Newsletter January 10, 2018
Our 2017 Performance:
The performance of our stock picks in 2017 was good with the three stocks that were rated in the Strong Buy range as of the start of 2017 rising an average of 18%. The 22 stocks that were rated (lower) Buy or higher rose an average of 15.6%. click the link to see the individual company names and results. My own overall portfolio was up 15.2%.
Meanwhile, the Toronto Stock Exchange Index was up just 6.0% but the S&P 500 was up 19.4% and the Dow Jones Industrial Average was up 25.1%.
My long-term result has averaged 13.55% annually since the start of the year 2000 (the first full calendar year for this Web Site). Perhaps surprisingly, that was enough to turn each $10,000 invested at that time into $98,400 over those 18 years.
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Investing versus Speculation
With all the excitement and the huge gains made lately in Cannabis stocks and especially in Bitcoin and other crypto currencies, it seems appropriate to give some thought to the difference between Investing and Speculation.
I am not sure that there is a hard and fast distinction between the two. Almost everything anyone does in arena of “investing” probably includes at least some element of investing and some element of speculation. There is a spectrum between virtually pure investment operations and virtually pure speculation operations.
Warren Buffett has described investing as the process of laying out money now with the reasoned expectation of receiving back more money in future after accounting for any taxes payable and any decline in the purchasing power of money due to inflation.
Speculation, might be described as the same thing except that while there is a hope for a gain there is no real rational reason and evidence to expect a gain.
The definition of investing does not require that a gain, especially over any given period of time, be a certainty. Rather it requires that there be a rational basis for an expectation of a gain over some holding period.
It’s not always easy to categorize any particular “investment” operation as qualifying as an investment rather than a speculation.
Purchasing a government bond that is yielding more than the expected inflation rate and with a view to holding it until maturity would clearly qualify as an investment.
When two people purchase the same stock, it might be an act of investment for one and an act of pure speculation for the other. Someone purchasing shares in the Royal Bank of Canada as part of a fully diversified portfolio that is intended to be held for many years is engaging in an investment operation. This would especially be the case if that person had reviewed the profitability ratios of Royal Bank and had given thought to the likely future for the bank or who had relied on the recommendation of one or more trusted financial experts. On the other hand someone using money needed to pay next month’s rent in the hope that Royal Bank’s share price would increase sharply in the next several weeks would seem to be engaging in an act of pure speculation.
Most investment decisions probably have elements of both an investment operation and an undertaking in speculation. Self-directed investors usually are not able to personally analyse and think about both the probable future earnings of a given company and, importantly, the extent to which the stock price already does or does not reflect the probable future earnings path. Often they are relying on the opinions of experts. Overall, they probably usually have some basis for an expectation of profit although they have not done a full analysis. The investment might be considered partly speculative to the extent that investors often have only a very limited knowledge of the prospects for each company they invest in.
I was tempted to suggest that buying Cannabis stocks or, even more so, buying BitCoin is almost surely an act of Speculation rather than Investment. But I suppose most buyers would argue that they do in fact have some basis for their expectation of profit. They would point to the fact that the total amount of BitCoin that will ever be issued is fixed. Or they would point to the expected large market for medical and recreational marijuana. In most cases these investors will not have been able to calculate an estimate of the true or intrinsic value of BitCoin or the Cannabis stocks, but they will at least have some rationale in mind for their purchase.
As an investor who relies strictly on fundamental analysis and who tries to ignore all aspects of technical anslysis, I am prone to labling those who rely on Technical Analysis and momentum strategies as Speculators. After all, they are relying on the idea that someone will later pay more for the stock even though they often have no idea of the value of the stock based on fundamentals. But these investors believe that Technical Analysis works and that it reflects the consensus wisdom of the market which includes a huge amount of analysis and so perhaps they do have a rational expectation of making a gain.
In closing, I would suggest that investors give some consideration to where their investments fall on the spectrum from pure Investment to pure Speculation and insure they do not get overly exposed to situations of rampant speculation.
Comments on the Trump U.S. Corporate Income Tax Reductions
The biggest feature of the U.S. corporate federal income tax reduction is a reduction in the federal corporate tax rate from 35% to 21%.
The tax reduction will substantially lower the accounting tax rate for all corporations reporting profits on an accounting basis. However, many profitable companies have lower profits for income tax purposes than for accounting purposes and therefore already pay substantially less than 35% tax rates on a cash basis.
There is also a new ability, for the next five years, to immediately claim the full cost of certain capital investments. For capital intensive businesses this could provide very substantial additional reductions in the cash tax payable.
It appears that “the market” expects most or all of the savings in income tax to fall to the bottom line therefore increasing earnings per share. It also appears that stock prices have already been at least partially bid up to reflect this.
In a competitive market I would expect some of the income tax savings to be competed away as some competitors should find that they can lower prices and still make an acceptable bottom line profit. However, there seems to be little or no expectation of that actually happening. If it does not happen then I would suggest that this is evidence that the U.S. economy has become overly concentrated in the hands of large oligopolies or even monopolies.
In addition to the ongoing reduction in corporate taxes which which will lead to ongoing higher profits and/or lower prices to consumers there will also be some large one-time impacts on profits and losses some of which will show up immediately in the forthcoming Q4 2017 results.
Companies with large deferred income tax assets, which usually relate to past losses which can be claimed to reduce income taxes in future profitable years, will have to sharply reduce the value of that asset on the balance sheet. This will be booked as a non-cash loss. I understand that a number of financial companies face such losses which will likely have to be booked when they next report results. Other companies that may have large past losses would including mining and energy companies, although in some of those cases it might be offset a reduction in deferred tax liabilities.
Companies with large deferred tax liabilities, which usually relate to assets that were “written off” (depreciated) faster for income tax purposes than for accounting income purposes or to recognized but unrealized gains on investment, will be able to sharply reduce the value of this liability. This will be booked as a non-cash gain. Capital intensive industries such as rail roads can be expected to book large non-cash gains in book value. Investment companies with unrealized gains can also be expected to book large non-cash gains. Berkshire Hathaway falls into both categories and may be the biggest beneficiary and is expected to book a massive non-cash gain in book value that has been estimated to be as large as $37 billion.
These non-cash losses or gains will be especially important to financial companies which are often valued in relation to book value.
Rate regulated utilities will be a special case where the benefits of lower income taxes are usually directly passed along to customers.
These U.S. income tax reductions will impact many Canadian companies that have substantial U.S. operations. These include Alimentation Couche-Tard, CN and CP rail, Stantec, the large banks and the large pipeline companies as well as many others.
Another feature of the reduction in U.S. corporate income taxes is that the maximum tax payable upon repatriation of profits earned in foreign jurisdictions has been lowered. While this will be a benefit, it could actually cause a one-time increase in taxes in for companies that would otherwise not have repatriated foreign profits. Due to the lower penalty they may have chosen to make a large repatriation in late 2017 or early 2018 that will increase their income taxes.
How to Invest in a Reasonably Balanced Way With Just One Investment
Experienced investors and/or those with larger portfolios typically spread their investments across many different securities. But many investors would find that to be over-whelming.
In the September edition of this newsletter I provided an article that explained how to quickly set up a low-fee diversified portfolio using Exchange Traded Funds. But even that simplified approach required five to nine different exchange Traded Funds and required the investor to set the percentage in each fund. Although guidance was provided, this too might be over-whelming and over-complicated for many investors.
The question arises as to whether there exists a single balanced Mutual Fund or Exchange Traded Fund that could be used to instantly invest in a balanced fashion by buying just one security.
Balanced mutual funds certainly exist, but many of these carry higher fees. The Mawer balanced mutual fund however has a management expense ratio, when purchased in self-directed accounts, of just 0.94% and is well diversified and has an excellent track record. A self-directed investor could use just this one fund if desired.
As far as diversification goes if an individual mutual fund or ETF is sufficiently diversified and is from a reputable company, I don’t see why any further diversification is strictly needed. My understanding is that if even if the fund management company went broke, the securities of the fund, but perhaps not any cash, are held in trust by a third party administrator and investors and not creditors would have first call on those assets. I am not entirely sure about that, but this is my understanding.
For whatever reason there do not seem to be any Exchange Traded Funds that are marketed as “Balanced”. There are however some multi-asset and income-oriented Canadian ETFs that arguably qualify as “Balanced”. The Globe and Mail recently provided a list. Of those in the list the ishares Diversified Monthly Income ETF (trading symbol XTR) struck me as a good choice. It has a management expense ratio of just 0.62 which includes the management fees of its component ETFs. This ETF is diversified between stocks and bonds. However it has only a modest equity exposure outside of Canada and invests only in income oriented equities and not growth-oriented equities. It would seem to be a good choice for those looking to for one security to get into the market with a focus on income to reduce risk.
There does not appear to be any ETF for Canadians that provides a balanced asset allocation as well as global equity diversification while maintaining also a material exposure to Canada. For that reason, I would suggest consideration of the Mawer Balanced mutual fund or other balanced mutual funds that have a good track record and low fees.
UPDATE: See the February 17, 2018 edition of this newsletter, Vanguard has in fact recently come out with three ETFs that provides a balanced asset allocation as well as global equity diversification while maintaining also at least some exposure to Canada.
January 10, 2018