Sunday, January 30, 2011

Another Break that can make your rich – owning your own business

Thomas J. Stanley has made a career of studying wealthy people. Surprisingly he concluded that most became millionaire in one generation, i.e. they did not inherit the financial spoils of their parents or grandparents .In the "Millionaire Next Door", Stanley and his co-author William D. Danko concluded that neither the millionaires' lifestyle nor their wealth was generated from being highly leveraged financially. "How did they accomplish this?" asked Thomas in his sequel, "The Millionaire Mind". They were not all "work and no play" type of people. They enjoyed life. They were not workaholics. "They spent a lot of time with their families and friends, borrowed little and became wealthy, in most cases before they were forty-five years old."

From Stanley's demographic sketch (book was published in 2000):
Most millionaires are married (92%) and of those, 95% have children. Only 2% were never married. The typical millionaire is 54 years old and has been married to the same woman for twenty-eight years. 25% has been with the same spouse for 38 or more years. Nearly all own their residence often with small outstanding mortgage balances. They purchased their current home 12 years ago. 61% live in homes currently valued over $1 million but bought initially for $558,718 (all in U.S. dollars). Nearly 90% of millionaires are college graduates, with 52% holding advanced degrees.

Nearly 16% of millionaires are senior corporate executives (duuh!), 19% are attorneys or physicians. One third of millionaires are retirees, corporate middle managers, accountants, sales professionals, engineers, architects, teachers, professors and… housewives. Oh... and 32% were BUSINESS OWNERS or entrepreneurs. That is right, many are owners of businesses. That is where you can get a Break too! Business owners are overall the richest millionaires. Before business ownership is discussed in more detail, I would like to give you some other stats as they were reported in Stanley's book "The Millionaire Mind" in 2000:

Average net worth: $9.2 Million – Median net worth $4.2 million. Median annual income is $436,000. The typical millionaire has never spend more than $41,000 on a car or $4,500 on an engagement ring. 25% of millionaires spend less than $1500 on an engagement ring while a full 7% did not even purchase an engagement ring. By the way, $1,000,000 is not what it used to be. These days to be cool, you have to be a decamillionaire ($10 million or more). Investor Economics Inc., as reported by the National Post, shows that in 2006 there were 471,000 millionaire households in Canada (4% of all households). There are "Mass Millionaires" with a net worth of $1 to 5 million comprising 410,000 households. Then there are 36,000 'pentamillionaires' with a household net worth of $5 to $10 million; and there are only 25,000 decamillionaires. With over 36 million Canadians and nearly 11,000,000 households, pentamillionaires represent only 0.3% of all households.

Now you know the stats. And one of the big breaks in life is owning your own business. According to 'Millionaires Next Door', a large proportion of millionaires were immigrant business owners married to nurses or teachers. A very conservative nearly boring bunch, those millionaires; but then most good investments are boring as well.

So it is not that you have to be an employee of a large corporation or a professional to become a millionaire. A whopping 32% are business owners that grew their business from zero to a multimillion dollar operation in one generation. There are basically two types of businesses: operating companies and holding companies. It is the operating company that has made many millionaires wealthy and it can do so for you as well. If you are a plumber, you can start a plumbing company and grow it over time. You may be an entrepreneur that starts a service or gadget production company. For companies to grow, you need a system of running things, something that you can delegate to others (partners or employees); something that you can do over and over again to making ever increasing profits.

It is not easy to start a business on your own and it is hard work. Eighty percent of businesses fail in the first year, mostly due to the lack of financing. So if you plan starting you business do your due diligence. Once past the five year anniversary, business failure drops off dramatically and with a good 'system' you may farm-out the entire operation and focus on other ventures. Holding companies are different, because often they have assets that are held apart from the owner's personal wealth - often for liability or tax management reasons. Real Estate investing maybe the exception because it does not only have an asset appreciating component but it also has an operational component (rental management, fund raising, etc.). In fact real estate valuation and resource company valuations are both about assets and sweat equity – they have a lot in common. That is the topic for one of our future blogs.

A simplified crash case history

As a follow-up on "How to deal with a stock market crash" let's do the numbers in a spreadsheet. Our only investment is in our favourite S&P/TSX60 iShares ETF symbol: XIU. This ETF represents a diversified portfolio of the 60 largest companies on the TSX, they are typically blue chips (other than Nortel which was in the far past made up part of the TSX), represent most market segments and they pay dividend which we like to reinvest. Although the dividends fluctuate, currently they are $0.45 per year per unit.

I mention Nortel, because it illustrates that sometimes even the TSX and TSX60 can get out of whack. During the High Tech boom of early 2000, Nortel was such a proportional large component of the TSX and the TSX60 that its value distorted those indexes and when it crashed in 2001, the indexes crashed much lower than the market excluding Nortel. Thus many investors wanted an ETF of the TSX that limited exposure to a single company. Hence the creation of the 'Capped TSX' ETF (symbol XIC).

For your information, the current top 10 stock holdings of the TSX60 (XIU) are shown in Table 1. The price history of the TSX60 iShares over the past 3 years are shown in figure 2. If you owned a $10,000 portfolio holding only XIU units in January 2008, it would contain 514.14 shares (See spreadsheet in Figure 3). At the depth of the Great Recession, that portfolio was worth 514.14 * $11.75 = $6,041.13 plus dividends earned over 5 quarters or $283.80. If you panicked and sold your portfolio at that point you would have lost: $10,000 - $6,041.13 - 283.80 = 3,675.07. WOW!! That is a 37% loss in one year. Heck, no wonder no-one sane of mind wants to invest in the stock market! Yep that would have been the end of my early retirement dream! Run, the world is coming to an end!!
Table 1 – Top 10 stock holdings of XIU as of January 2011

Eh, wait a minute. IF you hadn't sold then today in January your portfolio would have been worth: 514.14 X $19.38 PLUS Dividends worth $692.93 or a total of $10,656.94 and an annual return of 2.1% - Not great but no losses either. You're back on the retirement road.

But suppose you had $5000 cash in 2009 and bought perfectly timed at the bottom of the market? Don't bother, that is like winning the lottery. But what if you started buying in $1000 chunks after the main crash over a 3 month period? The spreadsheet in Fig 3 shows that your timing was far from perfect and that you never bought at the perfect bottom. The average purchase price was $12.07 not the bottom price of 11.75, but you bought 414.42 shares. Hé, that is strange! You bought more shares than if you bought the shares all at once for $12.07 – in that case you would have bought 414.39 shares. This is nickel and diming, but still…

I digress. So we kept our cool, we didn't believe that this time we really have the end of the world and so we bought 5 times after the crash when everyone shouted 'doom and gloom'. Now, a year and half later we own 928.53 (see Figure 3) shares worth $19.38 each and we received $1054.69 in dividends. Total profit: $4,049.53 or an annual average return of 8.3%! That while we are still climbing our wall of worry! I guess, you get the point.

Figure 2, XIU price chart over past 3 years from GlobeinvestorGOLD.

Figure 3 – Crash Scenaro Spreadsheet.

Thursday, January 27, 2011

How to deal with a stock market crash

In an earlier post "Next time I won't sell', we reviewed the theory behind 'Buy and Hold" strategies.Today's post shows how you could have benefitted in real life from the 2008-2009 crash.

The graph below shows the performance of the S&P TSX from Jan 2008 until today (Graph is from GlobeInvestorGold).  The TSX peaked in April 2008 but when comparing from the start of 2008 until now, one may conclude that we have now fully recovered. Add to that a 2-3% dividend return per year and we would have made money especially when including the dividends

The graph shows perfectly why you shouldn't panic during a market crash, when you own a diversified portfolio such as represented by the here often quoted Ishare ETF of the S&P TSX60 (symbol: XIU). There would have been no loss as long as you didn't sell during the crash with the proceeds deposited in a money market fund. Your net value on paper may have been down during 2008 - 2009, but all that is now recouped - as long as you didn't sell.

Timing stock market events doesn't work - nobody knew in April 2008 that we were at a peak; neither knew anybody that March 2009 was the bottom - I certainly didn't!  Only if you make a habit of taking profit when a market looks expensive and buying when prices are attractive would you have done better. Looking backwards gives you a 20/20 eyesight, but it also illustrates how to make money in stock markets. If you had held on to a portfolio of XIU shares and bought steadily more after the market was down 30% without knowing when the exact bottom occurred, you would have bought at the right price and your overall portfolio would have outperformed the market handily.

You would need to have cash to buy those shares during the market crash and that shows the importance of good cash management. Had you accumulated cash when the market started to look expensive by not reinvesting dividends while taking some profits from time to time on the way up then you would have been ready to buy when stock prices became attractive during the crash (a little bit at a time).

Stock market investing is not rocket science. But it takes discipline to carry out your investment plan and to  believe that the world won't come to an end no matter how bleak the short term outlook. Stock market crashes have occurred many times and none of them caused the world to end. So, at the next crash you know what to do, but do you have the fortitude to buy when everyone around you sells?

Saturday, January 22, 2011

Another Break that can make you rich - Options

In a previous blog we discussed that many corporate employees have the opportunity to participate in a company savings plan. This is one of the opportunities that constitute a 'break' that can not only make you financially secure, it can make you rich. Another break that is even more powerful is employee stock options.

When discussing the company savings plan, we mentioned that many of these plans encourage that you invest your savings in the company's publicly traded shares. If you do your stock market research you know which companies are the best stock market performers in your line of work. So aim to work for them, this is not only good for your career but it also gives you the opportunity to participate in its company savings plan were you buy its stock in the favoured 'cost averaging way'. Every month you buy a little bit of stock for a fixed amount of money. Thus, you buy more when the share price is relatively low and you buy fewer shares when they are expensive. This is the next best thing to buying a stock at the 'right price' – the way we advocate so often on this blog.

Since you not only buy shares using the cost averaging method, but you buy stock of a company that is the best in your field of work. Your shares will outperform over the long term the competition. There is one added advantage that may sound strange coming on a blog that wants you to diversify your portfolio. You know that Bill Gates and many others did NOT get rich by diversifying. Rather they put all their eggs in one basket – in Bill's case the eggs were all in the Microsoft basket. The difference between 'day-to-day' investing and Bill's investment is that he knew Microsoft better than any other company. This is quite different than investing in some publicly traded company where as shareholder you probably know nothing more than what's published in the annual report and what senior management tells you on BNN. When you work with your employer, you know a lot more about your company and your management than the typical retail investor. You yourself may even have a significant impact on corporate performance. In fact, many would consider you an 'insider' and you have restrictions when selling your savings plan's stock. Your company will announce 'black-out' periods when you are not allowed to sell your shares. Typically just around the time that your employer will publish its quarterly financial report or when a take-over announcement is coming.

Just like Bill, you have much more control/knowledge over your employer's company performance than a typical investor and thus you run less risk losing money than such a typical investor. For you it is O.K. to invest a higher proportion of your net worth in your employer's company stock – maybe as much as 30%. 'How much' depends also on your personal situation. If you are just out of school working for such a company, your entire portfolio may be comprised of your savings plan. Don't worry – first of all there is nothing you can do to alter this and because you're young it is sometimes O.K. to take on a lot of this kind of risk (note the careful wording?). But as soon as your savings plan's worth becomes substantial (say the size of a 20-30% down payment towards the purchase of your first residence), it will be time to start taking some of the profits and accumulate cash. Once you build up enough cash for a down payment or another investment then make that investment and then you are more diversified. Note, I did not say, sell all your stock, just a significant portion – say 50% - after all your company shares are the best investment you have up to now. So don't shoot the chicken that lays the golden eggs!

As said in an earlier post, you may get even a better break than a company savings plan. You may have the chance to borrow from your company a large number of shares interest free! Even better, if the shares lose value, you cannot lose money you only give the shares back to the company! How does that sound? Pretty sweet he? We call those loans, employee stock options! Now you see how important it is to choose your employer with care and don't just grab any job offer that comes your way! Be an action taker and pursue a job with the company you want, not the other way around!
When you have stock options don't ever loose eyes on how your company is performing – operationally, financial and… on the stock market. As you may soon realize, over the short term, there is often a disconnect between stock market performance and your company's true performance. If this disconnect gets out of hand, you may see real company insiders buying company stock or the company itself may do 'share buy backs' – this may be an opportunity to buy more shares or it may give you the confidence to holding on to your shares. When insiders are selling, this can be for many reasons, but if you feel that the stock is overpriced (and you are becoming an expert on that stock by now yourself), or if you see a lot of insider selling, that may be a signal to take some profits. NOT TO GO ON VACATION TO DISNEY LAND!!!! But to use the cash to diversify – to put it into another investment. These days, even Bill Gates does not only own Microsoft stock! Selling consumption items such as that BMW is the sure fire way to waste your Break. Instead of ending up with a nice nest egg you will end up with a pile of rust!

There are a lot of exclamation marks in the last paragraph but then this is a break that can make you ultimately rich. So it is critical that you manage it well. Too many examples of embittered employees who sold off their options for a boat on the lake and then they saw their company stock double and they literally missed the boat. They only have themselves to blame

An option is a share that the company lends you typically for five years. All the value increase of the shares from the moment they lend you the share until you sell it is yours! So say you work for the Bank of Montreal and when you start working, they give you 1000 options (i.e. they lend you 1000 shares) which trade at that time at $40.00 per share (the strike price). Two months later the shares trade at $50.00, a single option is them worth $50 minus the $40 strike price or $10.00. Wow! You got how many of those things? 1000 options! So in two months you made 1000 x $10= $10,000! That is more than your entire salary plus savings plan included! Sell, sell, sell!

Eh… not so fast. Many employers are good but they are not crazy. What would happen if you sold your options within 2 months and then you quit to go work for another company that gives its employees shares as well? So, although your own the options, you don't have the right to sell them right away. If you quit you lose your options. Talk about retention bonus. Well how can you cash in on your windfall?

Typically, you will earn the right to sell your options over time. Your options expire – i.e. you have to sell them before the expiry date; typically 5 years from when the options were given to you. You also get the right to sell a portion of your options – typically 20% of your options 'vest' every year. In other words, you earn the right to sell 20% of your 1000 options or 200 options. After five years all your options are vested. To stop you from quitting after five years, your sly employer gives you as part of the year-end bonus also some more options which expire five years later. So you will always have just enough options in your inventory to keep you from quitting! The more they like your work the more options they will give you with that year's bonus. Of course, it also depends on how the economy and the company overall is doing. But there is usually a connection/recognition with how good you're doing from the company's perspective.

What happens if the company shares don't go up? Well simple. Say your BMO option strike price is $40.00 and the shares trade at $30 per share. Then your option would put you theoretically in debt by $10 a share! That would be the risk of leverage and of your underperformance along with the rest of the company. "Oh… wait a minute, I don't feel so well! You mean I would owe $10,000 to my company for the borrowed shares? Eh… Eh…"

No, not really. You borrowed shares not money! So in the worst case you just let the options expire since nobody will buy your $30 dollar borrowed share for $40 or more. So the option is worthless and you won't exercise the option (i.e. sell the underlying share). The borrowed share is returned free of charge to your company. Pfff!

There are a lot of different strategies you can follow with options. Too many to discuss on this blog. Point is options are the road to becoming truly wealthy, maybe not as rich as Bill Gates but rich enough. Thank you Mr. Employer! However, I would like to discuss one major pitfall.

Many people prefer to work with at small corporations rather than large ones. The logic is that those small companies will grow much faster and so will the value of their options. This is not quite true as many found out the hard way. First of all, small companies are very risky – their growth is very dependent on the quality of the company and, of course, the state of the economy. But say you're lucky and the company doubles over five years in value and you hung on to all your one thousand small company options.

How much did you make as compared to working at larger company? Say, you got the options at a strike price of $1 dollar and now the shares have doubled to $2. Your profit is $2000 minus $1000 (1000 x strike price) or a whopping $1000.

What would have happened if you had worked at the large company which only grew at an incredible snail's pace of 10% over 5 years. What would those options be worth? Well, say the (strike) price of a company's share was $100. So now five years later they are worth $110 and each option is $10 worth. 1000x $10 is $10,000.

Where would you have done better? At the small or the large company? So don't fall for misconceptions, do your numbers. An opportunity such as getting employee stock options should be considered very carefully because it can be your ticket to become wealthy.

Wednesday, January 12, 2011

Today’s Markets are so volatile! Are they?

If you look at long term stock market charts, it seems that today's market swings are worse than ever before. Even the 1929 and 1987 crash are puny compared with today's volatility!

This is a bit of a spin-off from the previous post where we simulated a 30 year stock market index chart, starting at an index value of 100 and with a 10% average annual appreciation rate. Remember this chart in figure 1? See those enormous volatile swings in the last five to ten years? The trouble in earlier years seems to be puny in comparison!

Well, don't be fooled! These are absolute numbers not relative numbers! Percentage wise the swings in the early years are just as severe as the later ones. It is the scale of the graph that makes the past seem so much easier and simpler than today. Below is the same graph but only for the first 15 years and since the market value was not that high in those earlier years, the Y-scale (value scale) has been lowered to appropriate for that time (Max value is $1000). See how volatile those past markets were? It's a matter of perspective!

Next time I won’t sell!

New Year is the time of resolutions. "From now on I will do better", you say. Yet the average investor seems always to buy high and sell low. This weekend I read the statistic that over the last 20 years ending in 2009, the average equity fund investor made a ROI of 3.17% while those who stuck with the S&P500 through thick and thin made 8.2%. Why is this?

The average investor buys near market highs. Doug Ramsey, a U.S. investment researcher found that most investors bought when the market's P/E ratio (stock Price divided by that year's Earnings) is 21 and they sell when it is 14. Now think about this! Assume earnings don't change over time (not likely) so the investor buys $1 earnings for $21 and then sells it for $14. That is a loss of $7 or 30%! Oh boy, how do you make money that way? Everyone knows you should buy exactly the opposite way!

The true investment genius is the one who buys at $14 and then sells at $21 and... does this over and over again! That is the idea behind market timing. Guess what, nobody has consistently executed market timing. Even investor-extraordinaire Peter Lynch stated that he didn't see the 1987 October crash coming! In fact, he was on vacation, blissfully unprepared for the event. When we learn more and more about investing, we learn that over the long term market fundamentals such as earnings and earnings growth determine the value of a stock; while over the short term it is the market psychology (fashionable bulls and bears, panic sellers and buyers) rule. Day traders use technical analysis to help them profit from market psychology as do momentum investors, but only the most nimble ones appear to win. The best way is to buy when the price is right and then to hold on for a long, long time.

You may have seen this 'wisdoms' written in numerous investment write ups, but is this truly so? Well apart from the real end of the world, the end of capitalism or some other act of God, the answer is yes. No-one can see into the future but the power of an Excel spreadsheet with a random number generator is truly awesome! Yes, it is AWESOME!!!!

I simulated THE MARKET 30 years into the future. From past posts and from other authors, or even from personal observation, you may be aware that the market appreciates over time and that if you reinvest your dividends then according to Jeremy Siegel, over the long term you'll make around 11.2% annually. Market value fluctuates around an average rate of appreciations. In an previous post we noticed that over the last decades, markets crash from their peaks around 45% and increase 145% or so from the through to the next peak. That is why we predicted here on this blog that the TSX is likely to reach 18,000 over the next 3 to 4 years and then will likely crash again. Just dumb extrapolation! Will this really be the case? How the heck should I know? But it sounds like a good guess to me.

 Figure 1. Scenario 1 – with purchase at average market index valuation of 100
The ups and downs of stock markets are by many investors considered to represent 'risk', but if you are not forced to sell at a low and if you don't only buy at market peaks, these things are meaningless until the day you sell (or buy). If you just hang on, the value of your stocks will revert to the average market price. This average price will increase over time due to profit growth, economic growth and inflation. Starting with a market index of 100 where market prices fluctuate randomly from 30% below the average market price to 70% above it and with a time horizon of 30 years we can simulate the market on our spreadsheet. Assuming a dividend yield of 3.5% that dividend payments increase with inflation; an average inflation rate of 4% per year; and Jeremy Siegel's long term overall stock return of 11.2%, we reiterated typical annual index appreciation.

Based on the previous assumptions, the index has to appreciate on an average annual rate of 10%. The blue line on the graph in figure 1 shows you such a market index value trajectory. I fixed the final index value is at 1744.94 after 31 years based on 10% appreciation. In real life, after 30 years investing you don't cash in during a market low – you can wait 6 months or longer until you are at least at the averaged market price or better when the market is approaching a peak. Hence I fixed the final index value at the end of the simulation.

Whenever you press <F9> the spreadsheet recalculates the results and creates a new stock market 30 year scenario that starts with an index value of 100 and ends it at 1744.94. In between you see a continuous changing succession of market highs and lows alternating every 2 to 5 years, just like the real market. It is hilarious, just like the rope we squiggled when playing as kids. Upon pressing press <F9> in quick succession it looks like a movie of an undulating rope of which the end points (100 and 1744.94) are fixed. Just like in the real world, the ups and downs don't matter; the only things that matter are the starting value and the end value.

The second line on the graph represents the value of a stock portfolio invested in an ETF following the simulated market index. The ETF pays a dividend that started out at a yield of 3.5% or $3.50 annually. The dividend increases annually with inflation like the real world. The dividends are reinvested each year in the ETF at that year's price. So if the market peaks and the ETF is priced high you buy only a few expensive shares while during years of low valuation you buy more cheap shares. The orange line represents the portfolio value over time. It fluctuates just like the index but it outperforms the index more and more. After 30 years, the reinvested dividends represent close to 40% of the portfolio's value. That is why so many investors love DRIPs (Dividend Re-Investment Programs).

The spreadsheet calculates your portfolio value after 30 years. Every time you push <F9> and a new 30 year stock scenario ripples from start to end along the stock index valuation 'rope' (figure 2) and the returns for your DRIP portfolio are calculated. I pushed the button 20 times (20 stock market scenarios) and calculated how many total shares were accumulated and the portfolio's value based on the fixed end value of the index (1744.94). The results were enlightening. The average ROI for these 20 scenarios each lasting 30 years was 11.29% (not surprising because we tried to emulate Jeremy Siegel's 200 year average ROI on U.S. stocks), but the real surprise was the consistency of the ROIs. The 11.29% ROI for 20 scenarios showed a standard deviation of barely 0.1%. The portfolio's end value ranged from a minimum of $2652 to $2914 based on an initial investment of $100. 35.6% to 41.55% of the profits were the result of dividend reinvestment!

Figure 2. Another Scenario – with purchase at average market index valuation of 100
So, no matter what happened during the years in between, once invested you would make the long term average return typical for the stock market. If you panicked and sold out during a downturn your results would be a lot poorer. So it is only the beginning, the end and the average market appreciation over the long term that determine the success of your investment. But does it matter at what price you buy? The answer is... yes... to some degree.

Suppose you bought the shares at below average market value during a down turn, what would that do to your return? In our simulation, we 'bought' 20% below the average market value. So instead of buying $100 worth of stock when the index stood at $100, we bought during a downturn when the index stood at 80. Thus instead of buying 1 share we bought 1.25 shares for $100. The annual return of investment improved from 11.29% to 12.1% and with a standard deviation of less than 0.1%. In absolute dollars, the portfolio's end value was on average $3,451 versus $2753 if bought at average market valuation. If bought at a market peak (20% above average market valuation) ROI dropped to 10.32% again with a standard deviation of less than 0.1% and a final portfolio value of $2098 (on average).

So, when investing in the stock market, the price at which you buy is important, a difference $1,353 in profits between a purchase bought during a downturn or near the peak of a bull market is substantial when compared to the total profit of $3,451. But once out of the gates, it is just like riding bronco; you just hold on and you will make your profits. If you get thrown off and sell in a panic, you lose! Market timing is impossible, but an avid investor should be able to judge whether he is buying an overvalued stock or whether he is buying one that is undervalued. Your innards may be churning during a down turn when buying the stock index or a diversified portfolio of undervalued stocks of quality companies, but that is how above average profits are made not by running along with the herd and buying in an overheated stock market along with the masses.

Figure 3. Scenario 1 – with purchase at 20% below average market index valuation of 100 (compare portfolio value with figure 1)

Saturday, January 8, 2011

Overlooked Calgary Real Estate

I have not written a lot about real estate lately. Frankly, this is not because I have given up on it. To the contrary, after waiting out the Calgary market for months on end, I finally made two purchases late in the year, both in Calgary. While buying properties is often exciting (my wife says: when Godfried gets bored he buys a new property), reality is that rental investments are boring and hence, I tend to write less about them. Once rented and properly managed, you just hold up your hand once a month and then go back to sleep.
I don't like buying around the new construction site of the new West LRT line. I think too many current real estate owners seem to think that any profits of the LRT construction is theirs, not that of future owners. So the asking price of these properties is simply too high for an investor such as myself. If you invest in Calgary, consider NW Calgary along that LRT line. Especially near the university and other low priced rental apartment and condo complexes in that quarter. For the more adventuresome, consider NE Calgary. Prices of townhouses in that part are much lower compared to the rest of the city. Yet an enormous expansion of infrastructure and industrial development has taken place in that part of the city and seems to have gone unnoticed by many investors. The rental clientele of that quarter of the City may be a bit rougher; but the area will experience even more growth in the years to come. Major Nenshi is already pushing for a major tunnel below the run way expansion of the airport to accommodate this anticipated growth.
Although value appreciation of real estate is often higher near key infrastructure expansion points (e.g. within 800 meter radius of a new LRT station or traffic artery exit), one should not under estimate the profitability of real estate at more modest rates of appreciation. Flat rates or modest appreciation rates of 3% can still be quite rewarding, as often pointed out by REIN's Don Campbell. This does not count the positive cash flow from rental operations which in relative terms also may be boosted by leverage. Ah, I said it! Leverage, well it is the steroid that boosts your real estate return on equity.
Cash flow finances your operational and debt service costs. If positive it even adds to your profits. But rather than cash flow, it is profits that you want at the end of the day. The rate of profit growth (ROI) determines the rate at which your net worth increases. Profit itself represents your increased net worth. If cash flow is analogous to your blood circulation detected by measuring your heart rate, your height and weight increase measures your physical net worth while an adolescent. When older, you may not wish to grow in weight any longerJ; neither will you grow any taller. But then the emphasis is about the improving quality of your life and your personal mental growth and your contribution to society overall (something much more difficult to measure). Sorry, I digress.
Real Estate ROI? Eh, yes... So what would be the source of ROI, if only little comes from cash flow and asset valuation growth? Well, I only said that you do not need a lot of appreciation to get a decent rate of return! There are 2 profit centers that depend on the steroids of our real estate growth – i.e. leverage. Both relate to equity growth (not necessarily on a lot of property appreciation):
  1. Rental Income
  2. Modest appreciation
Rental income does not only go to pay for operational expenses, it also goes to pay for financing expenses. This is what many forget! Your debt service payments (except when using a line-of-credit), comprise interest expense and ... repayment of your mortgage principal. That repayment of principal goes towards your net worth, i.e. your equity in the investment.
Here's a typical monthly statement:
Monthly mortgage Payment:                            $    772.36
  1. Principal balance at start of month:           $ 63,795.04
  2. Interest payment:                                   $     330.68
  3. Principal repayment $772.36 – 330.68:       $     441.68
  4. Principal balance at end of month:             $ 63,353.36
Yep, part of your monthly mortgage payment pays off your debt and thus increases your equity in the property; and thus goes to your net worth. In the above example it is $441.68 and with future payments your debt principal continues to fall, your interest payment decreases and your monthly net worth growths accordingly.
Modest appreciation is the second source of ROI which is also leverage dependant. Your property may appreciate 'only' 3% but your ROI growths a lot faster!
  1. Property value at start of year:         $100,000
  2. Appreciation 3%:                            $    3,000
  3. Loan to Value 75%: your equity:       $  25,000
Your ROI is $3,000/$25,000 = 3/25 = 12% plus... your annual principal reduction. According to Don Campbell's calculation your total annual ROI on a 75% LTV for a property that appreciates at 3% is 14.6%, not counting your positive cash flow (rent minus operating and financing costs).
Today's Calgary real estate market, especially older (1980s) apartment units in well managed condo complexes in the NW or town houses in the NE are right now priced and receive rents that are fairly attractive. Cap rates on single units are 4 to 5% (Net Operating Income/Property Value). With the improving economy, rents and appreciation are set to rise in the coming years and this winter may be the last opportunity to buy properties for a very good price in a long time to come.
The same is true for Edmonton and Red Deer. I am writing specifically about Calgary because that is the area where it is most practical for me to operate rental properties and which I know best – I specialize in northwest Calgary around the LRT line; hence my examples.

Give me a break... and I don’t mean an ‘Alberta Break’

For most of us, saving $10,000 to $20,000 per year is not going to make us rich. It may make us financially comfortable, especially if we start early (before age 30) and we keep it up until 65. Ough! What about freedom 55? That is for insurance company adds! Not real life. So we need a break!
"Yep, I have been playing the lotto for years now. It is my main retirement plan", you may say. Well good luck but the odds are definitely against you. And even if you win, too often the winnings are spent unhappily in a few short years. "Oh, but I also count on the death of dear Aunt Jeremiah!" you may say. Well, many have waited for the death of a rich relative, but statistically the rich are happier, healthier and live longer. Ruining your life, getting an ulcer while trying to outlive dear Auntie may not be that happy an experience.

No I speak of other breaks. Breaks most of us will get in life but are not ready to recognize. I am thinking more along the line of creating 'Multiple Income Streams' as described in a book by Robert Allen. Or... as discussed by Eric Edelman in 'Ordinary People, extraordinary wealth". This is the direction we have to look in. One of the least appreciated and most wasted opportunities mentioned in Eric Edelman's book is the employee savings plan, where your employer ads one or sometimes even 2 dollars to every dollar gross salary you put in. Thus, you combine the 'pay yourself first' principle of David Chilton's Wealthy Barber with an amazing accelerated return on investment. Use this employment benefit to the absolute maximum. Many plans, for good employer reasons, restrict you total annual contribution to 10% of your gross salary. Use it ALL! Then invest it in whatever limited options you have within the plan. If the performance of it is acceptable just let it grow. Otherwise transfer it out into a self-directed investment account ASAP but ensure you don't incur any withdrawal or contribution penalties.

Say your annual salary is $70,000 and you can only save 10% with the rest sorely needed to meet your lifestyle. Put it all in this employer's savings plan. You save $7000 deducted in instalments from your pay check. After a while you will not even notice the deductions in your lifestyle. Within one year, your savings account balloons to $14000 or maybe even $21,000 thanks to your employer's contribution. Your portfolio value will be growing depending on the investment option you choose. This will last as long as you work at your employer – so say you work there for 5 years and the money was invested in a stock market index ETF like XIU or the Dow Jones that accumulates at 11.2% per year similar to Jeremy Siegel's numbers. It would be worth close to $92,000 on a dollar for dollar match plan and an amazing $138,658 if it was a 2 for 1 dollar matched program. This is of course before taxes and inflation but still a very impressive result. And... we haven't talked about the effects of your annual salary increase which when added to your savingsplan contributions could be quite substantial gains!

Would you be working at that same employer for 20 years, then your savings plan would be worth: $971,000 and $1,465,858, respectively. Now that I would call a break! But what about making this not just any break, but a SUPER break? Well, nothing to it! Many such company savings plans are issued by publicly traded companies. You, as an avid investor will know which companies are good stock market performers and which ones are only OK! So be careful where you work. When looking for a job, select a strong public company with good or excellent management and good earnings growth. One of the savings plan's investment options is often to invest in your company's shares (without paying commissions)! Well selected employers may have share value appreciation that easily outperforms the stock market. Since you are employed by this company you are better positioned to know whether management is good or mediocre. Whether management interests are aligned with the company shareholders or whether their interests collide. You know about company moral and many other important details that make you know your employer's public company much better than the typical stock market investment. Consequently you understand the risks and awards of investing in your employer's company very well and you can dedicate a large proportion of your portfolio to this potential outperformer with returns much better than the typical 11.2%. I would think that up to 20 to 30% of your overall net worth could be invested in such a company. So don't let any employer hire you, select the employer you want to work for and get hired there. This way your employment proceeds are truly optimized. Don't get greedy and put all or an excessive amount in your company's shares – remember the lessons of Calgary's Home and Dome who left many such employees penniless. "Bulls and Bears get rewarded, but Pigs get slaughtered".

What would be even a better break than this SUPER break? Of course, a SUPER-SUPER Break – A posting coming soon in a blog near you.

Sunday, January 2, 2011

Real Time Oil Prices - Economic barometer

I have added this real time oil price chart to the blog heading courtesy of There are several reasons for doing so.
  1. Classic bubble chart - many financial bubbles show the pattern of this oil price chart. From 2000 to 2007, oil prices gradually increased, then the speculators took over and prices increased at an accelerated pace. Followed by the crash in 2007-2008 and prices fell excessively below the long term equilibrium price. Upon a vigorous short recovery until mid 2008, oil reached their 'equilibrium price' and increased thereafter at the same pace as before the peak. Assuming no speculative peak, extrapolation of this chart suggests that we will be reaching $100 oil in the first half of 2011.
  2. Authors such as Jeff Rubin suggest that not sub-prime lending but unsustainable oil-prices caused the last recession, just as at previous oil shocks. Now that conventional oil production has peaked in 2006, even acknowledged by the EIA, it seems that oil prices can only go up along with world oil demand. But world economic growth and globalisation are dependent on cheap oil. When oil prices go up too high, China can no longer compete with local producers and we may experience another significant recession. So... when a new oil price peak develops or if we reach oil price levels approaching the 2007 peak we may be in for another recession. Thus, oil prices could be seen as the proverbial canary in the coal mine. Being such an important leading indicator, the oil price graph definitely deserves to head this forum.

What better post to start the year. How to get rich!

There are many ways to get rich and they all require patience, a cool head, and luck. We have over the last year discussed many aspects of investing and I feel we’re at a point that maybe we should take a step back from the details and look at the overall picture. So suppose, you save $10,000 per year and you are 30 years old. What will you be worth when you are 55 years?

 Using the after tax and after inflation returns of our posting: “After Tax and Inflation Returns on Stocks ”  you would have accumulated 25 years from now $578,000 in today’s after tax dollars and if you waited another ten years, when you’re 65, your portfolio would be worth $1.2 million dollars (see spreadsheet below).

Would that be enough to live off for the rest of your life? There are some considerations because our investment returns are based on long time investment horizons. So if in the year after your retirement at age 55 or 65 the stock market crashed would you want to be forced to sell stock? Probably not!

Consequently you would have to ensure you have enough cash flow from dividend income or fixed income to live off . If dividend income would be insufficient you could consider divesting into fixed income but that would reduce your overall ROI. If you held real estate you might be able to augment your cash flow that way. But for now let’s assume that you have to live of  the 2.5% dividend yield then, using the earlier portfolio valuations, your annual cash flow would be around $13,000 when you’re 55 or of $33,000 plus CPP if you retired at age 65.

With that amount of income you are not likely to consider yourself very rich. Now if you had saved every year $20,000 you would have accumulated at 65 around $2.3 million or an annual income of $58,000 plus CPP. That should not be too bad; especially because this income would be mostly tax free. But then, saving $20,000 from an annual income of $70,000 would probably mean that you have to lead a pretty frugal lifestyle, especially if it involved being married and raising two children.

Figure 1. Simplistic Wealth Planner spreadsheet using after tax and after inflation returns. Note the black line in the middle hides the rows from year 3 - 23.

If your household income was $100,000 and you saved $30,000 per year, then by age 65 after 35 years of perfect investing, you’d likely own $3.4 million or $1.7 million in today’s dollars at 55. Hmm, that comes closer to financial independence, wouldn’t you think? But would you call yourself rich?

What we’re doing now is nothing more than simple financial planning. We’re doing ‘what-if’ scenarios. It also becomes clear, that your salary or self-employment income better increases quite a bit over the years if you want to become really rich. With a $100,000 annual household salary it is tough to become a deca-millionaire!

It is clear that you need some breaks if you really want to achieve that level of affluence. This is where it becomes very important to be on the look-out for real breaks or opportunities in life. Most of us will experience hard times but we also will experience some pretty good opportunities. The art is to get unharmed (or as little harmed as possible) through the bad times and to grasp those opportunities that will make us ultimately wealthy. In the coming posts we’ll be talking about some of those opportunities – it is intended to show that you may have several of these chances – you just have to able to grab the right ones.