Friday, November 26, 2010

What is going on in the world of oil supply and demand?

I am never shy of copying data from other websites as part of my investment 'research' for this blog. One of the most informative sites is

So from time to time I crawl over this site and combine their data with my own knowledge and experience to come up with an idea about the future of oil. So let's first have a look at Canada's significance in the world's oil supply. Figure 1 shows world oil production from 1980 until 2009. Oil production increased for most of the 20th century but has flattened out in the first decade of the 21st century at 85 to 86 million barrels per day. Assuming an oil recovery factor from a typical reservoir of 50%, we empty a decent sized oil pool of close to 180 million barrels each day.

For comparison a typical S.Alberta pool, the Horsefly Lake Lower Mannville has been on production since 1965 in S. Alberta. Since then the pool went from primary production through a successful water flood production scheme. Starting in 2005, enhanced oil recovery (EOR) in the form of a Polymer flood has been attempted with mixed results. The pool counts 216 wells of which 51 are injectors and the remaining 164 wells are producers. Total oil produced from this pool as around 2007 was 14 million barrels.


 So obviously OPEC constitutes the largest group of producing countries producing 35 million barrels per day or so. The next largest group of producers are the countries of the Former Soviet Union. The OECD countries (including Mexico) produce around 20 million barrels. Canada is part of the OECD. Figure 2 shows its contribution to OECD exports. Canada exports to the rest of the world a whopping 1.2 million barrels per day compared to the OECD's largest exporter, Norway, which exports some 2 million barrels per day.

Fig. 2
   However, Canada is one of the few countries in the world whose oil exports are actually on the increase and if you believe future extrapolations we may export as much as 3 million barrels per day not that far into the future. In North America, Canada may be an energy superpower and we even may be so when compared to the other OECD countries, but we pale in comparison with OPEC and the Former Soviet Union. Currently Canada's total production is around 3.4 million barrels per day (Fig. 3) while it consumes just over 2.2 million barrels.

Fig. 3
  Let's dig a bit deeper. Many oil producing countries such as Venezuela, Saudi Arabia, Libya, Iran are dictatorships, or unstable budding democracies such as Indonesia and Mexico. Not only that, but in every single one of those countries, the oil industry is controlled by the state. That is why it is increasingly more difficult for the large traditional oil companies such as Exxon-Mobil to find and develop new reserves in the private sector. Canada is one of the last bastions of 'unfettered' oil capitalism. Yet, together with the U.S. and Europe we are also the leaders in hydrocarbon producing technologies. Strange, because many large research departments of the large oil companies, so prevalent in the 1970-1982 era, have been decimated. The oil industry seems to develop new technologies on a very empirical basis. Over the last decades numerous new technologies have been successfully implemented ranging from 3-D seismic, to horizontal drilling, multi-stage frac'ing and now SAGD and the resurgence of fire flooding (Petrobank's Heel to Toe technology). Still, Canada is one of the last free markets for oil and gas exploration and development. Coincidentally, we also have one of the most vibrant oil industry sectors where it is still possible to set up your own junior oil company with relatively little capital.

The dictatorships and budding democracies are facing a conundrum. Their populations demand fast economic growth and cheap oil prices. So in order to stay in power, these governments are forced to sell oil and gas to their population for virtual free. Iranian and Venezualan governments are in a similar situation, in that they have to fund subsidized, artificially low energy prices from their oil and gas export revenue. The combination of artificially low fuel prices; poor quality oil industry; declining oil reserves; a fast growing economy and a fast growing middle class that aspires western type prosperity results in an explosive demand for energy, in particular oil. Exports from those countries are diminishing rapidly. Here are some relevant graphs (Fig. 4A-E) showing the effects:


Fig. 4B

Fig. 4C

Fig. 4D

 Fig. 4E

The results of these developments can be observed in figure 5. OPEC's oil consumption is on the increase. After the collapse of the Soviet Union (1989-1991), the combined FSU consumption first decreased and has now stabilized; but oil consumption will likely recover over time along with the FSU economies. OECD countries are the only group of countries where oil demand had decreased due to its population's increasing concern about the environment and sustainable economies. This trend, accelerated by the 2007-2008 Great Recession will probably continue into the future. This OECD consumption decrease will be more than offset by the growing oil needs the BRIC countries, in particular Chine and India, whose combined imports have doubled over the last 8 years. Straight line extrapolation of this trend to 2020 shows that China and India alone would import close to 20 million barrels per day. This exceeds today's consumption by the OECD. Figure 6 is a forecast of total world oil demand by the IEA.

Fig. 5

Fig. 6

With oil production (using today's technology and economics) stable, or possibly already on the decline and with demand on the increase, it is hard to foresee lower oil prices in the near future (is that an understatement or what?). Some pessimists foresee oil and resource wars. This is in my mind not likely, today's communication and the existing global network of politicians and business leaders would make this unlikely, other than local conflicts. Will we have oil prices of $200 or higher? Not likely either.

The economy can tolerate only a limited increase in energy prices after which we will see declines in economic growth until the energy price balance is restored. Also, at high oil prices, the world would look for substitutes such as environmentally friendly natural gas, geothermal, solar, wind and nuclear energy. We may return to the use of coal combined with CO2 reinjection into the earth. But adaptation to a new energy regime will not be achieved in a couple of months, more likely this will stretch out at least over a decade if not longer. Apart from temporary price spikes and crashes as experienced in 2007-2008, I guestimate oil prices will be ranging from $85 to $110 per barrel in the near future and this price range will likely increase over time with inflation. This combined with a stabilizing world population in the 2nd half of this century, the impact of an ever changing climate, environmental concerns, less reliance on leverage and growing demand for food will make for a very interesting future (Chinese curse). Man will have to learn to prosper in a sustainable world economy.

Sunday, November 21, 2010

Why bonds are NOW so risky!

When looking back over the last century, we have experienced in Canada an average inflation rate of around 3.3% per year (Oct 2010 rate is 2.4%). This is based on data retrieved from Statistics Canada. The graph in figure 1 shows how inflation varied overtime. As you can see, the fear of us in 2010 being in a deflationary environment similar to that of 1930-1934 is clearly a gross exageration. But there were some major recessions where we actually got zero or near zero inflation as in 1939, 1953, 1974, 1994 and now again. Some of those recessions were quite severe, but during other severe recessions such as 1982-1983, inflation did not get even close to zero.

There maybe even a pattern observable where we alternate between periods of low inflation and of high inflation. These patterns seem to occur every 30 or so years, subdvided more or less 50/50 into a period of low and one of high inflation. Right after the 2nd World War (when there was lots of government war debt) and during the 1970-1980 period when there was lots of government debt and high commodity prices due to the oil shocks, we had very high inflation. It seems these are self propelling cycles of ever increasing inflation, commodity prices, taxation and interest rates. And now after an, in excess of 15 years long, period of low inflation we seem to be starting another period of high inflation. We are these day a lot more global oriented and when the U.S. or China experience high inflation and have high government debt, many other countries do so as well

Look at the relation between Inflation and interest rates in the figure below where the latter is expressed as the yield on 5 year bonds of the Government of Canada.

Do you see a pattern? I do. High inflation means high interest rates. However, the spread between the 5 year bond yield and inflation varies. In 2009, we experienced even the rare case where inflation was higher than interest rates. This also happened during the 1982-1983 recession. That was not a very pleasant economic time either. The difference between the 5 year bond yields versus inflation represents real interest for 5 year term loans to the highest quality borrower in the country –our government.

Some investors feel that there is a relationship between interest rates and the Canadian Dollar. This may be true for the short term, but as the graph below shows, over the long term there is no direct relationship between them.

However, there is a relation between the federal government debt/GDP versus Real 5 year bond rates (i.e. inflation was taken out).

So in simplistic terms, interest rates are strongly affected by inflation rates and government debt. When government debt increases, lenders interpret this as a deterioration of creditor quality and thus they want a higher risk premium. Also they want the principal of their loans protected against loss of purchasing power (inflation). On the other hand, currencies are more reflected by the comparison of the economies of different countries. These economies are affected many other factors than just the  inflation rate and  government debt levels. Consequently exchange rates do not correlate very well with interest rates.

In recent years, investors have focused on cash flow, yield and dividends. Many of those investors perceive government debt as the most secure form of debt, but they seem to overlook two significant factors. First, the quality of the government debt deterioration in one country versus another and second, governments that push their own currency lower compared to others. With the first factor, interest rates may rise because of the higher default risk of one country versus another. The second factor reduces the purchase power of the debt principal of one country visa vie that of another. Thus over the last decade U.S. debt devalued nearly 40% when compared to Canadian dollar denominated debt and the chance that interest will rise in the U.S. is higher than that in less indebted Canada (Canada's lower default risk). Meanwhile investors have poured billions of their cash in 'short term' U.S. treasuries for little interest return and a high risk of losing purchase power. This has created a high risky investment that many experts describe as a 'time bomb'.

Canadian bonds are not free of risk either. If the earlier described periods of higher inflation and associated increases in commodity prices, interest rates, taxes and government debt will come to pass again, even Canada will go along for the ride (although to a lesser degree than the U.S). Even if you would invest in Canadian bonds risks are high. To illustrate this, let's use one of the tools that was presented on this blog early on in February: Godfried's tiny bond calculator.

Canadian 5 year bond yields are currently at its lowest ever, around 2.25% (and so are Canadian mortgage rates based on these yields). If we bought a 5 year Government Bond with a principal of $100 right now, it would return $2.25 per year interest or $11.25 over the entire 5 year term. Say that the economy is recovered 2 years from now and inflation is back at 3% and real bond yields are at similar levels as during the low government debt years of 2003-2005 at 2%, then the 5 year bond yield would be 5%. A 5%, 5 year $100 government bond would deliver interest of $5 per year or $25 over 5 years. Would you still prefer your 2010 bond paying 2.25%? Of course not! In fact the tiny bond calculator shows that if you would want to sell your 2.25% bond, which would expire then in 3 year's time, it would be worth only $92.43.

But government debt will likely be still on the rise as well, so Canada's creditor quality may in the near future deteriorated too. In fact, just a poorer investor perception due to what is happened south of the border may decrease Canada's perceived credit worthiness. Taxes will likely increase as well and in response to all this real interest could easily creep up to 4%. Now your bond value drops to $87.34. Survivable but with interest on your bond of 2.25% and inflation of 3% you are not even keeping up with purchase power.On an after tax basis, your interest rate has dropped to only 1.35%; while in real terms and after tax  it is now -1.65%.

Thank the higher powers that you did not buy a 10 year bond! Because, in that case, after 2 years your bond would have been worth: $71.28. If we reach the interest rates of the old high government debt years plus a bit higher inflation, chances are that yields would have gone as high as 8 or 9%. If that was 5 year into your 10 year bond term, the value of your bond would have fallen to 73.29 and you lost over 25% of the original value in order to earn an interest rate of 2.25% in one of the 'safest' investments available. Oops, 25% down, we're getting close to the stock market losses of 2007 – 2008 that scared so many investors into the bond 'safe haven' in the first place. Finally if within 5 years we got back into the inflation madness of the 1980s, interest rates could climb as high as 15% and the value of your bond would be 56 cents on the dollar. Any one wants a 30 year bond?

Nobody knows whether we will be going back to high interest rates, high government debt, higher taxes and high inflation. But right now, chances are much more likely for higher than for stable or falling interest rates. Thus medium and long term bonds of the U.S. and even Canadian bonds should be avoided; the downside is way higher than the potential upside.

Saturday, November 20, 2010

Some updates on earlier investment ideas

I want to give some updates on 2 earlier investment ideas:

The first was posted on Friday, May 7, 2010 - Here is an idea for taking advantage of the recent currency fluctuations.

In short, the idea was to buy Microsoft (MS) with borrowed U.S. dollars. When I bought Microsoft myself, it was June, it was priced at $26.25 and the Cdn. dollar was 95cts per U.S. dollar.  Recently, I repayed the loan at an exchange rate of 99.2 cts. For that I paid interest of 7% per year for 5 months or 26.25*7%*5/12= 0.76cts . By repaying the loan at a better exchange rate, I gained: Cdn $26.25/0.95 = 27.62  minus Cdn $ - 26.25/0.992 = 26.46 =1.16 minus the interest of 0.76 = 0.40 cts per share in 5 months. That is an annual ROI of 3.6%

In the meantime I collected dividend twice (in June and in Sept) or ): $0.32 U.S. The stock is currently trading at US 25.69; somewhat less than I bought it for. But then I won't sell it for a while. So apart from appreciation I made $ 0.40 plus 0.32 = $ 0.72 or a annual ROI of 6.5%. Now, it is a matter of collecting further dividends and waiting for appreciation.

The second idea was posted on Thursday, October 21, 2010 - Call Options

In short, the idea was to write a call option 3 months out for BMO with a srtike price of $62. In this case I owned already BMO shares. But I figured that rather than running the risk of actually being forced to sell them, it was better to buy new shares to cover the call at $60.85 per share.

I got $1.05 for the option on Oct 21. Next the market moved up, but then we had last week's correction and the option price fell.  I bought it back for $0.40 on november 12. So that was $0.65 profit. On November 19, I wrote a new call option during a big rally. This is a two month option (exp Jan 22, 2011 for the same $62 strike price) and I sold it for $0.82.

So assuming BMO gets called for $62 coming January, I will hade made:
$1.87 in option premiums
$1.15 in cap gains
$ 0.70 in dividends (1 payment)

Total return in 3 months would be: 3.72 or an annual ROI of 24.5%

Ahh, Keep on trucking, Mama!

A friend gave me another idea, selling put options: the obligation to buy shares at a price you like. To do so, I have to adjust my account status but, it sounds like a very interesting way of making money too!

Monday, November 15, 2010

Who really pays for all the money that the U.S. is borrowing?

When Canada's national debt reached unsustainable heights, interest rates increased and the Canadian dollar fell to 0.6 dollar U.S. while earlier in the 1980s it was nearly on par with the U.S. Also, taxes were increased, which resulted in more inflation, which in turn resulted in higher interest rates, which then resulted in yet a higher Canadian budget deficit. This nasty cycle of ever increasing debt could only be stopped one way and Ralph Klein showed the way. The federal Liberals also reduced spending under the keen eyes of Paul Martin.

Well, really, how did Paul Martin and his Buddy Jean Chretien reduce Canada's budget deficits? Eh, they reduced the transfer payments to the provinces and so the provinces were really forced to do the dirty work. Oh, there was also the cold war that had come to an end, thanks to Paul Martin and the Liberals? Yeah right, but as a result we could reduce Canada's military expenses dramatically.
Hmm... it was Paul Volcker who drove interest rates up so high that the economy came crashing down in the early 1980s, as a result inflation began to fall and so the 3 decades of interest rate decline started, culminating in today's near zero interest. Of course, failing interest rates also helped reduce Canada's budget deficits and in the end we even got annual surpluses.

Also, the energy crises of the 1970s and the oil prices contributed to that decade's escalating inflation. Prices finally peaked around 1982 and their subsequent fall combined with the much hated NEP resulted in the collapse of Alberta's oil industry and declining commodity prices for the next 20 years. The disappearing fear of oil and gas shortages in the 1980-1998 period; the benefits of energy conservation starting in the late 1970s under Jimmy Carter; the benefits of deregulation and tax cuts under Ronald Reagan; the rise of cheap labour powered manufacturing in the emerging economies of China and SE Asia as well as globalisation overall; it all resulted in a booming world economy and enormous productivity gains. This was even further enhanced by a fiercely competitive oversized baby-boomer labour force and the high tech revolution's productivity gains.

Those were the real factors that brought down the government deficits of Canada. It was more serendipity than being Liberal or Conservative. No matter how hard Michael Wilson and Brian Mulroney tried, their deficits kept escalating and in spite of Paul Martin and Jean Chretien's reluctance to really cut social spending and to decentralize the government, they were dragged along in the above described maelstrom that resulted in Canada's debt reduction. Not all was luck; there were some good policies or better policies. Canadian Banking policies by many considered too conservative for normal economic conditions, made our banking system in 2007 and 2008 the envy of the world. However in previous decades it was City Group, JP Morgan, Salomon Brothers, Bank of Hongkong, ING and Deutsche Bank that were the leaders of the financial world. Blinded by their own good fortunes these institutions in their ever more voracious search for profits then became the focus of the U.S. and world's financial crisis of 2007-2008. Canada's banks conservatism was temporarily justified. But will that also be the case in the decades to come? Will the old banking establishment arise again from the ashes and retake their former leadership, albeit (hopefully) a bit less smug?

If you don't believe how serendipitous our national debt reduction was just remember that at the end of Bill Clinton's presidency, even the U.S. had achieved a budget surplus. So were many other countries! Of course, around that time the world economy was booming and demand for commodities started to escalate. In Alberta, the provincial government had created a pro-business tax and royalty system that worked well and set the stage for a booming economy along with the rising commodity prices. And after a long series of budget spending cuts at the expense of education, healthcare and the poor, money rolled into government's coffers during the 2000-2008 period like a tsunami – both on a provincial as well as on a federal level. There was so much money pouring in, we were wondering whether Alberta should cut income taxes to zero! $400 per capita government gifts(?) and no Alberta Healthcare premiums! Wow those were the times.

The times are changing again! After 9-11, after fighting wars in Afghanistan and Iraq; after combating the financial excesses of the late 1990s and early 2000s, following gross financial mismanagement by its financial institutions, the U.S. economy and that of many other countries finally collapsed. Just like the extreme affluence was not due to the brilliance of CEOs and bankers, neither was the collapse of the U.S. and European banking system their fault entirely. We all played a role in this; who in their right mind takes out a mortgage without having the means to make the payments no matter how the real estate prices rise?

Who is paying for the excessive debts of the U.S. and other governments? Not only the U.S. was involved in the Gulf War, Iraq and Afghanistan! Not only the U.S. provided crazy loans; the Deutsche Bank bought U.S. subprime and other securitized mortgage debt by the bucket full. The Irish banking system went ballistic! And don't tell me that the Chinese did not benefit from U.S. imports and kept on extending debt to the U.S. because it had more money than it could spend!

This was the Zeit Geist and it was a worldwide phenomenon. 2007 – 2009 was the time to pay the piper. So the pendulum is swinging, not necessarily back and forth, but more in yet a different direction. Yes action results in a reaction; but the reaction is not necessarily an opposing one. It is one that tends to move in the direction of least resistance. Somehow history repeats.
Although Canada's government finances seem to be brimming with health; the U.S. and many European countries are bloated with debt. One would think that the U.S. dollar would collapse and so would the Euro, but something strange is happening on the currency front. Look at the graph below which depicts the relative performance of the Canadian Dollar (CAD), the Australian Dollar (AUD), the Japanese Yen (JPY), the British Pound (GBP) and the Euro versus the U.S. dollar from 2001 until today.

Look the CAD and AUD have risen nearly 50 to 80% in value compared to the dollar. That must be the oil-price because everyone knows that these are petrol currencies (see also the price of oil graph below).

Oil production over the last decade barely increased. Some believe conventional oil production has peaked while demand kept on going up. Others don't believe in the Peak Oil theory, however, they must admit that production could not keep up with demand. Of course, now that the financial crises of 2007-2008 has abated and maybe has even passed, exploration funds by many oil companies were severely cut over the last couple of years and if we had already trouble before the financial crisis to meet oil demand, this will probably be even more difficult thereafter. It is not that one can switch on or off the supply of world oil like an electrical switch. With gas drilling down big time as well and with the decline rates of shale gas in the 80 to 90% range while the drilling of new wells probably requires a $8 to $10 per BTU price rather than today's $3-$4 price, we will be in for some nasty shocks.
No wonder that the petrol currencies are doing so well against the U.S. dollar. No big government debt and strong commodity prices. But... hé, if the U.S. dollar is so weakened because of the high U.S. debt created during the financial crises, how come the CAD is now exactly the same as before the financial crisis? Even worse! Look at Japan (yellow curve of the currency graph). It is nearly as high as the petro currencies! Japan has no oil whatsoever and everyone is aware of Japan's deflationary lagging economy! So why is it performing so well? Especially since 2007, it has blown away any other currency!

Worse, the Euro which should be hit by its banking crisis is certainly not a petro currency! Yet its performance over the last decade is not really that bad against the U.S. dollar. Other than last May, from which it is rapidly recovering, the Euro performed nearly as well as the much admired CAD. Even the British Pound, the closest thing in Euro to a petro-currency, was doing OK. But since the debt crises it is the only one of this set of currencies that performed worse than the U.S. The U.S. $ / GBP is now the same as it was ten years ago.

Clearly, the valuation of the dollar is not driven by commodity prices, because then the JPY and Euro would not have kept up with the CAD and AUD petro currencies. Neither has the so-called European debt crisis, other than early this summer, very strongly reflected in the Euro vis-a-vis the petro currencies! And all the Gurus that always look down on stodgy Japan and unionized Europe must have missed the gradual deterioration of the U.S. dollar against world commodity prices as well as against the other currencies. So what is really going on?

Is this the true reflection of the U.S.' ever present trade deficits and it current account deficits? Has the world discounted U.S. debt not only since the financial crisis but from the beginning of the decade – possibly even earlier? Have the Chinese not only pegged their currency to the U.S. dollar to prevent becoming un-competitive but rather to prevent a devaluation of their portion of U.S. debt financing? After all, that his how Canada discounted its debt in the 1980-mid 1990s! Once bitten, twice shy? The Chinese won't let the U.S. get away with shoving their debts onto the back of the Chinese! So, really it is us Canadians, the Japanese, the Aussies and the Europeans that pay for the devalued U.S. debt. Now after having discounted our own debts so heavily a decade earlier, I don't think us Canadians can complain too much about this little scheme. But it is an eye-opener isn't it? Anyone wants some more U.S. treasuries?

I guess their commercial is dead on, when it asks what the U.S. is doing with all the money it saves from buying a Toyota! This is truly a new way of looking at the slogan "Too big to fail"! The only ones not falling for this (yet) are the Chinese – no wonder Geithner and Clinton are red in the face when discussing the Chinese Yuan.

Sunday, November 14, 2010

How come all those investment experts make returns of 20% and higher and I don’t?

When reading newspapers about 'experts' making 15, 20 or 30% on their money, it is for many of us enough to get an inferiority complex! Here take my money and get me those returns as well! Please, please!

Guess what, most investors and Gurus don't make those returns. You may have been promised such returns, but the real life returns are quite different. Part is the selective memories of 'experts' advertising those returns. In the year following a market crash, a 20 to 40% return is quite often achievable, but when you include the returns of the previous year when the crash happened things may look a lot less exciting. Besides, the 'expert' may quote you the returns on his best performing fund, rather than on his money losing fund. And finally always remember the adage: "past performance is not a guarantee for future performance".

When we make an investment, we often evaluate the potential returns of an investment. We make a guess, e.g. a real estate property based on our APOD should throw off 4% cash on cash invested and a total ROI of 21%. Wow! Let's invest; what are you waiting for? Well this is our best guess when things go as we want to! Nobody expects failure, but I can assure you that I have failures and others do to; even worse, it WILL happen to you! We call that risk!

In our economy, we expect our savings to provide us a return! But the return you will be getting is determined by the current economic conditions and the conditions of the economy in the years to come. It is a matter of... investment capital supply and demand. Historical performance reviewed by authors such as Jeremy Siegel show that stocks over longer periods of time (25 -30 years) return after inflation 6.5 to 7% annually which is much higher than fixed income return. In fact, according to Siegel, the difference between fixed income and stock returns is 3 full percentage points. He calls this the risk premium - compensation for the short term risk or volatility in stock valuation. When expressing this risk as the percentage that a stock at a given time deviates from the average value trend (referred to as 'mean reversion', one may assign the following risk to Bonds, T-Bills and Stock prices over time:
Holding Period
1 year
2 years
5 years
10 years
20 years
30 years
(Copied from Siegel's graph in figure 12.2 of 'The Future for Investors')

In the short term, deviation from the average price appreciation trend of stocks is enormous (18%). However over the longer and especially over the very long term this risk level decreases to even less than that on a T-Bill. Thus one can conclude that if T-Bills are considered lowest risk (you get the entire principal back upon expiry and collect interest while holding the bill), then the higher returns of the other assets reflect the higher risk or short term volatility in the investment class valuation. Apart from risk, investment returns should reflect the ROI on the investment class that is least volatile in the short term. Those assets are T-Bills and the return on investment money is then expressed as the T-Bill yield.

When we buy an investment, we evaluate that investment based on our expectations of what the profits will be. We may anticipate returns of 10 to 20% or even higher. We the investor, base this expectation on the risk level that we perceive this investment may have as well as on the risk level that is build in the overall market price of the investment. This is what presents us with 'buying opportunities'. However, our perception of risk or that of the market at a certain time is not necessarily right and here lays an important source of investment losses or excessive profits.

No-one will ever invest in order to lose money and thus we all have the tendency to expect returns higher than they will be in real live. Some individuals may be extremely good at recognizing high return opportunities, Warren Buffett comes to mind. But even he makes mistakes and his average return is probably lower than he estimates at the time of investment. By using bench marks such as Jeremy Siegel's we can estimate how we measure up against the average market and the average return on a particular investment class. Unless we are pure investment genius, we should be satisfied with these returns which are often sufficient to make us wealthy over time.

Yet, there are many investors who do not earn those average ROIs and we can now also see why. They simply take on too much short term risk and thus they are often forced to sell rather than being able to hold on to their investments long enough to achieve the average return of the asset class they invested in.

One last point we should never forget, Jeremy's long term returns are based on the entire market. If you invest in only one or a few investments, the risk that such investment fails is much higher than that the overall market will fail. Yes your returns are potentially higher, but so is the chance you will lose all your money. Thus always ensure you have not all your eggs in one basket and be a diversified investor. Next time you see the Guru with his high returns, ask yourself what the risks were the Guru took and what his investment time horizon was. You will likely realize that you are not doing so badly after all and that there may be a need to educate yourself but that there is no need for an inferiority complex.

Sunday, November 7, 2010

May you live long and prosper!

As Don Campbell pointed out a while ago, some people need all five traffic lights on green before they invest. The problem with that is that following all five traffic lights on green, the only possibility that remains is that they will turn orange and red again. Right now, in my opinion, of the five lights the third is about to turn green. The stock market is a leading indicator, but that doesn't mean that it is wrong when you can't see why it signals a better economy ahead in six months; it simply is.

Regarding perennial bears such as David Rosenberg, Garth Turner and Harry Dent, their premise on demographics is often too one sided. As Thomas Beyer pointed out the amount of overall savings is likely on the increase (e.g. babyboomers with the kids out of the house). But savings also are higher than many predict(ed) because babyboomers keep on working rather than retiring. That his how they will finance the summer cottage and other recreational endeavours in the future. Thus, predictions of less investment funds and less spending by babyboomers are likely wrong.

Also, North Americans, in particular, people in the U.S. may become less wealthy, or better, less inclined to spend, but many in the emerging markets are becoming increasingly prosperous and aspire a similar lifestyle as ours. So now people in emerging economies will lead in consumption as well as in demands for insurance and a social net to protect them from adversary.

Demographers such as Harry Dent, and their apostles fail to see that the old spending habits from previous generations have changed; they failed to see beyond the North American economic patterns. They think that economies can only do well during population growth. Well, world population is anticipated to stabilize by 2050 and if we haven't figured out how to live prosperous by that time without an ever growing consumer base then it will be tough slogging for mankind.

Luckily, there is innovation, improved productivity, the benefits of people pursuing a sustainable economy! There will be an energy revolution where the world will no longer be dependent on fossil fuels; there will be a food revolution where people will be learning new ways to create food beyond plain inefficient agriculture. There will be a new education model that will wipe out the current obsolete school system. In our daily life things may seem to move at a snail's pace. The aforementioned visions may seem like a far off dream; but in twenty years, we all life in a completely revolutionized world, because when compared with historical rates of change, we're living in a whirlwind.

That is why the Harry Dents, the Garth Turners and even the Jeff Rubins are wrong. You cannot extrapolate from one or very few premises. When you do that, you end up in the black and pessimistic outlooks that many end-of-worlders would like us to believe. I have no clue how the future will look like, but I believe, like Warren Buffett, in this never ending societal drive for a new and ever improving future. Nobody knows the future, but we can get glimpses where we are going and from my stand point, the economic cycle is in tact; the world in a pendulous pattern will keep on getting better. Investors who are bold - not reckless - are the ones who will win they day!

You may have read my posts that always seem to be about analyzing numbers. That is to recognize near term trends. That is to manage cash flow; but I invest for the long term using my vision(s) or scenarios of the world. There I focus not just on cash flow but even more on ROI. May you live long and prosper!

Saturday, November 6, 2010

The third light is about to turn 'green'

This is one of the best analogies for investing; I heard it first from REIN’s Don Campbell and I would like to share it with you. It is about traffic lights and when you should start driving. Before giving you the analogy, a short introduction.

Investing is about risk management, we all want this risk free 20% ROI. We say things like, “I only count on cash flow, because including appreciation is speculative!” So, let’s look at this statement. Say cash flow in the form of dividends, is that risk free? Certainly not! The economy may go bad and even some of the best company’s may end up cutting dividends. Rental income, now that must be risk free! Duuh! NOT! Mortgage interest and payments may go up, there are vacancies, and the tenant may trash the place; you think that is risk free? What about 20% GICs? I invested in one and the GIC provider went broke and... if you get 20% on a GIC then inflation is probably close to 16% and taxes are high. So you get an after-tax return of say 20% x 50%= 10% and inflation is 16% or a real after tax return of -6%!

No investment is free of risk and appreciation should not be dismissed as being ‘speculative’. In my books, ‘speculative’ means excessive risk often for a low return. Example: low interest, medium to long term U.S. treasuries in today’s market. Oh, and investing in lottery tickets.

So going back to the traffic light analogy. Say we are in a green wave zone somewhere in downtown; there are five traffic lights in a row all on red. The depth of the 2008-2009 stock markets may have seemed like that. Now when do you start to drive or invest? When the first light goes on green? Speculators may push the gas pedal fully down, but most investors wouldn’t budge. What when the second light goes on green? Prudent investors would start to buy; we can start driving slowly and shop for the best deals – good companies on sale; affordable and rentable real estate in prime locations. The third light does not jump right away, but then after awhile, it jumps on green too; yes there is risk, but a lot is cleared up and the cheap deals are disappearing with it. The fourth light is on green and you are fully invested! There are still some stragglers, but you are well ahead of the crowd who is still waiting for all lights to go green.

When all five lights are on green everyone is blasting full speed over the road, ignoring pot holes and blinded by past profits that were missed, you, the prudent investor, knows that the lights are soon switching back to orange and before you know all is... red. So when all is green you take profits and let the masses go crazy; you build up cash while even the most fanatical GICer is about to buy dividend paying stocks (which are by now low in yield and near the top of the price range). When all lights are on green, the risk that a number of them will turn to orange and red is highest; when all light are on red, chances are that one will turn green soon with more to follow.

Right now, the third light is about to turn green!

Friday, November 5, 2010

Thanks to Brad Wall and Dick Haskayne the small investor has won in Potash

In early September I wrote about the unfairness of the Potash tackover bid. I also pointed out that unless the government intervened, the small investor would get crushed between BHP and Potash management. The Western provinces and several business leaders such as Dick Haskayne took a stand; the Harper government decided for political or for more sincere reasons that the Potash take-over was not in Canada's best interest.

I am happy with the outcome. I was also lucky enough to sell my Potash shares around $150 and made a tidy profit over the $114 purchase price. So now, it is a matter of waiting for POT to settle to a price level where it is fairly valued in today's economy. Since not a lot fertilizer will be sold over the winter, we should have until spring 2011 to wait for the right price.

Don't  wait for POT to fall back to $90 per share, however, a purchase price of $112 -120 should be achieveable. Keep an eye on upcoming quarterly reports and the price of potash. Chances are POT will make an attractive long term investment.  Now that would change your perception of reality (pun on POT)!

How to profit more from emerging market economies with less volatility

I read somewhere that the BRIC countries are the economic growth engines of the coming recovery. They will leave us slow over-socialized western economies behind in the dust. Well it seems, everyone knows that. That is why investing in those countries is all the rage and earnings multiples on their stock markets are going higher and higher. 

Eh, wait a minute...  If those mulitples go higher and higher does that mean that those markets are priced for 'perfection' and that they are expensive? Then how are we to make big profits there? Well dear Reader, you hit the nail on the head. Research shows that stock market proftis in these popular hot emerging economies is often difficult to achieve and easy to lose. It is like investing in a high-tech stock of the late 1990s!

But there is another way... You the reader may shout, "old news, I already invest in Canadian oil and gas and in Canadian mining buddy! I am way ahead of you!" Hmmm, that is not bad, but that was not what I had in mind. I was more thinking in terms of using strong Canadian dollars to diversify in bluestock companies with a worldwide presence that pay nice dividends.

Read further... (whisper, whisper).  Every one knows the U.S. economy is in a deep hole, although there is now a bit improvement. But there is the high debt, the traumatized U.S. consumer and a ruinous real estate market and so on. So why invest there? I gave you the answer!  Many large U.S. corporations make significant profits overseas, think Apple, Microsoft, General Electric, Johnson and Johnson, Proctor and Gamble, even Berkshire Hathaway has started to invest in China. All of them you can right now buy at depressed U.S. stockmarket prices and they pay decent dividends. Mind you, the dividends typically don't qualify for the Canadian dividend tax credit.

So what is the easiest way to buy a set of major U.S. large cap companies paying good dividends?  Buy them all at once in one fell swoop or swell foop. Consider using your strong Canadian dollar to buy ETFs of the Dow Jones 30 industrial index. You get the world's most successful dividend paying companies for a bargain (30 - 40% off in Cdn dollars compared to a few years back) and you get a lot of exposure to emerging markets and even to a recovering U.S. economy. What is that for diversification?

Thursday, November 4, 2010

Would I be presumptuous to state that we have been in a Bull Market now for some time?

Hindsight is 20/20, yet it looks like we’re in a bull market. We’ve been climbing that wall of worry now for some time and gradually our worries disappear one after the other. If you were courageous enough to have bought stocks and preferred shares or convertible debt during the downturn you have probably done quite well now for some time.

You may have recovered most of your lost portfolio value. In fact you never lost money if you did hold on to your investments. By buying additional good investments during the lows of 2008-2009 and during the following big wall of worry, chances are that you accelerated your personal recovery and you are now about to exceed your old net worth highs.

There is still lots of money on the sideline and there is still lots to worry about, but investments also are still far from overvalued. Real Estate is a bit different in particular in Canada’s largest cities except for Edmonton and Calgary. In those latter two cities there are still good deals to be found. If the stock market is a leading indicator and the real estate market is a lagging one, then it looks as if there are some very good months to come for the real estate investor. Never forget, in real estate you work in local markets there is no national market just some misleading national averages.

So we're climbing the ‘Wall of Worry’ and I would think we have now scaled about 2/3 of its height. Worries seem to be disappearing as snow in the recovery sun. This is still a good time to look for good value, but based on an earlier estimate on this blog, we are now well on our way to a TSX top of 18,000.

The TSX low was 8000 in March 2009; next we reached 12,000 after which we all got the jitters about 'European Debt' and 'Double Dipping'. In real life there was not even a 15% correction and against all expectations of major market turmoil, we experienced a fabulous September and no October Crash. Even better the market broke out of its whiny trading range and we are approaching 13,000. Like upon climbing any decent wall to worry about, corporate earnings are yet again better than expected and even the unemployment rates are on the mend.

My guess is that we are on the half way point to the next market top. Not a straight trip to the top though, but one that kind-of-zigzags. It won’t be long and you`ll hear all those gurus shout ‘Buy on dips’. Of course you, the prudent investor only buys when the price is right and if you haven’t employed all your cash yet (I still have a lot), then maybe the next month or so should be one of action – but remain careful. If you are not an experienced stock evaluator yet, consider buying ETFs of the TSX60. And ... don’t forget to use your powerful Canadian Buck in our neighbour’s market and buy an ETF reflecting the Dow or SandP500. Because, guess what, Uncle Sam is starting to wake up as well.

But watch out for the words: “Buy on dips”, the more often you hear those the closer we get to the top. My estimate of the top is just that. So once, we’re getting past 17,000 I suggest you stop buying and consider consolidating your profits and rebuild your cash position. 18,000 may be still some years away but when?

Here is another flag you want to watch for: declining or flattening corporate earnings, followed by more and more disappointing earnings. When that happens be ready to cash all your shaky investments, refocus on dividends and cash flow and take profits. Build cash for the next down turn.

How long? Well if you really believe in 18,000 then assuming a 10% annual stock market appreciation it is about 4-5 years away. If you assume 15% annual appreciation we’re less than 3 years away from the next major down turn (this is all straight line, elementary school math). In my books, forecasting is so unreliable that my simplistic math is probably just as unreliable as the most sophisticated computer model. Duuuh!

With high consumer and high government debt, first consumer and next government deleveraging will restrict economic growth rates. Do I really think that government will voluntary start cut spending? Yeah, when hell freezes over! So I suspect that the next major economic downturn is related to high government debt, rising interest rates resulting in higher budget deficits, inflation and finally frantic deficit reduction. You saw it across the pond in Europe; governments keep on spending until there is no further choice than spending cuts under the riotous auspices of an angry electorate. Alternatively the financial powers of the world will no longer lend to the country. We saw it in Canada 10 years ago; we’re seeing it in Europe and we will see it next time around in the U.S.A.

Is that our future Godfried? Well how the h.ll am I supposed to know?  But it sounds to me as a likely scenario. That is what investing is all about: creating scenarios, setting yourself up for the good ones and protect yourself against the bad ones. What will really happen? Nobody knows and it is probably different from any of the scenarios we have ‘foreseen’. As good scouts however, we investors must always follow our scout motto: “Be Prepared”.