Category: Finance

I love nearly everything David Merkel writes, and this is a gem:

The lesson is this: in investing, ignore yield to the greatest extent possible. Focus instead on earning a good return, with safety, and ignoring the payout. It is a little known secret that REITs with the lowest payouts tend to be the best performers over the intermediate-to-long term. It is easier to earn money off of taking equity risk than credit risk.

So, aim for best advantage in investing. Don’t trust yields, but rather look at the underlying economics of the business that you are investing in or lending to. Yes, it is a lot more work, but it is work that you should be doing.

One issue I have with a lot of “Dividend stock investors” is that they do not look at the underlying fundamentals of the company to determine whether yield (and growth of that yield) is sustainable. During the Canadian Income Trust mania (roughly in 2003-2006 before the government shut the whole operation down) you had corporate entities converting into a trust that had absolutely no chance of being able to sustain such distributions. To list all of the offenders in this post would be burdensome, but one of my “favourites” (not that I had ever invested in it, but because they were a local business I paid attention to them) was Hot House Growers Income Trust.

HHG went public in late 2003 after they had a good year. They had distributions which were higher than their net income and they had a significant amount of debt. They began to suffer operationally (too many people were crowding into the business sector) and a couple years later they collapsed and had to be taken over by the surviving entity, Village Farms, which is a penny income trust that will not be giving any yield because their business still has too much debt. They are still publicly traded, although they will likely have to recapitalize again to pay for their debt.

People were buying income trusts in droves simply because they saw the yield and did not consider the return on investment, i.e. whether you would be able to retain the capital in the investment.

My own income trust investments are quite “yieldy”, but their underlying business fundamentals are solid, and generate significant net income (not just cash flows) to sustain the business, after required capital expenditures. Probably the easiest screen you can perform is making sure that net income and cash flows are above the yield (dividend/distribution) rate and ask yourself if the business that is underneath it all can be sustained for the indefinite future.

The other question you should be asking is whether the company has the ability to invest capital that is left over after distributions and debt payment into other capital projects that will continue to give yields that are above the current cost of capital. If so, such companies should not have excessively high payout ratios.

Most dividend stock investors have the right idea, but they don’t do the rigorous research to ensure that they will be paid out without taking a disproportionate risk of capital loss – instead, they just look at the yield/dividend number, and just care that it has gone up historically over a period of many years. This blind-style of investment is akin to driving while looking at the rear view mirror.

The BC government in the previous budget is now enabling people that own homes and financially supporting somebody that is 18 years old or younger to defer their property taxes, at the rate of interest of the bank prime rate. Previously only seniors (55 and older) were able to exercise this option.

Essentially homeowners are given the option of borrowing money (the amount of their yearly property taxes) at the prime rate, and will only have to repay this amount when your property is transferred (i.e. you sell the place).

Almost everybody that is financially sophisticated that is eligible to do this should be exercising this option. Getting money at the prime rate outside a mortgage is not that easy, and at the prime rate you can very likely make an investment that would give a higher rate of return.

The trick is making the interest amount tax-deductible, and if you use the deferred property tax amount for income-generation purposes then in theory you should be able to deduct the interest.

Don’t believe anybody that says that market timing is not an important element of successful investing. Timing is a crucial part of it – basically you have to know when to buy (identifying when the prices are low) and know when to sell (identifying when the prices are high). I have historically found it more difficult to know when to sell than when to buy, presumably because markets crash quicker and harder than they go up. I have been actively working on this part of my investment experience for the past few years. I still do not feel comfortable with my exit tactics.

It is a very, very frustrating part of investing when you know you had the timing correct, but were unable to execute on any trades. Two days ago, on May 25th, I wrote:

I am generally of the opinion that the markets at this time are greatly oversold, with presumably most of the selling done across the Atlantic Ocean in Europe by panicked investment bankers and hedge funds. Unfortunately (or fortunately), I am still looking for areas to safely deploy cash.

I had placed a smattering of orders, starting at roughly 3% below the May 25th market close, but they probably won’t be executed now since the markets seemingly have reversed. I wanted to get about 10% equity exposure to the fossil fuel industry and I only have about 5% exposure on the debt side. Since the whole Canadian crude market has skyrocketed in the past couple trading sessions, I’m going to have to re-evaluate the short-term entry or hope for one more shock-wave coming out of Europe (which would be nice). My general thought is that while I don’t believe in the “10% of your portfolio in Gold” inflation-hedging technique, I do solidly believe that having a claim to future cash streams from Canadian oil and gas companies with significant reserves will be a good capital preservation technique over the long run – at least until crude prices rise to the point of unsubsidized alternative energy production costs.

After describing my inability to execute on what should have been a short-term winning trade, now is the time for a trading lesson to describe why the process I employed is correct.

Whenever I place orders, it is always with limit orders, and broken into price increments that are scaled below the initial point. I very, very rarely buy at the ask and sell at the bid unless if dealing with illiquid securities and somebody posts something juicy.

As an example, if a share is trading at $10/share and I was interested in purchasing 1,000 shares and thought market volatility would take it roughly 10% below current price levels before bottoming out, a simple execution would be to break it into five branches, such as the following:

Buy 200@9.80, 200@9.60, 200@9.40, 200@9.20, 200@9.00

The total cost of the order, excluding commissions, would be $9,400; a lot cheaper than just putting in an order for 1000@10. However, the cost of such a decision is that you may not get your desired quantity (or any at all) if there is not sufficient volatility in the marketplace. In the case of my fossil fuel equity trades, this is exactly what happened – market volatility took the market price up and not down as I expected.

Inherent with the breaking of such orders is the assumption that you don’t know what “the bottom” will be. I have learned many times over that predicting the exact bottom is impossible and that breaking orders into smaller quantities is the best way to capture value from this admission.

Using a real brokerage (e.g. Interactive Brokers) keeps trading costs of breaking orders into small bite-sized amounts cheap; a price-making order on the TSX incurs around 52 cents of commission for 100 shares. The increase in commission is inconsequential to the likelihood of saving capital costs with the lower-priced purchases. Even using a less sophisticated brokerage, you can still obtain significant price savings.

This same heuristic can also be employed with an exit of a position.

Note that it is very easy to modify this into a workable algorithm. When working with institutional quantities (e.g. millions of dollars), you typically employ algorithms to randomly time entries and exits depending on ambient market conditions and the volume seen in order to get the best execution on the entire order. When working with large amounts of dollars, masking the intention of your order is critical in order to be able to successfully accumulate or distribute share holdings.

One major advantage a retail investor has over the institutions is the ability to get in and out of positions with the click of a mouse button, as opposed to employing complex algorithms to do the same over the period of days or weeks.

The reason why you hold cash, as opposed to yield-bearing investments, is to take advantages such as times as this one and be able to purchase securities at low prices.

Right now, the markets are trading heavily down, presumably as a function of some fallout of the European economic situation and a not-so-hot US jobs report.

In the 21st century world, at least in western countries, the reality is that employment is not a proxy for corporate profitability. An investor invests to get a claim on a company’s cash flows or assets.

The following is a monthly chart of the S&P 500 volatility index, which is at around 45 right now:

The volatility of the main indexes are such that are equaling what happened during 9/11 and the Enron/Worldcom blowup. The only bigger spike in volatility was when Lehman Brothers went belly-up. This European sovereign debt crisis is nothing close to what happened during the Lehman Brothers time (late 2008). Although Greece is a canary in a coal mine, it is not that important in the grand scheme of economics.

The one thing I do know about markets is that there will never be a grand pronouncement that this volatility spike is ending. It could go to 50, or 60, or 70, but it could just float down from this point. One never knows. If I was going to guess, this financial soap opera has another month of legs left in it.

What a good investor does, and a good investor holds onto cash for this reason: to pick off the targets on your watchlist, that are being sold by international financial institutions carte blanche, that are trading well below what your assumed fair value for the securities are.

Since my Starbucks Duetto card was discontinued by Starbucks and/or Royal Bank of Canada, my intention was to take the new credit card RBC delivered and just use it as a backup card (after cashing out the 3000 points for gas money). When calling the credit card activation number, I was fully prepared for the script. You punch in your credit card number over the phone, get transferred to a person that then asks you for your credit card number (presumably because the information doesn’t get passed onto his computer screen?), name, birthdate and then says “While the activation is processing, as a valued RBC customer, I would like to offer you……..” and then went through a bunch of legal gibberish about their “balance protector insurance”. I have heard this spiel before. The guy’s accent (obviously Indian) was so thick that I had difficulty listening to him. He spoke it so fast that I’m amazed anybody would be able to understand him.

However, what was interesting was how they phrased the last question. “So, Mr. Peter, do you believe that maintaining your credit rating in the event that you cannot pay your credit card balance is important?”. This was a new way of phrasing it. Before they just simply asked “Would you like balance protector to protect yourself against your inability to pay a credit card if there is a life-threatening hurricane in your area?”

Most people have a huge psychological difficulty in saying “no”. I am not sure why, but it is taking advantage of the old-style Victorian culture of politeness. Most charities and aggressive marketers always love phrasing questions in such ways that it is very difficult to say no – from political life, “can I count on your support?” is the typical question asked. As soon as you answer in an ambiguous manner, they draw you in for more.

Anyhow, I said “NO, I am not interested in the offer” and left it at that. The fellow on the phone continued, “Because RBC values your opinion, tell me why…” – as much as I would like to get into an argument with the call center guy, I know it would be just a waste of time. First of all, RBC doesn’t care what I think. In fact, I know what RBC and all credit card companies think – I’m part of a statistical pool, and they don’t care what I think at all, as long as I pay the balance (with or without interest, preferably with interest) occasionally. The even more insulting part is that the line “While the card is activating, let me sell you this crap” is complete garbage, simply because activation happens as soon as the guy clicks a button on the keyboard and doesn’t take one minute to go through the system. The guy just says it to launch into a marketing pitch that his employer tells him to.

I can’t believe that people actually agree for the ancillary garbage, but since they have it on the books, they must be able to get enough suckers to warrant annoying the 97% of people that just want the card activated and to get on with their lives.