I will be taking a small break from posting for another week – posting will resume on or around mid-July.
It is vitally important for fresh perspectives to get away from the computer and once in awhile break the typical daily routines in life – ideally you will take note of random events that occur and this may strike the imagination in such a way that will make you become a better observer of your surroundings.
Portfolio Performance
My very unaudited portfolio performance in the second quarter of 2010 is approximately +0.3%, so rounding this off it is 0%. For the 6 months to June 30, 2010, my performance is approximately +9%. Most of the positive portfolio performance could be attributed to the CAD-USD exchange rate – indeed, if exchange rates were unchanged, my performance for the quarter would have been around negative 2%.
You can read the Q1-2010 report here. I also keep the links in the upper-right hand sidebar.
Portfolio Commentary
This has been a relatively boring quarter in terms of performance, but boring is better than the alternative, which is dealing with capital losses. An index investor in the S&P 500 would be down 8% for the year. As the general intention of the portfolio is geared toward risk aversion, while taking some snipes at various issues, I believe my financial intentions are being realized. Nobody said portfolio management has to be exciting.
I did make use of the “flash crash” to add to my existing positions in two names, but the dollar volume amounted to approximately a percentage of my portfolio. I also unloaded a slight amount of one of my debenture positions because there was some guy/computer putting up a rather high price on the bid that I couldn’t resist nibbling at.
Because of the end-of-quarter volatility, there was some trades that I engaged in less than liquid issues, amounting to a few percent of the portfolio. Looking at the ticker tape, it looks like that computer traders were randomly liquidating some of their shares. Although I am not too confident in the state of the economy in general, there are nuggets of value to be picked up here and there (on the equity side) which my research flagged and recent valuations have triggered some price alerts. I will continue examining these short-listed prospects and likely allocate some cash to them if they continue their downward trajectory.
Economic Ramblings
My issue with the economy is that stimulus spending has not translated into private sector investment, especially in the USA. Not helping the US picture is their pending tax increase in 2011 (specifically an expiration of the Bush-era tax cuts). There was a significant drop in inventories in 2009, but now that inventories have been built up in 2010, it is unlikely that we will see any sort of extra investment from the private or government sector that should lead the broad markets into a premium valuation multiple. It is seemingly likely that the rest of this year and a good part of this decade will represent a Japan-type scenario where you have a deflationary environment and a liquidity-trap situation. The only way to cure this is to liquidate bad debts, get the losses on the income statement, take the hit, and move on with life. This is not going to happen.
I have been closely examining the BP incident (as well as a lot of other financial, political and media analysts on this planet) and have some mental orders put in for the various drillers, but nothing has hit yet. Given the market action of the past month, I doubt those transactions will come to fruition unless if the US government decides to launch a frontal legal assault against them in addition to throwing BP under the bus and shaking them down for more money.
I will make a bold call and state that I believe Q3, at least the months of July and August, will be relatively boring, and fraught with conflicting stories on whether the economy is really recovering or whether the “double dip recession” scenario occurs. All one really has to do is look at the commodity and import/export markets to see the best leading indicators of economic activity. I continue to be long-term positive on crude oil, although there might be demand shocks (in the form of economic retardation, especially as the financial markets reverberate) and supply shocks (in the form of conflict arising in the Iran-Israel theater) that will result in price volatility.
It is a simple thesis that watching the world around me that I see planes, trains and automobiles continuing to function. They all require gasoline to run and as long as this is the case, the only thing that will prevent usage of gasoline are higher prices. We will get them eventually, along with $200 oil. It is just a matter of time. The only story that ends the inevitable climb up for crude is demand destruction due to high prices.
Minority governments and the Bloc Quebecois aside, Canada remains one of the most politically stable jurisdictions on the planet to do petroleum business with; as such, we should remain very attractive to international investors, especially considering that Canadian corporations have a huge incentive to doing business here compared to the USA in terms of the corporate income tax regime the Harper government smartly enacted in their late 2007 fiscal update. This is going to pay off massive dividends for Canada and it will pay off massive dividends for Canadians that choose to invest in their own corporations. Still, Canada is very dependent on trade, and our biggest partner (the USA) continues to be the overwhelming majority of our export market. When America gets sick, we will sneeze.
Portfolio percentages
I am going to introduce a new term, mainly the concept of “income equity”. Now that income trusts are converting into corporations, there will be quite a few Canadian corporations that will have relatively high dividend payout ratios. For those companies that have payout ratios that consist a “substantial majority” of their earnings, I will be classifying them as income equity. All other common shares will be considered plain “equity”.
Currently, equity consists of about 1% of my portfolio, income equity 40%, short term debt (maturing between December 2011 to June 30, 2012) is 23%, long term corporate debt (maturing between 2028 and 2033) is 28%, and cash is 8%. Blended together, the current yield on the portfolio is 8.2%. Excluding cash, it is 8.8%.
Assuming I twiddle my thumbs and security prices in my portfolio do not change for the rest of the year, my portfolio will have a 12% cash balance. The short term debt also includes debt that I consider to be a 99% guarantee for maturity at par, so those could be readily liquidated in the event I need to raise some cash. However, for tax reasons and also for the reasons that those securities still give off a fairly high single digit yield, I am not touching them unless if I find significantly better opportunities elsewhere.
Outlook
The investment outlook has changed little – while I am looking for places to deploy cash, I am finding little opportunity out there although May and June’s dip gives a little inspiration. As such, I am keeping a dry powder keg (of cash) ready in the event that investment opportunities arise. My research time (and effectiveness) has been somewhat compromised lately with the arrival of a newborn child, but one of the reasons why I have a low maintenance portfolio was just for this reason. Given what I do see out there, I would lean much more toward the equity side than the fixed income side, but I will not chase yield (or total return). Except for special situations (e.g. picking winners out of the BP fallout) I would also avoid large cap issues.
As such, I continue to wait and be patient. Rule one of investing is: don’t lose money. You lose money by forcing trades in sub-optimal situations. Right now is “sub-optimal”. If we saw more panic like we did in the month of May, I would start to get a little more optimistic. There’s a lot of doom and gloom out there – this generally bodes well for the markets.
However, in the meantime, caution is the name of the game. There is very little chance of any good performance (e.g. double digit returns) in the next quarter without taking more risk (which means selling debt and going for equities). I do not think this risk is warranted at this time.
I have read some posts by people out there that believe that Nokia is a value play and is worth purchasing. It is trading at a price that is lower than it has been in a decade ($8.36/share presently; as late as 2007 it was $40/share). I’ve briefly looked at Nokia and, financially speaking, while they have a decent balance sheet and some positive net income, their profitability is sliding down and this represents why the market has discounted the stock.
The first item I would like to address is the dividend – it is very likely it will be slashed. An investor putting money into Nokia for the dividend is going to be very disappointed, likely within a year. Nokia will need to go into a cost cutting and capital conversation mode soon and the easiest thing to go before making the very difficult decisions is the dividend.
However, the proper valuation analysis for Nokia is not a financial one; rather, it is determining who is going to be the winner in the mobile handset space. A decade ago, Nokia was clearly the champion in this industry – for the most part they edged out Motorola and Ericksson (now Sony Ericksson).
Between then and now, we have seen a huge quantum leap in mobile technology. Voice functions are trivial – it is all about mobile data, web and video. Apple has invaded the space with their hardware/software offering (iPhone), and Google has invaded the space with their software (Android). These two factors alone have likely put Nokia behind with inferior product offerings.
While I am not the techie I used to be when I was younger (I no longer follow the computer hardware scene and my cell phone is a 2004 Nokia model that I use exclusively for voice and will feel bad if I lose it), I still peripherally follow the industry. It has matured so quickly compared to when I was a teenager that it has gotten relatively boring. That said, there are plenty of people out there that follow it feverishly, and the following comment by somebody following Nokia’s operating system (Symbian) pretty much sums up the picture:
To Nokia, you guys are losing. Hard. Wake the hell up. Doing the same thing repeatedly while expecting different results is the definition of insanity. I’ve been a huge Nokia fan since my 2nd cellphone, and I just can’t do it any longer. You guys aren’t competing like you once were, and everyone but you seems to see that. You used to build the world’s best smartphones, the world’s best cameras, the world’s best GPS units – you’ve lost pretty much all of that, and with nothing to show for it. You unveiled your Ovi vision over 2 years ago – I was there. Today, it’s still a complete mess. I have to log in every single time I visit the site – regardless of how many times I check the ‘remember me’ box. I spent 6 months (and about 3 hours at Nokia World 2009) trying to find someone to help me with Ovi Contacts on the web – no one knew who to point me to. You spent millions of dollars purchasing your Ovi pieces – Ovi Files, Ovi Share, and a host of other little companies – are you proud of what you ‘built’ with them? Most of your own employees (that I’ve talked to) don’t even use them, so why should I?
This really reminds me somewhat of what happened to IBM’s OS/2 when they were competing against Microsoft in the desktop operating system marketplace. Another example is what happened to Cyrix when they were competing against AMD and Intel for the processor market. Both had inadequate offerings and were only running on steam before they finally folded – Cyrix was bought off by IBM, and OS/2 was canned. I am sure there is a better analogy that would apply to this particular situation, but the point is the same – Nokia’s mobile platform, in absence of something completely hidden and not marketed yet, is toast.
Without control over the platform, there is no opportunity for them to gain a market premium, and they will become a commodity producer of mobile hardware – a very low profit industry. Nokia’s best option is likely to sell out as quickly as possible to the highest bidder since with every passing week they will be commanding less of a premium on the market.
If Nokia’s board of directors are rational, they should be looking for an exit, but finding somebody willing to fork out $31 billion to buy out the company (this assumes no takeover premium) would be difficult. As such, I wouldn’t touch Nokia equity – investors are likely to face continued losses. You might even be able to make a good case for a short sale, but my knowledge in this area of the business world is not comprehensive enough to make such a decision.
The second quarter of 2010 ended today. I noticed there was a lot of trading going on, especially in less-than-liquid issues that tended to trade down. I am guessing there were some liquidations that were part of some window dressing and/or automatic buying/selling for indexing purposes.
In terms of the broader markets, the S&P 500 was down 12.2% for the quarter. The TSX composite was down 6.2%. Spot oil was down 10.0%.
Perhaps the most important broad market financial measure was the 10-year US treasury bond, down from 3.85% at the beginning of the quarter to 2.95% – the market has made a significant deflationary bet over the past three months. The Canadian 10-year bond was down from 3.56% to 3.09% (June 29th data). This decrease in long term interest rates has very interesting implications – banks are parking cash in bonds rather than lending it out.
The relatively large drop in today’s trading was attributed to a decrease in the reported consumer confidence (which is irrelevant) and China reporting lowered economic growth.
If you look at the Shanghai Index, you can see share prices are already ratcheted down since roughly in April. This also corresponds to the S&P 500:
I don’t have any strong opinions on the broad markets – I find the S&P 500 to be a fairly good screening tool, whereby I would not consider investing in an S&P 500 equity component unless if something really significant was going on that I thought the market had an incorrect take on. The last example I can think of was Philip Morris during the middle of the tobacco lawsuit settlements. Too much money is linked to the S&P 500 index so the equity is likely to be over-inflated. Not only that, but closet index funds do enough research on all of the components to make the markets relatively efficient, so it is generally worth spending your time on smaller and less liquid issues.
If growth in China, however, is slowing then you are going to see ripple effects in the marketplace.
Thanks to the comments from Jeff Usher, it appears my initial thoughts about the CRA prescribed rates were incorrect. I consider myself well-researched in these matters, but once in awhile, things slip and this was one of them. Thank you Jeff.
The CRA, on June 28, 2010, published the third quarter prescribed rates.
Apparently the reason for the delay is that Bill C-9 implemented a reduced rate of accrued interest for corporate overpayment of tax. Corporations were using the CRA as a savings account, where they were getting higher rates of interest than the banks. In the previous quarter, this amount was 3%, but going forward it will be 1%.
Magna International is a dual-class stock that retained control of the corporation in the Stronach family.
The Canada Pension Plan is unhappy that the corporation recently agreed to a deal with the Stronach trust to convert their class of voting stock into regular common stock, at a very high premium – $300 million in cash, plus 9 million class A shares. At today’s prices for class A shares, this works out to approximately $920 million in exchange for the voting rights of the company.
Suffice to say, shareholders are not too happy about the matters, including the Canada Pension Plan.
However, this should be a huge lesson to those that invest in majority-controlled companies – your interests have to line up with the interests of the majority holder in order for you to make any headway on your investment. In the case of Magna, its majority holder (Stronach) clearly wants as much cash and liquidity out of the corporation as possible – and the common shareholders, including those invested in the Canada Pension Plan, will be paying the price.
What is interesting, however, is that the deal was structured in a politically astute manner – common shares went up after the announcement since Magna was already trading at a discount due to the adverse interests of the majority holder. It is the company, however, that will be paying the price to buy out the Stronach voting stake.
If you have shares in companies that are majority controlled, pay careful attention to these agency issues.
Readers here might have noticed a lull in posting over the past week – it’s because I’ve been on a break and will continue to be so until mid-July.
A good deal of people on Wall Street take some part of the summer off – especially the month of August. Trading, as a result, becomes dominated by computer trading and volatility is typically higher due to decreased market volumes.
This last quarter has been quite dull on the trading front, but as the markets continue to dive, I am watching for opportunities.
Although I do not use Questrade’s platform for active traders, I do use their basic web-based interface. I don’t look at it too often since I don’t actively trade with the account, but I notice they are trying to implementing a cap on the amount of real-time quotes you can request to 1,000 per month. Anything else above that would cost 1 cent each. This doesn’t really affect me, but I was curious as to why they made the decision.
My guess is that it was designed to prevent an abuse of the system where you can pull data through the service with an application like Quotetracker or something. I did ask their customer support the following question:
Is there any way that the real-time quotations can be disabled after the free 1,000 quotes per month are reached? Or will there be any way to know how many quotes I have used in a month to date?
Their answer was the following:
Unfortunately there is no method to view how quotes have been utilized. We are, however, working to have a feature implemented on our platforms. In the meantime, please contact us and we will advise you of how many you have used. Thank you and I apologize for the inconvenience during this process.
I find this to be very silly on both a business and user interface perspective.
First, the data fees they pay to the exchanges to provide their customers with real-time quotes is probably on a fixed-price basis (either for the whole company or per-customer), so the excuse they gave for implementing a price is nonsensical. Secondly, it is very likely that customers that have more ready access to real-time data will trade more, generating more commissions for them, so by charging for quotations it is likely detrimental to their business of transacting trades. Thirdly, a customer has no idea whether they will be incurring billing for quotations, and asking for a customer to contact support for something like this is ridiculous for both parties.
It looks like this was a snap decision and done without any serious thoughts of the repercussions.
I continue to use Questrade for registered accounts (RRSP, TFSA) and non-registered holdings of TSX debentures, but as I mentioned in my previous review of them, security continues to be a lingering concern for me. They really need to implement a policy whereby if your accounts get hacked that they will cover you – similar to BMO Investorline, etc. Until then, my recommendation of them is lukewarm.
As readers of any of my sites know, I was a very big supporter of the Harper government’s decision in late 2007 to reduce the federal corporate income tax to 15% in 2012; it is currently 18% in 2010; and will be 16.5% in 2011. It was 21% from 2008 and 22.12% in 2007.
First, you had Tim Hortons moving its corporate headquarters back to Canada, where they will realize a substantial cost savings in taxes vs. their US operation.
Today, you have Biovail and Valeant merging together (note that long-time investors would know Valeant formerly as ICN Pharmaceuticals), but the key paragraph is the following:
Following completion of the merger, the new Valeant will be headquartered in Mississauga, Ontario and will remain a Canadian domiciled corporation, listed on both the Toronto and New York Stock Exchanges. In addition, the combined company will retain Biovail’s existing principal operating subsidiary in Barbados, which will continue to own, manage, control and develop intellectual property for the combined company. The location of the combined company’s U.S. headquarters will be determined after the close of the transaction.
This is purely for tax reasons. In Valeant’s California headquarters, they are subject to corporate income taxes of approximately 40% – 35% federal and about 8% state (which is deductible from federal taxes).
In Ontario, the current tax rate is 18% federal and 14% provincial; the provincial component will be reduced to 12% on July 1, 2010, for a combined rate of 31% in 2010. In mid-2011 and mid-2012, Ontario’s provincial rate goes down half a percent, and in mid-2013 it goes down to 10%. So the company will face the following effective corporate tax rates:
Calendar year 2010: 31%
Calendar year 2011: 28.25%
Calendar year 2012: 26.25%
Calendar year 2013: 25.5%
Calendar year 2014 and beyond: 25.0%
Corporations moving to British Columbia currently face a 10.5% provincial corporate tax rate, which will be reduced to 10% in 2011.
For Valeant, they reported $217 million in pre-tax income in the past 12 months. A 15% tax cut on this amount amounts to a yearly savings of about $33 million or nearly 40 cents a share. Also, any synergy benefits in the merger would also realize a 75% after-tax savings, as opposed to 60% if they had remained in California.
It is this huge 15% tax advantage that will cause more businesses to escape the USA and get into Canada. The US is going to be forced to cut corporate tax rates, otherwise they will continue to see investment leak out of the country like a thin helium balloon. As long as Canada doesn’t reverse this decision (which the opposition Liberal party has attacked the Conservatives on this very issue of corporate tax cuts) we will continue to be the beneficiaries of what is a very sound corporate taxation policy.