TFSA Update

A brief history of my TFSA: My strategy is to invest the TFSA in high risk-to-reward candidates that ideally will generate income that would justify its positioning in the TFSA for tax sheltering. My goal is a rapid compounding of capital with high risk/reward candidates. The TFSA will not be diversified as it is part of an overall portfolio, hence the lack of diversification.

In 2009, $5,000 was deposited into the TFSA. The first investing was invested in debentures of Harvest Energy Trust on February 2009, which was bought out by KNOC in October 2009. I cashed out the debentures and the account was left with a balance of $13,043 at year-end. Result: A 161% gain for the year. This is obviously unsustainable year-to-year.

In 2010, $5,000 was deposited into the TFSA. On January 2010, I invested the proceeds of the TFSA into debentures of First Uranium Corporation, which turned out to be a badly timed entry (if I had waited a week later I would have received a price 10% less than what I paid for due to bad news that was released literally a day after I had made the purchase) and the setback tested my investment acumen. The fundamental reason why I had invested had not changed, so I kept the debentures. In October 2010, I swapped half the debentures for (secured, convertible at a relatively low equity price) notes in the same company which has turned out so far to be a good decision. Result: The TFSA ended 2010 at $20,486, which after adjusting for the $5,000 deposit, is a return of 13.5%. Given the risk, however, I would judge this as a poor performance.

The two-year annualized performance (adjusting for deposits) of the TFSA was 72%. Again, this number will not likely be repeated in the future for 3, 4 and 5 year periods – this number will be going lower.

In 2011, after transferring in $5,000 into the TFSA at the beginning of the year, there is approximately CAD$5,500 sitting in the account that is currently languishing. I have been researching investment candidates and while I could deposit the proceeds into a relatively low risk investment that would yield around 6-7%, this is below my return threshold. The TFSA is still sensitive to the performance of First Uranium debentures and notes which should provide some element of growth in the portfolio (should be around 15%), but the rest of the cash needs to be deployed otherwise it will drag performance. I do not wish to invest in any more First Uranium at existing prices.

I do not want to invest cash for the sake of investing cash, so I will be patient and continue looking for opportunities. Such a bland strategy of holding zero-yield cash is boring and does not make for good writing, but it is disciplined.

ING Direct RRSP GIC – The price of liquidity

I was looking with curiosity at ING Direct’s RRSP GIC page to get an idea of what the retail risk-free rate would be. They had the following term and rate schedule:

1 Year 1.75%
1 ½ Year 2.50%
2 Year 2.20%
3 Year 2.25%
4 Year 2.30%
5 Year 2.75%

The “blip” in this schedule is the 1.5 year term, yielding 2.5%. The basic short-term ING account offers 1.5% on cash. If you break the 1.5 year GIC, you receive a rate of 0.5% instead.

So what a GIC investor would do is ask themselves about liquidity – how much are they paying to sacrifice liquidity? The quick answer everybody would give is 1%, but this is not correct. The actual answer is that liquidity becomes much more expensive as the term approaches maturity.

For example, if you assume the baseline cash rate is 1.5% throughout the 1.5 year term, if you invested in the GIC and then canceled the next day, your liquidity cost is very minute. In the next month, your cost is still fairly minute – you are paying $16.67 per $10,000 to access your funds.

However, if you canceled 17 months into your term, the cost of liquidity would be much, much higher. Giving a numerical example, at month 17 of the GIC, your accrued GIC interest would be $354.17 on a $10,000 investment. However, if you had to break the GIC to borrow the money (for one month as you would ordinarily be able to access your funds on maturity one month later), you have suddenly paid $283.33 in implicit interest for a one month term. This is approximately an interest rate of 33.7% to access your own funds.

So a rational investor that is considering locked products with penalty for withdraw has to strongly consider any liquidity considerations closer to maturity otherwise they could be paying a very expensive liquidity bill.

Most people willingly give up liquidity for a low cost – don’t.

Yield chasers to be affected by long bond yield

If a 10-year government bond yielded 8%, and a fixed income investment in some corporate debt for the same term gave out 6%, what would you invest in? Assuming sovereign default is not an issue, every rational investor would take the government bond.

So the floor price for the corporate security would be a yield of 8%, if that security was perceived as having zero default risk.

It is likely investors would demand a premium over 8% to justify the extra risk that is embedded in the corporation.

However, if the government bond yield went up, the yield for the corporate security should rise an equivalent amount.

Finance textbooks would like to isolate this to a single variable, but the reality is not that clear – finance and economics are a multivariate game, and hence you cannot say that a 1% rise in government bond yields would result in a 1% rise in the corporate security. However, more often than not, you would see a rise of “around” 1% assuming default is not in play.

Since income-bearing equity is a perpetual claim on a corporation’s residual assets and cash flows, it would suggest that an increase in long-term government bond yields would also increase the yields on equity (hence, lower prices).

Paying attention to the Bank of Canada long-term government bond rate, currently around 3.6%, would partially explain price movements in very “yieldly” equities.

If long-term rates rise, yield chasers will be burnt. Your only defense – shorten your portfolio duration.

The difference between ocean and land freight transportation

Apparently ocean freight rates for various commodities are tumbling simply because of the supply of vessels available to transport such goods.

I know very little about the ocean freight industry other than that internationally based companies, such as Dryships (Nasdaq: DRYS) have exhibited considerable volatility as the market has boomed and now crashed.

The big difference between ocean shipping and land shipping is that inexpensive freight transit can only be performed by railways, while oceans are only limited by the number of ships you can manufacture and port facilities. Trucking is not commercially competitive with rail freight (except for delivery to the “last mile”) and as energy prices continue to rise, rail will continue to be very relevant in the future.

The two large Canadian companies in this space are CN Rail (TSX: CNR) and CP Rail (TSX: CP), both of which are trading at healthy, but not ridiculously overpriced valuations.

Davis + Henderson – Valuation

Markets indeed move quicker than most anticipate, and I can say the same for the common shares of Davis + Henderson (TSX: DH) as I have unloaded them today for a mild profit. Readers may recall my entry into the former income trust units, and partial sale in October of last year.

I have no concerns with the underlying business – although I have concerns with the speed of their acquisitions – it assumes that management can execute on proper integration. The balance sheet of DH is less than stellar, with about negative $224 million in tangible equity, but their debt levels (about $200 million in low cost debt) is manageable in relation to their cash flows (due for about $100 million after CapEx in the 2010 year). They will be giving off about $100 million in distributions to income trust holders in 2010, however. In 2011 the situation will change somewhat as they reduce distributions by 35% and will also incur an income tax (which will cut their cash flows by about 27-28%).

Most people will look at the headline yield number (roughly 5.8%), but the company should be evaluated on cash flow generation rather than the dividends they give out. On a free cash flow basis, they should be generating about $75 million after the trust conversion or about $1.39/share. Given their share price, this works out to a P/E of roughly 15, or a 6.7% combined yield. It is a healthy valuation considering the various businesses they are involved with.

The capital will likely be better invested in other options throughout the year but presently the pickings are slim on the Canadian side. I suspect 2011 will involve a lot of waiting.

It wouldn’t surprise me to see DH go up to $23/share if they show they have executed well on their acquisitions, but I’m happy to get out now – my initial valuations were also somewhat fuzzy since I don’t have a full comprehension of their industry. Most of the gains from the price they traded at after they did their corporate conversion plan have been realized with the existing stock price. No point in getting greedy right now.