Newsletter March 21, 2010
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:
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.
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.
Shawn Allen, President
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