Activating a credit card – telemarketing spam

Since my Starbucks Duetto card was discontinued by Starbucks and/or Royal Bank of Canada, my intention was to take the new credit card RBC delivered and just use it as a backup card (after cashing out the 3000 points for gas money). When calling the credit card activation number, I was fully prepared for the script. You punch in your credit card number over the phone, get transferred to a person that then asks you for your credit card number (presumably because the information doesn’t get passed onto his computer screen?), name, birthdate and then says “While the activation is processing, as a valued RBC customer, I would like to offer you……..” and then went through a bunch of legal gibberish about their “balance protector insurance”. I have heard this spiel before. The guy’s accent (obviously Indian) was so thick that I had difficulty listening to him. He spoke it so fast that I’m amazed anybody would be able to understand him.

However, what was interesting was how they phrased the last question. “So, Mr. Peter, do you believe that maintaining your credit rating in the event that you cannot pay your credit card balance is important?”. This was a new way of phrasing it. Before they just simply asked “Would you like balance protector to protect yourself against your inability to pay a credit card if there is a life-threatening hurricane in your area?”

Most people have a huge psychological difficulty in saying “no”. I am not sure why, but it is taking advantage of the old-style Victorian culture of politeness. Most charities and aggressive marketers always love phrasing questions in such ways that it is very difficult to say no – from political life, “can I count on your support?” is the typical question asked. As soon as you answer in an ambiguous manner, they draw you in for more.

Anyhow, I said “NO, I am not interested in the offer” and left it at that. The fellow on the phone continued, “Because RBC values your opinion, tell me why…” – as much as I would like to get into an argument with the call center guy, I know it would be just a waste of time. First of all, RBC doesn’t care what I think. In fact, I know what RBC and all credit card companies think – I’m part of a statistical pool, and they don’t care what I think at all, as long as I pay the balance (with or without interest, preferably with interest) occasionally. The even more insulting part is that the line “While the card is activating, let me sell you this crap” is complete garbage, simply because activation happens as soon as the guy clicks a button on the keyboard and doesn’t take one minute to go through the system. The guy just says it to launch into a marketing pitch that his employer tells him to.

I can’t believe that people actually agree for the ancillary garbage, but since they have it on the books, they must be able to get enough suckers to warrant annoying the 97% of people that just want the card activated and to get on with their lives.

Valuing Western Financial Group Preferred Shares

Western Financial Group (common: WES.TO) is primarily an insurance brokerage in Western Canada. They have been able to grow their top line consistently over the past few years, while their bottom line, although profitable, has fluctuated with the market. It is likely they will continue to be making money in the future, so payment of debt and preferred securities should not be an issue, barring any huge global financial crisis.

They have an issue of preferred shares (series 5, WES.PR.C) that has the salient details:

$100 par value, 9% coupon, payable semi-annually;
Holders can convert into common at $2.81/share anytime;
Issuer can convert if common is $3.79/share or higher after September 30, 2012;
Issuer can convert if common is $2.81/share or higher after September 30, 2014.

As I write this, the common is trading at $2.87/share and gives a 4.28 cent annualized dividend (1.49% yield). The preferreds are illiquid and the bid-ask midpoint is $113/share.

To value this preferred share, you must break down the fixed income component and the embedded call option that you (a preferred shareholder) sell to the company.

The fixed income component is simply [coupon / (share price / par value)], which in this case is 7.96%.

The more difficult valuation is with the conversion component. This creates a few scenarios, and note that we assume we sell the common shares immediately after conversion:

1. If the common trades above $3.79/share on September 30, 2012;
2. If the common trades above $3.79/share between October 1, 2012 to September 30, 2014;
3. If the common trades less than $3.79/share after September 30, 2012, but trades above $2.81/share after September 30, 2014.
4. If #1, #2 and #3 do not apply and if the common trades less than $2.81/share after September 30, 2014 until X date.

Scenario 1 is fairly easy to calculate – if you anticipate this happening, you really should invest in the common shares rather than the preferred shares. If the common stock ends up at $3.79/share on September 30, 2012, you will essentially be receiving $135 of value for your preferreds, plus 5 semi-annual coupon payments. A $113 investment will result in $135 in capital gains, plus $22.50 in coupon payments over a 2.40 year period. Annualized, this works out to a 7.69% capital gain, plus a 7.96% income yield. This is contrasted with a common stock performance of 12.3% capital gains and 1.49% income yield (assuming no dividend increase) over the same time period.

In this event, the preferreds seem to be the better investment, especially when seniority is considered. If the common shares go higher than $3.79/share before 2.4 years, the returns between the preferred shares and the common will be proportionate.

Scenario 2 will result in the same absolute return, but depending on when the threshold common stock value is reached, it will result in the same absolute return in terms of capital, but the annualized yield will be less because of the extra time taken to reach the conversion threshold. As an example, if $3.79 is reached on September 30, 2013, the preferreds will have an annualized capital gain of 5.37%, and an income yield of 7.96%, while the common will have a capital gain performance of 8.52% and income yield of 1.49%.

Scenario 3 – assuming the common stock does not go anywhere (i.e. stays at $2.87/share) for the next 4.4 years, a common share investor will receive a 0 capital gain and 1.49% income yield; the preferred holder will receive a 6.4% capital loss on conversion (annualized will be 1.42% loss), but retain an income yield of 7.96%. There are multiple variables at play – when the conversion price is reached and what price occurs at September 30, 2014. For a 10% increase in common share value above $2.81, the preferred shares’ effective value on conversion also increases by 10%, but is capped to 35% when $3.79 is achieved.

Scenario 4 involves a loss – in this event, the fixed income nature of the shares will be more apparent and the conversion privilege becomes less valuable. A common shareholder will lose more capital than the preferred shareholder.

At a value of $113/share, the value of the common shares needs to be $3.18/share in order to avoid a loss of capital upon conversion. This is approximately 11% above the current common share price, but the preferred share holder is compensated for this by the higher coupon payment – they would receive payback for this difference in about one and a half years of coupon payments.

As such, somebody interested in Western Financial Group should be better off buying their preferred shares rather than the common shares as their preferred shares, for now, has a relatively high correlation to the appreciation of common shares, but will be giving out a significantly higher income stream. The only disadvantage is that the preferred shares are horribly illiquid and getting a fill at a decent price and/or size is not easy when nobody is trading.

The difference a weekend and a trillion dollar pledge

The following is the 5-day chart of the implied volatility of the S&P 500 index:

Trying to predict this in advance is very difficult and one reason why I generally do not believe people that say “I bought at 25 and sold at 40”. Trading is never that clean – you never know when the bottom will be, and you never know when the top will be. You only have a fuzzy idea whether something has been over-extended, but you never know whether you are correct or whether you will get the timing right.

Everybody is a perfect trader in retrospect.

Most of my portfolio losses from the previous week have reversed today. If I was going to guess, there will be another spike or two of volatility as traders test the waters, but I think this is it for the short term (i.e. back to “business as usual”). In the medium term, I would be very, very cautious. Markets tend to gyrate significantly in economic stagnant periods.

Other than using the spike down to liquidate some US currency into Canadian, and making a very minor trade (using some idle cash that has accumulated in the RRSP account), I’ve been twiddling my financial thumbs. The worst trades you can make are ones where you are forced, or trade for the sake of trading.

Aftermath of the May 6 financial earthquake

I have been diligently scanning the markets with respect to the very volatile trading session on Thursday.

Implied volatility on the S&P 500 is still at around 36-37%, which is considerably higher than the average of 16-17% it was in the month of April. Option traders buying volatility would have done very well, but volatility spikes are just as difficult to predict as price spikes.

I find it odd that income-bearing equity tends to be trading lower, but income-bearing preferred shares and bonds are relatively stable. This could be due to the decrease in the implied future interest rates.

My long-term corporate debt issues, however, have taken quite a haircut over the past few days. I trimmed some of the position last month at yields I thought were pretty low (around 8%-8.5% for 20-year paper), but didn’t sell enough as it is now trading about 150bps higher. One of the advantages of dealing with debt (debt that you know has a very high chance of not defaulting) is that you don’t stand to “lose” that much opportunity cost by waiting – you will receive your coupon payments and wait for a better opportunity to sell when yields go lower, or accumulate if yields go higher.

The net damage report for this week is about 6%, but I do not see any reason why the intrinsic value of my portfolio has dropped any – the investments that I do have should continue to generate roughly the same projected amounts of positive after-tax cash flows. The income being produced is significant and should continue to be this way.

Market history lesson – April 4, 2000

Today’s trading reminded me very sharply of what happened on April 4, 2000 when the Nasdaq fell by about 13% but recovered to end the day nearly flat. The CNNFN article has a few charts.

Ten days later, the Nasdaq was down 20%. The following week, the Nasdaq was up 10%.

For the next few months the Nasdaq gyrated, but peaked at the end of August before resuming its descent in September 2000, all the way until October 2002 when it plunged down to about 1200.

Is history repeating? I don’t know.

Is it a good time to be on margin? Probably not. The volatility will kill you.

May 6, 2010 in pictures

May 6, 2010 was the most volatile day in the marketplace in 2010. Here is a series of pictures:

Capital was rushing into the US dollar, US treasury securities and Gold – three major pillars of stability.

Neutral were energy commodities.

Market downturn

(Update: This post is already obsolete – this post was written before the 9% spike down in the major indexes!)

This week is the first week in a long, long time where my portfolio has taken a dive. I suspect it has been the same for others. If right now was the end of the week, it would be around -3%. This is not a reason to panic by any means, I think my financial strategy is appropriate for myself and I have enough cash (or cash-like instruments that can be liquidated) to take advantage of a “real” downturn, especially if this Greek crisis turns out to be something significant (which I do not believe).

However, what is interesting is to see what else has dropped:

Canadian Dollar vs. USD: down about 5%
Crude and Natural Gas (in USD): down about 8%
Gold: Interestingly, not much change, if not a little higher.
S&P 500, TSX 60: down about 5%
5-year government bond yields: down from about 3% to 2.8%
Implied future 3-month interest rate changes: Lower; December 2010 to 1.70%; June 2011 to 2.37%

What’s odd is why Gold (which is a commodity that got hammered during the 2008 financial crisis) has not tanked with the rest of the market. Maybe there is a fundamental psychological shift in action.

The other comment is that the consumption of fossil fuel energy is not likely to abate with the Greek crisis, and most Canadian oil-related stocks have been hit. I’ve always thought that if you are a consumer of fossil fuels (which almost everybody in society is), it is wise to hedge this with ownership in some energy-producing assets, purchased at the right price.

Never use market orders

A trading example (of which I did not participate at all) of the day – the company in question is Pacific & Western Credit Corporation:

We see the stream of trades:

Time Price Shares Change
14:11 3.000 200 -0.250
14:11 3.010 400 -0.240
14:11 3.000 3,000 -0.250
14:11 2.760 900 -0.490
14:11 2.900 500 -0.350
14:10 3.160 5,000 -0.090

What happened?

Some guy put in an order to sell 5000 shares, and got filled in at 3.16. This might have triggered a stop order, which was sent to the market at the nearest available bids, in this case 2.90 and 2.76. The market maker likely stepped in at this point and picked up shares at 3 and above. Right now the bid-ask is 3.12-3.17.

The advice I have for absolutely everybody is you should never, EVER use market orders. If you must hit the market, enter in a limit order buy at the ask or above, or a limit order sell at the bid or below, but never use market – it is just giving a blank cheque to people that most certainly rip you off.

Whoever was on the selling end of those 900 shares at 2.76 paid about $360 for the privilege of getting rid of their shares at a low price.

TFSA teaser rate dropped at ING Direct

ING Direct offered a 3% interest rate on TFSA accounts in early January; this was presumably done to capture people’s money in the account. They dropped the rate to 2% at the beginning of the month of May, which is more reflective of the market rate.

Ally continues to be the best option for short term savings accounts, offering 2%. They also offer 4% on a 5-year GIC, which is currently the best rate available.

As Garth Turner points out, GIC products have problems concerning liquidity (in the case of the 5-year GIC you will relinquish 1.5% interest), and also taxability (as ordinary income is fully taxable). He is suggesting the world of preferred shares or corporate debt, two fixed-income products which have different characteristics than GICs.

James Hymas has an excellent document which explains the differences between preferred shares and GICs.

If your goal is to preserve income (note: not capital) then preferred shares generally are a better option than GICs for a multitude of reasons. The only problem for most people, however, is that you’ve got to be doing your homework. If this is done correctly, you will be able to obtain a tax-preferred advantage of likely 200 basis points, if not more, than the prevailing rates offered by GICs. Judging from most of the comments seen in an average post on Turner’s site, it seems that most want to be spoon-fed ticker symbols to purchase.

A good investor but not a good fund manager

Imagine an investment manager that is so good that they can double their money whenever they put money into the market. However, this manager is only able to do so once every five years and is smart enough to know when he is invested outside his “window of opportunity” he will dramatically underperform the market and thus will go to cash during the rest of the time. This investor would be in the top percentile of all investors by virtue of his ability to obtain a 15% compounded return, year over year (doubling your money every 5 years is very close to 15% compounded annually). However, just imagine if he had a hedge fund and investors piled on board after his first 100% year and reading his annual reports:

Year 1 letter to shareholders – We were fully invested in the market, but have now gone to 100% cash. Our performance on equities has resulted in a 100% increase in our net asset value since the beginning, a very good year. We will look for more opportunities in the future when they present themselves.

Year 2 letter to shareholders – Thank you to the new investors for joining hedge fund XYZ. We have been 100% invested in cash, earning 3% on cash. We have found nothing suitable to invest in.

Year 3 letter to shareholders – We have been 100% invested in cash, earning 2.5% on cash. We still have found nothing to invest in.

Year 4 letter to shareholders – We have been 100% invested in cash, earning 2.75% on cash. We have found nothing to invest in. Believe me, we are trying!

Year 5 letter to shareholders – We have been 100% invested in cash, earning 2.5% on cash. We’re really looking hard for investment candidates, some might be on the horizon soon, but we can’t tell at this moment.

By this time, most of the people invested in the hedge fund would have already exited. “Why bother investing with this guy when he isn’t going to be investing our money?” If the investment manager was working for a larger company, chances are the manager would have been removed, even though he was working in the long-term interest of the fund.

Of course, by the time clients have removed all of their money from the hedge fund, the manager on year 6 sees opportunity and has another year of a 100% return. People, attracted by the performance, come back to the fund in droves, only to witness their money being invested in money market instruments for another 4 years.

This is one of the big advantages that an individual investor has, assuming they are capable enough to hold high levels of cash during significant market downturns. An individual investor does not have to sacrifice their strategy for political reasons (i.e. fear that their clients will pull money out of their fund). This political advantage can be exploited by those with ironclad discipline to hold cash for lengthy periods of time.

It is usually very difficult to measure the performance of these individuals over a short time period – it would have to be measured over a lifetime. The Buffett/Munger partnership is the best example of people that were not afraid to hold onto their cash for opportunistic moments.