Newsletter September 6, 2009

InvestorsFriend Inc. Newsletter September 6, 2009

Why Not Invest By Lending Money to Your Neighbours?

Many of you might be happy to get a 5% return on your excess cash these days. Meanwhile your neighbours, friends and relatives might be very happy to be able to borrow at 5%.

Is this a match made in heaven or what? Shouldn’t small groups of people borrow and lend amongst themselves in this fashion?

That would cut the evil bank middle men out of the equation and would be great right?

Well, maybe not…

Most of us would not even think about lending money to our neighbours and except in extreme circumstances, not to friends and relatives either. Part of the reason is that we are not set up with contracts and the general infrastructure to make this work. And a huge part of the reason is the risk that we would not get paid back on schedule and that if that happened the difficulties and the social awkwardness of taking any kind of legal action.

When you think about the risks of lending money to people, you can start to see that banking can be a very risky business.

Banks obviously face much lower risks in lending to your neighbour than you would.

Banks diversify by lending to thousands or even millions of people. Lending a $100,000 to 1 person is many times more risky than lending $1000 each to 100 people. In the first case there is a chance of losing all your money but there is realistically no chance of that in the second case.

Banks of course have the infrastructure to lend and collect. They have access to credit records, they have contracts, they have all the procedures in place to take fast action when any borrower starts to fall behind in payments.

Nevertheless, Banking can still be quite risky. If a bank lends $100,000 each to 100 people and makes $1000 net profit per year on each one, after all expenses, then just one single borrower who fails to pay wipes out the expected profit not just from the one but from 100 borrowers.

In a strong economy banks tend to do well but when the economy weakens it only takes a small percentage of people to default on their loans and suddenly the bank can be in trouble.

In the United States there are many small banks. U.S. banking regulators have shut down 89 banks this year. And in the past year or so some of these bank failures involved huge banks.

In Canada we don’t have many small banks. But we do have some small banks and lots of small credit unions.

One example is Western Financial Group. This company’s main business has been to buy up small independent insurance sales offices and consolidate them with central systems. That has been quite successful and we have generally been a fan of the company. However, several years ago they started up their own bank (Bank West) and that worried us. We believe that banking is a business in which you can basically “blow your brains out” if you are not careful. Bank West has no established branches as such.

It offers Guaranteed Investment Certificates through independent deposit brokers. That means it does not get access to the “free” money sitting in chequing accounts that bigger banks get. It can generally only attract deposits by offering higher interest rates. On the lending side it has essentially no walk-in business. (It get’s a bit through its insurances offices). So it started going to places like Travel Trailer businesses and offering to finance those for customers. That is quite scary to us since travel trailers are often purchased no-money down and with payment terms of up to 20 years. And if you re-possess a trailer you may find you can’t sell it for even half of what is owed on the loan. One wonders how they win the business (lower interest rates charged on loans?, possibly commissions paid to the trailer dealer? approving credit that competitors would not approve?)

Still, with the strong western economy few buyers would likely default and all might be well. Over the past few years we continued to think Western Financial Group would be a good long-term investment. But now as the western economy cools off the risk of loan defaults must be rising.

More recently this bank bought into a business that lends money to farmers. Maybe some farmers do well, but it always seems like in the news they are constantly crying the blues. This year I understand crop yields are way down due to low rainfall in much of the West. I’m not sure I want to be dependent on farmers paying me back in that situation.

For these reasons and others we finally started to sour on Western Financial Group. It may do very well and has a number of positive attributes. But we grew uncomfortable with them.

How I saved $8,000 with a five minute phone call.

Still on the topic of banks, I was recently able to get a HUGE reduction in a bank fee.

In February of this year, a friend was attempting to sell her home. She was a single-mom with a modest income and was finding that she could not afford her mortgage payments. Her mortgage had almost three years left at 8.05%. That was the lowest rate she could get last year when she renewed in November 2008. (Normally open floating rates are lower, but when you are a higher-risk customer, normal need not apply). The mortgage was about $162,000. The penalty on selling the home and paying off the mortgage early was then estimated by the Trust company at about $12,000.

Looking at the situation I was a bit angry. The Trust company knew she wanted to sell the house but the mortgage had to be renewed or else even higher interest rates would apply (9.75%!) and the three year term was the lowest interest they offered and so she was almost forced to take that because she did not have the extra cash flow to incur a higher interest rate for however long it would take to sell the house. So it seemed like they trapped her into taking the three year term which created a large penalty if she were to sell the house.

There would be an interest rate differential penalty on paying off the mortgage because interest rates had dropped since the renewal. Her rate in November has been their posted 3-year rate plus 1.35% (the adder for a lower credit score). The interest differential would consist of the amount that their posted 3-year rate had dropped PLUS the 1.35%. I can understand the logic. But this is all quite maddening for those with lower credit scores.

Numerous calls to the Trust Company’s Call Centre produced no relief. The $12,000 penalty would apply and that was that. Also no reductions to the payments or interest rate could be arranged

So… I contacted investor relations and got the name and phone number of an assistant vice president in charge of such matters. My approach was to be friendly and acknowledge that the penalty was perfectly legal and they had every right to charge it. But I looked for some sympathy on the single parent situation.

He was not very sympathetic and pointed out that my friend had decent equity in the house. I asked if he could lower the interest penalty and he said he could change it to $8,000. I thanked him because that was a $4,000 saving. But I said I had been hoping for something closer to $2 to $3,000 so my friend would have more equity left after the house sale. We chatted a bit more and just before hanging up I asked if he could go any lower. He said $7,000 and that was his final offer and he said he would add this to her file and it would be good for a sale within a year. I thanked him and told him he was a “good man” and hung up having saved my friend $5000.

By the time the house was sold in August, interest rates were substantially lower and the interest differential penalty had risen to about $15,000! The trust Company applied “only” the $7,000 penalty as agreed and so my five minute phone call ended up saving my friend $8000!.

Some lessons here are:

Don’t be afraid to ask for discounts and concessions especially on big-ticket items. The worse that can happen is that they say no. But often at least some concession will be offered.

Go big or stay home. Speak to an executive who is authorized to make the concession. The Call Centre is often not empowered in that way.

Be polite. Don’t insult the company or call them crooks or whatever.

Thank the company for any concession made. They could have said no.

Businesses That Solicit Charity Donations at the Cash Register

One of the strangest business practices that I have encountered is when the cashier solicits some donation as I make my purchase.

For example Eddie Bower used to ask customers if they wanted to add on a dollar to the charge to help plant a tree. A Shoppers drug mart a few years ago asked me if I wanted to donate to something. And I was very surprised one day to be asked by Wal-Mart about adding on something for a donation.

This is a dumb business practice for a number of reasons.

A customer does not go into a store with the idea in mind of making a donation. That is probably the furthest thing from their mind at that time. In many cases the customer will say no. Why would a business that should be trying to get its customers to say Yes (Yes, I will buy that) solicit a donation that is very easy to say no to. This practice is likely to embarrass the customer. Many customers will say yes but go away at least a little resentful of being asked. Many others will say no but will feel that they should not have been asked. They will wonder if the cashier considered them to be a cheapskate. It just takes away from the whole purchase experience.

Business should not do this.

As customers perhaps we should say no and also request that the bosses be informed that we resented being asked.

Businesses are free to ask for such donations if they want to but I think it is a poor business practice that will certainly do nothing to attract shoppers.

A much better practice is things like Tim Hortons Camp Day and Dairy Queen’s Children’s Hospital day where proceeds go to charity on that day. If a business wants to donate money, by all means it can do so, but it shouldn’t ask its customers to make the donation.

A business would be wiser to solicit its vendors for donations rather than its customers.

Government Pension Plan Expenses

One item that has not much hit the news is the large increases that governments are facing to fund their pension plans.

For example, the Alberta Government Public Service Pension Plan employer contributions have gone from $66 million in 2001 to $165 million in 2008. That a 150% increase in 7 years! And it’s set to go up by a staggering 40% more in 2010 to about $231 million.

36% of this 40% increase or about $59 million is due to increases in pension funding rates. The remaining approximate 4% is due to higher salaries.

Back in 2002 the pension funding rate for this Pension Plan was an average of 10.1% of wages split evenly between employees and the government. Now, with the losses in the stock market and lower expected returns and longer life expectance, the required funding rate is 19.9% of wages split evenly between the employees and the government.

This would be funny if it were not so painful. For every government worker making $50,000, about $10,000 is going into the pension plan. Seven years ago it was $5000. That is taking a LOT of money out of the consumer economy and diverting it into pension plans.

And that’s just for the main government pension plan in Alberta.

The story for other Alberta government pension pans like Teachers, Police, and municipal employees is the same. HUGE increases in contribution rates. And much the same story applies to federal pensions and all the other provinces.

Contributions to the Canada Pension plan are large as well at 9.9% of salary split between employees and the employers (Including government employers) although only up to a maximum salary of $46,900.

As it is, people have complained about rich government pension plans for years. Now tax payers should start hearing about the higher payments. This is contributing directly to deficits and perhaps soon to tax increases.

I am surprised that the media has not yet picked up on this story (to my knowledge at least).

Corporate pension plan contributions are rising rapidly as well.

All told, pension plans are taking up a much larger share of gross wages than was the case just a few years ago.

Stock Market Valuation

Warren Buffett has always said that the stock market can’t be predicted in the short term but that the long term trend is definitely upwards.

He has said that you can observe whether or not the stock market is “cheap” or “expensive”.

In late 1999 with markets soaring he famously pointed out in FORTUNE magazine that the large gains could not be expected to continue. Many laughed and said he was out of touch with the new high-tech world. He could not predict where the market would head in the short term as we entered the 2000’s but he could observe that the market was expensive and could not be expected to continue providing double digit returns. He looked at the double digit average returns earned in the 17 years from 1982 to 1999.He stated that the mathematics suggested that an average gain of perhaps 6% per year was more realistic for the next 17 years from 1999 to 2016. As of 2009 it looks like, if anything, rather than being too pessimistic, he was perhaps too optimistic. The total return on the S&P 500 (including dividends) from 2000 through to today is negative.

Using the type of Analysis that Buffett laid out, I recently updated our analysis of the valuation of the S&P 500 index.

The analysis indicated an estimated fair value of the S&P 500 index of 886 (though with a wide range around that depending on assumptions). Given that the index is currently at 1016, it would appear to be moderately over-valued.

Nevertheless there are always individual stocks that offer good value and a good probability of satisfactory returns.

Winter Vacation

With Summer winding down, thoughts turn to winter vacation.

If you are looking to rent a vacation home I recommend the site Vacation Rentals By Owner

This site offers vacation homes for rent all over the world.

More specifically, my sister has a home in Tampa, Florida for rent on that Site which may be of interest to some of you. This house is available for all weeks except February and the first week of March are now booked. Now that Fall is arriving, the other weeks and months will be going fast.

Personal Advertisement: If anyone is looking to rent a newer vacation home (with screened-in pool) near Tampa Bay, Florida, my sister  has a 3 bedroom, 2 bathroom house that is now for rent by the week (discount for 1 month rental). The house is in Riverview which is adjacent to Tampa to the South. Only about a 20 minute drive to downtown Tampa. The house is in a quiet and newer subdivision. Most of the neighbourhood houses are owner-occupied and working families so this is a quiet area. The neighbours mostly do not have pools so they are not even outside that much.

Here is a link to check out pictures of the house and more details. There is a calendar that shows you availability. From that Site you can also “Inquire About the Property” In your note, mention I sent you.


Shawn Allen, President
InvestorsFriend Inc.

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