Portfolio review, 2009
The portfolio performance in 2009 can only be described as a home run. Using a crude adjustment for withdrawals and deposits (i.e. assuming they were all made on January 1, 2009), 2009 was a +104% year. If I used a proper method (i.e. a net asset value system) this percentage would be higher.
The TSX in the same period was up 41%, while the S&P 500 was up 28% in 2009, so I suspect a lot of people that have stayed in the market in 2009 will be feeling a bit better – especially if they had made purchases in early March, they would have been up about 70% or so if they did so in March and held on until the end of the year.
What I find particularly more stunning about the portfolio is that the bulk of these gains were accumulated through fixed income transactions, which are lower risk securities than investing in equity indexes. The bulk of the portfolio gains were accrued through debt purchases between March and May.
There was little leverage employed in the portfolio – at no point in time was margin (loaned money) was ever more than 10% of the entire portfolio value. I would estimate that average margin employed was roughly 2-3%, quite a conservative figure. I distinctly recall thinking of aggressively going on margin in April, but decided against it. It makes you look really good when it works, but it also does a good job of bankrupting you the markets turn the other way. If I had cranked up my leverage up to about 20-25% margin, it would have had a disproportionate effect on my returns (I would have been able to goose up my returns to around 150% for the year) but this is complete retrospect thinking – every good trade wants to be larger.
The portfolio is ending the year with a 4% cash balance, and that will go to around 10% when my Harvest Energy debenture sale transaction finally settles (January 2010). Adjusting for this, the portfolio is roughly 25% short term debentures (maturing in less than 2.5 years), 27% long term corporate debt (maturing in approximately 20 years) and 37% equity/income trusts. My currency exposure is roughly 75% Canadian, 25% US. The current yield is slightly under 9%.
Just as an interesting side note, in 2009, I spent 44% less than what I spent in 2008 on trading commissions. In terms of percentage of assets, it is slightly above what you would pay for a cheap index fund, but leagues below your typical actively managed Canadian fund (around 2.5% when I last checked).
There is also a lot in the portfolio for the Canada Revenue Agency to be happy about – in the form of unrealized capital gains. These represent future tax liabilities, but it also gives me some flexibility to smoothing out the income for the future. Hopefully they will still be unrealized gains instead of realized losses when the time comes to sell the investments or see them mature.
Financial Outlook for 2010
I do not believe the portfolio performance of 2009 will be repeated for a long, long time. I would be delusional to think otherwise. The market, however, can remain irrational longer than anybody expects, and this is the feeling I get going into 2010. It makes proper positioning much more trickier than in 2009 where it was a very easy decision to pile into bonds.
The economic numbers for the first half of 2010 will look good, but they are being compared to against very adverse 2009 numbers. I tend to think most of the equity rally has successfully priced in the recovery, but markets rarely stop at rational valuations – they overshoot it. In some cases, like Amazon, they have likely overshot by 50% or so. It is very difficult to determine where market sentiment will take prices. On the balance of probabilities, however, the market appears to be heading higher for the early part of the year. People will see the index funds delivering very good performance on equities, compared to fixed income, so money will likely flow toward the equity portion.
Not helping the case for bonds is that yields have been compressed significantly from last year – they are not quite at 2007 levels where they were trading a few pips above government, but bond yields today are significantly less compelling. Just as an example, 6% 38-year General Electric senior bonds were trading at 48 cents on the dollar in early March. An investor at this time could have collected 12.5% annual interest payments, year after year, as long as GE did not go bankrupt. Today, that same bond is trading for 97 cents, which means you will be collecting a paltry 6.2% instead.
There are too many examples of this type in the bond market to go through in detail. Suffice to say, the huge screens that I had that prompted me that I should be investigating the purchase of the entire bond market in March of 2009 is now telling me that there are only a couple of instruments in fixed income that could be considered for purchase. They still come with higher risk.
The bonds that I picked up in 2009 will get closer to maturity and will subsequently trade closer to par if there is no credit crunch looming. I can settle for this and just collect coupon payments in the meantime. Even if I make 7% on something trading at par, it is better than nothing to keep my capital parked there while looking for superior returns elsewhere.
A theme of 2010 will be “chasing yield”. Smart investors will avoid chasing yield – it is exactly the trap that Canadian income trust investors got into during the last period of very low interest rates. Chasing yield is to be avoided at all costs – although short term cash will earn you at most 2%, it is a far better option to hold cash than it is to lose money when yields rise due to increasing uncertainty. For example, I look at something like Rio-Can – right now your yield on their trust units is 6.95%. If you had to throw your money at something, it is almost better to bite the bullet and invest in those General Electric bonds mentioned above with respect to the risk vs. reward equation – taking equity risk in Rio-Can for an extra 0.75% doesn’t seem worthwhile. What I find amazing is I can see investors bidding up Rio-Can to 6% ($23/unit from $19.85 currently). But to trade on this is pure gambling – and I would feel more comfortable gambling at a casino than the stock market.
My advice would be – if you want to park cash, park it in cash. Don’t park it in a proxy investment for an extra percent or two since it is likely not going to be worth the risk of principal. If you must, go up the seniority chain – to preferred shares if you want better tax treatment or better yet, senior bonds.
In any event, the Bank of Canada is going to likely increase interest rates in July from the basement level of 0.25%. My guess is they will use the four meetings remaining in the year to raise rates 0.25% each meeting, leading to a year-ending rate of 1.25%. While this is still lower than historical rates, it will be soon be somewhat more rewarding to hold cash.
The topic of gold comes up occasionally. At US$1090 per troy ounce, there is no compelling reason for me to look into it. If the price did correct some 30% from present as the survivalists retreat back into the woods (to roughly US$750) I might look at it, but I am always very aware that the marginal costs of extraction are below this value. Crude oil is my commodity of choice – as long as I see airplanes flying (despite terrorists trying to do otherwise) and cars driving, the black liquid will continue to be the true gold – at least you can use it, while with gold bars you just store them in a safe area. Unfortunately, others seem to share a similar opinion about crude and while I think the major Canadian oil companies are strategically in the right space, their valuations reflect this. Looking at some of the smaller players will be worthwhile.
On the balance, I do not see a compelling investment environment for equity – while I suspect the equity markets will rise in the first half, the current valuations we see are already assuming a significant recovery in earnings. One can snipe away at individual (smaller) issues and probably do well, but I will remain skeptical of the broader indexes. I also still see a low interest rate environment and do not see long term bond valuations increasing too much, nor do I see the threat of inflation coming on this year. The theme, as I see it right now, is raising cash and concerning myself with inflation-proofing later.
The situation is very fluid and continuing to watch it is the most prudent course of action. I am always vigilant to look for specific opportunities (mainly on the equity side) but I am not finding anything that screams at me. My current estimation is that I would be very lucky if my existing portfolio delivered me more than 9%. Still, this is healthily above the risk-free rate.