Monday, February 18, 2013

“F..k is that all?”

If the executives of Canada Pension Plan Investment Board (CPPIB) were like Encana’s executive you might have heard some expletive after revealing their investment portfolio’s target performance of 4%. You may have caught a whisper like “4%? F..k is that all?”

Fortunately, the CPPIB’s executive is a lot better mannered than Encana’s and probably bright enough not to split its oil and gas business into two separate companies. In fact, Encana’s executive did not only split their company into Encana and Cenovus (I guess to realize shareholder losses J) but today the new Encana’s  board has the incredible foresight to diversify from natural gas into… oil. Wow!!! No wonder they’re scared (vowels ‘i’ and ‘e’ are missing - sorry no other language possible) about a foreign takeover!  Those pampered executives would lose their overpaid jobs the moment the take-over was formalized.
So what has this to do with the CPPIB and the National Post’s header: “CPPIB ‘cautious’ amid competition in real estate, debt capital markets”? Just as little as the relevance of the Post’s headline to the real message of the story! He! My blog’s headlines have to grab your attention too! J
The true story is here about today’s realistic investment expectations and asset allocation.  The first significant take-away from the article is CPPIB’s investment performance expectation. And if this expectation is set by a conservative, highly reputable, investment board such as the CPPIB then maybe we should pay some attention. For 2013 the fund’s expected real return is 4% [or 6% after inflation - my estimate based on 2% inflation].
The CPPIB also states that it has NET assets of $172.6 Billion of which $85.4 billion is in equities (stocks), $57.8 in fixed income and real estate, and another $29.6 in infrastructure.  If I do the math right then the asset categories add up to $172.8 Billion. But he! What is a discrepancy of a mere $0.2 Billion or $200 Million to the CPPIB… after all it’s not their but our money!  That or maybe the National Post had problems adding things up.
Thus, our Canada Pension is 100% invested today, other than funds needed for its daily operations (including this year’s pension cheques and of course it’s executive compensation). Thus its asset allocation is 49.4% in stocks another 33.4% in fixed income and real estate (strange asset mix!) and another 17.1% in infrastructure.  Speculating that the CPPIB’s split between real estate and fixed income is 50%, sets their fixed income portfolio at only 16.7%.
There two other things we may learn from this newspaper article. Firstly, Mark Wiseman, chief executive of the CPPIB says about its real estate acquisition policy: “we have the luxury of not having to invest… and we can pick our spots”.  This is also true for us small investors, we do not HAVE to invest… instead we can stay in cash and keep our powder dry. Apparently that is often not the case for professionals.  I would call this our ‘competitive edge’. Secondly,  Mr. Wiseman states that he won’t be lured into competition for hot real estate that could drive down returns and neither will we.
But Mr. Wiseman, if you are truly happy with the expectation of a 4% real return in 2014 and if I sat on your board then I would probably whisper: ““F..k is that all?” Lucky for you, you don’t pay taxes on your investment income as us small investors have to.

Saturday, February 9, 2013

ETFs in today’s bull market – a contrarian view

When looking at the S&P500 we’re seeing that prices have similar levels now as at the peaks in 2000 and 2007. Once again the S&P is at 1500. So is the next market crash unavoidably near?  Not really but it is not the best time to buy a lot of stock either. “Godfried, how can you say that when we’re near all-time highs ?”, you may ask. Because today, stock prices are still reasonably valued in terms of book value and P/E metrics.

You see, in spite of the media howling about how bad the economy is, our economies: Canada’s, that of the U.S. and that of the world in general have been growing. Yes, the 2008 crisis was severe but it only stopped economic growth for a short time. Europe overall was most of the time during its credit crisis growing and only lately it is experiencing a recession (contrary to some individual member countries such as Spain and Greece). Did the press not tell you about that?
Over the long term economies grow, inflation goes up and profits grow, even if just nominally (i.e. without correcting for inflation). In terms of P/E (the price we pay for a dollar in earnings; or the years it takes to earn back the money you pay for a share; or the stock price divided by the earnings per share) the market is reasonably priced. At the peak of the 2000 bull market, the S&P500 was close to a P/E of 29. In other words, you would have to pay 29 times the earnings per share to buy a share, or you would have to wait 29 years for the stock's current earnings to pay for the stock purchase, or your earnings yield would be 1/29 or 3.4% compared to the interest rates around 2000 which I recall were typically 6 or 7%.  In 2007 the P/E was around 17 which was not excessively expensive but pricey when compared to historical valuations. In 2009 at the bottom of the market the P/E was only 10.9.  So would you prefer to pay $30 for $1 earnings or $10.9?  Right, and that is why we said that the stock market was on sale in 2009.
So when do you think it was the most risky time to buy stocks? At the peak in 2000 when everybody shouted “Buy, buy, buy!” or at the lows of 2009 when everybody shouted “Sell the world is coming to an end!”? Hindsight is 20/20 that is the difficult thing with investing. We cannot time these market turnarounds but we can prepare for them because just by checking PEs or the Price/book ratios (the stock price divided by the company’s net worth or net asset value) you can figure out what kind of turnaround is in the making and… in the market either kind is always in the making. You cannot time a particular turnaround but you be a good Boy Scout whose motto is “Be prepared”.
What is this thing about ETFs? Well, in general, I like the ETF idea, that is why one of our portfolio strategies is dedicated to market index emulating ETFs. But many investors are today investing in ETFs and mutual funds are apparently in the dog-house. After all, everyone knows that the MERs and commissions combined with the efficient market hypothesis are causing mutual funds to systemically underperform!  Isn’t that true? Godfried you said that yourself just a few posts ago! 
Yep, but the theory also says that if something is known the market will near instantaneously adjust. So why is not everyone in ETFs? Well, because the theory is not perfect. In fact if it was true that markets are efficient then how can the market trade one moment at a P/E of 30 and the next at 11? How would you react if someone told you that your house was worth 30 dollars last week and that next week it is worth 11?  You would probably think that that someone is out of his/her mind, wouldn’t you?  What about the place that you work? Would that be worth $30 today and $11 tomorrow?  What has changed overnight at your workplace? One bad quarter of earnings? Come on!
First of all, markets are not rational they are hysterical. So are the press and everyone who believes them.  You have to look at the real facts to judge what a company is worth – it’s earnings – not for one day or for one bad quarter but for the next 5 or 10 years. You have to look at a company’s financial structure and its state of obsolescence or innovation. You cannot price it based on how you or the world feels right now. If you do that, you’re likely to end up in the poor house no matter what you’re salary is.
I guess the Efficient Market Hypthesis (EMH) is far from perfect contrary what many ETF advocates may tell you. Now remember investment legend Ken Fisher, who likes to try to figure out what is not known by the market and does not go opposite to the market trend but tries to guess what alternative directions the market may take. Well here lies the opportunity, as I see it.

The EMH is about the average market performance. Who determines the average market performance? The bulk of the buyers and sellers in the market of course. Now, ask yourself, in the 1950s to 1970s who constituted the ‘markets’?  My guess, retail investors, banks and some other institutions with the retail investors having a lot of influence. Between the 1970 and 1990s it were the mutual funds and hedge funds who did the heavy lifting and now it may be that ETFs will take over from mutual funds. The heaviest traders today of course are the high frequency traders but they do not necessarily influence market directions, just the level of volatility.
What are the consequences of this change in market makers?  Retail investors were amateur stock pickers (still are); mutual fund managers are professional stock pickers many of whom hold corporate management accountable. When ETFs become mainstream who is going to hold corporate management accountable?  Yep, nobody! Don’t count on analysts many of whom are just corporate cheerleaders who don’t want their brokage being left out at the IPO trough. Talking about conflict of interest!
Guess what else is likely to happen? Indexes such as the S&P are based on market weight; the largest companies (in market capital) make up the largest portion of the index and thus of the index ETFs. When people buy index ETFs these large caps will be highest in demand and their prices will go up and thus the index will go up and then more people are buying the index and so on and so on. This is a self-feeding frenzy that ultimately will form the peak of the next bubble. When the crash occurs, it will be the ETFs that everybody will bail out from and consequently it will be ETF investors that are going to be hardest hit. 
Mutual fund managers buy their stocks selectively and especially those who buy based on valuation metrics like PE, book value and market cap size will likely be least impacted in the crash that follows the ETF-bubble (every investor will lose portfolio value but contrarian managers such as Warren Buffett and David Dreman or past managers such as John Templeton will likely be least affected). My guess is that index ETFs will outperform in this bull market (and several of the following bull markets) but that they will also be hardest hit in the subsequent crash(es) as they will set the ‘average market performance’. When you see index valuations rise significantly start taking profits and accumulate cash for the next major down turn.






Saturday, February 2, 2013

ETFs belong in your TSFA

The second strategy that we want to employ in our overall paper securities portfolio (as opposed to your real estate portfolio) is a simple ETF strategy. Our first strategy is the LOW P/E with moderate Dividend yield portfolio. In the 1960s, academic stock market researchers such as Eugene Fama came up with the “Efficient Market” theory. The theory stated that news that impacts company performance specifically and the market in general travels so fast and is evaluated equally fast by knowledgeable investors that it is nearly instantaneously reflected in the market prices. Thus the stock markets are extremely efficient.

As a result, other than by sheer luck, nobody can outperform the markets.  The existence of investors such as George Soros and Warren Buffett were considered aberrations that will overtime revert back to the average market performance. If from that average return investors have to pay commissions and management fees and other expenses to mutual fund managers then it is impossible for the mutual funds to consistently outperform the markets; to the contrary they are likely to underperform. So why would one want to buy an expensive mutual fund or sweat on the research and purchase of individual stocks when just buying the stocks that make up the market index will deliver probably better results? Even better, if you pooled all investment funds and buy the market index, especially smaller investors, would probably get even a discount on brokerage commissions – the Exchange Traded (Index) Funds (ETFs) were born. An early pioneer was John Bogle who created through his fund company Vanguard numerous ETFs. Today, you can buy all manner of ETFs and market index ETFs are quickly outnumbered by those that aim at specific market segments or track specific market strategies.
For small portfolios, market ETFs provide instant diversification at minimal costs. So they are ideal for small and beginning investors. The ease of buying ETFs and the instant creation of diversification with a modest (average market) dividend is also attractive to larger investors in order to build a ‘core portfolio’. For me it is also a way to create very efficiently a portfolio of international stocks in markets with companies that I am not familiar with. Finally it is a tool to create a ‘I am gone fishing’ portfolio, in other words, it does not require a lot of time and work.
But reality remains that markets are not truly efficient – certainly not in the short term. Nearly every day over the last 4 years, the savvy investor could buy shares from great companies for cheap and dirt cheap prices. But in order to do that, you have to be able to determine with significant accuracy what a company is actually worth and how good its management is while buying when everyone else is running for shelter and nobody else wants to touch stock. The theory of buying low and selling high is much more difficult to execute than the simplicity of this statement suggests.
I don’t consider myself the fool-prove stock picker with nerves of steel who can consistently buy stocks as well as Warren Buffett. And even Warren is known to make mistakes. We’re talking genius here! So, an ETF portfolio should be suitable for me. And… I happen to know the ideal place to hold my ETF portfolio: the Tax Free Savings Account or TSFA. There are numerous different views on this account type as well as on its older brother (or sister… maybe I should say ‘sibling’ J) the RRSP.
The reason I prefer a TSFA over an RRSP is straight forward. RRSP only provides you a true investment advantage when you contribute at a lower tax rate than when you withdraw the money. The math is simple: your tax refund is proportional to your current top tax rate. Say you’re making today $30,000 and you your top tax rate is 17%. Your tax refund on a $1000 investment would be $170. So $1000 pre-tax dollars invested at say 10% would after a year provide you with $1100 proceeds. Say your tax rate has gone up that year and you top tax rate is now 38%.  Thus, after that one year you pay upon withdrawal $418 in taxes and your after tax return is: $682
Suppose you do not put your $1000 in pre-tax income in an RRSP. Then you pay $170 in tax first and you have $830 to invest that at 10% returns $83 over which you pay 38% tax upon withdrawal at year’s end or 38% of $83= $31.54 (that is the worst case – i.e. you have pure interest based profits – no capital gains and no dividends). So after tax you have now $830 + 51.46=$881.46
Ehh… what?  I made less in my RRSP? Yep $881.46 outside and $682 inside the RRSP.  Did your investment ‘advisor’ tell you that? Now let’s do the same with a TSFA. You invest $1000 in pre-tax dollars or $830 in after tax dollars in your TSFA for one year at 10%. After one year, you have $830 + $83 = $913 dollars and when you withdraw that… no taxes! You walk away with… $913.  Anyone wants an RRSP?  Anyone expects to make less next year than today? Anyone expects to make less 30 years from now than today?  If you say ‘Yes’ to that last question then why the hell are you investing?
So Godfried LOVESSSSSSSS the TSFA, The only real drawback is that I can only put in $5000… oops $5500 per year. But heck, if you have put in the max contribution since inception you would have contributed $25,500. Not bad considering that that is about the size of the average investment account in the first place! There is one more drawback: When you lose money, you really do lose it – there is no capital loss tax deduction to soften the blow.  But heck we’re long term stock market investors and the chance that you make a loss on a diversified stock portfolio held for 10 years or longer is zilch! Yes if you hold the portfolio for a day or a week your chance to lose money is over 50% but not when you invest for the long term.   In fact, stretched out over decades a stock market index portfolio typically makes 7% plus inflation annually according to research by Jeremy Ziegel (yet another professor).
Now, as a faithful student of stock markets you may have noticed that not all stock markets perform similarly. Often Canada’s TSX underperforms (due to its high emphasis on resource stocks) when the Dow and the S&P500 are on a roll and… vice versa. European markets go their own pace as well. When directly investing in emerging marketsthere is the risk of lower accounting standards, political risk, etc.  This makes these markets more volatile and less desirable for me personally. Canadian resource stocks as well as U.S. large caps often benefit from the growth of these emerging economies as is. Hence, TSX and DOW or S&P500 index funds are good enough and even European large caps will benefit from strong emerging market economies. So why take the risk of investing in them directly?
Now here is another reason I like ETFs… it is called with-holding taxes and Canadian dividend tax credits.  Dividends from Canadian companies get taxed less (by nearly 20%) than interest income and than dividends from international companies. On top of it, when not in a tax shelter such as a RRSP or TSFA you have to pay with-holding taxes (typically 15%) right of the bat. So really, if you hold international stocks you want to hold them in a tax sheltered account. That way you don’t pay tax on your dividends and there is no with-holding taxes (may depend on host country).
Really, can the creation of a well-diversified global portfolio with minimal taxes be any simpler than creating an ETF portfolio of Canadian and international stocks in a TSFA?  I don’t think so. Here is my ETF portfolio:
       1.       Canadian Stocks (XIU or XIC): 40%
2.       US stocks (XSP): 40%
3.       European Stocks: 20% (IEV)