Sunday, January 29, 2012

Correlation between asset classes

We have recently taken a look at allocation of asset classes. As a Calgary based investor, I have always been concerned about how similar or dissimilar the appreciation has been for different asset classes. To do so, I opened my spreadsheet that compares the Dow Jones with Calgary Real Estate prices (for a Single Family Dwelling). I have updated it for 2011 and… I have added a 3rd asset class: Gold.

The results were striking. Between 1973 (the start of my data base) and today (year end of 2011), $1 invested in Calgary Real Estate has appreciated to $17.46 while the Dow Jones appreciated to $14.36 and Gold to $16.92. Isn’t that something! All three classes show over time a very similar amount of appreciation (not counting net rental income and dividends). But the path that each class followed was quite distinct (see the graph below).
 Figure 1 - Appreciation of $1 invested in Gold, Dow Jones and Calgary Real Estate
A numerical expression of how distinct their paths were is called correlation. The poorer (lower) the correlation, the better for diversification. Gold is poorly correlated to the Dow (0.50) and it is a lot better correlated , but far from perfect, to Calgary real estate (0.84). The Dow and Calgary Real Estate are also showing a poorer correlation (0.82) than gold and real estate.  

The graph above shows that while the Dow was up big time in the 1990s, real estate was subdued; yet from 2000 until 2007 the pattern reversed showing rapid real estate appreciation. Gold was even more subdued in the 1990s  than the Dow and it performed also poorer than Calgary Real Estate. Yet since 2000, Gold has taken off like a rocket.

We have discussed risk before, but not in terms of standard deviation. Let’s see how the asset classes (Gold, Dow Jones, Calgary Single Family Dwelling) compared on that basis (table below).

Figure 2 Returns and Risk of Asset Classes
Not counting dividends and net rental income, there seems to be a relation between risk and reward. Since 1973, Gold has had the highest average annual return (10.2%) and Calgary Real Estate has had the lowest (8.5%). But real estate also experienced the lowest volatility (S.D. =9.7%) while Gold the highest (23.2%). During gold market downturns losses are typically as high as -36% (calculated based on average return and 2xS.D.). Yet, somewhat contradictory, the worst annual return experienced in the real world was a modest -25%, i.e. only slightly worse than Calgary Real Estate in 1984. The Dow Jones lost most between 1973 and 2011 with 34% in 2008 alone. On the positive side, both in real terms as well as when calculated for a typical bull market (Maximum Expected Return), gold has the best upside. So, a bit of the ‘Risk versus Reward’ equation is probably at play here.

In terms of appreciation, gold has since 2001 appreciated much faster (17.1% annually) than its bench mark rate of return (10.2%). This begs the question: 'for how much longer?' Calgary Real Estate experienced explosive value growth from 1996-2007 (12% annually) and in particular during the 2006 and 2007 years (39% and 27%). After 2007 appreciation has flattened to around 1.3% per year and the asset class appears to revert back to its long term bench markrate. Still an average long term annual appreciation of 8.5% (which equals a compounding rate of 8%) is still astounding. However, after removing the effects of oil price shocks a more normal pace of appreciation (3%) is revealed similar to what Calgary experienced between 1983 and 1993.

Finally, the stock market experienced appreciation above its 8.6% benchmark rate between 1994 and 1999 (25% per annum), followed by a volatile but modest actual appreciation from then onward (2.6%). Thus, it appears, that the stock market has now underperformed for the longest time, while Gold is an ‘accident waiting to happen’ and Calgary Real Estate is in a ‘Steady Eddy’ mode.

When looking at these three asset classes combined, they appear to create excellent components for a diversified portfolio. We also have an idea, based on the principal of ‘reverting to the bench mark,’ as to which of the three classes appears most promising and which appears most risky.

 Another other asset class that we have not yet mentioned in this post,  but that also has overshot its long term benchmark by a wide margin is bonds, in particular North American government bonds. With inflation not far away, these bonds are also due for a period of significant negative adjustments.
Nobody can look into the future but maybe we can extrapolate some of the trends we see here to create a suitable asset mix for the foreseeable future while controlling our risks. Gold has always played a very subdued role in my portfolio and I am reluctant to add a lot to my portfolio at this stage of the market. Yet, once gold has reverted to the benchmark or to even lower prices, I will definitely add it to my portfolio mix.


Saturday, January 28, 2012

Portfolio Allocation and Performance I

 Recently I have started to analyze my portfolio performance as far back as 2003 (that is how far my Quicken files go – older files got corrupted and the data was basically lost). What motivated me? Well, simply the current stock market and all the screaming media types we have been coming across during the current market hysteria. Also, my investment reading list has focussed a lot on long term performance and as regular readers of this blog may have noticed, Jeremy Siegel, David Dreman, Ken Fisher and more recently James O’Shaughnessy are amongst my favorite authors. I have always been aware of the importance of asset allocation, it is kind of an intuitive truth to me, hence the title of this blog. However, I have not read a lot of books on asset allocation until recently.  I looked for one recommended by some sophisticated fellow investors and came across William Bernstein’s ‘The Intelligent Asset Allocator’. I am sure that any resemblance with Benjamin Graham’s ‘The Intelligent Investor’ is purely coincidental (yeah right!).

It was definitely a book worthwhile reading and it seemed to draw on similar data sources as James O’Shaughnessy's work.  One of the main messages I took away from it was that diversification works and may even augment performance during rational times. However, during stock market panics there is little protection against a falling portfolio value. At best your paper value losses during such events are about 25% less than that of the overall market. The 2008-2009 collapse was the the most severe since the Great Depression with some markets losing over 55%. Contrast that to the heaviest losses reported by William Bernstein of 35% and more typically of 25%. Of course, over the period that follows such a market collapse and if you held on rather than sold during the collapse, you’ll do just fine. If you have the nerve to add cheap stocks at heavily discounted prices during such a bear market you will do even better.

How was my own performance over the last 10 or so years? Although I am suspicious of bugs in Quicken’s software (things don’t always ad up correctly) it is the best personal finance software around that I know. One of its newer features I just love – it is a series of asset allocation and investment portfolio performance graphs. Pity it’s tracking of non-stock market investments such as real estate is not that good and it is not included in the above mentioned graphs. So, we’re just looking at the performance of my investment portfolio and try to break it down so we can see the effects of stock allocation on performance. I’ll show a fair bit of graphs, so we’ll spread this topic out of several posts.






Portfolio Allocation and Performance II



Here is my portfolio performance expressed as $10,000 invested in May 2003 which would be worth $45,000 today. Over the last 9 years the portfolio's value quadrupled or in other words it doubled every 4.5 years and then some. Using the rule of 72, that suggests an annual rate compound rate of return of 72/4.5= 16%. Not bad for a stock market that many claims to have resulted in an annual return of 3-4% over this so-called 'lost decade'.

So does that mean that this blog writer is an investment genius? I wouldn’t count on that!  Some, or better a lot of serendipity was involved. In the beginning of this decade I worked for one of Canada’s premier petroleum companies; in my books it is ‘the best’.  I received options and participated in the company savings plan. You may recall my earlier postings that state that with normal savings and returns you will become 'well off', but that to become truly wealthy you need a break. Many people get breaks during their life and do not take advantage of it. I described a number of these breaks and how to use them to your benefit in earlier post; I certainly used mine. My break was my employment at this great company. But already in the 1990s did I overweight my investments in oil & gas – a sector I was quite familiar with.  Between 1998 and 2008 the sector exploded and I certainly did profit.

The graph above shows how I fared without the oil and gas sector investments. Now, $10,000 invested went to $18,000 in 2012 – not quite a double. So, for convenience sake let’s assume I doubled, which results in an annual compounded return of 72/9 = 8%. Ok. Ok!! I still outperformed the stock market but by a lot less. Let’s dig in a bit deeper and see what is left of this investment genius after that!  Let’s look at what I did between May 2008 and today.

Oh, oh! The ‘genius’ underperformed!! How smart is he now? $10,000 went to …. $10,000. No losses no gains!  What happened?  Answer: those same oil and gas stocks underperformed! Although I did cash in on some of the profits between 1998 and 2008, I was still on overweight in 2008 -2010. Thereafter, in the summer of 2010 Oil&Gas really started to really underperform. 

Next question is, then how did my non-oil&gas holdings perform between 2008 and today? Well look at the figure above. Now isn’t that interesting?  Those investments outperformed the market until the Spring of 2011. In fact if you go back to the non-oil&gas portfolio graph of 2003-2012,you can see that another big change happened around September 2011. So lets discuss that in the next post.

Portfolio Allocation and Performance III

I thought to leave this graph for last. My performance over the last 12 months! We all freshly remember this summer’s tribulations focussing one day on U.S.  debt load and political paralysis, the next on Greece and the European debt crisis and before the day was over we fretted about a collapse in the growth of emerging markets, specifically a hard landing in China. While pundits announced sagely that the ‘end is near’ yet again, stock markets experienced a significant correction if not a mild bear market. In September, I decided that the risk of actually ending up in a severe bear market was too great and I removed the riskier assets, in particular oil & gas stocks from my portfolio. My cash level, already 15% jumped to 30%.

 I knew, there was a new risk. Not one of losing a fair bit of net worth (temporarily) in case of a market collapse but the opposite: losing in upside because nearly 30% of my portfolio would not take part in a possible market rally. Hence the portfolio’s under performance.

As of today, I am still struggling with my real emotional motivation about this move. Was it, what behavioral finance experts call “recency”, i.e. the effect of a recent occurrence in the investment environment (the 2008-2009 crash) that influenced my thinking more than the long term investment history justifies or… was it a truly calculated move because of my changing investment requirements (I am getting older and maybe I should consider a 'lower risk' profile).
So over the last decade or so, overall performance of my portfolio was tremendous. But there were some major asset allocation shifts and changes in specific market sector performance that affected this overall performance. Investment performance, as James O’Shaughnessy points out, is to be compared to benchmark performance. Both O’Shaughnessy and William Bernstein point out that performance of an investment class or type always reverts back to its long term median annual return (the benchmark). From 1998 until 2008, the oil & gas sector outperformed its benchmark by a large margin; after 2008  its performance has coincided with the overall market and lately it has underperformed. The sector is in the process to revert to its benchmark. As far as I can see, with the economy placing a cap on oil prices and with gas prices near a 10 year bottom, this process is likely to continue for some time. But, I would not bet the barn on that.

The risk of a market crash and double dip recessions are on the decline and we seem to be in a grinding slow moving bull market that is climbing an enormous wall of worry. Overall, stock markets have underperformed their benchmark (7% plus inflation), and based on the principal of reverting to the benchmark, there is a good chance we’ll do better in the future. Yet with investor’s sentiment turning rapidly bullish (though not extremely so), the market could do the opposite.
The other principal we have learned is about defining risk. The main risk about investing in the stock market lies in its volatility and the time it takes to recover from any temporary decreases in portfolio value. This is often expressed in terms of the standard deviation of the investment type from its benchmark. I hope to discuss this topic in more detail in future posts but for now, one could describe it as follows. O’Shaughnessy calls its: ‘Minimum expected (annual) return’ and it basically describes the average fall (bear market) of an investment type based on historical performance data.

Take the next example: a portfolio of low P/E stocks has an average annual return of 18.23% and a standard deviation of 18.45%. Then the value decline one should expect in a typical bear market equals the benchmark rate minus twice the standard deviation. In our example that would be 18.23 – 2x18.45 = -18.68%.  However, the worst historical performance measured between 1927 and 2011 in a single year was a fall of 52.6% (call it a ‘black swan’). That occurred in 2008-2009 (not surprisingly). The best performance for this Low P/E category was + 81.42% for the 1927-2011 period.

The risk of losing 52.6% in one year is the motivator for a diversified portfolio. Diversification is achieved by investing in different asset classes or investment types. Most of the research on this has been focussed on stocks and bonds. Very little is known about the risk profiles of real estate, but just looking South should remind you that risk is everywhere. 
My conclusions: an investor should aim to have a well-diversified investment portfolio and as shown earlier, shifts in the allocation of the various investment types (which should have widely different performance patterns – or have a ‘poor correlation‘) is key to surviving (but not necessarily avoiding) significant market down turns. The latter are usually highly emotional and irrational events. After a time of above average investment type performance a reversion to the benchmark should be anticipated, i.e. a period of underperformance and the asset allocation should be based on that expectation. At the same time, dramatic asset allocation changes, such as going to high cash levels, may result in severe underperformance. This may be justifiable in a period after experiencing excessive profits, but overall it is best to stick to your long term allocation targets with minor adjustments.












Saturday, January 21, 2012

The Pipeline Debacle

First Keystone now Gateway appears to be targeted by environmental interest groups – not only Canadian ones but also those funded by foreign so-called charitable organizations. It is not that oil companies are always innocent bystanders but I would surmise neither is any other industry group.
Yet, oil companies seem these days to carry the brunt of the activists. Especially Canadian ones, not because they are polluting more than others or because Canada is a fascist dictatorship, but rather the opposite. Canada's oil industry is paying more attention to environmental regulations and  Canada is a democracy contrary to many other oil producing nations, and thus  it is an easy target. If activists tried to pull off similar tricks in say Saudi Arabia or Venezuela, they likely would not experience the end of the day, so to speak.
Many of the activist groups seem to think that by focussing on the pipelines and other Canadian mega projects they can stop consumers from using fossil fuels and that those fossil fuels in their deluded dreams are the culprits causing that elusive and difficult to prove issue of global warming.
As pointed out by many geoscientists, climate has changed as long as the earth has been turning around. Whether CO2 or another greenhouse gas released by mankind is even influencing the climate remains to be seen. The evidence is basically inconclusive. Be that as may be, that doesn’t mean that we shouldn’t strive for a sustainable economy - that is being careful and wise in the use of our resources. Ironically, that would make economic sense!
The real problem with many of those activist groups is that they are ideologically driven and that many have been involved in those games since their socialist high school days. They are frustrated by their never ending fights and continuous losses. Now they are trying to stop the world from going around – in particular they dream of fossil fuel free energy sources. Problem is, there are no fossil fuel free energy sources that are large enough. Even the much lauded electric car, and the hydrogen fuelled car before it, needs in the end a true energy source to generate hydrogen or electricity.  Unfortunately the true (main) energy source for electricity and hydrogen are once again coal, gas and oil. 
Yes, we have wind energy and solar, but it is not so easy to energize the entire world with it. In fact it is not even enough to energize the existing demand for electricity generation let be that it also could fuel the entire transportation system.  Even if you would ad, heaven forbid, nuclear energy you would not get even close. And really, would you want a hundred tower windmill farm in your back yard, or many square miles of solar panel farms to look out over?  What about nuclear waste disposal adjacent to your summer cottage?
We love to hate banks and we love to hate the oil and gas industry, but really we’re all depending on them. Even the activists drive or fly to their conventions and demonstrations using fossil fuels. Man over time has become increasingly efficient in its energy use, but simultaneously our lifestyle needs everyday energy for yet another gadget. Add to this the emerging market population who also would like to enjoy a lifestyle such as ours; top it off with a still increasing world population and you see why energy and consumption are becoming such hot buttons in spite of our efforts.
 Most oil patch geologists and engineers that I know love the outdoors; individually they are all very responsible people – however, they do tend to get swept along with the drive to do things quickly and cheaply in order to enhance the so-called bottom line. But that is the capitalist way we’re living and operating in – it is not just the oil industry that is guilty here. We all are, including investors who want ever higher quarterly earnings and consumers who want vacations in Thailand and Hawaii.  You may want to blame the overpaid execs but really the buck often stops with you – consumer, investor, whatever.
Many of today’s anti-pipeline groups are funded by billionaires such as Intel’s Moore family. Guess what? Remember the high tech boom?  Dot.com companies?  Ring a bell?  Wasn’t that capitalism and greed and innovation? Not only that, but a lot of manufacturing and high-tech booms of the 1990s along with the China explosion and the low inflation era of said 1990s were dependent  on cheap energy prices.
The current low gas prices in North America are an aberration due to the landlocked gas reserves on this continent combined with the success of the multi-stage fracturing technology (invented by those same ‘evil’ oil and gas companies).  But worldwide, energy is getting ever more expensive.  According to several economists, including Jeff Rubin, the 1990s boom was based on low commodity prices, in particular oil and gas. But these cheap fossil fuels are now passé and only the deeper and lower quality; more expensive hydrocarbons are now brought to market.  Jeff Rubin went so far as to state that the high oil and gas prices of the 1970s and again in the early 2000s are the real culprit of economic malaise and that the chicanery of the banking industry during the financial crisis was just a sideshow.
You may not agree with this interpretation, but with North American activists trying to interrupt the supply of affordable energy by its manipulations in B.C. and Keystone and where-ever else they can cause significant havoc the outcome will be even less energy supply . To think that alternative energy can take the place is a pipe dream for at least another decade or two. Thus it will be just a matter of time that oil and gas prices will peak once again and the economy will tank again and again.  When that happens, don’t blame the big oil conspiracy; blame the Moore Foundation and similar institutions as well as their groupies.
This does not mean that Keystone or Gateway should go ahead without a critical review of its environmental and other impacts. To the contrary, but the current approval processes have nothing to do with technical and environmental issues rather it is an ideological circus that if not stopped will leave a very sour economic taste for years to come. As with the hysteria of climate change which took on near-religious proportions, the same self-righteous crowd now aims their negativity at the oil industry while forgetting that parable about a splinter in the neighbour’s eye and the beam in their own.

Wednesday, January 11, 2012

Big new hopes for U.S. housing


You may have read my earlier posts regarding the improving U.S. housing market and its potential impact on U.S. GDP. Here is an important tidbit from GlobeInvestor that supports this idea.

 By: DAVID BERMAN
12:28 EST Wednesday, Jan 11, 2012

Lennar Corp.’s fourth-quarter results are having a big impact on U.S. home building stocks: The S&P industry group rose 5.2 per cent on Wednesday amid the latest signs that the housing market is showing signs of life. In the case of Lennar, it reported that new orders rose 20 per cent in the fourth quarter from a year ago, suggesting that demand for new homes is on the upswing.
Of course, this isn’t the first rustling among home builders. The group has surged 80 per cent since the start of October, with big gains by PulteGroup Inc. and D.R. Horton Inc. contributing to the gains as well. Part of the earlier pickup was due to upbeat news on the U.S. housing sector – particularly the rise in housing starts in November and rising builder confidence.

Bloomberg News quoted Lennar’s chief executive as sounding upbeat as well: “As I look ahead to 2012, I’m cautiously optimistic that we’re seeing a real bottom form and we’re beginning to see a recovery. I feel that stabilization will emanate from the most desirable markets and spread slowly outward.”
Despite the strong gains by the S&P 500 homebuilder index, it is still 77 per cent below its high in 2005

Tuesday, January 10, 2012

Do not rush into REITs

There are numerous REITs (Real Estate Investment Trusts) listed on the TSX and knowing all their in and outs is too much unless you're specialized in it. To choose which one is better is even more difficult and these days I prefer investing into ETFs comprising REITs, in particular 'iShares S&P/TSX Capped REIT' symbol XRE. In general the largest REITs are usually of the best quality and many have their own area of specialty such as RioCan for shopping malls, BoardWalk for Western Canadian apartments, Canadian Real Estate Investment Trust (symbol REF.UN) for high quality retail, office, and commercial real estate, Calloway for senior housing, Brookfield Office Properties (well this is a corp not a REIT), etc. If you want to learn more about specific REITs check the internet or watch BNN Market Call that features sometimes money managers specializing in REITs and Real Estate investments. They discuss many of those REITs including the latest gossip about them. That is a great starting point for research.

The point I am trying to make though is that REITs are dependant on a healthy real estate market, some inflation and low interest rates. In the last year or so, many of those REITs have provided above average profits and now they are becoming a bit expensive. Yields are modest compared to the past and the payout ratios of several are streched. In other words, you may be buying high or near the top of the market and the risk of disappointment is high. REITs, utilities, pipeline and communication companies such as BCE are all priced at high PEs (prices that do not allow for any earnings disappointment). A trigger for a significant down fall may be increased interest rates and those, as discussed earlier, may not be that far off.

Finally, REITs such as Boardwalk and Main Street Capital are western based apartment operators. Oil prices may not have much upside in this economy and with new technologies North American markets may become oversupplied as happened with natural gas. Our markets are landlocked and with new pipelines to the West Coast and the Gulf of Mexico being the focus of much controversie, oil markets in North America may weaken significantly. This would undoubtedly also reflect in less Alberta jobs and rental demand, which in turn make investing in REITs such as Boardwalk riskier.

In my books, REITs, especially Western Canadian REITs, are a hold NOT A BUY.

Thursday, January 5, 2012

Many Guru’s like investing in energy, but…

 I am an oil and gas guy. I worked in the industry for over 30 years, since May 10, 1979 to be precise. “Oh Godfried”, the female followers of this blog may say, “But on your photo you look SOOOO good! Yet you must be a pretty old geezer”. My modest answer: “It’s the vitamins Ma’ am”. J

Apart from the BS’ing, I have seen a fair bit of the ups and downs of the oil industry over the years. That’s why I am not a fan of investing in junior oil companies. You’ll need, in addition to expertise, a lot of wind in your back. I have seen some very smart people bite the dust. Large companies have staying power, but they may also fall victim to a take-over.

Right now, the Alberta petroleum industry is not doing as well as the oil price may make you believe. The reason is that the oil industry has two legs; yes the oil leg is strong and muscular; for now. But the other one, the gas leg is shrivelled. So Mr. Petroleum is limping. The oil industry is not only capital intense, it is also ego-intense. If you think CEOs of any industry are egocentric maniacs, then the petroleum industry has a disproportionate number of them. Not just any entrepreneur can make it in this industry, many try though. I would say that Alberta’s Petroleum industry is as entrepreneurial as you can have it with many very smart people.
It seems easy at the end of a downturn to get a start-up going and then, along with all others, your company ‘explodes’ in the next oil and gas boom. But the tough part is the down-turn that unavoidably follows. During a boom, in addition to oil and gas prices, labor prices, drilling prices, land prices rise rapidly and simultaneously investors’ money is pouring in. Your new company’s shares are doubling and quadrupling. The ‘upturn’ is often one massive slugfest, but… something else goes up in this rising tide of wealth and that is the entrepreneurs' ego. They outbid each other for land at ever higher and crazier prices. They run all after the same ‘hot trends’ – just like ‘investors’ in the stock market. And then, a trigger-event – say a recession; a warm winter with an abundance of gas supply, or a new technology happens. The oil or gas price goes down and with that the profits of the new entrepreneur’s empire –the economics of their projects during the boom were often so marginal in order to get that much desired ‘growth’ that even a slight decline in oil or gas prices spells financial disaster. The next ‘black Monday’ has arrived with a vengeance. Somebody has to pay the piper and all those ‘hot entrepreneurs’ and CEO’s see their future crumble and succumb in Warren Buffett’s falling tide.

The last boom was from 2004-2008, when both gas and oil prices were high. It is not only the juniors that get caught in this crazy circus; large company CEOs are dragged along as well – especially those who want to leave a ‘legacy’ can do some really stupid things. My prime example is EnCana.  During the last boom it forgot all about the importance of diversification and to increase so-called ‘shareholder value’ it copied the strategy of other conglomerates. However, EnCana forgot that those other conglomerates were spread out over much broader market sectors than just ‘oil and gas’. EnCana in its vanity thought that it could enhance shareholder value by splitting off their oil and gas operations; yes they created Cenovus focussed on heavy oil with the remaining gas assets staying with EnCana. This was done at the veritable top of the oil and gas boom. And ‘nobody’ saw the 2008-2009 recession coming. The recession lowered energy demand in North America and both oil and gas prices fell. But to make matters worse, there was this new technology – multi-stage frac’ing or fracturing that allowed the old reservoir rock fracturing technology to revive. It enabled operators to fracture ‘tight gas reservoirs’ that were considered un-producible by generations of oil and gas people. Using the new technique, these reservoirs produce at high initial gas rates followed by a super fast decline rate. With good gas prices, the initial high gas rates could pay-off the well in just under a year and the rest, however small, would be gravy. And of course the ‘reserves’ that could be added to the company’s inventory (which determines its book value) were just incredible. The economics were slim, but the reserves…. Aaaah!
The stock market loved it. Next you knew, as with any new fad, everyone wanted ‘resource plays’; ‘unconventional gas’. Whole companies switched strategy overnight to join the band wagon. Non-performers like Talisman dumped many of their properties and bought into the new ‘unconventional gas play’ with a vengeance. EnCana bought up enormous amounts of tight gas holding land in Texas; and promoted pipedreams like ‘Cut Bank’ in NE BC. They locked in the gas price by hedging their production for many years out and to fulfill their obligations they had to add more and more production capacity. Many others drilled into the bandwagon as well – until the enormous initial gas supply combined with the Great Recession caused the gas prices to crash. Kaboom! Just then EnCana spun-off Cenovus! The timing couldn’t have been worse – but EnCana had one big reprieve – their gas price hedging program – it allowed it to keep on being ‘profitable for several more years while they kept on drilling until they hit the wall!  The gas price hedge programs came to an end and a hoped for recovery of gas prices had not occurred. The company got into the red.


EnCana was not the only one that got hit – so did numerous small gas producers. The juniors, along with EnCana had one thing in common – they all were focussed on gas. Many of the juniors hit the dust; while EnCana – no longer diversified – is rapidly becoming a speculative play on that elusive long-hoped for rise in gas prices. How any management team could expect oil and gas prices to stay high is still a mystery to me – other than the ever-present ego of executives blinded by the success of the ongoing 2004-2007 boom.  Dome, Home, Petro Canada, Ulster, Rio-Alto, Big Bear… do I have to mention more companies that all fell into the same trap – boosted egos that lost all sense of caution.

So, if you think that the same breed of managers doesn’t run the oil side of the industry then I have a bridge for sale in Manhattan. And guess what, the new technology to cause a possible oil price crash is here as well. Multi-stage frac’ing! This time not of tight gas reservoirs but of oil reservoirs. The concepts have been proven by companies like Crescent Point and copy cats such as NAL and PetroBakken. In the U.S. and in Canada the technology is gaining steam. In North Dakota the Bakken reservoirs are coming alive with a vengeance. Next are Colorado and Utah; old oil targets from many generations ago are coming alive again.  The U.S. is rapidly become a net exporter of oil again.
Today the tensions in the Middle East are driving up the oil prices. Yet, the new oil plays and their supply are rapidly on the rise; oil production in Iraq, Libya and Syria may soon resume and the Iran hot spot may cool. The new plays are not cheap though – more expensive than SAGD and Oil sands mining and this may place a bottom under oil prices.

But then so was there a bottom supporting the gas price that did not work – break even costs for gas projects are close to $6,50 per mcf  while the gas price is hovering around $3.50.  There may be factors for companies to drill longer than economically feasible such as stock-market-sexy reserves addition, Pugh clauses and of course the gas liquids. The same could be the case for oil and we may see a period of lower, more moderate oil prices in the not too distant future.

Yes, energy companies are undervalued right now, but don’t expect a dramatic recovery. Don’t run into the sector blindly because there are definite clouds on the horizon as described above. Also, with an era of lower, moderate oil and gas prices ahead along with an economic recovery that is likely better than many expect, industrial companies, manufacturing and high-tech are the ones most likely to benefit. I expect a resurgence of these sectors, especially in the U.S.  Also, with cheaper energy prices, the BRIC countries may resume rapid economic growth soon – both in exports and domestically. It is this thinking that mostly drove my November outlook for 2012 – I am still sticking with that one.

Wednesday, January 4, 2012

Lease that fancy car from yourself NOT from the dealer

My car lease is due pretty soon. I need only good quality transportation from point A to B and I am not likely to buy a Lexus, BMW or Mercedes because of the poor economics. But I also realized that leasing is nearly an artform.

The lease that the dealer offers you may be unsuitable. In fact try to compare leases by using 'residual value' and interest rates. Also figure out how interest is to be charged - over the new price of the car for the entire lease period or is there a reduction of principal and associated lower interest payments akin to a mortgage?

The idea behind the lease is that you 'pay for what you use' and that your capital layout is zero. In reality the lease terms offered by your dealer maybe so poor and/or the return that you get from the invested saved capital layout is so minimal that the whole thing is a money losing proposition.

I came accross this solution - be your own leasing agent! Very simple - you set the residual value of the car, you can determine this using the black book, or easier just to do a stab at it. Say you plan a four year lease. You could set the remaining car value (residual value) after 4 years of depreciation at 45% of the purchase price.

This is what you have to know when dealing with a dealer lease, your depreciation is set by the dealer and it is often not consistent with other dealers - consequently a low residual value results in much higher payments than compared to the expectation that a car will hold its value (high residual payment). In addition, when you trade in the car at lease end, you're supposed to get the trade in value (just like any other car). If you leave the car on the lease lot and walk away you may loose out on the difference between residual value and the actual trade in value. That difference can be in the thousands. I kid you not!

So you estimate the residual value after four years to be 45% of the car's purchase price. If you bought a $50,000 car that would mean you used up 1-45% = 55% of the cars original pruchase price or $27,500 over four years.

With a traditional lease, you pay the interest rate set by the car dealer - mine wanted 4.8% or 4 x 50,000 x 4.8% = $9,600. However, if by lease end you had paid off the car to its residual value of $22,500 you'd owe a lot less and amortarized you probably would only have to pay $6,960 in interest over the lease term. Even worse, if you used a LOC to finance the lease yourself, your interest rate would probably be 3.25% and you'd pay only $4,712.5 over the term of the lease - Ouch that is nearly $5000 less than the dealer's lease!

I figure that leasing the car from myself wil save me over $7,000 and... you can buy your lease out whenever you please, just pay off the LOC.

This is what you could do. Pay for the car cash and finance it through a secured line of credit on your house or on another property you own. Next estimate the value of the car that you use up over the lease term. In the above example that would be $27,500 divided by 48 months. To determine your monthly payment ad interest of around $4712.5/48 = more or less $100 (with a LOC the bank will calculate the interest every month for you to the penny). So that would be $572.92 (car usage) plus $100 (interest) or $672.92 as your monthly payment if you 'leased from yourself'.  Your car dealer would charge you a lot more for a $50,000 lease. The only negative is that you would have to pay GST (plus PST if not in Alberta) over the entire car purchase price rather than over the leased portion of the car. But that is minor compared to your total savings.

I hope that this is helpful. I am planning to do it this way myself. Just think of all the options I can add to my new car using the savings: heated leather seats, navigation system, bluetooth, sigh...



Monday, January 2, 2012

After the Gold Rush

Last August, I posted a warning about gold bullion and Gold bullion ETFs. The chart for gold showed a steepened price curve reminiscent of a bubble market pattern ('went asymptotic"). This was when gold traded near $1900  and I suggested to take profits and to wait with buying bullion until prices stabilized around $1400.

After hitting $1400 there is a good chance that gold resumes its appreciation at a highly respectable rate of 20% per year. A rate that would make most of us salivate. Well, we're now around $1500 and not far from the aforementioned level. Stay alert.

An alternative of buying bullion is investing in a the more diversified S&P/TSX Capped Materials Index (XMA) as suggested in September. This also offers a chance to participate in agriculture and mining.

Sunday, January 1, 2012

Low PE and Moderate Dividend Portfolio - Purchased

Last year we explained the thinking behind the Low PE and Moderate Dividend Portfolio. We also explained that for calculus convenience we set this real life portfolio at $100,000. The latter is not the portfolio's real value, which I won’t disclose – but I do own these stocks as of December 2011.

The data for the $100,000 portfolio is shown below as it was on December 29, 2011 when the last purchase was made. We will update the portfolio progress quarterly.  Portfolio re-balancing (i.e. re-invest the dividend income, reset each holding to 10% of the total value and replace holdings that no longer meet the portfolio criteria) will be done near the end of 2012.

Please, note that upon rechecking the data, it was discovered than Canfor Pulp did pay a much higher dividend yield (13.4%) than our screening data allowed (2-6%). Consequently, It was not included with the portfolio. The idea of not including stocks of the lowest dividend decile (1) was that extreme dividend yields often indicate distressed companies and thus present too much risk for our purposes.

To enlarge, click on the table