Newsletter October 23, 2014

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.


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Shawn Allen, President
InvestorsFriend Inc.