Tuesday, February 22, 2011

Egypt, Tunisia, Libya, Iran. Impact on Investments?

The headlines are full of unrest and toppled governments in the Middle East. I wish that these countries will all become democratic and that their often brutal leadership is being served the bill for the atrocities they committed over the years. But stock markets prefer the status quo, they don't like uncertainty. As soon as something changes, for the better or the good, the markets get a bout of hysteria. Especially following the incredible run up since last September, it is time for a correction and the Middle East events provide a good excuse.

But overall the economy is doing fine. Not great; just fine! And why should we be so black when a large portion of the world population is finally throwing of its bonds and aspires democracy? After all, wasn't it Bill Clinton who pointed out that for a society to truly prosper its people had to be free? Not that us Westerners are truly free; there are laws and political parties to follow. Jean Chretien was referred to as the 'Friendly Dictator' by Jeffrey Simpson and Rex Murphy called him the 'Great Dictator of Canadian Liberalism'. So everything is relative. Yet, overall we live in a free society and we have the right to own property and we have something that generously is referred to as 'Law'. These form, according to many great thinkers, the basis for a truly 'prosperous nation'. Despite expressing a certain amount of sarcasm, this writer also believes that those are winning conditions for prosperity, along with good education and the absence of corruption.

So, we should celebrate and praise the demonstrations in the Middle East since they promise a better life ahead for these people. That would benefit us too, because with less social injustice in the world we will likely also have less terrorism, better business partners and additional prosperous markets to trade with. Over the long term, the rise of Middle Eastern democracies is positive and the current market 'hic-up' is just that (I certainly hope so) - a small correction in a much larger bull market.

Sunday, February 20, 2011

Example of a successful long term investment

Not all my investments turn out like Vermillion, but it shows the power of long term buy and hold.
I bought Vermillion in 1998 and held it until recently when the stock price of $47.00 became too heady for me. I should have held on, but then… pigs do get slaughtered. Here is the chart over the time I held the shares:

Now this does not include dividends. The table below shows you the detailed investment transactions involved. Very simple, I bought shares twice in 1998, I took profits to recover most of the original profits in 2002, when prices had shot up too much and I got worried about a downturn. The chart shows a significant correction later that year. But really, over the long term it was not a brilliant move unless I had had the courage to buy during that downturn, which I didn't.
In July 2008, I did have the courage and increased my shareholdings and dividend payments by nearly 50%; I bought twice. Total investment (proportionally adjusted from the real amount invested) was $3549.41. Note that the sales proceeds were 'only' $6617.99 plus the earlier sales proceeds of $1216.38 for a total appreciation of 4284.95 or 121% over the amount invested. Dividends were a whopping $2165.43 or 61% of the invested amount. Average Annual Return was 18.31%

Certainly a beautiful flower in my investment garden!

The Emerging Market Myth

Economists and investment gurus seem never to tire of pointing out the incredible growth of the economies of 'emerging' countries. China is the obvious prime example. So investors often hear how profitable it is to invest in said markets. But reality is that the stock market investment performance of these countries is often much less rewarding than many would think. For one, everyone wishes a chance to invest in such 'promising' economies and we tend to pay too high a price for such investments. For years China's economy has hauled in not only large trade surpluses because of ever growing export markets, but also investors and foreign companies have thrown investment capital at these countries in an astonishing amounts.

As a diversified investor you would also like to participate in the nearly never ending profit streams from these countries. But think again! First ask yourself why countries like China are at an ever increasing rate buying up resources? First in Africa, then in S. America and now in Canada. Well, here is my investment record (with the actual investments reduced to $1000) for some ETF funds including the one based on the MSCI Asia index excluding Japan going back to March 2007 or close to 4 years.

My return on stock markets in Pacific Countries including India and China was 3.54% since March 2007. Wow! Now Japan, which was not included in this ETF, has had an even poorer return -3.55% - not surprising. Let's compare that to the return of Gold over the same period of time:
Oops! That is a return of 22.52% Slightly better J "Duuhh! Everyone knows gold is unbeatable." you might say. Right you are, maybe we should compare it to a stale G7 economy very close to our heart: Canada. The result is:
What? 15.74% and I didn't even buy more units at the depth of the recession like with Gold or the Asian ETF! So who's your Daddy?

Saturday, February 19, 2011

“Sell Everything Right Now!” is NOT in my investment vocabulary

Portfolio management is not about emotional sells and buys. That may be fine for the casino, lotto players and day traders but it does not belong in the tool kid of an investor. Portfolio management is like gardening, weeding out the bad and keeping the good. Sometimes a plant can go bad and so do individual investments.

If you have followed the postings on this blog, you have by now set your investment goals, you have learned how to set up your portfolio's asset allocation, and you know how to invest for the long term. The longer you hold your stock portfolio and individual stocks the less likely it is that you lose money. The longer you hold a diversified stock portfolio and re-invest the dividends the more likely it is that you will achieve the long term overall stock market returns as described by authors such as Jeremy Siegel. You may also notice that I am a proponent of buying instantaneous diversification by using stock market index based ETF's. For Canadian Investors I highly recommend the iShares S&P/TSX ETF (symbol XIU), but there are several other similar products available in the market.

You may by now also realize that diversification does not only restrict us to investing in stocks and bonds. It also involves other investment classes, in particular, owning real estate. In future postings I may become more specific on what types of real estate investments may help your pocket book most. I have made by now enough mistakes to know so.

Also discussed is the need to open your eyes to the 'breaks' in life: company savings plans, employee stock options, owning a business (not a holding company) and owning your own real estate business. I can think of numerous other 'breaks' and they happen to each to us. It is just a matter of recognizing your breaks and taking advantage of them. We all show often admirable strength when confronted with life's adversities but recognizing and taking advantage of opportunities (breaks) seems more difficult. Oh, and remember, I am not talking about inheritances or lottery wins which often seem to bring out the worst in us.

Diversification is often frustrating, because when one investment class is doing well, the other seems to be going no-where. Right now it is not a lot of fun to own Calgary or Edmonton rental properties with vacancies and falling rents. But during the crash of 2008-2009 it protected my portfolio nicely, not to speak about 2004 – 2007 when the real estate portfolio value exploded. Seems right now it is the turn of stocks. BTW I just 'lost' money on call options because the value of one call option shot up dramatically along with the stock market. I had the choice of buying the options back at a significant loss but regain the opportunity to un-cap my upside on the underlying stock investment or… to sell the underlying stock at a tiny profit and be happy with the sales proceeds of the options. I was not really willing to let the shares (Bank of Montreal) go, so I bought back the call options. I digress…

It takes a long time to build a well-diversified portfolio, just like creating a beautiful garden. So portfolio management is more about 'tweaking' your portfolio rather than 'Sell everything right now – the world is about to end'. We prefer to buy more good company stock during downturns and take some profits during the subsequent bull market. We are now in the second leg of a pretty strong bull market which started (hind-sight is 20/20) in February 2009. Earlier I predicted based on past bear-bull market performance that the TSX would likely become ripe for the next crash 3 to 5 years later (2012-2014) when it reaches 18,000. Don't sell your entire portfolio when it does reach this level which is only 22% above today's index number. The 18,000 is just intended as a danger signal, indicating that valuations are likely too rich and that the stock market's chance to crash is quite high.

Many investors feel confident in bull markets and morose in bear markets. You should realize that the successful investor has the opposite view. Near the heights of a stock market risks are high as well, while near the nadir (bottom) of a bear market the risk that stocks will lose even more value is small.

Don Campbell of the Real Estate Investor Network came up with the 'Five traffic light analogy' (posted November 6, 2010). Right now, I estimate that the fourth light has turned green. So we should enjoy the ride for now. But rather than looking for the 'green sprouts' in the waste land of economic debacle, we should be more cautious – keep our feet on the ground – and start looking for danger signals. Once the last light jumps to green and nearly everyone is euphoric we should take profits and build up our cash position to get ready to buy again in the next down turn. Because from then on, lights can only turn red again!

Up to now, I quoted often from Jeremy Siegel's book: "The future for Investors". I promoted the Index ETFs as a way to start an instantaneous diversified stock portfolio. Now it is time to turn to more specific stock selection techniques. You will hear me quote from David Dreman: "Contrarian Investment Strategies: The Next Generation", published in 1998 by Simon & Schuster. You will also read more about the techniques of the Canadian Shareowner Association and its valuable "Stock Study Guide and Data".

If time permits, I will edit the previous posts and convert it into an e-book. This is my intend, but I may be restricted by the realities' of available time.

Wednesday, February 16, 2011

It is dangerous to stand in the path of thundering bulls - all lights green?

Since the break-out last September, the stock market has been rocking. Now we hear news that more and more investors are venturing into the stock market. So there is a herd of bulls running up this market and it is time to get a bit more careful. If all lights are green (see earlier posts) it is time to get worried because they can now only turn red. Maybe 4 out of five lights still signal a worry free run, but if then when yet another light turns red we're definitely ending up in riskier waters.

For now, enjoy the bull ride and keep an eye on our TSX target of 18,000. That was to be still 3 years out, but now that we're flying past 14,000 we have only another 22% to go. Too fast?  Maybe a correction is due later in the year. For now the momentum is forward; but we must start to wonder whether bargains are still to be found in this market.

There is no-way to know when and at what value the market will peak, but with oil over $100 in the international markets (and WTI lagging nearly by 15%), with food riots in the Middle East, we rapidly approach price levels where the economy will be pulled back to earth. China is fighting inflation and so are other developing economies. Europe is still overdebted and with severe government austerity programs. The U.S. economy is definitely in pick-up mode but mortgage defaults are still not peaking.

So don't think that from hereon the investment world is worry-free. Yet the stockmarket hasn't looked back since September. This is likely a case of too much too fast. Compared to the economy this stock market is getting ahead of itself. Start too think about what stocks you would like to sell because of poor performance. Sell the poor ones in the months to come and maybe later in the year take some profits to offset your losses and optimize your tax bill.

Second leg of the current bull Market which started in February of 2009. The current leg started last October (see post of October 8, 2010). Chart is from GlobeInvestorGold

Sunday, February 6, 2011

How I invest in the stock market on a daily basis

We're coming to a point where I have discussed many of my investment ideas. But especially after the last blog on valuing stock investments, you may ask yourself whether Godfried really understands all those companies he invests in. The honest answer is no, I don't. I am the CEO of my 'investment company' and set directions and make decisions often following advice of my 'contract staff' – stock brokers, financial planners, lawyers, accountants, realtors and property managers.

They bring the ideas and the data required to make a decision. I make the decision though and I am taking the blame for the downs and reap the rewards for the ups. If my 'contractors' don't perform I let them go, they literally expire (I don't fire). I own doorknobs in the shopping malls of RioCan . I own some tires in the Syncrude mines and a flare stack in CNRL's Horizon oil mine. I own counters in TD bank branches and some chairs in the offices of the Royal Bank. I also own a couple of miles of optical cables at Bell Canada.

Of course, I hardly know or understand any of those companies. I never met their CEOs nor their board members. They can lie or tell the truth about their companies of which I am supposedly a part owner, - I wouldn't know the difference. I hope these are mostly trustworthy individuals out not only for their own wellbeing but also for the well-being of their employees, shareholders, and the people in whose communities they work. I see them sometimes on BNN selling their companies to me. Diving into each of these companies to fully understand them would take me a lot more than a couple of evenings per month. My portfolio counts over 60 different investments in the stock and bond market. Then I own a significant amount of real estate. I sit on some of the condo boards and rental pool boards for properties I own. I enjoy doing it and I learn a lot about my investments. But fully understanding them? No, I don't.

I provide the direction for my portfolio; I look out for the landmines in the future. However, mostly I don't see them until I stepped on them. When I entered the elevator to my office on the morning of 9-11 in 2001, I first thought that the planes crashing into the towers of New York were a practical joke. It was unthinkable! Only later did I realize the severity of the event. So, no I am not especially gifted with knowledge or foresight; neither do I consider myself overly smart. I do think I can analyze data and news pretty well in order to come up with some general principals and trends. That is also my strength in my real day job as a geologist. Neither are my people skills exceptional, just ask my teenage son. He will be happy to enlighten you.

So how do you then invest Godfried? I listen, I learn, I read a lot. I like to make little unreadable spreadsheets to help me understand the consequences of my investment moves. I love figuring out how to analyse a property on a spreadsheet. In real estate, I do more the numbers than with stock market investments. Over the years, I walked into enough walls to know what I consider risky or just dumb. I used to buy IPOs (not anymore), I used to buy wind farms and Ballard Fuel Cells to learn that these investments are often pies in the sky. Let someone else lose their retirement on them. I do not like high-tech investment because 99 out of a hundred are obsolete before they are on the market; or 'management' does not have the perseverance to bring it to a successful end.

I learned to stick with large companies, preferably ones that pay dividends. They have often experienced senior managers that have been working in their field for years and years. Not that I trust them and even Manulife's management makes major mistakes. But overall, they perform well. So I buy shares in those large companies and follow the news a bit. Since I have over sixty investments, I do often just add to my existing investments. My full service broker comes from time to time up with new ideas, but lately we just add to existing stock investments. I follow a newsletter by Gordon Pape – highly recommended. He and his co-writers provide from time to time new ideas or confirm holdings I already own.

Internationally, I only invest through ETFs, except in the U.S. where I also buy the largest and best companies (at reasonable or low prices). Berkshire-Hathaway, Microsoft, Johnson & Johnson, Procter & Gamble. Sometimes a real deal comes along, like Telefonica during the European debt crisis with a temporary setback and a dividend yield of close to 10%. Microsoft trading at a P/E of 9. I jump on those. Sometimes I catch a 'falling knife', other times it is a big winner. At yet other times it is just dead money sitting for years in my portfolio.

Getting older, I realized that when I invest in stocks, I basically lend those companies my money. Instead of interest, I get dividends and parts of the profits. When I hold on long enough, I usually do better than plain investing in interest bearing instruments. I learned that I should NOT see a recession as something bad and bail out with a big loss. I hold on and possibly buy more stocks in good large, dividend paying companies at P/Es far below their normal levels. Then sit back and enjoy the ride (to some degree). I discovered that with some stocks you can supplement your dividend income substantially by getting good at selling their call options. You can sell these call-options, buy them back or let them expire dependent on the situation. Individual stock holdings are good for this.

Apart from investing in large cap stocks in North America, I have realized that many mutual fund portfolios and ETFs all hold the same stocks over and over in some form or other. I realized that my favourite ETF, iShares S&P/TSX60 (symbol XIU), holds all the stocks I already own or which I would like to own. It is hard to outperform those indexes. I do so only with special opportunities – the 'breaks' I have talked about in earlier posts. Buying into stocks or markets that everybody likes is usually expensive and profits are limited while risks are high.

I also invest in real estate. This is a long term game as well. I am doing OK and it protected me from the big 2008-2009 stock market crash. I have more control here, but a lot is in the hands of property managers. I seem to more 'manage' the managers than the properties and that with mixed success. But overall, it all works out.

So I listen to my full service broker and sometimes we buy a new investment. I worked with him now for the last 30 years and use him as devil's advocate. He gave me many good ideas. I also work with a discount broker for dealing with my call option deals (lower commissions) and buying my own stock ideas. These ideas are often selected using the Canadian Shareowner data base for a quick look or Gordon Pape's Internet Wealth Builder. I also check my company's stock charts on GlobeInvestorGold and Quarterly reports when they come out. I own many investments for 3 to 5 years. Some I have owned for a decade or longer. I sell when management starts to make multiple mistakes and there is no clear light at the end of the tunnel. Manulife I held for 10 years, ending up selling it for some meagre profits. Brookfield I have held for over 15 years and I am still adding shares. Vermillion I held onto for over 10 years and sold them recently at a sweet price of $45 (4 times the average purchase price) not counting distributions. Canadian Oil Sands I own since the 1980s and I bought more over the years. Distributions have exceeded the total purchase amount of investment. I lost my shirt on Laidlaw and Bombardier, trying to catch falling knifes. I won't touch Air Canada the perpetual money pit. I hold on to my winners until they become priced excessively or when they comprise too large a portion of my portfolio. I have bought and sold Boardwalk several times – every time I bought, it took off (not due to my brilliance, just luck) and after profits exceeded 40 to 50% in a matter of a few short months I took profits. The share price became 'too good to be true'.

If I had to start over, I would buy ETFs like those of the TSX60, the Dow Jones (Spiders) and some world index ETFs for Asia and Europe. Then sit back. If there is truly a cheap stock, I would add it to my portfolio, but it would have to be some special opportunity; something that happens like during the 1982, the 1987 or more recently the 2008-2009 crash. I would buy preferred shares as well during such times and trade call options 'for fun'. Overall investments should be 'boring' so you forget about them and do things more important in your life.

I have learned that it is best to buy large companies, reinvest the dividend in the same or in other large, high quality companies. Then just sit back and only sell when something goes seriously wrong with the company itself, but don't sell just because it is a recession. These strategies provide you the best bang for the buck. Be pragmatic, always be suspicious of the herd and follow Ken Fisher's advice: don't do the contrarian thing but expect something entirely different from the crowd's expectation. Mistakes are something to learn from. That is maybe expensive education but it is also unavoidable. Although avoiding mistakes may be cheaper, their lessons won't stick always well. Nothing is for nothing – unless you refuse to learn.

Valuing an investment

When we buy shares in a publicly company, one of the most difficult things to do is determining its value. This is, in part, because there are so many ways or perspectives that may lead to putting a value on a company. Take Microsoft and Apple. In terms of assets, profits and revenue Microsoft outperforms Apple: Earnings in 2009 were $18.8 billion versus $14 billion and in 2008 Microsoft made $14.5 billion while Apple made only $ 8 Billion.

In terms of Assets, Microsoft owns $86 billion and Apple owns $65 billion. Yet in the stock market you buy $1 earnings of Apple for $13.3 while those same $1 earnings by Microsoft go for only $10. So it is a matter what price the buyer is willing to pay for a company. Let's look at the other high-tech giant, Google. You pay $26 for $1 dollar's earning of this company. Its profits are 'only' $8.5 billion on a whopping $57.8 billion in assets but its return on equity is only 20.7% compared to Apple's 35% and Microsoft's 43.7%. If Microsoft is the most profitable then why is its profit least valued?

Why are companies like Apple and Microsoft valued less than the average Canadian Bank, where investors pay $15 dollar for $1 earnings/year? Why do investors pay for $1 earnings in Canadian Oil Sands $15.6 and $10.6 for Encana's? Ah… you may say it's because Encana owns mostly gas (and who wants that these days) and COS owns oil. Oh yeah? Then why does Canadian Natural, one of Canada's best oil and gas operators and owner of the Horizon's oil sand mines and numerous SAGD and CSS projects, get only valued at $10.5 per $1 dollar earned?

Why is a typical Calgary homebuyer willing to pay $250,000 for a typical two-bedroom condominium and why would a rental property investor not want to pay more than $200,000 for that same property? It is because the value lies in the eye of the beholder. One buys the condo to provide its owner with a certain life style, the other buys it strictly for income and profit.

Investors in the stock market obviously do not buy stocks for lifestyle, but often it is bought based on perception rather than facts. Apple makes sexy gadgets and it has iconic leader Steve Jobs. Steve is perceived to be a super-designer who is nearly infallible. Microsoft is considered an underperformer with a monopoly and a habit of strong-arming its competition. Yet it is Steve Jobs who bans software developers from Apple equipment. Microsoft provides most flexibility. If Steve sneezes, Apple's stock tanks, while no-one cares about 'arrogant' Bill Gates who gives billions to his charity foundations. Google's revenue is growing less than Apple's (20.7% vs. 39%) so why do many perceive Google as the Hi-tech growth engine and not Apple?

Do you buy your stocks based on how a company is perceived, or do you buy it based on earnings, profitability and growth prospects? If you do the first, like many stock market investors, you are basically gambling on horse races, even worse, you're gambling on how other investors may perceive the stock value of a company and based on what? If you buy based on fundamentals you look to buy value at the right price, but how do you correctly tell how much a company is worth and when will you be able to cash in on your profits?

Investment books on Warren Buffett tell us, that Warren only buys what he (and Charlie) understands. Warren doesn't understand 'hi-tech'. Well that is not entirely true. Warren loves to play bridge on the computer. He is close friends with Bill Gates for years. I bet he knows a lot more about that business that you and me. What is meant is that Warren doesn't understand how to value a high-tech company. In particular, he didn't understand how you could pay thousands of dollars for shares of .net companies that didn't make any money. What is the business model?

When you buy a company like Coca-Cola, you know what it makes, you know how much profit it will make, and you can extrapolate its earnings way out into the future. So you can calculate the Net Present Value (NPV) of the earnings and cash flow stream of such a company. If you want to earn 10% over the long haul, then you can calculate how much you can afford to pay for a share based on its NPV. If cheaper than NPV it is undervalued; if you have to pay more than NPV it is too expensive.

Organizations such as Canadian Shareowner collect this kind of data and members are provided with the software and data to calculate the fundamental value of a share. But many companies cannot be valued as a 'gadget' producer because apart from a cash flow stream they own assets that rather than depreciate, appreciate! Yes a factory has buildings and equipment that go down in value when they get older and this depreciation is deducted as costs from revenue. But what if the assets increase in value or if the company ADDS value to its assets?

What about service companies? How do you value SNC-Lavelin, an engineering contracting company? Yes it has an income stream, but it has no assets. Tomorrow its work contracts may be cancelled; its personnel may rebel and leave for better pay somewhere else. Once SNC loses it staff, the company is worthless. Where is its expertise? Along with the staff its worth is out of the window. It has to acquire new expertise or it is out of business.

In its rawest form, a fundamental investor looks at the expected cash flow stream of a company and uses a discount rate to determine what that income stream is worth. The big question is, what should the discount rate be? The same as you get on a GIC? A big manufacturer will likely not go under in the foreseeable future (unless your name is GM or Ford), so the predictability and reliability of that income is not much worse than that of interest income from a Government of Canada bond. Thus the discount rate may equal the bond's interest rate. On the other hand, SNC's income is a lot less reliable and predictable, it may change by tomorrow. So, maybe SNC-Lavelin's discount rate should equal that of a 'junk-bond'

But how then do you valuate an oil and gas company or a mining company? A resource company produces oil or gas or ore – its earnings are a function of how much it produces and how much it costs to produce it. So, although commodity prices are volatile and depend on the overall state of the economy as well as the supply of the commodity in question, you can generate a profit stream and calculate its discounted value. But does that reflect the true value of such a resource company?

Not really. The profit statement of a manufacturer assumes that the costs of equipment wear and tear are built into the profits. For an oil company, that would be the depletion value of its reserves. However, an oil company also buys new land (mineral rights) to drill on and it drills wells to prove reserves underlying those lands. The reserves added to the company this way often outstrip the amount of oil produced. So the company's assets may have increased in value by its exploration operations; especially when the costs of acquiring the lands and the drilling of the wells was less than the value of the newly added reserves.

A real estate conglomerate, such as RioCan or Brookfield, earns money from its rental operations: the positive cash flow resulting from the rents minus maintenance, administration, property taxes and debt servicing costs. But the value of the underlying assets: the apartment buildings and land, increase over time. A large portion of such a company's profits lie in the value increase of their buildings and may exceed that of their long term predictable rental operation discounted profit stream. The evaluation of real estate companies and that of resources companies are in some ways more alike than when compared to that of a manufacturer.

This is why investing in the stock market is so complex. You have to know and, as Warren Buffett says' understand a company you invest in. You have to know how to value that investment visa-vie other investment opportunities. Is it better to invest in an oil company than a bank? But even worse, even if you understand a company's business model and you can apply a discounted value on it; the market with its numerous perceptions – real or imagined, may price the company quite differently – sometimes way above your valuation, sometimes below. The market is not 'efficient' and thus you as an investor (not a gambler like many others that run with the herds), will have to decide whether the price you pay is 'right'!

In that lies Warren Buffet's genius. He knows what he 'understands' and he knows how to value the companies he 'understands'. If he does not understand a company, he stays away from it. And… even Warren makes mistakes. So how about you?