The Emergency Fund concept

In a lot of basic financial advice that I read, there is usually the mention of the concept of an “emergency fund”, which is a cash stash that can be deployed in the event of unforeseen emergencies (e.g. losing your job, medical emergency, etc.).

Maintaining a cash reserve to survive many months (ideally a year) in theory is good practice. It is very difficult to run a completely leveraged lifestyle (typically known as “paycheque-by-paycheque”) because it does not take many external circumstances to impact your financial situation. However, if you have cash-like assets that can be liquidated at a moment’s notice, then it makes the concept of an emergency fund highly redundant. You can be impairing your returns by having capital deployed in low-return products.

The question is a matter of resource utilization – keeping the cash literally stored as pieces of paper (hundred dollar bills) underneath your mattress surrenders any ability to gain interest, and present a security risk if you are robbed, or if your house goes on fire. So keeping the cash in a risk-free savings account (e.g. Ally offering 2%) is the next best alternative. For most people, this is probably the best option for the “emergency fund” since their decision-making abilities to invest the proceeds might incur negative expected value.

For most financially sophisticated people, seeing the cash stored at a fully-taxable 2% might be a bit unbearable, especially when one considers that it will be a below-inflation return. Where else could you put your emergency stash? You could move into short-term corporate bonds of stable companies, but in this low interest rate environment, would be unlikely to yield more than 2%. The next step up would be preferred shares, but that entails the risk of principal loss in the event of an untimely liquidation.

Finally, this leaves longer-term maturity corporate/government debt or even low-risk equities (e.g. utility companies with stable yields). You can see why “chasing yield” becomes dangerous – as long as bond/share prices remain stable and keep pumping out the coupon payments or dividends, you feel “safe” (a very dangerous feeling in finance if you are expecting a high reward for your “safe” risk). But it only takes a 2008-type event before everything gets flushed in the marketplace. Still, there were quite a few securities out there that were relatively unaffected by the financial crisis, and you can assume they will be an acceptable risk for emergency fund capital.

Giving a numerical example, let’s say your lifestyle requires you to save $25,000 to maintain a one-year operating cash cushion without drawing any subsequent income. If you had invested the money in a short-term savings account, and had your cash-requiring emergency at the same time as the 2008 financial crisis, you still would have $25,000 in principal to draw. A few button-clicks and you will magically have $25,000 at your fingertips.

However, let’s assume you wanted to reach for yield and invested the $25,000 in a TSX index fund at the beginning of 2008. The peak-to-trough amount the TSX dropped in 2008 was 42%. So had you been forced to withdraw proceeds at the bottom of the market, you would have had $14,500 left.

This would suggest that an emergency fund, if invested in a broad-based index of equities, should be about 1/(1-0.42) = 1.73 times larger than the amount you actually need to operate. So your $25,000 emergency fund, if you want to invest them in equities, should be around $43,000 if you want to be able to have a large degree of confidence of being able to withdraw $25,000 even in the middle of a 2008-style financial crisis.

This type of math suggests that people with about 1.73x the assets required to maintain their lifestyle in the event of an emergency should really have no emergency fund at all.

If your remaining assets are in safer securities, such as secured corporate debt, the impact of a 2008-type financial crisis is significantly less; there were plenty of corporate debt issues which barely budgeted during the crisis. As an example, the debentures of a company like Penn West Energy Trust (where their ability to pay out principal is never really in doubt) fell about 10% during the financial crisis. If you could structure a portfolio around such securities, then your ratio would be about 1.12x – or about $28,000 of the “emergency fund” invested in corporate debt.

Buying stocks on margin is dangerous

Time Magazine had an article about two university economists proclaiming that young people should go on margin when investing in stocks. They came to this determination after mining the 130-year set of historical data, and taking into consideration 45-year investment periods. They suggested a 2:1 ratio.

So for example, if you had $5,000 sitting in the bank, you should go and purchase $10,000 in stocks. I would not suggest this.

David Merkel (who incidentally writes probably one of the best pages on the internet regarding real-life economics) blasts the argument for many reasons. I want to elaborate on the first counter-point, mainly that mining historical data is not sufficient to determine a future course of action.

Whenever you walk into the office of a financial adviser (salesman) person at a retail bank, the most frequent chart you will see on the back wall is the Dow Jones composite index, roughly from 1900, in non-logarithmic format (designed to make the 1929 and 1987 market crashes look like nothing). They will usually give you a pitch how the stock market, on average, has gone up 9% (in nominal, not real terms) a year since eternity and therefore, your money should be invested in some equity fund that the adviser will presumably make a healthy commission selling.

The assumption that the markets will continue going up 9% a year in the long run is incorrect. If you believe this, you will lose money.

Throughout history, markets in countries have a frequent habit of collapsing. Around 1900, the top three capitalized stock markets were in the USA, United Kingdom and Russia. Not many people would have guessed Russia, but we all know what happened after – they were utterly destroyed after the Bolshevik revolution in World War 1. In fourth place was British India, and that country looks completely different (consisting now mainly of Pakistan, India, Bangladesh) than what it was back during the dying days of colonialism.

It is very difficult to predict whether the USA will still be around in 100 years, let alone compound market gains by 9% a year.

The other comment I will make with respect to buying stocks on margin is that even if you know what you are doing, it is very psychologically difficult to watch positions go underwater when on margin. Typically you will be receiving a good (low) price during periods of very intense volatility, and it is very unlikely that you will be receiving the “best possible” price had you looked at a chart 6 months in retrospect. There are far too numerous examples of this in my own life, but one was during the middle of the financial crisis in March 2009, when ING Group’s hybrid debt was cratering:

Recall that par value on the above issue is $25, and the coupon is 6.125% given out quarterly. Looking at my own trading records, I see I purchased shares between $6.26 and $4.70, which would have equated to a 24.5% to 32.6% annual yield (assuming they do not default). The best price I could have received is $2.83, or a whopping 54% annual yield! Looking at the chart it is very easy to say “Sacha, why didn’t you put your life savings on margin into the thing at $2.83/share?” – in retrospect, I would have loved to, but there are a few complexities to take into consideration:

1. When you place your order, you implicitly acknowledge that it will likely go lower before it goes higher;
2. You have no idea how low the low will be.
3. If the issuer defaults, you are in deep do-do.

Now, I remember when placing my order that I thought I was already getting a good deal, but underestimated, by some 40%, the extent to which the market was willing to take this thing down.

Imagine if I had the snippet of knowledge that on April 16, 2010 that this would be trading at $18.91 a pop and went on 2:1 margin at a price of $4.70/share. I would have had my account liquidated on a margin call well before the bottom was reached. Even if I knew what the “true value” of something was, by using excessive margin, you are giving the market the ability to wipe out your investment before you can realize its true value. For stable asset pricing and stable yields, the argument to use margin is more coherent, but when you introduce volatility, margin will absolutely kill you.

This was a one-security case, but even when diversifying the portfolio a bit, you still would not have been able to avoid margin call issues simply because the whole market was being flushed in March 2009.

Telling young people to employ margin based on historical market data analysis is absolutely foolhardy and will only result in losses. It is difficult enough to be able to invest in equities and doing it on margin will just compound the agony even if you’ve done your research correctly and have a general idea that you are purchasing stocks below their fair value.

So for my final parting shot of the day, when a young person buys a condominium and makes a 10% down payment, and mortgages the rest, they are making a 9:1 leveraged bet on their concrete box in the sky. Does the past 10 years of Canadian real estate price history data suggest that you should be making the minimum 5% down payment and go on 19:1 margin?

The following quotation is golden advice:

One final note: when I wrote at RealMoney, I took a contrarian view that for average investors, no one should be fully invested. Even the great Ben Graham never exceeded 75% invested. My view is that average people must limit their risks or they will not be able to sustain their investment plans. A 50/50 or 60/40 balanced fund approach is best for the average person — they will never get scared enough to abandon it.

By always keeping some black powder in the keg, you will be able to pounce on opportunities that others cannot because of their leveraged circumstances. Late 2008 and early 2009 was a time to be doing this, and there will be times in the future where keeping a stack of cash will be of great benefit. I don’t sense that “now” is one of those times to be deploying cash, but certainly if we are in a 1970’s type market, we will be seeing 30-40% market gyrations both to the upside and downside.

Vancouver Moneyshow / Financial Forum

I try to make the effort to go out to the annual Vancouver Financial Forum, usually held at the Vancouver Convention Centre (where the Pan Pacific Hotel is on Waterfront). This year, apparently the conference was acquired by another company and is now re-branded as the Vancouver Moneyshow and was held at the Hyatt on Burrard Street.

The reason why I try to show up to this is because I have found it to be a rather uncanny barometer of investment sentiment, and what the “strategies of the day” tend to be. As a result, I know what to stay away from for at least the next year. I consider it to be more entertainment than anything else, although occasionally you will get some corporate swag that is actually useful.

The themes to avoid this time around seem to be heavily concentrated on gold and silver (both bullion and mining ventures), and also real estate limited partnerships.

So this year, I would like to thank the two ladies at the booth of Vale Corporation, who gave me a steel thermos. Considering I never heard of the corporation before, I much later realized that the reason why the two ladies had Latin American-sounding accents is because the company is headquartered in Brazil, and does about $30 billion in revenues a year in the mining industry.

There were a few other large-cap companies that showed up, including Proctor and Gamble, Cemex, National Bank and a couple others. I truly believe the only reason why they show up to these things is to get some vacation time out in Vancouver, although the weather this time of year was pretty rainy and windy and not hospitable.

I enjoy listening to bad investment pitches, and about half of them I classify as bad, so it takes a bit of cherry picking and research to determine which is the worst of the worst. To protect the guilty I will leave out the specific names of the companies involved.

There were three “trading schools” that had tables. One of them in particular, had a 5-day training course which you could pay $4000 for, and they give you a live account to trade 100 share lots of Apple or some stock of the day with using technical indicators they train you with. They then explained you could take the course as many times as you want with no charge, and that they train their people to do around 60 to 80 trades a week. They also said their classes have 21 people and despite them trading furiously in training, they collectively don’t lose more than around $200. I found that tough to swallow. I liked their marketing front, however – one guy and three attractive women – it implied “Want to meet women? Sign up to trading school!”. Fortunately as I left the table, I still had my wallet with me.

There were plenty of real estate “opportunities”, ranging from commercial real estate to residential apartment investing. They typically pitched a limited partnership format. One of them, which I thought was particularly atrocious, was pitching a limited partnership that proposed redeveloping a strip mall in northeastern Edmonton. The partnership would then acquire the property from a related party through a leveraged buyout (this is where the promoters truly make their ‘money’ even if the underlying project fails), the limited partners get a substantial tax-loss writeoff in the first year, and then they very patiently have to wait many, many years for payback (i.e. 2022). A great deal for them – get your money today, and maybe give it back to your investors 12 years later.

When asking the guy “So, let’s pretend I have $25,000 in my wallet, why should I invest in you guys than Rio-Can?” and the salesguy basically gave three minutes of speech about how great their property is, and how they are not exposed to “market risk” like Rio-Can is… I did say this was entertaining, right?

The companies providing charting services were also equally amusing, although they have been a mainstay at the financial forum – charts that can produce the fanciest lines and do a wonderful job of extracting value out of historical data, but with no predictive value whatsoever.

For the first time, I’ve noticed a few firms trying to get into the fundamental data analysis sales business, but the companies were relatively uninspiring. The worst of them pretty much copied all the information out of a company’s annual information form and just put it in a research report with some very bland extrapolations of their financial status in a typical research report.

I truly wonder how many people that go to these things actually think the information they receive at these forums can be acted upon with real money.

Investment returns must be calculated after-tax

One critical consideration of computing returns is that pre-tax is an easy calculation, but after-tax involves a bit more effort.

In Canada, interest income (and distributions of income from trusts) is taxed at your marginal rate. Foreign dividends are also taxed at your marginal rate. Dividend income from publicly traded Canadian companies are taxed at a very favorable rate. Capital gains are taxed at half your marginal rate.

As a result, portfolios should be structured such that income is maximized in sheltered vehicles (RRSPs, TFSAs) while Canadian dividends and capital gains are preferentially outside the RRSP and TFSA.

Your marginal rate depends on what province you live in and also what income bracket you are in.

So if you live in British Columbia, and make a taxable income of $50,000, your marginal rate rate on an extra dollar of interest income would be 29.7%. So to realize a 10% after-tax return on investment, you need to earn 14.2% on a pre-tax basis. Alternatively, you could also earn a 11.7% return via capital gains, or a 10.1% return via eligible dividends. It all amounts to the same: a 10% after-tax return.

The following tables are a simple illustration of the required pre-tax returns required to achieve a 10% after-tax return:

BC 2010 Tax Rates 10% after-tax equivalent
Marginal Cap. Eligible SB
Low Range High Range Rate Gains Dividends Dividends
$ $ 35,859 12.5% 11.1% 8.9% 10.4%
$ 35,859 $ 40,970 12.9% 11.3% 9.2% 10.8%
$ 40,970 $ 71,719 14.2% 11.7% 10.1% 11.9%
$ 71,719 $ 81,941 14.8% 11.9% 10.6% 12.5%
$ 81,941 $ 82,342 15.7% 12.2% 11.2% 13.3%
$ 82,342 $ 99,987 16.2% 12.4% 11.6% 13.7%
$ 99,987 $ 127,021 16.9% 12.6% 12.1% 14.3%
$ 127,021 and above 17.8% 12.8% 12.7% 15.1%
BC 2010 Tax Rates 10% after-tax equivalent
Marginal Cap. Eligible SB
Low Range High Range Rate Gains Dividends Dividends
$ $ 35,859 12.5% 11.1% 8.9% 10.4%
$ 35,859 $ 40,970 12.9% 11.3% 9.2% 10.8%
$ 40,970 $ 71,719 14.2% 11.7% 10.1% 11.9%
$ 71,719 $ 81,941 14.8% 11.9% 10.6% 12.5%
$ 81,941 $ 82,342 15.7% 12.2% 11.2% 13.3%
$ 82,342 $ 99,987 16.2% 12.4% 11.6% 13.7%
$ 99,987 $ 127,021 16.9% 12.6% 12.1% 14.3%
$ 127,021 and above 17.8% 12.8% 12.7% 15.1%

The following is for an 8% after-tax return:

BC 2010 Tax Rates 8% after-tax equivalent
Marginal Cap. Eligible SB
Low Range High Range Rate Gains Dividends Dividends
$ $ 35,859 10.0% 8.9% 7.1% 8.3%
$ 35,859 $ 40,970 10.3% 9.0% 7.4% 8.6%
$ 40,970 $ 71,719 11.4% 9.4% 8.1% 9.5%
$ 71,719 $ 81,941 11.9% 9.6% 8.4% 10.0%
$ 81,941 $ 82,342 12.6% 9.8% 9.0% 10.6%
$ 82,342 $ 99,987 13.0% 9.9% 9.3% 11.0%
$ 99,987 $ 127,021 13.5% 10.0% 9.7% 11.4%
$ 127,021 and above 14.2% 10.2% 10.2% 12.1%

The kiss of death – a mention in Forbes Magazine

I notice with amusement an article in Forbes – “Five Canadian Trust Survivors“, where the author basically states the following will still give out “solid” distributions after distributions are taxed in 2011:

Baytex Energy Trust (BTE.UN)
Cineplex Galaxy Income Fund (CGX.UN)
Vermilion Energy Trust (VET.UN)
Brookfield Renewable Power Fund (BRC.UN)
Keyera Facilities Income Fund (KEY.UN)

There is only one good that can come out of this article: it saves you the time from having to bother even looking at these companies. Just scratch them off your candidate list – if Forbes magazine is extolling the virtues of these companies, then it is a virtual guarantee that you are likely to be paying fair (if not greater than fair) value.

I wonder how many people actually base their purchase decisions on magazine articles such as these.

I have spent the greater part of the day trying to screen income trusts, and I don’t see any exceptional value out there. The only one (and literally one out of the forty or so that I took a detailed look at) stinks so badly that even I have no idea how their business can be made viable, but at least their market valuation is trading such that they think this company is going out of business really soon.

Canada Interest Rate Projections – March 2010 – Effect on mortgages

With all the talk about the Bank of Canada wanting to raise rates, it is instructive to look at what the futures market is saying about the issue. It should be noted that the next scheduled rate announcements are as follows:

April 20, 2010
June 1, 2010
July 20, 2010
September 8, 2010
October 19, 2010
December 7, 2010

A rate increase on or before the July 20, 2010 meeting is a guarantee. The question is how much?

The markets currently say the following:

Month / Strike Bid Price Ask Price Settl. Price Net Change Vol.
+ 10 AL 0.000 0.000 0.000 99.480 0.000 0
+ 10 MA 0.000 0.000 0.000 99.440 0.000 0
+ 10 JN 0.000 99.320 99.325 99.360 -0.040 21736
+ 10 SE 0.000 98.870 98.880 98.910 -0.040 33614
+ 10 DE 0.000 98.400 98.410 98.450 -0.050 19923
+ 11 MR 0.000 97.980 97.990 98.030 -0.040 6402
+ 11 JN 0.000 97.630 97.640 97.690 -0.050 3215
+ 11 SE 0.000 97.320 97.350 97.410 -0.080 1445
+ 11 DE 0.000 97.040 97.060 97.140 -0.090 707
+ 12 MR 0.000 96.810 96.840 96.910 -0.080 50

The three-month interest rate will be:

June 2010: 0.68%
September 2010: 1.13%
December 2010: 1.60%
March 2011: 2.01%
June 2011: 2.37%

Reading my tea leaves, this would suggest that the Bank of Canada will raise per the following schedule:

April 20, 2010 (No change – 0.25%)
June 1, 2010 (No change – 0.25%)
July 20, 2010 (+0.75% to 1.00%)
September 8, 2010 (+0.25% to 1.25%)
October 19, 2010 (+0.25% to 1.50%)
December 7, 2010 (+0.25% to 1.75%)

It is also likely that by June 2011 that interest rates will be around 2.5%.

The only effect these rate increases will have on mortgages are for floating rate mortgages (ING Direct offers them at prime minus 0.4%). This would mean that rates would go up from 1.85% to 3.35% by the end of the year and roughly to 4.1% by the middle of 2011. For most borrowers on floating rate mortgages, they will likely see their interest payments at least double over the course of the year. As an example, for somebody borrowing $300,000, their interest payments will increase from roughly $450/month to roughly $1000/month by the middle of 2011.

In terms of fixed rate mortgages, rates are essentially set by the bond market, and the bond market has already “baked” in these projected rate increases. The best available 5-year fixed rate mortgage is 3.69% currently. Given a choice between these two options, it is a rare time where taking the 5-year rate would be the prudent option.

It is likely once interest rates start to increase that banks will increase the “prime minus” spread from a typical 0.4% currently to around 0.8% – the peak discount which was seen in the last housing rush.

Either way, the lack of ultra-cheap credit will have an effect of slowing down the housing market considerably.

Psychology of ETF investing

Nelson writes the following:

It seems to me that the financial advisory industry as a whole spends a great deal of time creating instruments and building an investor culture that tries to act as if investing (or trading) can be simplified to a set of easy-to-follow rules and, hey, we’re professionals, so leave your money with us. I think it’s made even easier for them to convince people because the majority of people want to be convinced. They’re not that interested in thinking about how to invest their money — not really — so they do their best to wipe their hands of it, with all the consequences that entails.

This is absolutely correct. The psychology of “easy investing” has not changed since the dawn of cheap trading on the internet – the initial “brain-dead” way to invest was always going with a “trusted professional” (financial adviser, stockbroker, etc.) to make your decisions for you, since they clearly knew more than you did. Then for those that got jaded with the performance of such “trusted professionals” and eventually want to do-it-yourself, you have a whole host of products that essentially boil down to “stock pick” type newsletters (e.g. publications like the Motley Fool and TheStreet.Com, which are really fronts for subscriptions to newsletters). All of these don’t really involve any type of thinking – monkey see, monkey-do – if Cramer’s buying Amazon, might as well buy Amazon, eh?

Big banks, especially in Canada, will have you sit down in a branch with a “financial adviser” (who is really a salesperson for the funds the bank sells) and get you to fill in a simple questionnaire, which asks many questions to put you in one of three risk categories. If you were high risk (likely a “young” investor), you were suggested to invest 70% in equity funds, and 30% in bond funds. If you were medium risk, you are suggested to invest 40% in equity funds, 30% in “balanced” funds, and 30% in bond funds. If you are close to retirement and low risk, the suggestion will be 10% equity, 40% balanced, and 50% money-market funds. More “modern” suggested asset mixes may include 10-15% for “commodities”. Simple formulas to make investing easier.

Unfortunately, such cookie-cutter solutions will never provide superior returns. In fact, they will dramatically underperform. The reason is because of the fallacy that asset mix determines 90% of portfolio performance and neglecting to look at valuations.

Once an investor starts to realize that there is no informational benefit to newsletter-type subscriptions, or mutual funds, they will eventually shift to another form of control – exchange-traded funds, which essentially are mutual funds that are easier to buy and sell by virtue of being exchange-traded and not having to deal with an annoying bank middle-man. Once you give up and realize you can’t beat the market (the literature that suggests this starts to be compelling when you suffer losses), you will invest in the S&P 500 index fund, which apparently has slipped the actual index by 0.19% (which is actually not that bad, but slippage should be less than 5 basis points for such a large fund).

Even investing in different ETFs you have to do your homework and cannot apply a “cookie cutter” solution. There is no better example than with commodity-based ETFs.

Commodity-based ETFs that invest in underlying commodities with futures are very bad products. They experience huge trading losses when they have to rollover front-month contracts – the biggest culprit so far has been UNG, the United States Natural Gas ETF. Traders have absolutely ripped UNG’s investors to shreds, and rightfully so – investing in futures is not the same as investing in the commodity itself.

Commodity-based ETFs that invest in the underlying commodity (not futures) are legitimate long-term investment products – the best example is the Gold Trust (GLD), which invests in the physical metal. Your cost of investment is 0.4% per year instead of taking delivery of a gold bar and storing it in your own safety deposit box.

Note that I am making no opinion on the future pricing of natural gas or gold – I am just using these ETFs as an example. If I wanted to bet on a higher price of gold over the long run, I could consider the Gold Trust ETF. If I wanted to bet on a higher price of natural gas over the long run, I would not use the UNG ETF.

I have no issues with investing in ETFs – they provide much cheaper coverage than most mutual funds do, although there are some ETFs out there that are clearly geared towards traders/gamblers than actual investors. People that invest in most ETFs would likely be much better off looking at the top ten holdings and just investing proportionally in the common shares of such companies and will be able to save significant amounts of money from management expense ratios.

Just as an example, if you think energy will be a hot product in the future and choose to invest in XEG.TO (a Canadian energy sector fund), we see the following as the top 10 holdings:

17.74% SUNCOR ENERGY INC
14.02% CANADIAN NATURAL RESOURCES
9.31% ENCANA CORP
7.36% CENOVUS ENERGY INC
6.72% TALISMAN ENERGY INC
5.09% CANADIAN OIL SANDS TRUST
4.45% NEXEN INC
3.63% IMPERIAL OIL LTD
3.05% PENN WEST ENERGY TRUST
2.82% CRESCENT POINT ENERGY CORP

The MER of the fund is 0.55%, so if you invested $10,000 in XEG, you are paying roughly $55/year for management of the fund. This $55 is reduced from the dividend payments you would otherwise receive had you been invested in the common shares (which is a tax-inefficient way of paying for management expenses since such dividends are tax-preferred eligible dividends – a better way would be to bill ETF holders directly and they can take a full deduction for this expense from income). If you can scale into the 10 positions for less than $55 (which is easily done at a properly selected brokerage firm) then with a little mouse-clicking, you can save money on your long-term investments. Since 74% of the fund is invested in its top 10 holdings, the tracking error is trivial since the top 10 securities (74% of investments) are likely to be highly correlated investments to the other 26% in a sector fund.

The conclusions are fairly clear – for most passive index funds out there, it is better to just invest in individual components unless if you are dealing with small amounts of money, or small amounts of time.

True out-performance is difficult to achieve – it requires research, work, and sharp decision-making. It is very unlikely that Joe Investor out there will be able to outperform without going into microscopic details of individual securities. This requires skills such as being able to read financial statements, and knowledge of the sector. Not many people will want to do this – and thus, they will dump their RRSP money in some index fund since it is an easy decision to make and will likely underperform since others will be doing the same thing.

Replacing ING Direct

The place where I normally park cash is in ING Direct, which has been a mainstay financial institution for myself for a very long time. When they first opened, they were by far and away the best place to park cash. Now they are a mediocre offering of the many online products that are available out there. I am guessing that they achieved their desired level of deposits and have achieved their desired debt-to-equity ratio with their residential mortgage offerings.

ING Direct hasn’t contaminated their customer experience by spamming their customer base with too many useless services, but this encroachment to simplicity has been eroding at a faster pace as of late – see my post about RSP loans, for example. It is simplicity that has caused me to stick around with ING Direct instead of shopping for other services. However, that time has now come.

So today I sent in a cheque to Ally, which used to be known as GMAC. Obviously since GM tarnished their brand with their bankruptcy filing and investing money in an institution that shares the same name with a bankrupt entity doesn’t inspire much confidence, they changed their name in 2009. In Canada, they are run by a firm called ResMor Trust Company, which otherwise does mortgages. In any event, they are CDIC insured and this means that the taxpayers of Canada will be picking up the guarantee for deposits up to $100,000.

Since I will not be depositing more than $100,000 in Ally, the safety issue of the institution is more or less mitigated.

Their peak offering is a savings account which delivers 2% interest (which is subject to change at anytime), but since this is significantly higher than ING Direct’s offering at 1.2%, it is a trivial process to click a few mouse buttons and transfer the money. Every dollar counts.

As interest rates rise, it will be interesting to see the spread between these two institutions since they are competing for the same bucket of capital from Joe Saver.

Knowing the difference between cash and income

One of the most powerful concepts that most beginning investors confuse is the concept of cash flow, and the concept of net income. In capital-intensive industries, an investor must know enough about the underlying accounting in order to make a proper investment decision.

Probably one of the easiest textbook cases for this concept is looking at the year-end report for Sprint Nextel Corporation. For 2009, they reported a net loss of $2.44 billion, but generated about $2.7 billion in cash at the end of the day.

The simple reason for this is that the company made huge investments in telecommunication assets in prior years and is continuing to depreciate those assets – the actual cash has been long since paid and as such, the depreciation expense does not represent a cash transaction.

So while Sprint will be reporting net losses for the foreseeable future, the company will still be generating cash to pay off its debt. Eventually this process will stop when the assets have been further depreciated, but it is up to an investment analysis to decide whether the company will put more cash into more capital projects, or whether to milk their existing investments and just spend money on maintenance.

Telecommunication companies, in this respect, are relatively easy to analyze.

Finally, as a bondholder in Sprint, all I am concerned about is their ability to service debt. The company does not pay a dividend and at the rate they are able to generate cash, will be able to service their debt for the foreseeable future. Back in October 2008 and March 2009, I was busy picking up equivalent units of debt that will continue to give off insane returns on investment (averaging roughly 18% in coupon payments and 5% in annualized capital gains upon maturity). There is no chance that equity will be able to repeat this at the risk I am taking!

Even today, such units are trading at about a 9.3% current yield, and about 1.9% capital growth to maturity, which is likely better than what you would get from equity over the next 19 years.