Saturday, December 24, 2011

Rough year

Well this was a rough year for investors including myself. The TSX was down 11% or so for the year and including dividends of approximately 2.4% total return was negative 8.5%. My stock portfolio was down 7%. Oil and gas were the worst performers followed by insurance companies and banks. The stars were REITs, telecom and pipelines while strangely enough real estate giant Brookfield lost close to 14% including dividends. The U.S. market outperformed the Canadian. Emerging markets lost big.

Also, the power of diversified portfolios was shown once again. On a net worth basis, I was down 4.8%. Thank you Mr. Real Estate. Not that real estate was such a grand performer overall. My Alberta property values barely budged but there was decent rental income. Vacancies are low but rents have not significantly gone up over the last 3 years. This summer showed some improvement and I hope this trend will continue next year along with a resumption of appreciation.

I wish things were more uplifting, but there is no doubt in my mind that this was a tough year. The Santa Claus rally was good for moral, but I don’t know whether it will carry through into the next year. Europe is quieting down, the U.S. economy is improving and Canada is holding its own.

My outlook for 2012 posted last month stands - for now and maybe another week or so. :)

Wishing you all a Merry Christmas and a Happy New Year. We’ll resume in January with the continuing saga of building wealth.

Monday, December 19, 2011

Godfried’s Low P/E with moderate dividend yield portfolio

Earlier on we discussed how to allocate funds in a portfolio based on multiple cash flow streams. Now we’re focusing on a strategy you may use to invest in specific stocks. Yes, you got it right, here we’re trying to outperform market index ETFs.

If you liked Ken Fisher’s “Market’s never forget…” then you want to read O’Shaughnessy's updated “What works on Wall Street”. Ken Fisher shows that ‘this time is not different’ based on selected headlines supplemented by some historical statistics. If you want to see lots of numbers and historical stats on various ‘value investment metrics’ then you have to read O’Shaughnessy.

Based on U.S. stock market database ‘Compustat’ dating back to 1963 and on CRSP (Center for Research of Security Prices) dating back to 1927, O’Shaughnessy shows that over the long term (10 years and longer) stocks selected based on value investing metrics such as low P/E; Price to Book Value; high(er)Dividend Yield; and high Interest Coverage do outperform the average stock market indexes and their emulating ETFs significantly.

He also shows that the risk with stocks selected based on some of those metrics is actually less than that of the market index stock basket and for sure they are less risky than high P/E and no-dividend paying market darlings. O’Shaughnessy is not alone in this; other authors often mentioned on this blog such as Dreman and Siegel show similar stats, although in less detail and with data that does not include the last 10 years.

All these authors show also that ‘the efficient market theory’ does not really work. There are many ‘Black Swan’ events that do not fall in the Gaussian probability distribution and that disrupt portfolio performance. O’Shaughnessy shows that bull markets and bubbles go through varies stages of irrationality and that the emotional investor is easy prey to those who stay cool and unemotional. I show below some of O’Shaughnessy’s stats for the lowest P/E decile of the U.S. stock market:

For relevant metrics, such as P/E ratio or dividend yield, O’Shaughnessy, subdivides the stocks that make up his database in 10 equal sized groups (deciles). When analyzing the impact of P/E on say stock market performance, he measures the P/E of each stock in the database and then groups those stocks in ten equal sized groups (deciles) ranging from low P/E to high P/E. From January 1, 1964 until December 31, 2009 a portfolio of all stocks listed on the New York Stock Exchange returned annually 13.26% while the stocks comprising the 10% of stocks with the lowest P/E (decile 1) returned 18.23%. 

The risk or standard deviation from this average historical return is 18.45% (above or below the average return) for the decile 1 stocks compared to 18.99% for the entire market. In other words: a return of 18.23% + or -18.45% for 'decile 1' versus 13.26% + or -18.99% for the overall market (All Stocks).


From: O'Shaughnessy: 'What Works on Wall Street' (published in 2011).
  O’Shaughnessy’s data also gives an idea about investment risk through various parameters such as the standard deviation, tracking error and Sharpe ratio. If you invested in the decile 1 stocks for 1 year (according to the data table above, your worst annual return if you hold the stocks for 1 year is minus 52.60% (that was in 2008-2009 recession); the best return, on a 1 year basis, is 81.42%. Based on a holding period of 10 years, the worst annual return was positive 6.07%, i.e. you would have made at least 6.07% ROI during any 10 year period since 1963 and as high as 28.2%.

The figure below shows the chance of beating the ‘All Stock Portfolio’ over time and by how much.


From: O'Shaughnessy: 'What Works on Wall Street' (published in 2011).
 Over any 10 year holding period since 1963 a decile 1 portfolio would have a 99% chance of outperforming the ‘All Stock’ benchmark by a whopping 4.63%. This shows the benefits of investing with a long term time horizon but also the fact that investing systematically in low P/E stocks should help you to outperform the overall stock market. If you want to learn more of these statistics and their merits, you’ll have to get O’Shaughnessy’s book. Here I just want to show you some statistics on low P/E stocks and how I used this to create my own portfolio.

I used the GlobeInvestor Gold Advanced Stock Filter. I am not interested in micro-cap companies so first I filtered out companies with less than $200 million market capitalization. The Globe’s database came up with 531 common shares, including ‘A’ and ‘B’ shares. ‘B’  shares are typically non-voting shares in family owned enterprises. Owning stocks without voting privileges is something I do not recommend because it means that management is not accountable to you the share holder but rather to the family (‘A’ share owners) that is in control. Examples of investors being fleeced by the families are recently the holders of Shaw B shares or those of Magna class B shares. Then I proceeded to identify the 10% of  TSX stocks that trade at the lowest P/E (price-earnings ratio)

I came up with 67 stocks that traded at a P/E of 8 or lower. I refined the search by demanding some dividends (but not excessively high dividends which may point to troubled stocks). The dividend yield had to fall between 2% and 6%. This resulted into a list of 26 stocks. I whittled the list further down by omitting ‘B’ shares and by ignoring companies I considered low quality. The end result was:

Toromont TIH
Sherritt International S
Rogers Sugar Inc RSI
Churchill Corp CUQ
Brookfield Office Properties BPO
Cannaccord CF
Canfor Pulp CFX
Bird Construction BDT

8 Stocks! I also searched for stocks with a P/E below 11% and a yield between 3% and 6% which counted 45 stocks, including many banks which I already owned in my other holdings as well as several of the stocks above. But 3 new stocks stood out:

Canadian Helicopters CHL.A
Cervus Equipment Corp CVL
Corus Entertainment CJR.B

Although Corus is a ‘B’ share which is controlled by the Shaw family, its other financial ratios (EBITDA, interest coverage, return on equity, etc) looked attractive enough to overlook the ‘B’ factor. So these are the 11 stocks that I selected for my ‘low P/E with moderate dividend yield’ stock portfolio. I will start this portfolio in real life for 2012 with equal proportions invested in each stock. At the end of 2013 I will revisit these stocks, rebalance them and/or replace them if they no-longer meet the above mentioned criteria.

We will also revisit this portfolio at various times during the year to track their performance based on a ‘$100,000’ portfolio starting January including commissions and dividends. At those times I will not make any changes to the portfolio itself. Note, I make no recommendation regarding these stocks; I am just following a strategy and testing how it works. I will own these stock in real life but I won’t disclose the real size of this portfolio – let the games begin.





Wednesday, December 7, 2011

Bet on growth because that is where we’re heading.

The European debt crisis seems to be stabilizing; a solution seems to be in sight. We’re all sick and tired of the shrill screams of pundits that, no matter the topic, always shout “Too little too late!” Whether it is a political commentator, a member of the opposition, financial pundits or ratings agencies, their entire vocabulary, no matter the topic, seems to be “too little too late!”

S&P and Fitch have lost so much credibility that even the threat of downgrading the ratings of several European countries at once results in a mere shoulder shrug by the markets. These agencies are the real losers of the debt 'crisis'. Investing is about confidence and the ratings agencies have shown their shortcomings and their hysteria. What else can it be called? They can no longer be trusted.

Think a tiny 30 years back, when inflation in Canada and the U.S. was over 10% - the early 1980s. Did government bonds then yield below 7%? Of course not! They were in their teens and did did that bankrupt Canada and the U.S.? The answer is ‘No’, so why should Italy go broke if their bonds yield rises above 7%  for a few panic days ?

In the past governments defaulted on debt not because they could not print money to pay the interest. They defaulted because they no longer possessed the political will to make their debt payments. Yes, default was the remedy often choosen by the debtor country – they basically said “Sorry guys we’ve decided not to pay you back”. So short are our memories as Ken Fisher states. Of course, lenders will not lend any more money to the ‘defaulting’ country. But... just wait a few years and after the election of a ‘new government’, lenders are at it again. There always seem to be suckers to lend governments money.

The real issue in Europe is that if Greece or any of the other Euro denominated countries would default, that this would reflect on the other Euro countries as well. No longer can any Euro country default by itself and no Euro country can inflate their debt into oblivion by itself. This in effect makes European debt more secure! It also explains the reluctance of the other European countries to let the ECB print money to devalue Greece’s and Italy’s debt – it would cause inflation and poorer (i.e. more expensive) credit for all.

If the weaker countries need help from the EUC, the ECB or the IMF, it comes with strings attached – the price is less fiscal sovereignty and more power to the EUC overall. It looks to me that Europe under leadership of Germany and to a lesser degree that of France is moving towards a community with stronger financial oversight of its members. This, in the end will make Europe even stronger. Yes it has a $500 billion stabilization fund and now it provides the IMF with another $200 billion Euro in back-up funds to support the debt of its weaker members. The total backstop for 'risky' loans is now approaching the magic $ trillion line, but… That is far for the printing press output in the U.S. which is a somewhat smaller economy than that of the EUC. Yet, the U.S. printed close to $7 trillion TARP money not to mention market manipulations such as operation Twist and QE2.

Neither region is truly in trouble, they are bickering politically and the markets don’t like bickering. But in the end, the bickering may not change a lot in Europe’s debt load nor that of the U.S. The austerity plans may slow down debt growth but it also will reduce government spending and thus economic growth. It is really economic growth that will bail them out some years from now. Here is something to consider for the doomers: corporate profits are growing; corporate jobs in the U.S. are on the increase the only reason the total number of job growth is stagnant are government lay-offs that counteract all the growth. When we’re limping on one leg, is it any wonder that we go slower than when sprinting on both?

All the whining has created uncertainty in the markets amplified with the remnants of the 2008-2009 stress syndrome The result is that markets are willing to lend money to, out of all governments, the U.S.  at a near zero rates – that is before taxes and inflation! We’re so afraid of risk that we don’t want to pay for tax-advantaged dividends and we’re pushing stock down market valuations and commodity prices by sheer anxiety.

In the short term, markets are driven by emotions, by fears that ‘this time it is different’ and that the ‘end of the world is near’. Don’t tell me that the average investor is that smart when he/she cannot even outperform mutual funds that are handicapped by MERs and commissions. Don’t tell me that ‘the efficient market theory with smart well informed investors’ is here at work. In the short term the market is a ninny! Over the long term it will come to its senses and it is likely to go even overboard to the upside!

A truly smart investor will realize that the current anxiety will come to an end. Remember the debt-ceiling debacle, the down grading of the U.S. credit rating? Is that why U.S. treasuries trade at such incredible low yields? The world was supposed to have ended already many times over if you believe the politicos and pundits; strangely enough it hasn’t happened. We should be in a major depression if you believe the Harry S. Dents, Rosenbergs, Roubinis and other self-professed doctors of doom! It hasn’t happened. Instead the U.S. is growing, Canada is growing and even Europe is not in a recession yet.

I think 2012 will be better than 2011 and 2013 will be even better yet. I think the negative thinking will exhaust itself. Markets will realize: ‘he we haven’t died yet! Wow!’ then they will regain their confidence or become even over-confident. Markets will first drive stocks to fair and then to excessive valuations. You can buy now to profit 2 or 3 years from now; you can buy now to enjoy every increasing dividends for years to come. But don’t forget that right now dividends are popular and that the real companies in the penalty box are ‘growth stocks’ and U.S. financials. Don’t forget to place a few bets on growth because growth that is where we’re heading.

Tuesday, December 6, 2011

Do you think the world does no longer exist three years from now?

There is a good chance that three years from now Yellow Pages still exists, but holding on to its preferred shares is kind of painful. Would I buy them today? Not likely, but when I bought these preferreds they looked OK and today I have the choice to lock in 80% plus losses or to keep on collecting dividends until it goes kaput or the preferreds expire and I will get $25/share principal returned.

The choice is not difficult for me, I’ll hold on. Yellow Pages or better Yellow Media is a sign of the times. Today’s world is emotional; the air is filled with crises, panic and conflicting opinions and we assume that everything will go to hell in a hand basket. But do you really think we’re dead 3 years from now? Do you think we will lose all our retirement savings? Will Europe go under and what does the new world look like other than a small stack of smoke and with only small amounts of land still sticking out above sea level due to global warming? :)

Come on, we have never lived as prosperous as today! Yet, at the same time we’re scared by everything that can go wrong. Analysts and media make us build in pricing for the worst case scenario while trying to convince us that only they can foresee the future and provide you financial security… for a price. Many of these people are just observers standing on the sidelines; they are not the entrepreneurs that build companies like Blackberry, Apple or Microsoft. They do not even run the Royal Bank branch nor Seven-Eleven on the corner of your street for that manner. The same is true for all those much-quoted academics that watch from the economy’s sidelines without really participating. They are the worst backseat drivers you can find; they are like the obese soccer fan who can barely run, let be that he can play the game as well as the players he critiques.

The investor invests because he/she believes in the future why otherwise not stash all your money under the mattress or invest in U.S. treasury bills for 0.5% return which is 0.3% after taxes and minus 2.2% after inflation. They call THAT preservation of capital? No the investor knows in his/her heart and based on historical data that these times will pass too and that since nobody else wants to buy, this is the time to put his/her money down to work for the future. Corporate North America makes super high profits yet hardly anyone wants to pay for those profits even if the dividends and earnings yields are blowing us out of the water.

But when you every day go to work, do you feel that your job will be gone 3 years from now? That the company where you work will not be there 3 years from now? Why work for a lost cause? Why would senior management work so hard for a lost cause?

The answer is that nobody who works at a company, being manager or floor worker, truly believes the world is coming to an end. Look around in the company and see hard working co-workers laughing at the water cooler during coffee breaks. All of a sudden, the urgency and doom & gloom of the stock market are forgotten and you’re living in the ‘real world’. The thought that you can’t live in your home three years from now; that your kid’s daycare will be out of business tomorrow sounds like utter nonsense. Yes there is a remote chance that the world will go kaput in the next three weeks; probably because we’re hit by this one-in-a-trillion-chance meteor. But really, overall things have been very good as long as you don’t believe the news; the observers that always seem to see the glass as half empty. Investors, entrepreneurs and people who work in the real work place every day right besides you, know better. They believe in the future and they know these ‘bad times’ will pass and replaced  by good times. If the world evolved and improved year in and year out, for hundreds of years, then so will it likely in the future.

These are the times to invest in the companies that you believe will be around. Invest in companies that will not be around just a year or three from now - the 'fads'. Rather invest in companies with a real future that will be around for decades. That was the mistake I made with Yellow Media - its business model was no longer working and its future dim. Tellow Media will have to prove its new model is workable and that they can make the switch. Over time people will realize that things aren’t that bad after all; that things keep on getting better every day and that good investments will increase in value.There will come a day that even the sideliners realize that things got better. By that time you will not only have collected oodles of dividends but it will also be the day that your investments will have risen to reflect their true value. That is the time to take profits – many, many profits!

A diversified portfolio of real estate and paper securities makes sense

In earlier posts we have made various comparisons between investing in real estate and in paper securities such as stocks and bonds. One such major difference is that real estate, in particular rental real estate, is a business that , apart from money, requires your time and sweat; i.e. labour, while paper securities provide a return without your labour;  you can receive dividends without having to leave your recliner.

Real estate gives you direct control over the investment asset while stocks and even more so bonds give you little or no control over the asset (other than the right to sell). Also, an investor in real estate can regulate his/her level of risk and cash flow through leverage. With paper securities leverage is often built in and beyond the control of the investor. For example, a bank may have 10 times as much debt than shareowner equity without the investor having a say other than the buy/sell decision.

Here is another matter to consider which relates to diversity. Real estate is local; its performance depends on the economy of where it is constructed. Valuations in Vancouver vary greatly from those in Calgary. Based on affordability, Vancouver real estate is extremely expensive – close to if not in bubble territory - while Calgary is one of the most affordable real estate markets. Vancouver real estate is dependent on overseas investor capital while Calgary’s reflects a combination of inflation and commodity pricing, in particular that of oil and gas.

Compare this dependence on location for a real estate investment to that of the stock market, especially in today’s volatile macro-economic crises. Thethe performances of stock markets througout the world is so strikingly similar that many financial advisors prefer to invest in different sectors rather than regions to build a diverse portfolio.

Canada’s TSX may be a bit of a maverick in this regard as it comprises mostly financial, natural resource and real estate stocks. It is closer correlated to Alberta real estate than many other stock exchanges. U.S. or Chinese securities have a much higher correlation to the global economy. Thus, when investing in real estate, be aware that you are dependent on the local economy which may be quite different from the national or even more so from the global economy; the opposite is true for paper securities. Now that you are aware of these differences, does it not make sense to diversify your portolio in equal weights of real estate and paper securities?