A good investor but not a good fund manager

Imagine an investment manager that is so good that they can double their money whenever they put money into the market. However, this manager is only able to do so once every five years and is smart enough to know when he is invested outside his “window of opportunity” he will dramatically underperform the market and thus will go to cash during the rest of the time. This investor would be in the top percentile of all investors by virtue of his ability to obtain a 15% compounded return, year over year (doubling your money every 5 years is very close to 15% compounded annually). However, just imagine if he had a hedge fund and investors piled on board after his first 100% year and reading his annual reports:

Year 1 letter to shareholders – We were fully invested in the market, but have now gone to 100% cash. Our performance on equities has resulted in a 100% increase in our net asset value since the beginning, a very good year. We will look for more opportunities in the future when they present themselves.

Year 2 letter to shareholders – Thank you to the new investors for joining hedge fund XYZ. We have been 100% invested in cash, earning 3% on cash. We have found nothing suitable to invest in.

Year 3 letter to shareholders – We have been 100% invested in cash, earning 2.5% on cash. We still have found nothing to invest in.

Year 4 letter to shareholders – We have been 100% invested in cash, earning 2.75% on cash. We have found nothing to invest in. Believe me, we are trying!

Year 5 letter to shareholders – We have been 100% invested in cash, earning 2.5% on cash. We’re really looking hard for investment candidates, some might be on the horizon soon, but we can’t tell at this moment.

By this time, most of the people invested in the hedge fund would have already exited. “Why bother investing with this guy when he isn’t going to be investing our money?” If the investment manager was working for a larger company, chances are the manager would have been removed, even though he was working in the long-term interest of the fund.

Of course, by the time clients have removed all of their money from the hedge fund, the manager on year 6 sees opportunity and has another year of a 100% return. People, attracted by the performance, come back to the fund in droves, only to witness their money being invested in money market instruments for another 4 years.

This is one of the big advantages that an individual investor has, assuming they are capable enough to hold high levels of cash during significant market downturns. An individual investor does not have to sacrifice their strategy for political reasons (i.e. fear that their clients will pull money out of their fund). This political advantage can be exploited by those with ironclad discipline to hold cash for lengthy periods of time.

It is usually very difficult to measure the performance of these individuals over a short time period – it would have to be measured over a lifetime. The Buffett/Munger partnership is the best example of people that were not afraid to hold onto their cash for opportunistic moments.

Mutual fund disclaimers

Bad Money Advice, written by a fellow that is apparently a Boston hedge fund manager, writes about how useless mutual fund disclaimers are. Specifically, he quotes a study saying that the insertion of the line “Past performance is no guarantee of future returns” has no bearing on the decision to purchase a fund.

This reminds me of trying to legislate warnings against smoking cigarettes – it started with a small warning on the box saying “Warning: The Surgeon General says that smoking is bad for your health”, but it has progressively stepped up to now, where half the package has a picture of some person that hasn’t brushed their teeth in a century and a picture saying “THIS WILL BE YOU”.

You can take it to the ultimate step of packaging them in black boxes called “death sticks” with skulls and crossbones all over them, and it still wouldn’t matter.

Same thing for fund advertising, except consuming mutual funds will only kill you financially.

First Uranium concludes recapitalization

First Uranium has concluded their recapitalization proposal by issuing $150 million worth of notes due to mature on March 31, 2013.

This is a very bitter pill for the equity holders to swallow – they will be heavily diluted by virtue of the conversion privilege attached with the notes, at $1.30/share. Assuming conversion occurs, this will result in 115.4 million shares outstanding more than their existing 166.8 million. In addition, to settle the contractual arrangements with another partner, they will be issuing 14 million shares extra.

All of this means that First Uranium’s existing stockholders, assuming full conversion, will have their holdings reduced to about 56% of the company. However, a significant shareholder (Simmer and Jack with 37% of the prior equity ownership) will also have $40 million of the issue of the notes, which if fully converted, will leave them with approximately a 31% stake.

Probably the only reason why they got into this offering to begin with was to salvage their ownership in the company, which was clearly going to slip away in an upcoming and very messy bankruptcy proceeding.

Gold Wheaton, a company that has purchased a fractional interest in the gold mined from First Uranium, also will be investing $20M and receiving 14 million shares as a result of a settlement on a contract that First Uranium failed to live up to. Assuming full conversion, this will give them about 10% of the company.

The Notes are guaranteed by the subsidiaries of the Company, secured by second ranking security over all assets currently encumbered by Gold Wheaton and first security over all other current and future assets of the Company, not be redeemable until maturity.

Assuming First Uranium will remain above $1.30/share, their recapitalization should be half done.

The other medium term issue for First Uranium, other than the establishment of its mining operations (and subsequent cash flow that would be produced by such operations) is that they have a $150 million issue of unsecured debentures that are due to mature on June 30, 2012, which I so happen to be holding.

First Uranium has a few options.

One is that they should be prioritizing their operations to be cash flow positive, which will make it easier to float another equity or debt offering that the market will be receptive to, enabling them to pay the subordinated debentures.

Another option, concurrent to the above, is that they have the option of paying off the debentures in shares of common stock at 95% of market price; at current market prices of $1.45/share, it would involve issuing another 109 million shares, for a grand total of another 27% dilution of common shareholders. This option will be progressively more attractive as the common share price goes higher. Such an action would be done in 2012.

Another solution is to renegotiate directly with the debtholders and sweeten the terms of debt (i.e. increase the coupon, lower the conversion price) in exchange for an extension of maturity date. This would require ratification of 2/3rds of the debtholders.

Ultimately if the company doesn’t pay up, the unsecured debtholders can force the company into bankruptcy. While their rank in the company, by virtue of subordination to this new issue of debt, will lead to low recovery, it is unlikely the owners of the company would want to proceed with this action and thus it is more likely than not that between now and the 2.2 years to maturity that there will be a way found to make the June 2012 debtholders whole. Simmers and Jack would not want the subordinated debtholders to pursue the “nuclear bankruptcy” option and thus it is more likely than not there will be a solution.

I do not believe First Uranium equity is a good risk at present prices, while I think the June 2012 debentures have probably priced in the right amount of risk and would present themselves as a speculative high risk opportunity.

Time spent maintaining the portfolio is relevant

There are two reasons why I invest. Both reasons tie into each other.

The first reason is because I want to realize a return on my capital that is higher than the risk-free rate that I would get at a financial institution. Almost everybody invests to do this.

The second reason is because I find it interesting. I genuinely like going through financial haystacks and finding needles, which is what investing is typically like – the only way to get rewarded is to work smarter (employing computers to automate manual work) and harder (doing things that computers can’t). Most value that an individual investor can bring to their own portfolios comes from the latter part.

I do not “day trade”, although there have certainly been moments in my life where I have traded very frequently (i.e. buy one day, sell the next). I have never actively looked at a chart in mid-day and said to myself “that looks good, it must be going down so I will short”, nor have I employed any computer software to automatically pick off technical indicators. I figure that if others are trading purely on price and volume information that they would have me beat by a mile.

However, an important part of individual portfolio management is that because I don’t have an investment committee, my portfolio has to be managed in such a way that I don’t have to spend too much time to “maintain” it. If I had to actively spend 4 hours a day managing positions then investing would not do me much good. Right now maintaining my portfolio is a simple matter of checking for news and once every quarter, read the quarterly report and see if the financial result is roughly in tune with what you (and not the analysts) had expected.

Out of the 10 positions I currently hold, only two of them I would say that my knowledge of their industries is “less than comprehensive”. By virtue of the fact that I expect to get paid off in those fixed income investments, the lack of knowledge is appropriate since I can spend time doing other investment research.

Screening for candidates and determining when to get into positions is the most time intensive part of investing. In this process you discover candidates, look at valuations, and determine whether something is worth ploughing capital into. If not, what price? If so, what are the exit conditions? Obviously price is one, but another exit condition could be a change to the industry, or some other information that usually is not considered at the time of initial purchase.

There is also the time to know when to not bother looking. The worst trades are marginal candidates that you put into the portfolio just because you want to be “fully invested”. While marginal trades such as these in fixed income securities are less punishing than in the equity world, both serve to deprive an investor of their ability to maximize their returns – having cash in a major down market is the best way of ensuring superior returns.

I have been doing some research, but have found marginal candidates. I don’t have much solid conviction behind this market, other than the fact that it seems to be pricing in an economic recovery which I believe is occurring, but I do not think the market is seeing further out than 2011 at present. 2011 should be a banner year for corporate profits; however, 2012 and beyond will likely be more shakier. One of the reasons is due to inventory buildup. I don’t know if the markets have priced in the post-2011 world yet of “back to normal” tepid growth.

In the meantime, I will continue looking for needles, hopefully not hypodermic.

Living off of government benefits

There is an article in the UK that describes a family with 8 young children, and the husband quitting his job because the benefits they get from the government are higher. Their take-in is about £815/week which is about £42,380/year, or about CAD$65,100 using current exchange rates.

I do not know whether the numbers are correct, and I highly suspect the article is designed to be inflammatory. I also have no idea what specific social benefits are available in the United Kingdom.

However, I have pondered what somebody in Canada or British Columbia could get if their goal is to minimize work and live off the government. I can’t think of a situation implied like the above article where you effectively have an over 100% marginal tax rate for working. There are situations that come close. There are hypothetical scenarios if your job in life is to maximize government benefits. Note the majority of these use the most current up-to-date 2010 figures, but some 2009 figures may have inadvertently slipped into the following calculations:

1. Assume you have 1 child. This will qualify you for a lot of benefits. It’s also usually better, for government benefits purposes, that you are single as having a significant other making money seriously impairs your ability the claim the benefits discussed below. If you do desire a significant other, do not marry them and live in separate accommodations will maximize the ability to obtain benefits (for you and them!). Having two children will decrease the marginal benefits received compared to having one child.

2. Earn $21,816 in the year. This will qualify you for the following PROVINCIAL benefits:
– Full MSP assistance (free for those under $22,000/year, a $1,224/year annual benefit). I am also assuming no benefit with respect to Pharmacare (which has a lower deductible for lower income individuals).
– Starting July 1, 2010, the BC HST credit (for a family under $25,000/year, a $230/year annual benefit plus $230 for dependent)
– Climate Action Dividend (for a family under $35,843/year, a $105/year benefit, plus $105/year for first child)
– BC Tax reduction credit, essentially a non-refundable reduction in the income tax rate for low income individuals (for $17,354/year, $390/year benefit, reducing by 3.2% above the limit, so in this specific example, $247.22/year benefit)
– BC Child Care Subsidy; while the requirements to qualify are not specific (they do not give a monetary threshold) this would qualify for up to a $750/month ($9000/year) subsidy for early child care. I am not factoring this in to any future calculations in this post.

You will make too much money and miss out on:
– BC Sales tax credit (for a family under $18,000/year, $75/year annual benefit, reducing by 2% above the limit) – I believe this might be phased out with the BC HST credit.

3. A $21,816 income will qualify you for the following FEDERAL benefits:
– Assuming you were working at $21,816/year before having the baby, 50 weeks of Employment Insurance benefits of $230.75/week, or $11,537/year.
– The child will enable you to receive the $100/month Universal Child Care Benefit (UCCB), which is $1,200/year until the child turns 6 years old.
– Federal GST/HST credit (up to $32,506/year income, annual credit amount $631/year with the child)
– Working Income Tax Benefit (WTIB), which is complicated to explain the actual calculation in a sentence, but for a single mother of one child making $21,816/year, works out to a refundable tax credit of $751.28/year.
– Canada Child Tax Benefit and National Child Benefit Supplement and BC Earned Income Benefit – under $23,855/year income, the benefit is $3,528.84/year.
– Canada Learning Bond (CLB), which if you open up an RESP for your child (not frequently done I am sure) will result in a $525 benefit in the RESP immediately, plus $100/year providing you qualify for the National Child Benefit Supplement.

4. Live in social housing or get rental assistance. Although it was difficult to find exact numbers to work with, apparently you can get rental assistance that will net out your rental balance to 30% of your net income. This is also why it is important to keep your income relatively low if your job is to maximize government benefits. If you earn $21,816/year, this will result in an effective rental rate of $545.40/month, which is significantly under market in Vancouver. I am going to take a gross approximation and assume $1,000/mo for a 2-bedroom apartment somewhere in Greater Vancouver which would be a subsidy of approximately $455/mo or $5,460/year.

You add all of this together and get the following results:
a. Excluding EI (which you can claim a credible argument for having paid into the program by virtue of being employed), you will receive approximately $8,252.34/year of either cash payments or payments that are otherwise mandatory that you will not be required to pay; this does not include social housing benefits, and I am excluding the RESP boost since almost nobody will be taking this option.
b. With social housing, that goes up to approximately $13,712/year.

So somebody earning $21,816/year (note: this is about $10.50/hour, full-time 40 hours/week) with a child will be receiving a subsidy of about $13,712.34. This is about 63% of their existing income level. In terms of their income statement, it would be this:

Salary – $21,816
Minus: CPP – $907
Minus: EI – $377
Minus: Income taxes – $0 (none; the child vastly increases the tax credit amounts available to the parent, plus provincial taxes are reduced to zero by the BC Tax Reduction Credit)
Net cash from work: $20,532

Add all of the following:
BC HST Credit: $460
BC Climate Action: $210
UCCB: $1200
GST/HST: $631
WTIB: $751
CCTB and supplement: $3529

Net cash after benefits: $27,313

Minus rent: $6545 (30% of income, assumed to be the “salary” in this case)

Net: $20,768

This is a good sum of money after taxes and rental. Looking at my own personal budget, assuming I had the appropriate rental subsidy as #4 above, I would actually be pulling in a mild surplus. The only real difficulty is the ability to maintain work while taking care of the child at the same time (not easy!).

Now, let’s assume that you earned $35,000/year ($16.83/hour for a 40 hour/week full-time job) as a single parent. This is the most you can earn and still be eligible for social housing benefits. This is how the math would work out:

Salary – $35,000
Minus: CPP – $1559
Minus: EI – $606
Minus: Income Taxes – $1968
Net cash from work: $30,867

We now factor in the benefits:

Minus: MSP – $1224
Add: BC Climate Action – $210
Add: UCCB – $1200
Add: GST/HST – $506
Add: CCTB and supplement – $2185

Net cash after benefits: $33,744

Minus rent: $10,500 (30% of income, assumed to be the “salary” in this case)

Net: $23,244

The difference in earning $13,184 in more pre-tax income will translate into approximately $2,476 in disposable cash after housing rental payments. While the effective marginal tax rate in these circumstances is below 100%, it is quite high (81%).

The quick conclusion that I have is that there is a high level of incentive to work part-time if you are in a middle-wage job if you are single and with a child. For example, if you are working in a clerical type job with a moderate amount of experience, the cost of having to stay at home one, two or even three days a week without pay is not that financially punishing because the government subsidies significantly make up the shortfall. Especially when you net this out with the cost of childcare, it is easy to see how people in BC that value their time more than their money would purposefully keep their income levels below the specified thresholds in order to maximize their government benefits.