Newsletter February 16, 2003 Newsletter February 16, 2003

Investment Goals and Risk Tolerance

Every investor is advised to think about their goals and their risk tolerance. My latest article provides a framework to help you think this through in a logical fashion. My conclusion is that your goals should be fulfilled in a sequence from having an emergency fund, to insuring sustenance in old age, to insuring comfort in old age, then luxury in old age and then ONLY if all of those have been assured to work on simply getting “stinking rich” if that is what you want. In terms of risk my article argues that as you begin to save for each of these levels in sequence you can take substantial risks but then as each level is reached you should lock in that level by focusing on capital preservation. That way you never risk your comfort in old age just because you are working on the next level of luxury in old age or getting “stinking rich”.

It then becomes illogical to say that you are a conservative or an aggressive investor. Instead, we should all be conservative with the future grocery money and fairly aggressive with a certain amount in the current level that we are trying to complete. Also investors that have already accumulated a significant amount should generally lock in a certain amount of that by focusing on capital preservation and only putting a portion of their portfolio at risk. Risk tolerance is not really a matter of risk preference but should be much more driven by when the money is needed and what it is needed for.

For more detail see my article on this ratcheted solution to retirement planning.

This article is in contrast to some of my earlier work that supports the logic of being 100% in equities. It is true that 100% equities on average will lead to the largest pot of money in the end. But as I thought more about risk tolerance, I have changed my thinking. I guess there would be no point for me to do the amount of reading, studying, and thinking that I do if I were not prepared to change my mind, so I make no apologies for that.

What To Buy Now

My model portfolio for 2003 is up about 5.9% in 2003 to date, despite the fact that North American Market have declined. My Strong Buys are up an average of 7% in the first 6 weeks of 2003. After several years of giving away all of my advice for free I decided I was no longer motivated to continue all of this work for free. You can access all of my research electronically and instantly for $10.00 per month on a subscription basis and you can cancel at any time. Therefore you can get access to all of my research and specific strong buy picks for an investment of as little as $10.00. However with very few exceptions, the people that have subscribed have chosen to maintain their monthly subscriptions.

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TELUS on Friday, reported Q4 and 2002 earnings (well actually a loss). I’d like to give you my opinion on their shares as an investment. But I can’t. They predict earning only 40 to 55 cents per share next year so that puts the P/E at just over 40 at the current stock price. So that in isolation would point to a sell.

But I need to understand their cash flow. Maybe all those investments they are expensing to acquire mobile phone customers will pay off in huge profits in years to come. And I would think that their historic local phone wireline business would be a huge cash cow. But I can’t see the evidence in their report.

Their quarterly reports always run to well over 40 pages and contain reams of discussion about customer growth and “earnings” BEFORE depreciation, taxes, interest, depreciation and (phew this a long list) amortization. That’s all well and good but what if all this growth continues to unprofitable? And what if depreciation, taxes, interest, depreciation and amortization are all actually real expenses as GAAP accounting implies that they are?

Their debt is huge and they have only a BBB credit rating.

My bottom line is that I don’t think that their reports are user friendly at all (despite that the Chartered Accountant’s keep giving them gold metals for their annual reports). I can’t figure out at all what the shares are worth. I recently sold half of my TELUS shares. I consider the shares I now hold to be a pure speculation.


Calpine a big U.S electricity generator that I follow also reported earnings last week. My big complaint is that U.S. companies including Calpine normally do not provide a balance sheet in their earnings releases. The balance sheet will come weeks later in a formal 10Q report. In this respect I far prefer our Canadian reporting system where the balance sheet is always included in the quarterly earnings press release. Vive le Canada!

I also prefer fairly short quarterly reports. It’s funny how when a company is nicely profitable, the numbers tend to tell the story. Profitable companies don’t have to blather on for pages and pages.

I’m not going to update my Calpine report until I see a balance sheet. Another problem with Calpine is that they just wrote off a large amount to get out of certain contracts to buy some $4 billion worth of equipment and construction in the future. The problem is that this is at least the second such write-off and who knows if this is the end.

RRSP Contributions

Do not use the low markets as an excuse to skip your RRSP contribution. In fact lower markets should make you more inclined to invest. But more importantly you can just deposit cash to your RRSP now and decide what to do later. Many investors seem to think that RRSP means mutual fund. It of course just means that the funds are registered as being retirement money and are eligible for a tax break. The money can be left in cash or invested in short term fixed income or a huge variety of stocks or mutual funds. Just put the money in now to get the deduction and you can let it sit if you want. (Of course this assumes that investing in an RRSP is right for you, that is another discussion you can have with a financial advisor, but don’t forego it just because of low markets).

Fixed Income versus Growth Stocks in the RRSP

For years I have read that RRSPs should be mostly fixed income and growth stocks should be kept in an unregistered plan. Being stubborn, I did not really believe this since the people saying it fid not really offer any arguments as to why this was the case.

It definitely makes sense if you are committed to having some fixed income in your portfolio (i.e. you are not 100% equities) and if you are lucky enough to have maxed out your resisted savings plans including RESP. Clearly if you have taxable accounts then the stocks which are taxed at lower rates should be outside the RRSP leaving the fixed income sheltered inside the RRSP.

But if all your investments are in RRSP I was of the opinion that it could logically be 100% equities if you were younger since equities have historically always out performed in the long run.

But when you consider that something unforeseen could happen and you might need to cash your RRSP to live on much earlier and considering the need to focus on capital preservation to lock in incremental levels of lifestyle in retirement as discussed in the article above, I begin to agree more with the idea of having a fixed income component inside the RRSP.

Also there is another logic. The market is generally thought to provide a higher return for stocks at the expense of higher annual volatility. The market return for securities is set by taxable investors. This is clearly demonstrated by the fact in the U.S. tax-exempt municipal bonds have lower yields than regular taxable bonds. Pension funds and registered plan investors would prefer the higher yield and would not bid up the price of tax-exempt municipal bonds to create the lower yield. This proves that the taxable market sets securities prices not the registered plan market participants. Logically, growth stocks are also being driven down in yield by that fact that at least some tax is payable due to capital gains. In a pure tax exempt environment the yield on bonds would fall more than the yield on stocks. The taxable market rewards stock investors with a certain incremental additional amount of return on an after tax basis.

RRSP investors and pension plans can take advantage of the fact that yields on taxable bonds have been driven up to compensate for the taxes. But RRSP investors can defer the taxes for decades and thus get something of a free ride by enjoying the higher bond yields set in the taxable market. Therefore, all else being equal an RRSP investor should have a higher allocation in bonds and fixed income compared to a taxable investor.

The RRSP investor is not getting as much additional incremental return for stocks versus bonds as compared to the taxable investor. This is because the RRSP investor’s bond return is not reduced by taxes and so the favorable capital gain treatment of stocks is not worth as much to the RRSP investor as it is to the taxable investor. The bottom line is that there is a certain amount of market inefficiency in putting stocks into an RRSP. Now this is partially or even perhaps totally offset by the much longer time horizon of the typical RRSP investor. If you have a “lot of religion” about the long term benefits of stocks then you can still justify a heavy allocation of stocks in the RRSP. But due to the market efficiency factors you should probably take some advantage of the favorable yield on bonds. And for Canadians this works even better with higher yield income trust products.


I am increasingly convinced that Income Trusts are a superior form of business organization. They create added shareholder value by lowering the total taxes paid to revenue Canada. This is explained further in my popular past article on Income Trusts.

Canadian investors would be wise to include Income Trusts in their portfolios.


I am not an oil and gas analyst and I believe that analysis of oil and gas companies requires a different approach. Their value is not necessarily revealed in financial statements but is more dependent on their oil and gas reserves in the ground. However, my sense is that oil and gas is a good investment at this time and should be included in portfolios.

Air Canada

I love to hate this company. I have to laugh when Robert Milton expresses incredulousness at the fact that small profitable airlines are worth more than huge unprofitable airlines. In a recent speech to students in New Brunswick he made it sound like the market is completely irrational for valuing the likes of Jet Blue at a higher value than the hugely larger American Airlines. It is scary if he really thinks this is irrational. Why shouldn’t an airline with say 50 planes be worth more than one with 5000 airplanes if the big airline loses money while the small one actually makes money? The planes themselves have value but if an airline has huge debts and huge losses then it is very rationally close to worthless.

If Robert Milton believes what he said in that speech then he is even dumber than I thought. I don’t think he is quite that stupid and so it is disappointing that he would (in my opinion) mis-lead students in this fashion.

He is right that the Airline industry suffers from structural problems. Chief among these is the fact that Airlines compete viciously and ruinously on price to the point of losing money. Air Canada has been among the leaders in pursuing this type of destructive behavior. There is surely a problem in the industry and Robert Milton is in my opinion surely a part of the problem.


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