Sunday, August 26, 2012

The End of Peak Oil? Not really!

You may have become aware of the recent paradigm shift in energy.  New sources of natural gas and oil – both heavy and light – are discovered every day. The ‘new technologies’ behind this paradigm shift are horizontal drilling combined with multi-stage hydraulic fracturing or frac’ing.  To be honest, those technologies have been known since the mid-1980s but have reached economic viability and operational merits over the last decade or so. In fact, economically drilling horizontal wells and frac’ing them could not have become a reality without peak oil!

Peak Oil may have taken on different meaning than originally intended but then who does have 20/20 vision far into the future? Peak Oil was a term coined by a Shell geologist as far back as the 1950s. It is a strictly logical concept that assumes that our resources on this planet are finite. The moment you take out the term ‘on this planet’ the concept would completely change because there are probably infinite hydrocarbons to be found throughout space and, if you believe Star Trek and other science fiction stories, numerous other sources of energy. Problem is that it would not be economically nor technically feasible at this point in time to go where no-one has gone before (not counting aliens). To get back to M. King Hubbert’s Peak Oil idea, it basically extrapolates what every petroleum professional knows about individual reservoirs: you discover a pool, drill delineation wells then you fill in the pool with development wells until you achieve the maximum amount of production after which production peaks and subsequently declines until the pool is depleted. You could follow the same reasoning for Canada as a whole or North America (see figure below) or for that matter the entire world. Hence the peak oil theory.

Click to magnify
 This theory assumes though that we can only extract oil or gas from a pool by pumping it out until reservoir pressure is so low that oil is no longer producible. Combining reservoir pressure with pumping creates the energy to flow the oil to the surface. When that pressure is insufficient to get oil to the surface the reservoir is considered depleted. In some cases reservoirs are depleted with up to 95% percent of its original oil content in place. In the 1960’s Canada’s heavy oil was unproducible. But what if you find a way to keep the oil flowing or if you could dig out the oil using mining technology?  It is new economically feasible technology that stretches out Hubbert’s Curve. First we discovered that we could inject water back into the reservoir to replace the produced oil and thus to maintain the pressure in the reservoir. This resulted in increased oil recovery and as a consequence we got significant more recoverable world oil reserves.
What stopped us originally from ‘waterflooding’ older pools? Simply: we were not very good at it and it did cost too much money (we were making a loss) doing so. But that situation changed rapidly – we developed better and cheaper technology and… oil prices went up and before you could say ‘boom’ every oil company in the world started to waterflood. The combination of technology and economics postponed the world oil production peak. Then came enhanced oil recovery schemes that used different but more expensive injection materials: CO2 flooding, polymer flooding, alkali floods, fire floods, steam injection, cyclical steam injection, huff & puff, mining, and SAGD (segregated assisted gravity drainage).
So, really there is peak oil and this is not a conspiracy of oil companies; it is a fact of life. Every time we’re approaching a new ‘peak oil’ condition we see prices spike, people become more afraid of running out of energy, we’re crying about how we need alternative energy, we’re cursing the oil industry for not being able to maintain our lifestyles that are so dependent on oil and gas and then… a paradigm shift – a new technology that postpones the inevitable and soon we forget about the environment and high oil prices and we’re once again happily splurging away our new found ‘cheap energy’.
But today, we’re no longer paying $1.50 for a barrel of oil, or $35 as at the peak of the 1970’s oil crises. No we’re paying $85 to $100 per barrel and consider that affordable. The oil and gas industry has found now the latest technology that is reliable and efficient enough to produce oil and gas at economically affordable prices but we have to get that oil out of reservoirs that even 10 years ago were considered unthinkable. In fact, horizontal drilling combined with multi-stage frac’ing in natural gas reservoirs was so successful that it unleashed a drilling boom in North America that increased our gas reserves to levels sufficient high that we can expect another 100 years of blissful CO2 emissions. Now that, what many geologist felt was the ‘climate change scam and panic’ is finally abating the danger exists that we will neglect the impact of human activity on the earth completely. As a petroleum geologist I implore you: please, don’t give up striving for a more sustainable economy!
The natural gas industry’s success and the subsequent drilling boom has created a glut of gas in North America. Elsewhere in the world prices are 3 or four time as high as here in North America and we don’t have enough pipeline capacity to export the excess gas. This has resulted in a collapsing natural gas market and the destruction of the gas industry. The industry will decline until it stops drilling, losing its skilled workers and until our production and prices have declined and translated in a new shortage of gas supply. Then the story repeats itself.
Today, we see a similar story developing for oil. When Peter Tertzakian wrote his 2007 book ‘A Thousand Barrels A Second’ the world produced 86 million barrels a day and even this expert as well as Jeff Rubin were thinking that we reached peak oil, not many thought that 5 years later we’d produce 95 million barrels per day. And that is just the beginning! Are we heading towards an oil glut as severe as that in natural gas?  Not likely, the oil industry has learned from the natural gas story. But at the same time, both oil and gas prices will over time reflect the price of production plus a modest profit margin. We start seeing today already that gas prices are trending back up and hopefully the industry stabilizes soon; but we won’t any longer held hostage to OPEC and petroleum dictatorships. This is a source of hope for everyone and it probably helped the people of the Arab Spring in fighting the evils of dictatorial regimes. The new energy paradigm may help North America overcome its debt problems and maybe allows for more competitive manufacturing in North America.
But as we have seen now for many years, new inventions such as cell phones, the internet and computers may spur growth in new industries and create another GE, IBM or Microsoft that may last for a hundred years or longer. But it will also create much corporate wreckage. After the initial start-up rush everyone wants in on the new profitable market and soon competition is thus intense that hardly anyone makes a profit and even companies such as Apple lose market share. Then when the market stabilizes we’ll see only the strongest and most efficient survive on modest margins and worldwide branding. It is not difficult to make mayonnaise, but hardly anyone can compete with Kraft. It is not difficult to make a bit of flavored sugar water, but nobody can compete with Coke and Pepsi. It is not difficult to make operating systems for computers but not many can stand up to Microsoft. The same will be true for the oil and gas industry where only the most adept will survive and prosper.
In the end it is all about economics – no matter the spin, in the end it is economics that will prescribe what the energy source of the future will be; economics will prescribe real estate, operating systems, cell phones and other computer gadgets. The beauty is that the next development that matures and becomes economically viable is unpredictable even if it already exists today. Computers existed far before the 1980s when the personal computer broke through. Horizontal drilling and frac’ing existed in the 80s and only broke through in the last decade or so. Some technologies were promising such as the hydrogen engine (Ballard) and Hybrids and Electric cars such as Volt. In the end the economy and the reliability of these technologies will determine when they break through or fail.
Investing in such rising technology industries is risky as has been shown over and over again. It is better to wait and buy them once they are established as blue chips and when their business model is proven. Some savvy investors make money investing as angel investors in new ventures. Our earlier analysis about viable stock market analysis provided some insights as to why this can be extremely profitable. But for most of us, this is not required in order to build a prosperous portfolio and life. So stay away from these forms of investments and stay away from IPOs. In the meantime, I hope you will still believe in the new improved model for peak oil.

Blueprint for getting rich – part IV

Our generic plan for getting rich is shown below. We also have discussed the main elements of the plan – owning your first home, creating an ETF portfolio in a Tax Free Savings Account, and last but not least saving through an employee savings plan.

1.      Your Belize (Vision for the future):

You want to retire 25 years from now at the age of 22 - J

That means you want to have a net worth of at least $1.5 million 25 years from now so that you can live and work independently of an employer. (In plain English you want to be able to say to your employer “scr/// you!” without losing your meals and house - J - I am having so much fun).

2.      To do so you, as a household, will have to save around $10,000 per year. You do that by living below your means. Saving will initially be difficult but over time with increased pay cheques that will get easier. Maybe you can at later age save $15,000 per year and speed up reaching your ‘financial adulthood’ also known as retirement.

3.      First you save a down payment for your first house using your TSFA

4.      You buy the house

5.      You put your annual $10,000 savings in ETFs which are tax protected in your TSFA

6.      You will work for an employer who provides you with an attractive company savings plan.

7.      That’s all folks. See you in 25 years.

So let’s discuss some of the finer points regarding these approaches. First of all let’s discuss real estate.

Owning your own home is great. It allows you to use leverage in order to maximize your ROI that results from appreciation; it is a forced savings plan and you may have lower monthly payments compared to paying rent. But what happens when you pay off your mortgage? This is the end goal in many people’s thinking when it should be just the start. Here are some points to consider:

·         Your house is paid off and all future appreciation is tax free. But from now on your ROI on all that money tied up in your house does equal its appreciation and yes, it is cheaper than renting the place. But can you do more?  Of course you can. Before your mortgage payments were not tax deductible, but now you may put a line of credit on your place and use the proceeds for further investments. The interest you pay on any outstanding balance is now tax deductible.  So not only can you borrow money on a moment’s notice, you pay 40% (tax bracket dependant) less interest than you did on your old mortgage.

·         Now, that the leverage on your house has increased, so does the ROI on the equity that remains in your house. Don’t take out more than 50% in borrowed money – after all, your home is your castle and financial foundation. The money in the LOC must now be invested at a higher ROI than the interest you pay on your loan. So where to invest? What about investing in another property? Not a property to live in but a rental property! So we can use the LOC to fund the down payment on your next rental property. The details about how to buy and manage a rental property are discussed in earlier posts and if you want even more information join REIN.

·         Sometimes, you don’t have to wait to set up the LOC on your apartment before the mortgage is completely paid off. You can do it earlier provided you don’t endanger your financial stability.

·         Next you buy your first rental property with a prudent amount of leverage and your ROI on your own home as well as on rental property increases dramatically.

·         If you are not happy in your current home, you may buy a new residence and use your previous residence as rental. There are some tax issues involved with this, so talk to your accountant.


Yes, that is right, by now don’t try to do everything yourself. Because your time may be better spend on your next investment opportunity than doing your tax returns. You will start to expand the staff of your investment company (because that is what your building) to include a trusted accountant that can help you with tax planning; you’ll need a lawyer for your real estate deals and for estate planning and you’ll need a realtor, stock broker or financial planner. Watch out for the latter three ‘staffers’ because many are there just to sell you stuff. They can be very charming until the day you don’t invest enough through them. There is here an inherent conflict of interest that you have to be aware of. Having said that a good realtor, financial planner or stock broker is worth the money you spend on commissions and fees (see Should I fire my stock broker? )

·         You could use you’re LOC money for stock market investing but I do advice against that until you have a significant level of net worth and a lot of experience in the stock market. If your net worth is less than $1 million and you have less than 10 years of intense stock market investment experience don’t even dream of it. But for experienced investors leverage is an extremely powerful tool that helps enhance ROI and sometimes even cash flow when used with caution.

So now you’re ready to include real estate investments as an important component of a diversified portfolio. In the next post we’ll put the dots on the ‘I’s for your employee savings plan.

Sunday, August 19, 2012

Active and Passive investments

I am in the process of turning the articles of this blog into a logically organized e-book. Once I've worked out the kinks, it should be available to all of you (for a modest price). Yes, following the COI and ROI philosophy, I am trying to create yet another income stream.

Anyway, while compiling the postings for the book, I realized that I have not explicitly explained the difference between active and passive investing. Here is my attempt:

Apart from different investment classes such as stocks, bonds, gold and real estate we also can divide investments into actively and passively managed. This may be a good point in our discussion to discuss these terms and how their use is somewhat confusing.
First, when you run your own business you are in active investment mode, i.e. you are in control. You decide the direction of your company, you decide about its products or services, its working hours, how much money or equity you put in, whether you take on partners and whether those partners have a say  or no say in your company. You decide whether you want to borrow money and on what terms.
Of course there are constraints because you and your company do not live in vacuum. The bank or creditor who lends you funds will set conditions and limits; so will your clients and then there is the ever present most silent partner of all – in the U.S. we call him Uncle here in Canada it is the government.
Not only do you have equity in the company that is supposed to make profits for you and your partners, there is also your sweat – you work full- or par time in the company, you are often a or the board member and CEO. Thus in active management you put in money and sweat. The sweat returns are defined as your compensation while the rest of your returns are in the form of appreciation and dividends. 
Some active investors make the mistake to count the sweat as part of the return on equity (the money they’ve got invested in the company) and include it in the rate of return. However, to compare performance of active with passive investments you should only use your return on equity.
Your sweat return should be compared with the salaries or sweat returns of passive investors. They often get salaries and other forms of compensation from their own businesses or places of employment. They don’t typically include those returns in their portfolio performance considerations either.
When comparing returns from real estate versus that of stocks, one should make a clear distinction between sweat return and return on equity. For example when investing in rental properties, we’re running our own business while when investing in shares of public company we’re only buying the profits and do not ‘sweat’ unless the temperature in your arm chair is turned up too high.
There is a second form of active and passive investing.  When investing in specific shares, bonds and other paper securities of a company you control the content of your portfolio. This is opposed to investing in an ETF where you just buy the index and sit back and collect the dividends and appreciation. These approaches are also called active and passive investing, but it is now about controlling the composition of your portfolio. The passive investor has given up control even further, delegating the selection of individual investments to an portfolio manager who is paid via commissions and MERs (management expense ratio).  

So basically, active and passive investment is related to the various degrees of investor control.  In this blog we use the terms ‘active and passive’ depending on its context. In real estate  it is of the first form (it deals with controlling a business) .When dealing with stocks and other paper securities, active and passive relate to how the portfolio’s composition is controlled.

Blueprint for getting rich – part III

All the ingredients for getting rich have been presented on this blog over the last number of years. So you have made the plan below and are now looking at the details of implementing it.  You defined your vision for the future; wyou’re saving $10,000 per year. The savings for the first two years were used to buy an apartment or townhouse condo.  The $10,000 annual savings for the next 23 or so years are invested in an ETF portfolio that is tax sheltered in a TSFA. And now we’re ready for step 6.

1.       Your Belize (Vision for the future):
You want to retire 25 years from now at the age of 22 - J 
That means you want to have a net worth of at least $1.5 million 25 years from now so that you can live and work independently of an employer. (In plain English you want to be able to say to your employer “scr/// you!” without losing your meals and house - J - I am having so much fun).
2.       To do so you, as a household, will have to save around $10,000 per year. You do that by living below your means. Saving will initially be difficult but over time with increased pay cheques that will get easier. Maybe you can at later age save $15,000 per year and speed up reaching your ‘financial adulthood’ also known as retirement.
3.       First you save a down payment for your first house using your TSFA
4.       You buy the house
5.       You put your annual $10,000 savings in ETFs which are tax protected in your TSFA
6.       You will work for an employer who provides you with an attractive company savings plan.
7.       That’s all folks. See you in 25 years.

Many employers offer their employees the option to participate in a company savings plan. The deal is that an employee typically is allowed to contribute up to 10% of his/her gross salary in the plan and the employer will contribute the same amount and sometimes up to 1.5x the employee’s contribution.  So, that is a guaranteed 100% to 150% one year return and you, the employee hasn’t done anything yet.  Typically you have to follow a couple of rules – you cannot take out any money for one year or somewhat longer. The money can only be invested in the company’s stock or in a limited number of often mediocre and high commissioned ETF funds or even worse in mutual funds. So let’s do some calculations.
First of all, you may only buy company shares. Thus, your job choice should include a consideration of how the corporate performance is – this is easy when you’re dealing with a publicly traded outfit but a lot more difficult with a privately owned company.  Investing in the latter goes beyond the scope of this post but we can have a look at a publicly traded company. You should look for an average corporation (or better) and avoid working for duds. Duuuh!  We know the average corporation should provide a 9 to 11% ROI including dividends.
Now put in the maximum contribution. This may be difficult when you are already trying to save the normal $10,000 per year but if you show some discipline and frugality early on in your career then this should become easier and easier overtime when your salary increases. If you absolutely cannot save more, then save first for your down payment and next for the savings plan. Then after a year, you can take out your own contribution and put that in the TSFA.  Assuming an average annual income of $60,000 then you are allowed to put up to $6,000 in the company savings plan. Then with next year’s 5% salary increase, you should be able to contribute $6,300 and the following year $6.650 and so on. So the results are shown in the table below:
Click to magnify
We’re assuming that the stock of you company increases at a steady rate of 10% per year. This is not very realistic. Using a random number generator creating an average return of 10% (and thus your annual return varies randomly between 0% and 20%) the outcome can be quite different and ranges between a total savings balance of $2 and $3 million dollars.  Now you will have to pay taxes on this over the years and they are quite substantial. However, most is deducted by your employer from your paycheque and changes are you won’t really notice it. How much tax in total? Well, in Alberta you’d pay $166,633 on your employer’s contribution and when you cash in all at once after 25 years you’d pay another $337,957 in capital gains taxes.  When converting the final balance to today’s dollars (NPV discounted for 3% inflation) you would still have saved $932,923 in NPV.
Whatever the case, combined with the proceeds from your home and your ETF portfolio in the TSFA you cleared the hurdle of an NPV of $1.5 million 25 years from now. That was easy. Now you have to only execute this plan over the next 25 years. And that won’t be always easy. J

Saturday, August 11, 2012

Blueprint for getting rich – part II

All the ingredients for getting rich have been presented on this blog over the last number of years. So you have made the plan below and are now looking at the details of implementing it.  You defined your vision for the future; you’re saving $10,000 per year. The savings for the first two years were used to buy an apartment or townhouse condo.  And now we’re ready for step 5.

1.       State ‘Your Belize’ (i.e. your vision of the future):
You want to retire 25 years from now at the age of 22 - J 
That means you want to have a net worth of at least $1.5 million 25 years from now so that you can live and work independently of an employer. (In plain English you want to be able to say to your employer “scr/// you!” without losing your meals and house - J - I am having so much fun).
To do so , you as a household, will have to save around $10,000 per year. We do that by living below our means. Saving will initially be difficult but over time with increased pay cheques it will get easier. Maybe you can at later age save $15,000 per year and speed up reaching your ‘financial adulthood’ also known as ‘Financial Indepence’.
2.      To do so you, as a household, will have to save around $10,000 per year. You do that by living below your means. Saving will initially be difficult but over time with increased pay cheques that will get easier. Maybe, at a later age, you we will be able to save $15,000 per year and speed up reaching your ‘financial adulthood’ also known as retirement.
3.   First you save a down payment for your first home using your TFSA (Tax Free Savings Account)
4.       You buy your home
5.       You put your annual $10,000 savings from now on in ETFs which are tax protected in your TFSA
6.       You will work for an employer who provides you with an attractive company savings plan.
7.       That’s all folks. See you in 25 years.

In spite of having bought a house your savings are not suffering and with each year passing you see your pay cheque increase as well. So, saving $10,000 per year should be no problem.  In numerous previous blog posted we have looked at investing in individual stocks or in ETFs. Building up a diversified portfolio is not difficult with ETFs. But we learned from Bernstein’s Four Pillars of Investing that we should not expect to do more than maintaining our saving’s purchasing power for later years. This may be a bit disappointing and we are ambitious enough to push beyond the envelope to make a bit more if possible.
For that we have to look at Bernstein’s assumptions.  He assumes that the typical investor cannot handle a lot of risk – so to minimize volatility he first of all recommends to diversify between stocks and bonds. That is not a bad idea normally, because when stock markets fall, central banks tend to lower the interest rate and thus bond yields often follow. This results in increased bond prices.
Bond yields though have fallen over the last 30 years since inflation peaked in 1982 and we have experienced overall a bull market for bonds. The fall in inflation has also reduced the nominal interest rate (i.e. the interest rate plus inflation) and this was good for stocks too. So both asset classes have experienced extraordinary returns .During stock market crashes like the one in 1987, bonds increased dramatically in value resulting in reduced losses for the overall portfolio.  Historically though, bonds have underperformed stocks significantly during most periods and that is because bonds, especially short term bonds (with maturities up to 5 years) are less risky with the chance of losing principal being very low. On the other hand, the chance of losing your stock investment was and is significantly higher. Higher risk means higher returns and thus on average stocks outperform bonds.
Stock price swings are much more severe than those of bonds and it is not unheard of for a stock portfolio to lose over 50% of its value. However, typically time will restore the portfolio value and then some more. Thus, as long as an investor doesn’t panic, i.e. has a strong stomach, his portfolio should bring the anticipated long term returns. But ‘long term’ may represent a very long time – we’re talking decades. When you’re planning a retirement portfolio we have decades to work with, in our Blue Print we’re planning 25 years out and possibly even longer. Just focus on the long term returns and consider the volatility a nuissance that does not affect your long term return. So instead of Bernstein’s 60% stocks and 40% bonds lets have 80% stocks and 20% bonds.
Jim O’Shaughnessy’s research showed us that not all stocks are created equal. Yes the overall market return may be 13% or using Gordon’s modified formula 12.6% or Jeremy Siegel’s 7% plus inflation. However, you instead may elect to invest in value stocks that are typically lower priced than growth stocks or even lower than the average stock. That is the thought behind our Low P/E Moderate Dividend Portfolio. O’Shaughnessy’s research of value stocks suggests average annual returns of 18% but losses during a bear market may temporarily be as high as 55%. Rather than selling during those down turns one should buy more thus improving your portfolio’s performance even further (over the long term).
Finally, Bernstein assumes inflation (about which we cannot do a lot) and taxes. For protection from taxes we Canadians are blessed with the TFSA and to a lesser degree with RRSP.  Our earlier blogs compared both tax shelters and the message is simple. If your current tax rate is lower than your future rate then the TFSA beat the RRSP hands down. Especially if you are currently in a low income bracket you should use up your TFSA contribution first and then place the remainder of your savings including the tax refund inside a RRSP. When dealing with dividends and capital gains, a normal investment account may even do better than a RRSP. Fixed income is better inside the RRSP rather than in a normal account.  So first we fill up the TFSA.
If you’re just turning 18, you are worst off because your max TFSA contribution will be $5000 and the rest of your savings should go into a regular account unless you’re in a high income tax bracket. In this latter case the surplus should go into a RRSP. Every year that you’re over 18 or if you have made no TFSA contributions to date then your max TFSA contribution increases by $5000 up to a maximum of $20,000 in 2012. Basically, each year a person over 18 is allowed a maximum contribution of $5000 and this contribution increases every year by $5000 minus your contribution made in that year. The good news is that a withdrawal (once a year) from your TFSA will increase your total contribution limit. Gorden Pape has an excellent book on the detailed workings of a TFSA.
Suffices to say that after two years of saving for your down payment and its subsequent withdrawal, an individual typically has in the following year at least a $15,000 maximum contribution space and up to a maximum of $25,000. When dealing with a couple the contribution space could be double and range from 15,000 to $50,000. Bottom line is that after buying your first home, there is plenty of room to put your $10,000 annual savings in a TFSA and protect it from taxes.
Now, taking this into account, you could invest in our ‘Low P/E Moderate Dividend’ portfolio with 10 Canadian stocks or in a U.S. ETF that follows a similar philosophy. Alternatively, when you hear billionaires like Jim Rogers talk about commodities in the not too distant future you should love to invest in Canada’s stock market which is overweighed in commodities and for further diversification you also should select a U.S. ETF mirroring the S&P500 or Dow. ETF purists would prefer the S&P500.  Finally purchase a short term bond ETF for your portfolio’s bond portion; preferably a Canadian one (nobody knows what will happen to the most indebted nation in the world – i.e. the U.S. so avoid their debt).  Now you have a tax sheltered and diversified portfolio that should return you between 7 and 18% annually – let’s assume that Jeremy is right and assume an average ROI of 7% plus 3% inflation or 10%.
Then after 25 years of $10,000 annual contributions for a total of $250,000, your portfolio value should be: $985,500 with no taxes due and thus a net present value (corrected for 3% inflation) of:  $470,000. Now that is a lot better than just maintaining purchasing power. Adding up the value of our apartment to that of your portfolio in 25 years, by your retirement you’d have close to $1.4 million or $670,000 in today’s dollars. We are well on our way to meet our retirement goal.

Thursday, August 9, 2012

Blueprint for getting rich – part I

All the ingredients for getting rich have been presented on this blog over the last number of years. So now we’ll try to make this into a plan – a “Blueprint to get rich”:
1.       State ‘Your Belize’ (i.e. your vision of the future)
You want to retire 25 years from now at the age of 22 - J 
That means you want to have a net worth of at least $1.5 million 25 years from now so that you can live and work independently of an employer. (In plain English you want to be able to say to your employer “scr/// you!” without losing your meals and house - J - I am having so much fun).
2.      To do so you, as a household, will have to save around $10,000 per year. You do that by living below your means. Saving will initially be difficult but over time with increased pay cheques that will get easier. Maybe, at a later age, you we will be able to save $15,000 per year and speed up reaching your ‘financial adulthood’ also known as retirement
3.       First you save a down payment for your first home using your TFSA (Tax Free Savings Account)
4.       You buy your home
5.       You put your annual $10,000 savings from now on in ETFs which are tax protected in your TSFA
6.       You will work for an employer who provides you with an attractive company savings plan.

7.       That’s all folks. See you in 25 years.
Really, this should get you pretty close to $1.5 million in 25 years. You want details?  OK, you get details.
The secret of getting rich is RETURN ON INVESTMENT (ROI) also defined in ‘Godfriedese’ as the speed at which your net worth increases. But speed is not all, just ask the speed bumps. You need cash flow to get through the bad times. It is really about COI (cash on investment) and ROI.
The best source of funds for a down payment is your job and some generous parents. Really, a down payment is doing more for your future lifestyle than a vacation in Mexico or the Caribbean. How much do you need?  Not a lot, you can probably scrape it together in under two years!  So, we’re starting with a cheap place – hopefully even cheaper than cheap.  So buy an older townhouse or 2 bedroom apartment. In Calgary you can get that from around $200,000 which means that you can buy with as little as 5% down or $10,000. But then you have to pay mortgage insurance to protect the bank. And if the house value falls just a little bit, your mortgage is ‘under water’, i.e. you owe more than the place is worth. It is safer to aim for 20% down because then you don’t have to pay mortgage insurance. That would be 40,000 down.
$40,000 down would be ideal and if you can get help from parents, I highly recommend it. For most people however, would be best to go with 10% down or $20,000. Even with not a penny in your bank account now, when saving $10,000 per year starting today then you would have this together in 2 years.  Why is owning your own place so important?  Well let’s do the math – yes if you want to get rich you need to do some basic math. No Calculus mind you, but plain high school math is a must. Remember the APOD (A Viable Investment) ? Well, we’re doing here something similar.
If you currently rent a normal apartment in Calgary you pay typically $1200 to $1300 in rent plus another $150 or so for utilities. Would you be able to pay that rent to yourself instead? So be your own landlord and run the APOD as shown below:
Click to magnify

Now deduct your ‘operating expenses’ (Oh lordy, lordy I hope my tenants don’t read this blog J):
Click to magnify
  Hmmm, after expenses you have still $10,340 in net operating profits that you use to pay your mortgage. In Calgary, you can get a 25 year mortgage for around 3% interest or for monthly payments of… $851.84 with your $20,000 down payment. Historically your Calgary apartment will appreciate around 4 to 6% per year. In the APOD I am using an even more modest rate of 3% - just a smidgen above the inflation rate. $851 per month is nearly $10,340 per year. Thus rather than pay rent to some anonymous landlord you pay the rent to yourself. Use this ' rent'  to pay for operating and financing costs. In effect your cost of living hasn’t changed from when you were a renter and you can keep on saving your regular $10,000 per year! Which from now on you will invest in ETFs stored in a TFSA. We’ll talk more about that later.
So, how much do you make on your first real estate investment? Well here is the rest of the APOD:
Click to magnify
 First of all, your mortgage payment goes to two items: interest and principal pay down! Your total annual mortgage payment is $10,222.10 of that goes $5299.65 towards interest (in coming years the interest goes down), the mortgage pay down reduces your debt by $4922.45 in the first year!  This money is of course yours! The mortgage is nothing more than a forced savings plan and so each year you save an extra $5 grant on top of your normal $10,000. So consider, just like with a rental property, the $5 grant as profit. Now add to this profit the annual appreciation which is 3% of $200,000 or another $6000. Your total profit in the first year is $11,040.35 on your investment (down payment) of $20,000 or a return on your investment of 53%!!! You won’t get that in the stock market!
But remember you’re using leverage and your ability of making your mortgage payments is the biggest risk factor. If the apartment appreciates nicely at 3% per year (which it likely won’t do – it is more up and down) then after 5 years, your property is probably worth $232,000 and you own the $32,000 appreciation plus you paid down your mortgage by that time by another $27,000. Now how is that for wealth accumulation? Oh, and do not forget the 5 years of $10,000 annual savings or $50,000 you socked away in the TFSA.  After 25 years your mortgage is paid off and your apartment is now 100% owned by you and worth around $405,000.00
They say the first $100K is the toughest, well you just saw how it’s done. 

Friday, August 3, 2012

ETF investing does not make you rich

I am currently reading a truly excellent book on investing; it is not only describing the many topics discussed on this blog in a systematic fashion rather than in the opportunistic chaos of a blog, it helps you set up a stock market and bond portfolio that will perform over the years. The book is the latest edition of William J. Berstein’s ‘The Four Pillars of Investing’.

One of the topics not discussed on this blog is evaluating a stock in terms of the net present value of its  future dividend income stream. This technique was first proposed by Irving Fisher and rumour has it, that Warren Buffett also used to calculate investment value in terms of net present value of its future income stream. Irvin’s method is official called: DDM or Discounted Dividend Model. You may have come across the world famous future value/net present value equation which goes as follows: 

FV  = Future Value of an investment
PV = present Value of an investment
i   = the discount rate (or rate of desired return on investment) per year
n = is the investment life expressed in years.

Thus a dividend of $3 to be received 5 years from now (FV = $3) and assuming an interest rate or required ROI (i or further down it is: DR) of 10% would be worth today $1.86 using the equation below:

You could not only calculate the net present value of each dividend you will receive over the next five years, you could do so for an infinite number of years (assuming your investment never terminates, i.e. the ultimate Buy&Hold).  When you add up all those to net present value converted dividends then the sum would represent the share's (net present) value.  This would entail a lot of calculator math, but fortunately, mathematicians found that the answer can be expressed as a very simple equation:

                             MV  = Market Value (of a share)
                             PD  = present or today's dividend per share
                             DR  = aforementioned discount rate
                            DGR = Dividend Growth Rate

For the Dow Jones Industrial Index, the dividend growth rate historically averages 5% (more or less the same as nominal GDP growth of the U.S. economy). The current dividend yield is 2.5% or $319.73 and today’s index price is: $12,789 (the Dow is 12,789 right now - just put a dollar sign in front of it).
Thus if an annual return on investment (DR) is required of 10%, then according to the DDM the DOW should be at $6,394 rather than $12,789.  Thus, the expectation of a return on investment of 10% per year is likely unrealistic. Based on its current value, a ROI (DR) of 7.5% should be a more reasonable expectation.

You may manipulate this DDM equation to express the expected market return (DR) as follows:
                                DY = Dividend Yield (PD/MV)

I know, the math is excruciating in its complexity J). Today’s DY = 2.5% and the DGR=5% so the expected annual rate of return or DR is 7.5%.
Of course, the Dow Jones fluctuates due to a hyper emotional investment community and as such is on a day to day basis completely unpredictable . Howeverrrr, over the long term, if you invested today in the Dow Jones Spyder ETF (DIA-N) according to the above equation, officially known as the Gordon Equation, your annual return should average 7.5% with all emotions cut out of the estimate.

Thus if you saved $10,000 per annum for 25 years and invested it in DIA-N with a return of 7.5%, your investment would be worth $679,778.  A tidy sum assuming there is no inflation and no taxes. So let’s assume 3% inflation and a marginal Alberta tax rate of 38.8% or a 19.9% rate on capital gains (lets forget about the taxes on the dividends right now).   So taxes are $85,525 the remainder being $594,253. Discounting $594,253 at 3% inflation, the net present value of your original investment (25 years x $10,000 = $250,000) is: $283,818.  You basically broke even in terms purchasing power.
This is one of the significant observations made by Bernstein, that investing in the stock market only protects the purchasing power of your original savings. Basically it is a postponement of today’s spending to spending 25 years from now. Do I agree with it? Not necessarily. I have run passively managed portfolios for my children. I invested the money in their education trusts in a number of reputable diversified mutual funds and the results were indeed very mixed. The funds did their job but not brilliantly.

On the other hand, we have reviewed long term stock market performance on this blog or reviewed the work of Jeremy Siegel (which Bill Gross now claims to represent a ‘historical fluke’) or the work of Jim O’Shaughnessy that goes back to the early 1900s. These works indicate returns of 13 to 18% or 7% plus inflation.  Another non-emotional way of estimating the return to expect from a stock is to use its earnings yield instead of its dividend yield. 
After all, you the shareholder owns the entire profit not just the dividends. As such, not only do dividends grow but the retained earnings are added to the assets of the company. This should result in capital gains in addition to the dividends. So if we use Gordon’s modified equation and assume that earnings growth is as fast as the dividend growth while the Dow currently trades at a P/E of 13 or an earnings yield (EY) of 1/13= 7.6%  then return over the long term should be:
                                EY = Earnings Yield (1/PE)

The result is DR = 7.6+5 = 12.6%. In this scenario of $10,000 annual savings over 25 years would be worth $1.46 million minus $241K in taxes with a NPV discounted for inflation (3%) of $583,316.  Since  one needs a net worth of around $1.5 million to retire (A Portfolio of Viable Investments) with some comfort I do not think that investing in the Dow Jones will make you very rich. Over the next while, we will discuss how we could try to become rich(er).

The BC obstruction

Western Provinces have always gotten along fairly well despite significant cultural differences.  These differences are based on the micro-settings many of us live in. For example, a Vancouverite lives in a much milder climate along the sea. A setting many people dream of, but apart from headquarters of mining companies, most of Vancouver‘s economy is service and transport oriented.  It is a lifestyle city depending heavily on tourism and there is no question, Vancouver is a fantastic city with over 3 million people living in an around it in the Fraser Valley.

The rest of B.C. is mostly empty. Its population counts 4,4 million people of which over 60% or 2.8 million live in the Greater Vancouver Area.  B.C.s population grew on average by 7% (close to Canada’s average of 5.9%) compared to Alberta’s astounding 10.8%. However, the Greater Vancouver Area and Fraser Valley grows by close to 9%.  Not many in those areas have much to do with mining or oil and gas.  Oil and Gas in B.C. is mostly in the forgotten corner of NE B.C. on the Alberta side of the Rocky Mountains where people often feel closer aligned with Albertans than with the rest of B.C.

Only 14% of the B.C. population or around 616,000 live in a rural setting with the rest in smaller towns located mostly in the interior and southern part of the province where ‘cities’ usually are in the 7,000 to 179,000 (Kelowna) population range. In the Okanagan many people live of tourism, mining, forestry and agriculture. The latter mostly fruit and wine. That is quite different than in the Vancouver area where agriculture entails dairy, vegetables and some grains.   Thus the culture here again is quite different from Vancouver and NE BC.  Not to mention the numerous First Nation communities and Fishery areas. All this disparity is glossed over by the Vancouver colossus which basically dictates the political terms of the province.
Alberta is approaching rapidly the 4 million population mark. Its population is mostly located in the central and southern part of the province. Nearly have the population is located in the Greater Edmonton and Greater Calgary areas. Edmonton with a large ‘blue collar’ and civil servant population is quite different from Calgary which is a financial headquarter area dominated by the oil and gas industry. Edmonton’s population grows at 12.1% and Calgary’s at an astounding 12.6%. All these numbers are collected by the Canadian Census in 2011 and compared to 2006.  Alberta has several larger cities and communities spread out through the southern 2/3 of the province. The northernmost large community is Grand Prairie with a population of 55,000 although on the eastside of the province and not much further south is the Wood Buffalo Census Area with 66,000 people.  Red Deer, Lethbridge, Medicine Hat are all cities of 100,000 and over.
No matter where you go in Alberta, the oil and gas industry are large employers. Agriculture in the form of wheat and grains along with cattle are an important part of Alberta’s heritage. Forestry and to a significantly lesser amount tourism also contribute significantly to the economy. While B.C. is known as a pleasant lifestyle province with grow-ops as a sideline, Alberta is a more rugged province with the Rockies in the West, prairies in the East and forests in the North. There is a lot of economic mingling in this province where agriculture and oil & gas live side by side. Entrepreneurship is an essential ingredient in a province where one can start an oil or gas company with a few neighbours or friends.
So really, it is not Quebec’s sole claim to have a distinct society. Yet, in general Alberta and B.C. get along well until the era of the pipelines. Alberta is the area any product from BC has to cross to reach the large markets of the continent’s east coast and Alberta does not claim any of B.C.s tax revenues as compensation. Lots of Alberta grains and oil and natural gas is transported to the ports of the West Coast and B.C. does not ask for a part of Alberta’s tax revenue. Now this has suddenly changed and B.C. want to claim part of Alberta’s tax revenue in return for allowing a significant pipeline expansion. This is an unheard of demand. No other province in Canada tries to hold their neighbours hostage in this manner and thus it is not surprising that both Alberta and Canada’s federal government are in uproar.  Nobody denies B.C.’s rights to demand revenue from industries active in their provinces; nobody denies that BC demands industry funded money pools to pay for the environmental risks they incur because of said pipelines and hazards from other sectors of the economy. Many other jurisdictions do not interfere in the taxation powers of other provinces; it is not appropriate and cannot be on any negotiation table because, as Alison Redford, Alberta’s Premier pointed out it goes to the hard of Confederation and our Constitution.  Next we see Alberta demanding a part of BC tax revenue because of the TransCanada Highway and Canadian Pacific rail road.