Canada Pension Plan, Q3-2010

The Canadian Pension Plan reported its fiscal third quarter, with a 1.8% return on investments between October 1 and December 31, 2009. The asset mix of the fund is as follows:

* Equities represented 56.1 per cent of the investment portfolio or $69.5 billion. That amount consisted of 43.9 per cent public equities valued at $54.4 billion and 12.2 per cent private equities valued at $15.1 billion.
* Fixed income, which includes bonds, money market securities, other debt and debt financing liabilities represented 30.0 per cent or $37.3 billion.
* Inflation-sensitive assets represented 13.9 per cent or $17.2 billion. Of those assets,
o 5.8 per cent consisted of real estate valued at $7.1 billion
o 4.9 per cent was infrastructure assets valued at $6.1 billion
o 3.2 per cent was inflation-linked bonds valued at $4.0 billion.

The TSX reported a 3.1% gain over the same period of time, so when one considers their asset mix (together with the fact that fixed income yields have slightly risen, thus resulting in value declines), the CPP had an average quarter.

The CPP requires a 6.2% nominal rate of return (4.2% real rate) in order to meet its long term investment objectives. While this number is realistic, it will also be challenging to realize these returns strictly within the North American confines – in order to achieve disproportionate returns, the CPP investment managers need to be looking abroad. Investing outside your known jurisdictions, however, can be very hazardous to your financial health, so I hope these guys know what they are doing.

Since April 1999 the CPP has realized 5.3% nominal returns, which means they are trailing by about 15% when you do the math – the actuary will likely have to boost the target rate of return needed to keep the CPP solvent to around 6.4% in order to catch up.

Still, the CPP is light-years ahead of the USA equivalent, social security. Canada did most of the heavy lifting on this issue in the 1990’s and it is one of the unspoken achievements of the Jean Chretien administration to put in a relatively permanent fix to this issue.

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.

The Canadian version of Prosper – CommunityLend!

I couldn’t help but notice that I signed up some time ago to be informed when Canada’s peer-to-peer lending service, CommunityLend, would go active. The service is otherwise very similar to that of Lending Club and Propser – people can bid on other people’s loan requests and the lenders get charged a 1% fee on the money they receive, while the borrowers have a significantly larger charge depending what credit bracket they are in. On the front page of CommunityLend, they advertise that you can borrow money with a 6% to 29% return:

Right now you can only lend money through CommunityLend in the provinces of Ontario and Quebec, although they are trying to expand to other provinces. The other hitch is that you have to be an “accredited investor“, which is a securities legislation definition of an investor that can legally purchase securities while waiving the standard legal protections that you would otherwise get if you weren’t exempt from the accreditation criteria.

The only issue for CommunityLend is that the easiest way to qualify to being an accredited investor is having net financial assets of greater than $1,000,000, or to be a registered adviser. Just by this stratification, which was likely discovered during the consultation process with the respective provincial securities commissions, the lenders are going to be a much smarter breed of people. Judging that the risk taken by people using the Canadian peer-to-peer lending facilities aren’t going to be any less riskier than those using the US equivalents, I would guess that interest rates received on loans will be slightly higher simply because you will have less people bidding rates down.

My prior statement about peer-to-peer lending remains the same:

There is educational value for people to invest small (and I mean small) amounts of money just to demonstrate how difficult it is to make money even when allured with the promise of high rates of return. Instead of a return on capital, the return of capital becomes paramount in the loan business.

Just to give future investors some sort of barometer, you can pick up corporate debt from relatively stable and smaller publicly traded corporations with a 3 year maturity for about a 9% yield to maturity. Thus, anybody bidding for unsecured consumer debt at a 6% interest rate should get their heads checked.

Selling debentures above par value

The decision to sell debentures that are trading above par value is an interesting challenge of capital allocation and tax optimization. Assuming the premium is dictated by the underlying company’s likeliness to pay rather than a conversion premium, there are a few variables to consider. A real-life example is the best illustration.

The company formerly known as True Energy Trust (now Bellatrix Exploration) has an $86M issue of 7.5% debentures that are scheduled to mature on June 30, 2011, which is 1.4 years away. The underlying company is otherwise debt-free and has recently performed a successful equity offering to fund the next year of capital projects. Additionally, the company has a market capitalization that would suggest that even if it was not able to raise capital before the maturation of debt, that they would be able to equitize the debt upon the maturity date.

In other words, getting paid out is a very likely scenario and would only take extraordinary risks (fraud or an absolute collapse in oil prices, etc.) over the next 1.4 years to prevent debenture holders from getting paid.

The debentures have a call provision, where the company can purchase the debentures at 105 cents before June 30, 2010 and 102.5 cents after June 30, 2010. It is unlikely they will use this call provision before June 30, 2010, but there is a low probability chance they will use it just after June 30, 2010, which implies a 4.9% yield to maturity on June 30, 2010. The company will only exercise this option if they can raise cheap money – it doesn’t necessarily have to be at a lower coupon than 4.9%, but rather an extension of the maturity is the functional objective.

In terms of tax optimization, the debentures were purchased at a cost basis significantly lower than par value, which means there is a bottled up capital gain embedded within them if I choose to sell them in 2010. The other decision is to wait until January 1, 2011, which means capital gains taxes will be deferred to an April 2012 cheque to the CRA. I will also be receiving interest income as a reward for patiently waiting.

The debentures are trading at 101.5 cents between the bid and the ask, which means that I can sell today and receive a 1.5 cent capital premium in exchange for the interest I will forego between now and June 30, 2011. This does not match up to the 10.5 cents of interest income I would receive between now and the maturity date. In terms of the capital that I am locking up to receive this interest rate, it implies my current yield is 7.4% and my capital gain will be -1.3% annualized assuming I do not sell today.

In order for a sell decision to be worthwhile, I would need to be able to realize a total yield of greater than 6.3% on my subsequent investment, not factoring in the tax liability, which would increase my hurdle rate by requiring me to divide 6.3% by (1-t), where t is the marginal tax rate for selling.

Since there is nothing with this return for a comparable risk that is not already in my portfolio, it means I will be holding onto the debentures for the next little while and keep on accruing interest. 6.3% at present is about 5% better than what I can get at ING Direct for risk-free money, so taking a very slight risk for a 5% premium still is very worthwhile.

RRSP Loans never made sense

I have now received three unsolicited solicitations (two through postal mail, one through email) for pre-approving me for an RRSP loan. The rates both institutions were offering were 3%, up to a low 5-digit dollar amount. The terms of such loans are such that you have to pay it off in a year.

The advertising always tries to grab your attention by stating that by loaning money you can get a good fraction of it back from the government when you file your income taxes and some people probably use this to rationalize making a loan. Unfortunately, the true financial value of the tax credit is worthless. I won’t get into why in this post, but some fellow wrote about it here and it is a much better way of thinking about one’s RSP than what is otherwise intuitive – his reasoning is not intuitive, but it is correct.

I have always wondered why anybody would ever bother doing an RSP loan from a rational perspective and the scenario that comes into mind deals with a high-income individual that has their cash flows so lumpy that they will only receive it after the March 1, 2010 contribution deadline and where this person’s balance sheet is in such crummy (or illiquid) shape that they cannot pull out non-taxable reserves into the RRSP umbrella. It would also imply their cash management in prior years is equally crummy since they failed to save enough money to pay for the RRSP.

Such people are likely to have high levels of debt, which highly suggests they should be putting their cash into their debt. However, in the event that their debt has a low interest rate, then the RRSP loan would make sense.

In other words, the number of people that truly need RRSP loans are next to none. I can’t fabricate a real life scenario where somebody working a full-time job would want to loan money for an RRSP.

Ever since the advent of the TFSA, the retirement savings game has changed considerably – although there are exceptions to every rule, if I had to make a “one rule fits all” criteria for RRSP vs. TFSA contributions, the math highly suggests the only people that should ever be considering to make a contribution in an RRSP are those making more than (note: 2010 year) $81,941 a year, which is where the 26% federal tax bracket kicks in. Otherwise you should contribute money to your TFSA first, and then your RRSP with any leftover amounts you have left to save.

If you make less than $81,941 a year, your first dollars should go to your TFSA and then if you have money left to save, into your RRSP. In no way should your net taxable income go below $40,970 – you can still contribute to your RRSP, but you should wait until a future year where you make more than the lowest bracket to actually deduct the income.

Taking out an RRSP loan to defer the income tax is financially foolish, especially since the interest on the loan is not tax-deductible. The only exception I would make is if you are supremely confident you will be able to make more than the loan interest on an after-tax basis (so let’s say you are in the 40% tax bracket and your RRSP loan is at 3% interest; you would need to make 3%/(1-0.4) = 5%) but I do not think this is appropriate for most and that taking an RRSP loan is functionally equivalent to borrowing money in a brokerage account to invest. The only difference between an RRSP loan and borrowing to invest on margin is that at least when you borrow to invest on margin, you can deduct interest expenses from your income tax.

Rogers Sugar, aftermath

Since Roger Sugar announced its fiscal Q1-2010 results in the middle of February 2’s trading day, the stock has been on a relative free-fall:

The current price of $4.40 is skimming the bottom of my fair value range for the units and it will be interesting to see if it slides below that.

Normal volume for the units are about 140,000 a day, so it is clear that there is some institution or fund that is trying to unload their units. They are not getting much liquidity in the market, which is why the price takes a dive. Opportunistic investors love to wait for moments like these to add to their positions, although it is difficult to game whether the institution or fund dumping units have half a million, or five million units to sell. If the entity dumping units is interested in selling more, they will be pressing the market further.

I would venture that a disproportionate amount of holders of Rogers Sugar are people that will be holding for a very long time, simply because the units do provide a good flow-through entity for investment capital – at a $4.40 unit price, there is a 10.5% yield and even better yet, the yield is sustainable with true earnings.

I also do not think the announcement of the fund considering a distribution cut because of the income trust taxation due 2011 is new news – all profitable income trusts will be doing the same. From my own investment perspective, it will mean shifting units out of my RSP and into my taxable accounts since eligible dividend income is taxed much more favorably than interest income that comes from the trust.

Rogers Sugar reports quarterly result

My largest holding, Rogers Sugar Income Fund, reported a solid but not spectacular quarter. What was odd is that they released the result at 1:30pm eastern time, which was mid-day while the market was open. The market hardly blinked and then a couple hours later there was some minor volume at slightly lower prices to end the day.

The debentures (which I do not own) are trading at around 105% of par value both with a yield to maturity of less than 4%; they do not mature until June 2012 [$50M/6.0%/$5.30/unit conversion] and 2013 [$85M/5.9%/$5.10/unit conversion]. They can be called away at par in June 2010 and 2011, respectively, which is possible if they can secure cheaper financing. The debentures could even be converted to equity if the units trade above the conversion price, which is another possibility. Either way, at present, the solvency of the trust is not in question – they have very good access to credit.

I absolutely love the external reporting style of management – they do a very good job walking you through the GAAP numbers, which are contaminated with inflated and deflated numbers as a result of management’s rigorous hedging of input costs. Management then gives you metrics which separate the timing effects of the hedging. They do it in such a way that is simple, yet elegant, and this is presumably a reflection of CFO Daniel LaFrance‘s style. It is also a textbook example of why GAAP is not the be-all-and-end-all of financial reporting – this will equally be true with the implementation of IFRS (International Financial Reporting Standards), another scheme mainly to enrich accounting consultants and make financial statements even more unreadable than they are presently.

The sugar industry is something that I never quite intended on being relatively knowledgeable about, but over the past few years I’ve accumulated quite a bit of information of the industry, at least of how it applies to Canada. The industry is fairly easy to research, which makes the evaluation of management’s ability to keep costs down and be able to make educate guesses on where the marginal risks are critical, which I think Rogers Sugar has done a good job doing.

Rogers Sugar Income Fund (through Rogers Sugar in Western Canada and Lantic in Central Canada) services mostly the domestic Canadian sugar market – there is one significant competitor in Central Canada (Toronto) in Redpath Sugar and there are also fringe competitors such as Sweet Source Packaging in Toronto, which is under the label of Sweet Source Sugar. The domestic market demand for sugar has been very slowly dropping over the past decade, presumably due to industrial usage shifting toward sugar knock-offs (such as high fructose corn syrup and artificial sweeteners), but otherwise is relatively stable. Despite what one sees at Superstore and Costco, the vast majority of consumption is through industrial usage (such as most of the stuff you would see at Tim Hortons).

Because most countries heavily subsidize their sugar industries, there is a high degree of protection in the industry. As a result, Rogers Sugar, Lantic, and Redpath are able to compete primarily on domestic fronts. There is some small volume of competition that will be coming through Costa Rica through the free trade agreement implemented with them, but it should have a small impact on the domestic marketplace. In addition, the USA and Mexico occasionally open up some component of their own domestic marketplace whenever they face domestic sugar shortages – such as when an adversely located hurricane decides to wipe out their production capability.

Most of the input costs come from importing raw sugarcane from locations south of the USA and processing it into granulated sugar products. In Taber, Alberta, Rogers Sugar additionally harvests and processes sugar beets into raw sugar. The primary cost (other than labour) of refining this raw product comes from the energy consumption required to transform the product – which is through natural gas.

A positive change in price of refined sugar will have a positive impact on gross margins for Rogers Sugar, at the expense of cannibalizing some of the marketplace for substitutable sugar products as those suppliers will convert to high-fructose corn syrup. As sugar prices have been at record highs lately, it remains to be seen whether the positive impact on gross margins will be more or less offset by the reduction in sales volume.

Rogers Sugar gives off a distribution of $0.46/unit (9.75% on the current unit price of $4.72), and this quarter is the first time that management has announced that they are looking into alternative structures with respect to the onset of income trust distribution taxation in Canada. Specifically, they have stated:

We are investigating corporate structures as an alternate to our current income trust structure. Whether we convert to a corporation and as a result pay corporate income taxes or continue with our income trust structure beyond 2010 and become subject to distribution tax, we currently anticipate paying dividends or distributions at levels that would provide an after tax distribution equivalent to that currently enjoyed by our Canadian taxable Unitholders.

This statement implies that their distribution will be reduced to approximately 32 to 33 cents per unit (6.89%). This is a few pennies lower than what I was expecting (mainly 0.46/(1+26.5%) = 0.36 in 2011; 0.46/(1+25.0%) = 0.37 in 2012) but we will see. The company has been doing a good job keeping distributions lower then their free cash flow and have applied the retained earnings into a reduction in leverage – something I find to be a wise decision that will facilitate a much easier refinancing of the debentures.

Merits of the GIC-only investment strategy

I was reading an article on the Globe and Mail about David Trahair, who advocates a GIC-only investment strategy.

Despite the relatively negative income tax implications (the income from the GICs are fully taxable unless if sheltered in an RSP or TFSA), it is not a bad strategy because it can be implemented with a few clicks of the mouse and should provide protection of principal in most situations. It is something even the most unsophisticated investor can perform and you can shop around for the best GIC rates by using a site like as a guideline for where to get the highest rates.

The only relevant risk worth mentioning is that you are exposing yourself to is inflationary risk (loss of purchasing power of principal), but given the relatively low duration of investment (an average of roughly 3, assuming you are using a GIC ladder) should properly capture heightened interest rate expectations if and when CPI inflation does occur. Right now the best 5-year GIC is a good 100 basis points higher than the equivalent Government of Canada 5-year benchmark bond rate (2.47% vs. 3.5%).

The other comment is that James Hymas makes a very good argument for preferred shares in a portfolio that will diversify the risks associated with having a GIC-only portfolio, and makes for a very good read. Implementing such a change in a portfolio does involve quite a bit of financial sophistication for the do-it-at-home investor, however.

First Uranium will be an interestnig story

Ever since the environmental permit for their tailings mine got revoked by the South African government, First Uranium equity has traded lower. Their debentures have also traded from roughly 75 cents to 71 cents.

Today, however, they will likely trade lower because of First Uranium’s corporate update. In it contains the following words:

The announcement of the withdrawal of the EA has not only delayed construction of the TSF, it has also disrupted certain well-advanced corporate financing opportunities, which, along with the slower than expected production buildup at the Ezulwini Mine, would, if alternative financing is not obtained, severely compromise the Company’s financial position. The Company is now reviewing strategic alternatives, and is engaged in discussions with respect to alternative financing opportunities.

My guess is that the common stock will trade down about 10% on Tuesday and the debentures will trade down another 3 cents. The company will likely have to sell more equity in future gold sales (as they have done previously), or equity in their company in a heavily dilutive offering. Management does not own too much common stock and is likely to dilute through equity to reduce the influence of Simmer and Jack.

The latest financial update from First Uranium was at September 30, 2009. The debentures are CAD$150M and they would be first in line (after a $22M facility) in the event of a default.

The valuation of First Uranium, as its operational woes continue, have to increasingly be looked with respect to what the asset value of operations would capture in the event of a bankruptcy proceeding. As long as the price of gold does not crash, there is value in the operations and debenture holders will likely be able to still make a fair recovery.

Most of the value of the debentures, assuming they are paid, will be in the form of capital gains so keeping these outside the RRSP is likely the best option – at 65 cents on the dollar, your split will be 1 part income to 3 parts capital gains, assuming they mature. Any resulting income will be taxed at around 62% of the income produced from the investment.

Debt and confidence

John Mauldin summarizes a part of the book This Time is Different by repeating that a sudden drop in confidence is what drives economic crises. A lack of confidence is more pronounced in debt crises because if the market collapses for debt renewals, you will have to default, which triggers a worse cascade of events.

It is also difficult to predict when the confidence is lost, but when it does occur, it is usually sudden, as witnessed in the 2008 financial crisis.

Whether another financial-type crash will occur in North American markets is up for debate, but whenever such a crash happens, one is best to brace for impact in terms of one’s portfolio and personal financial situation – high debt leverage is the big killer.