Sunday, January 27, 2013

When is the current bull market coming to an end? What!


You may have recently been reading about the impending end of the current bull market as some pundits may ‘forecast’ with great certainty. Heck, what bull market?
Yet, if you look at a recent stock price chart of the S&P500 it is obvious that since March 2009 we have been in a powerful bull market which has risen from a bottom of 800 to today’s 1500. Yes that is right, we’re back at the market heights of 2007-2008 and investments bought in March 2009 have ON AVERAGE nearly doubled in value.  In the U.S. that is! Well Europe has in spite of all the debt crisis and recession whining gone up as well. Since last September when we recommended to aggressive investors on this blog to buy Ishares European 350 fund (IVV) it has gone up from $36.16 to $41.85 per share; that is a whopping 15.7% in less than 4 months!

Chinese stocks have come to life again recently as well thanks to the latest economic data released by the Chinese government (J). Even the Canadian markets have shown some improvement, but due to the still depressed commodity prices and the landlocked position of Canadian oil and gas, our economy and market has lately been lackluster.
Still although we’re in a bull market, many Canadian investors have barely experienced its benefits. But then, in the first 8 years of this century, Canada’s stock markets were rocking and we’re still having a hangover! Remember, investment returns are volatile but do tend to revert to its average long term performance. Also, the U.S. economy is only recently showing some solid performance; so does China and in Europe they’re still in recession. Commodity economies (like Canada) tend to trail the industrialized economies; so our good times lie still a bit in the future.

But yes, we are in a bull market with this wall of worry that seemed to never end. Now things are changing, the majority of investment advisers and gurus and pundits claim that the stock market is likely to go up in 2013. Well, before you know, these guys will have forgotten their client’s pain from this last decade and start cheering that the market ‘can only go up’ and that this is a ‘new economy’ and that ‘winners buy only speculative growth stocks’ and that ‘Warren Buffett’ is passé!’
Just like we were looking for the silver linings and ‘sunshine at the horizon’ during the dark times, now we have to turn a bit more cautious and start to look for signs to worry about.  Not to run at the first sign of trouble, but to be prepared for the speculative froth of the masses and to start building cash for the next major downturn. Considering that the current bull market is now running for close to five years, we should expect the next major downturn to be here in 2 to 3 years. But before that, I’ll bet that there are still quite a lot of market highs waiting for us. These are not times to run along with the hysterical masses and start buying loads of stocks. To the contrary we want to take profits in the most popular investments and build our cash piles and to fortify our portfolio to withstand the coming slaughter and solidify our cash flow.
One thing we should have learned over the years and certainly over the last decade or so. We want to own solid cash-flow creating investments; their market prices will fluctuate with the psychological moods of the markets, the media, and the public in general. We don’t care about market price unless it becomes so unbelievably cheap that we can no longer miss the opportunity to buy them or… if prices will get so unbelievably expensive that we cannot ever hope to make so much money again and sell (some of our stuff). Our approach is that we let the fools do whatever fools do while we accumulate cash flow at a good price.

Monday, January 21, 2013

Diversification in investment strategies


We all have our own investment tastes which depend largely on our personality. Some of us are risk takers, others are traders. Many amongst us consider ourselves value investors without realizing that buying value is in the eye of the beholder. Is it value investing if you buy a growth stock with annual earnings growing at 20% for a price earnings ratio of 12?  Or do you buy value when an investment has a dividend yield of 8%? Is it value if you buy a company’s assets at 50cents on the dollar?
I could ask similar questions for momentum investors or growth investors. In the end, you will invest with what you feel comfortable with. Personally, approaches such as the Low PE and Moderate Dividend portfolio are ‘too much shot-gun’ for me. But research shows it has merits. Yet, I am sure that my method is not quite what Jim O’Shaughnessy had in mind – I still weed too much.
ETF investing does make sense to me. It should be difficult to be above average and if you have to deduct management expenses such as commissions and broker fees, I do see why using a market index as performance benchmark is reasonable. It is like driving cars – in polls most people that are asked think they’re better than the average driver. This is an mathematically impossibility. The same with investing, and is the extra 1 or 2% per year in 'extra' return worth the effort and worry to perform above average?  So, just in case the Low PE an Moderate Dividend portfolio doesn’t work out, I also have a portfolio of Market ETFs. My bias is Canadian stocks with whom I am more familiar. But, our market is small and focused on resources, banks and real estate. What about High Tech companies such as Apple or Consumer product companies such as Procter & Gamble or Coca-Cola? What about Europe and Asia? In my ETF Portfolio, I would like to have 40% Canadian, 40% U.S. Stocks, 20% European Stocks. Asia is being taken care of by Canada’s dominance in commodity prices (which are responding to BIC country demand) and by many of the U.S. giants who often have significant overseas profits and businesses. So, we will in future blog posts we will create and track this portfolio – which I have put my TSFA (Tax Free Savings Account).  I want dividends and appreciation and I want it tax free. International dividends are not tax deductible!
Investing in blue-chip high quality companies such as Brookfield Asset Management; the Canadian Banks; Kraft; Microsoft; Proctor & Gamble; BCE and reinvesting the dividends for ‘ever and ever’ is another market outperforming strategy. Typical long term returns are 15% annually. So if the other 2 portfolios don’t perform as well as hoped for, this one may make up. More details in later blogs this year.
Dividend stocks such as the ones above replace currently my fixed income portfolio as well. The Bond markets over the last decade or so have outperformed the stock markets. No wonder, with falling interest rates as far back as 1982! Stocks are assets that increase in value in a modest inflationary setting when nominal price increases combined with leverage enhance corporate profits beyond mere GDP growth. We examined this in great detail last year in our stock evaluation spreadsheets. Bond values, especially long term bonds, will lose value in a more inflationary setting with interest rates rising. Today, with central banks suppressing interest rates while printing money (possibly 1 trillion dollar coins) the risk of inflation has increased dramatically. Some recommend gold as protection and that has merit. But gold does not earn cash flow which is the number one objective for us who pursue ‘financial adulthood’, while most other hard assets provide inflation protection as well as income – especially real estate. So, at this point in time, I would consider using the dividend strategy inside your RRSP if you already have one.

Here is a big exclamation mark !!!!! Remember, an RRSP is only worthwhile if you expect in future years to have a lower marginal tax rate than today. With governments taxing the ‘rich’ this is not likely. Since most of us plan to be richer rather than poorer over the years, I suggest using your TSFA first and do not put additional money in your RRSP.
Capital preservation is quite important for RRSPs as you cannot claim ‘capitol losses’ and it is difficult to make up for them within RRSPs. So, yes we want our most conservative portfolios in the RRSP. In addition to the above dividend strategy, use your existing RRSP to invest in short term bonds and money market funds or short term GICs. Holding cash in your RRSP is losing money since inflation will decrease its value!
Investing in ‘themes’ is the most dangerous game that I know. Investing in ‘Energy’; Wind Power; the Hydrogen Economy; Green Ethical Businesses has been one of my biggest losers (remember Ballard?). I suggest you stay mostly away from it. But we’re living today in a North American energy revolution- this is not 'theme' investing in the strictest sense. It is investing in a severely depressed market where many have given up, i.e. 'with blood in the street'. I think, as far as producer companies is concerned there is more 'blood' to come - high on my list is a possible take-over of Encana. 

However, there are also investments in the gas industry that pay dividends and have a lot of upside in the natural gas markets. Pipeline companies; LNG transporters, service companies. I think that in gas infrastructure money is to be made in the near to medium future. Then there are the oil and gas producers themselves – North American companies are caught-up in the land-locked battles and their production is sold at severe discounts. We want to see who’s left standing 3 to 5 years from now and when everyone has given up on this sector it may be time to come back. Personally, I think that the gas producers have reached the bottom or are near. Since we can’t precisely time the bottom we can apply the aforementioned ‘Nibble’ strategy.
Deflationary – inflationary cycles are long 15 to 25 year trends and we’re just starting to re-enter the inflationary part of the cycle. For now, I suggest not to invest in debt that extends beyond 2 years. Just treat it as cash. Remember cash does not earn real returns and as such you should not have more than 15% cash.
Currently my ideal total portfolio looks as shown below:
A - Investment Real Estate (not paper securities): 50%.
B - Paper Securities (Stocks and Bonds): 35 – 50%
C - Cash: 0 – 15%

We’ll refine this during the year.

Saturday, January 12, 2013

The 2013 Low P/E with Moderate Dividend Portfolio

This portfolio is constructed following guidelines set in James O’Shaughnessy ’s book “What Works on Wall Street”. O’Shaughnessy concluded that based on historically data the decile (1/10th) portion of the stocks with the lowest Price-Earnings Ratio and with good, but NOT the highest (and often riskiest) dividend yields outperform the average market (in our case the Canadian Stock Market) by 4% annually.
 
Last year’s portfolio returned 6.3% just slightly less than the S&P/TSX60 did as represented by the corresponding iShares ETF (symbol: XIU). So, somewhat disappointing – but then this is a long term (10 to 30 year) game. So let’s create our 2013 portfolio of 10 stocks that meet the criteria.  To find our possible candidates, we used Globe Investor’s GOLD database and found that 10% of TSX stocks with a market capital of $200 million or more trade at a maximum P/E of 10. Of these stocks I selected those with a dividend yield between 3 and 5%.
Thus I identified eighteen stocks. It turned out that several  of these stocks traded in the same market segment. For example there were several banks. In the Oil Service sector we found 2 companies that performed hydraulic fracturing including multi-stage fracturing. Also we found three stocks from last year’s portfolio still meeting the criteria.  Weeding out duplications and/or clearly unattractive stocks due to high debt or poor performance resulted in common shares of 10 excellent companies.
Drum roll! Ladies and Gentlemen, I hereby present to you the 2013 Low P/E and Moderate Dividend portfolio! 
Click on table to magnify
 
I must confess that I was shocked by the high quality of the stocks in the portfolio. I do want to note that I bought these stocks in the early part of this year before publishing this post and in amounts that I will not disclose. The theoretical initial investment in 2012 was $100,000 so this year we invested all the cash from dividends received last year plus the proceeds from the companies that we sold. We did not add to last year’s stocks that remained in the portfolio.

This blog does not make stock recommendations – it is only a ‘how-to’ blog and I don’t make any warranties or take responsibility for how you, the reader, use this information. Most stocks that I mention, favorably or unfavorably I do own or have owned in the past and may own in the future.
Oh! The 2013 TWIST! I promised a twist… Yeah right. I did not buy the stocks of the National Bank and BMO yet.  Instead I sold PUT options with a strike price that equaled the price at which I would LIKE to buy either bank.  You may want to review the discussion on buying and selling options posted last year on this blog.
Basically an option is the right to buy or sell a share of a company, e.g. Bank of Montreal (symbol BMO) for a certain price (the strike price) over a certain period of time. The time period maybe a couple of days, two months, three months or an entire year!  The longer the option is valid, i.e. not expired, the higher its value, also referred to as its ‘premium’, will be (just like in insurance).
I don’t buy options, i.e. buy insurance which is a form of gambling but rather I SELL ‘insurance’. For example, the BMO put option with strike price $60 expiring this April 21, 2013: I have sold to someone this option, i.e. I  collected the premium for the right to sell to me (my obligation) a BMO share for $60 between now and April 21, 2013.  To take on the obligation to buy this stock, the PUT option buyer paid me a premium set by the market and which in this case was $1.90 per share.
Rather than buy the BMO for $60 per share as we were more than happy to do, we collected $1.90 and we must buy the stock for our dream price if BMO falls below $60. If BMO shares don’t  fall below $60 between now and April 21 then we put the $1.90 in our pocket without having invested a penny i.e. we have an infinite high ROI. Of course, you need a line of credit or cash to be able to buy the stock if the option is exercised. 
If the PUT option is exercised then, in fact we have not bought BMO for $60 but for $60 minus $1.90 or $58.10 per share. Shares we’re willing to hold for at least a year in our Low P/E and Moderate Dividend Portfolio. However, even if by the end of 2013, either BMO or NA (National Bank) do not longer meet the criteria of the LOW P/E moderate dividend strategy; they would easily fit in one of our other portfolio strategies, in particular “buy quality companies that pay good dividends to be reinvested and hold ‘forever’. Long term returns for this second strategy are typically around 15% per year.
Thus buying BMO and NA for the long term for $1.90 less than our ‘dream price’ is perfect and has reduced the investment risk to less than when buying it outright. Bank stocks, typically fluctuate enough during the year, that we should fill our portfolio sometime during 2013 and in the meantime we can write every three months another put option until it gets exercised. The result is a final ROI that increases our originally projected return each time we write another put.
Say that we can sell a put option with a strike price of $60 twice between now and May, after which stock markets tend to fall (markets often peak between January and May). Remember: "In May... ", according to the expression "we go away" and in the fall (September and October) markets often fall. So, say in July BMO falls temporarily below $60, the option gets exercised and we buy BMO for $60 per share. The result is that we collected $1.90 between now and April and say another $1.60 between April and July;  we bought the stock for $60 and (with some luck) by year end the price has recovered and increased to $65.00. Then our annual profit is not $65-$60 or 8.3% as when the stock was bought right away in January 2013; rather the profit is $65 - $60 + $1.90 + $1.60 or $8.50 or a return of 14.2%. Hmmmm!
In fact profits are a bit lower because if you ended up buying in July, you missed 2 dividend payments of $0.77 per share. However, I am sure you’re getting my drift. Next post I will add even more profits!

Saturday, January 5, 2013

LOW PE and Moderate Growth Portfolio - 2012


We have reached the end of the portfolio’s first year and it is time to review its performance and rebalance it. Here are the numbers. Just click on the table at the bottom of this post to enlarge.
Overall portfolio performance, including dividend income, was 6.3% for the year compared to 7% for the TSX60 (ishares-  symbol XIU). Not bad but not stellar either. We performed as well as the Canadian market which is our benchmark. Cervus (CVL), Rogers Sugar (RSI), Corus(CJR.B) and Bird Construction(BDT) were great performers. Churchill(CUQ) and Cannaccord (CF) were big disappointments.

Sherritt(S) was the most volatile and because of its Madagascar mining project and sensitivity to China through its coal and other energy holdings, I felt that its upside potential ($9-$10) warrants keeping it for another year. We sold the losers and the winners that no longer met the portfolio’s criteria in order to restack the portfolio for 2013 with companies that do (next post). For tax reasons, we sold the losers and an equal amount in winners before year’s end the remaining winners were sold in early January to defer capital gains taxes by another year.
Brookfield Properties (BPO), Bird Construction and HZN (HZN.A - formerly Canadian Helicopters) still met our portfolio criteria and stayed in for 2013. Currently I am constructing the new 2013 portfolio. Since I made the commitment to have this as a real life portfolio (putting my money where my mouth is) I am currently in the process of buying the new portfolio with a twist about which I’ll talk in the next post.
This may be a good time to recap our investment philosophy.  Investing is a lifelong learning experience that starts with living below your means (how else can you save?) and by buying your residence which is not only your home base but also your financial base.  What I learned as a real estate investor, a business owner and former retiree is that Cash Flow is NUMBER ONE. You may have all the investments in the world but if you don’t have cash flow what are you going to live of?
Our goal is to be financially adult, i.e. we have enough cash flow to live of – your other income including salary from employment is extra! This way you will never be forced to sell your investments at rock bottom prices – you'll have the financial strength to wait things out and to buy and sell on your terms. Thus no more panic selling during stock market crashes. This does not mean that you hold onto an investment all the way to ground zero; later this year we’ll dive into 'trailing stops'.
Cash flow is NUMBER ONE and the most reliable part of our investment profits. Investment appreciation is the second component of our profits but that will come when it comes and it is the least reliable.
We want to diversify. The big problem with investing in stocks and bonds lies in that you do not control the investment – it is passive. Thus you have to trust others such as governments and management to look out for your interest which they usually don’t.  That is why it is so important to diversify and as a rule of thumb you should have not more than 5 to 10% of your stock and bond portfolio invested in a single company. Also, you have to be investing internationally – just compare U.S. versus Canadian stock market performance as far back as 1980 and you will see why. 

It took me a long time to see this because it is a long term thing.  The Canadian markets outperformed the U.S. in the 1970s up to 1982 – the end of the previous commodity boom. Between 1982 and 1998, the U.S market outperformed the Canadian (especially when taking the U.S. and Canadian Dollar into account); then between 1998 and 2008 Canada outperformed the U.S. big time and right now things are reversed once again.
My three core investment regions are Canada, the U.S. and Europe. I don’t like emerging economies – they are too risky and provide poor cash flow. Besides most commodity investments and multinationals provide plenty of exposure to emerging economies such as China, India and Brazil (BIC). Sorry but for me Russia is the perpetual loser and Putin… let’s not go there.

There are many ways to invest in the stock market. Typically I look for value and income; yet I am not a classic 'value investor' - I don't have the patience nor is my outlook long enough. So, I recommend to have a 'portfolio of strategies' as well. For me that is:
1. Invest in market index ETFs of Canada (40-60%), the U.S. (30-50%) and Europe (10%).
2. Invest in Canadian Low P/E and moderate dividend companies (Jim O’Shaughnessy: "What works on Wall Street).
3. Invest in high quality and dividend paying stocks both in Canada and the U.S. and re-invest the dividends
4. Invest in energy (today invest in infrastucture (e.g. TransCanada Pipelines, CalFrac); from 1990 to 2008 it was in producers (CNRL, Canadian Oil Sands).

Real Estate and my own business are the other 50 to 60% of my portfolio -  my 'active investment portfolio'. Those investments I control to a large degree.  Rental properties have vacancies and thus I like to mitigate this risk by having modest loan to value ratios (50% max), participating in and sitting on the boards of rental pools and condominium corporations. If you have more than 10 rental properties then you have a lower vacancy rate risk than with one.  If it is not rented, with one property, your vacancy rate is 100% and that can be problematic (it reduces cash flow big time!).
There are people who swear by stocks; others by real estate – me, I like both and more. One final thought: if you really would be immortal, how are you going to live a decent lifestyle if you don’t know how to live of your investments? Ooh and think of the effect of compound returns! When you are 200 years old and using compound returns, I bet that you’d be able to afford a cute 25-year old nurse. Oh Godfried… you’re gross! J

Click table to magnify