Sunday, February 17, 2019

Getting richer all the time


Sometimes investing feels like an endurance race with nothing but frustration. Why do we bother? It is all a matter of perspective.  We, investors, are accumulators of assets: real estate; businesses; loans; etcetera. Assets that produce cash flow and/or appreciation. Cash and gold are stores of wealth, and it may feel like they don’t produce anything but…

When last December the market went down, holding cash or even better gold looked pretty smart.
 Figure 1 Ray Dalio's Economic Model from the video: How The Economy Works.


But think about all the businesses in which you own shares. Most of these businesses are profitable or better said they make profit. A portion of these profits results in dividends and/or share buybacks. The rest is reinvested to make even more money (appreciate or increase bookvalue). When you own those businesses, or at least part thereof then you make money every second of the day!  So how come you feel poorer during a market downturn?

If you are self-employed, everyday you work in your business you add value. The value may not immediately translate into revenue, but you are building. It may be a while before you ‘monetize’ your work but the value of your business increases.  

In Ray Dalio’s video (link at the top of this blog) shows another concept. The economy comprises 3 components:  Economic growth through productivity (straight line) and economic cyclicity of the short and the long-term debt cycles. Cyclicity is just that: cyclical. The economy goes up and down but… overtime the net effect of the cycles is zero or nearly zero depending on how you act. Meanwhile productivity increases make the economy truly grow. During ‘good’ or ‘bad’ economic times, the economy is in fact growing (out-of-sight and hidden by the cyclicity) and if you are invested in the economy you grow richer and richer.

Markets are places where buyers and sellers exchange typically stuff of a similar type (oil market; grain market; etcetera).  These are the places where often the price is set for you to buy or sell things. If you sell things for less than it costs you to own them, then you make a loss and vise versa if you sold things for more then you make a profit. Market prices typically fluctuate with the state of the economy, i.e. with productivity and with the short- and long-term debt cycles. Unless you buy or sell, you don’t lose!

Pricing of all kinds of assets are mostly based on the stages of the various economic cycles and thus to monetize your assets you must be smart about when to buy and sell. In the meantime, you get richer through your businesses, whether partially or wholly owned. Next time you invest, realize that prices may be volatile but basically you are making money all the time.

This is a key investment insight. Because you only make losses if you are selling during a bad time of the cycle(s). If you have enough cash on hand to live through the bad portion of the cycle by funding your cost of living as well as other immediate obligations, then there is no need to sell. It is forced panic selling (because you need cash) that often results in financial losses and that is easy to control with prudent cash management.

How do we make money through investing?  First, the most basic form is by providing credit – creating liquidity in return for interest. Second by owning companies that augment their profits and growth by using credit. If a company grows as fast as the economy, its revenues and profits increase along with productivity growth. Third: you can use leverage yourself by investing for example in real estate. Real estate increases in value with inflation and leverage will result in real (inflation corrected) returns on your capital as well as provide inflation protection for your capital. Real estate also provides rental income typically expressed in terms of ‘Gross Rent’ and ‘Capital Rate’.

By owning real estate in areas of strong GDP growth or by owning businesses that grow faster than the economy, you may enhance your investment return even further. Thus, when investing e.g. in the stock market your return on investment is typically 7% plus inflation – that is when you hold on over long periods of time (10 to 20 years) during one or better several business cycles.

Another way to earn a rate of return on your investment is by taking advantage of market volatility (driven by emotions and valuation levels during Ray Dalio’s short and long-term credit cycles). The most obvious example is ‘buying low and selling high’. Or earning income by trading options – especially ‘option writing’ is a conservative way of earning income. You are basically renting out the stocks you own. It also has a lot in common with selling insurance.

Taking advantage of volatility is usually in the realm of the ‘trader’ rather than the investor. Also speculators take advantage of volatility, such as someone buying oil and gas assets in the hope that rising oil prices trigger a boom those asset prices. This is different than investing which is just ‘buying an income stream’. Speculators need something to happen, a trigger, that causes the value of an asset to increase.

No matter how you like to make money on your savings, which underly all wealth, the economy and business cycle is a major force to help you. Thus you better start learning more about how our economy moves and what the underlying drivers are.

Tuesday, February 12, 2019

Canada will likely get a lot worse before it gets better

If you think a Liberal government is bad? Wait until after October!  As it looks now, Liberals will be taking a licking in the coming elections. But who will form the next government?  Say Andrew Scheer has just enough seats to form a minority government, who will keep him in power?  The NDP or the Green Party?  What did the Greens do to the NDP in British Columbia?  Is this even acceptable to conservative voters?  I say, the only way for Canada to move to the right is a Conservative majority government.

Anything else and their will likely be a Liberal-NDP or a Liberal-Green coalition in power which will push us even further to the left. Sorry, for the bad news but this is the most likely outcome in October.  We will get the government we deserve, not the conservative government we need. Canadian and international investors will be moving even more money outside the country until we have a Conservative government . That may be another 4 years from now and probably when the Canadian oil industry is destroyed. 

If you don’t like that, do something about it. You have 10 months and probably not a prayer.

Monday, February 11, 2019

Investing using fundamentals - Enbridge

We are adding Enbridge Inc. to our fundamental portfolio. Enbridge Inc (ENB) is one of Canada’s largest pipeline companies. With Line 3 approaching completion this year, the company has a large competitive moat with its enormous infrastructure of pipelines. It owns not only a network of oil and gas pipelines but also Canada’s largest natural gas distribution company. It is splendidly positioned to take advantage of Canada’s 1.3 million barrels/day of anticipated production  increases over the next decade or so, in spite of the current oil patch difficulties.

Recently some less good news has emerged regarding Enbridge, its large debt, in part stemming from the recent take over of Spectra Energy in the Eastern U.S. where it owns a large high-quality net work of natural gas pipelines. Just like Canadian Banks a decade ago, both Enbridge and TransCanada Pipelines (its largest Canadian competitor) have concluded that growth in the current Canadian business climate is constrained. They decided to expand heavily into the U.S.  This combined with Line 3 and many other smaller pipelines set up Enbridge for enormous growth. 2020 dividends are expected to be increased by 10%.   As you may notice on the time-value spreadsheet, the dividend payout is currently 119%. But this is due to the impact of the high debt incurred because of its enormous growth of assets.

Figure 1 Enbridge fundamentals. DCF means discounted cash flow method. Click the image for a better quality view.

Last year, Enbridge committed to selling off at least $3billion of none-core assets to reduce its debt.  The company has followed through and this year sold off even more than $3 billion in non-core assets. Enbridge has build a rather complex corporate structure over the last decade but is now in the process of simplifying it. The result is a significantly improved balance sheet that with the expected increase in revenue and earnings over the coming years should improve its debt load significantly and thus its dividend pay-out ratio.  In spite of the wobbly nature of its earnings graph, Enbridge’s management is very competent and considered one of the highest quality management teams in Canada if not the world. Despite the oil-crash in 2015, earnings over the last 4 years have shown significant growth and I expect a lot more.
With a dividend yield of 6.16% and a potential recouping of the share price within 11 years based on the cumulative dividend estimate, I consider Enbridge a must-own holding for every Canadian stock market investor. There is more risk than I would like to see in a core holding such as Enbridge but it’s potential is hard to deny. Manulife and Power Corp are 'show-me' stocks but Enbridge is a ‘Benefit of Doubt’ stock – for now. We will learn soon enough.  I am building a 4% position in my paper securities portfolio.

As mentioned earlier on this blog and on this post series about fundamental investing, these are my opinions and they do not constitute investment recommendations. Neither do I claim the data above is correct.  These posts are intended to show you ways to invest in order to meet your goals in life. But I nor anyone affiliated with me is liable for any action you undertake as a result of my postings and/or opinions. You are solely responsible for your own actions.

Saturday, February 9, 2019

Investing is a lot about your attitudes in life

Ray Dalio, the Billionaire founder of Bridgewater Associated likes adversity and mistakes, so he can overcome them and make them into principles for life and work. He categorizes these moments of set back as “One of those things” and literally writes them down along with the ‘principles’ he used to overcome them. This way he can deal with them over and over again in the most efficient way. He also loves the challenge to improve on his principles whenever they don’t work.  This, he feels will make him better and allows him to grow to his maximal potential which is his ultimate goal in life.

If you see parallels in my mantra that you should aim to do the things you feel are worthwhile to do, you get the message although I am not a Ray Dalio, nor am I a Billionaire. But then we don’t need all to pursue the same goals.  

Reading his latest book: Principles: Life and Work gives the impression that Ray is nearly obsessed documenting his adversities and his principles or recipes for dealing with them. It made him hugely successful, but to document this diligently is not me. That would be fine with Ray, as according to him, we are not the same and that we all have to define for ourselves what we want to do in this life.

Ray has many other ideas about life and how we fit in an evolution that is not concerned with us individuals but rather with a continuous improvement of the entire creation since the big bang and possibly before as there are numerous galaxies and universes. Although immensely important to ourselves, in this enormous creation we are less than insignificant which can be liberating and puts the onus on ourselves to make most of our potential. But all with the end goal to evolve the universe for the better.

One of the ways Ray deals with the difficulties of life is by “looking at those things that affect you in order to understand the cause-effects that drive them and to learn principles for dealing with them effectively”. This is the main mantra of his book, which if you haven’t done so is very worthwhile to read. If you are one of those persons that gets over and over trapped in similar nasty situations of life, Ray's system is one to make you overcome them.

Ray Dalio has made a series of videos. One about a template for the economy and one about being successful (Principles for life and work). You can find links to those videos in the resources listed at the top of this blog.

Energy at an economically attractive price

Alberta is a place very rich in natural resources.  In the mountains we have hydropower; we also have enormous coal reserves and other hydrocarbons. Mining for metals is less so, as most of the province lies in a sedimentary basin rather than a basin rich in metamorphic and igneous rock. Sedimentary rocks are derived from the erosion of other sedimentary rocks, metamorphic, and igneous rocks. Igneous rocks are rocks derived from the cooling of magma, whether this magma is from intrusion into the earth crust (plutonic) or from the eruption onto the crust’s surface of the planet as lavas and ashes (volcanic).  Metamorphic rocks are all rocks that are reshaped (metamorphosed) by a combination of pressure and heat.

Sedimentary rocks are typically rich in quartz (sands), clay (shales) or rich in calcium minerals such as limestones. They do not contain a lot metal rich minerals such as ores. Ores are mostly formed in igneous (granites, basalts) and to a lesser degree in metamorphic rocks (marble, slate, gneiss). Ore veins are pathways along which magma rich in metallic minerals flowed and  cooled to crystallize into ore and other mineral types. 

Thus, Canadian provinces along the active subduction zone (also called an active continental edge) of the West Coast are high in igneous rock content and so are the provinces with the much older rocks of the Canadian Shield. Those are areas of prolific metal mining while Alberta and Saskatchewan are rich in coal and hydrocarbons. Canada’s East Coast, is formed as a passive continental edge and just like Alberta and Saskatchewan (as well as Eastern B.C.) are rich in sedimentary rocks and thus rich in hydrocarbons and coal. You see, because of our enormous size, Canada has it literally ‘all’. Especially when you include potash and water!  Ontario is well endowed with mining resources as well as enormous potential for hydro-energy.

It is to Canada’s benefit not to favor one energy form over another. What is important is to develop all possible resources in an economically attractive way. It is bad practice to subsidize one form over another because in the end we, all Canadians, make that way less money. 

Exploiting all forms of energy comes at a costs. We sometimes don’t yet know what those costs are. But wind energy comes at a cost and so does oil or natural gas. The latter two mostly in the form of emissions. But the concrete used in building massive wind farms also is a major contributor to emissions.  Solar energy is not only unreliable but there is also the costs of mining silica and melting it into solar panels as well as the use of rare metals. What is the impact on our planet to divert a large portion of solar radiation towards these panels?  What about the amount of energy reflected by those panels back into space?  How does that affect our climate?  You see, nothing is free and that is why economics are so important. The economic cost is, in a free market, the closest thing to assessing the costs of those variable types of energy, including their impact on our environment and our quality of life based on our current understanding.

Many salivate over the switching from the Internal combustion Engine (ICE) to Electric Vehicles(EV) or Fuel Cell Vehicles (FCV). But in in the end it is about what is the most economic way to move across this planet and that is not only regarding vehicle emissions.  Yes, it may take subsidies to research these various ways of energy, and that is fine. The more we research the more we learn to do things efficiently. But it is not right to do so based on misconceptions and utopian ideas. 

We must realize that Hydrogen and Electricity are NOT forms of primary energy. They are energy carriers. Geothermal energy or coal or other hydrocarbons are primary sources of energy. So is solar, but they all have advantages and disadvantages.  Hydro, whether it is converted by the century old water mill or through hypermodern electric generators is primary energy. Nuclear is primary energy.
Electricity has to be generated before it can be used in EVs and Fuel Cells. Those fuel cells require the production of hydrogen before it can be used in FCVs. FCVs are basically EVs using Fuel Cells rather than Batteries. With rare metals such as cobalt so hard to mine without significant environmental impact, mankind may well decide to use FCVs instead of EVs.  But they still need a primary energy as input.

I personally feel, that with all those abandoned oil wells in B.C., Alberta and Saskatchewan, geothermal may be a terrific way to go. I still dream of converting old oil wells into producers of geothermal energy.  There are some entrepreneurs pursuing this idea and I still don’t understand what the hold-up is.
But in the end, we need enough primary energy to not only power our houses and industries but also our transportation. Hydrocarbons play a key role there because it allows for numerous small and relatively cheap energy generators in the form of internal combustion engines.  The demand for hydrocarbons on this planet is increasing every year by another 1 to 2 billion barrels per DAY.

How are we replacing all this with electricity, the majority of which is generated from coal, natural gas and to a much lesser degree oil?  We do not only  dream to replace these hydro carbons but also to meet this planet’s ever-increasing demand for more energy. When considering the costs of first generating electricity and then again converting it into transportation how much of this energy is lost?  Think about how much electric energy is lost along the current electrical grid from generator to user? For me, the difference is that the ICE is a localized small power generator and the EV is a vehicle using energy from a large centralized power station.  Both emit.
As announced on this blog, I am currently building a new residence.  I am planning to make it work with solar energy. I like the idea to not to emit that much, but the economics are marginal these days.  The life of such a system is about 25 years and it takes 20 years or so to break even with today’s technology not considering the emissions to create this set-up. Still, I am willing to give it a go, as soon as my personal finances have stabilized from the construction project. But it is not truly economic compared to directly powering my house using natural gas. 

It is nice to dream of the end of hydro-carbons and to hate nuclear energy but that is not realistic. Certainly not with another 4 or 5 billion people aspiring to join our lifestyle over the coming decades. When attending gatherings on CO2 emissions in Paris or Kyoto, we can dream of these things. We can dream of an electric emission free world, but we should not lose sight of the fact all this still has an economic price and environmental costs.
I think we have made great progress on our environmental awareness and our willingness to try new ways of living. But we shouldn’t throw away the baby with the bathwater. We shouldn’t blindly dream of an electrical, self driving world and penalize our hydrocarbons and our nuclear forms of energy and support political movements that promise ‘nice policies’ just so they can better control our lives. 

If you believe that a world of centralized energy generation (smart grid), of centralized information gathering (think Google, Amazon, Facebook), of centralized income and wealth distribution, of having governments interfering more and more in our individual lives is desirable please vote with your money and your political capital that way. But for me, this whole system leads us to a totalitarian life style, and I don’t care whether you call that Fascism, Socialism, racism, climate change religion, far right or far left, these systems are just scaring the bejeezus out of me.  That is why everyday, I am willing to shout from my perch to be self-reliant; self-accountable and aim for less big business and government control in our own lives.
This blog wants to help you become financially independent and self-reliant. It wants to give you the tools rather than the social subsidies which make you a financial addict to this ‘we-will-take-care-of-you’ society also known as the social welfare hell.  Give a man a fish and you will feed him today; teach him to fish and you will feed him for a lifetime. For the more sensitive amongst us, feel free to use ‘her’ instead of ‘him’. 😊

Investing using fundamentals - Conclusions

When you summarize our fundamental analysis in a table like shown below, the story of these financial companies becomes clear. Brookfield Infrastructure is one of Canada’s most promising and yet conservative investments. It doesn’t have the overvaluation of many Hi-Tech companies. If it can maintain its compounding growth rate of 8.78% and its IRR of 17.71% it would be a stellar portion of any portfolio. Its share price would nearly quintuple of the coming 25 years, what is not to like? The beauty is that it has a dividend that would recoup the share purchase in around 11 years!  

The Canadian Banks are also part of such a core portfolio. It is a well known investor trick to buy the worst performing bank of the year and it will likely outperform the other banks over the foreseeable future.  Insurance companies like Manulife and Power Corp are not as attractive. That stands out like a sore thumb. Power Corp has been very hard hit last December and as such it is trading nearly 25% below last year’s typical pricing around $30 and far below its intrinsic value. Including a 5.76% annual yield, a Power Corp price recovery could result in a one year return of 13.4% or better.  Not shabby in the current economic environment.

You may like Manulife’s dividend yield but we are near the end of the current business cycle. Maybe we will be without a market crash for another year after such a dramatic December. But why take on this risk and hope for a major turn-around?  Too risky for me. I would not buy this stock today or if it was in my portfolio, I would sell it and hold on to the cash until the economic clouds are cleared.

Figure 1 summary of our fundamental analysis.  Click on image for a more detailed view.
Isn’t that something? You could easily transform the above summary into a portfolio!  Based on simple portfolio allocation rules, often advocated here, you should not have more than 5% of your paper securities portfolio in one single stock. An exception to this rule maybe stock options or shares you earned through employment in your employer’s company. But even there you have to be very confident to do so.
A maximum portfolio exposure of 5% is for risk management. If you combine it with a stop-loss of 25% then the maximum impact of loss on your portfolio is 5% x 25% or 1.25%. If you have a $100,000 with 5% or $5000 invested in say Brookfield Infrastructure, then if things go wrong you’d sell at a maximum loss of 25% of $5000 or $1250; the impact on your total portfolio is minimal. Especially when the other holdings in your portfolio aren’t affected. 

If like in a stock market downturn, your entire portfolio crashes this game may not work. I strongly advice against selling off your entire portfolio in the panic of a crash. It is better to rebalance your holdings based on asset allocation or sell off extremely high-priced assets during the climb to a market peak – especially during an euphoric market. And sit through the downturn as discussed in many previous posts.

In the above portfolio, I would allocate 5% of total value to , BIP, TD, BMO and RY each. POW would be no more than 3% as it is nearly as safe as a GIC (except in a market crash) and there is the possibility that it will revert to its former glory.

That we have gone through the process of fundamentally evaluating or stock holdings does not mean that our projections come true. The world always changes, sometimes right in front of our eyes. You, the investor, must judge what these changes mean for your portfolio or for specific companies that you own. Investor pain never goes away. The closest thing to protection is the ‘All Weather’ portfolio allocation designed by Ray Dalio which is back tested for the last forty years and shows astounding performance. 


Figure 2 Converting the fundamental summary into a portfolio.  Click on image for a more detailed view.
Obviously, figure 2 does not represent a complete paper security portfolio – a portfolio of stocks, bonds, mortgage Investments, and whatever is easily liquified into cash. You can also supplement this portfolios with ETFs. A good nugget on BNN I recently learned, was that individual stocks can literally go to zero but not the entire market which evolves over time adjusting for obsolescence and other forms of business failures.

Nobody really knows the future. You can only outline the most likely scenarios and prepare for them. And then there are the back swans! Canada’s markets are currently cheap, especially the resource industry. But is it reverting to its previous high valuations?  What is the impact of the incompetence of Trudeau and his indifference if not outright animosity towards the West?  What about erratic Trump and the trade war with China and his behavior towards his ‘allies’? Will the U.S. economically outperform the world, or will Canada outperform the U.S. in the next commodity boom?  Nobody really knows and investors should acknowledge that by not betting on just one egg in the basket. You must diversify – no matter how right you believe you are.

Having said that, especially when investing in individual stocks, fundamental analysis makes buying stocks like investing in real estate. You become the owner of good business rather than an erratic trader that lives of nearly random stock market movements. Over the long term, our economy grows and stock portfolios grow with them. This is especially so when we can take advantage of the emotional and sometimes hysterical movements of the markets. When I mentioned in this post the use of 'stop-losses', I have to warn you not to use this tool blindly. Financial companies and other sectors with predictable earnings may be ideal for the use of stop-losses. But in the commodity space this is much more questionable. 

As always, in investing there are no hard rules. The same goal – making money – can be achieved in many different ways. A lot depends on your own mentality, your goals and the risks you are willing to take.  Good hunting!

Investing using fundamentals - MFC

Manulife Financial Corporation is the last company whose shares we analyze. Manulife was the stock market darling for many years. This insurance company could do no harm and paid a reliable dividend until the financial crisis when it was hit by the damage of an too aggressively marketed financial product. The next CEO, Donald Guloien promised to transform Manulife’s balance sheet into a ‘fortress’ but the company became too conservative while the impact of legacy bad financial products kept on hurting the company along with a low interest environment enforced by central banks.

The company is still not back to its pre-2008 standing and performance. 
Figure 1 Manulife Financial Corporation fundamentals. DCF means discounted cash flow method. Click the image for a better quality view.

 The earnings graph in the upper right shows Manulife’s poor earnings quality and reflecting its management problems. The company has excellent exposure to insurance in Asia and as such it is not a complete write off. Also, it pays an excellent dividend although its pay-out ratio is good at 75% it is not optimal and clearly a lot less than the other companies we analyzed. If its current earnings trend persists, the company is on its way of extinction.  It is a falling knife no matter how great its dividend looks. It needs a lot of wind in its back before it turns around.