Monday, December 29, 2014

Looking into 2015 – BTW expect my opinion to change as early as tomorrow


So this is the time of the year when we’re trying to see what the next 12 months may have in store. The key word being MAY! Let's start with today’s situation and then extrapolate from there.
Right now the U.S. economy is growing at a good clip. In fact an estimate for inflation adjusted economic growth for the 3rd quarter of 2014 was an incredible 5%. What do these guys think? This is not China!  The economic growth is created by a super low interest rate environment, increased consumer confidence, more jobs and cheap commodities including lately cheap energy. 
Really, what more do you want as a manufacturer or service provider.  These things put an economy like the U.S. on steroids and Europe is not that far behind. When the U.S. and Europe do well, guess what, the Chinese will see their exports take off again. All these guys love cheap energy.  No wonder the S&P 500 is up a whopping 23% for the year.  ETFs anyone?  You bet!
Canada and Australia are classic commodity supplying economies and with commodity prices in the K.O. corner of the economic rink, these resource based economies are not so hot right now.  Yet, the TSX60 (Canada’s 60 largest publicly traded companies) returned an impressive 12.4%.  Many of these 60 companies are not resource companies but insurance companies, banks, hi-tech, and real estate companies. On top of that, resource companies in the TSX60 are large enough that they are somewhat diversified either in hydrocarbon style (gas, bitumen, conventional light oil, tight sand-light oil; unconventional gas SAGD oil, etc.) or they are diversified through an upstream and downstream portfolio. 

It are especially the mid and small sized resource companies that have been hardest hit. Also, royalty income and land sale proceeds as well as corporate and income taxes for provincial and national governments are likely to suffer.  Maybe this time Canadians will learn how much they benefit from the resources industry that so many of them seem to hate.

Apart from the U.S. and, to some degree, Canada not many economies in this world are doing very well. Countries like Russia, Venezuela and Argentina are in deep ‘doodoo’. So are Middle Eastern countries with their never ending infighting. They blame the Jews, the West, the large multinationals, the infidels, anyone but themselves for their misery.  Now, finally, after none seem left who can be blamed, they’re fighting themselves over religious or tribal  differences.
It is the North American energy revolution that has finally lifted the veil of the causes for Middle Eastern fighting. Good, maybe they can finally stop blaming the stereotypical white male for this evil in the world. Plenty left to blame the stereotype for anyway.
As far as commodities is concerned, the fall in pricing is blamed on oversupply.  Personally, I think that a rising U.S. dollar, the currency in which many commodities are being priced, is at least in part to blame.  With western economies finally on the mend and with exporting economies probably soon to follow, I think that demand for raw materials and energy will pick up pretty soon. Also, the current energy prices are excessively cheap – in several cases below the cost of production.  Part may be due to speculative forecasts made by companies such as Goldman Sachs who seem to confuse their own interest with those of their clients. How can you trade for your own accounts while  providing advice to your clients against whom you often trade?

So, for 2015 I foresee continuous improvement in economic growth with slightly higher interest rates in the latter part of that year. 2016 is probably when we’ll see more tightening in the U.S. to more normal levels. With Europe and Asia improving, the U.S. dollar may stop its upwards trajectory while other currencies strengthen a bit. With falling supplies and increased demand, energy prices are likely to improve say up to $75 dollars per barrel of oil and close to $4.00 per mcf for gas (in North America). That may not sound like a lot, but that is close to a 50% increase for oil from current levels and an 25% increase for the gas price. Hmmm…. How would oil and gas companies benefit from such a turn-around? 
Pipeline companies are not as much affected by oil prices, yet their share prices have dropped significantly as well while the shortage of transportation capacity remains an environmental, economic and safety issue.  As such, right now, you can buy pipelines cheaply, especially on further weakness. They are likely the first to benefit from stabilizing and improved oil and gas prices. Other commodities such as copper, silver, zinc, etcetera  will likely benefit as well from the improving world economy.
Yes, there is a lot of rosiness for investors to look forward to as we leave the depressed state of the Great Recession farther and farther behind.  But with that, so will our memories fade of the dangers of the stock market and investors may throw their caution out of the window and grow outright euphoric right before the next market crash which is sure to come – not IF but WHEN?
I have become more and more a proponent of international investing.  First the U.S. which likely will have yet another good stock market year – 10 to 15% appreciation?  But if so, brace yourself for more volatility and a crash in 2016 or 17. This is becoming a very long bull run.  Canada and Europe will do well too and the Chinese stock market is likely to extend the gains of this year into next – another 30%?

But if this scenario becomes reality, do not be afraid to take money of the table. Use a stop loss to sell under performers and sell highflyers with prices that exceed their normal valuations by a wide margin.  You will have to balance the need to let profits run with risk management because the higher the market flies, the riskier it becomes.  

My allocations for 2015 for new investments are Canada 30%; U.S. 30%; Europa 30% and 10% in emerging economies such as China, India and Brasil. Also build your cash holdings so that you have around 15% cash near the end of 2015. Ohh, by the way – this forecast may change starting tomorrow

Sunday, December 28, 2014

How much leverage do I need in real estate? BTW Is anyone looking for a pension plan indexed for inflation?

If you buy an asset that rises 15% per year in value and you use only half your own money while lending the rest, you’re making close to a 30% return that year.  Especially if the interest costs of the loan is covered by net cash flow generated by that asset.

If you only put 20% of your own money down and borrow the remainder, that same asset will return 5 times 15% or an absurd 75%. So why not borrow 80% and go for this investment?  Well… what if… the asset loses 20% in value instead? Oops, the asset is worth only 80% of your original investment and that is what you borrowed from the bank!  So how much is left of your 20% down payment?  The answer: Nada, Nothing, Zilch, Zero!  Your loss is 100%!  Hmmm.
That is why many consider leveraged investing high risk. And it can be! Look at the stock market.  Say you bought $80,000 to invest $100,000 in a high flying oil company last month?  Ouch, those companies dropped often 30 or 40% in one month. So, your oil investment today is worth say $65,000 and that wipes out your $20,000 plus you owe the bank $15,000! Many real estate millionaires have bitten the dust because of leverage and remember the stories of 1929 when people jumped out of tall buildings during that market crash? Yep that is leverage at work.
Some say, that real estate is stable and much less volatile than the stock market. Maybe, but remember the U.S. 2008 real estate bust?  Did you ever buy that piece of recreational real estate in Whistler?  Did you own real estate in Calgary 1982 when that market dropped nearly 30% in less than three months and 50% during that entire debacle? 

So, what is better for investors, real estate or bonds or stocks?  To be honest, I don’t know. They all have their good and bad days. I do know that over the last 40 years or so Calgary real estate and also real estate in other parts of Canada appreciated 3 to 6% per year on average. I also know that the net cash flow in Calgary from rental properties prior to mortgage payments varies between 3 and currently 4.5%. Real estate investors call that the ‘cap rate’ which is current operating profits (comparable to the EBITDA of many companies) divided by the current market price of the real estate asset.
Jeremy Siegel has studied stock market performance over the long term in his classic book: “Stocks for the Long Run”. He has done so in each of his numerous updated editions. He calculates that stocks are the best performing financial asset you can invest in and that it outperforms bonds, T-Bills, Gold, GICs and whatever you have. Its long term return is 7% plus the inflation rate.  So currently the inflation rate in Canada is around 2% and thus the stock market's average annual return should be around 9%. Jeremy’s work is based on U.S. stocks but others have compared his work with international stock markets and get similar results. So let’s use Jeremy’s number of 9% (including inflation) and see what leverage it takes to make the same returns in real estate.
I made this little spreadsheet (see below) and ran 4 annual appreciation rate scenarios for real estate. I also used the current Calgary Cap Rate of 4.2%. I calculated how much leverage you need to make a return equal that of Jeremy (9%). The results are shown in the table below. The input data is Jeremy’s and shown in yellow. The Loan-to-Value ratio (i.e. the loan amount as a percentage of the purchase price) in the blue fields expresses how much leverage is needed if real estate appreciates by 3, 4, 5 or 6% per year on average to achieve the same returns as Jemery's.  The current cap rate is set at 4.2% which I currently achieve on my rental apartments in Calgary. In the last portion of the sheet, in the white fields you can see how an older 2 bedroom Calgary apartment, typically valued at $220,000 cash flows after making the loan payments).
The loan payments are based on the assumption that each $100,000 borrowed results in a loan payment (interest and repayment of principal) of around $500 per month.

 
I found the results revealing if not shocking! Last year, Calgary real estate appreciated by 10% but over the long term, it is closer to 5%. Basically, with the current cap rate, an investment would not need any leverage to equal Jeremy’s long term stock market and $9,240 of the profits would be returned as cash!  He, anyone wants a GIC?  J 
Even with modest appreciation of 3%, to equal stock market performance only a leverage level of 28.6% would be required and your property would still throw off $5,468 in cash ignoring the principal that is being repaid as part of the loan payments! Considering a repeat of Calgary’s worst real estate price decline in the 1980’s of about 50%, no lender would recall the mortgage with this leverage level and you could easily outwait the crash to rebuild your profits.
So, for a conservative investor who wishes a return comparable with the stock market and probably a less volatile investment on a day to day basis, what are you waiting for?  Before closing this post I would like to point out two more things.

When you invest in stocks, you have leverage involved. Many companies have substantial debt on their balance sheet – debt that is not under your control but your stock value can get wiped out because of it.
Secondly, with this kind of leverage (4.8% LTV) 6 properties or 1.3 million in real estate investment would receive close to $50,000 per year in cash to live from as a retiree.  Hmmm, combined with Canada Pension and Old Age Security that is not a bad retirement income don’t you think so? And this retirement plan is indexed to inflation!

Why is Canada underperforming the U.S. stock markets – Asset Allocation


A few years ago, between 2008 and 2011, many stock markets performed similarly and asset allocators where saying that investors should diversify their portfolios by sector rather than by geography. Now, just a bit later, the divergence between Chinese, European, Canadian, and U.S. markets is remarkable, or in Asset Allocator lingo the correlation between said markets is poor. When you dig deeper, you may notice that it are the Materials and Energy sector that performed poorly in Canada and that e.g. our Banks performed well if not better than U.S. banks. If you compare the performance of many Canadian oil and gas companies with those in the U.S., say compared to Exon-Mobil, you may notice that the latter performed better than its Canadian counter parts.  Why?  The answer lies in diversification and asset allocation.
Exxon –Mobil not only explores for oil and gas like most of its Canadian peers, it also refines and sells hydrocarbon products to the consumer. It doesn’t only produce oil and gas from land-locked Alberta, it also does so from the U.S. and many other areas of the world. Exxon-Mobil is a truly diversified oil and gas company and although its price did fall a few percentage points; its Canadian counterparts were often decimated with losses in the 20% to 70% percent range because of their lack of diversification; their specialization into either oil or gas, their specialization into a region (Alberta, BC and Saskatchewan).
The divergent economic performance of various geographies was also striking this year and now, with the fall in oil prices, it may diverge even more in 2015, with oil-importing economies outperforming the hydrocarbon (and other resource) producing economies. For a while, that is; my guess is that oil and gas demand will improve with the economy and the current, much heralded surplus of oil production is barely a million or 2 million barrels compared to a worldwide supply of 90 million barrels per day. With current oil prices dropping below the cost of production or below the price required by countries such as Saudi Arabia, Venezuela and Russia to maintain economic and political stability it should not take long before the ‘surplus’ melts away as snow under the Calgary Sun during a Chinook. But then, I am an optimist – I really have no clue.
There is the other side of the coin, ETF funds representing major market indexes such as the S&P500, the TSX, or the Han Seng index once again outperformed 96% of mutual funds and most retail investors.  The combination of diversification and low transaction costs has once again outperformed most funds with active management. I haven’t checked our own Moderate Dividend and Low PE portfolio yet, but I guess, it has performed OK as well. The reason of this outperformance lies in diversification and time in the market.  This becomes even more obvious if you avoid transaction costs such as buy and sell commissions, account fees, and… minimize taxes.  Especially capital gains taxes are critical as they basically represent an interest free loan from the government on your best performing stocks.  And… unlike mutual funds (outside your TSFA and RRSP), when you lose money, the government shares in the pain in the form of a capital loss tax credit. Mutual funds are collecting their fees regardless whether you win or lose but the government shares a bit in your pain.  Isn’t that sweet? J J
Many U.S. and other stock markets are now in their 6th year since the lows of 2009 and have often gained 200% or more from their lows; this bull market is definitely becoming long in the tooth. You may feel inclined to build up your cash position. The unavoidable question is how much?  What is the price or better the opportunity cost of holding cash?  This raises other questions about allocation such as what in terms of portfolio performance the cost is of holding on to a loser?
If you have winning investments averaging a return of 13% and you have diversified your portfolio with an average stock comprising no more than 5% of the total portfolio value, then how is the total portfolio affected if you were 1, 5 or 10% in cash? The answers are 12.87%, 12.35% and 11.7% respectively (see figure below). On the other hand, if you had one 5% holding that lost 20% in addition to the cash your total performances would 12.54%, 12.03% and 11.38%. You can experiment yourself with other combination of allocations.  If you hold cash, it limits your upside versus being fully invested, but having cash, even when you lose everything else, provides you a chance to fight another day. The same with a stop-loss. If you limit your investments to a maximum of 5% and sell as soon as an investment falls 20% then the effects are barely noticeable. But on the other hand if you had all invested in one big winner, you could have been rich. But what are the odds of that? 
The odds of picking a winner and having the nerve of running along with the profits until you are rich are like winning the lottery; well…  ?  Pretty close. What do you think are the odds that you will perform better than the market when more than 90% of professional investment managers cannot? Even Warren Buffett, after his death, plans to put his holdings in market ETFs! However, do realize, that even with all your stock holdings invested in ETFs, you will underperform the markets because ETFs hold no cash while your portfolio typically does.
There may be times, when market prices have fallen so deeply and when brilliant companies are so cheap that purchasing them directly becomes a no brainer.  Like buying Microsoft for $18 in 2009. But those times are few and long in between. Some commodities may lend themselves to humongous profits on occasion, but never buy them unless there is a clear turnaround. Gold has not yet turned around; oil has not turned around. Take your hand out of your money pocket and wait for the turn around, which could be years away. Only then, when it is obvious that a brilliant company is way too cheap, think about buying. Do not be in a hurry, and realize that because of your maximum 5% limit for your portfolio holdings your profits, just like your losses are limited. So, if you miss that profit opportunity it won’t impact your performance dramatically.

 Right now, regional performance is quite divergent.  The U.S. is on a tear – and typically during times of cheap commodities a manufacturing and service economy like the U.S. outperforms Canada easily. Once economies overheat and supply shortages of commodities develop will it be Canada’s time to outperform. Europe trails the U.S. but possibly not for much longer – it is also likely to outperform commodity dominated countries.  Next will be the emerging economies like China and India and Brazil.  For now focus on putting some money in U.S. ETFs that track the S&P500; buy lesser amounts in Europe and Canada which are cheaper.  When the market in the U.S. gets too expensive, switch your allocations elsewhere and don’t forget to take some profits from time to time.  About that more in later posts.