Newsletter February 19, 2005
InvestorsFriend Inc. Newsletter February 19, 2005
Property Insurance as an Investment
This weekend, Canadian car and home insurance companies are under attack for making obscene profits. This may lead you wonder if this sector might offer good investment opportunities. You might wonder who are the Canadian property and liability insurance companies and do their shares trade on the stock exchanges? In fact there are 206 non-government-owned companies competing in this sector. Some of these are smaller private companies. Many of them are subsidiaries of American and and European companies. There are only about five separate companies that have shares trading that you can buy. They are not very well known.
While there are always risks, I believe that this sector does continue to offer strong investment opportunities. This is an industry on which I have been focusing in the past two years. Reports on several of these companies are available to my paid subscribers.
Interest Rates and Implications for Stocks
While very short term interest rates have risen, particularly in the U.S., the somewhat surprising fact is that 10-year interest rates are back down to record low levels.
The 10-year Canadian bond yield is at about 4.16%. Meanwhile the real-return bond rate is hovering at about 2.0%. These are incredibly low interest rates.
I believe that this is very positive for stock markets. There is always the risk that interest rates will rise, which would hurt stocks and bonds. However, meanwhile stocks compare very favorably to bonds. A stock with a P/E of 25 has an earnings yield of 4.0%. So basically, stocks could be considered competitive with the 10-year bond at a P/E of 25. Meanwhile many – many high-quality stocks are available at P/Es in the 15 range. At 15, a stock has an earnings yield of 1/15 = 6.67% and often about 2% of that may come in the form of dividends. To my mind it is no contest, stocks look cheap compared to bonds.
If interest rates stay this low, we should expect investors to continue to bid the prices of stocks up and 2005 could be a another very good year in the markets.
The High Canadian Dollar and its impact
Recently I have seen commentary that Canadian exporters need to “adjust” to our higher dollar such as by cutting costs and becoming more productive. Even the Governor of the Bank of Canada recently suggested this.
In one sense I agree, if the dollar is high then exporters have no choice but to adjust as best they can. But I find it ludicrous that anyone thinks that very many of the exporters that are hard hit by the high dollar can somehow simply “adjust”. I figure if there was a way that they could cut costs or increase profitability they would have already done that in order to earn higher profits. I’m not saying that anything can or should be done about this. I simply believe a lot of exporters may no longer have viable businesses in the face of about a 20 to 25% drop in the value of the U.S. dollar, relative to our dollar over a short time period.
Regarding the value of our dollar. I note that Canadian interest rates are now almost as low as U.S. interest rates. That situation usually leads to a fall in our dollar. I believe that there is today a bigger chance of our dollar declining by five cents than there is of it rising by five cents.
The essence of fundamental analysis is to examine financial and other company information to try and find under-valued stock. Many would argue that this is impossible today because information is so readily available and all of the various analysts have already baked all of the available information into the existing stock price. That’s a worthwhile argument but I don’t happen to agree with it.
In fact, some information is now getting harder to come by. Companies are trying to get away from mailing out annual reports. For many years Canadian investors were automatically sent annual reports, unless they opted out through their brokers. Recently this has changed, in many cases you will not get an annual report unless you specifically opt in with the company. And you may have to opt in anew each year. The end result is going to be that fewer ordinary investors are going to read annual reports. Sure, these reports are available on the internet, but bound paper copies are still easier to work with. I have a small laser printer, but I don’t want to print 100 page annual reports. Just because material is on the internet does not mean it will be read.
In other developments, management is now sharing less information with analysts. If companies are more secretive, then that creates more opportunities for diligent investors to discover trends in the financials that management is not yet talking about.
So, while I am philosophically in favor of more disclosure, today’s lowered level of distribution of annual reports will lead to more opportunities to find value in the stock market.
Investing in Bonds
To date, I have focused this newsletter and Web Site (and my own portfolio) strictly on equities with no coverage of bonds.
Interest rates at record lows implies two things for long term bonds. 1. Long-term bonds have been a fantastic investment, almost every year, for the last 25 years. 2. Long-term bonds are almost guaranteed to provide mediocre returns going forward.
These two items may sound contradictory, but they are not. The drop in interest rates caused the interest rates on bonds issued in any of the past 25 years to look more and more attractive as current available interest rates fell. Imagine a 18% 30-year bond issued in 1980. As interest rates fell over the ensuing years, not only was the 18% interest paid, but in most years the value of the bond would have increased as well.
This little “party” has gone on far longer than anyone could ever have suspected. A few years ago I might have argued that a 6% government bond would likely earn a return of 6% at best, since I would likely have thought interest rates were more likely to increase than decrease. But lo-and-behold a few years later the market interest rate is closer to 4% and the bond holder has earned 6% plus a large capital gain on the value of the bond.
But there is a limit to how low long-term interest rates can go. In some theoretical sense perhaps the limit is zero. But for practical purposes I don’t think it can be much lower than today’s rates of about 4% on the ten year bond.
So… anyone buying bonds to day should not expect a return any higher than the stated interest rate. For a 10 year-investment-grade bond, this is in the range of 4% for a government bond and perhaps a 5 to 5.5% for an investment-grade corporate bond. The actual return in the next year could be higher if interests miraculously continue to fall or could be lower if interest ise. So… the very same 4% 10-year government bond interest rate that mathematically caused long-term bonds bought in prior years at higher interest rates to produce exceptional returns now pretty much guarantees that the future return will be mediocre.
Nevertheless many investors will want to hold some bonds perhaps for diversification or to provide a guaranteed return of principal even at a low return. The next section discusses how to invest in bonds.
How to Invest in Bonds
By investing in bonds I mean buying a longer term bond with the intention of holding it, possibly until maturity. In a future newsletter, I will address how to trade in bonds with the intent of short term gains.
The easiest way to invest in bonds is to purchase a bond mutual fund.
When it comes to investing directly in bonds, retail investors seem to enter a dark and mysterious world.
I was taught in business school that the value of bonds traded annually far exceeds the value of stocks traded. That makes some sense when you consider that a typical large corporation may have 60% debt and 40% equity. Recently, there was a rare appearance of a bond analyst on ROBtv. He claimed that bonds actually trade 100 times the value of stocks. I don’t particularly believe that, but the point is they do trade more value than stocks and yet to the retail investor remain shrouded in mystery.
While stocks trade on stock exchanges, where it is always easy to see the bid price, the ask price and the last traded price, bonds trade in the mysterious “over-the-counter” market. Rather than one central exchange it seems that various bond dealers will quote prices at which they will buy or sell a particular bond. It reminds me of the way that old coins are traded. It all seems rather mysterious.
I would estimate that there are many hundreds of individual issues of Canadian corporate bonds that trade in the market. Yet TD Waterhouse lists for sale a grand total of just 11 bonds over 10-years in term. I also found that TD requires a minimum purchase of 5 bonds, which generally means a minimum investment of $5000 (and since many older bonds trade at a premium, the minimum is actually typically closer to $7000. Even for short-term corporate bonds of 5 to 10 years, TD lists a scant 21 as available. For corporate bonds under 5 years, things are better with TD listing 73 for sale.
Our National Business newspapers also have skimpy coverage. Saturday’s National Post did have a list of about 225, but they only list the the five most active, weekdays. On the internet, I do not know of a free source where etail investors can access Canadian bond quotes.
The bottom line, is that it is not that easy to invest in bonds. However, you can buy them through a traditional full-service broker. It would be more difficult to buy bonds through a discount broker, since they are not going to provide any recommendations.
It seems to me that the investment industry has made it rather difficult for ordinary retail investors to invest in bonds. Possibly this is because retail investors are not very interested in bonds. But when the traditional advice is that all investors should hold some bonds, it is hard to understand why the retail investor is so under-served in this area.
Investing in Convertible Bonds (Convertible Debentures)
I recently came across a list of about 80 Canadian convertible bonds. You can find the list at
These are relatively complex bonds. The terms to maturity are anywhere from a few months to about 20 years. However many of them are in the 3 to 5 year range. An investor would generally expect to earn a minimum of the yield to maturity (barring extreme financial difficulty – which is a possibility). A possible up-side would be a capital gain on conversion if the underlying stock price rose rapidly. Generally, the option that is included when you buy these bonds is well “out of the money” at the outset. In general you accept a lower yield, in return for the possibility of a gain by converting to shares. It seems to me that this would be a reasonable way to invest in a company where you think that there is a very good chance that the stock price could rise substantially but where you also fear the chance that the stock could fall and stay down. The convertible debenture route removes much of the down-side risk, while preserving a good portion of the up-side risk. (Some of the up-side is removed because you effectively pay more for each converted share than could buy the shares for.)
The value of these convertible bonds can be greatly affected by features such the right of the company to redeem the bonds prior to maturity and the time period over which the investor has a conversion right. It is necessary to examine the prospectus that was filed when the convertible bonds were first issued. This document will detail the rights of conversion and redemption.
I find it interesting that so little information is available regarding convertible bonds. You will seldom see a mention of it in the financial press. When I tried to buy some of these bonds on TD Waterhouse, my order appeared to go through. But then a TD representative called to explain that in order to buy 100 of these bonds with a face value of $100 each, one had to actually enter 10,000 as the number of shares. In other words the order entry screen on TD did not really work. It all seems very mysterious.
It seems as if the investment community is not interested in having retail investors buy convertible bonds.
Free Trade and Investing
I am firmly of the view that investors should support free trade and elimination of all trade barriers, and any programs designed to subsidize or protect certain industries.
Adam Smith argued in his 1776 masterpiece (The Wealth of Nations) that the division of labour was the greatest contributor to our general prosperity. Although some people still don’t get it, this has been proven beyond a doubt to be true. No one would argue that each household should try to produce its own food, clothing and shelter entirely by their own hands. Rather it pretty well universality accepted that individuals should specialize to produce a very limited scope of goods and//or services, becoming very productive, and should be paid for that work and then trade with the rest of society for all the goods and services that they don’t directly produce themselves. This implies that free trade at the individual level is pretty much universally accepted. This system has led to the great prosperity we enjoy today.
What works at the individual level also works at the level of countries. Free trade between countries allows each individual to maximize his own welfare by trading with the rest of the world.
Everyone tends to recognize that individuals should not restrict their trade to their own neighborhood and that everyone is better off when trade is broader. But for some reason we start to forget this when it comes to Countries or provinces. We may be encouraged to buy cars made in Canada to protect Canadian jobs. We allow our government to set up a milk marketing Board to protect Canadian farmers.
But I don’t see why I should care more about an auto worker of farmer in Ontario than about a similar auto worker or farmer in the U.S. or in China for that matter. They are all people. When it comes to economics I am not on “Team Canada”, rather I am on “Team Me”. And it turns out that I and every other Canadian can probably help Canada out more effectively by simply looking out for myself, rather than by particularly trying to look out for other Canadians.
Adam Smith said “By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it”. This is true and it is really quite wonderful. It means that society as a whole is better off if we each go about simply trying to maximize our own welfare and not go out of our way to trade preferentially within the borders of our City, Province or Country.
Frankly, despite considering myself a proud Canadian, I have really started to wonder about the significance of Countries and provinces when it comes to trade. These are just lines on a map. It makes no sense to give preference in trade to someone just because they happen to be on the same side of some arbitrary line on the map.
In conclusion, as individuals, and as investors, I believe that we should all promote the maximum amount of free trade. In our daily purchases we should buy the products and services that we want with no special regard to where in the world the products come from since people everywhere should be considered equal and since such behavior will ultimately benefit all of society world-wide. Adam Smith demonstrated this over 200 years ago, but many people have not yet learned the