How to generate income from investments

If I had to select people to manage my money, there are only two people that I can think of that I would trust sufficiently to generate good performance – James Hymas and David Merkel. One can easily tell by how they write that they have very disciplined and narrow-focused techniques for generating market-beating performance.

On Merkel’s site, he has a small gem of a paragraph which seems to be quite relevant to increasingly aggressive investors that are chasing yield at any cost:

[…] total return matters more than current income. Income can be generated by liquidating small amounts of funds expected to underperform.

Apparently hordes of retail investors are out there just looking at the “dividend yield” number and using that as a basis for investment, which it should only be used to determine how effective management is at allocating capital. For example, if you have a debt-laden company that continues to give out distributions far beyond cash flow generation, it is probably a good sign you shouldn’t be investing in that company.

Investors in many income trusts that went public during the 2006 income trust mania learned this lesson.

(Addenda: I wonder how long it will be before you have “experts” trying to get retail investors to sell covered calls on their equity portfolios for additional income.)

The Priszm story continues

I wrote last week about Priszm Income Fund (TSX: QSR.UN) earlier, especially about their near-bankruptcy situation they are currently facing.

Today, they announced that the transaction to liquidate over half their franchises was proceeding, but subject to approvals by two consenting partners, the franchiser (YUM Brands) and the senior creditors. Notably in the release there were two statements:

Although there is no guarantee that the required approvals will be obtained or that the remaining conditions will be satisfied, the transaction is scheduled to close on February 28, 2011 unless the parties agree otherwise.

Presumably February 28th was the mutual date that the various parties agreed to in order to see if they could pursue something a little more substantial, alluded to in the next paragraph of the press release:

The Company also reported that it remains in discussions with its senior debt lender and franchisor on various options to restructure the business which may include the sale of all assets. The Company’s interim agreement with its franchisor, YUM! Restaurants International, with respect to the franchise agreements for 70 restaurants expired on January 15, 2011 as did its interim agreement to defer unpaid continuing fees. The Company continues to work with the two key stakeholders to come to both short and long-term resolutions that are mutually satisfactory.

As of September 5, 2010, the company has a senior credit facility of $65 million to pay off; the aforementioned agreement to sell over half the franchises would result in gross proceeds of $46 million. The company also has about $41 million in other current liabilities and accruals. The subordinated debentures amount to $30 million face value.

It remains to be seen whether the company can generate enough cash through asset sales to pay off the creditors and liabilities; at the current trading price of 21 cents per debenture, the residual value predicted by the marketplace amounts to $6.3 million.

There were 432 franchises as of the September quarterly release, leaving 200 franchises after the execution of the sale agreement.

Tightening the screws on housing market credit

The Government of Canada came out with an incremental announcement regarding the policies surrounding mortgage credit:

Specifically, the following provisions will be enacted immediately:

* Reduce the maximum amortization period to 30 years from 35 years for new government-backed insured mortgages with loan-to-value ratios of more than 80 per cent. This will significantly reduce the total interest payments Canadian families make on their mortgages, allow Canadian families to build up equity in their homes more quickly, and help Canadians pay off their mortgages before they retire.

Notably, this does not prevent people putting 20% down from getting a 35-year amortization mortgage; it does prevent people putting less than 20% down from getting a 35-year amortization mortgage. This change will only impact those mortgages where mortgage insurance is required.

On March 18, 2011 the following will come into force:

* Lower the maximum amount Canadians can borrow in refinancing their mortgages to 85 per cent from 90 per cent of the value of their homes. This will promote saving through home ownership and limit the repackaging of consumer debt into mortgages guaranteed by taxpayers.

This lessens the amount, slightly, of the home equity people can withdraw in a second-line mortgage.

On April 18, 2011 the following will come into force:

* Withdraw government insurance backing on lines of credit secured by homes, such as home equity lines of credit, or HELOCs. This will ensure that risks associated with consumer debt products used to borrow funds unrelated to house purchases are managed by the financial institutions and not borne by taxpayers.

This is probably the most important of changes – second-line mortgages will no longer have the public guaranteeing the loan value via CMHC.

Clearly the government is worried about CMHC guaranteeing mortgages that will eventually default. My opinion is that the government should not be in the market of guaranteeing mortgages at all – this is precisely why we have a financial industry, which can appropriately price the risk. If they cannot price the risk properly, they should either get out of the business or go bankrupt.

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.