You Accumulate Through Investing?

It depends on just three factors:

1. How Much you invest (and later withdraw) either initially, monthly or yearly

2. The average annual return that is earned on each dollar invested

3. The time that each dollar is left invested

Of these, the last, the time invested will often be, by far, the most important factor. Consider that $10,000 invested at 7% for 20 years will grow to $38,697. But $10,000 invested for 40 years (twice the time) at the same 7% return will grow to $149,745. By leaving the money invested twice as long, the accumulated amount is not merely twice as high, instead it is 3.9 times higher.

The average annual return earned is very important as well.

$10,000 invested at 8% for 40 years grows to $217,245. That’s 45% more than the result from a 7% return! And if you could somehow find a way to get double digit returns over a period of decades the wealth than can be generated is truly staggering. If you could squeak out an extra 1% by, for example, lowering your investment management fees, the extra wealth generated is quite stunning over 30 or 40 years.

If you are interested in accumulating a significant amount through investing (and especially if you are just getting started) you will need to try to maximize all three factors. It will help if you are younger, if you have more discretionary dollars to invest and if you are willing to leave the money grow for a very long time.

At this point, you cannot change your age, and you cannot change how much you invested (or withdrew) in the past, nor your past returns,  but you can still exercise considerable influence over each of the three factors listed above from this point forward.

It’s really all up to you. That, for better or for worse, is how the world works.

Compartmentalized Thinking

One thing that can be dangerous in investing is a human tendency toward compartmentalized thinking.

Consider the following two examples:

1. You own three stocks and each gains 10%, for an overall portfolio return of 10%.

2. You own three stocks, two of them rise 20% and the third loses 10%. Your overall portfolio return is the same 10%.

Many people seem to feel better about the first scenario, the loss in the second scenario bothers people even though the portfolio return was the same.

If you hold a stock and sell it and reinvest in another stock that rises 40%, and the first stock rises 30% after you sell it you may be bothered by this. Most will feel that they “missed” out on the 30% gain and they forget that the money was used to make an even bigger gain. In our minds we tend to somehow think we should have gotten both the 40% and the 30%.

When a companies outlook changes to the negative and we lose money on a stock we are often reluctant to accept the loss and move on to better investments. We often feel that we should hang on hoping that the stock will recover. In reality it is true that you don’t have to make back the money in the same place you lost it. But somehow our compartmentalized thinking habits seem to think we do need to get the money back from the losing stock.

The Meaning of Buffett’s Rule number 1: “Don’t Lose Money”.

I understand that Buffett has said that rule number 1 is “Don’t lose Money” and that his rule number 2 is “Don’t forget rule number 1”.

This advice can easily be seriously misinterpreted. When Buffett says “Don’t Lose Money”, he is certainly not suggesting that you should never buy a stock that could decline in price. That would mean you could never buy any stock.

Buffett does not consider the stock market (especially in the short term) to be the arbitrator of the “true” value of stocks.

What Buffett is referring to is don’t invest in a company that is at all likely to suffer a permanent decline in value. Stock market fluctuations are not of much concern to Buffett as long as the underlying value of a company continues to increase over the years as it retains part of its earnings and reinvests those and grows over the years.

My understanding is that Buffett would agree that preservation of capital is a good thing, he just measures it far differently than most other people.

When investors insist on never risking a decline in the market value of their investments they are usually making a serious mistake — unless they plan to spend the capital fairly quickly and are unable to ride through any temporary dips.

How Buffett Measures His Returns

Warren Buffett has had the vast majority of his vast wealth in a single stock, Berkshire Hathaway for about 45 years. I saw him state on television that over these many years there have been four occasions on which Berkshire’s stock value has declined by at least 50% from a prior high. I know there were huge declines in the stock in 2008 / 2009, also around the year 2000 and back in the early to mid 70’s.

I am sure he did not enjoy these price declines and felt badly for his investors. But basically these things don’t bother him much.

He has said from the very outset of his investing career that what really matters is the intrinsic value of his companies, not the market value. This is increasingly true in his case because when he buys a business outright (Berkshire makes an acquisition) he buys for keeps. I don’t think he has ever sold a subsidiary of Berkshire after buying it. He has had to close a (very) few down but he never sells. It’s part of his strategy that when you sell him a business he promises that Berkshire will never ever sort of strip it and sell it off for parts or sell it to another owner just to make a fast gain. When it comes to Buffett’s larger investments in stocks (Coke, American Express, IBM, Proctor and Gamble etc.) he is not in the habit of selling shares just because they spike up in price. He can buy on dips but he really can’t sell on rallies. Can you imagine what would happen if it was reported that he was selling even a tiny fraction of his Coke or American Express shares? The stocks would likely tank.

That is not to say that he can never sell shares. He does reduce his position in some companies from time to time. In earlier years this was much more frequent. Today he can do that with smaller positions especially partly because he now has two portfolio managers that handle part of his investments and with smaller positions the market would not know if it was him selling or his two portfolio managers.

In any case by desire and in part by necessity, Buffett tends to buy for keeps. Because he intends to keep investments indefinitely, he concerns himself with the profits from the businesses and not the price he could get if he sold. Even in the case of stocks, if the earnings per share grow at a strong rate over the years then the stock price will eventually reflect that notwithstanding its shorter term meanderings.

When it comes to Berkshire he annually makes a rough estimate of its intrinsic value per share (which figure he keeps to himself) and his goal is to increase that intrinsic value per share over the years. He relies on the increase in book value per share as an imperfect and understated proxy for intrinsic value and the growth in book value per share is dutifully reported to shareholders each year. As of the end of 2012 book value per share had risen by 587,000% or 5,870 fold since Buffett took control of Berkshire Hathaway in 1965.

Buffett’s goal is not to push Berkshire’s share price higher, as such. His goal is to continue to increase the intrinsic or true value per share of Berkshire and he is confident that the stock price will reflect such growth in the long term.

Meanwhile most investors are left to obsess about movements in share prices rather than focus on gains in the intrinsic values of our shares. In part, this is because the vast majority of investors have no ability to estimate changes in intrinsic value or to recognize if the current share price is above or below that intrinsic value.

Subscribe

Those of you who are not already subscribed to it can learn more about subscribing to our Stock Pick service at the following link:

Subscribe

You can also check out our testimonials page.

END

Shawn Allen, President
InvestorsFriend Inc.

To see older editions of this newsletter, or to get off of this email list , click here.

InvestorsFriend Inc. Newsletter December 26, 2013

Company Earnings and returns Versus Investor Returns

Most mature Companies on the stock market tend to make profits almost every year. And some companies show earnings that advance fairly steadily without great volatility. Investors in such companies however tend to see returns that lurch around violently.

Even a very broad index like the S&P 500, since the year 2000,  has seen “gains” as low as minus 38% (2008) and as high as 28% (this year). In these 14 years, four years have been negative and ten positive. The index gained only 19% in that entire time (about 1.25% per year). In only one year out of the past 14 was the gain on the S&P 500 index relatively close to its long term average.

Meanwhile the S&P 500 earnings, though they were volatile, were positive each and every year. The S&P 500 earnings are up 97% or 5.0% per year.

So the companies in the S&P 500 did well. They grew their earnings at a decent rate. But investors, on average, did not do well. This was because the P/E ratio fell 38% from a bloated and bubbly 30.5 at the start of the year 2000 to about 19 today.

The fact that investor gains and losses in the S&P 500 were hugely volatile in the past fourteen years while the earnings on the index were far less volatile (and never negative) may see strange. But it’s actually pretty normal.

Stock prices and the stock index levels are, in theory, the market’s best estimate of value of the expected future earnings of the company or the group of companies in the index. When estimates of the growth in earnings change moderately, this can have a fairly dramatic impact on valuation. And when the market’s consensus view of the required return on the index (which directly affects the P/E ratio) then changes in valuation can also be dramatic.

And while the valuation and returns on a broad index like the S&P 500 can be highly volatile even while the earnings are much more stable, the situation for an individual stock is far more dramatic. For a given company estimates of future earnings can change quite quickly and dramatically. Given dramatic changes in earnings estimates and changes in the required return (affected by interest rates and risk perceptions), the changes in a stocks value can be very dramatic indeed.

Therefore we arrive at a confusing situation whereby companies can make money while investors lose money. Or the opposite. There is nothing unusual about that. But that’s in the short term. Over the life of a company investors will ultimately make returns that are highly correlated to the actual earnings of individual companies and of the group of companies in stock indexes.

This being the case, it makes sense to focus investments on companies that are making good profit levels. (As opposed to focusing our investments on guessing which way the stock price will move in the short term). The following article addresses how companies make money.

The Dupont ROE Formula and How Companies Make Money For Investors

If you want to make money, go where the money is!¹

In the stock market it is possible to make money by buying a stock in a company that is not making any money and that will never make any money. If you buy the stock at one price and are able to sell it at a higher price, you can make money no matter that the company is losing money. But that’s a dangerous and risky strategy.

A far more reliable way to make money in the stock market is to buy (reasonably priced) shares in a profitable company and to benefit as the company continues to make profits over the years.

Investors should understand how companies make money.

This article will review the basics of a balance sheet and income statement and will out components that illustrate how companies can make attractive returns for their owners.

Click to read the full article.

Independent Advice

It occurs to me that most stock market advice is not all that independent. Certainly some of it is but much advice is not independent.

A great deal of stock market research is supplied by large investment banks. Here are some of the ways that independence of that advice is compromised:

• The companies being rated are often (though not always) clients of the bank both as commercial banking customers and as investment bank clients (the bank raises debt and equity capital for these companies).

• The analysts rely on having good relations with the company so that they can be kept apprised of certain developments at the company. These analysts often forecast the earnings of companies. I suspect that this is usually done with some assistance from the companies. It’s hard expect such assistance if an analyst is critical of management and/or suggests that the stock is over-valued.

• Analysts working for big firms cannot safely depart from conventional methods of analysis. If an analyst gets something wrong while following the same procedures as others, there is little risk. But woe betide to the analyst with an unconventional approach or conclusion that ends up wrong.

• Analysts working for big firms will usually have their work second-guessed by supervisors, therefore the result will trend towards average thinking and away from truly independent thinking.

With respect, it’s my conclusion that my work at InvestorsFriend is unusually independent. That is not to say that my work is unbiased. Everyone has their biases. But I believe it is fair to say that the stock picks at InvestorsFriend Inc. are based on highly independent research. I developed my own unique approach to stock research. I borrowed ideas from here there and everywhere. But I did the math and the thinking to convince myself of the merits of all of the various parts of the analysis.

END

Shawn Allen, President
InvestorsFriend Inc.

To see older editions of this newsletter, or to get off of this email list , click here.

InvestorsFriend Inc. Newsletter October 26, 2013

The Ideal Investment

The ideal investment would provide the following features:

– a high return that was constant and therefore predictable
– the high return would be after inflation
– the investment would never decline in market value
– It would be cashable or saleable at any time
– It would give you the choice of taking income each year or letting it compound
– It would allow injections of new money at any time

This ideal investment would be something like a very (very) high interest bank account paying some “X”% plus inflation.

In thinking about the return or interest rate that an ideal investment could realistically provide, the following is helpful:

In most 30-year periods the S&P 500 index (including dividends) has returned an average of 6% to 8% per year after inflation (although with very wide annual fluctuations around the average). At times the 30-year average has been below 6% (never below a 4.4% average  per year over any 30 calendar year period in our data base which starts in 1926). At times the &P 500 has returned more than an average 8% per year, after inflation, over a 30 year period with the highest being 10.6%.

Warren Buffett’s Berkshire Hathaway has returned about 20% per year over the past 48 years since Buffett took control. That’s about 17% per year after inflation.

It therefore seems reasonable to suggest that an ideal investment might return more than 6% but not more than 15%. And, it’s probably not realistic to target more than 8% to 10% per year after inflation even for an ideal investment.

Sadly, the ideal investment does not exist.

But it may be useful to think about which, actually available investments might be the closest to this ideal. The two main investment categories are stocks and bonds.

Bonds – 30-year government bonds are currently yielding about 3.4%. This is before inflation. High quality corporate bonds currently yield no more than 5.0%, before deducting inflation. It therefore seems clear that an investment in government bonds cannot possibly even approach our ideal target of at least 6% per year after inflation as a long-term average. Bonds can be good investments at times. That time does not appear to be now.

Stocks – When it comes to stocks we need to remember that stocks are ownership shares of corporations. In the long term the average return from owning stocks is limited by the earnings returns of the corporations that trade on the market. Many corporations on the market are earning 10% or higher returns on equities. This is before inflation. Logically, and mathematically, if a corporation continues to earn 10% or 14%, as the case may be, then long-term investors are ultimately going to benefit from those returns.

Unfortunately companies that are earning 10% and higher ROEs and are expected to continue to do so can rarely if ever be purchased in the stock market without paying perhaps two to three times book value. This can lower the return to an investor. Still, if an investor can later sell at the same multiple to book value then his return (except for dividends) is unaffected by paying a multiple of book value. And, if an investor holds for a very long time then the investors percentage return will not be greatly affected even if the multiple falls.

Stocks (the S&P 500) have historically usually achieved after-inflation long-term average returns of 6% or higher. And there are logical reasons to think that they may continue to do so given that they are oven earning in excess of 10% returns on their book equity. And they are, on average, retaining a good portion of their earnings and have historically been able to earn 10% ROEs on the retained amounts as well. Actually, at last check the average Return on Equity of the companies in the Dow Jones Industrial average was almost 18%. I would expect ROEs to trend down. But it does not seem unreasonable to assume that ROEs will remain above 10%. A company with a long-term ROE of 10% and which has a dividend pay-out ratio of 50% and which trades at twice book value would provide long-term average annual returns of 7.5%, before deducting inflation) to investors if those conditions continued. This possibly gets us to the minimum return of 6% from an ideal investment. And if the companies can continue to earn higher than 10% ROEs, as they currently are, then our expected return would increase. And if we can select better than average stocks (admittedly no easy task) then we can expect even better returns.

It is well known that higher return investments such as stocks and even longer-term bonds expose investors to large fluctuations in the market value of their portfolio.

So stocks at least offer the possibility of achieving the returns, although not the stability of our ideal investment.

If your situation is such that failure to preserve your capital could leave you freezing and starving in the dark at some future point then you may have no choice but to accept the low returns of the very safest investments. You will therefore, sadly, have no chance of getting ideal-investment-like returns.

If, on the other hand you are not ever going to be reliant on your investments to cover your most basic living needs then your goal may be to become rich through investing. If this is the case you will have to accept a good deal of volatility in your portfolio in order to reap the higher returns that are expected (but not guaranteed) from stock investments.

If you hope to make 6 or 8% or more after inflation, it makes sense to “fish where the fish are” You would need to invest in entities that are earning those kind of returns. Investing in things that earn 5% or less (before deducting inflation) is not likely to help you attain your goal.

None of this is meant to imply that stocks will make good returns, or even beat inflation, over any particular shorter period of time (like 10 years or less).

Recent and Future Stock Returns

Stocks, and especially U.S. stocks, have provided investors with outstanding returns in the past few years. The S&P 500 is up 23.4% in 2013. Including dividends, that is a return of about 25%.

Obviously stocks cannot and will not return 25% every year. After this recent gain of 25% it is very possible, perhaps even likely that stocks will decline or at best return very little in the next year.

Stocks however are not at the kind of extreme valuations where investors would be wise to avoid investing in stocks.

My strategy, which I do not suggest is suitable for others, is to place 60 to 70% of my funds in equities and the remainder in cash. I am not holding cash primarily to cushion my portfolio from volatility (although that is part of the reason I hold cash). I can live with considerable volatility. I am holding cash primarily in order take advantage of volatility (lower prices) whenever it occurs.

THERE’S PROBABLY NO ESCAPE FROM TAX ON RRSP WITHDRAWALS

If you are lucky enough to have amassed a fairly large RRSP account you may be wondering how to avoid income taxes on withdrawals.

My rather harsh conclusion on this is that the tax usually cannot be avoided and and also that we don’t deserve to avoid it.

Those who are greatly disturbed by paying high income taxes on RRSP withdrawals may need to be reminded that “their” RRSP was effectively subsidized by an income tax refund at the time the money was contributed to the RRSP.

Mathematically, $10,000 originally invested in an RRSP cost the investor only $6000 assuming a $4000 tax refund, which applied if the contributor’s marginal income tax rate was 40%. If the $10,000 in the RRSP later grows to $100,000 and if $40,000 is paid in taxes, this can be thought of as giving the government back “its” 40% of “your” RRSP while you net $60,000 which is precisely equivalent to your cost of $6000 grown completely tax-free to $60,000.

The “deal” was we got an initial tax break and then years of tax-free compounding but then we pay tax on withdrawals. No one was forced to contribute to an RRSP.

In any case whether the income tax is fair or not, it is is not likely that it can be avoided.

I am by no means an income tax expert and so the following is not meant to be exact but does give a reasonable idea of the income tax rates paid on RRSP withdrawals.

Consider the marginal Income tax rates in Ontario.

Taxable Income	Marginal Income Tax Rate
First $39,723 of taxable income	20.05%
Next $3,838 ($39, 723 to $43,561)	24.15%
Next $26,402 ($43,561toat $69,963)	31.15% (add 15% old age pension claw back if net income is over $70,954)
Next $9,485 ($69,963 to $79,448)	32.98% (add 15% old age pension claw back if net income is over $70,954)
Next $2,974 ($79,448 to $82,422)	35.39% (add 15% old age pension claw back if net income is over $70,954)
Next $4,701 ($82,422 to $87,123)	39.41% (add 15% old age pension claw back if net income is over $70,954)
Next $47,931 ($87,123 to $135,054)	43.41% (add 15% old age pension claw back if net income is over $70,954 but this ends at net income of $115,034)
Next $373,946 ($135,054 to $509,000)	46.41%
Taxable income over  $509,000	49.53%  (A nice “problem” to have)

If you are lucky enough to have $500,000 in an RRSP, here is how things might look if you begin withdrawing at age 65.

Your Old Age Pension Amount $6,612
Your Canada Pension Amount $12,150 (current maximum)
Your RRSP withdrawal $25,000 (based on 5% withdrawal)
Total Income $43,762
less personal deduction ($10,822)
Pension Income Deduction ($2,000)
Taxable Income $30,940

In this case the tax rate on the entire $25,000 RRSP withdrawal appears to be 20.05% or $5,012. This hardly seems at all unfair given that the original income tax refund rate was probably at least that high and quite possibly double that.

The only way to avoid the 20% tax here would be to have year where you only make  $12,822 and so the basic and pension deduction shelters all your income. So, for example, one could quit working a year early at 64 and could pull a whole $12,822 out of the RRSP and avoid the 20% tax or $2,564. Quitting work a year early simply to avoid a rather measly $2,564 in tax would not seem too wise.

Let’s look at another scenario where we also have $50,000 in pension income and so are in a higher tax bracket.

Your Old Age Pension Amount $6,612
Your Canada Pension Amount $12,150
Your Pension $50,000
Your RRSP withdrawal $25,000
Total Income $93,762
less personal deduction ($10,822)
Pension Income Deduction ($2,000)
Taxable Income $80,940

In this case, let’s assume that the old age pension claw back of 15% also applies to each dollar taken out of the RRSP (the net income here is almost at the start of the claw back threshold even before any RRSP income). Now the tax on the $25,000 RRSP withdrawal is:

35.39% plus 15% = 50.39% on the $1492  that is above $79,448
32.98% plus 15% = 47.98% on $9,485
31.15% plus 15% = 46.15% on the remaining $14,023

The total income tax on the $25,000 RRSP withdrawal is $11,775 or 47%.

In this case with the average tax on the RRSP being about  47%, it is certainly worth thinking about how to avoid it. The biggest reason to try to avoid the tax is the extra 15% “tax” due to the old age claw back. But the old age pension only starts at age 65 and most pension income could not be deferred. It might be worth deferring the CPP which is a maximum of $12,150 and will increase if deferred. This could save 15% of that amount in taxes or $1822. It might be possible to withdraw a large portion of the RRSP before age 65. But that lowers the time for tax-free compounding. It could also mean giving up work earlier than planed.

Those who retire well before age 65 may benefit from lower taxes on RRSP withdrawals since the claw back would not yet apply. But the available savings do not appear to be enough of a reason to retire early simply to avoid RRSP taxes. Retiring one year early saves little tax. Retiring ten years early could save a fair amount of tax by taking withdrawals before the old age pension applies, but retiring ten years early means foregoing significant income.

A possible scenario, which might make sense for a few people who will be in the old age claw back range is to withdraw RRSP money while still working (say ages 55 to 64 or 60 to 64) and avoid the 15% claw back and then make no RRSP withdrawals from age 65 through 70. (RRSP withdrawals become mandatory at age 71)

Overall, there does not appear to be that much opportunity to avoid income taxes on RRSP withdrawals. However, if you consider that “your” RRSP was subsidized to the tune of 30 to 40% through tax refunds on RRSP contributions then a 30 to 40% tax rate on RRSP withdrawals does not seem unfair. And decades of tax-free compounding can mean that you are ahead of the game even with 50% tax rates.

I have read about schemes to offset taxes on RRSP withdrawals by borrowing money to invest and deducting the interest paid. This requires that the invested money attract no near-term taxable return – such as by investing and holding non-dividend stocks. But at today’s low interest rates it would require the borrowing of massive amounts of money. Creating $25,000 in interest payments requires a $625,000 loan at 4% interest. Also it can be difficult to borrow on an interest-only basis. I don’t think it is a worthwhile strategy. Avoiding 40% tax on an RRSP by paying all of the RRSP withdrawal in interest payments, does not strike me as a winning idea. If one is lucky enough to have large RRSP income, one should probably just pay the tax and not engage in aggressive attempts to avoid it.

Our Performance in 2013

Our Stock Picks in 2013 have performed beyond expectations. 2013 is shaping up to be one of our best years since our inception in 1999.

Ponder the following chart:

This chart shows the percentage gain or loss on each of the 23 stocks that we rated as Buy or Sell at the start of 2013. Since we mostly look for stocks that we think will rise, only one stock, the one at the bottom was rated Sell. 19 out of the 22 Buy rated stocks rose in price. 5 of the 22 have risen more than 40%. 14 of the 22 have risen at least 20%. Only 3 of the 22 fell in price and the largest decline was 16%.

We would be the first to admit that the above chart looks too good to be true. It is our true performance for 2013. But we would not expect to do this well in an average year. But we have beaten the market by an average of 11% per year for the past fourteen years. We only trailed the market in two years, which was 2007 when we trailed by 8% and 2010 when we trailed by only 0.4%.

Subscription Service

We make absolutely no guarantees about our future performance. But if you agree that InvestorsFriend Inc. appears to provide good stock picks based on logical analysis then why not subscribe now? (Click the link at the top of this page for more information.) The cost is $15 per month or $150 per year. Many stock picking services charge double or triple this amount or even more.

END

Shawn Allen, President
InvestorsFriend Inc.

 

InvestorsFriend Inc. Newsletter September 29, 2013

Stock Market Returns (Recent and Future)

Investors in U.S. stocks have, on average, done very well in 2013 and very well since 2009. But if 2008 is included then they have not done well. Investors in Canadian stocks did well, on average, in 2009 and 2010 but not since then.

Here are some figures.

	2008	2009	2010	2011	2012	2013 through September 29
Toronto Stock Index	-35%	31%	14%	-11%	4%	3%
S&P 500	-38%	19%	13%	0%	13%	19%

The recent past pattern of investment returns is of little value in predicting future returns. In fact, I don’t think it is possible to predict the short-term direction of markets.

What we can do however is make reasonable judgments as to whether current stock market prices are reasonably priced in regards to the potential to make reasonable returns in the long run.

My most recent analysis of the Toronto Stock Index concluded that a reasonable value for the Toronto stock index (if a 7% return was targeted) was in the range of 12,630. Since the Toronto index is currently at 12,844, my assessment is that the Toronto index is reasonably priced and should provide a long-run return in the range of 7%. The range around the estimated 7% average over 10-years is large and it could feasibly instead average 4% to 10% per year. We should expect the return to be negative in some years.

My most recent analysis of the S&P 500 Index concluded that a reasonable value for the S&P 500 index (if a 7% return was targeted) was in the range of 1410. Since the index is currently at 1692, my assessment is that the S&P 500 index is somewhat over priced and should provide a long-run return in the range of 5%. The range around the estimated 5% average over 10-years is large and it could feasibly instead average  2% to 8% per year. We should expect the return to be negative in some years.

World Economic Events and Investing

World economic events including various wars, terrorist threats, recessions, bankruptcies of counties, slower growth of emerging counties, climate change, trade treaties and trade wars and many others can certainly  have major impacts on investment values. However, these events are unpredictable. Many events such as the demise of the euro or the insolvency of countries are constantly predicted to happen but usually don’t happen or have not yet happened. When these events do happen, it is usually too late to react. Stocks can open lower with no opportunity to sell before the decline.

The best approach to world economic events is usually to ignore them. Warren Buffett has always said that the fear of such events does not impact his investment decisions. To be sure, if stock prices decline after such an event he often takes advantage of that. But he does not sell stocks or refrain from buying them out of fear of such events.

Recently investors feared the impacts of the civil war in Syria. But it appears that the situation has cooled down somewhat and it appears that it would have been unwise to sell stocks due to fears related to the situation in Syria.

Today, the fear of the moment is about the possible shut-down of the U.S. government as the house and senate appear set to fail to pass a budget bill. It does seem likely that stocks would decline somewhat on that news. Then again perhaps the situation will be averted at the last minute. I am prepared to buy if stocks fall due to this but I am not prepared to sell on speculation that stocks could fall.

Next up will be the debt ceiling debate which again appears set to go down to the last minute in mid October. The market took this seriously when it happened back in August 2011 but then the crisis was averted and the market recovered. Perhaps this time the market will decide to ignore the political theatrics. We shall see. Again, my strategy is to keep some cash on hand to take advantage of possible bargains but I do not intend to sell stocks due to this fear.

Defined Benefit Pension Plans – Relief May Finally be in Sight

Ever since stock markets crashed in the early 2000’s, defined benefit pension plans have been hammered by bad news including another stock market crash in 2008 and, most damaging of all, brutally low interest rates that have caused pension liabilities to soar. Most defined benefit pension plans are in a deficit position despite large increases in contributions. Many defined benefit pension plans have been closed to new members or shut down altogether. Even government plans are reducing benefits to deal with the problem.

However in 2013 many defined benefit pension plans are starting to turn the corner. Market returns have improved and most importantly, interest rates have started to rise. Pension deficits are starting to shrink. This topic is explained further in my updated defined benefit pension article.

Attractive Value Ratios Are Neither Necessary Nor Sufficient

Whenever a potential stock investment is mentioned the first question that is often asked is “does it pay a dividend”?

The assumption appears to be that only dividend paying stocks are good investments. If so, someone forgot to tell stocks like Berkshire Hathaway which has been a spectacular investment despite the fact that its last dividend consisted of a lowly and lonely ten cents paid in 1967. Another example is Stantec Inc. which has risen over 2000% from $2.50 in September 1999 to $53.66 today. It traditionally did not pay a dividend and only started to pay a dividend in 2012.

Many investors insist on a high dividend yield. Others insist on a low price to earnings (P/B) ratio. Others insist on things like a low debt level, strong cash flow, strong revenue growth, strong earnings growth or a high return on equity.

These are all good qualities to look for in an investment. And they may tend to work on average. But there simply is no valuation ratio of this sort that is either strictly necessary or sufficient, on its own, to qualify a company as a good investment.

For one thing these ratios are calculated at a point in time. At many companies profits can be notoriously volatile. A profit figure that is affected by a large and unusual gain or loss can completely distort ratios such as the P/E ration, the earnings growth, return on equity and return on capital.

The payment of a dividend is no guarantee of a good investment. There have been many cases where companies continued to pay dividends even as earnings evaporated. Obviously, that can only occur for a limited period of time.

In some cases investors are far better off if the company does not pay a dividend. If a company has the opportunity to grow and can invest in highly profitable projects and expansion opportunities then investors may be better off if the money is used for that investment rather than paid out as dividends.

In theory, every good investment in a stock should be made at a share price that is not greater than the estimated true (or intrinsic) value per share. In theory then, a price to intrinsic value ratio must never be grater than 1.0. In practice it is impossible to ever precisely know the intrinsic value. However, for some companies reasonable and conservative estimates can be made.

In conclusion, investors should be cautious when adopting strict rules about dividends or other value ratios. There simply is no one ratio that is both necessary and sufficient to assure that a given stock is a good investment. Nor can any one ratio conclusively rule out a company as a good investment.

END

Shawn Allen, President
InvestorsFriend Inc.

To see older editions of this newsletter, or to get off of this email list , click here.

InvestorsFriend Inc. Newsletter July 28, 2013

To understand stocks, you should first understand business.

I think it is safe to say that most investors struggle to figure out which stocks might be a good investment.

There are basically two broad ways to analyze stocks. The first way is by fundamentals (such things as earnings per share, book value per share, growth outlook, competitive advantage, and quality of management). The second way is by analysis of the price chart looking for trends or patterns.

My view is that attempting to analyze stocks based on price trends and  patterns and charts is usually sheer folly. This method attempts to figure what “the market” thinks of the price and where the price is headed. A fundamental flaw in this approach is that if the market really thought that a $20 stock should be $10, it would already be at $10. Price or chart analysis may work for some people but I have no interest in it at all.

In order to make any sense of a stock’s value based on fundamental analysis we have to look not at the stock but at the underlying business.

In order to understand stock valuations we must first understand the basics of business.

Every investor who is selecting their own stocks should learn the basics of accounting, finance and competition.

It’s not possible to understand the profitability of any company without knowing something about accounting. You can’t determine which companies might be at risk for financial difficulty without knowing a little bit about how to read a balance sheet and understand debt levels in relation to assets and in relation to profits and cash flows. You can’t judge whether a company is vulnerable to price competition without knowing a little bit about competitive advantages.

Think about the businesses in your City that are busy and that appear to be profitable. How many of them are national brand name businesses as opposed to one-off privately ran firms. How important is brand recognition and advertising to their business? How important is their location. Do they have high fixed costs? Are they forced to offer the lowest price to compete for business or they the only game in town for a particular product or service? How price conscious are their customers, do the customers shop around for this product or service based on price? Do they sell a product or service that people need to buy regularly or is their product more of a one-time sale? Can customers easily switch suppliers with each purchase or are there things that keep them tied to a particular business?

And think about the businesses that have fewer customers or that otherwise appear to be making limited or no profits. What is the problem? Too much competition, bad location, poor service, high costs, too few customers to cover the fixed costs, lack of repeat business, lack of buying power?

The more you think about businesses and which ones appear to be profitable, the more you will understand which type of companies on the stock exchange make the best profits and the better able you will be to select good investments.

The Basis for an Investment Recommendation

The Chartered Financial Analysts code of ethics (part V A 2) requires that CFA members must Have a reasonable and adequate basis, supported by appropriate research and investigation, for any investment analysis, recommendation, or action.”

In my experience this rule is violated routinely by investment analysts appearing on television. In the investment world the amount of diligence and analysis that goes into recommending something as an investment ranges from reports of 50 pages or more prepared by an analyst (or team of analysts) that is familiar with an industry and who has become familiar with a particular company over a period of years to recommendations that are seemingly based on nothing more than a feeling that a stock still has “room to rise”.

At InvestorsFriend our recommendations cannot and do not always turn out to be correct. But we never make recommendations without some basis and analysis behind the recommendation.

Before we rate any stock we first fill out a fairly lengthy standard template that crunches the numbers and summarizes many non-numerical aspects of the company. To add a new company to our list would typically take at least 10 hours of effort and often more. Companies that have been on our list for years often have hundreds of hours of work invested in creating and updating the report and attempting to understand the business over the years. The current  recommendation is informed by all of that work. Again, our rating may turn out to be wrong, especially in the short term. But we always have a detailed and fully documented basis for the recommendation. Our stock ratings or recommendations however are always generic in that they cannot and do not take into account the circumstances of any individual investor.

When asked for “our take” on any company not on our list, we will not provide it. In fact we typically have no such “take”. We try hard not to arrive at opinions in advance of analysis. Therefore we have ratings and opinions on a only small group of companies, but backed up by considerable (although not exhaustive) analysis. Many analysts do not appear to follow such a rule.

On television, we see many analysts who are willing to give a buy or sell rating on a stock with what appears to be almost no thought at all. Television loves 10 second sound bites. We don’t think that is a proper basis for investment.

We don’t think the so-called technical analysis of price charts provides much value. And we don’t think it should ever be relied on in the absence of also looking at the fundamentals of the company including the price in relation to those fundamentals.

The next time you hear a stock recommended on television, think about how much of a basis the analyst appears to have for that recommendation.

I suspect that watching investment analysts on television is usually counter-productive because it usually promotes a day-trading mentality and an approach often devoid of any real basis.

InvestorsFriend’s 2013 Stock Picks

In 2013, to date. our Stock Picks are once again performing very well.

The Dow Jones Industrial Average and the S&P 500 are each up 18.7% this year to date. Toronto has lagged significantly and is up only 1.7%.

Our stocks picks include both U.S. and Canadian stocks.

Our three Strong Buys from January 1 are up 21%, 27% and 23% for an average of 24%. None of these were tiny companies or penny stocks by any means. One of these is a very large U.S. Bank, one is a large Canadian retailer and one is small (but not tiny) Canadian property development company. All pay dividends.

Our 19 companies that were rated in the Buy range as of January 1 are up an average of 14.2%. The individual price changes range from minus 11% (a large Canadian REIT) to a gain of 31% (a very famous U.S. conglomerate). Most of these 19 companies pay a regular dividend and they range in size from small to extremely large. None are remotely close to being penny stocks and none are micro cap companies. (Tiny companies are considered much riskier). In other words our strong returns came from some pretty normal sort of boring companies.

None of our 22 stock picks from January 1 were energy stocks or resource stocks or commodity stocks of any kind.

Since January 1 our ratings have changed somewhat. We currently have just one company that we consider to be in the Strong Buy range. In general our ratings have declined somewhat due to the price rises in our stocks.

To learn more about how to subscribe to our Stock Picks, click this link.

Can Stocks Provide A Decent Return when GDP is growing at 2%?

Some of those who believe that stocks are no place to make money like to question how investors in stocks can even possibly expect the make money if GDP is growing at only about 2%.

It is true that stocks will tend to make higher returns, in the long run, when the economy is growing faster. (Although some of that higher return can be negated by the higher inflation which is usually associated with higher economic growth.)

However, it would be wrong to conclude that you can’t make decent returns in stocks if GDP grows at only 2%.

Firstly, we should remember that GDP growth is almost always stated in “real dollars”, before inflation. GDP in actual dollars is higher because it includes inflation. So if we have 1 to 2% inflation then GDP growth of 2% really means 3% to 4% in actual dollar terms.

Second, we should remember that dividends add to stock returns. A company that grows earnings per share at 4% per year and pays a dividend of 3% can be expected to provide a long term return of 7%, assuming that the P/E (price to earnings) ratio is relatively unchanged in the long term.

So, if GPD growth is 2% in real (inflation adjusted) dollars and 3% to 4% in actual dollars and if the dividend yield is 2% to 3%, then we can easily forecast stock returns of 5% to 7% assuming no change in the P/E ratio.

In the shorter term, P/E ratios change all the time. In the longer term they tend to be relatively stable for the market as a whole.

We should also remember that individual companies grow at vastly different rates. No matter how fast or slow the economy is growing there are always some companies that are growing very rapidly and others that are shrinking. In the case of individual companies however the P/E ratios can be very volatile and one has to be cautious about paying too high of a P/E ratio.

There can also be a significant trade-off between growth and dividends. Growth usually requires that a large portion of current earnings be retained by the company and invested in expanding the business. That leaves less or no money available for dividends. On average, if the GDP rate for the country is going to be lower then companies will be investing less for growth and on average the dividend payouts and yields should rise.

If you think about the businesses where you live, many of them don’t require growth to provide excellent returns to their owners. If a 200 seat restaurant is sufficiently busy and is making a good profit, that situation could go on indefinitely without any growth in the number of customers served. The owner of a single Tim Hortons location may make an excellent living for may years without ever expanding the location and with a constant level of traffic.

The fact is that growth is neither a necessary nor a sufficient condition for a company to be a good investment.

A proposal to facilitate investment portability – To cut the chains that bind investors to a single advisor or broker

Most investors today are effectively chained to a single broker or advisor. It’s inconvenient to switch advisors and it is somewhat inconvenient to deal with more than one broker or advisor. I don’t know the exact history of how this evolved but I believe the following is basically how it happened.

Some decades ago, when you bought bonds or shares through a broker you paid a one-time commission and you soon received the bonds or share certificates in the mail. You kept these in a safe place such as a bank safe deposit box. When you wanted to sell you brought the share certificates to any broker of your choice. You were not tied to any particular broker. You could buy from several brokers and sell through several if you wished.

There are advantages and disadvantages to such a system. In this system your broker did not hold your assets and so you did not receive consolidated statements. Dividend cheques were mailed directly to you. Your broker(s) did not send you summaries at year end for income tax preparation.

With this system brokers could work to sell shares to anyone. They could do a one-time sale to a new customer. In contrast, today a broker tends to get all of your business or none of it. This older system was open to some abuse because it was possible to market shares door-to-door or by telephone and no-doubt some of these turned out to very dubious or outright frauds.

Some people found it convenient to have their broker look after their share certificates for safe-keeping and faster access for trading. Some of these had the shares held in the name of the broker in-trust for the client. In this case the customer was to some degree tied to his or her broker.

Eventually it became normal to leave shares in the name of the broker. Customers became tied to their (usually) single broker. The advent of registered tax advantaged retirement accounts also tended to tie customers to a single broker since the account had to be registered through a broker.

With this new model, brokerages began to think of themselves as in some way “owning” their customers. They began to count their customer’s investments certificates, which they held in trust as brokerage assets under management. This model eventually allowed a move away from paying brokers and advisors only for buy / sell transactions to paying an on-going annual fee for assets under management.

In more recent years, paper stock and bond certificates have become virtually obsolete. Brokers no longer hold your shares as paper certificates. There is a central stock transfer agency that holds the name of who owns each stock and bond. Usually the shares are held in the name of the broker but it is possible to register shares in your own name. Shares held in tax advantaged registered plan may have to be held in the brokers name.

With the demise of paper ownership certificates and the advent of all electronic ownership lists it may be time to rethink some things.

If I own 200 shares of Bank of America, in what sense does my (discount) broker (TD Waterhouse) have those shares as assets under management?

When I bought the shares my broker arranged the sale trough the stock exchange. My broker arranged for the money to flow from my account to the account of the seller at the seller’s brokerage. The share transfer agency recorded that my broker now held those 200 shares. But they are held in trust for me. They are not assets of my broker. My broker retains certain responsibilities for those shares including receiving dividends and crediting those to my account. My broker must also, in the case of U.S. shares not held in an RRSP account, withhold a portion of the dividends as taxes and submit those to the U.S. taxation authorities. My broker must pass along and mail out to me (unless I opt for electronic delivery) certain materials from Bank of America including the annual report and voting instructions. My broker must include the 200 shares of Bank of America on my monthly investment statement. And they provide an online account summary as well. They facilitate my ability to sell those shares online in seconds.

When it comes to something like shares of Bank of America my online broker must do a large amount of administrative work. The only payment they receive from me for that is a one-time payment of $9.99 when I buy or sell shares. This is actually very small compensation especially if I end up keeping those shares for years. They also get the use of any cash in my account which is effectively a short-term deposit that they can use to fund loans since not all their clients will withdraw or spend the cash in the investment account on short notice.

While this model of my discount broker “holding” or administering all of my investments in one account is cost-effective and works well, it does have its disadvantages. It definitely ties me to my broker. If my broker is not participating in a certain initial public offering then I simply cannot buy those shares via the initial public offering. (I could buy at the IPO if I opened an account with the second broker and I can buy when they start trading.) If my discount broker does not deal in certain bonds then I simply can’t buy them in that account. If another broker was recommending a certain stock I could not simply buy the stock through him and have it go into my TD Waterhouse account. I would have to open an account with that other broker, which is inconvenient.

Given that the ownership of all bonds and stocks is tracked centrally through the stock transfer agent, I believe a new or alternative model is possible.

I propose that the stock transfer agent allow retail investors to deal with it directly. In the model I propose, the stock transfer agent would not offer cash accounts to customers. It would continue to simply keep track of who owned what. A retail investor would open a money market or a bank deposit account that trades like a mutual fund. (Banks already offer deposit accounts that can be purchased inside of any investment account, these can be bought and sold like mutual funds).

The retail investor would then open an on-line account with the stock transfer agent. This account would look like existing discount broker accounts. Cash would flow from and to the investor’s designated cash account (typically a cash mutual fund account). Stocks, bonds and mutual funds could be bought and sold on-line  just like in existing discount broker accounts. A key difference would be that these accounts would be open access. Investors would be able to buy shares through various third parties like any broker or advisor or mutual fund company or perhaps directly from a corporation. That seller would receive the money and would direct that whatever was purchased would go into your account at the stock transfer agent. Brokers and advisors would charge a one-time fee for the trade. Investors would be tied to the stock transfer agent but not to any broker or advisor. The stock transfer agent would have to take on the administrative duties currently carried out by brokers. The existing system of having your account tied to a particular broker or advisor could also continue in parallel with this new system.

If the above cannot be done then, at the very least I propose that the stock transfer agent record the name of the ultimate owner of each share. That is, all shares and investment would be automatically “registered” in a manner that includes the investors name by default. (Probably with an ability to opt out for privacy.) The issuing companies would be allowed to access the list of their owners and communicate directly with them.

Possibly my proposal solves a problem that does not exist. I’d be interested in your thoughts. Click to email shawn@investorsfriend.com

END

Shawn Allen, President
InvestorsFriend Inc.

To see older editions of this newsletter, or to get off of this email list , click here.

InvestorsFriend Inc. Newsletter June 15, 2013

The First Rule of Finance, Courtesy of Aesop’s Fables:

“A Bird in the Hand is Worth Two in the Bush.”

In his annual letter for the year 2000 Warren Buffett explained that Aesop’s ancient insight that “a bird in the hand is worth two in the bush” provides the basics of a universal and immutable formula for evaluating all investment or lending situations where you are laying out cash now in expectation of receiving more cash sometime in the future. Therefore it applies to placing a value on all stocks, businesses, bonds, farmland, lottery tickets, oil royalties, manufacturing plants, and collectibles (to name just a few).

It’s worth reviewing this, the most basic of the rules and formulas of finance, because it is impossible to fully understand more complex aspects of finance and investment valuation without first fully understanding this basic concept.

Consider the case of the value of a dollar in your hand today versus the value of a dollar to be received in the future and where it is 100% certain  that dollar will be received in the future.

A dollar in your hand today is worth more to you than a dollar to be received in a month, a year, a decade or fifty years. The most basic reason for this is that if you have the dollar on hand today you can choose to use it to buy and consume something today or you can chooseto hang onto it and buy something in a month, a year a decade or whatever. In the case of a dollar to be received in ten years you no longer have the ability to spend that dollar now or anytime between now and ten years from now. Rationally you will value a dollar today more highly than a dollar to be received in ten years. And this is universally true even before considering the risk of inflation or any risk that you will not in fact receive the dollar as promised in ten years.

Investments in the securities of strong governments like the U.S. or Canadian government are considered to be completely risk free. It is considered that if you invest in a U.S. government treasury bill or bond that you will – of a certainty – receive your money at the maturity date as scheduled. There can be no certainty regarding inflation but it is considered certain and risk free that you will receive your money back as promised.

As of today, the annual interest rate on a 10-year zero-coupon U.S. treasury bond is 2.25%. The market price today to receive $1.00 from the U.S. government in ten years is therefore 80.05 cents. Of course there are minimum dollar amounts that would have to be invested but the market rate is 80.05 cents invested today (effectively loaned to the U.S. government) gets you $1.00 in ten years.

The math works like this 80.05 cents times (1.0225) (to the power of ten) equals $1.00.

For various time periods the following table shows in effect the current value of a dollar to be received, on a risk free basis, in one month, one year, ten years etc.

Time delay before $1.00 is received	Interest rate per year	Value today ($1.00 divided by 1 plus interest rate to the power of the number of years)
One month	0.04%	99.997 cents
Six months	0.08%	99.96 cents
One year	0.13%	99.87 cents
Five years	1.01%	95.10 cents
Ten years	2.25%	80.05 cents
30 years	3.53%	35.32 cents

Applying Aesop’s terminology, we might say 35.32 cents in the hand is worth a dollar in the bush, if the $1.00 in the bush is going to emerge into our hand of a certainty in 30 years. Or $1.00 in the hand is worth almost $3.00 that will emerge from a bush and into your hand in 30 years.

Today’s interest rates (i.e. the discounts to be applied to money to be received in future) are close to the lowest in history. The reasons for that are numerous and complicated and I will not attempt to discuss the reasons in this article.

From the above table you can see that if you invest on a risk free basis there is almost no return available unless you are wiling to invest for at least five years.

If instead we invest in situations where there is some risk or uncertainty about whether we will actually receive the dollar when promised and/or where the amount we will ultimately receive is uncertain then investors require an expected return that is higher than and often dramatically higher than the risk free interest rates in the above table. It is often forgotten or left unsaid but when we speak of investors having a certain required return on a risky investment it is actually a required expected return. If the return were absolutely certain (instead of onlyexpected) then the much lower risk free rates would apply.

Today’s market returns on risky investments such as equities (stocks) are not directly observable and vary with the perceived risk. The following table illustrates the value of a dollar at various required expected (but not certain) returns.

Time delay before an estimated but risky $1.00 is received	Expected but not guaranteed return	Value today ($1.00 divided by 1 plus expected return to the power of the number of years)
One month	4%	99.67 cents
Six months	4%	98.06 cents
One year	5%	95.24 cents
Five years	6%	74.73 cents
Ten years	8%	46.32 cents
30 years	8%	9.94 cents

The above table presents the discount that would be applicable to a risky dollar to be received at various times in the future based on the required expected returns indicated.

In Aesop’s terms the table above suggests that if the required expected return is 8% then $1.00 in the hand today is worth about $10.00 expected (but not guaranteed) to emerge from the bush into your hand in 30 years.

This concept of the the discounted value of a future dollar, also known as the present value is perhaps the most basic concept in the world of lending and investing. It truly pays to understand this concept.

Do Not Hoard Business Ideas

Have you ever had an idea for a new business venture? Have you hesitated to talk about it out of fear that people would steal your idea? My advice is don’t worry about such theft. It’s unlikely that more than one out of a hundred people that you talk to would seriously consider starting a new business venture in the next year or so. And of that one in hundred it is highly unlikely that they will share your passion for your particular idea. Business ideas are probably relatively plentiful. What is much more scarce is people with the money and the time and the drive and the guts and who are actually in a position to start a business venture in the near term.

So my advice is to go ahead and talk about your idea and get some feedback. It’s very unlikely that anyone will steal your idea (despite it’s brilliance).

I will share with you now a business idea that I have been thinking about for many years. It’s the idea of signing up home owners to have the maintenance of their homes professionally managed. Most people might never consider paying to have basic home maintenance done for them. But there are certainly a lot of affluent home owners who could benefit from such a service. Services that might be included under a flat rate might include: Yearly furnace cleaning, yearly dryer vent inspection and cleaning, empty and clean central vacuum annually, inspection of roof (on-roof) every three years, annual changing of smoke detector batteries or testing of wired in units, perform scheduled maintenance on washer, dryer and sump pump annually, inspect drains and plumbing annually.

Optional services could include lawn maintenance, annual window cleaning, snow clearing, visit and monitor house while you are on vacation, install and maintain decorative lights, change light bulbs in hard to reach places, attend to leaking faucets and drains as required, perform small handyman projects as needed, tree trimming, gardening.

Such services may already exist but they would seem to have a very low market penetration and I believe there is an opportunity for this type of business. You are free to “steal” this idea if you wish.

Solving the Pension Crisis

It is well known that defined benefit pension plans like those offered by governments and certain large corporations are now unsustainable. I have studied this issue and I have rather immodestly taken on the task of laying out the design for a sustainable and attractive pension plan in my new pension article. Read it to see if you agree with my design of a better pension plan.

Don’t Buy or Hold Long Term Bonds?

My updated article on the (lack of) attractiveness of long-term bonds suggests that they are poor investment to buy or to hold at this time, and especially long-term government bonds.

Subscribe to Our Stock Picks

InvestorsFriend Inc. has a stock picks service where we select and rate selected stocks and other investments on the basis of our knowledge of the mathematics of finance and our knowledge of business. We have an excellent track record but we never make any guarantees about future performance (nor can any honest financial analyst). Click the link to subscribe or to learn more about this service.

END

Shawn Allen, President
InvestorsFriend Inc.

To see older editions of this newsletter, or to get off of this email list , click here.

InvestorsFriend Inc. Newsletter April 7, 2013

The Joy of Owning Companies

Most people really enjoy owning things. People love to own houses, cars, trucks, jewelry, fancy cloths, cottages, travel trailers and all manner of toys and accessories.

You can also get a certain joy out of owning shares in companies. People who own businesses such as franchises, car dealerships, retail stores, farms, hotels and all manner of businesses certainly tend to enjoy owning them. The same can be true for shares of businesses.

Many investors think of shares as being simply blips on a screen. I prefer to think of shares as being tiny slices of businesses – which they are. I like owning a piece of some of the stores where I shop. If I can shop at a business in which I own shares and see that it provides good products or services at good prices and if I can see that it is busy and successful, that is great. Second best is to own shares in a business that perhaps I can see but where I can’t shop. That could include a business that caters to other businesses. For example I can’t shop at Stantec but I can see their building in downtown Edmonton.

My first concern in owning shares is to make a good return. But if I can add in the psychic income that comes from pride of ownership of a business that I can see and touch, that is certainly a bonus.

Also, we are often in a better position to judge the success of a business that we can see and touch.

So why not look to own shares in some of the businesses that you enjoy shopping at, if those shares are available at reasonable prices? And why not remember to think of yourself as an owner every time you visit or pass by a business in which you own shares?

The Recovery of the American Housing and Credit Markets

The U.S. housing market has recovered considerably. The latest Case Shiller index of house prices indicates that the average home across 20 cities has recovered 9% from the lows. Phoenix is up 26%,  San Francisco is up 25%. The lowest increase is for New York at 3%.

Credit markets as measured by delinquent loans have also recovered substantially. The following discussion is based on delinquency data as at the end of 2012. You can see the data at the following link:

http://www.federalreserve.gov/releases/chargeoff/delallnsa.htm

The one credit area that has not recovered much however is mortgage loans. 10.2% of U.S. residential real estate loans are at least 30 days delinquent. There has been very little decline from the peak levels of about 11% delinquent in 2010. I believe that the reason for this is that it takes a very long time to clear out the foreclosures. Also various government programs may be encouraging loans to remain in a delinquent state rather than move into a foreclosure state. This delinquency rate was historically about 3% and so it has a long way to recover.

Other forms of loans have seen dramatic reductions in delinquency rates. Credit card delinquencies are at 2.78% which is a record low. In the 1990’s this delinquency rate was running at about 4 to 5%. I suppose this much lower delinquency rate reflects tighter standards and follow-up on the part of the banks. But it probably also reflects a population that is better able to make the payments than was the case a few years ago.

Commercial real estate loan delinquencies had been falling rapidly and are at 4.08%, down dramatically from the 6.04% level of the previous year. And it is less than half the peak level of about 9% in 2010.

This data supports the contention that the U.S. housing, real estate and credit markets have markedly improved.

The Canada Pension Plan

It is sometimes suggested that the Canada Pension Plan is not sustainable or will not be available when people retire. This is false. The Canada Pension Plan in fact is in great shape financially.

The Canada Pension Plan is much more conservative and prudent than most defined benefit pension plans in the following ways:

• CPP is designed to pay out a maximum of only 25% of final wages. And eligible wages are capped at a wage of $51,100 as of 2013. Defined benefit plans can result in pensions that are 70% or more of final wages. And if there is a wage cap it is often based on income tax rules and depending on the benefits of the plan the wage cap is currently at least $120,000 for most DB plans.

• In order to collect the maximum amount of CPP you must have contributed at the maximum wage level for 40 years. This means that for each year worked your CPP pension is about 0.625% of final wages (up to a maximum). In contrast the best defined benefit plans provide pensions of 2% of wages for each year worked. That is three times the benefit.

• Most defined benefit plans allow a pension based on the final five years’ earnings even if the early earnings were much lower. CPP effectively prevents that as a year employed at half the YMPE amount only earns half a “point”. Only years employed at or above the YMPE earn a full point towards the maximum CPP.

• Most defined benefit plans include the ability to retire before age 65 with no reduction in pension as long as years of service and age add to a certain figure. CPP does not include this benefit. CPP can be collected at age 60 but there is a significant and actuarially sound reduction in the pension to do so.

• Defined Benefit plans include the ability to collect the commuted value of the benefits. The calculation of the commuted value is generous because it assumes that the money would be invested strictly in bonds rather than partly in equities. With today’s record low interest rates it takes significantly more money to fund a pension with strictly bonds. The legal requirement to provide these high commuted values places a financial strain on defined benefit plans. CPP does not allow for the collection of commuted values.

• CPP currently collects 9.9% of wages (up to the maximum eligible wage level of $51,100). The 9.9% is split equally between employees and employers at 4.95% each. However about 25% of this 9.9% goes toward funding survivor, disability and death payments. The contribution that is funding the 25% pension at age 65 (which requires 40 years of contributions) is about 7.5% of wages. In contrast many DB plans are targeted to fund pensions of up to 70% for 35 years of service at retirement ages as young as 55 and where the pension is based on the final five years salary rather than considering wage levels in all 40 years as does CPP. Today, contribution ates for BD plans are very high and include amounts to make up for past short-falls. In the past DB plans were projecting that they could achieve their generous payouts with contributions in the range of 12%. This has proved to be woefully inadequate.

The CPP money is set aside from other government funds and is professionally managed.

While most DB plans face large funding deficiencies the latest actuarial report on the CPP concludes that the current 9.9% contribution rate is sufficient. No increase in the contribution rate was called for.

In conclusion, the Canada Pension Plan is financially sound and fears that it will not be available when today’s workers retire are unfounded.

The Canadian Economy

We have updated our brief article that succinctly describes the Canadian Economy in terms of the components of GDP by industry and the imports and exports of Canada by product category and by country.

Next Newsletter

In the next newsletter I plan to update a number of articles that show the performance of stocks versus bonds over the years. While the last dozen years have been not been stellar, the evidence is that over the long term investing in stocks has been very rewarding. And I suspect that will continue to be the case.

Subscribe to Our Stock Picks Service

In addition to this free newsletter and the many free articles on our site we off a paid subscription service that rates selected Canadian and U.S. Stocks. Our track record is strong. To find out more about this, click the link.

END

Shawn Allen, President
InvestorsFriend Inc.

To see older editions of this newsletter, or to get off of this email list , click here.

InvestorsFriend Inc. Newsletter February 18, 2013

Stock Traders are (Vastly) Different Than Stock Investors

Stock traders, in their purest form, focus only on share prices. A “technical” analyst looks at the chart of the stock price and tries to discern where the stock price is headed. He basically tries to follow the smart money. He does not look at the fundamentals of the company because he believes that all that information is already embedded in the stock price. A stock trader will often use stop losses and will be inclined to sell if a stock price drops. A pure technical analyst has every reason to sell in a panic if the share price drops. He or she has no basis to know if the stock price will recover. A pure technical analyst has not even glanced at the actual earnings of the company underneath that stock ticker. Stock traders or technical analysts by definition trade often and trade swiftly with little time for analysis.

Stock investors, in their purest form, consider that they own tiny shares of actual corporations. They look to own shares of companies that are likely to make increased profits ver the long term. And they look to buy those shares at attractive prices. They are happy to own the shares for a long time if the earnings of the company keep growing. They aim to sell if the stock price gets too high in relation to the true value of the company. A fundamental analyst believes that he can look at the value of individual companies and find some companies that are trading below their real value. A (fundamental) stock investor is inclined to buy more shares if the price declines unless there has been some change in fundamental facts to account for the price drop. A fundamental stock trader is ultimately trying to be the smart money rather than follow the smart money. A fundamental investor who believes that a stock price is undervalued and has good reason to think so is in a good position to be calm about a drop in the market price. He or she may have good reason to be calm and to have confidence that the share price will recover as the earnings of the company grow. Fundamental stock investors by definition trade infrequently and buy and sell only after thoughtful analysis. They inherently move slower than stock traders who follow “technical” or charting techniques.

Most retail investors are somewhere between the two extremes. Whether they do their own analysis or follow other analysts they understand that fundamentals matter a lot but they worry a lot that if a stock price declines it might keep going down. Different investors are at different places along the spectrum from day trader to long-term value investor. And individual investors move along this spectrum as their mood changes. Fear can make a a value investor panic and sell like a day trader. And greed can turn a value investor into a one who chases a stock up a price chart.

InvestorsFriend.com is a service that is uses strictly fundamental analysis. Charting techniques do not suit our intellectual interest or emotional makeup.

Here is a little analogy I have to illustrate the difference between a fundamental stock investor and a technicals based stock trader. Imagine  the two of them in action getting their cloths washed. Let’s imagine that before this day they have never witnessed a washing machine or cloths dryer in action. (Mom always did the laundry).

The fundamental stock trader studies the machines before approaching with his cloths. He has read how the machines work. He knows that his soiled but dry pile of cloths will need to get wet and twisted up before they will eventually emerge fluffy and warm and dry. He puts the cloths in the washer and then watches calmly as the cloths get all wet. He later puts them in the dryer and ultimately collects the clean cloths.

The technical based stock trader walks in never having seen a washing machine in his life. (He cares nothing about fundamentals and how washers and dryers actually work). He puts in his cloths. A few minutes later he notices that his cloths are now “under water”. In a panic, he pulls the cloths out and leaves. He had no basis to understand that the cloths first needed to get wet before later emerging dry and clean and fluffy.

Okay, that is a total exaggeration of the situation, but hopefully illustrates the point.

Fundamental Investors Need to Understand Economics

A good fundamental investors should strive to learn something about both micro economics (how individual companies make money) and about macro economics (how the economy works).

It’s probably more important to understand how individual companies make money and to identify some bargains than it is to understand the macro economy. In fact, I am not sure anyone truly understands the macro economy and things like the implications of and limits to national debts and money creation.

We’ll start with some macro economics.

The Magic of Our Economic System

Writing in 1776, Adam Smith wrote about “the division of labour” and said that it was the greatest contributor to the the increase in human labor productivity.

Adam Smith noted that in a factory setting, using the division of labour, 10 men were making 4800 pins per day each when he doubted that each, working without the machinery of the factory, could  make one and certainly not more than twenty per day working on their own.

Ponder for a moment the complex manufactured goods we are all able to buy. Most employed adults in the developed world today can afford to buy, a car, a refrigerator, a large flat screen television, a computer, light bulbs, an electric stove, a vacuum cleaner, a toaster, a coffee maker, furniture, cloths, and more (and certainly a boatload of pins if wanted).

Not all that many years ago almost everyone on earth toiled very hard just to survive. Only a hundred years ago in Western Canada, home steaders worked very hard indeed to eke out a living that did not include electricity or indoor plumbing.

Today, our economic system allows most of us to trade about 40 hours per week for enough money or compensation to provide for the bare necessities of life (food, clothing and shelter) along with quite a bit of goods, services, entertainment and general comfort over and above the bare necessity.

Admittedly, our economic system is far from perfect. Some people certainly garner an outsized share of “the spoils”. Others get too small a share of “the spoils” for their efforts.  Some people are highly educated and willing to work but can’t find suitable employment. But overall, our economic system is really a wonder to behold. When we feel deprived, it usually more that we are deprived in relation to others rather than literally deprived (few go without adequate food, clothing and shelter).

Recently I saw a full size refrigerator on sale for $500. In Canada a wage of $25 per hour would probably be considered pretty normal. (Higher than average but certainly not abnormally high). Is it not a marvel that a fairly typical person can exchange just 20 hours of their time for something as complex and useful and large as a refrigerator? Even after taxes most people can earn a refrigerator in about four days. Even at minimum wage it would not take more than two weeks effort to earn a refrigerator.

Can you imagine the hours it would take for even a very skilled tradesman, with a well equipped shop, to build his own refrigerator? I would hazard a guess that just to buy the components would cost FAR more than $500. And to try to do it from basic materials would be almost impossible. And if someone could build a refrigerator from raw materials can you imagine how ugly it would be? Think about the wonders of our system of factories and division of labour that can build a fridge and ship it to a store near you such that most of us need exchange only about four days labour to buy it?

And yes, perhaps it was built in China. To me, that makes it all the more amazing and wherever it was built we can still buy it in exchange for a quite small amount of our time.

The Magic of Our Organized Systems.

It is our organized market system that creates our overall high standard of living. Several key things are needed for a well functioning economy. These include law and order, property rights, education, incentives to work, a relatively free market exchange system, a monetary exchange system, banking and probably some others that I am not thinking of.

Think about all the aspects that come together for a factory to make refrigerators. Other factories need to exist to supply components such as the compressor and motor, the tubing, the plastic, the metal, the insulation and other components. Electricity needs to be generated and delivered to both the factory and the customer’s house. The factory had to be built in the first place and equipped with production machinery. That involved someone making a long term investment. It may have involved money borrowed from a bank and likely involved (somewhere along the way) investors buying shares in a company. The factory will have a production line and a division of labor. Refrigerators are ultimately shipped to retailers. The retailers reliably pay the factory. There are entire systems set up to insure that factories can ship refrigerators to retailers without much worry of not getting paid. There are computer systems in place that make it easy for the retailers to order refrigerators and for the factory to manage its inventories of finished products and components.

Once everything is set up and in operation dozens and dozens of systems interact in such a way that the refrigerator production is almost automatic. It becomes easy for everyone involved. And it manages to produce refrigerators that people can buy in exchange for not very many hours of their labor at all.

Systems are everywhere. Very few of us work outside of the system of division of labour. Most office workers would turn around and head home if the computers were down for a day. We may not feel like we are part of an assembly line. But invariably we are. We all depend on numerous systems and numerous others to get our jobs done. (Well except for that one in a million guy who went totally off the grid and ekes out a living off the land while living in a hovel someplace.)

Who Deserves the Credit for Manufactured Goods?

Factory workers may like to claim credit as being the true producers of goods like refrigerators. And they do deserve some credit. And certainly the owners of the factory deserve some credit for supplying the factory and the machinery. And the office workers in the factory that order the components and work the computers and run the payroll and hire the shop workers are also needed. In fact it is the entire inter-related economic and government system as a whole that makes it possible to manufacture goods in a factory.

Factories could not run without electricity and water. They could not run in a lawless society. They would not exist without the various inventions and technologies that they use. They would be pretty useless without roads and delivery trucks and retailers. It’s all interconnected.

No individual worker or manager or owner is essential to the process. The harsh reality is that we are all quite replaceable.

Most of the credit for the ability of factories to produce refrigerators must go to the collective market and governmental system. No individual deserves much individual credit and yet we all contribute to it collectively.

To me it is a sort of magic for which we should be grateful.

Is Leadership as Important as Systems?

Recently I read an editorial that claimed that what we actually need are a lot less leaders and bosses. That bosses and leaders just mostly get in the way.

The editorial (by Bill Bonner) said:

The point is, the world needs a lot fewer leaders than it has. Most of the time, people go about their business with no need for the expense and distraction of leadership. That is true in businesses as well as government. A leader just gets in the way, wasting everyone’s time and energy.

That is a good point. Think about some of the most successful businesses around.

Walmart obviously benefited greatly from the leadership of Sam Walton. Sam started with one store. Had he been a typical leader he would have been too busy micro managing everyone to have ever found time to expand beyond one or at most a few stores. It must have taken a focus on systems to allow the huge expansion. Sam Walton first developed a successful formula for operating and managing one store. But his real genius must have been in the ability to implement systems that would cause his formula to be reliably replicated in dozens and then hundreds and ultimately thousands of stores.

In Canada we have Alimentation Couche-Tard which has grown in 35 years from a handful of stores in Canada to now about 10,000 most of which are in the United States and a good
number in Europe. The main founder is now a billionaire. It has developed a decentralised business model that allows it to acquire many stores per year and fold them smoothly into its network. Whenever I personally think about running a store I cringe at the idea of having to hire and fire people and make sure they show up for work and treat the customers properly and not take the product or allow their friends to help themselves. There would be so many details to take care of just to run one convenience store properly. It would be exhausting. Couche-Tard obviously has developed systems that allow it to grow rapidly and yet also insure a consistent service and consistent profitability. This cannot be accomplished by micro management. It has got to be done systematically. The founding owner is still CEO but clearly there would be many stores that he has never visited. Yet they operate as he intends.

If you are a leader do you spend your days putting out fires and making endless little decisions? How about following up on your employees? If so, you are probably like most leaders. But highly effective leaders simply don’t act that way. Real leadership does not come from micromanagement. It comes from putting in a system that reliably produces the desired result.

A cloths washer is a system. It runs a cycle and produces a desired result. No leadership required.

How does a busy restaurant manage to custom make meals for hundreds of people in a few hours and manage to serve the meals relatively rapidly? It cannot be by managers running around telling people what to do. It has to result from systems whereby people are trained for certain parts of the job and they do it. There has to be a high degree of systemization at work. Yet there also has to be a certain degree of autonomy. In an efficient restaurant, a waiter does not have to ask permission about how to deal with a diner’s complaint. He is empowered to make a decision. Yet he operates within a system. I imagine that running a busy restaurant must be difficult. But having reliable and repeatable systems in place must make the job far easier. A restaurant chain with fantastic systems to follow can probably be ran by mediocre managers. Trying to run a single restaurant with no established systems in place would probably require a highly effective and energetic leader. (One who would be wise to develop some procedures and systems if she did not want to spend her life busily putting out fires.)

Leadership is fine but real leadership requires implementing systems. Real leadership is the kind of leadership that makes the putting-out-fires kind of leadership unnecessary. A business that wants to grow to multiple locations will have a very hard time doing that if it tries to rely on micro managing and putting out fires.

What’s this got to with Investing?

As an investor, I am always impressed by businesses that “are on their game”. Certain businesses just seem to get the job done reliably and without appearing to really break a sweat. Think about the likes of Costco. All it has to do is open a new store and people flock to it. It’s systems clearly work smoothly. As you go about your daily life you should be able to see which businesses are running smoothly and appear profitable. Those kind of business will not always be a good investment (the stock price might be too high). But the opposite kind of business with inconsistent service from one location to the next or harried looking and grumpy employees (who are probably micro managed) will very seldom be a good investment.

END

Shawn Allen, CFA, CMA, MBA, P.Eng.
President, InvestorsFriend Inc.

To see older editions of this newsletter, or to get off of this email list , click here.

InvestorsFriend Newsletter December 29, 2012

What’s Your Million Dollar Strategy?

It was in 1998 that I read a little book called Michael Decter’s Million Dollar Strategy. Michael Decter had started with $50,000 in RRSP savings at the start of 1987 and set a goal of accumulating a million dollars. By the end of of 1996, Michael Decter had contributed a further $62,000 in savings for a total of $112,000. By astute investing in stocks, in his RRSP account, he had turned this $112,000 into $1.3 million dollars. Then he wrote a book about it. By 1998 when the book came out his portfolio had grown to $1.5 million.

Michael Decter’s book explained how he analyzed individual companies  by reading their annual reports. Michael Decter’s large gains were partly due to some very good luck when some very large bets on a few companies paid off really big time. (One of his large investments gained 399% and made him $507,000). But it seemed clear that he was onto something. Having invested $20 in his book I decided to give his methods a try. At 38 years of age at that time and with a good job I knew I had the time to eventually accumulate a orthwhile portfolio.

Michael Decter’s Million Dollar Strategy became a catalyst for my own Million Dollar Strategy.

So far, it has worked out pretty well. At the start of 1998, our two RRSPs totaled $74,049 consisting of $43,440 in original contributions and $30,609 in gains. In the 15 years since then then we have contributed a further $88,239. The two RRSPs are now worth a combined $830,336 consisting of $131,679 in contributions and $698,657 in gains. 2012 has been an excellent year with a 28% gain. The gain alone in 2012, $180,082, is significantly larger than the total contributions that were made over a period of 23 years. That is what compound returns can do for you when applied over a long period of time.

So what should your own strategy be? Can investing in stocks work for you like it has for me and for Michael Decter? Everyone’s starting portfolio is different. And people have different amounts that they can save. And some of you are already drawing down savings rather than adding to them.

But can stock investing work for you? If you are younger can you have your own Million Dollar Strategy? If you are investing in stocks perhaps our Stock Picks service can help you. Basically, you can look over my shoulder and know the stocks that I am already invested in and investing new money in and exactly why. And, at your own risk, you may decide to invest in some of the same stocks.

A Dangerous and False “Observation”

Those who don’t like and don’t trust the stock market are often very fond of asserting that “No one has made money in stocks since the year 2000”. Taken literally, this is clearly false since even in a falling market there are always some people making money.

It is true that the U.S. stock index (the S&P 500) is still down about 8% since the start of the year 2000. If we added in dividends it would be up slightly. But after investment fees it would likely be down. And so it is true that on average a pot of money invested in U.S. stocks at the start of the year 2000 has not grown. But most investors add new money each year.

The following chart shows how $10,000 per year invested in the markets has grown.

$10,000 per year invested since the start of the year 2000, is a total investment of $130,000. If the money earned nothing each year it would now total $130,000. If it was invested in the S&P 500 index it would have grown to $149,061 (and that excludes dividends). That ‘s not a lot of growth but it does put the lie to the assertion that the average investor in stocks  has made nothing since the year 2000. If the $10,000 per year was invested in the TSX index it has grown to $164,359. And if it was invested equally at the start of each year in the Buys and Strong Buys here at InvestorsFriend.com, it would have grown to $292,253.

An interesting thing about the graph here is that while it shows a very large decline from the end of 2007 to the end of 2008, there is little sign of the big market plunges in 2000, 2001, and 2002. The reason for that is that this is showing a cumulative portfolio that started out at $10,000 in 2000 and with $10,000 added each year. When the S&P fell 10% in 2000 and 13% in 2001 and 23% in 2002, the portfolio was still growing due to the $10,000 per year new investments.

In any event even if stocks have, on average, provided poor returns in the past 13 years that in no way implies that the returns going forward will be poor. In fact, all else equal, we should expect the opposite. A series of below average years in stock markets tends to be followed by above average years.

A True But Dangerous Observation.

Those who don’t like and don’t trust the stock market are also often very fond of pointing out that over the past one, five, ten or even twenty years, an investment in government bonds has beaten the return on stocks. That is a true observation. But it is a dangerous and in fact deeply mis-guided observation if it is meant to imply that bonds are are likely to do better than stocks in the next ten or twenty years.

The reason for this was explained in detail in our article regarding the attractiveness of stocks versus bonds in 2012.

Back in 1979, Warren Buffett compared the returns on Stocks versus Bonds and observed that stocks were earning an average of about a 13% ROE, and could be purchased at around book value, and 20-year government bonds were yielding 9.5% and he said:

Can better results be obtained over, say, 20 years from a group of 9 1/2% bonds of leading American companies maturing in 1999 than from a group of Dow-type equities purchased, in aggregate, at around book value and likely to earn, in aggregate, around 13% on that book value? The probabilities seem exceptionally low.

And what happened? Well a 20-year zero coupon government bond would have earned 9.5% per year if bought in 1979 and held until 1999. The S&P 500 meanwhile earned a compounded 18% over the next 20 years as stocks continued to earn at least a 13% ROE (on average) and as the multiple of the price to book value rose with the very strong stock market of the 1990’s. Score one for Buffett.

But, more recently bonds have indeed beaten stocks. Let’s look at the situation  at the end of 1981. By then 20-year government bonds were yielding 13.34%. Stocks had risen 50% since the start of 1979 and therefore could no longer be purchased at book value. At that point bonds may have looked more attractive than stocks.

And consider the end of 1999. 20-year government bonds were yielding 6.82%. Stocks meanwhile had an average P/E of about 30 which equates to an earnings yield of 3.3%. In 1999 Buffett wrote an article in which he calculated that stocks might be expected to earn about 7% (6% after investment costs) over the next seventeen years. On that basis, I don’t think Buffett will have been too surprised that it turned out that bonds purchased in 1999 have (so far) beaten stocks purchased that year.

And what would Buffett’s 1979 observations suggest for today? 20-year Government bonds are yielding 2.5%. The average stock in the Dow Jones Industrial Average has a P/E of 14.85. That’s an earnings yield of 6.7%. Now, 6.7% may not be a great return, but it easily beats the 2.5% from long-term government bonds. And if some of the earnings are retained and earn high ROEs are earned by companies then the return from stocks will be higher than 6.7%. On this basis, Stocks are clearly a better buy than long-term government bonds as of today.

So, the observation that bonds have beaten stocks over the past one, five, ten and twenty years is correct but very dangerous if used to justify favoring bonds over stocks at this time.

Warren Buffett has recently suggested that stocks are about the best investment at this time. I certainly agree with that.

END

Shawn Allen
President, InvestorsFriend Inc.

InvestorsFriend Inc. Newsletter November 17, 2012

Can You Get Rich Through Investing?

Today I address the somewhat politically incorrect topic of getting rich.

When it comes to investing, we all have different goals and we are all at different stages of life and have different income levels and different abilities to invest.

As one wag put it: “You’re unique… just like everybody else.”

lf even the possibility of getting rich by investing is not of interest to you, or not relevant to you or your children, or you think such a goal is immoral, feel free to to stop reading now. (I will pause briefly while you go away.)

Okay, for those of you interested, what is the evidence regarding the possibility of getting rich through investing? And how might you do it?

First I will look at the purely theoretical possibilities. Then I will look at actual return from stocks and bonds over  long periods of times and then I will look at the results that I have actually achieved.

The purely theoretical possibilities of getting rich by investing money

The following table shows what happens to $1000 invested at various returns and for various periods of time.

Return	10 years	20 years	30 years	40 years	50 years
-2.0%	$817	$668	$545	$446	$364
0.0%	1,000	1,000	1,000	1,000	1,000
2.0%	1,219	1,486	1,811	2,208	2,692
4.0%	1,480	2,191	3,243	4,801	7,107
6.0%	1,791	3,207	5,743	10,286	18,420
8.0%	2,159	4,661	10,063	21,725	46,902
10.0%	2,594	6,727	17,449	45,259	117,391
12.0%	3,106	9,646	29,960	93,051	289,002
14.0%	3,707	13,743	50,950	188,884	700,233

The first row shows what happens to your $1000 if it loses 2% per year. This could occur with cash subjected to 2% inflation. It loses 2% in purchasing power per year. You can see that over the years the value of your $1000 subjected to a 2% annual loss (such as due to inflation) gets whittled away quite badly. So much for preservation of capital.

The 10 year column shows that your $1000 does not grow much in 10 years, unless, that is, you can achieve double digit returns. At 2%, it increases by only 22%. At 4%, it manages to grow by 48% in the ten years. However at 10% it grows by 159%. And at 14%, the money grows by 271%. It may not be that exciting to turn $1,000 into $3,707 in ten years. But the idea of turning your $10,000 into $37,070 in ten years or your $100,000 into $370,700 in ten years might be be at least mildly stimulating.

The 30-year column starts to get exciting even at much lower and more realistic returns. Even at 6%, your $1,000 grows by almost 500% to $5,743. At 8% your $1,000 grows 906% to $10,063 in 30 years. And it grow almost 5000% in 30 years  at 14% to $50,950.

The 50-year column shows that even $1000 can grow to a substantial sum and will do so even at annual compounded returns of 6% or 8%. And the gain is truly staggering at 14%. And this can be after inflation if you wish since all the returns here are purely theoretical. (“All” you have to do is find the 6%, 8% or 14% returns and then wait the 50 years!)

But with rare exceptions, such as for an inheritance or trust fund, people don’t invest in the form of a one-time lump sum amount.

So what happens if you invest $500 per month ($6000 per year) at various theoretical returns for various long periods of time?

The following table shows what happens to your $6000 per year invested at various returns and for various periods of time.

Return	10 years	20 years	30 years	40 years	50 years
-2.0%	$54,878	$99,718	$136,355	$166,290	$190,749
0.0%	60,000	120,000	180,000	240,000	300,000
2.0%	65,698	145,784	243,408	362,412	507,476
4.0%	72,037	178,668	336,510	570,153	916,003
6.0%	79,085	220,714	474,349	928,572	1,742,015
8.0%	86,919	274,572	679,699	1,554,339	3,442,621
10.0%	95,625	343,650	986,964	2,655,555	6,983,451
12.0%	105,292	432,315	1,447,996	4,602,549	14,400,109
14.0%	116,024	546,150	2,140,721	8,052,151	29,967,128

After 10 years, $60,000 has been invested. At 8% this has grown to $86,919. And even if that is after inflation, this is not overly exciting. Even at 14% your money has not quite doubled. (But keep in mind it has only been invested an average of five years since it is invested at $6,000 per year).

After 30 years though things start to get interesting as the $180,000 invested will grow to $474,000 at 6%, $680,000 at 8% and over $2 million if you can achieve 14%.

After 40 years, $240,000 invested at $6,000 per year for the 40 years has grown to almost $1 million at 6%. This seems worthwhile.

After 50 years the results are quite motivating. The $300,000 invested over the 50 years grows to almost $1 million at 4% and to $3.4 million at 8% and a staggering $30 million if you could somehow achieve 14%.

I think the message from all of this is that in order to get rich through investing, three things are required. 1. Sufficient funds must be invested. 2. A decent return (or preferably an indecently large return) is needed, and 3. A lot of years are needed. Allowing money to compound for many years may be the most important requirement.

Has Stock and Bond Investing Historically Made People Rich?

In this section we replace the theoretical returns above with the actual historical total returns from the stock market and from long-term corporate bonds.

It may be argued that it would have been impossible to achieve these historic returns due to trading costs and income taxes. However we could assume that trading costs were paid from other funds and that the money was in a tax-sheltered account. Also trading fees are very low when exchange traded index funds are used (though those were not around years ago). Realistically the returns that we will show here are the maximums that could have been obtained from investing in stock and long-term corporate bond indexes.

I use calendar-year real dollar (after deducting inflation) total returns from  a well-known reference book called “Stocks, Bonds, Bills and Inflation” 2012 edition. The book is published annually by Morningstar. (Ibbotson SBBI classic yearbook). The data begins with the returns for 1926. The data is for the total returns on the S&P 500 index and for U.S. Corporate bonds.

I will show what could have been achieved from investing in either 100% stocks (the S&P 500 index with dividends reinvested) or a balanced combination of 60% stocks, 35% long-term corporate bonds and 5% cash. To show this we will use a standard 30-year savings period and $6000 saved per year. Since we are using real data, the $6000 is also adjusted for inflation each year.

Using this data there are 57 historic different 30 calendar year periods that we can look at. The first period was 1926 through 1955, the second period was 1927 through 1956. The latest period available is 1982 through 2011.

Here is a graph of how an investment of $6000 per year invested in the stock market index (The S&P 500), and with dividends reinvested, would have grown over each of the 57 different 30-year historical periods. There is one line for each of the 57 different 30-year periods.

$6000 per year invested for 30 years amounts to $180,000. The ending values here, in real dollars, after deducting inflation, range from $277,471 all the way up to $1,374,265. This is a wide spread of results over the 57 different 30-year saving periods. The average is $754,511, but that may be cold comfort to those that were unlucky enough to have had 1952-1971 as their particular savings period and who ended up with just $277,471.

Note that there was huge stomach-churning volatility in the portfolio values for each of the 57 different periods. A few lines are marked in dark red to better illustrate the volatility. There was also volatility in the early years but it’s not visible due to  the scale of the chart.

In order to lower volatility, it is often suggested that a balanced approach be used. Below we illustrate the results using an allocation of 60% stocks, 35% corporate bonds and 5% cash.

In this balanced portfolio case, the $180,000 invested over the 57 different 30 year periods grows to a final amount that ranges from $202,559 to $860,218. There is still a very wide range of results. Volatility is reduced but is still substantial.

From the graphs above, it is not possible to see when the best 30-year savings periods were and when the worse periods occurred. Nor is it possible to see above if there were any periods where a balanced portfolio beat out a 100% stock portfolio in terms of ending value.  These questions are answered in the following graph.

The graph above shows only the ending portfolio values after 30 years of saving $6000 per year. Again. this in in real inflation-adjusted dollars. The blue line shows the ending value for a 100% stocks approach, the pink line shows the ending value for the balanced (60% stocks, 35% long-term corporate bonds and 5% cash, rebalanced annually).

The leftmost points on the two lines show the results for the 30 years from 1926 through 1955. The (S&P 500) stock index investment grew to just over $1 million. The balanced portfolio grew to almost $600,000. Continuing across the graph, the rightmost points show the results from the most recently available 30-year period, being 1982 through 2011. The 100% stock approach grew to a little over $500,000 and the balanced approach was very similar and slightly higher.

Neither line on these graphs shows anything about the volatility of the portfolios over the 57 different 30 year savings periods (volatility was shown in the prior graph).

The graph above shows that over 30-year periods a 100% stock approach has almost always out-performed the balanced approach as of the end of the 30-year period. However, the out performance has, in all but a few cases,  been modest for 30 year savings periods that started since about 1955. For the 30 year periods that started in 1926 through about 1942, stocks outperformed very significantly. (For 30 year savings periods that start in 2012, I am confident that stocks will outperform significantly. This is explained in our recent article).

Overall, the graph above would suggest that investing is not necessarily  a sure path to getting rich. At least not by investing $500 per month for 30 years. It would appear that a higher investment and/ or a longer period of time might be needed.

Editor’s Experience At Getting Rich Through Stock Investing

My own experience is detailed on our performance page

My money has compounded at an average of over 11% since 1989. In the 10 years ending with 2012 (to date) my return has been 16% per year. The Stocks that achieved this and the rationale for selecting these stocks has been shared on this web site since mid 1999.

My best portfolio is one of my two RRSP portfolios. This RRSP account has had a total of $62,488 deposited to it over the years starting with an initial $2000 in 1991. The average time each dollar has been invested in this RRSP is under 12 years. Today this RRSP account sits at $442,751. Therefore each dollar originally invested has grown to $7.09. That is a septupling of money. This was not achieved by taking great risks. Most of the stocks in this portfolio over the years were mid to larger cap stocks that paid dividends. There were essentially no micro-cap stocks and very little to no resource stocks over all those years. his portfolio has lost money in only three of the 22 years it has existed. The biggest loss was 17% in 2008 when the TSX index lost 35%.

We know from the theoretical tables above that it is possible to get rich through investing within 30 years, if double digit returns can be achicved. I have achieved that and hope to continue to achieve that, or something close to it, by continuing the same methods that have worked well for me over the years.

In my experience then, you can indeed get rich through investing. But it takes a sacrifice, and it takes a long time. And it may require making above average returns. Our Stock Picks have achieved above average returns for our subscribers. Click here for information on subscribing, if you are not already a subscriber.

Testimonials

This Web Site has about 500 paying subscribers to our Stock Picks. I am gratified to have received many testimonials over the years. Apparently this site truly has been a friend to investors.

National Hockey League Business and the Strike / Lockout

I know a little bit about hockey and quite a bit about business. Here are some comments on this national hockey league strike lockout from a business perspective.

All power to the players if they can achieve over 50% of the revenues. In a free market economy we all have the right to charge what the market will bear.

The Players say they “gave-up” a lot in the negotiations the last time. That is one perspective. On the other hand the players certainly seem to have been paid well over those years so I can’t really agree that they “gave up” anything. I am sure they “got” as much as they could in the last negotiations.

The reason that NHL hockey can take in billions in revenue is obviously because fans pay the ticket prices and watch the games on television.

I don’t happen to believe that the fans pay and watch mostly because of the talents of today’s particular cohort of players and superstars. If fans watched sports primarily for the display of athletic skills then amateur sports would have more viewers.

Fans pay and watch because they have developed a large emotional connection to the outcome of the game. They frankly care a lot more who wins than they do about  a graceful pass of the puck or a wonderful shot. Fans view the home-City team as “their” team. They almost feel a part of that team.

The emotional connection that fans have to the outcome of games and to their team winning the playoffs has been built up over decades. It includes inter-city rivalries. In includes memories and stories of games and series of many years ago. There is a brand value to NHL hockey that has been slowly built up over approximately 100 years.

The brand value of NHL hockey leads to the emotional attachment and the caring about the outcome that leads to viewers and big revenues. CBC’s hockey night in Canada was a HUGE part of building up that brand over the years. So was CBC radio in decades past. The entire minor hockey system with its hundreds of thousands of players and hundreds of thousands of volunteers and paying parents over the years has also contributed to building up the value of hockey as a sport and the brand value of the NHL. That includes all those towns that built hockey arenas over the years.

It is said that hockey is Canada’s game. Well, Canadians may not be able to claim ownership over the NHL, but they can claim to have paid for much of its value.

The players and especially the super-stars of the past contributed greatly to the value of NHL hockey that exists today.

Today’s players also contribute to the value. But mostly all they have to do is maintain they value. They certainly don’t have to grow it from scratch.

Today’s players are largely temporary contributors to and beneficiaries of the value of NHL hockey. A few of the superstars will contribute to the value in a way that will live on for decades, but the mast majority are temporary occupants of their jersey’s (their numbers will not be retired).

The brand value of the NHL is mostly an intangible thing. It does not legally belong to anyone. But the tams and the league largely control the brand value.

The teams and the league can continue to exist indefinitely. The players come and go. The players can play largely because of the existence of the teams and not the other way around. Sure the teams need players but willing hockey players number in the many thousands, while the teams number just 32 and there is but one national hockey league. In my opinion the players, given this situation, already get an astoundingly large share of the revenue.

The CBC created much of the value but has no ongoing ownership in it aside from whatever value there is in the Hockey Night in Canada brand. I suspect fans would still watch the games if the CTV out-bid the CBC for those games.

It’s a strange union when players bargain both collectively and individually.

It’s a strange manner of competition when we have 32 teams competing against each other but also in many ways cooperating with each other. There may be 32 teams but there is only one league. Each team may want to be as rich and as strong as possible. But the league knows that in order to maximise revenues no one team can be allowed to get too dominant. People will not pay top dollar to watch a foregone conclusion.

Today’s crop of players and the teams and league will jockey for the best outcome they can get from the other side. Both will do some damage to to the brand this year. Both will give up substantial revenue that is currently not being generated. Fans, affected employees of arenas, restaurants and Hotels and the CBC all stand by, interested in the outcome but with no voice. However if these groups feel sufficiently abused and disillusioned it will show up in lower ticket sales and lower brand value. Both the players and the owners should keep that in mind.

Neither the players nor the owners are required to listen to the views of fans. They can and will do what they think is best for their own self interests. In that respect hockey is like any other aspect of the free market. It is not a perfect system, but it is better than any alternative system. And things will work themselves out. And hockey will resume. The money at stake will automatically insure that this happens (eventually).

P.S. If you get REALLY rich through investing you can buy your own NHL team and then help to insure that future strikes are avoided.

Subscribe

If you are looking for stocks to invest in then you can subscribe now. The cost is just CAN $13 per month or $120 per year. When you think about the potential returns from just one well-researched Stock Pick, you can see why our subscription service has been a great investment for our subscribers.

END

Shawn Allen, President
InvestorsFriend Inc.

To see older editions of this newsletter, or to get off of this email list , click here.

InvestorsFriend Newsletter September 9, 2012

To Invest Better, Watch the Market Less?

Most people seem to believe that do-it-yourself investors in stocks need to watch their stocks closely during the day.

In fact, watching stock prices move during the day is probably counter productive in most cases. It probably leads to panic selling more often than astute trading.

And what about watching analysts talk about stocks on television? Most of them are closer to day-traders than long term investors.

Fear and panic may keep ratings high but they are not useful emotions for long-term investors.

A better use of time would likely come from reading investment books rather than watching what amounts to minute by minute “noise” on television.

Also reading annual reports would be a better use of the time. These days companies don’t automatically send out annual reports sine they are available on line. Investors would be wise to obtain copies of annual reports of the companies they own and to read them carefully.

The average standard of living in North America has never been higher. And yet pessimism abounds. Too much television focus on bad news is part of the reason.

A Rational Approach to Investing

A rational approach to investing is to invest in (i.e. own) entities that can rationally be expected to earn attractive returns on their money and which are available at attractive prices.

Let’s review how to find investments like that.

Ideally, the companies that you invest in will earn good returns on their money. This is measured by return on equity or ROE. All else being equal, a company that can be expected to earn a higher ROE will be a better investment.

But what kind of businesses can be expected to earn above average ROEs?

In a highly competitive market high profits (high ROEs) attract competition and prices get driven down so that profits are no longer abnormally attractive.

In order for a company to sustain a particularly attractive ROE over the longer term, it must be at least partly protected from aggressive competition. It must also be largely free to set its own prices (not regulated by government as to prices).

There are a number of ways that this can happen:

Collusion is one way, industry participants can collude and agree to keep prices higher for the good of all producers. This occurred in the 1970’s with the Organization of Petroleum Exporting Countries (OPEC). But usually it is illegal. Also collusion often tends to fall apart as individual members of the group jockey to do better than others.

Patents and other proprietary knowledge can lead to very high returns on investment. Certainly this is the case for Apple. It was definitely the case for Microsoft as well over the years although less so in recent years.

The Network Effect can lead to very high returns. The Network Effect refers to cases where the more people that use a product the more useful it becomes to each user. As Microsoft Word became the dominant word processor it became easier to share documents across companies. At some point when the great majority of offices were using Microsoft Word it became almost impossible for a competitor to make inroads into that market. It’s no good to have a better word processor if few others can read or use that file format. And consider eBay. Once it became the go to site for sellers, because all the buyers were there and for buyers, because all the sellers were there, it became virtually impossible to compete against except perhaps in small niches. And consider credit cards.  Merchants and consumers are willing to carry two or three main brands (Visa, MasterCard and maybe American Express) but beyond that it became extremely difficult to try to get traction with another main brand.

Brand Power. Coke, Pepsi, Rolex, Nike and many other brands can make very high ROEs because of the power of their brand names. Often consumers know that they are simply paying more for the name and not even getting a better product in many cases. But for a variety of complex reasons we pay up.

Scale. Sometimes being the biggest player in an industry offers cost advantages that competitors can’t match. Possibly, this applies to Wal-mart. Overall however, it may be over-rated as a potential advantage.

Cost Advantages. With a true commodity product like most minerals, agricultural products and natural resources a sustainable high return (absent chronic shortages) will require cost advantages. The cost advantages may come from a variety of sources but in this situation it is only a low cost producer that will sustain a high return on equity.

Access to Scarce Resources – This could occur in the case of rare minerals. Often however, the high ROEs have a way of attracting competition and new resources are found which alleviate the scarcity and eliminate the high ROEs.

Sticky Customers. In some businesses, like airlines and most restaurants you essentially have to win your customer’s business anew with each purchase. But for other businesses including insurance, money management, cell phone service, and basic banking services customers are very sticky indeed. These industries often invest heavily to acquire new customers. But once they build up a large number of customers the returns are often very attractive.

Managerial excellence and execution – There are cases where superior management effort including motivation of employees and superior cost controls have led to sustained high profitability. A number of companies have grown large and made high ROEs by a steady process of making small acquisitions. Their competitors could have done it but simply did not and do not.

Companies do not get into the position of having any of the competitive advantages listed above without a certain amount of managerial excellence at least at the outset. In the ideal case the initial managerial excellence has led to certain competitive advantages that are now so strong that they can now be sustained even by average or mediocre managerial effort.

Warren Buffett refers to companies that possess characteristics that allow them to make high ROEs as being companies with “wonderful economics”. Examples he gave were owning the dominant newspapers in large cities in the days before the internet. Also owning television stations affiliated with one of the three main networks in the days when those networks were extremely dominant. Companies that Buffett invested in because of their wonderful economics include See’s Candies, Coke, and American Express. In most cases Buffett places heavy emphasis on management ability and attitude in addition to the wonderful economics.

In contrast, what kind of businesses can be expected to earn poor profits?

Any business that faces intense price competition will have a difficult time making a high ROE.

The most notorious cases are industries in which the product has a high fixed and a low marginal cost and where there is excess capacity in the industry.

Commercial passenger Airlines seem to be a poster child for an industry that reliably loses money. Due to the low marginal cost of carrying one extra passenger, combined with the availability of empty seats, airlines are often willing to sell seats at prices that fall far short of covering fixed costs. Passengers see travel as basically a commodity product. Despite all the marketing efforts customers usually have almost no loyalty to any particular airline. At the end of the day customers choose the lowest airfare that gets them to their destination.

Any business where customers tend to shop around on each purchase is unlikely to offer high returns on equity.

How do we find specific companies with high ROEs?

We are looking for companies that will continue to have high ROEs in the future. A good place to start is to look at companies that have a consistent  history of making high ROEs in the past and where we can also identify some competitive advantage (such as the type of things listed above) that is likely to continue.

Buying at Attractive Prices

Finding a company with a high expected return on equity is not sufficient. We have to be able to purchase it at a reasonable price.

This requires analysis to compare the ROE to the price being paid.

A company that is expected to continue earning a 15% ROE would be quite attractive if it could be purchased at book value. However if it is trading at three times book value then it may not or may not be attractive.

The reciprocal of the P/E ratio tells you the initial earnings on your investment. A P/E of 10 represents an initial earnings on market value of 10%, while an initial P/E of 20 represents an initial earnings on market value of just 5%.

But it is not the case that the company with a P/E of 10 is automatically a better investment than one with a P/E of 20. What really matters is what will the company do with the earnings and to the extent they are retained, what ROE they will they earn. A company that has a P/E of 20 and trades at four times book value has an ROE of  20% (since Return on year end equity = P/B divided by P/E).

If this company dividends out its entire earnings and, perhaps as a result, never grows then the return to the investor will be stuck at the reciprocal of the P/E of 20 that was paid by the investor or 5%.

If however, this company retains all the earnings and reinvests it and earns the same 20% ROE then the investors return will eventually approach the ROE of 20%.

Warren Buffett suggests that we make very few investments and that instead we bide our time until we find a company that is expected to continue making a high ROE and that is available at an attractive price. These may be rare but we only need a handful of them to be very successful as investors.

Our Stock Research subscription service attempts to identify and track these type of companies. Click the link to try out our service at a very reasonable price.

Avoid Long-Term Bonds at This Time

Our new article explains why long-term bonds, purchased or held today are almost certain to be a terrible investment over their lives.

Is the Overall Market a Good Investment at This time?

Based on the S&P 500, our updated analysissuggests that the overall U.S. stock market appears to be about fairly valued and priced to return an average of about 7% annually over the next decade. This 7% is certainly not guaranteed and in any given year there could certainly be negative returns. The 7% seems attractive compared to long-term bonds at about 2.4%.

END

Shawn Allen, President
InvestorsFriend Inc.

To see older editions of this newsletter, or to get off of this email list , click here.

InvestorsFriend Inc. Newsletter July 1, 2012

An investment and investment advice success story:

My long-term track record of success as an investor and investment advisor has been well documented on this Site. Basically I have been able to compound money at an average of about 12% per year for a long time. Those who subscribed to our Stock Picks and followed the advice (at their own risk of course) were also provided the means to compound their money an average of 12% per year. We have NEVER made any guarantees of performance in the past and make none about the future. Nor can we even make any predictions about future returns. Still, I do like our chances of continuing to beat the market.

Of course there is no suggestion that our returns were steady at 12% each year. Not at all. My own annual returns in the past 12 years have ranged from minus 23% in 2008 to positive 44% in 2009. But the only other negative year was 2002 at minus 8%. So certainly most years were positive. Our Stock picks from the start of each calendar year have had average returns for the year (as a group of stocks) that ranged from minus 34% in 2008 to positive 57% in 2003. There was only one other negative return, minus 1% in 2007.

Turning to more recent times, we have done very well in this first half of 2012.

My own portfolio is up a surprising and rather gratifying 16.4% in the first half of 2012. For the group of stocks that we rated in the Buy or strong Buy ranges, the average return has been 7.3%. This compares very well to the Toronto stock index which is down 3.0%. The Dow Jones Industrial Average is up 5.4% and the S&P 500 index is up 8.3%.

My own success in 2012 has come from concentrating my investments in a few good companies. Right now 64% if my equities portfolio is invested in my top five holdings and 90% in my top 10 holdings. And at times during the year the concentration has been even higher.

Each of top five holdings are very established companies. Basically, they are blue-chip type stocks. Three of these are U.S. stocks. One is a conglomerate. Two of the five are retailers. One is a large bank. One is a real estate developer. The average gain on these five in 2012 has been 14%.

During 2012 I have been very close to 100% invested in equities. I have trimmed some positions, mostly on gains and I have bought on dips.

Over the years I have invested almost exclusively in somewhat boring profitable companies. These companies lend themselves to fundamental analysis based on their past earnings. I have rarely to almost never invested in oil and gas stocks and resource and commodity stocks. I don’t invest in early stage companies that are not yet making money. These companies that I tend not to invest in are more exciting and one could win the lottery playing them. But I have favored a steadier and less risky approach. It has worked out well. However I have had to stomach some major price declines, especially in 2008. And certainly not all of my stocks have worked out well.

If you are not already a subscriber to our stocks picks, you can get access to our stock picks and to the composition of my own portfolio by subscribing.

How Warren Buffett motivates his managers to achieve remarkable results.

The topic of how t motivate people is extremely important. After all, little would get done in this world without motivation. And I think it is obvious that a positively motivated worker is a happy worker. And that’s true whether that “worker” is the CEO or a front-line worker.

I have written an article that documents how Warren Buffett motivates his direct reports. Most of the article is simply quotes from Buffett’s writings.

Dollar Laws:

A dollar saved is a dollar earned : Obviously if you can save a dollar on a purchase, that is every bit as good as an (after income tax) dollar gained by working.

A dollar can only be spent once: Many people will purchase an item because they can “afford it”. But this thinking neglects to consider that there might be a better use for that particular dollar. A better purchase today perhaps. Or a better purchase tomorrow. When a dollar is spent, what is really being spent is the opportunity to spend that dollar elsewhere or at a future time or to investment that dollar.

A dollar invested should be invested at the best available combination of return and risk: A dollar invested at 10% is probably a great investment. But not if an equal or lower risk investment at 15% was available.

A Manipulated Market?

Many investors fret that markets are manipulated and that “there is no chance for the retain investor”.

This may be  a valid concern for those who invest based on “technical analysis” buying what is hot. Manipulators could drive  stock up in price and then drive it quickly down leaving retail  investors behind with large losses.

But value oriented investors should view market manipulation as an opportunity rather than a problem. In the long run a stock’s performance will reflect the underlying earnings. If market manipulation causes stocks to swing more wildly from under- to over-valued then this simply creates more opportunities to buy low and sell high.

Financial Crisis and European Worries?

Many investors are afraid that stocks will plunge due another financial crisis emanating from Europe. And they could be right.

But it’s unlikely that any such plunge would be permanent.

If you were the owner of the local Tim Horton’s franchise it’s not likely that you would be losing much sleep about the impact of a financial crisis upon your business. And it’s exceedingly unlikely that you be looking to sell your franchise due to the risk. So why then do the owners of shares in Tim Hortons and other good businesses fret so much?

It may be prudent to keep some cash available just in case of a financial crisis. But it’s probably not a prudent move to avoid stocks altogether.

END

Shawn Allen, President
InvestorsFriend Inc.

To see older editions of this newsletter, or to get off of this email list , click here.

InvestorsFriend Inc. Newsletter April 6, 2012

Imagine. You. Rich.

Getting rich through investing is simple but, unfortunately, neither quick nor easy.

The mathematical steps to get rich through investing are quite simple and are as follows:

1. Gather and set aside money to be committed to investing for the long term. Repeat this each month or year.

2. As it is accumulated, periodically allocate the money into investments that are expected to earn the highest possible long-term return without taking unacceptable risks. Monitor and reallocate periodically.

Amazingly enough, that is it. Yes it will take a long time to become rich this way. But the time will pass by whether you follow these steps or not.

When it comes to Step 1, setting aside part of your income and dedicating it to be invested for the long term, the percentage of income that could conceivably be saved and the resulting dollars being saved will vary all over the map depending on circumstances and priorities.

A teenager who is really committed to getting rich might be able to invest at least half of every dollar they take home. Similarly a high-income professional who is single and willing to live frugally might be able to save a large percentage of take home pay. (Remember, I said this is not easy).

But what about the average working guy? Well, really almost no one is truly average. The take home pay of families varies enormously as does their living costs. There is really nothing average about the amount that people can save.

What is realistically possible?

I did a comprehensive analysis of what would happen to someone who invested $500 per month or $6,000 per year for 30 years. The amount invested was increased for inflation each year. I looked at investing this money at the start of each year into either 100% stocks or a traditional balanced mixture of stocks and bonds. I looked at actual annual returns – after inflation for each possible 30 calendar year period all the way from 1926-1955 to 1981-2010.

This means that in real dollars, adjusted for inflation, a total of $180,000 was invested over 30 years. (Realistically, someone starting this in 1926 would likely have invested closer to $600 per year than $6,000 but in terms of the resulting percentage increase in dollars over time the result is the same.)

Here are the results, in real dollars adjusted for inflation, if all the money was invested in stocks:

Lowest ending portfolio value: $277,471 (1952-1981), 46 times annual savings of $6,000 for 30 years.

Average ending portfolio value: $758,942, 126 times annual savings.

Highest ending portfolio value: $1,374,265 (1970 – 1999) 229 times annual savings.

If the money was instead invested in a traditional balanced fashion of 60% stocks, 35% bonds and 5% cash then the inflation-adjusted results were as follows:

Lowest ending portfolio value: $202,559 (1952-1981), 34 times annual savings of $6,000 for 30 years.

Average ending portfolio value: $494,252, 82 times annual savings.

Highest ending portfolio value: $860,218 (1970 – 1999) 143 times annual savings.

The above ending portfolio values are fully adjusted downwards for inflation.

The May 27, 2007 edition of this newsletter also covered some mathematical examples of how much initial money, return and time was required to amass $3 million. (Why think small?)

Warren Buffett, world champion saver and investor

By the age of 12, Warren Buffett had read every book on investing in the Omaha Library. At age 12 he bought his first ever shares of stock, 3 shares that cost him a total of $114.75, essentially his life savings at that point. He studied compound interest tables. He announced to a friend that he would be a millionaire by age 35.

By age 12, in 1942, Warren Buffett not only hoped to get rich, but he had a plan of how to do it. He would find every possible way to make some money, he would save that money and invest it in stocks where it would compound and grow. Because he had this clear plan, I believe he not only hoped to get rich, he knew he was going to get rich.

He earned and saved around $5,000 from delivering a massive amount of newspapers mostly when he lived, with his family, in Washington D.C. for about four years as a teenager. When he finished college he had a net worth of $9,800 amassed from savings and investment.

Upon graduation from college Warren worked for a time in Omaha at his father’s small brokerage office and then worked for a short period of time with Benjamin Graham in New York. He returned to Omaha in 1956, at age 25 with a net worth of $174,000. He was married and had at least one child by then. But he had no plans to look for a job. They could live on $12,000 a year and his net worth would still grow through investing. He then started a partnership, initially with friends and family only, to invest additional money. The rest, as they say, is history.

He ended up earning substantial performance fees from his partnership funds from 1956 through 1969. He lived frugally.

After 1969 his wealth grew almost entirely due to growth in his own investments. He has never taken more that $100,000 per year in salary from Berkshire Hathaway. He owned roughly one third of Berkshire, and that, after a time, represented over 99% of his net worth. But even the remaining less than 1% of his wealth was invested and eventually amounted to some hundreds of millions. I believe he would have earned some money from sitting on corporate Boards over the years as well. But the vast vast majority of his wealth came from investing and compounding the wealth that he had amassed by 1969. In March 2012, Forbes magazine pegged him the third richest person in the world at $44 billion. And this is after he gave away approximately $2 billion per year in each of the last 6 years.

Warren Buffett became one of the world’s richest people by following a simple plan that was well formed in his head by the time he was 12 years old. It consisted of earning and saving up an initial seed capital and investing his capital at the highest returns he could find while not taking undue risks.

Where to Invest?

While Warren Buffett is best known for investing in stocks  he is perfectly willing to invest in bonds but only when they represent the better investment.

In most circumstances stocks are the better investment.

I recently updated two articles that compare the long-term results of investing in stocks versus bonds.

Stocks versus Bonds, Cash and Gold: since 1926 and for selected 20-year periods

Stocks versus Bonds and Cash over all possible 30 calendar year periods since 1926

And for good measure here is a detailed article on investing in stocks versus bonds versus a balanced portfolio for every possible calendar 30-year period from 1926-1955 all the way to 1981-2010.

This shows not only that stocks won in the end but, importantly, it shows the ugly volatility along the way.

100% stocks versus Balanced Approach over all possible 30 calendar year periods since 1926 and including the Volatility along the way.

Is it too late to Invest?

No, it is not too late to invest.

The P/E ratio on the Toronto stock exchange is 15.8, which is close to historic levels.  A P/E of 15.8 is an earnings yield of 6.3%, which compares very well to 10-year government of Canada bonds which yield about 2%.

The P/E ratio of the S&P 500 stock index in New York is 15.3, for an earnings yield of 6.5%, which compares well to 10-year U.S. government bonds that yield 2.1%.

What are some Good Stocks to Buy?

We have some ideas available for those who subscribe to our stock research. The cost is just CAN $13 per month or $120 per year. I don’t think even Warren Buffett would consider that to be an extravagant price. As of April 6, our Strong Buys are up by an average of 10.4% each in 2012.

END

Shawn Allen, President
InvestorsFriend Inc.

To see older editions of this newsletter, or to get off of this email list , click here.

InvestorsFriend Inc. Newsletter March 18, 2012

Our Performance

This site, www.InvestorsFriend.com provides a large amount of free educational material. We also offer, for a small charge, Buy / Sell ratings on a select group of Canadian and American stocks. The proof that we actually have something valuable to say comes in our Stock Rating Performance.

And, our performance suggests that our analyses and our approach to investing is quite sound (either that or we have been uncommonly lucky over the past twelve years).

Our six Strong Buys are up an average of 13.0% each since January 1. Our editor’s own portfolio is up 11.3% this year.

Stock investing is not for everyone, and there are no guarantees, and there WILL be years where returns are negative. However, the data shows that over time, stock investing is quite rewarding, and especially if one can manage to beat the stock index averages. You can click to see the details of our subscription service to access our specific stock picks.

Is it Too Late To Invest in Stocks?

The best time to plant a huge oak tree in your yard was probably 50 years ago. But the best available time is today.

In general, almost anytime can be a good time to invest in stocks. Exceptions would include when the stock market is clearly over-valued or when “something bad” is about to happen to the markets. The problem is that “something bad” can happen at any time but is generally not predictable. So, it probably seldom makes sense to avoid investing on the basis that “something bad” might  happen, although if one can’t afford or can’t stomach the risk then investing in stocks (at any time) may be unacceptable.

In terms of whether or not the stock market is over-valued, we recently took a look at three large North American Stock Indexes and they did not appear to be over-valued.

S&P 500 index Valuation

Dow Jones Industrial Average Valuation

Toronto Stock Exchange Valuation 

Wiley Warren Buffett Wins Again

The financial genius of Warren Buffett is still under-appreciated. Consider the following example.

On August 25, 2011, it was revealed that Berkshire Hathaway would invest $5 billion in newly created Bank of America perpetual preferred shares.

What would Buffett / Berkshire get for its $5 billion?

Firstly a yield of 6% per year. That will continue until the Bank of America redeems the shares in which case it has to pay a 5% one-time premium.

Okay, so far that sounds like an “okay” investment but nothing to really write home about.

But wait!, there was more…

Berkshire also received warrants (or options) to buy 700 million shares in Bank of America  at a price of $7.142857 at any time in the next ten years. That price seems rather odd and exact, but it turns out that it means that Berkshire has the right to invest exactly another $5 billion at any time in the next ten years, for which it will receive 700 million shares.

It’s not immediately obvious what would be the value of these 700 million 10-year options.

On August 24, Bank of America shares closed at $6.99. So, at issue these options had no intrinsic value. (They could not be immediately exercised for a gain.) But they definitely had a value. The value of options increases with their term, and these were ten year options.

I suspect that standard calculations would have suggested that these options may have had a value of very roughly $3.00 per share or a total value in the range of $2 billion. And I suspect that Buffett figured the true value was more than the standard models would suggest.

In December 2011, the Bank of America shares dropped briefly to as low as $5.00 and it may have appeared that Berkshire’s options were not worth much.

However, as of March 17, 2012, the Bank of America Shares have (rather suddenly) risen to $9.80.

Suddenly, Berkshire’s 700 million options to buy at $7.142857 have an intrinsic value of $1.86 billion. And if we add another (say) $2 billion to account for the time value of these options which don’t expire until August 2021 we can see that these options are worth perhaps $3.9 billion.

Looking at these numbers, and considering that Bank of America appears to be on the mend, it is very easy to predict that Buffett will end up making $5 billion, or probably a lot more, in addition to continuing to collecting 6% per year on his $5 billion investment.

Even for Berkshire, a $5 billion gain is significant. Berkshire’s common equity at the end of 2011 was $169 billion.

And, when Berkshire ultimately exercises these options it will end up owning, at a bargain price, about 6.3% of the Bank of America Corporation, assuming its share count has not increased by then.

I fully expect that these shares will result in several billions in unrealized gains for Berkshire by the end of 2012.

Should a Business Rent or Own its building space?

Most people would probably guess that a business would be a better off to own its building space rather than rent from others.

After all, why pay rent when you can own?

Individuals know that owning a house rather than renting has usually proven to be a good way to build equity over the years. The U.S. has certainly had its faith in home ownership shaken to the core in the past few years. The Canadian experience however has definitely been that owning a house has been better than renting. Canadians tend to believe that even if the value of the house does not rise, the payment of a mortgage represents a beneficial forced savings plan.

Business owners as well, often conclude that it is better to own space than to rent.

But, in fact, it is easy to think of examples where a business is better off renting.

Imagine a retail operation that has ample opportunity to expand. Imagine that it makes 20% on the capital (money) that it invests in its retail operations. Also imagine that it has only a limited amount of capital from its borrowing capacity and its retained earnings each year. (Certainly private businesses tend to have limited capital and even publicly traded companies do not find it easy to go to the market and raise new equity capital). Landlords recently have been happy to lease out space at annual rents that amount to about 7% of the value of the building. In this case, it makes perfect sense for the business to rent multiple locations. It can preserve its scarce capital to invest in adding to the number of its locations which are earning 20% on capital rather than tie up its capital in owning space that can be rented at 7% of the capital cost it would take to buy the building. In other words it does not make sense to forego a 20% return in order  to avoid an expense of 7%.

Dollarama is an example of this. The retail chain is highly profitable and has expanded very rapidly. It does not own its stores. It leases the space.

How much money went “into” the Stock market in Canada in 2011? (try none!)

Consider the following figures regarding the Toronto Stock Exchange, for the year 2011:

Total value of all stocks: $2,202 billion (end 2011)

Total raised in public offerings in 2011: $40 billion

Total paid out in Dividends in 2011: $40 billion (Based on dividend rate of about 1.8%)

Total paid out in share buy-backs: $unknown

Based on the above I would conclude that the total net amount invested in (or more properly through) the Toronto Stock Exchange in 2012 was something less than zero. While $40 billion was raised by selling shares to investors , this was completely offset by about $40 billion paid out as dividends. In addition there was some unknown amount of share buy-backs.

Perhaps this should not be too surprising, large corporations tend to make money and to pay dividends. They usually can finance expansion through retained earnings and borrowed money. Large established companies on the TSX seldom need to go to the market to raise new equity.

When people buy shares they tend to think of it as investing “in” a company or investing “in” the market. In reality, if pressed, they would admit to knowing that the money they paid for their shares went not to the company but to whomever sold the shares.

We constantly hear about investors (as a population) “pulling” money out of a company. It’s nonsense. While an individual investor can indeed pull his or her money out, investors as a whole population must be content to trade with each other. With rare exceptions they have no ability to sell their shares back to the company. Investors as a population can bid the value of a company up (thereby creating wealth) or down (destroying wealth), but they cannot inject or pull out money as a population, except to the extent that the company wishes to raise equity money, buy back shares or pay dividends.

In Toronto in 2011, investors, as a population,  made trades, among themselves, worth $1,480 billion. The companies whose shares were traded certainly take an interest in both the volume of trading in their shares and especially in the price paid. But (with the rare exceptions of buy-backs and public offering of shares from the company) the companies are not a party to these trades and certainly do not receive or pay the amounts traded.

With trading at $1,480 billion and a total market value of 2,202 billion, it is interesting to note that the value of the Toronto Stock Exchange “turned over” about 0.67 times in 2011 implying a dollar-weighted average holding period of 1.5 years (18 months).

The situation on the Toronto Venture Exchange is somewhat different.

Total value of all stocks  $49.0 billion (end 2011)

Total raised in public offerings in 2011: $10.1 billion

Total paid out in dividends: unknown but likely less than 1% or  0.5 billion

Total paid out through share buy-backs: (unknown but probably tiny)

Based on the above it appears that the total amount invested into the Toronto Venture companies in 2011 was roughly $10 billion or 20% of the market value.

The total trading among investors was $42.5 billion. This suggests that the Toronto Venture exchange shares “turned over” about 0.87 times and that the average dollar-weighted holding period was about 1.15 years (14 months).

END

Shawn Allen, CFA, CMA, MBA, P.Eng.
President
InvestorsFriend Inc.

To see older editions of this newsletter, or to get off of this email list , click here.

InvestorsFriend Inc. Newsletter February 18, 2012

Investment Performance this new year.

Stocks are off to a roaring start in in 2012. The Dow is up 6.0% since January 1, the Toronto Stock index is up 4.2% and the S&P 500 is up 8.0%. Our six Strong Buys are up an average of 9.0%. My own portfolio is up 6.1%.

The Definition of Investing

Warren Buffett gave a definition of investing in a Fortune magazine article this month. Warren Buffett said “investing is forgoing consumption now in order to have the ability to consume more at a later date”. This article, like anything that Buffett writes, is a must-read for serious investors.

I like his definition of investing. Actually I applied the same thinking in my article back in 2001 about whether people should invest some money rather than spend it all. I described investing in terms of the choice between eating all your potatoes now as opposed to cutting some up and planting them so as to eat more potatoes next year.

The Wonders of Compound Interest and Returns

Albert Einstein said that the most powerful force in the universe is compound interest.

Consider if you will, the following fundamental truths about compound interest and compound growth:

If any thing, no matter how small it is today, grows annually and forever at a rate larger than the growth of some other thing that today is vastly larger, then eventually the small thing must surpass the larger thing in size.

Ponder the implications of this.

A single dollar growing at 15% will surpass a hundred thousand dollars growing at 1% after 90 years. And it will surpass a million dollars growing at 1% after 108 years.

Yes, that is a long time, but in the history of man it is nothing.

A single dollar if it can be grown at 20% per year will surpass a million that is not growing in 77 years. Perhaps of more interest, $1000 growing at 20% annually will surpass a million that is not growing in 40 years. And $10,000 growing at 20% reaches a million in 26 years and it reaches 10 million in 38 years.

For a real life example, $1000 invested in Berkshire Hathaway in 1965 when the shares were $15 is worth $7.9 million today, 47 years later, with Berkshire trading at about $119,000. The compounded return has been about 21% per year.

You can understand why compound growth is a great worry to the likes of David Suzuki. It’s a fact, if the human population grows at even a very slow rate then there WILL eventually come a time when we would occupy every square foot of the planet.

No company can forever grow faster than the growth in the overall economy since it would eventually be larger than the entire economy — an impossibility since it is a part of the economy.

No invested pot of money can forever grow faster than the entire economy since it would eventually be larger than the entire economy — an impossibility.

It would be impossible for a majority of the population to grow wealth at a rate faster than the overall rate of growth of wealth in the entire world. Obviously, only a minority of the population can ever grow their wealth at a rate faster than average.

My Personal Experience in Compounding Wealth

Back in 1989, I was 29 years old and my financial net worth was just below zero (given that I had little equity in my house or even my car and given a modest student loan and almost no savings). But, not to worry, I was highly educated and was several years into my career by then. It was in 1989 that I started to think more about investing. I read one of those books (Common Sense by A.L. Williams) that showed how much you can grow your money if you get a reasonable return, but that the real key was starting young.

Well it was too late for me to start investing at age 20, but I did the next best thing and started investing in the stock market at age 29. At first in mutual funds and later in individual stocks.

It’s worked out pretty well. I have tracked the figures meticulously over the years. Using my average annual returns for each year, I calculate the following.

The $2000 that I invested in 1989 is now $24,282. Perhaps surprisingly, it “only” took an annual compounded return of 11.5% to get there. The power of time and compounding is illustrated if you consider the fact that if I now achieve an 8.3% return on this $24,282, that is $2000 or another 100% on the original investment.

The $7500 that I invested in 1990 is now worth $83,349. (I borrowed the money for a large RRSP catch-up contribution, and I have not deducted the interest paid here, but clearly this was a great investment even after paying the interest on the loan). Following this I had several years of not investing at all but most years I did invest.

Turning to more recent years, the $4,884 that I invested in 1999 is now worth $22,477. The $11,105 that I invested in 2006 is now worth $19,267.

And, yes, I did have some negative years. I lost about 8% in each of 1998 and 2002 and I lost 23% in 2008. In all other years since 1989, I made money.

When it comes to compound returns and investing for long periods of time, I can attest that it has worked for me.

Some readers will protest that they don’t necessarily have 23 more years to live or that they simply are not prepared to wait that long.

Well, most readers will still be around in 23 years and those years will go by whether they invest or not. But some will not invest and some will be net borrowers. And ultimately those of us who can invest can only do so if some of you are net borrowers or corporate users of investor’s money. And if you think that’s not fair, consider that no one could borrow unless others saved and invested.

In 2007, I wrote in detail about compound returns and how you could use them to plan to get rich (rather than merely hope).

Do You Know Anyone Who is Rich, And do you know how they got that way?

I believe I read in his autobiography that Benjamin Franklin used to have some kind of regular social club meetings and that a standing order of business was to discuss the question “Do You Know Anyone Who’s Rich, and do you know how they got that way?”

Well that was over 200 years ago but I think that is still a useful question. I suspect most people around us who are rich got that way through owning businesses of one type or another. Most of us are not in a position to own and operate a business, but we can certainly own our share of businesses through owning stocks.

Last year I wrote an article that compared owning a business to owning shares in a business.

If you have interesting information on someone who is rich and how they got that way, I’d be interested in hearing about it at shawn@investorsfriend.com

People everywhere tend to want the same things

I’ve recently had the opportunity to do some traveling. And, of course, I like to observe a bit about shops and restaurants that are doing well in the areas that I visit.

In North America we tend to have plenty of national chains of stores, restaurants and Hotels.  In many ways that takes away from the uniqueness of our towns and Cities. But it’s a fact, from Miami Florida to Anchorage Alaska or from Los Angeles to St. John’s Newfoundland, we like our Starbucks and our Holiday Inns and our McDonalds and our Coke. In Canada we have blanketed the country with Tim Hortons and Canadian Tire stores and also with Walmarts and Staples and Costcos and Starbucks.

When I was in Europe (London, Paris, Lucerne, Florence, Venice and Rome) in 2010, I certainly saw lots of Starbucks, McDonald’s and Coke. In Paris some of the more popular stores were brand names that also exist in New York and I suppose most other large cities in the world.

On a Caribbean cruise last month I saw Subway sandwich shops and McDonalds. Tiny St. Thomas which as I recall is not larger than about 3 miles by 20 miles was crowded with cars. The cars were not tiny either, instead they were the same size as in North America. Cell phones were everywhere. It may be sad, but the stores that I bought something in included Tommy Hilfiger and Guess, although I did buy a few small things from local shops as well.

I just heard today that China is the second biggest television market for the NBA.

My conclusion is that people everywhere tend to want the same things. We are just not that different.  The consumer society will continue to spread around the globe. And I think that is a very good thing. (I mean is it fair that anyone live in squalor or in some primitive village while most in North America sip lattes?).

This has implications for investing as well. Warren Buffett concluded decades ago that big consumer brand names could be great investments. He invested heavily in American Express, McDonald’s, Coke, Dairy Queen and Gillette among others. He also invested in smaller brand names like See’s Candies, Benjamin Moore’s, World Book Encyclopedia, Pampered Chef, Kirby Vacuums, and many more. In a world that is going to continue to globalize, “consumerize” and standardize, the future is very bright for the best brand names in this world.

This year with the Arab Spring, we also saw that people everywhere want democracy and self determination. Perhaps there is hope that world wide consumerism can basically help us all live in harmony. And what is consumerism other than wanting to get more out of life? I see nothing wrong with that.

And if you think too much consumption is wrong, consider that investors must FORGO consumption today in order to save and grow their wealth. In the end investors have the right to consume more in future, but a lot of times they never spend much of their wealth. Investors as a class of people have nothing to apologize for.

END

Shawn Allen, President
InvestorsFriend Inc.

To see older editions of this newsletter, or to get off of this email list , click here.

InvestorsFriend Inc. Newsletter January 14, 2012

The Wisdom of Warren Buffett

Warren Buffett is generally acknowledged as one of the best investors in history. He started investing in 1942 at 12 years old and today at 81 he is not done yet.

His annual letters are a treasure trove of investment wisdom and advice.

Here is some of his wisdom:

Way back in his 1961 letter Buffett said the Dow Jones Industrial Average total return over the future years will probably be 5 to 7%. (Which was not as good as recent years had been). Interestingly, he would essentially repeat the 5 to 7% figure some 39 years later in a famous Fortune magazine article written at the tail end of the 1990’s stock boom.

In 1961 he also said his job was to pile up yearly advantages over the Dow. That it was not important that his return be positive, just that it be better than the Dow. (Since the DOW itself would do well over time, he would do well if he could beat the DOW)

In 1963 Buffett noted that he makes no attempt to time the market. He considered attempting to gauge stock market fluctuations to be a very poor business.

In 1964 he said “If a 20% to 30% drop in the market value of your equity holdings is going to produce emotional or financial distress, you should simply avoid common stock type investments.”

In 1965 Buffett described how the partnership he ran had been accumulating shares in Berkshire Hathaway since 1962 on the basis that it was trading significantly below the value to a private owner. The first buys were at a price of $7.60 and the average cost was $14.86 reflecting heavy purchases in 1965 as Buffett (the investment partnership he ran) took control of the company in the Spring of 1965. The 1979 letter reveals that: “The book value per share of Berkshire Hathaway on September 30, 1964 (the fiscal year-end prior to the time that your present management assumed responsibility) was $19.46 per share.”

These are the very same Berkshire Hathaway shares that closed out 2011 at $114,755. This is a gain of 772,000% over his average purchase price of $14.86. What is perhaps most remarkable is that this represents “only” 21.0% per year compounded for the 47 years from 1965 to 2011 inclusive.

In 1975 Buffett also talked about his lack of diversification.

He described a new “ground rule” whereby the fund diversifies much less than other fund managers and might invest up to 40% of the money in a single security if there was both a high probability that our facts and reasoning are correct and a very low probability that anything could drastically change the underlying value of the investment.

Ideally he would put 2% each into 50 un-correlated investments that all had an expectation of beating the Dow by 15%. Then he could have a high certainty of getting near that 15% advantage. But, “it doesn’t work that way”. He worked extremely hard to find just a very few attractive investment situations. Where the expectation by definition is at least 10% higher per year than the Dow. “Our business is that of ascertaining facts and then applying experience and reason to such facts to reach expectations.” It is imprecise and emotionally influenced.

“A portfolio that expects to beat the market and yet contains 100 securities is not being operated logically. This is the Noah school of investing – two of everything.”

“The optimum portfolio depends on the various expectations of choices available and the degree of variance in performance which is tolerable”. More securities leads to less variation but lower returns (as you invest less in the securities with the highest expected returns). Buffett was willing to accept quite a bit of variability for higher returns. Therefore he concentrated in the best investments and accepted that there would occasionally be a very sour year.

In 1966 he said: “We don’t buy and sell stocks based upon what other people think the stock market is going to do (I never have an opinion) but rather upon what we think the company is going to do”

In 1975 he said:

“Our equity investments are heavily concentrated in a few companies which are selected based on favorable economic characteristics, competent and honest management, and a purchase price attractive when measured against the yardstick of value to a private owner.”

“With this approach, stock market fluctuations are of little importance to us – except as they may provide buying opportunities – but business performance is of major importance.” Market fluctuations in bond investments held (due to interest rate movements) were also of little importance since the bonds would unlikely be sold other than at times of Buffett’s choice.

In 1979, at a time of high inflation, Buffett made some interesting comments on the future value of money and printing money

“One friendly but sharp-eyed commentator on Berkshire has pointed out that our book value at the end of 1964 would have bought about one-half ounce of gold and, fifteen years later, after we have plowed back all earnings along with much blood, sweat and tears, the book value produced will buy about the same half ounce. A similar comparison could be drawn with Middle Eastern oil. The rub has been that government has been exceptionally able in printing money and creating promises, but is unable to print gold or create oil.”

“We have severe doubts as to whether a very long-term fixed-interest bond, denominated in dollars, remains an appropriate business contract in a world where the value of dollars seems almost certain to shrink by the day. Those dollars, as well as paper creations of other governments, simply may have too many structural weaknesses to appropriately serve as a unit of long term commercial reference. If so, really long bonds may turn out to be obsolete instruments and insurers who have bought those maturities of 2010 or 2020 could have major and continuing problems on their hands. We, likewise, will be unhappy with our fifteen-year bonds and will annually pay a price in terms of earning power that reflects that mistake.”

Nevertheless, Buffett never wavered in his belief that he could make excellent returns by investing in companies, in the same letter he said: “We continue to feel very good about our insurance equity investments. Over a period of years, we expect to develop very large and growing amounts of underlying earning power attributable to our fractional ownership of these companies. In most cases they are splendid businesses, splendidly managed, purchased at highly attractive prices.”

In his 1984 letter, Buffett spoke about buying attractive bonds at that time but also wrote about the irrationality of investors buying long-term bonds at times of very low interest rates. (This may be very relevant to the situation in 2012 and InvestorsFriend would note that Berkshire Hathaway today has only a very tiny amount invested in long-term bonds).

“Our approach to bond investment – treating it as an unusual sort of “business” with special advantages and disadvantages – may strike you as a bit quirky. However, we believe that many staggering errors by investors could have been avoided if they had viewed bond investment with a businessman’s perspective. For example, in 1946, 20-year AAA tax-exempt bonds traded at slightly below a 1% yield. In effect, the buyer of those bonds at that time bought a “business” that earned about 1% on “book value” (and that, moreover, could never earn a dime more than 1% on book), and paid 100 cents on the dollar for that abominable business.”

“If an investor had been business-minded enough to think in those terms – and that was the precise reality of the bargain struck – he would have laughed at the proposition and walked away. For, at the same time, businesses with excellent future prospects could have been bought at, or close to, book value while earning 10%, 12%, or 15% after tax on book. Probably no business in America changed hands in 1946 at book value that the buyer believed lacked the ability to earn more than 1% on book. But investors with bond-buying habits eagerly made economic commitments throughout the year on just that basis. Similar, although less extreme, conditions prevailed for the next two decades as bond investors happily signed up for twenty or thirty years on terms outrageously inadequate by business standards.”

Conventional wisdom is that stocks are riskier than bonds, but here is what Buffett said about stocks versus bonds (this was at a time of relatively high inflation):

“While there is not much to choose between bonds and stocks (as a class) when annual inflation is in the 5%-10% range, runaway inflation is a different story. In that circumstance, a diversified stock portfolio would almost surely suffer an enormous loss in real value. But bonds already outstanding would suffer far more. Thus, we think an all-bond portfolio carries a small but unacceptable “wipe out” risk, and we require any purchase of long-term bonds to clear a special hurdle. Only when bond purchases appear decidedly superior to other business opportunities will we engage in them. Those occasions are likely to be few and far between.”

(And InvestorsFriend’s opinion is that such occasions right now would only be found in a very few high yield bonds and most certainly would not be found in long-term government or investment grade bonds.)

Buffett also wrote in 1979 about stocks being superior to bonds at that time. He wrote again in 2001 about the 1978 situation and said:

“Back in 1978, as I mentioned, we had the Dow earning 13% on its average book value of $850. The 13% could only be a benchmark, not a guarantee. Still, if you’d been willing then to invest for a period of time in stocks, you were in effect buying a bond–at prices that in 1979 seldom inched above par–with a principal value of $891 and a quite possible 13% coupon on the principal.

“How could that not be better than a 9.5% bond? From that starting point, stocks had to outperform bonds over the long term. That, incidentally, has been true during most of my business lifetime. But as Keynes would remind us, the superiority of stocks isn’t inevitable. They own the advantage only when certain conditions prevail.”

InvestorsFriend would note that today, stocks are earning about 14% on their book values but trade at twice book value and so they are earning 7% on their market prices. We think that this implies that Buffett would once again conclude that stocks will certainly beat all government bonds in the long run given that long-term government bonds yield in the 2 to 3% range.

In a 1999 article Buffett said:

“The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.”

InvestorsFriend’s Stock Picks for 2012

At InvestorsFriend, we never make any promises or guarantees about investment results. What we can do is point out that we have a consistent track record of beating the market significantly. We intend to continue to evaluate and rate stocks on the same basis that has been successful in the past.

Check out our Performance here:

InvestorFriends’ Performance

Borrow to Invest?

Normally, it is a dangerous idea to borrow to invest in stocks. Only those with very secure jobs and with very little other debt should consider it. Right now may be a good opportunity to borrow to invest for those who are in a position to take that risk.

Bank of Montreal is offering a fiver-year mortage locked in at only 2.99%. Meanwhile there are many preferred shares and dividend stocks that pay more than 3%. This includes bank preferred shares. For centuries banks have operated by taking in money at a low interest rate and lending it out at a higher interest rate. Right now you have the the opportunity to effectively do the same. Imagine borrowing from the bank of Montreal at 3% and simply investing the money in Bank of Montreal preferred or Common shares which are expected to (but not guaranteed to) earn more than 3%.

END

Shawn Allen, President
InvestorsFriend Inc.

To see older editions of this newsletter, or to get off of this email list click the following link.

http://www.investorsfriend.com/news-letter-list

Regards,
Shawn Allen CFA, CMA, MBA, P.Eng.
President
InvestorsFriend Inc.

Comments by return email are always welcome.

InvestorsFriend Inc. Newsletter December 27, 2011

Another Year of Beating the Market

As we close out 2011, my own portfolio is up 3%. That may not be great but it certainly beats the Toronto stock exchange index which is down 11%. Meanwhile, the Standard and Poors 500 index is up 1%.

My own portfolio has done better than the TSX index in 10 out of the past 12 years. The average out performance has been 9% per year. My portfolio has returned a cumulative 302% over the past 12 years while the TSX index is up just 41% and the S&P 500 index is down 17%.

An investment in an equal amount of each of the Buy or higher rated stocks on this web site from the start of each of the past 12 years has returned a cumulative 325% and has beaten the TSX index in 10 out of the last 12 years since the inception of this web site.

Here is how we have accomplished these excellent returns:

All these years our basic approach has never varied. We have applied fundamental analysis to a select group of companies to identify those which appear to be under-valued. Almost all of the stocks have been middle to larger size companies. There have only been a very few penny stocks. There have been (many) financial companies, pipeline companies, retailers, restaurant chains (including two large coffee chains), beer brewing companies,  software companies, a property developer, a lumber company, rail roads, telco and cable companies,and a number of miscellaneous companies.

And, by the way, I call these “companies” rather than “stocks” for a specific reason. Those who invest based on fundamentals including earnings and earnings outlook are necessarily thinking about a company. A company has revenues and expenses and customers and profits and assets. On the other hand if you think in terms of investing in “stocks” then you may fall into the habit of thinking of your stock as just a squiggle or chart on a screen. Those who invest in stocks may try to guess where the stock’s price will go without even thinking much about the underlying company. That simply is not our style.

For the most part there has been no mining companies, and few commodity companies of any kind.

The analysis has been 100% fundamentals based. We have studiously ignored technical analysis and momentum based approaches. I have not used stop losses in my own portfolio and we have not recommended their use.

We have not used any “target” prices.  Our “Buys” occasionally turn into “Sells” when the price has risen a lot or the earnings have declined. More typically a Buy or Strong Buy later becomes a (lower) Buy or a Weak Buy / Hold and at that point we have often indicated that we have sold some or all of our position to move into stocks with higher ratings.

As far as market timing goes, we don’t do a lot of it. But some years we find very few Strong Buys and other years we find many stocks to rate Strong Buy. My own portfolio has mostly been fully invested in equities but very occasionally I have held as much as about 40% in cash. And I have used some margin or borrowed money at times as well.

As far as dividend stocks or income, we have not really targeted that although in more recent years we do include some higher yielding companies on the list.

Our stock picks from the start of each year and how they did are fully documented on our performance page. Click each year to see the specific stocks. But enough of the past; what will tomorrow bring?

Investments for 2012 and beyond:

When it comes to thinking about companies to invest in for 2012, most investors ask the wrong questions. They ask, will the market go up? and will this particular stock go up?

The problem with those questions is that quite simply, nobody knows. There is an infinite number of things that can happen to the the world economy, the North America economy, to world and local politics, to a particular company, to interest rates. With all of these variable it is never possible to know with certainty which direction a company’s stock or even the entire market is going to go over a short period of time like one year. There is little point in dwelling on questions that cannot be answered.

Better questions that CAN be answered are along the lines of: Does the stock market appear to offer good value at this time? Does company XYZ appear to offer good value?

It’s impossible to guarantee that investing in the market, or in a particular company, will turn out to be a good investment even over the long term. But it is certainly possible to do some analysis and conclude whether it appears to be a good investment.

Over a lifetime if you make good decisions by investing in good companies at reasonable prices, then things are very likely to work out well for you.

So, Are the Markets Attractively Prices at This time?

Yes, our analysis suggests that North American stock markets on average are reasonably priced and likely to provide a reasonable return over the long term.

What about Individual Stocks?

We have identified about five company stocks that we rate in the Strong Buy category heading into the new year. And we may find a few more by January 1. And in addition to that we have identified at least six more that we would rate as  Buy or higher Buy.

We never make any guarantees. But overall we feel that there are lots of good investment opportunities available. I certainly feel good about owning my share of profitable corporations.

Success in Investing:

It has been said that in many endeavors just showing up can be 90% of success. Stocks have been that way over the years.  Yes, there have been plenty of bad years. But history shows that an investor who simply kept their money in the markets through good times and bad over the years has made a good return over the years. There are ALWAYS reasons to fear being invested in stocks. And there are many people who simply cannot afford the volatility. Perhaps they can’t afford the risk of loss, or perhaps they can’t handle it emotionally. Many people however can afford to take some risks and can learn to deal with the emotional aspects.

Picking The Best Company Stocks of All:

Ideally, I would like to analyze hundreds of stocks and choose those few that appear to offer the very highest expected returns. Realistically, I can’t do that. Instead, I analyze a group of companies and invest in the best that I can find from that group. One rule that I have followed, almost without exception, is that I invest in only what I have analyzed.

Future Analysis:

By the end of March 2012 we will be updating our articles that analyse the overall value of the Dow Jones Industrial Average, the S&P 500 and the Toronto stock index. This update will incorporate the 2011 earnings. We will also update our Article that lists a broad range of exchange traded funds and provides an indication of which funds and sectors appear top offer good value based on their dividends and P/E ratios. This analysis is provided free of charge. This ETF article alone provides sufficient information from which to choose a diversified low-cost portfolio.

We would also like to add more companies to our list. There are many promising and interesting companies to look at. Not only might we find some good investments, but we enjoy learning about different businesses and how they operate and make money (or not).

Get Our Stock Picks for 2012

If you are interested in knowing which stocks we are buying and why and if you not already a subscriber to our Stock Analysis service you can access our stock picks by subscribing for as little as one month for just $13 per month or at our Boxing Day Special reduced rate of  $100 per year. Click for more details of how to subscribe.

Real Estate

It is well known that house prices in the United States are down dramatically from their peak values. According to the latest Case-Shiller home price index, (released just today) the average house price in the United States has declined 32% since peaking in July 2006. But that does not tell the whole story. Houses in Dallas Texas are only down 8% since mid-2006. But those in Los Vegas are down an average of a whopping 61%. Florida is down an average of 50%, and there would certainly be some homes down much more than that.

Meanwhile, in Canada the Teranet index shows that the average house across the country has increased in value by close to 40% since mid-2006. In Vancouver the average gain was about 60%.

House prices in Canada are now substantially higher than those in the United States. Roughly speaking, it’s not unusual for house prices in Canada to be double those in comparable sized cities in the U.S. (But it varies greatly depending which cities are compared in various parts of each country.)

That disparity will not last indefinitely. It seems to me that house prices in Canada are vulnerable to a decline. It may take higher interest rates or higher unemployment to trigger a decline, but before too long a decline is quite possible.

Meanwhile house prices in the United States are probably at or close to a bottom and will likely be rising over the next few years.

Many younger Canadians with huge mortgages are at risk financially if interest rates rise. It might be prudent for homeowners with large mortgages to lock in their interest rate for 10 years or more. Unfortunately, for unknown reasons, Canadians simply do not have access to reasonable interest rates when it comes to locking in for 10 or more years. And if Canadians do lock-in for 10 years or more, they an face massive penalties if they need to get out of the mortgage. Such penalties usually do not apply in the Unites States.

I high-lighted the problem in a recent email to some journalists

In (last week’s news from the United States I see:

WASHINGTON (AP) — The average rate on the 30-year fixed mortgage fell to a record 3.91 percent this week, the third time this year that rates have hit new lows.” Meanwhile in Canada the posted mortgage rates for longer fixed terms are:

5-year fixed 5.29% but 4.09% special deal (so similar to U.S. 30-year fixed rate)

10-year fixed 6.75% but 5.45% special deal (39% higher than U.S. 30-year fixed)

25-year fixed 8.75% (call for special deal) I called and the mortgage specialist was not aware what the special deal might be and had never heard of anyone locking in for 30 years. The posted rate is more than double the U.S. 30-year fixed rate.

http://www.rbcroyalbank.com/mortgages/mortgage-rates.html

Americans can get 3.9% locked in for 30-years (with the ability to refinance or pay-off without any interest rate differential) while Royal Bank’s posted rate is 8.75% for 25 years (and massive interest rate differentials could apply if you pay it off early).

Money is the ULTIMATE GLOBAL commodity and yet Canadians pay more than 100% higher interest rates than Americans for a 25-year locked in term . In both cases on government insured housing loans. And yet our government interest rate is 2.50% versus a higher 2.98% in the USA. Something is vastly wrong here.

I don’t think this has to do with any lack of Canadian bank competition, it has to do with the fact that the Canadian banks presumably cannot access 30-year deposit/investor money through securitizations but the American banks can. Yet our banks have CMHC insured mortgages, so what is the problem in getting the low cost  investor money?

Whatever is the reason that Canadians cannot get an affordable locked in rate for 30 or even 10 years (affordable being the key word), we need this. Now.

Interest rates are about the lowest in the history of humanity

Investors are willing to lock in and lend money to the Canadian government for 30 years at 2.50%.

It is an urgent matter of national financial security that we find a way to give our homeowners 30-year locked in rates at something affordable (under 5% and maybe as low as the 3.9% that Americans can get).

Investors will likely accept some kind of early pay-off features as well. They accept it in the U.S. so why not in Canada? (with CMHC/government guarantees)

Many home owners are at serious financial risk if interest rates rise.

Furthermore, why not take advantage of idiot investors willing to lend for 30 years at rates as low as 2.5%?

Seriously, this is the opportunity of a lifetime for Canadians to lock in at the lowest interest rates in history. (If only affordable rates were made available like they are in the USA)

How can we get the banks and CMHC working on this immediately?

Are you interested in asking CMHC why Canadians must pay about 8.75% per year to lock in a mortgage for 25 years when Americans pay just 3.9% AND have the ability to refinance or pay off the mortgage without paying huge interest differentials? You can email CMHC at chic@cmhc-schl.gc.ca. And you can email Rachel Swiednicki of the Canadian Bankers Association at rswiednicki@cba.ca. I wrote last week to both of these organizations to request an explanation and to request that they work to provide Canadians with the ability to lock in their mortgage rates on terms comparable to those available in the U.S. If some of you email them as well, that might light a fire under them.

END

Shawn Allen, President
InvestorsFriend Inc.

To see older editions of this newsletter, or to get off of this email list , click here.

InvestorsFriend Inc. Newsletter October 9, 2011

First the Bad News…

A World of Fear About Stock Prices

Fear has been gripping stock investors all over the world. Investors are told that Greece is almost certain to default on its debts before too many more months. And a Greek default could be followed by defaults by several other European countries. And all of this could cause insolvency in many European banks who may be owed more money by these weak countries than the banks have in investor capital. And it is thought that this, in turn, could lead to losses for at least some of the larger United States Investment banks. And in a worse case all of this leads to another credit crisis whereby banks refuse to lend to virtually anyone or any company. Interest rates would soar. (Except if certain governments like the United States are considered risk free, then Treasury bond interest rates could plummet even further). A credit crisis could cause a world-wide recession. Stocks would fall due to lower earnings.

And some fear that the United states will ultimately print too much money and/or that there will be a loss of confidence in the United States dollar and we will have hyper-inflation and interest rates even on United States Treasuries will soar.

Some investors believe that the world economy has benefited from a huge credit boom for the last 80 years but that this is now OVER and we face credit contraction and declining economies for decades to come.

Others observe that stocks have been on a downtrend and believe that this will continue and believe that there is no point to investing new money or even holding existing stocks until the downtrend is over.

Still others are convinced that it was abundant energy that fueled our rising standards of living but that oil reserves are now declining which will push standards of living down.

And if those things don’t “get us” then others fear it will be global environmental catastrophe, world war, pandemic disease or something else that will surely “get us”.

It’s hard to get excited about investing in stocks in the face of such fear.

Now for the Good News:

A World of Stocks On Sale!

Stocks all over the world are selling at cheaper valuations than they have in many years. Based on Price / Earnings ratios they are generally cheaper even than they were at the bottom of the market after the 2008 stock market crash.

While there are always risks, it is a fact that stocks at least appear to be cheap, on a price/earnings basis.

No one really knows the extent to which any of the fears listed above will come to pass or how severe they will be or how along the ill effects would last.

But if those fears are largely unfounded then it is going to turn out that right now was a very good time to own stocks or buy more stocks.

Investing Globally

It’s one thing to be told that you should be investing more globally. But it’s quite a different thing to actually know exactly how to do that.

If you have a brokerage account that allows you buy individual stocks, then a good way to invest in other countries is to purchase certain exchange traded funds.

I have provided for you a list of Global Exchange Traded Funds that allow you to easily invest in a basket of stocks of companies from (for example)  Japan, China, Brazil or Italy. This article also succinctly provides the P/E ratios and dividend yields and more, for each ETF. And I have indicated which country ETFs seem attractive (But I make no guarantees that these will in fact be good investments in either the short or long term. No honest person can make such a guarantee).

North American Markets

I have updated several analysis articles that examine whether or not now is a good time to invest in stocks in North America.

S&P 500 Index Valuation

Dow Jones Industrial Average Valuation

Toronto Stock Market Valuation

Opinion Versus Informed Unbiased Opinion

Everyone has an opinion on just about everything. Be it the economy, global warming, the quality of education, tax levels, the performance of politicians, the price of gasoline, traffic congestion or what have you. Opinion is everywhere. It bombards us daily. What is less common is informed opinion. And especially informed unbiased opinion.

My approach to investing has always been to try to arrive at informed unbiased opinions. That does not guarantee a correct opinion that will to lead to investing success. But I am pretty sure it helps a lot. (My own investing has been quite successful, I like to think that is because I invested based on my informed opinion – but it’s possible I have simply been quite lucky.)

I try to stay unbiased by never getting into the game of being paid to promote any investment. I have never been paid a dime to feature any company on this Site nor have I ever made a single dime in commission as a result of my subscribers investing in certain companies. I even try to avoid much if any contact with the companies rated here. If I were too friendly with any company it would impact my ability to be critical of the company when needed. Certainly some biases will remain but I do what I can to be unbiased.

My opinions are almost always informed by hours of analysis. My approach is generally to obtain key information (words and numbers – primarily from annual and quarterly reports), analyze the information and then indicate what I think the data means. I could be wrong, but at least I am not merely guessing. I try to avoid sharing any opinion whatsoever on investments that I have not analyzed.

InvestorsFriend.com – a work in progress

This Web Site, InvestorsFriend.com went “live” on the internet in June 1999. (It was called investment-picks.com for the first few years.) I incorporated InvestorsFriend Inc. in 2002.

It is largely a one-man effort. I write all of the articles myself and currently do all of the stock research (I have had some assistance at times in the past)

Today the Web Site has over 500 paying customers of our stock research. There over 10,000 email addresses on the list for this free investment newsletter. Mostly through Google searches, the Site receives over 25,000 visits per month and over half a million page views per year. (Thank you, Google).

There are over 100 articles on the Site plus about a 100 archived newsletter. I believe the articles in particular represent a valuable body of investment education.

I plan to continue with this Site indefinitely. I am gratified by the support from repeat visitors, those who have made room in their inboxes for this free newsletter and from the paying customers.

Get Our Stock Picks?

InvestorsFriend inc. offers internet access to individual stocks picks on a monthly or annual subscription basis. The type of analysis involved is illustrated by the following old sample reports.

But it’s not for everyone.

If you don’t have a brokerage account that allows you to buy individual stocks then there would be no point to paying for these stock picks. (And you would obviously need some existing money in investment accounts, the minimum is probably around $25,000 including RRPS and RESP money that you have or wish invested in stocks). To be clear, I don’t take in investment money. Our customers trade their own stocks.

If you wish to see reports on tiny Gold mining companies (or really any mining companies or commodity companies) then this research is not for you. We will never feature any junior mining companies (junior meaning they are still digging the mine and have no revenues yet, let alone profit). We will rarely, if ever, feature any mining companies because that is a specialized field of investment that we simply don’t follow and they are not suitable for the type of analysis we do. In general commodity companies are not our forte, although we will sometimes have an oil or natural gas company. (We also have some ETF information to cover those sectors, but we have been providing that free of charge, so you don’t need our stock picks for that).

If you are convinced that the way to make money in stocks is based on charts and momentum and has little or nothing to do with things like the price to earnings ratio, then this research is simply not for you.

If you don’t have the financial ability to accept some risk of loss or if you cannot tolerate the emotions of sometimes losing money, then you should not even be investing in stocks.

If you are convinced that a stock analyst should always be able to prevent you from losing money (even on a temporary basis) then this research is not for you. (Our customers must be mature and take responsibility for their own investment results). In other words, if you require a guarantee as to results, then our stock picks are not for you.

However if you are a self-directed investor who is interesting is getting internet access to our buy / sell ratings on a selected group of stocks then please consider subscribing to our stock picks. (This link has a small discount on the annual subscription price).

Our Stock Picks tend to be mostly larger profitable companies. Most pay dividends. About half trade in the United States. The other half trade in Toronto. Sectors include financial, restaurant, real estate development, retail, cable, transportation, stock exchanges, manufacturing and more. This service is well suited for people who believe in a fundamental approach to investing. People who think in terms of of investing in companies as opposed to squiggles on a screen. People who have long term goals to grow their wealth and who recognize that the path to building wealth while generally an upward path does have its down hills at times. People who are comfortable making their own decisions about what to buy or sell but who are looking for some guidance from a trusted and rational (but never guaranteed) source. If that describes you, then consider subscribing today. For questions, email shawn@investorsfriend.com

END

Shawn Allen, CFA, CMA, MBA, P.Eng.
President
InvestorsFriend Inc.

To see older editions of this newsletter, or to get off of this email list , click here.

InvestorsFriend Inc. Newsletter September 4, 2011

Bloodied and Bruised Investors

As of early September 2011, most investors are feeling bruised and bloodied by the stock markets this year. The Dow is down 3% this year, the S&P 500 index is down 7% and the Toronto stock index is down 6%.

And, the Dow is down 12% from its high for the year on April 29. The S&P 500 is also down 13% from its high which was reached on May 10. The Toronto stock index is down 11% since its high on February 28.

These markets have declined roughly 10% in the past 6 weeks alone.

These are very scary times in the stock market. There is speculation that we are entering another recession despite not having recovered from the 2008 recession. Worse, there is speculation of European countries defaulting on debts. The U.S. government’s credit rating was down-graded. The U.S. apparently came close to a catastrophic refusal to approve an increase in its borrowing limits in August. There are fears of deflation while others fear runaway inflation. There are fears that all western counties face insurmountable debt issues due to pension liabilities and health care liabilities as their populations age.

And these are just the mainstream fears. On top of that we have fringe groups warnings us of all manner of doom ahead. These range from the end of the world at the end of the Myan calendar next year, to starvation as the world runs out of the ability to feed 7 billion inhabitants to all manner of floods, fire, disease and pestilence.

Bond investors have pushed the yield on a ten-year U.S. Treasury bond down to just  2.0%. And the 30-year bond is at 3.3%. Now surely these investors are not buying these bonds because they like the idea of earning just 2 or 3% per year. They are buying these bonds because, among other reasons, they are scared to invest in stocks.

It is often said that investors emotions oscillate between fear and greed. Surely fear is the dominant emotion in the stock market at this time.

So what is a beleaguered stock investor to do?

Well, I can’t predict the future. But I can point out some data that suggests that stocks are cheap.

If you buy stocks when they are cheap, they may get cheaper still, but ultimately you are likely to make a good return.

STOCKS ARE CHEAP BASED ON P/E RATIO

The most basic indicator of whether or not stocks are cheap is the the Price / Earnings or P/E ratio.

Here is some recent data that shows the P/E ratios for the S&P 500 Index: (The P/E ratios below were calculated when the S&P 500 index was at 1159 but these numbers still apply today as the S&P 500 index is relatively unchanged at 1174)

S&P 500 Index Earnings Type	Annual Earnings on Index	P/E Ratio at 1159 S&P	Earnings Yield
Actual latest year (trailing four quarters) GAAP earnings	$83.90	13.8	7.2%
Latest year “operating” earnings (removes “unusual” items)	$90.89	12.8	7.8%
Forecast forward GAAP earnings for the next year (next four quarters)	$93.75	12.4	8.1%
Forecast forward operating earnings for the next year (estimates summed by individual company)	$105.45	11.0	9.1%
Forecast forward operating earnings for the next year (estimate for the group of companies)	$99.34	11.7	8.6%
For Comparison here are S&P 500 Earnings in prior years:	Earnings	Historical P/E	Historical Earnings Yield
2010 Actual GAAP Earnings	$76.97	16.3	6.1%
2009 Actual GAAP Earnings	$50.97	21.9	4.6%
2008 Actual GAAP Earnings	$14.88	60.7	1.6%
2007 Actual GAAP Earnings	$66.18	22.2	4.5%
2006 Actual GAAP Earnings	$81.51	17.4	5.7%
2005 Actual GAAP Earnings	$69.93	17.8	5.6%
2004 Actual GAAP Earnings	$58.55	20.7	4.8%
2003 Actual GAAP Earnings	$48.74	22.8	4.4%

What this table demonstrates is that the S&P 500 index P/E ratio is relatively low at about 12 based on forecast earnings. This is low compared to the historic average P/E of 16.

Furthermore today’s extremely low interest rates would support a P/E ratio that is higher than could be justified at a time of high interest rates. At else equal, you would think the P/E rtio today would be higher than the historic average.

The last column of the table indicates that these companies are expected to earn about 8% on the price paid for the stocks. This is substantially higher than the amounts these companies were earning compared to the price paid at the end of each year since 2003.

It is true that even if these companies do earn the projected 8%, their stock prices might still fall. But if they continue to earn the 8% (and in fact they tend to earn more than 8% on retained earnings), the stock prices will rise over the years.

So, the FACTS indicate that stocks are at least better value compared to earnings  than they have been in many years. Even at the lows in the Spring of 2009 the S&P 500 index P/E ratio was higher than it is now because the earnings were depressed.

I have found that this examination of the P/E ratio of the stock index has accurately indicated when the market was over-valued and when it was under-valued. This past accuracy is documents in the table at the bottom of the linked article regarding the valuation of the S&P 500 index.

The FACTS based on the price of the S&P 500 index and its current and projected earnings indicate that stocks are about fairly valued, meaning that they are priced such that we should expect to achieve a long-run return that averages about 8% per year. (And they would be considered under-valued if you would be satisfied with even a 6% return per year, given today’s low interest rates). Note that this 8% per year can be expected to vary wildly in individual years and it is by no means guaranteed.

There are only two things that could cause an investment in the S&P 500 index today to fail to earn a decent return over the future.

First, the P/E ratio could decline due to investor fears. But even if that occurs, it is likely to be a temporary situation. We have demonstrated that today’s P/E ratio is low compared to historic values. Over the future the P/E ratio will vary, but there is probably a higher chance that at any point in the future it will be higher and closer to its historic average rather than lower. But, yes, there will no doubt be some periods in the future where it is lower.

Second, the forecast earnings could fail to be achieved. In fact if recent fears of a renewed recession materialize, then it is likely that corporate earnings will be depressed for a time. But that is also likely to be temporary. Recessions tend to end and in the longer term earnings do rise. It is plausible that in five years or ten years from now corporate earnings will only have risen by say a few
percent per year rather than by the hoped for 5% or more per year used in our S&P 500 valuation article. But it’s really not very plausible that corporate earnings will fail to grow at all or will shrink over a five or ten year period. Anything is possible, but it just does not seem plausible.

My conclusion, based on my S&P 500 valuation article, is that stocks are about fairly valued on average. Most of the past decade they have appeared over-valued. Despite that I was able to select individual stocks that gave me a good return. With the market now looking fairly valued on average, I like my chances of being able to continue to find stocks that offer a good return over the years.

At the same time I recognize that stocks would likely decline if we do get a renewed recession. My strategy will be to remain invested in stocks and to be positioned to add to my investments over the years and particularly at times when they fall in price.

Not everyone has the emotional tolerance or the financial ability to take the risk of investing in stocks. But those that do should consider that the occasional bloody nose is the price we pay for the fight to accumulate wealth through stocks. This is a battle in which the average fighter does win in the end, based on history, but where the average fighter certainly does sustain some bruises and does some bleeding along the way. Only you can decide if you wish to stay in or enter this battle or whether you prefer to take a permanent or temporary break from it.

BORROW TO INVEST?

Borrowing to invest is not for the faint of heart. Most investors have neither the emotional nor the financial ability to tolerate the risks of borrowing to invest.

But certainly some investors do have the incomes and net worth such that they can withstand the risk of borrowing to invest.

With the cost of borrowing at record lows and with stocks appearing to be fairly valued (and hence offering long-run expected returns in the 8% range) it may make sense for more affluent investors to CONSIDER borrowing to invest in stocks.

Anyone doing this should be very careful not to over do it. Also, there should no hurry to race into the market. A rational strategy might be to borrow a small amount of money to invest each month and ramp up to maximum level of borrowing over six to ten months.

SINO-FOREST (Accused of Fraud)

I owned Sino-Forest shares from 1999 to late 2005. The company was recommended as a Strong Buy on this site at the beginning of each of 2000, 2001, 2002 and 2003. It went no where most of that time but soared 341% in 2003. For 2004 we rated it a Sell and it did fall 34%. For 2005 we rated it a Buy and it rose 44% that year.

However by late 2005 I had become uncomfortable with the company and lost trust in it. I even speculated it might possibly be a fraud. This is fully documented here. After I abandoned the company it subsequently soared some 400% or so. But I never added it back to this Site because I had lost trust. It appears I was years ahead of my time in smelling a rat at Sino-Forest. The fact is that it is very difficult for investors to detect fraud. But sometimes the warning signs are there.

Investment Basics and Math

In investing as in most things in life, you can never review the basics too many times.

Here are a few of my basic articles that explain some of the fundamentals of investing.

How the Stock Market Works

Essential Investment Math

The Only Two Sources of Money from Stocks.

Subscribe

If you are looking for stocks to invest in then why not subscribe now? Remember the cost is just CAN $13 per month or $120 per year. When you think about the potential returns from just one well-researched Stock Pick, you can see why our subscription service has been a great investment for our subscribers. Could it be that (not) subscribing would be the best investment you (n)ever made?

END

Shawn Allen, President
InvestorsFriend Inc.

To see older editions of this newsletter, or to get off of this email list , click here.

InvestorsFriend Inc. Newsletter June 12, 2011

Sino-Forest

Sino-Forest Corporation has been very much in the news in recent days. Its stock price plummeted about 75% from about $18 down to about $4.50 after a report was released that accuses it of being a fraudulent operation with a true value of under $1.00 per share.

Sino-Forest has been listed on the Toronto Stock Exchange for since the early or mid 90’s. But all of its operations are in China.

The report by “Muddy Waters Research” is available here:

http://www.muddywatersresearch.com/wp-content/uploads/2011/06/MW_TRE_060211.pdf

The company is defending itself and denying the allegations. It remains to be seen whether there is any truth to the allegations.

I am particularly intrigued and interested in the whole situation because I once had over 4% of my portfolio invested in this stock. I was a big fan. I held it for about 5 years and I read it’s annual reports and studied its financials for over five years. However, by late 2005 I was growing wary because it seemed to have changed its business model. Trees that I understood it had planted throughout the 1990’s and which it said would mature in 5 to 7 years did not seem to have been sold by 2005. When I called the company to inquire I recall I was told they had only started planting trees around I believe they said 1999. That did not accord with what I thought I had read in their annual reports.

In fact the 1996 annual report states

At December 31, 1996, Sino-Forest has phased in a total of approximately 37,600 hectares of plantation lands, or 6% of the plantation lands currently under contract.

Now maybe 37,600 hectares of planted trees is not much but that did not explain why approximately none of these trees, some of which were said to mature in just five years, were apparently not sold by late 2005. And it contradicted the information I received when I called the company and was told that the reason the trees were not sold yet is that planting had only started in, I believe they told me 1999 or it may have been even later. The point is based on that conversation and the other risks I perceived I decided I could not trust the company.

I have now re-posted my old 2005 report on Sino-Forest and highlighted the concerns I had at the time.

http://www.investorsfriend.com/2005%20Sino-Forest%20InvestorsFriend%20report.htm

Now, it is not clear even today whether my lack of trust was justified. I just want to point out at this time that I in fact lost trust in the company in 2005 and let my customers know that.

UNDERSTANDING STOCK MARKET RISK

One of the hardest concepts to understand when it comes to stock investing is; What exactly is risk? How should risk be measured? How much risk should we take? How risk can we afford to take financially? How much risk are we prepared to take emotionally?

The investment industry is leery to be responsible for deciding how much risk any of us should take. It’s too tough a question fro them to ask and they face risks if they get it wrong. So, quite naturally, they leave the decision on how much risk to take to the client. The industry pretends that clients can decide this by checking off a box on a know-your-client form. The reality is that most of us have little basis to decide how much risk we should take. It’s really a question that is impossible to answer “accurately”.

The academics of the investment industry like to pretend that risk can be measured rather precisely using statistical measures like standard deviation and “betas” and various formulas. They are wrong, risk by its very definition can never be measured precisely. And anyhow once disaster strikes, the fact that statistically it was a very low risk is cold comfort. What comfort is it to the people in Japan that the risk of an earthquake and Tsumani causing a Nuclear disaster was (or was thought to be) so small as to be insignificant. It’s cold comfort indeed.

In 1985 when I was taking a Finance course at St. Mary’s University I was taught  that risk in the stock market was unmeasured by the standard deviation in the movements of as tock price. In other words to him, as an academic, stock risk was measured by these usually small squiggles up and down in a stock’s price. I recall I challenged the professor at the time since to me, the real risk was not that my stock would move down by 3% or something. The real risk to me was that for some reason it would plunge suddenly and unexpectedly towards zero and stay there and essentially never recover. That to me was the real risk, and I failed to see how that risk could be measured by squiggles in the stock price.

Sino-Forest is a perfect example. Nothing in its stock price pattern was ever going to predict that one day a report would come out and suddenly send the stock price down 75%.

In fact the academics seem to contradict themselves. They will tell you that technical analysis if absolutely useless. That it is bunkum. They will tell you that under the efficient market hypothesis, every stock is priced correctly based on the available information. They say the past price pattern is of zero predictive value. But then they turn around and use the past volatility of the price to measure risk. And they use the past correlation of the stock price to the overall market to measure risk. In fact what they are attempting to do is to measure what is ultimately to some degree random and not measurable.

By nature the academic measures of risk tend to be useful for measuring smaller risks but tend to fail completely when it comes to rare catastrophic risks. The “Black Swan” events.

I have written before on the nature of risk in the stock market and the many fallacies about risk that are believed.

See:

Risk and Return Fallacies

Risk and Reward

and

Practical Lessons From Modern Portfolio Theory

Portfolio Theory

The full Phalanx of my articles on risk are available here

Risk and Return

Is Now a Good Time to Invest in Stocks?

This is always the question. We can never be sure it is a good time to invest in stocks, especially for shorter time periods.

Here are some reasons why it might not be a good time to invest in stocks:

Economic growth in North America and Europe is fairly slow and seems to have little prospect of a sharp turn-around.

Oil prices remain high at near $100 which is a drag on the economy.

Housing prices in the U.S. have continued to fall which hurts the economy.

Greece and some other countries in Europe are at some risk of defaulting on bonds in some fashion or other. Such a default would cause interest rates to rise and stock prices to fall. In the United States itself there is some talk of a refusal to increase the ceiling on the national debt and apparently that could cause a shut-down of all non-essential government services and could even cause some kind of technical default on government debt even if only for a few days. These things could cause another credit crisis. Credit is truly the grease of the economy. Not much trade can happen without credit. A credit crisis would definitely send stock prices down.

Some would argue that the valuation of the market in terms of its dividend yield or its P/E ratio is higher than historic averages, or high in terms of the growth outlook and that this is a negative indicator for stock prices.

There are ALWAYS reasons that can be listed out that indicate that investing in stocks is risky. They could fall in price.

However, here are some factors that argue in support of investing in stocks:

To invest in stocks is to own a share of “corporate America” or of the corporations of the world. Few would argue that large corporations are going to stop making money. As an owner stock investors tend to make a good return over the years.

The P/E ratio of the market (for example the Dow Jones Industrial Average) was 14.0 at the end of May based on earnings reported in the previous 12 months. The long-term average P/E on the Dow is 17.8 and when some high outlier years are excluded (years when the Dow P/E was very high due to abnormally low earnings) the historical average is 15.5. So today the price you pay for each dollar of earnings is a little lower than the historic average. And consider that interest rates are at historic lows. When interest rates are very low it justifies paying more for each dollar of corporate earnings (a higher P/E). Basically if you can’t get much interest on your money then stocks which an earnings yield of a 1/14 or 7.1% look like a good investment. When you could get 10% on your money in the bank a 7% earnings yield on stocks would not look attractive. But 7% compared to close to nothing at the bank seems okay. Of course you are not guaranteed this 7% if you invest in stocks.

Stocks in the past have always done well over longer periods of time like 25 years.

Predictions of gloom about the economy are probably ill-founded. North America and the world continue to benefit from technological innovation. Trade is growing. Populations are growing. There is little reason to think that major corporations will not continue to grow over the years. The question is will you own your share(s) of this?

Canadian Exchange Traded Funds

Exchange Traded funds are often recommended as an alternative to mutual funds. However, in order to invest in exchange traded funds one needs to know the trading symbols of some funds. It would also be nice to know of the P/E ratios n and other fundamentals of the funds.

To my knowledge, our reference article is the only source that has compiled this for a group of Canadian Exchange Traded funds. We have the data for quite a few funds but not all of them.

Click to see this reference article which was recently completely updated.

Subscribe

If you are looking for specific stocks to invest in then why not subscribe now? The cost is just CAN $13 per month or $120 per year. When you think about the potential returns from just one well-researched Stock Pick, you can see why our subscription service has been a great investment for our subscribers.

END

Shawn Allen, President
InvestorsFriend Inc.

To see older editions of this newsletter, or to get off of this email list , click here.

InvestorsFriend Inc. Newsletter March 5, 2011

First – Time and Beginning Investors

First-time and beginning investors often wonder where to start.

To new investors, almost everything is confusing. Stocks, bonds, P/E ratios, TSX index, the market is up 200 points, then down 100 points. Oil, gold, silver, GIC, RRSP, RESP, Tax Free Savings Account. What does it all mean and where do we start? What are the good investments, what are the scams?

I liken the process of learning how to invest to the process of learning a foreign language. At first everything sounds like gibberish. But if you learn a few words and if you have someone to practice with, then a few words can grow into more words and phrases. Soon you have a little island of knowledge and you can grow from there. There are unlimited individual words to learn. But you never need to know all the words. The structure and syntax and grammar rules for the language are always of great importance. If you learn how to make a word into the past tense that can be applied to many words. Once you learn enough and have a good base of knowledge you are able to start learning new words on your own. At some point you will know more than enough to get by, but you will never know every word in any language. Nor will you ever need to.

Learning to invest is similar in many ways. Rest assured that no one is an expert in all areas of investing. Some people know a great deal about investing in mutual funds and nothing about investing in stocks. Some know stocks but not bonds. Only a small percentage of investors have much knowledge in the area of options. Fewer still know much about foreign currency trading. Some investors specialize in certain commodities or commodity stocks. Warren Buffett is perhaps the most successful investor in history. Yet he has consistently said he restricts his investments to certain types of companies and avoids others that he claims are too complex for him to predict their earnings.

If you are just getting started investing or otherwise have limited knowledge, don’t worry. You can always start investing now while you continue to learn and broaden your scope.

To get started investing you need two things. 1 Money – either ready cash or a commitment to contribute cash regularly each month.  2. An identified product to invest in.

When I talk about beginning investors, I am not talking about merely saving money in a bank account. I am talking about getting started in investing in stocks and bonds (including investing in stocks and bonds through mutual funds).

One of the confusing and intimidating aspects of getting started investing is simply all the jargon and abbreviations.  You’ll probably find that you will learn the jargon and abbreviations a little at a time as you go. You can always look up terms in Google as needed.

Most beginning investors need the assistance of a financial advisor of some kind. This can be, for example, a representative from Investors Group or from an insurance company. You can also ask to speak to a financial advisor at any bank branch.

Most investors will start out investing in mutual funds rather than in individual stocks and bonds.

Investing in individual stocks and bonds requires more sophisticated financial knowledge or the services of a more sophisticated (and usually higher cost) financial advisor and it requires a certain minimum amount of money. Mutual funds are ideally suited to the situation of getting started in investing.

Many people are convinced to start investing in mutual funds by a financial advisor from Investors Group or an insurance company. These financial advisors often find new customers at trade shows (of almost any kind) where they set up booths or by personal referrals or by direct mail advertising.  These advisors will usually make house calls, especially for initial referrals when they are trying to get your business as a new customer. If you come across such an advisor that can be a good way of getting started investing.

If you are trying to get started investing and don’t happen to already have a friend or relative or other such person in the business then the best approach is probably to ask to speak to a financial advisor at your bank branch. Using a financial advisor at your bank branch will probably prove convenient in terms of transferring money into an investment account, both initially and on a monthly basis.

With mutual fund investing you will not typically be charged any fee to set up an investment account. And you will not directly pay any fee when you buy additional mutual funds each month. Instead, the mutual fund company will make its money essentially by keeping a portion of the money that you would otherwise have made. If the stocks and/or bonds within the mutual fund earn an average 7.5% in a year you may receive only 5.0% with the mutual fund company effectively deducting their “cut” before you ever see your share. Additionally if the stocks and/or bonds in the mutual fund lose 7.5% in a year, you may see a loss of 10.0% as the mutual fund company more or less reports to you a loss of 10.0% because they took out their 2.5% fee.

Many financial commentators would advise you to avoid mutual funds because of the fees that often are in the range of 2.5%. However, there may simply be no feasible alternative for those just getting started investing small amounts of money. Also in the early years of an investment program, what really matters is the amount you save up each month, and a 2.5% fee should not initially be a big concern. For example imagine you invest $300 per month and end up with $3600 after one year. 2.5% of that is $90. It would be difficult to argue that $90 was a very high price to pay for the opportunity to invest in a diversified group of stocks and/or bonds and to have a financial advisor to talk to as often as you wished during that year. And at the end of the year you would have paid 2.5% in fees but 97.5% of the money you invested that year would still be in your account (plus or minus the gain or loss in the stock market).

Now imagine that after 5 years of investing $300 per month you have $21,000 invested. ($3600 times 5 or $18,000 in contributions plus say $3,000 in gains). Now in the sixth year you might pay $21,000 times 2.5% or $525 in fees to the mutual fund. At this point the 2.5% fee is starting to get more noticeable since it represents almost two months of your $300 per month contributions. But it still may be less than you would pay in fees if you attempted to invest in individual stocks and bonds. And you would not likely find a financial advisor willing to take the time with you to pick individual stocks for $525 per year. (Keeping in mind that the financial advisor would face trading charges to be paid out of the $525 or might have to share that with his or here employer.)

However, imagine that after 30 years you have managed to accumulate $200,000 in mutual funds. Now those 2.5% fees amount to $5,000 per year or probably more than you can save in a year. Certainly at that point there are better alternatives than mutual funds unless you are particularly “wedded” to your financial advisor.

My point is that you should not worry much about the fee on mutual funds when you are first starting out. What you should worry about is investing a reasonable amount each month.

“Graduating” from Mutual Funds to Exchange Traded Funds and to Individual Stocks and Bonds

A small percentage of investors will make stock picking something of a hobby and or obsession. They will want to get out of mutual funds and into picking their own stocks as soon as possible. These investors should open a self-directed investment account. All of the major banks offer self-directed accounts through their discount brokerage arms. The trading fees are about $30 for each buy or sell of a stock (the dollar amount traded does not matter). If the investment account or even the sum of all investment accounts in the same household is over about $100,000 then the trading fees may drop to about $10 per trade. In most cases it will not make sense to open a self-directed account unless the amount is invested is about $20,000 or higher. However, in theory if you initially only wanted to own one stock you could start with as little as $3,000 or so in a self-directed account. Again, this self-directed approach is only for people who want to pick their own stocks.

Self-directed investors tend to pick up ideas for investments by watching investment television shows, reading the financial pages and sometimes by purchasing investment newsletters. Also the discount brokerages provide a huge amount of investment ideas on their Web Sites.

The majority of investors may never have the time or inclination to select their own stocks or make their own trades online. Also they may fear the risk that they will make sub-standard returns. These investors may feel most comfortable with continued use of a financial advisor. Obtaining personalized financial advice on which stocks to buy usually requires a full service broker. Due to the fees involved this may require a larger investment amount such as at least $200,000. The use of a full service broker will allow you to be invested in individual stocks and bonds as well as Exchange Traded Funds. Below a total family invested amount of about $200,000 it way be more cost effective to stay with a mutual fund advisor (this assumes you are notwilling to be a self-directed investor). For larger amounts such as $500,000 it may be cost effective to use the services of an an Investment Counsel. These firms will invest your money on a discretionary basis. (They don’t have to call and get your permission every time they trade your account).

There are certainly many other ways to invest money. The categories above are the mainstream categories that I am most familiar with.

How do RRSPs, RESPs and Tax Free Savings Accounts Fit into the picture?

In Canada there are several tax-advantaged ways to invest. These are special accounts that your financial advisor, bank or broker must “register” with the government. In each case only limited amounts of money can be invested each year.

What follows is a very brief and simplified description of the three most commonly used tax-advantaged plans. This is not meant to be a detailed description of these plans and all their rules. For the full details talk to your financial advisor or bank branch staff. There are also other tax-advantaged plans that may apply to some people such as disabled persons.

Finding the money to contribute to these various plans is easier said than done. I recognize it can be very frustrating to those on tight budgets to be hear about all the tax savings that some people are getting. And down right maddening to be lectured about not contributing to these plans – when your budget may simply not allow it. (Adequately feeding, clothing and housing the family today will always trump saving for tomorrow). So please don’t take the following as being lectures. I know these plans are simply not affordable to everyone.

A Registered Retirement Savings Plan (RRSP) Account provides for an income tax deduction when you put money into it. The amount you may contribute is limited, as of 2010, to no more that 18% of earned income to a maximum of $22,000 per year. And, if applicable,  this maximum is reduced by the “value” (called the Pension Adjustment) of contributions that you and your employer make to your registered pension plan. Money is allowed to grow tax free inside this plan. When money is withdrawn it is taxed. This can prove very advantageous when your tax rate in retirement is lower than when you contributed. It can be very advantageous when money can be left in it to compound and grow tax free for many years and decades. Money that you were allowed to contribute to an RRSP but which you did not contribute may be carried forward indefinitely and contributed in a future year. The down-side to this is that for every year of delay you lose the growth that you might have obtained.

With a Registered Education Savings Plan (RESP) the government adds 20% to your contribution to a maximum of $500 per year. This means you can contribute $2500 per year per child to receive the maximum grant amount. The funds then grow tax free. If the funds are spent on your child’s education after high school then the growth and the grants are taxed in the child’s hands (presumably at a low rate of tax). Your original contributions when removed and spent on the child’s education are not taxed at all since that is a return of your own money. There is a limited amount of ability to “catch-up”. I understand you can obtain a grant of $1000 per year per child if you start late and then contribute $5000 per year. The best scenario, if affordable, is probably to set up the plan and begin contributing the year the child is born. The downside of delaying is that you may never be able to catch up fully on the missed grant money and you lose years of tax-deferred growth.

With a Tax Free Savings Account, each Canadian, aged 18 and over, can contribute (as of 2010) up to $5000 per year. There is no tax deduction and no grant money. However no income is payable on the earnings in these plans – ever. It’s your own legalized tax haven! Any money removed from the plan can be returned to the plan, but only in the following calendar year. Any unused contributions can be carried forward indefinitely starting with 2008, the year these plans came into effect. The disadvantage of carrying forward amounts is the loss of the opportunity to invest sooner on a tax free basis.

Under government rules, each of the three plans above allows the funds in the plan to potentially be invested in a varity of things including a simple savings account, a bank guaranteed certificate of deposit (GIC), mutual funds and individual stocks and bonds. However your ability to invest in different things may be limited by the financial institution that provides your plan. Your financial institution may not allow your plan(s) to be invested in individual stocks and bonds unless you set up a self-directed plan or you deal with a full service broker at the bank. If you deal with a mutual fund advisor at either a bank or an organization like Investors Group they are often not licensed to allow you to invest in individual stocks and bonds or even Exchange Traded Funds. You can, if you wish, start these plans with mutual fund investments and later perhaps “graduate” to investing in Exchange Traded Funds and/or individual stocks and bonds.

Each of the three plans above has the benefit of reducing income taxes paid. And the RESP has the added advantage of receiving grant money.

Perhaps the biggest advantage of these plans is that they provide a strong incentive for us to save and invest money.

Is now a good time to Invest in Stocks?

I have recently updated a number of important articles that look at whether stocks are a good investment or not.

Is the S&P 500 index a Good Investment? 

During the last 6 weeks or so, I also emailed links to the articles below to those on the list for this free newsletter. For convenience, here once again are those links

“Time in The Market” shows what happened to investments that have been in the market for 1 year, 2 years, 3 years etc. all the way back to 85 years in the market. See

http://www.investorsfriend.com/Time-In-The-Market

An article on the historical performance of stocks:

http://www.investorsfriend.com/Historical%20Total%20Nominal%20and%20Real%20Returns%20on%20Stocks%20(S&P%20500%20Index).htm

Historical results for 30-year savings periods, 100% equities versus the balanced approach:

http://www.investorsfriend.com/Asset%20Allocation%20Real%20Growth%20Scenarios.htm

Historical results for 30-year retirement periods, 100% equities versus the balanced approach:

http://www.investorsfriend.com/Asset%20Allocation%20Real%20Scenarios.htm

Are Stocks Riskier than bonds?

http://www.investorsfriend.com/stocksriskierthanbonds.htm

Asset Performance – Stocks, Bonds, Cash and Gold

http://www.investorsfriend.com/asset_performance.htm

Subscribe (for those not already on our paid service)

If you are looking for stocks to invest in, we have a paid  subscription service The cost is just CAN $15 per month or $150 per year. When you think about the potential returns from just one well-researched Stock Pick, you can see why our subscription service has been a great investment for our many subscribers. Many subscribers have been with us for years. We make no guarantees as to future returns, but, so far, we have been successfully growing wealthy together.

END

Shawn Allen, President
InvestorsFriend Inc.

To see older editions of this newsletter, or to get off of this email list , click here.

InvestorsFriend Inc. Newsletter January 8, 2011

How Much $ Can You Expect to Make from Stock Investments??

Let’s think about how much money we should expect to make from our stock portfolio? Should we expect 5%, 8%, 15% per year on average? How about minus 10%?

As I start to write this article I don’t know the answer I will arrive at – but I have a pretty good idea and and I know how to calculate it. In the rest of the article I will walk through how to calculate an expected average annual return.

First, let me be clear that the answer will only be an “expected” number, it will in no way be a precise number that we can count on. But as Warren Buffett has said, it is far better to be approximately right than it is to be precisely wrong.

And let’s be clear that while we can calculate an expected average annual return, the variability around that average (even if we get the average correct) will be huge in any given year. Even if the average is 8% per year, you can count on the fact that the returns from stocks in some years will be negative.

As I have explained previously we can divide the returns from stocks into precisely two sources: 1. returns made from other investors through astute trading and 2. returns made by the companies in providing products and services to their customers.

Trading is by definition a zero sum game (well, actually it is negative after deducting the fees and other costs of trading). So by definition, on average, zero (or a little less) is made from trading by the average investor.

So, let’s accept that the average return we can expect to make from stocks is solely related to the money that the companies we own will make from serving their customers. (After calculating that, if you think you are a smarter-than average trader you can add something on for that, but for the average investor, let’s accept that trading adds zero).

I will use my own portfolio to work through the math of calculating an expected average annual return from stocks.

My portfolio of stocks is really part ownership of a group of companies. My portfolio, as of the start of 2011, has the following characteristics

• Average Dividend Yield 2.14%
• Average Price to Earnings Ratio 15.99 (normally I would call that 16.0, but I am working with two decimals here to insure the math works out despite rounding)
• Average Return on Equity 14.19%
• Average Price to Book Value 2.27

The price to earnings ratio of 15.99 means that the stocks are trading at 16 times their current earnings level. Expressed another way the earnings over price is 1 / 15.99 or 6.25%.

So the stocks (the companies – always remember it is companies you own, the stocks are just certificates of ownership in companies) I hold earn just $6.25 per year for every $100 of my portfolio.

I will pause here to note that this is a little scary. If my stocks (my companies) are earnings only 6.25% on my money, how will I expect to earn more than that? Well the good news is that I can indeed expect to earn more than that as I will explain below.

But first let’s look at the dividend. It’s a 2.14% yield so $2.14 per $100. Some people claim that dividends are the only return that matters. If so, I have to expect a lot of growth in this dividend in order to bring the total return up to a reasonable level.

Now, the stocks (the companies) I own have an average  price to book value ratio of 2.27, meaning that the companies only have book equity of $100/2.27 or $44.05 for each $100 in stock value that I own.

The companies on average make 14.19% on that $44.05 which, not coincidently, works out to my $6.25.

So, I own a group of companies which for every $100 in value on the stock market have accounting book equity of $44.05, on which they earn 14.19% or $6.25, resulting in an earnings yield for me of 6.25%.

If the companies were to dividend out the entire $6.25 in earnings and if therefore their earnings would not grow then I could expect to earn precisely 6.25% on this portfolio.

Fortunately, the companies retain some of the earnings for growth. In this case the companies retain $6.25 minus $2.14 or $4.11 or 66% of the earnings.

Let’s assume that the companies continue to make the same 14.19% return on their existing equity and on the additional equity provided by the retained earnings.

In this case, we will make our 6.25% on the 34% of earnings that is paid out in dividends and 14.19% on the 66% of earnings that are retained. In that case our average return is 6.25% times 0.34 plus 14.19% times 0.66 or 11.5%.

So my expected average return on this portfolio assuming the companies continue to make 14.19% ROEs and continue to retain 66% of earnings is 11.5%. An attractive return and far better than the 6.25% that the 16.0 P/E (1/16 E/P) at first suggested.

We can also calculate this on the basis of dividends rather than earnings.

The dividend yield is 2.14%. If 66% of the earnings are retained and a 14.19% ROE is earned then we should expect the dividend to grow by 14.19% times 0.66 or 9.36% per year. Our expected return can then be calculated as the 2.14% plus the 9.36% growth or, not coincidently, 11.5%.

So, I have calculated that my portfolio can be expected to earn me 11.5% per year.

But that assumes my companies can continue to earn their historic 14.19% ROE on historic equity plus on retained earnings.

If instead, I assume the ROE on historic equity will be 14.19% but that ROE on retained earnings will be lower at 10%, then my expected return drops to 6.25% times 0.33 plus 10% times 0.67 or 8.76%.

To calculate the expected return on your own portfolio you can use either of the following two formulas:

Average annual expected return equals:

1. E/P (i.e. 1/P/E) times earnings payout ratio plus future ROE times (1 minus earnings payout ratio), or

2. Dividend yield plus expected average annual growth in dividends

Dividend yield plus expected ROE times (1 minus earnings payout ratio)

Now these formulas do assume that the ROE is not going to change and also assume the P/E ratio is not going to change.

In my case with a portfolio ROE of 14.2% it may be a little aggressive to assume that this will not decline. Perhaps the scenario where I assumed a 10% incremental ROE on the retained earnings is more reasonable.

In my case with a portfolio P/E of 16, my assumption that the P/E ratio is not going to change is not unreasonable. If my portfolio P/E was 25, it would however be unreasonable to assume that it would not decline in future.

Note that while  these formulas may work approximately on a portfolio they are very unlikely to work for an individual stock since the assumptions are much less likely to hold for one stock but may approximately hold for portfolios.

Unfortunately, these formulas may not be that easy for you to apply since it will take some work to figure out the average dividend payout ratio of your portfolio, or even the weighted average P/E and dividend yield. However for those who are mathematically inclined and who are prepared to do some work, these formulas may be quite useful.

We also have an article that looks at the overall returns to expect from stocks.

MENTAL MODELS

Charlie Munger, Warren Buffett’s partner advocates the use of mental models to make sense of a complex world.

Scientists use simplified models all the time. The motion of an object falling through the air is modeled first as the motion of an object falling through a vacuum. The vacuum model does not give the same precise answer as the more complex situation of an object falling through the atmosphere. But often is is close enough.

The book Blink: the Power of Thinking Without Thinking, discusses how we can use certain quick mental models to recognize instantly when something is obviously false. And that there are huge benefits to the ability to make snap decisions based on certain mental models. And let’s face it we need to make snap decisions all the time. Do we engage that stranger in conversation or not? Do we cross the street when we see the lone stranger ahead walking toward us at night?

Mental Models and the Economy

The economy is very complex, and we are often confronted with various claims about the economy and it would be useful to have mental models that allow us to make a quick decision on whether a certain claim is true or even has any chance of being true.

Here are some common examples of big economic claims:

• Citizens can protect jobs and become better off by buying locally
• There are only so many jobs to go around
• Americans can become wealthier if the price of houses rise
• Every country should strive to Export more than it Imports
• An earlier retirement age is a good idea to create jobs
• There is money on the sidelines that may soon make stock markets rise
• The world has too much debt
• Every household should spend less than it makes
• A stocks is worth what someone will pay for it. End of story
• You won’t make any money in stocks

And here are some of the mental models that I use to decide that all of these claims are false.

1. I think about whether the economic claim could be true if applied to the world as a whole.
2. I think about whether the economic claim could be true if the entire world economy consisted of a village or town of a few thousand people.
3. I think of the real wealth of the world as being its natural resources, plus all of the accumulated knowledge of man, plus all the built infrastructure including roads, buildings, bridges, factories, production processes etc., all the stock of manufactured goods that exist, all of our ability to provide entertainment, services, and desired comforts of all kinds to each other. Money is not wealth itself but rather represents a claim on the real wealth.
4. I think of stocks as part-ownership claims on companies.
5. I think of the stock market as a place where people exchange stocks with each other (and usually not with the actual companies they buy or sell) for money.
6. The wants, needs and desires for pleasure and comforts of (the vast majority of) individuals and of populations is basically infinite.

So let’s apply my mental models to some of the claims above.

Citizens can protect jobs and become better off by buying locally?

Well, everyone seems to accept that trade within a village is good. We are far far better off due to the fact that we don’t all grow our food, make our own cloths and make our own houses from our own trees, and build our own cars etc.  Accepting the truism that trade within a village is good, and knowing that to make things like cars requires trade, within a country, I have to conclude that trade within a country is good. And I then can’t see any impediment to concluding that trade with other countries is bad. My mental model tells me that trade is good. I therefore categorically reject the idea that convincing people to buy local (even to the point of paying a higher price for local) is usually a good idea. Adam Smith wrote in 1776 that the way the market works is that if we each look after ourselves then the greatest collective economic good will be done. As soon as you try to vary from making decisions that are in your own rational best interests, you are odds with the basic model of free markets and will obtain sub-optimal results for yourself and for your community.

If you are a business owner and want to buy local in the hopes that others will do the same that may be entirely rational. And I am not suggesting that it is bad for individuals to favor local (especially when all else is equal) if they wish to. What I do conclude, based on my mental models of the world, is that a general behavior of encouraging buying local is a step back towards the stone age.

There are only so many jobs to go around?

Hmm so let’s see, if a “job” represents being paid to perform work of some kind that someone values enough to pay for it, then it is hard to imagine any intrinsic shortage of jobs. If the world consisted of 10,000 people living off the land, would there ever be a shortage of things that needed doing? Is there a shortage of things that need doing around your house? Are your desires completely fulfilled so that there is not a single thing that you would at this moment pay someone else to do? So no, I don’t accept that the number of jobs is limited.

The World has too much debt?

Well, consider that one man’s debt is the receivable or the investment (the savings) of another man. So the net amount of debt, being debt minus savings, it seems to me must always net out to zero. It seems to me that too much debt implies too much savings, and I can’t quite accept that there is too much savings. The world as a whole has not borrowed from future generations since they are not around to lend us any money. The world as a whole has not borrowed anything from outer-space. So maybe you have too much debt, or your neighbor does, or the U.S. government does. But based on thinking about the world as a whole it seems rather impossible for the world as a whole to have too much debt.

You won’t make any money in stocks?

Wells since to own a stock is to own a piece of a company, this claim is requires that companies will not make any money. Since I believe companies will continue to make money, I have to believe that the owners of companies will continue to make money in the long term.

Our Performance

Our Performance figures for 2010 were once again good. Our long-term track record since our inception just prior to year 2000 is stellar.

If you are looking for stocks to invest in, from a trusted (but never guaranteed) source then why not subscribe now? The cost is just $13 per month or $120 per year. When you think about the potential returns from just one well-researched Stock Pick, you can see why our subscription service has been a great investment for our subscribers.

Could it be that (not) subscribing would be the best investment you (n)ever made?

Right now is a particularly great time to subscribe since we have just updated most of our stock reports for the new year. We update our  stock reports throughout the year, but on average our stock reports are more up to date at the start of each year than at any other time. Also we will soon be updating important articles to reflect the returns from 2010 and 2009. (I have pre-ordered the yearbook with the updated data I need, at a cost of about $180, it will be published shortly). Some of these articles are only available to our paid subscribers. I update these articles only every two years.

END

Shawn Allen, President
InvestorsFriend Inc.

To see older editions of this newsletter, or to get off of this email list , click here.

InvestorsFriend Inc. Newsletter December 11, 2010

Is the End Nigh?

The End is Nigh!, The End is Nigh!

It seems that humans have been predicting the end of the world since, well, since the beginning of the world.

From being cast out of the Garden of Eden to the biblical Great Flood to today, the end of civilization, or at least pending mega disaster has been predicted continuously.

During my life some of the things that were going lead to the end (of our prosperity, if not of the world) included war, communism, pollution, acid rain, ozone layer depletion, over-population, running out of energy, AIDs, flu pandemics (Remember SARs?… neither do I…) , hyper inflation, terrorism, West Nile Virus, excess debt, and climate change. I am sure I have forgotten some. Some of these have been of concern for decades but have tended to mostly be in the background and then periodically come to the foreground as the panic de jeur.

I begin to think that there is something in the human psyche that is very much attracted to the idea that humans are going to destroy themselves or that God is going to inflict some great punishment and so… we constantly expect and predict that The End is Nigh!

People also seem to generally be convinced that life is difficult and not fair. That we live in a time when making a decent living is more difficult than it used to be. Give me a break…

I’m 50 years old and when I was growing up just on the edge of a small town in Nova Scotia, there were still a few people around without running water in their houses. Lots of families did not own a car and two car families were the exception. Houses had one bathroom and certainly more than one kid per bedroom. Cottages typically had outhouses. If Mom didn’t work outside the house, it was usually because she was too damn busy working 16 hours per day at home! My parents grew up in houses without electricity. My grand-parents grew up in horse and buggy days. They lived through two world wars and an ACTUAL depression. So it truly boggles my mind when people complain quite seriously that standards of living are dropping and that life TODAY is rough. Again, give me a break!

So I don’t take all this whining and predictions that The End is Nigh! very seriously at all.

Still, as an investor it behooves me to give some thought to the worries that now circulate in some circles about the the coming implosion of the U.S. dollar and the world financial system.

Many investors claim that due to debt and the printing of money, the U.S. dollar is not to be trusted and that this is why the price of Gold has soared as people look for a store of value.

Can the U.S. dollar be trusted? Will it fall against other currencies and/or suffer from high inflation?

I certainly can’t provide a definitive answer to that. But I can look at some evidence.

Many people are predicting that the U.S. dollar will suffer from greatly reduced purchasing power in the years ahead. For Americans this can only happen if there is high inflation. For U.S. dollar holders in other countries it can also happen if the U.S. dollar falls in value against their particular home currency.

Some analysts suggest that the record high price of Gold is proof-positive that investors are fleeing the U.S. dollar due to these fears.

Now I don’t know very much about Gold. But I do know that there are lots of other possible reasons for the high Gold price that do not involve fleeing from U.S. dollars. There reasons include demand created by speculation and demand for the jewellery trade and the general scarcity of Gold.

In looking at investor attitudes toward the U.S. dollar, there are much better and more direct indicators of this attitude than the price of Gold.

One of the best indicators of investor confidence in the U.S. dollar is the interest rate obtained from buying 30-year U.S. Government bonds (known as U.S. Treasuries).

That interest rate is currently about 4.43%. This means that investors who buy these treasuries do so knowing they will receive an annual  yield of 4.43% on their money. For example $100,000 invested in such a treasury bond would provide an interest payment of $4,430 per year for 30 years followed by the return of the original $100,000.  Gee, let’s see if I had a million dollars I could get $44,300 per year, fixed with no inflation protection. Sweet! NOT! This seems to suggest that these investors are not expecting much inflation and certainly not hyper inflation. Even with 2% inflation per year the purchasing power of the $4,430 will have dropped to $3291 after 15 years and the $100,000 in 30 years will only have a purchasing power of $55, 207.  And if inflation runs at 3%, the $4,430 annual interest payment will have a purchasing power of just $2,843 in 15 years and the $100,000 returned in 30 years would have a purchasing power of just $41,199. A rational investor who expects high inflation would not agree to invest their money for 30 years at 4.43%.

And imagine if on top of the inflation, you are a Treasury bond buyer in a foreign county and you expect the U.S. dollar to decline in value against your own currency. That would further erode your return. It’s hard to imagine why a rational foreign investor who expects the U.S. dollar to lose significant value due to inflation and or de-valuation against his home currency would nevertheless lock up money in U.S. dollars for 30 years at 4.43%.

Now some will claim that the 4.43% interest yield on 30-year bonds is not really set in the market but rather is manipulated as the U.S. Fed buys these bonds in the market. I am sure there is some truth to that. However, there are other buyers of U.S. Treasures besides the Fed. I would wonder why American investors would buy any 30-year U.S. Treasuries at a yield of 4.43% if in fact they expect inflation. And why would foreign investors buy if they expect both inflation and a devaluation of the American dollar. I don’t believe that any of these investors are forced to buy these treasuries. They are voting with their wallets and therefore it is fair to ask what those votes are telling us.

So, let’s take a look at who buys 30-year U.S. Treasuries.

Treasuries trade in huge volumes on the market and I don’t have a data source for who the buyers are in the market. But I do have a data source for who buys directly from the U.S. Treasury when these bonds are issued.

Coupon Auctions – Data

For the latest auction of 30-year Treasuries (November 15, 2010), here are the buyers and the percentage of the total bonds sold that each group of buyers bought.

Federal Reserve Banks 2.6%
Depository Institutions (banks) 0.0%
Brokers and Dealers 56.2%
Pension and Retirement Funds 0.2%
Investment Funds 16.7%
Foreign & International 23.9%

Now this table suggests that the Federal Reserve Banks are only small players in this market. Possibly they are much larger buyers in the secondary markets.

Another area to look at, is who are the holders of 30-year U.S. Treasury bonds?

I could not find a listing of all the major holders. I did find a list of foreign holders

Major Foreign Holders of US Treasury Securities – www.treasury.gov

China $884 billion
Japan $865 billion
Oil Exporters $231 billion
Brazil $176 billion

And it was reported that the U.S. Federal Reserve owns about as much as China $891 billion

The total debt of the U.S. government was listed at $13,861 billion, of which $9,275 billion was held by the public.

I was not able to see separate listing for the 30-year Treasuries

My overall conclusion is that it appears that there are investors who are buying 30-year U.S. treasuries at 4.43% and therefore are indicating, by voting with their wallets, that they do not foresee any great drop in the value of U.S. dollars either through inflation or a decline in value in comparison to other currencies. If they did, why would they buy?

But What of Gold?

It has often been claimed that Gold is a hedge against inflation and that it holds its purchasing power value over the long term.

Experience does not support that claim. In the 60’s Gold was about $35. Prior to 1933, Gold coins circulated in the U.S., but in 1933 citizens were forced to turn in the gold coins and accept paper dollars for them. From 1933 to 1972, I understand that foreign governments could exchange U.S. dollars for Gold from the U.S. government, at about $35 per ounce. In 1972, the U.S. removed all remaining promises to exchange $35 U.S. dollars for one ounce of Gold and allowed U.S. citizens to again buy Gold coins. Gold immediately starting soaring and reached an annual high of $595 in 1980 (the daily price peaked out at over $800 that year). Even considering the high inflation of the 70’s it is clear that Gold’s purchasing power value soared in the 70’s. Gold however then fell and languished for the next 25 years and surpassed its 1980 annual high only in 2005 when it reached $513 on an annual basis. Given inflation and its lagging price Gold certainly did not hold its purchasing power value over those 25 years. Now Gold has soared to about $1430 despite our very low inflation environment. Clearly the purchasing power of Gold has soared in the past few years. So, I can’t agree that Gold tends to hold its purchasing power steady.

I have heard claims that an ounce of Gold today has similar purchasing power to that of say 2000 years ago. I have not seen proof of that. I think any economic data from 2000 years ago has to be considered rather suspect. Furthermore, if in fact Gold holds its purchasing power over periods of time measured in centuries but can not be trusted to so so over a period of 25 years, then that seems of little value to an investor.

I have never seen any charts of the purchasing power value of Gold over a long period of time. But, I was able to create my own chart of Gold versus U.S. inflation since 1926.

The red line here is the price of Gold in U.S. dollars per ounce. It starts at $20.67 in 1925 and ends up at $1430 in late 2010.  The blue line is an index of inflation from 1925 to now.

The goal of this chart is to illustrate how well the price of Gold has tracked inflation and to illustrate whether or not Gold is currently above its long-term trend line with respect to inflation. In order to best show this I have scaled the inflation index to try and line it with the Gold price. The graph shows that the price has Gold has trended up with inflation but has not tracked inflation very closely at all. And, it appears to show that Gold is currently well above its trend line. The only other time Gold was this high relative to inflation in these 86 years was the average price for 1980. Note that for 2010 I have shown today’s price rather than the average for 2010.

Before jumping to the conclusion that Gold is over-priced, we should stop to consider that from sometime prior to 1925 and up to 1971, the price of Gold in U.S. dollars was effectively controlled by the U.S. Government. (Or the price of a U.S. dollar was controlled by Gold, which amounts to the same thing). So, it may be better to just focus on the picture since 1972 when Gold, as priced in U.S. dollars, has floated freely on the market.

Since 1972 the price of Gold has again not tracked inflation very closely at all, although both are higher over the 39 years. Looking at the trend one would conclude that if Gold is supposed to track inflation (giving a constant purchase power for Gold) then Gold currently is above trend. In 2002, Gold at $340 was tracking well below the inflation trend line. Gold “needed” to rise to about the $600 level in 2010 just to get back up with the inflation trend line. But at $1430 it appears to be well above the trend line.

Now it may be that Gold was never meant to track inflation and that any relationship to inflation is purely random. So there are lots of reasons why Gold could remain well above the inflation trend line. But anyone who believes that Gold is moving higher simply due to its being a store of value should be aware that it appears to have moved well above the inflation trend line. (Why should a “store of value” increase sharply in value, in terms of the goods and services it can buy?)

Buying a Gold ETF

My reason for mentioning Gold here was not to analyse it as an investment but mostly to discuss Gold as a signal that the U.S. dollar is about to crater or as a signal that, as many fear, the end of the Financial World is Nigh. I don’t believe it is such a signal at all.

In fact I am pretty certain that The End is Not Nigh. Financial markets are always unpredictable. But whatever happens I am confident we will emerge on the other side and the standard of living will continue to rise.

If you are interested in Gold ETFs the trading symbols are available in our Canadian Exchange Traded Funds reference article. The prices there will be out of date but the trading symbols are there and you can click through for the latest price. And you can see there which Gold ETF owns physical Gold and which merely buys futures to mimic a holding in Gold.

Buying Stocks

I have never owned a Gold ETF. And the only time I ever owned a Gold company was way back in the Bre-Ex days when I briefly held some Bema Gold. I was lucky to get out of that without much of a loss and I never examined any Gold companies after that. The reason for that is that Gold companies are not amenable to financial statement analysis and I had no ability to analyze which Gold companies are under valued. So I will stick with stocks.

For the last decade I have done very well in a variety of stock investments. Surprisingly this has included not only no Gold but essentially no  energy or resource companies either. Instead I focused on various financial, retail, communication, restaurant, real estate manufacturing and other such boring companies that have mostly been excellent investments. To a certain extent I have also traded in and out of these stocks in an advantageous manner. If you are not already a subscriber, you can get access to the names of the stocks that I hold and full details of why I hold them by subscribing to our Stock Reports service.

END

Shawn Allen, President
InvestorsFriend Inc.

To see older editions of this newsletter, or to get off of this email list , click here.

InvestorsFriend Inc. Newsletter November 7, 2010

Makin’ Hay and Makin’ Money

The old saying is “make hay while the sun shines”. Well the sun has been shining brightly on our Stock Picks. So… I will “make hay” by taking the opportunity to tell you about that.

As of August 1, the stocks that we had rated Buy or higher at the start of this year were actually down about 2% after having had a spectacular year in 2009  when they were up 37%. However, in these last three months, the sun has been shining and our Stock Picks are up 11% in the last three months. Our long-term performance record is summarized here.

With this kind of recent and long-term performance I am understandably pumped about the prospects of making ever larger amounts of money by investing rationally in stocks. There are no guarantees, especially for the short term. But I for one am excited about the prospects.

With the Q3 earnings reports rolling in I am busy updating InvestorsFriend Inc.’s ratings for our stable of Stock Picks. Every year at this time we make a special effort to update as many of our reports as we can so that we will have current ratings on all the Stocks Picks for the start of the new year. Although we rate stocks all year, we measure the performance based on the performance in calendar years and that is one reason to get everything as up to date as possible for the new year.

So… if you are not already a Subscriber to our Stock Picks or your subscription has lapsed, then right now is a very good time to subscribe. Click to check out the details. We accept payments by credit card through PayPal (our highly service owned by eBay) or by cheque. But, as always there is no pressure to subscribe to the paid service and we are gratified also by all those who choose to allow this free newsletter into their busy lives and inboxes.

Stock Analysis Education

One of the best sources of education on how to select stocks is the collection of annual letter to shareholders written by Warren Buffett, the world’s most successful investor. Investors who bought Berkshire Hathaway shares around 1964 when Buffett was taking control of the company have seen the share price rise almost 1 million percent, from the $12 to $14 range to a current $125,560. An early investor (and the now wealthy heirs) in his partnerships from the late 50’s who stuck with Buffett and rolled the Partnership money into Berkshire shares when the Partnerships were wound up in in 1969 are up, by my estimate, somewhere in the order of 10 million percent.

So yeah, I am a HUGE Buffett fan. I did not start out that way. I started out simply applying my knowledge of finance and business and accounting to stock picking. I did calculations to figure out, for example,  what kind of Price Earnings ratio was rational to pay. As I started to read a little of Buffett’s work I realized that my own thinking was already largely in line with his. And where my thinking differed, I soon found after a bit more thinking and analysis that Buffett’s thinking was correct.

I soon started reading his annual letters when they came out each year. At first I did not read his older letters which I figured would mostly focus on things specific to those years and not be relevant today. But when I looked at a few of the old letters I realized that much of the material was completely timeless. Each of the old letters contained material that was in effect a chapter of an investing book by the world’s greatest and most intelligent investor.

So… I printed off copies of all those letter and put them in a binder and have read them all. This year I decided  to read them all again. I started with his brief old Partnership letter from 1957 and I am currently reading the 1994 letter. It may sound odd to re-read this material multiple times. But after all this is absolutely brilliant material. A scholar does not read a classic text only once, he studies it. As a scholar of investing, I will not merely read Buffett’s work, I will study it.

And I have been amazed at how much I am picking up on this third reading. Great pearls of business and investing wisdom. Every investor should read this material. You can find links to it on our links page. Other than the most avid Buffett fans can probably dispense with the very early letters. Start with the group of letters on Berkshire’s Web Site those from 1977 forward. I found the letter from the 80’s to be particularly full of educational material. These letters constitute a free investment book by the greatest investor ever. This is must-read material.

When Forgetting the Past Can be a Good Thing

If you are like me, you have a hard time buying a stock at say $30 if you had the chance to buy it previously at $15 and thought about it but did not buy. In this situation I get a sort of mental block against making the purchase. It’s as if by buying at $30 today I would be admitting I was a fool to have not bought at $15 sometime in the past when I had the chance. An even if it was some years in the past the mental block surfaces.

Similarly, I think most of us experience a very large mental block against selling a stock for $15 if we paid more than that for the stock. And the more we paid the bigger the mental block. Our minds tell us that this stock owes us money.

Logically the price we paid for a stock has no bearing on what it is worth today. And the fact that we passed on buying a stock at $15 should logically have no bearing at all on whether or not it is a good value today at $30.

In cases like this we need to forget our past history with a stock’s price and simply focus on whether the stock should be bought or sold today.

In my own case I find that when I update a stock report on this site and go through all the numbers and the other factors that usually allows me to do a sort of mental reset. If the analysis says I should buy at $30, I am then able to let go of the fact that I failed to buy at $15 (after thinking about it) sometime in the recent or (more likely) distant past.

Not surprisingly, Warren Buffett is able to forget his past mistakes and focus on today’s price and value. In his 1985 letter he admits that he sold Berkshire’s Capital Cities shares at $43 in 1978-1980. But then he bought back all those shares and a lot more in early 1986 at $172.50 (four times the price!) Well it’s a good thing Buffett was able to “forget about” his sale at $43 and remove any mental block to the purchase at four times the price. That investment at $172.50 worked out absolutely brilliantly.

And Now For Some Editorial Content

I will sometimes include material in this free newsletter that is not related to investing but rather is something I think might be interesting to readers, humorous or is just something I want to say.

You Get No Respect and Maybe it’s a Good Thing

The late comedian Rodney Dangerfield made something of a career pointing out all the examples where he got no respect.

Rodney was onto something.

I am willing to bet that all of you have experienced what feels like an appalling lack of respect on numerous occasions. Kids often fail to respect parents, teachers and other authority. Young people fail to respect their elders. Experts on various topics are dismissed by people who know nothing.

Even the greats of our society are routinely treated with a lack of respect. Not only do people routinely rail against the polices of sitting Presidents. They go well beyond that to question their integrity, intelligence, fidelity and anything else that comes into their minds. Bring up Warren Buffett’s name as a great investor and many will point out that Berkshire Hathaway’s stock has not risen much in the past decade. For at least 20 years many have dismissed Buffett as yesterday’s man. Many (while knowing nothing about it) will criticize his lack of conspicuous consumption over the years.

At the end of the day this is human nature. No man or woman ever wants to admit being inferior to another. Finding success in this life demands that each of present ourselves as worthy individuals. It seems ingrained in our brains that praising others detracts from ourselves. Our first instinct is to speculate on why the greats of this world are not in fact so great after all.

And maybe all of this lack of respect is a good thing. Kids need to find their own way in this world. A blind adherence to the views of teachers, parents, and other authorities will not make kids independent thinkers. New inventions will come from independent thinking not from blind respect to the old theories.

So… if you are sometimes frustrated by a lack of respect, take comfort that you are not alone. Nobody in this world gets the respect they are due, let alone what they think they are due. Too much respect goes against human nature and it’s a good thing.

Public Washrooms

Okay, this is a weird topic but one that I wanted to write about for a long time but figured people might think me strange for my views. But so what? here goes.

Another name for a washroom is a privy. And privy means private.

Well maybe I can’t expect public washrooms to be very private but I think they could be a good deal more private than is usually the case.

Why are public washroom partitions almost always made out of thin flimsy material that does not extend from the floor to the ceiling?  Worse than that are the cracks at the door which you can usually see through while occupying these facilities. Even in a fancy office tower, shopping mall or restaurant this will often (though not always) be the case.

I have heard some reasons or excuses for it. Cost may be an excuse. But I don’t think so. It simply does not cost that much to build proper partitions with proper doors. Another excuse is it easier to clean the floor if the walls don’t reach the floor. A lame excuse given what society pays cleaners. Yet another excuse is that the usual setup allows someone to quickly check if the bathroom is occupied or not – as in when trying to catch a crook or in a fire evacuation situation. Well it would not be that hard to install doors that can only be closed and locked from the inside and then if the door is closed and locked it is occupied, otherwise not.

Oprah Winfrey was brave enough to discuss this matter and mentions that she does not like public washrooms because people can see and hear her in there.

So if you are responsible for such matters, please install real partitions and real doors in your next public washroom project. And if you have some existing ones, consider upgrading for better privacy. Your customers or tenants or visitors will appreciate it.

Moving on to Urinals

It is almost beyond belief that most urinals do not even have a privacy partition between them. Many do, but probably most don’t. Even at brand new installations. So a 12 year old is required to expose himself to the possibly prying eyes of whatever person sidles up next to him, fine upstanding citizen, or dirty old man, as the case may be. This is too stupid for words. Privacy partitions should be installed forthwith.

Health Clubs

Am I the only one who has never greeted with enthusiasm the fact that in a health club or public pool situation we are supposed to get and even shower naked with whoever else happens to be there? Men and boys required to be naked in front of each other? Has the average health club ever stopped to think that, for example, a middle aged man in dire need of exercise might not want to be naked in front of his friends colleagues and whatever teenagers might be there? Is this not all too incredibly stupid for words?

In Summary

How about some common sense and independent thinking when it comes to washrooms. You don’t need to blindly build it in a criminally stupid way just because that’s the way it’s always been done.

END

Shawn Allen
InvestorsFriend Inc.

Subscribe

For those on our mailing list for this free newsletter, who are not already subscribers to our Stock Picks service, there is never any pressure to subscribe to the paid service. We realize that not everyone has funds to invest and not everyone has a self-directed investment account. Some visitors to this Site have subscribed to the paid service the same day they first visited this site. Others may wait a year or more before deciding to access the Stock Picks.

But, if you are looking for stocks to invest in then why not subscribe now? Remember the cost is just CAN $15 per month or $120 per year. When you think about the potential returns from just one well-researched Stock Pick, you can see why our subscription service has been a great investment for our subscribers.

END

Shawn Allen, President
InvestorsFriend Inc.

To see older editions of this newsletter, or to get off of this email list , click here.

InvestorsFriend Inc. Newsletter 10 10 10

How to Invest in Companies and Stocks

Before turning to stock investments, let’s think about an ideal scenario for investing in a small business.

Imagine that a good friend of yours has a strong history of success and accomplishment. You highly admire, trust and respect this friend. And imagine that your friend has a private company which is highly profitable and growing and has a great future.  Also you understand the nature of the business and as a result of all of this you are highly confident that your friend’s business is likely to grow and prosper over the years and deliver many years of high profits. You’re happy for your friend but also a bit jealous.

Now, imagine that you have money available for investment and that your friend needs money to expand the business and offers you the opportunity to invest. This is a “ground floor” opportunity. And your friend is offering to sell you say 10% of the business at a very fair price.  If the business grows as expected this will be a highly profitable investment for you. And imagine that everything will be done professionally and written up in a proper legal form.

What I am describing here is just about the ideal investment. It meets the criteria that Warren Buffett has set out for investments. Warren Buffett said in his 2007 annual letter to shareholders:

“Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag.”

Most investors would agree that the opportunity presented above is a good one.

And after your investment, you would not be thinking of yourself as merely a “shareholder”. You would think of yourself as a part owner of your friend’s wonderful business. This would be a long-term perhaps virtually permanent investment for you. After a few years of ownership you would likely be very interested in how much profit the business was making and how its sales were growing. You would not likely spend much time thinking about how much you could sell your shares for.

So okay, that was a nice fantasy investment but in reality the kind of opportunity discussed above is not likely to come along for most of us.

So let’s turn to investing in Stocks. First here’s the wrong way to think about investing stocks.

90% of the public seems to believe that successful stock investing requires a person to guess which stocks will rise in the short term and buy those.

I would guess that 90% of people would agree with both the following statements:

1. Big corporations are making too much money

2. Owning Stocks is not a good way to make money these days.

It’s difficult to see how both of those statements could be true.

These investors see stock investing as being the opposite of what Warren Buffett describes as his ideal investment. They see themselves investing in companies:

– with businesses they don’t understand (how many really understood Nortel?)
– with long-term business economics that they also don’t understand
– with management that may or may not be capable and is definitely not to be trusted (far from being trusted management are often expected to “rob” shareholders blind)
– and selling at a share price which investors have no idea is fair or not
– and they fear that the stock price will continually be manipulated by powerful traders

In this scenario, investors seem to think that the best they can do is buy stocks on the up trend, hold them for a gain and then sell to someone else before something bad happens. Investors think of themselves as (quite temporary) shareholders, not as partial owners. They don’t think much about owning a share of the companies’ earnings. They think of any gains as coming from dividends and especially from share price increases and they don’t see much relationship of those gains to the actual earnings of the business in many cases.

The above dismal scenario of stock investing has played out far too often in the past decade or so (Nortel, Enron, the Wall Street Banks, seemingly almost every company in 2008…). So, it’s no wonder that so many investors are disillusioned and afraid of the stock market.

And now here is the right way to invest in stocks

Legendary value investor Benjamin Graham said “Investing is most intelligent when it is most businesslike”.

The right way to invest in stocks is to make it as businesslike as possible. Ideally we want our stock investments to be as close as possible to the fantasy scenario described above of investing in a wonderful business, with high profits and a great future and ran by people we like and trust and available at a bargain or at least a sensible price.

It is of course very difficult to find that scenario in the stock market, but it’s not impossible.

It starts with an attitude that you are going to a long-term share owner of a business, not merely a temporary share holder of an abstract stock symbol.

And it’s quite easy to reject businesses which you have no hope of understanding, or where management appears incompetent or untrustworthy, or where the share price is too high.

At InvestorsFriend we try to identify businesslike investments. For every company we look at, we discuss the business and how simple or complex it is and what its competitive advantages appear to be. We discuss management ability. We look at executive pay as an indication of trustworthiness. And of course we spend a lot of time trying to see if the share price represents a bargain or not.

In many cases we don’t have all that much information to go on  for things like management competence and trustworthiness, but at least we do address these topics, every time. And our expectation for growth of the company may not turn out to be achieved. Predictions about the future are always subject to error. So we certainly make no guarantees. But we do think our businesslike approach is the right one and so far our track record is strong.

Information about how to access our Stock Ratings for a modest fee is available by clicking here.

And our article on to get started and open an investment account at your local bank is available by clicking here.

CMHC  – Canada Mortgage and Housing Corporation – A Bankruptcy Candidate?

CMHC  – Canada Housing and Mortgage Corporation provides mortgage insurance so that banks can lend mortgage money to homeowners even when those potential home buyers have very little money for a down payment and when affording the house is not going to be easy.

It’s been much in the news that the American versions of CMHC namely the somewhat comically-named and government-sponsored but shareholder-owned Freddie Mac and Fannie Mae basically blew their brains out, became insolvent  and are now operated directly by the United States Federal Government.

I would guess that the vast majority of Canadians, including investors got through most of their life without even knowing the names Freddie Mac and Fannie Mae. But now, most Canadian investors have heard these names and know that these are two giant government mortgage insurance providers who somehow effectively went broke as house prices in the United States plunged.

Could the same happen here in Canada to CMHC?

The first place to look for financial strength of any corporation is its balance sheet.

CMHC’s balance sheet for 2009 is available here:

http://www.cmhc.ca/en/corp/about/anrecopl/upload/CMHC_AR2009_ConsolidatedFinancialStatements.pdf

Assets are $272.8 billion (so far so good), but liabilities total $263.6 billion and owners equity or net worth is a comparatively tiny $9.3 billion. So that means that the equity is just 3.4% of assets. That’s pretty hilarious isn’t it? That’s less equity than the minimum 5% down that home buyers have to pay! It means that if the the assets of CMHC were to drop in value by just 3.4% they would have  a net worth of zero. That is often know as insolvent. But not to worry, the government would no-doubt bail it out.

The great majority of these assets are invested in mortgage receivables. So, as long as Canadians keep paying their mortgages, CMHC should be okay as far as the value of their assets. But, if a significant number of Canadians were to stop paying their mortgages (due to job loss and or bankruptcy), well then CMHC could quickly see its equity disappear and would have to go to the Canadian government looking for money.

As an insurance company we also have to look at their liabilities – since some of the liabilities are only estimates and could be understated . They show $1.3 billion as the amount they expect to pay out in claims for mortgages currently insured by them, in respect of defaults that have already occurred.  The amount of insurance in force is $472.6 billion. So they have just 0.28%% of their insured mortgages recognized as a liability. There is no liability booked for mortgage defaults in the future on the existing block of insured mortgages. Those would be covered by future revenues including a portion of the $7.2 billion in already received revenue that has not yet been booked as revenue. There may be a huge risk that this $7.2 million will turn out to be inadequate to cover defaults on the existing block of mortgages, in the event of a recession or if a large drop in house prices causes too many Canadians to declare bankruptcy.

If mortgage defaults were to rise, CMHC could increase insurance fees on new mortgages. But the fees on the entire block of existing mortgages have already been paid and could not be adjusted upwards to cover the higher loss.

The other main place to look at to determine the financial health of a company is its income statement. CMHC has booked a profit of around 1 billion per year for the past few years.

Here is something interesting. In 2008 they paid out $0.372 billion in claims (payments to banks to cover banks losses on foreclosed homes) . In 2009 they budgeted to pay out $0.279 billion in claims but the actual came in at $1.112 billion. So that’s triple the 2008 level and more than triple the 2009 budged amount!

When I then look at the $1.3 billion they have recognized for claims on defaults that happened by the end of 2009 that seems pretty small considering they paid out almost that amount in 2009 alone – which given the time delays involved, probably largely reflected defaults that occurred in 2008.

Consider that the recession never hit Canada all that hard and housing prices did not drop much and then they recovered and rose to new highs. And yet in 2009 CMHC saw its claims triple. I shudder to think what would happen to CMHC if there was a severe recession and if house prices dropped materially. It seems obvious that they would wipe out their equity pretty quickly.

I notice also that in 2009 CMHC paid out $2.6 billion to support low income housing programs. That may be a great government initiative. But I have to wonder why a mortgage insurance entity is using mortgage insurance premiums to subsidize housing. This expense for housing programs is considerably higher than the expense for insurance claims paid out.

It looks to me like CMHC is very weak financially. It probably has not recognized realistic amounts for future claim payments to banks in the event of continued recession or a large slump in house prices. I will certainly not be surprised if CMHC ends up like its America cousins, Fannie and Freddie, and comes begging to the government for money in the next few years.

The High Cost of Free

It’s great when stuff is free isn’t it? Well not always. A wise person once told me “nothing is free, free just means someone else is paying for it”.

Not a whole lot in this world is free, and there are good reasons for that.

Free tends to lead to over-consumption and line-ups and ultimately lack of production. (Who is going to produce what is not being paid for?).

Think about free medical care in Canada. Yes, it has it’s advantages and it may be a great idea overall. But there are some costs. Most of us have to wait to see a Doctor. The waiting time in emergency rooms can easily be 8 hours. And what can you say?, not much. You are not directly paying for the visit and so you are at the mercy of the system.

I asked my Doctor about getting a certain medical test done that is recommended for men my age (50). He said no, and explained that while the test was a good idea, there were no enough doctors to do the test and unless I had a specific family history, I simply could not get that test. Also, when you get a routine blood test done, they don’t test for sort of everything. There are dozens of diagnostic tests that that simply don’t do – even though these tests might warn of a critical illness developing. The tests are considered too expensive.

Would you like to get a whole body scan done just in case? Well too bad, you will not receive that free on demand in Canada. Would you like to pay for it yourself? Well, again, too bad, it’s generally not available in Canada, and its generally illegal for a private clinic to set up and offer that to you on a fee for service basis. Would you like such a scan for your dog? In that case you can probably pay to get it.

The point is while free medical care in Canada is arguably the best system, it certainly comes at a high cost. There is the direct cost of possible waste and over-use of the system. But perhaps more seriously we  give up the right to seek and pay for the best medical treatment and tests that we can afford. In some cases people will ultimately give up their life as a result of that.

What about the high cost of (nearly) free money?

Governments can now borrow at some of the lowest interest rates in the history of the world. Even you and I can access mortgage money at as low as about 2.2% per year interest. Financially strong corporations can borrow money at rates like under 2% for 2 years and under 5% for 30 years. That has its advantages but it comes at a huge cost.

Savers are being offered interest rates like 1% for a one year term deposit and 2.1% for a five year deposit.

Pension funds and Life Insurance companies that invest in government and corporate bonds are in danger of becoming insolvent due to the low returns on fixed income investments.

Investors may feel almost forced to reach for the higher yields (but higher risks) of preferred shares, lower quality corporate bonds or high yield stocks.

All of these groups are paying a very high price indeed so that governments can have (nearly) free money.

To the extent that extraordinarily low interest rates are the result of manipulation by government rather than free market forces, they are likely to cause untold damage to the economy.

END

Shawn Allen, President
InvestorsFriend Inc.

To see older editions of this newsletter, or to get off of this email list , click here.

InvestorsFriend Inc. Newsletter September 11, 2010

Invest in Stocks or Long-Term Bonds?

Which is likely to give you the better return over the next ten years, stocks or long-term bonds?

The return from long-term bonds is easy to observe.

The return on 10-year U.S. government bonds is 2.8%. If you buy a 10-year U.S. government bond today and hold it until maturity in ten years you will earn a compounded return of 2.8% per year (before considering any Commission paid to buy and sell the bond and before deducting any income tax payable). The equivalent figure on a 10-year government of Canada bond is slightly higher at 3.0%. The return on these government bonds is known at the time of purchase. It will be 2.8%  for a U.S. ten-year bond held to maturity, no more, no less.¹

What about corporate bonds? Those pay a bit more. High quality 10-year Canadian corporate bonds currently yield about 4.3%. Barring bankruptcy of the corporation, which is a low risk in regards to high quality companies with strong credit ratings, the return on these bonds, if held to maturity in ten years, will be 4.3%, no more and no less.

In contrast, the returns from holding stocks for the next ten years can only be forecast. It cannot be known with certainty. In fact, it is subject to a good deal of uncertainty.

But some educated predictions can be made regarding future stock returns.

The return from stocks will be based on dividends and, most importantly, the price the stocks can be sold for in ten years. The price that stocks can be sold for in ten years can in turn be estimated by forecasting the growth (or decline) in earnings and by forecasting the multiple to earnings at which stocks will sell.

The Toronto Stock Exchange Index currently has a dividend yield of 2.7%. The Dow Jones Industrial Average is currently yielding about 2.75% and the S&P 500 is yielding 2.1%.

We can stop right there and observe that the dividend yield alone on these large stock indexes is returning about 75 to 100% of the yield on 10- year U.S. government bonds. And about 50% of the yield on Canadian high-quality 10-year corporate bonds. Mathematically, this means that unless dividends are going to decline, stocks will not need to rise much in price over the next ten years in order to beat the return on bonds.

Imagine stocks have increased in price by just 15% ten years from now. That would be very disappointing and represents a compounded gain in price of 1.4% per year. If that happens, then stocks will (adding in dividends) have returned about the same amount as 10-year bonds.

So all that stocks have to do is increase in price by about 1.5% per year on average  and they will beat those 10-year bonds. And if stocks can manage to increase in price by 5% per year or more then their returns will about double the returns from those ten year bonds.

Right now the trailing earnings P/E ratios on the S&P 500 at 16.3 and on the DOW Jones Industrial Average at 14.2, are neither abnormally high, nor abnormally low. In this situation, we might expect stock index prices to rise roughly along with the growth in the economy. Most economist predictions call for real GDP growth of about 3% per year. Adding in inflation of 1 to 2% results in a projection that nominal GDP will grow at 4 to 5% per year. On average, earnings should grow by about the same amount. And if the P/E ratios remain about constant then the stock indexes will rise by a similar 4 to 5% per year on average.

With this outlook, stocks can be expected (but are not guaranteed) to beat today’s low bond returns quite easily over the next ten years.

Looked at another way, the earnings yield on the Toronto Stock Exchange is currently 4.9%, and the Dow earnings yield is currently 7.0% and on the S&P 500 is 6.1%. It simply seems quite logical to expect to earn more, over the next ten years, from a group of companies that are earning, on average, 4.9%, 6.1% or 7.0% on market value (and which earnings tend to grow over time) then it does from bonds with fixed returns in the 3.0% to 4.4% range.

One has to be quite pessimistic to expect that stocks will not beat these ten year bond returns. Certainly if one believes we are heading into a depression or end-of-the-financial-world-as-we-know-it scenario then one can expect stocks to trail bonds.

Warren Buffett has written about comparing expected returns from bonds and stocks.

In his 1984 letter, Buffett states:

We believe that many staggering errors by investors could have been avoided if they had viewed bond investment with a businessman’s perspective. For example, in 1946, 20-year AAA tax-exempt bonds traded at slightly below a 1% yield. In effect, the buyer of those bonds at that time bought a “business” that earned about 1% on “book value” (and that, moreover, could never earn a dime more than 1% on book), and paid 100 cents on the dollar for that abominable business.

If an investor had been business-minded enough to think in those terms – and that was the precise reality of the bargain struck – he would have laughed at the proposition and walked away. For, at the same time, businesses with excellent future prospects could have been bought at, or close to, book value while earning 10%, 12%, or 15% after tax on book. Probably no business in America changed hands in 1946 at book value that the buyer believed lacked the ability to earn more than 1% on book. But investors with bond-buying habits eagerly made economic commitments throughout the year on just that basis. Similar, although less extreme, conditions prevailed for the next two decades as bond investors happily signed up for twenty or thirty years on terms outrageously inadequate by business standards.

Today, once again investors are happily buying long-term bonds on terms that are outrageously inadequate by business standards. It’s an abomination.

I am not advising anyone to avoid all long-bonds. But I can’t justify the purchase of long-term bonds. Those with more pessimistic outlooks for the economy may be able to justify it, but I can’t.

Stock Market Valuation

You would not want to invest in stocks if they were clearly over-valued. Our very popular article that looks at the valuation of the Dow Jones Industrial Average has just been updated.

United States Dollar and Risks

Many analysts believe that the United States is hopelessly in debt and that eventually it will default on its bonds either directly or through its dollar becoming “worthless” leading to hyper inflation.

If so, then whoever it is that is lending money to the United States at an interest rate of 3.9% on a 30-year bond clearly and 2.8% on a ten-year bond “did not get the memo”. If there is a risk of hyper inflation or really almost any inflation over 1 or at most 2%, then these investors are going to regret loaning out their money at that kind of rate for 10 or 30 years.

I don’t think I am in any kind of position to be able to predict things like hyper inflation. I simply observe that the “bond market” is not fearing it.

Our Performance

This year to date the Toronto Stock Exchange index is up 3% while the Dow and the S&P 500 are about flat for the year. Meanwhile our Buys and Strong Buys are up an average of 1.8%. Our only Strong Buy rated stock at the start of 2010 was Shaw Communications, and it’s up 4.4%. These figures exclude dividends. My own portfolio is up 2.7%.

Over the longer term our Stock Picks have strongly outperformed the market.

On August 7th I and this Web Site were featured in the Edmonton Journal in a very positive way. As a result, we gained an astounding 1000 new subscribers to this free newsletter. Greetings to all the new subscribers. I believe people were attracted by both the strong long-term performance and also the honesty and lack of hype that was projected in the article. Not only did about 1000 people join this free list in response to the article, but about 150 of them have immediately joined our Paid Stock Picks Service.

END

Shawn Allen, President
InvestorsFriend Inc.

To see older editions of this newsletter, or to get off of this email list , click here.

1. Technically the actual return on a ten-year bond could be a little more or a little less than the current yield to maturity depending on the interest rate at which the annual interest payments received are reinvested, but that will not have a material impact given that these interest payments are small, given today’s low rates, and it would take a large change in interest rates for this factor to have much impact.

InvestorsFriend Inc. Newsletter August 1, 2010

Good is the Enemy of Great

In investing as in life, “good” and “good enough” are the enemies of “great” and “truly excellent”. In life, let’s face it, more often than not we don’t do our very best work.

There are many examples of this phenomena at work.

The athlete who trains four hours per day might be settling for “good” whereas it might take eight hours per day to become “great”.

Due to time constraints or lack of energy or lack of intense motivation we all tend to complete most jobs to less than a 100% great standard. And most times that is appropriate. Other times we probably should have pushed ourselves a little harder to achieve something great instead of merely good.

Perhaps automobile companies could build cars to much more exacting standards that would last much longer. But the time taken might make the cars unaffordable.

Good is also the enemy of great when it comes to investing. Ideally, you would invest in only the absolute best investment opportunities.

In an ideal world you (or your financial advisor(s)) would examine every investment opportunity in the world and somehow identify a short list of only the absolute best investment opportunities available in the world.

In the real world it’s not possible to construct such a list. Even if 10 of the top analysts in the world were given the time and resources to construct such a list, they would no-doubt come up with 10 very different lists.

In the real world investments always tend to get added to our portfolios in less than a perfect way. Some investors may be selecting investments after very substantial analysis – but which still must fall short of the ideal world scenario described above. Other investors may be selecting investments in a completely haphazard fashion – a tip from a friend here, a stock mentioned in an investment newsletter there, and so on.

Just because a company is likely to be a “good” investment does not mean that you should invest. Ideally you would restrict your investments to “great” opportunities and eschew the merely “good” opportunities. Your money can’t make 10% if it is all tied up in companies destined to make closer to 6%.

Remember, there’s a company under that there stock

Most investors appear to invest as if a company’s shares were not really very much connected to the actual company.

When you ask for a graph of a company’s performance you will almost certainly be given a graph of the share price performance over the years and not a graph of how earnings per share have grown (or not) over the years. And as a typical investor, that is what you expected to see.

My belief is that if a company grows its earnings at a strong rate then, unless the shares started out way over valued, the share price will take care of itself by following the earnings per share growth upwards over time.

If you owned your own business it is likely that you would keep a close eye on its earnings and you would not be primarily concerned with how much you could sell the business for. Yet when people own a small share of a business they seem to obsess about the price at which the shares could be sold and pay little attention to the actual earnings per share of the business.

What return can you expect to make in stocks?

There are ways to calculate the return that you might reasonably expect on your stock portfolio. The calculations require you to make certain assumptions.

Consider my own portfolio. It has an overall P/E of 16.0. This means that the earnings yield is 1/16 or 6.25%. One estimate of my expected return is this 6.25%. If all of the shares that I own paid out all of their earnings and dividends and if therefore the earnings would not grow and if I expected to sell the shares at some point in the future for the same 16.0 P/E then my expected return would be 6.25%.

However my portfolio only dividends out an average of 32% of the earnings. The rest is retained and reinvested by the companies I own shares in. The weighted average ROE of my portfolio is 14.1%. If I assume that the retained earnings will also earn this same 14.1% ROE (which is only an assumption), then the earnings on my portfolio should grow at about 14.1% times (1-0.32) = 9.6%per year. For each of my stocks I have estimated a reasonable lower and higher estimate of the P/E at which I might sell those shares. Applying the 9.6% growth rate, the dividends and the assumed selling P/E I can calculate that my expected return is 10.3%.

If I hold these shares for five years and if they continue to earn their current ROEs and if they can be sold at the P/E ratios that I have estimated then I can expect (but am certainly not guaranteed) to earn an average of 10.3% per year. In any given year I certainly can’t expect to make 10.3%. Actual returns tend to be volatile as share prices move around.

While my expected 10.3% per year average return is not guaranteed it at least gives me some basis in reality. If I hope to make 20% then I had better be planning to trade astutely because there is no rational basis to assume that the portfolio that I now hold can earn me an average of 20% per year.

See our new Article that explores in detail the question of how much return to expect on a stock based on its ROE, the dividend policy, the P/E ratio paid to acquire the stock and the P/E ratio at which it might be sold after a five year holding period.

Beginning Investors

At InvestorsFriend we fully recognize that not everyone is a seasoned do-it-yourself investor. We have an article on how to get started investing in stocks.

Stocks to Buy Now

InvestorsFriend Inc. picks stocks on the basis of the performance of the underlying company in combination with the price at which the stocks are available. Our approach is designed to produce better than average returns. We recognize that beating the market is not easy. But in our first ten years of existence we managed to beat the market nine years out of ten. On average we have beaten the market index by 12% per year from 2000 through 2009. We can’t make any guarantees about the future. But we can promise to keep picking stocks in the same manner that has been quite successful for us in the past. Click for details on how to subscribe now. The cost is just CAN $13 per month or $120 per year. When you think about the potential returns from just one well-researched Stock Pick, you can see why our subscription service has been a great investment for our subscribers.

END

Shawn Allen, President
InvestorsFriend Inc.

To see older editions of this newsletter, or to get off of this email list , click here.

InvestorsFriend Inc. Newsletter June 29, 2010

The UP-SIDE of DOWN

The Canadian stock market lost 3% today (Tuesday June 29). And it’s down over 8% from its recent highs.

Most investors will see that as bad news. But a drop in stocks is both bad news and good news.

For most investors, it’s probably good news.

Now obviously if you are planning to cash out of the markets tomorrow to buy a house or something it is bad news.

And if you are retired and living off a 100% equity portfolio it’s generally bad news especially the older you are. That’s because you would have no cash to invest in stocks at lower prices.

But for most investors, lower stock prices are good news.

Consider a young investor just starting out, cheaper stocks are obviously unadulterated good news.

And consider a 50-year old who plans to keep investing for ten more years and then retire. Lower prices hurt the current portfolio value but also allow purchases at lower prices. In ten years today’s market dip is likely to be a distant memory. The portfolio is likely to recover and so it’s only impact will likely be the fact that it allowed some bargain purchases. Basically, volatility is an investors friend. It is something to be taken advantage of rather than feared.

Will stocks continue to plunge? Maybe they will, maybe they won’t. I don’t know and I don’t think anyone else really knows either.

Will stocks ultimately recover and move to new highs? Almost certainly although it may be a while.

My strategy during this latest market dip is to slowly add to positions in stocks I like. Many investors would question the sanity of buying into a market correction. But my belief is that no one knows when stocks will go back up. If I am to buy at lower prices then buy I  must. I don’t need to spend all my available cash all at once. But if I am to take advantage of lower stock prices then I have to pull the trigger and buy at some point.

Remember March 2009, when portfolios were decimated by losses? That really hurt. But it was also the golden opportunity of a lifetime to invest at low stock prices. To those who could see the opportunity, who had the funds to act and the bravery to buy went the spoils.

Warren Buffett’s Advice

I have read Warren Buffett’s advice over the years. His advice has been remarkably consistent over the years.

Recently I summarized the advice that he gave in his earlier investment years. In those early years he was investing smaller sums of money and it is instructive to see what his thinking was. You can get some understanding of how he though about bull markets (dangerous) and bear markets (opportunity). You can review my summary of Buffett’s early letters to investors here.

END

Shawn Allen, President
InvestorsFriend Inc.

To see older editions of this newsletter, or to get off of this email list , click here.

InvestorsFriend Inc. Newsletter May 29, 2010

Do You Buy Shares in Companies or just Squiggles on a Chart that you hope will squiggle higher soon?

It appears that most investors, even large investors, don’t really think of “shares” as representing a part-ownership in a business.

After all, these investors are not hoping to make their money by holding their shares for many years and collecting dividends and benefiting from their fair share of the companies’ earnings.

These investors simply to hope that the shares will go up in price (the sooner the better) so they can sell at a profit. And they don’t seem really understand or even care about the reasons that the stock price might go up. They just want the price to go up and right now too.

And why do investors think that way?

Well, in part because it’s easier to think that way. It’s a lot easier to buy a stock based on a stock-price chart that seems to be rising than it is to think about or calculate or research how the stock’s price actually compares to its current and expected earnings.

It seem like at least 99% of commentary on financial television shows is about the trend of the stock price, not the fundamental value of the stock. You will rarely if ever see a chart of earnings per share growth.

When earnings are discussed, it is only as regards the very immediate reaction in the share price. The long-term trend in earnings is seldom mentioned. What about return on equity? it’s not a term you will hear very often even though it is at the essence of corporate valuation.

Ultimately it is a sort of group laziness that leads people to look for advice about a stock’s likely future price in the entrails or squiggles of a stock’s price history rather than looking at its earnings prospects or even its earnings history.

How should investors think about stocks?

Investors should think about stocks as what they are; ownership shares in corporations. Investors should think about the value of a share and its future price as being related to the future earnings and dividends of the corporation. They should think of themselves as share owners and company owners and not as mere share holders (the very term share holder seems to suggest it will be a temporary holding).

Is anyone Interested in the fundamental statistics of a stock such as the price to earnings ratio, the price to book value, and the dividend yield?

Well certainly some of us are, but we may be a small minority.

The other evening I was updating my valuation analysis for the Dow Jones Industrial Average (DJIA).

Bizarrely enough, I was unable to find the full Statistics for the Dow Jones Industrial Average on the Dow Jones Site itself. The Site requires users to register for a free password and I have one. Those Statistics have always been there in the past including P/E ratio (trailing and forward and based on both GAAP earnings and and adjusted earnings with negatives removed), and including Dividend Yield and Price to Book Value. And there is no indication that even under the paid section of the Dow Jones Site that these figures are there any longer. They are apparently just gone! Clicking fundamentals for the DJIA they give some fundamentals but the last update was some 15 months ago!

I then did some Google searching for the current DJIA P/E and yield did not really find what I wanted but did find enough to get by with for my update.

To me this is truly bizarre, the Dow Jones Industrial Average is one of the most watched stock indexes in the world. The change in the Dow is dutifully reported across the world in many thousands of newscasts and financial publications. Can it possibly be the case that there is not much interest any more in the earnings of the Dow that actually drive the level of the Dow? Is 100% of the focus these days on the level of the Dow with no real interest in the earnings that ultimately drive the level of the Dow. Has the whole investment world gone mad to the point where they think that the level of the Dow is really just a popularity contest? Yes, that does seem to be the case.

What are Some of the Implications of This?

Increasingly even institutional investors have drank the Kool-Aide of (so called) Technical Analysis. (It’s beyond me, what is “technical” about looking for patterns in squiggles).  They all study price charts looking for patterns instead of looking directly at the earnings and fundamentals of companies and stock market indexes. This means stocks will be increasingly mis-priced. There are and there will continue to be bargains and extremely over-priced stocks. There will be volatility. All of this is fantastic news for more intelligent investors willing to view stocks as part-ownership in businesses – who understand that stocks have values based on future earnings and that this value can be roughly estimated – and compared to the current price in the search for bargains.

What about market manipulation? Well bring it on! If it exists it too drives stocks away from their true values and creates opportunities.

By-the-way, the companies you own shares in don’t think of you as owners either. I occasionally email a company and I always indicate if I am a share owner (I use the term share owner not share holder). Often the response concludes with  the thoughtless and insincere looking line “Thank you for your interest in (company name)”. That bugs me.  I feel like writing back and pointing out that I am not some outsider merely “interested” in the company, I am an owner. I feel like then thanking them for being part of our company’s “hired help”. But hey, if investors don’t think of themselves as owning anything more than a squiggly line on a chart that might go up in price, I guess why should these companies think of investors as being actual owners?

If you are interested in selecting shares of companies to buy (based on earnings and value, and not based on squiggle analysis) you can access our Stock Picks for a nominal cost by clicking this link.

Or, if your prefer to invest in Exchange Traded Funds – again based on earnings and not on squiggles – you can access, free of charge, our Summary Table of Canadian Exchanges Traded Funds. This is the most useful reference document for Canadian Exchange Traded Funds that we know of – we have not seen anyone else even attempt the job.

Has the World Consumed Beyond its Means and Used Debt to do it?

There can be no doubt that many individuals have consumed well beyond what their incomes would allow and they did it by going into debt. Paying back that debt can be expected require a period of consuming well below what their incomes would allow.

Many commentators have stated that in affect the United States as whole has used debt to live beyond its means. Citizens a a whole have done it and so has the U.S. government, they say. And not just the United States, other guilty countries include, they say, Japan, the United Kingdom, Greece, Ireland, Italy, Spain, Portugal and others. A whole world of debt.

But that leads to the question:

Is it possible for the entire world to be in a net debt position?

It seems obvious that the answer is no, the world as a whole can’t be in a net debt position. After all, no money has been borrowed from sources off this planet. Clearly every dollar owed by an individual or a corporation or a country is owed to some other individual, corporation or country. And it nets to zero.

That does not mean it’s not a problem, but it would be a bigger problem if somehow the whole world was in debt on a net basis to the Martians or something.

Another related question is:

Is it possible that the world has been consuming more than it’s really capable of producing and paying for? More houses, cars, food, energy , and entertainment than it’s capable of paying for?

Although it seems like a lot of commentators assume the answer is yes, in reality the question almost answers itself. Of course the world did not consume more than it produced. Countries can do that by importing, but the world as a whole is not importing anything (except sunshine, which is free).

It is however, possible that the world was consuming more that it is capable of sustainably producing in the, long run.

For example, it is clear that some of what we produce and enjoy comes from the use (or exploitation, if you prefer a more loaded term) of non-renewal fossil fuels.  So we can consider the use of non-renewable fossil fuel and other non-renewable to be a large check mark under the column of unsustainability.

When it comes to cars and food and entertainment we pretty much consume as we produce and so that looks sustainable.

What about all the buildings and roads and power plants and power distribution and communication networks? With all of those it seems clear that the world as a whole consumes less of those than we produce each year. We continually invest in additional and improved houses and roads and power plants and distribution networks of all kinds every year. We could stop investing and just consume what we have and let these things “run into the ground”. But we don’t. We invest more than we consume every year.

According to statistics Canada data, in Canada, some 21% of GDP is plowed back into investing as opposed to consuming each year. That seems like a huge rate of “savings” that never gets talked about.

Overall, I would argue that the condition of the world as a place for humans to live is improving year after year and has been for thousands of years, with no end in sight. Even on a per-capita basis this is the case. The average quality of life on this planet has never been better and is on track to continue getting better every year. Human investment in long-lived improvements and knowledge and technology is the reason.

From this point of view any notion that the world as a whole is in debt and has borrowed from the future, that it is exploiting its resources without investing for the future, and that our children will be forced to pay back our collective debts is utter nonsense.

Today is in fact the best time in history to be born, and tomorrow will be even better.

And it’s a darn fine time to be an investor too!

END

Shawn Allen, President
InvestorsFriend Inc.

To see older editions of this newsletter, or to get off of this email list , click here.

InvestorsFriend Inc. Newsletter May 2, 2010

The State of The Canadian Economy

Investors always worry about the state of the economy.

By most measures the Canadian Economy is doing pretty well.

CIBC World Markets indicates that Canada’s GDP grew by over 5% annualized in each of the last two quarters and will grow at 3.1% for 2010.

Statistics Canada’s Leading indicators show strong increases:

http://www40.statcan.ca/l01/cst01/cpis03a-eng.htm

But there are some things to worry about.

The recent surge in the Canadian dollar makes Canadian manufacturers less competitive and can easily threaten the existence of many. Consider a manufacturer that was making a 10% profit selling goods to the U.S. when each U.S. dollar was worth $1.10 Canadian. With just a 10 cent rise in the Candia dollar the U.S. dollar is now worth just $1.00 Canadian and a 10% profit margin turns into zero profit.

And consider that a few years ago those America dollars were worth $1.30, even $1.50. There must be hundreds of Canadian manufacturers that primarily sold to the U.S. that are now losing money. And even those that sold only to Canadians now face the threat of much cheaper imports from the U.S. You want Chapters to give you the American price for books and similarly every store and factory wants to get those lower U.S. prices as well. How does a Canadian manufacturer compete with that when its wages and most other costs have not dropped?

Tourism too can be expected to be severely impacted as Americans find that Canada is not the bargain that it was when two of their dollars bought about three Canadian dollars just a few years ago.

The Unemployment rate in Canada is about 8.2% and not expected to decline any time soon. What about all the people whose unemployment insurance and severance benefits are running out and with few new jobs in sight?

Interest rates in Canada are heading up which always tends to cool the economy.

Mortgage delinquencies in Canada are still very low in spite of job losses. Can that last?

The bottom line is that Canada has had a surprisingly strong recovery from the recession, but that recovery may not last. Investors should therefore be cautious.

Your RRSP – It’s (Much) Smaller Than You Thought!

“Your” RRSP is not really all yours at all – You should think of it as being about 50% to 75% “Yours” with the other 25% to 50% belonging to the government. The more money you expect to be making when you retire the more of “your” RRSP is not yours at all.

We all know that we have to pay income tax on RRSP withdrawals but the actual way things work can be rather surprising.

Consider a simplified example.

Imagine you contribute to an RRSP and receive a 40% tax break and imagine that your marginal tax rate in retirement will also be the same 40% in this simplified example.

Actually, most Canadians face marginal income tax rates while working and while retired of closer to 30% and some as low as 20%. But the reality is that most people contributing to RRSPs have significantly larger incomes and do face marginal tax rate closer to 40%. In retirement, those with individual incomes over $66,000 face an extra 15% marginal income tax to claw back their old age pension. With this extra 15% their marginal income tax rates are (in Ontario) 48% at $66,000 and rising to 58% at $82,000.  The claw back and its extra 15% finally ends at incomes over $107,000.

Despite the old theory that you would be in a lower tax bracket in retirement, the truth is that the people who are most likely to make larger RRSP contributions tend to earn relatively good incomes and could easily be in a higher income tax bracket in retirement thanks to the 15% old age pension claw back.

My simplified example here with a 40% tax deduction when the RRSP contribution is made and a 40% marginal tax rate on withdrawals won’t fit every situation, but is a reasonable approximation of reality for many RRSP contributors.

So imagine you make a $10,000 RRSP contribution at age 40. You get 40% back as a tax refund and so your net cost is really only $6000. Now imagine that you withdraw this over several years in your 70’s. And imagine that it has grown to $100,000 and you pay 40% or a hefty $40,000 in income taxes on the withdrawal.

The usual way to think about this is that you have paid $40,000 in taxes out of “your” RRSP.

But consider another way to think about this.

Your net cost for the RRSP was only $6000 and it has grown tax-free to $60,000. The government in effect contributed the other $4000 by giving you a tax break.

In effect you always really owned only 60% of the RRSP and the government really owned the other 40%. When the government takes its $40,000 back, all it is doing is taking back its original $4000 plus all those years of growth on the $4000.

You still got 30-plus years of tax-free growth on your net $6000 investment.

The $60,000 that you receive is the exact same amount that you would have if you invested the $6000 in a Tax Free Savings account at the same rate of return.

Here are some of the implications of this:

A $1 in an RRSP is really worth only 50 to at most 80 cents after considering tax must be paid on any withdrawal. In contrast a $1 in a Tax Free Savings Account is worth a full dollar.

When you contribute a $1 to an RRSP however, your net cost is typically only about 60 cents.

So your choice is put 60 cents into an RRSP and the government kicks in another 40 cents and it looks like you have $1.00 but really after considering taxes on withdrawal, you only really have the same 60 cents you put in. Or put 60 cents into a Tax Free Savings account and have 60 cents. It’s the same thing as long as we assume the tax rate on withdrawal from the RRSP is the same as it was when you made the contribution.

The RRSP looks larger because the government in effect will lend you 40% of the contribution through a tax break. But the government wants their share and all of the growth on it back when you withdraw the money.

Contributing to an RRSP or Tax Free Savings Account are both smart things to do because they allow for tax-free compounding of investment returns.

With an RRSP the government is effectively a 40% (or so) silent partner in your RRSP. It will take back roughly 40% of whatever the money grows to. And that is fair, it contributed roughly 40% so it wants its fair share back. Meanwhile the tax-system gave you many years of tax-free compounding on your approximate 60% share of the RRSP, so you still benefit greatly.

When doing a net worth statement you should realize that “your” RRSP is not really 100% yours, it’s more like only 60% yours and you should only count 60% of it when doing a net worth calculation. (Although possibly as high as 80% of it is yours if you can somehow get into a lower tax bracket in retirement, and possibly as little as 42% of it is really yours if you are in Ontario and will make between $82, 000 and $107,000 in retirement and will therefore be paying old age pension claw back of an extra 15 cents on every RRSP dollar withdrawn).

So… in summary… A dollar in the hand is worth (about) two dollars in the RRSP bush.

Understanding The Canadian Economy

We have updated out article on Understanding the Canadian Economy. Key conclusions are that manufacturing remains a very large component of the economy and that the United States remains far and away our major trading partner. The contribution of energy and other natural resources to the Canadian economy appears to be wildly exaggerated in the popular press compared to what this data shows.

In Praise of Big Retail

It’s a shame that big retailers like Wal-Mart and Home Depot come in and push out independent stores.

But the fact is that big retail is simply a more efficient method of getting products from manufacturers to the consumer.

It’s often said that the big chains undercut the small independent retailer because they have buying power. According to this theory, the big stores can buy their products cheaper. That is no-doubt partly true, but it is not at all the full story.

Big retailers also charge a much smaller markup. Wal-Mart for example marks its products up by an average of only 33%.

Target marks up by an average 45%, Costco with its wholesale approach and limited selection marks up by an average of only 15%.

I don’t have the figures for what an independent store would mark things up. I do see that Reitman’s in its Q3 report mentioned a gross margin of 64%. That means, on average, they buy an item for 36 cents and sell it for $1.00, a mark up of 178%.

Yet Reitman’s is not more profitable than the huge retailers I mentioned. My conclusion is that smaller retail must simply face far higher administrative and building-related costs as a percent of their revenues.

Big Retail is extremely efficient and can afford to mark things up by 15% to 45% and still make large profits. Meanwhile a small retailer probably needs mark things up by at least 100% just to survive.

My conclusion is that Big Retail is simply a far more efficient way to get products to the store shelves.

There are many other factors to consider such as better service at small stores. It’s no real savings if your shoes were half the price at Wal-mart but they actually don’t fit your feet.

But for commodity type products where you don’t need any special help to make your purpose, it is very difficult to argue against shopping at big retailers who can save you a lot of money due to their efficiency.

Stocks to Buy Now?

We rate selected stocks as Buy, Hold or Sell. Click for more information. Unlike almost any other source we also tell you what we are buying and selling personally.

END

Shawn Allen, Chartered Financial Analyst
President
InvestorsFriend Inc.

To see older editions of this newsletter, or to get off of this email list , click here.

InvestorsFriend Inc. Newsletter March 21, 2010

Don’t Be Fooled By Attractive Dividend Yields

Not all Dividend or bond yields are as good as they seem.

Especially tricky are preferred shares that trade on the stock exchanges. In many cases these are trading above the price at which they will be redeemed. (Not all preferred shares will be redeemed, that is bought back from investors by the company, but some will be). The cash yield that you see in a stock quote will not in that case reflect the true yield or return to maturity. In this case the true return will be lower than the cash yield due to the fact that a capital loss will occur if the preferred shares are held until “maturity”.

I recently sold some bank preferred shares that had an annual cash yield of 6.6%. I would not have sold if I could have expected to actually earn 6.6%. But these shares were trading at $27.61 and the company has the right to redeem them (buy them back from investors) at $25 in four years. So that means if held to maturity, the 6.6% annual yield is reduced by a 9.5% capital loss that will occur. If the capital loss occurs evenly over the next four years then that is a loss of about 2.4% per year. That brings the true expected return or yield to maturity down to about 4.2% which is quite a bit lower than the 6.6%. Investors buying these shares on the basis of the 6.6% nominal or cash yield are likely to be disappointed.

The only time the cash yield on a preferred share or bond will actually match the true expected return on that share or bond is when all three of the following conditions are met. 1. There is a definite maturity date on which the company will redeem the preferred share or bond at a known price. (This is almost always the case with bonds but only sometimes the case with preferred shares). 2. The preferred share or bond is currently trading at its maturity price so that there will be no capital or gain or loss if held to maturity,  and 3.There is little or no chance that the company will run into financial difficulties and default on the dividends, interest or maturity value. Even if all of these conditions apply, the actual return on a preferred share or a bond that is not held all the way to its maturity date is uncertain.

Note that longer-term preferred shares and bonds expose investors to the risk of capital losses if interest rates rise. It will often be possible to avoid the capital loss by holding until maturity, but if interest rise then it is likely that inflation will reduce the real return that investor makes.

Common shares and some preferred shares have no maturity date. In this case the cash yield is equal to the expected return assuming that market interest rates do not change and assuming that the dividend amount does not change. If interest rates go up the share price will likely drop, lowering the return.

This is not to suggest in any way that investors should avoid fixed income securities. The point is though that the return you can expect on a dividend paying stock may be less than the current cash yield in some cases. And the actual return over your holding period could be vastly different than both the cash yield that exists now or the return that is expected at this time.

Is the Stock Market Over Valued at this time?

We have just updated our very popular article on the valuation of the U.S. stock market. (As represented by 500 of the largest U.S. companies, the S&P 500 index).

We conclude that if an investor requires about an 8% return, then buying the U.S. S&P 500 index at this time is unlikely to return that 8% if held for the long term. (Our analysis is based on a ten-year holding period). Even if an investor requires only a 7% return, our analysis suggests that the U.S. stock market is priced too high for that to be a reasonable expectation. (This assumes a U.S. investor so that currency fluctuations are not involved)

The analysis math that we use is one we learned partly from Warren Buffett’s articles in Fortune magazine in late 1999 and updated in late 2001, where Buffett calculated stocks were over-valued at that time. Which has turned out to be very much the case. (Surprise, Buffett was right, again…).

Our analysis is very much dependent on assumptions about the growth of corporate earnings and the long-run Price / Earnings ratio that can be expected to apply at the end of a ten year holding period. Our article includes scenarios around our assumptions so that readers can see if the market is fairly valued based on more aggressive assumptions for earnings growth or the ending P/E ratio.

Our article is available at the following link:

http://www.investorsfriend.com/S%20and%20P%20500%20index%20valuation.htm

Canada’s High Dollar emergency?

When Canada’s dollar soared above the U.S. dollar in the fall of 2007, I explained in detail why it was a national emergency. Luckily the Canadian dollar then fell as low as 77 cents and spent a lot of months in the 80 to 90 cent range.

Now, the dollar emergency is back. The alarming things that I pointed out in the 2007 article are still valid except now the unemployment rate is already higher heading into this round of the emergency.

The type of company that will be absolutely crushed by the high dollar is a company that makes a product in Canada with its costs in Canadian dollars but sells most of its product into the U.S.  In the worse case, virtually all its costs are in Canadian dollars (wages, property taxes, utilities, interest on loans, land costs, building costs..).

For this exporting manufacturer (or an exporting producer such as a hog farm) , a rise in the Canadian dollar simply lowers its revenues in Canadian dollars while its costs in Canadian dollars are unchanged. These type of companies face a situation where formerly a product that sold for $1.00 in the U.S. translated to say $1.30 Canadian (and it was closer to $1.42 for a number of years when the Canadian dollar hovered at the 70 cent level). Now that same U.S. dollar translates into just $1.00 in Canada, a 23% drop from when our dollar was 77 cents and a 30% drop from the days of the 70 U.S. cent Canadian dollar.  For these type of companies this is clearly an emergency. A 23% drop in revenue with costs unchanged can easily take a company from profitability to insolvency.

Some analysts have commented that Canadian manufacturers have basically benefited from a low dollar for many years. The “charge” is that Canadian manufacturers were basically subsidized by our low dollar. They had an easy time selling into the U.S. They got fat and lazy and failed to innovate and become more productive. Those are the “charges”.

But there are many problems with these charges.

The “charges” implicitly assume that the Canadian dollar was in fact “low” when it was at 70 cents or 80 cents U.S.  Such an assumption fails to recognize that the Canadian dollar (despite the similar name) really is a separate currency from the U.S. dollar. There is simply no reason to think that the Canadian dollar should be at par with the U.S. dollar.

The Canadian dollar was last at about par some 35 years ago during the 1970’s. It then moved relatively slowly down all the way down to about 63 cents in 2002 and then climbed quite steadily to 90 cents in 2006. Then it fairly rocketed briefly above par and as high as $1.10 in late 2007.

http://finance.yahoo.com/echarts?s=CADUSD=X#chart2:symbol=cadusd=x;range=my;indicator=volume;charttype=line;crosshair=on;ohlcvalues=0;logscale=on;source=undefined

The “charges” that Canadian manufacturers had an easy time at a 70 to 80 cent dollar implicitly assume that they faced the same costs as their U.S. competitors. I don’t have figures to compare the costs. But neither do those who makes these charges. My impression is certainly that many costs in Canada were and still are higher than in the U.S. I believe factory workers in Canada often earn more in Canadian dollars per hour than the U.S. workers do in U.S. dollars per hour. Certainly gasoline and vehicle prices were notoriously higher in Canada. Personal income taxes were and still are higher in Canada. The point is that those who assume that Canadian manufacturers had it easy at a 75 cent dollar, have generally not offered any proof of that.

The irrefutable fact is that unless the type of Company I described above facing revenue in U.S. dollars and costs in Canadian dollars was making very high profits at a 75 cent dollar, it is almost certainly losing money with the Canadian dollar now rather suddenly at about U.S. $1.00. Unless it could cut its costs how could it not be losing money? And how easy would it be to cut wage costs? How about fuel and rent and property taxes and utilities and bank interest costs? With the exception of fuel, most of those do not budge at all when the Canadian dollar rises.

Well you ask, why don’t they just hedge the currency risk. Firstly it is too late now, the hedge would have had to been done when the dollar was much lower. Secondly in many cases it is impossible to hedge for more than a year or two. Hedging costs money. It also requires a strong balance sheet. The other side of a hedge contract is going to worry about whether our Canadian manufacturer would honor the contract if in fact the Canadian dollar fell instead of rising. So the counter-party is taking a risk if he agrees to hedge with a Canadian manufacturer. What if the Canadian dollar had fallen back to 62 cents as it did in 2002? Now how profitable will our hedged Canadian manufacture be who locked in (hedged) at say a 90 cent U.S. dollars (where a U.S. dollar of sales is worth Canadian $1.11) while his competitors are enjoying the 62 cent which translates to a U.S. dollar being worth $1.61. Hedging quite simply has its own risks, its own costs and may simply be financially unavailable especially for periods beyond a year or two.

Should the Canadian Government try to get the dollar back down?

I really don’t know the answer to that. I would lean towards saying, yes it should. My understanding is that the government is not trying to push the Canadian dollar lower. I attended a Bank of Canada speech in which we were told that the bank targets about 2% inflation. Period. The Bank of Canada speech indicated that managing the Canadian dollar would contradict the goal of about 2% inflation. The Bank said it cannot serve two masters and therefore it sticks to managing the inflation level and not the level of the dollar.

The finance minister seems to have bought into the idea that Canadian manufactures can adjust to the high dollar. Well, there have been some offsets that have helped like much lower borrowing costs (will that last?), and much reduced corporate income taxes. The costs of importing machines to improve productivity is also lower with the high dollar (but replacing workers with machines hurts employment in the short term). Maybe over time with wage freezes or lower wages for new hires the Canadian manufacturer can get their wage costs back down as a percent of revenue. But generally speaking for a company that faces costs in Canadian dollars and revenue sin U.S. dollars that are suddenly worth about 20 to 30% less than they were a few years ago, there is simply no way to adequately adjust to that. These companies are simply and very suddenly extremely less competitive compared to their U.S. based competitors. The only possible adjustment may be to move to the U.S.

What is Going to Happen?

Market forces may also push the dollar back down. If Canadian exports become uncompetitive and if Tourists stop coming due to the high dollar, and if U.S. investors reduce foreign direct investments in Canadian companies (because of Canadian companies losing money) then the demand for Canadian dollars in currency markets goes down and the Canadian dollar should go down.  The problem is though that if oil prices rise, those exports continue to generate a big demand for Canadian dollars and foreign investment in the energy industry continues and grows and that could prevent the dollar from correcting to a level that allows profitability for a Canadian manufacturers that sell into the U.S.

I can’t predict where the Canadian dollar is headed. I think it has a least as good a chance of falling in the next 12 months as it does of rising. If the Canadian dollar remains around par, I think it is an extremely safe prediction that we will hear about thousands of job losses because of it. It is a simple fact that the ability to make a profit for any Canadian business that faces costs largely  in Canadian dollars and revenues in U.S. dollars has been decimated by this rapid rise in the Canadian dollar. And there is almost nothing that those companies can do in the short term. Therefore it seems certain that layoffs and bankruptcies will occur if the Canadian dollar stays much above even the 90 cent level.

And I consider that to be a national emergency.

END

Shawn Allen, President
InvestorsFriend Inc.

To see older editions of this newsletter, or to get off of this email list , click here.

InvestorsFriend Inc. Newsletter February 13, 2010

THE RETIREMENT SAVINGS MONSTER

Have you noticed that the whole concept of saving for retirement has morphed into an obscene, irrational and hideous Monster? This Monster is a huge threat to corporations, all levels of governments, employees and even current retirees.

Consider the current situation:

Individuals are told they need to save at least one million dollars to achieve any kind of decent retirement. Some experts have suggested that people need to save as much as 34% (based on recent articles in the Financial Post calling for the RRSP limit to be raised to 34%) of their income for retirement!! Corporate Pension plans are reported to be under-funded. Governments plans are under-funded or even unfunded.

The President of the C.D. Howe institute went so far as to suggest that in order to replace 100% of income in retirement, you need to save half your income. He bases this on the absurd notion of near-zero returns.

Some large corporations have gone broke partly because of pension obligations. This has led to cuts to the pensions of retirees and cut the retirement plans of displaced workers off at the knees.

Pension contributions have sky-rocketed for both employees and employers. Traditional pension plans that often provided a “guaranteed” pension amount of 50 to 70% of earnings for those with 30 to 35 years of service are being closed down and replaced with “defined contribution” pension plans that provide an unknown pension amount that depends on the return earned.

Accounting rules result in corporate earnings being subject to large gains and (more typically) large losses) as pension assets fluctuate and as estimated pension liabilities fluctuate.

The Pension Monster was created by numerous factors including:

• Stock market returns that have been lower than assumed in the plan designs and which are now assumed to remain lower.
• Low interest rates that dramatically increase the pension obligations, because it takes more money to fund a fixed pension obligation when available interest rate investment rates are lower.
• The fact that pensioners are living longer in retirement than expected.
• The Societal expectation that the retirement age should remain steady or even decline even though people are living much longer and even though the nature of work has changed to be much less physically demanding in most cases.
• Early retirement incentives and subsidies build into many pension plans.
• Unrealistic expectations of opulent retirement lifestyles.
• Separation of pension plan management from employers, leading to managers that don’t care how high the pension contributions go.
• A financial industry that has every incentive exaggerate the amount of savings that are needed.
• Declining birth rates whereby there are fewer workers for each retiree, a situation that is will get much worse in the decades ahead.

This retirement savings monster has now become the “tail that wags the dog” for many corporations. (It is not unusual for the pension assets to be larger than the shareholder’s equity in the company).

This retirement savings monster is threatening to become the “tail that wags the dog” of our very lives! How crazy is it that people are being told they need to scrimp and save 20% or more of their income all their working lives in order to enjoy their retirement? It’s gotten to the point where people are being told to sacrifice all their working lives for the sake of retirement. And they are told that this is the normal thing to do. They are told that they are failures if they can’t do that. The reality is that this 20% savings suggestion is almost impossible except for cases where the employer pays at least half and the other half is deducted at source into a pension plan.

The current Retirement Savings Monster implicitly assumes that all work is drudgery and that we are all saving to eventually escape from the drudgery of work. This Monster asks you to treat your entire working life as something that you look forward to escaping from as soon as possible.

When we are 20 years old, we expect that we will cover the expenses of our lives by working. We are not told to live in fear of how we will pay for things in our 50’s. We tend to get a job and pretty much assume that in our 50’s we will be perfectly capable of working to support ourselves. But the financial industry asks us to please panic about how we will pay for things in our 70’s. We are encouraged not to even think about working at that age. We must please take huge slices off our current incomes in our  30’s,40’s and 50’s and give it to financial planners lest we end up eating dog food at 70. This is an insult to seniors to assume that they are not capable of any work and that neither will we be at that age.

Did this system ever work?

Yes for a generation or two the formulas seemed to work for those with pension plans. Partly this was because if the pension plans of their parents were underfunded, the larger baby boom generation helped make up that shortfall. Also the stock markets gave unexpectedly lucrative returns in the last half of the 20th century. The first big wave of corporate pension recipients who retired in the 60’s and also those who retired in the 70’s had not yet been indoctrinated with the idea that they should be able to afford to do things like travel extensively in retirement.

But as of now the system is not working. The “pension” system has essentially proven in recent years that it is not capable of funding the longevities we expect today – not with retirement ages of 65, 60 or even 55, and not without 20% (or higher) contribution rates that choke off living today for the sake of retirement.

As far as people saving up their own funds for retirement outside of a pension plan, that has not worked on any wide scale. A majority of workers cannot afford to make the contributions that are required. Only a small minority (ironically typically those with good jobs and pension plans) and a few people like doctors and lawyers have been able to accumulate truly significant retirement savings on their own. Also some unusually dedicated savers and unusually successful investors.

The Origins of the Retirement Savings Concept

In the beginning I imagine our hunter-gatherer ancestors had little ability to even store any food for the days when they would be physically unable to provide for themselves. I imagine that retirement was not a concept that had yet been invented. I imagine the elderly were looked after by family during any (probably short) period of age-related infirmity until they died. Can you imagine that these people would have told an able-bodied but older person that their days of hunting and gathering were over and that they should go relax for the rest of their days? They would not have done that because no doubt every able body was needed for subsistence of the group.

When did the concept arise that older people who were still able to work would nevertheless stop working and be taken care of by government programs, corporate pensions, and or personal savings? And when did the ability of a few to do this become an expectation that everyone should be able to do this? To an economist, this should be a rather strange concept. Generally in any economy whether primitive or modern there is always a hunger to consume more goods and services. Clearly the early idling of vast numbers of older people (before infirmity requires it) must diminish the amount of goods and services that are produced and available in total. Mathematically, this in turn must lower the average standard of living. One cannot raise living standards by encouraging less production in the economy.

When programs like old-age pensions, social security, corporate pensions and even personal retirement savings first were developed, the reality was that people did not live that long in retirement. The concept was for example to work 45 years or more to age 65 and then “enjoy” a short retirement. It was much easier to fund this type of retirement when many people died before they even reached 65 and the average retirement life span was under 10 years.

Somewhere along the line the unrealistic and economically harmful notion arose that it would be possible to work for say 35 years and somehow fund an idle but healthy retirement of 25 years or more. And to do it by saving about 10% or less per year. The fact is, that math don’t hunt!

For millennium untold, humans lived happily without any retirement savings. Now we are told it is a disaster not to squirrel away some 20% per year!

Let’s Bring Retirement Planning and Savings Back to Reality

The solutions to the retirement savings “crisis” that have been proposed by the pension and financial planning industry all seem to involve ever higher contributions (and not coincidently) ever higher Commissions for these managers. The financial planning industry also constantly calls for more tax subsidies for saving in the form of higher RRSP contributions and other ways to save money and not pay any tax on the earnings.

New and economically rationale solutions are needed.

A logical system of retirement planning needs to recognize that people are living longer and that most people are capable of working and earning a living well into their 70’s and often 80’s. We need a system that recognizes that work is often something that we enjoy doing and get fulfilment from. We need a system that recognizes that leisure time away from work is something we should enjoy every year over our whole lives and not something to be hoarded for “retirement”.

A logical pension system would always be portable between companies. It would eliminate today’s features like overly generous early retirement provisions that are simply not mathematically justifiable.

A logical system of retirement would encourage people to keep on working and being productive (remember more workers means more goods and services to go around) and would certainly not encourage the early idling of millions of people.

A logical system of retirement would include a phased departure from work and not a system where one goes from full-time work to retirement with no transition.

When our older decades are viewed more logically as a time of reduced work and reduced paid earnings, rather than of no-work, we can stop obsessing about saving completely unrealistic amounts. We can relax and do things like take a year-off periodically through our working lives. We can take more weeks of vacation or un-paid time off and use some of the money that we are now being told to save. Yes that will deplete our savings, but we will make that up by working part-time in “retirement”.

Let’s try to remember that retirement savings are for the benefit of the future retiree and not the investment industry. I am all for saving money but let’s shoot for realistic numbers and not for 20% of our gross pay.

Let’s slay the Retirement Savings Monster and start living a little more for today.

The Down-side of Tax Assisted Retirement Savings Plans

Things like pensions, RRSPs, RESPs and Tax Free Savings Accounts are all forms of tax-assisted savings. If you use these plans then your taxes are reduced. So that’s good…(for you).

But who is harmed by this?

Well, if everyone could use these tax-saving investments plans equally then no one would either benefit or be harmed. The tax rate would be higher than it would be in the absence of these plans but then we would all save taxes by using them which would cancel the impact of the higher tax rate and no would benefit or be harmed in the end.

It is a mathematical fact of course that tax deductions for these savings plans results in a base income tax rate that is higher than it would be in the absence of these plans.

So what about a high income earner who has no pension plan? He or she is faced with a higher tax rate to make up for the tax deductibility of other people’s pension contributions. Both the employee and the employer share of pension contributions are income tax deductible. How ironic, not only does this person not have a pension plan, their taxes are higher in order to allow the tax deduction for those with pension plans. But this is all good right, because governments need to encourage corporations to have pensions plans, right? Well maybe, but it is really a dangerous and slippery slope when we allow government to decide what is good or bad for us and to use tax policy to encourage it. And who says that encouraging people to have pensions so that they can ultimately stop contributing to the work of the world is really such a good thing?

Any high income earner who does not contribute at least the average amount to RRSPs, RESP and now Tax Free Savings Plans is effectively paying  a higher tax rate in order to allow the tax breaks for those who do contribute more than the average. Where is the fundamental fairness in this?

Any higher income earner (and by “high” I only mean perhaps $75,000 or more) who does not have a pension plan would have to set aside perhaps 25% of their gross income in order to make use of all the tax-assisted plans. Otherwise they are being forced to subsidize those who maximize these tax-assisted plans. The inescapable fact is that a only small minority of the population is able to fully maximize all of these tax-assisted plans including pension. They are clearly being subsidized by all those who cannot maximize these things.

Now these high income earners are themselves subsiding those in lower tax brackets. But let’s assume for a moment that higher tax rates on higher incomes is “fair”. It is an inescapable mathematical fact that those who have pension plans and/or can fully utilize tax-assisted savings plans are being subsidized by those with similar incomes who cannot or do not fully use these plans.

Personally I am one of the people who is being subsidized. But that does mean I think it is right. And with the new Tax Free Savings Account I am certainly finding it harder or impossible to completely maximize all of these things.

Inheritance – Neither a Getter nor a Giver Be…

Are you in a position where you expect an inheritance? Why should you expect it? You’re a competent adult right? You’re capable of looking after yourself, right? Your parents don’t really have “excess” wealth do they? I mean do they really have no use for their own wealth? How do you know it won’t be needed for private medical treatments and senior care at some point? Shouldn’t you encourage you parents not to think about leaving any money? Their days of giving you money should be over by now, right?

Of course if you do get or have received an inheritance then of course you should accept it gladly. But I just don’t think anyone should think they are in any way entitled to an inheritance. Parents should be told that there is no expectation of an inheritance and that they should use their money as they see fit and hopefully for their own comfort and enjoyment.

Are you in a position to think about what inheritance you will leave to your kids? Refer them to the above. I don’t think children should be expecting inheritances. Especially not when they can on average expect to be over 50 when their parents pass on. Surely by then they are capable of looking after themselves. Isn’t planning to give an inheritance to an adult child a vote of non-confidence in that offspring? If you do plan to leave an inheritance, it might make sense to make it a surprise. The impact of expecting, or feeling entitled to, an inheritance is not likely to be a positive one.

Okay, But How Can We Make Some Money?

Well enough editorializing, how about some ideas to make money?

Warren Buffett teaches that a way to make money is to buy and hold the best pieces of “corporate (North) America” and to buy them when they are available at attractive or at least at reasonable prices. (Yeah, I know, people make fun of buy and hold, but Buffett’s done “okay” by that method). Identifying companies that are among the best and that will stay that way involves either finding someone who can select those companies for you or learning enough about some predictable type business so that you can select them yourself. For example you might feel that you understand Apple well enough to conclude that it is a great company and likely to stay that way.

At that point a further step is required. You or the advisor you are following must be able to form a conclusion as to whether Apple is selling at or below a reasonable price. Even for great companies, you don’t want to pay such a high price that it is the seller of the shares that makes the big return, while you make a small return due to over-paying for an asset. (Even a golden goose has some finite upper value that could be paid if a reasonable return is to be made).

Buffett also has said that if you can’t pick the right individual stocks then you will do perfectly well in the long term if you invest in a broad index like the S&P 500 (as long as you don’t pay too high of a management fee for this). And he has said this consistently all his life and as recently as early 2010.

By reading the material on this Site and by reading other high-quality investment analysis you can build your own expertise in selecting stocks and making judgements about whether or not they are priced at reasonable values.

Also we have a subscription service where we share our analysis of a selected group of companies. So far we have beaten the market nine out of our first ten years in existence. But we make no guarantees about the future. (And no knowledgeable stock investor would ask for a guarantee, since any such guarantee is impossible and would be a big red flag for a scam situation).

END

Shawn Allen, President
InvestorsFriend Inc.

To see older editions of this newsletter, or to get off of this email list , click here.

InvestorsFriend Inc. Newsletter December 8, 2009

My Investment Performance

As an investment newsletter writer, it seems to me to be important that I reveal my own investing success.

The fact is that my personal investment results have been very good.

And 2009 has been an exceptionally good year.

The biggest earner in my house this year is not me and it’s not my wife. It’s our money! (Unfortunately or fortunately, it’s not money we can spend as it is almost all RRSP money)

One of our two RRSPs is up 49% this year. If we look at the return on the total dollars that we invested, it is even more impressive. This RRSP has earned $1.54 this year alone for every dollar ever invested in it!! In other words on an historic cost basis (as opposed to a market value basis) this RRSP is up 154% this year. Our other RRSP is up 27% this year on a market value basis and 83% on an historic cost basis.

Here is a graphical picture of our cumulative earnings on money invested each year since we started investing 21 years ago.

The graph shows the following:

The money I invested 1 year ago is up about 40%

The money I invested 2 and 3 years ago is not up much at all (thanks to the crash of 2008)

The money I invested 6 years ago has now doubled

The money I invested 7, 8 and 9 years ago has about tripled (up 200%)

The money I invested 15 and 16 years ago is up 400%

The money I invested 21 years ago is up over 800% Unfortunately I was just starting out investing and so the amount I invested 21 years ago was just $2,000. But that is worth over $16,000 today.

And note that my overall average compounded return on the money invested 21 years ago is 11.3%. That’s a good return. But it’s not spectacular or unbelievable or anything like that. A good return will grow money quite spectacularly when the time frame gets over 20 years.

The graph above illustrates that rather than timing the market, what is really important is Time In the Market. It’s extremely unlikely that you will make 300% in a year. But in a couple decades it’s easy to do.

Defining Financial Independence

One definition of financial independence is that it would be reached when you have enough investment assets that the return on your investments is as large as a a “good salary”. Such a financially independent person would be able to quit their job and still have a “good salary” coming in the door.

The following section discusses how it might be possible to reach the point where your money is making the equivalent of a “good salary”.

When Your Money Makes More Than You Do.

Imagine a person making $50,000 per year. Assume 5% or 2500 per year is invested. Assume an 8% return.

The result after 8 years is a portfolio of $31,219. What is interesting is that at 8% the return on that would be $2,500. So, in just eight years your money is now contributing as much to the pot as your annual contribution.

If you can keep this up for 39 years then at that point your portfolio would be $647,647. And the return on that at 8% would be just over $51,811. Remember this assumed your salary was $50,000 per year. So in this example, your money is eventually making more than you do.

Now imagine you are in a Defined Benefit type pension plan. You contribute5% of you salary and your employer also contributes 6%. Now we have a $50,000 salary and $6000 per year invested. Assume the same 8% return.

Now, after 29 years this money would be earning about $50,000 per year. After 29 years it earns more per year than its owner does.

Basically this shows that Freedom 55 is still a possibility. It would take a savings of probably 12 to15% or more of salary (including an employer funded portion) and it would take getting a good return on money. But it is possible.

The point is that it is possible for an investor to get to a point where his money earns more than he does. It’s a nice place to be.

I’ve gained temporary residence to such a place this year myself. But it took a 40% return to do it. I won’t likely be in that place next year but I am almost sure to be there again in a few years and before too many years can realistically hope to take up permanent residence there.

Is the U.S. Stock Market Over-Valued at this Time?

We have just updated our popular article that analyses whether or not the S&P 500 index is over-valued or not. Click to see the results.

END

Shawn Allen, President
InvestorsFriend Inc.

To see older editions of this newsletter, or to get off of this email list, click here.

InvestorsFriend Inc. Newsletter November 29, 2009

Stock Market Direction

The question that investors always want answered is: “Will the market be higher or will it be lower in 3 months, 6 months, one year or two years?”.

The honest but unsatisfactory answer to this question is: “Nobody knows”.

That is a frustrating answer, investors often argue that their advisors are “paid to know where the market is headed”. It’s frustrating when stock market experts claim they can’t predict where the market is headed.

In fact, many experts will claim to be able to predict where the stock market is headed, even in the short term. And many investors are attracted to such claims of being able to predict the future.

But here are some reasons why the real answer is “nobody knows” where the stock market is headed in the short term.

The level of the stock market today and at any given point in time represents the consensus view of market participants as to the fair value of the stock market. If experts could see that the market is likely to fall in six months they would tend to sell stocks now and push the market down now. The actions of buyers and sellers in the market is always pushing the market level to a neutral level where approximately half the participants may believe it is under-valued and half believe it is over-valued.

Random economic news affects the stock market. When news that was truly unexpected arrives it will drive the market in one direction or the other. Many events in the economy are unpredictable and the actual results will tend to move markets in one direction or the other. For example economists might on average predict unemployment to be 10% next month. If the actual figure is 11%, that will tend to push stock markets down. If the actual is “only” 9% then stock markets will tend to rise.

Surprise political events like terrorist attacks and saber rattling between countries, can occur unexpectedly and cause unexpected movements in the stock market.

Warren Buffett, probably the world’s most successful investor, has always said that he can’t predict the short-term direction of stocks markets.

An Intelligent Approach to Investing

I indicated above that stock markets can’t be predicted in the short-term.

Buffett has argued (For example in Fortune magazine in 1999 and updated in 2001) that there are times when stock markets can be observed to be over-valued or under-valued based on reasonable and rational analysis.

Buffett recognizes that just because the stock market is over-valued that does not necessarily mean that it will drop any time soon. And similarly when it is under-valued that does not mean that it will soon rise. But he does believe that markets that are over-valued will tend to give lower long-term returns than markets that are under-valued.

I have applied an analysis, based on my understanding of Buffett’s approach to attempt to determine if markets have recently been under-valued or over-valued.

See: Valuation of S&P 500 and Valuation of the Dow Jones Industrial Average.

Canadian Mortgage Delinquencies

The latest Statistics on Canadian mortgage delinquencies have just been released. They show that as of September 0.43% or 1 out of every 233 Canadian residential mortgages were in arrears by three months or more. This is a noticeable increase from the approximate 0.30% level or 1 in 333 that prevailed from early 2004 all the way to the end of 2008. (For much of that time period the delinquencies were at 0.25% or just 1 in 400 mortgages).

This report provides figures back to January 1990. At the start of 1990 the delinquencies were about 0.20% or, incredibly, just 1 in 500! During the recession of the early 90’s the delinquencies got as high as 0.65% or 1 in 154. It again reached a similar level in 1997.

My expectation is that such delinquencies will reach at least 0.65% and quite possibly  1.0% or 1 in 100 before this recession is over.

The Burden of High House Prices and jumbo mortgages

The average price of a Canadian home has approximately doubled in the past 12 years. (See Teranet National Bank home price index which shows a 92% gain since February 1999)

Medium family incomes have not come close to doubling in that period. Statistics Canada shows that the median after-tax income for families of two or more individuals rose from $52,000 in 1998 to $61,800 in 2007. If I am generous and assume a 5% gain in the past two years, the result is that incomes have risen 25% in the past 12 years.

Families were able to afford the doubling in house prices because of the dramatic decline in interest rates, increased use of lower floating rate interest, longer amortization periods (up to 40 years from the previous 25 year maximum) and lower down payments (as low as zero, from the former minimum 10%).

Recent buyers of these double-the-price homes obviously face the risk that interest rates will rise at the renewal of their mortgages and that the new payments will be unaffordable.

But there is a related problem that is quite insidious and little talked about.

It’s the fact that the large mortgages associated with buying a home today are almost impossible to pay down early. Families may be able to afford the monthly payments, but they cannot find the extra money to make any meaningful extra dent in the principle and pay these mortgages down early.

Consider that in 1998 a family making $52,000 (after-tax) and having