Chasing yield is easy until the party ends

I have successfully liquidated my debentures in Harvest Energy (series D and E) for 101.5 and 102.0, respectively. Since they are trading above the 101 that will have to be offered after the takeover, it is unlikely that investors will tender the debt. I am happy to be rid of the bonds so my capital can find some more productive areas. My opportunity cost of this transaction is giving up about a 6% yield, but there are equivalent risk instruments that the money can be parked in the interim.

I have another issue (Bellatrix Exploration, formerly True Energy Trust) that has seen its equity rise about 400% over the past four months and its bonds have correspondingly traded near par. It is very close to my liquidation point and there will be a high probability it will be sold very soon.

As such, my portfolio is starting to look cash rich. While cash is good, it is also earning a return that is less than flattering (mainly zero) and while I can shift the funds into a short term savings account for 1.2% (or 2% if I shopped around) I am always looking for a better place to put my money – something that will give a yield.

In my tax sheltered accounts, I am looking for investments that will generate income. Outside the tax sheltered accounts, I am looking for investments that can generate capital gains (taxed at half the rate) or eligible dividends (taxed significantly less depending on what income bracket you are in).

Most of the income trusts have been bidded up to yields that are not representative of the risks embedded within the company – for example, a trust that is always on my watchlist (but I never get around to purchasing) is A&W – currently yielding about 8.01%. This is not adequate compensation for a company that is distributing more cash than its distributable cash allotment. It is possible that A&W could trade higher (and yield lower) but this is essentially the equivalent of gambling and could just as easily go to 8.5% ($14.82/unit) as it could to 7.5% ($16.80/unit). I do not want to get into coin flipping competitions with the market.

Since my hurdle rate is above 8%, I am forced to lower my standards if I am to seek a home for my cash. This means either accepting higher risk, or accepting a lower rate of return.

Right now if I accepted a lower rate of return, I estimate I could generate about 10% a year with debentures, but this is still a relatively low rate of return in consideration of the risk taken.

As such, I must broaden my search to more obscure securities and companies. This will also require some research and time. It will also require appropriate market conditions when people are less confident.

Fortunately, time is on my side – while the cash is sitting there, earning nearly nothing, it will at least be there when I need it. The temptation to quickly deploy cash is one of the most destructive psychological behaviours one has while investing.

An inflation-protected investment

This does not scale up beyond a couple hundred dollars, but if you are planning on sending a large quantity of first-class letters across Canada, investing in some stamps is not a bad method. Currently stamps are 54 cents and are marked as “permanent” which means that the face value of the stamp will increase as prices increase. Stamp prices will increase to 56 cents in 2010 and 58 cents in 2011.

Implicit in this price increase is a 3.7% protection against price increases in the future. Since interest rates are currently well below this figure, there is a minor amount of inflation-proofing available to buy stamps now for the next few years.

Ability to remain irrational longer than ability to remain solvent

John Hempton at Bronte Capital writes another high-quality piece about how having superior information doesn’t necessarily translate into stock market returns. It is just like people that shorted the stock market in 1999 because of insanely high valuations (or shorting Amazon in 2009 at $100/share!) – even though they might be correct, the market can remain irrational longer than your ability to remain solvent.

It is always frustrating in markets to be right, but to get the timing incorrect. This is why option markets are always so brutal to those don’t get the element of market timing to be correct. It is also an indication that even when betting against the majority, you will only be able to win if some of that majority decides to see the world your own way – this process can take years, just like it did for the former Dow Jones Industrial stock Eastman Kodak, or for the poor fellow (Alfred Wegener) that developed most of the geological theory on plate tectonics – he was completely correct, but ridiculed in his own scientific community and died before he was proven correct about 40 years after he proposed the theory.

You can also see other stocks that are on their death throes, such as nearly anything involved in newspaper or paper-based publishing. It also makes you wonder what industries today that aren’t visibly dead will be on their deathbed in the next 20 years – look around you and see what you use today, and wonder if it will be replaced with some substantial technology innovation that is just in its infancy today. Maybe this is why Amazon is trading so highly – maybe they will be exterminating conventional retail shopping?

I remember back in the late 90’s, back in the days when I started investing and didn’t know too much other than technology companies, that I did a lot of research on flat panel displays. Back then, 17″ CRT monitors were still about $500, but it was imminently clear to me that flat panel displays would be the way of the future – if anybody tried lifting up a 21″ CRT monitor you would end up breaking your back trying to move the thing. It lead me to two companies, Genesis Microchip, which did semiconductors in FPDs, and Photon Dynamics, which made diagnostic and factory equipment for the manufacturing of FPDs.

Both of these companies didn’t skyrocket like I anticipated them to and I never even invested in them, but it was worth noting that despite the fact that flat panel displays became the future of computer displays, I never was able to financially capitalize on it in the marketplace.

Fact checking on charities

In Canada, charities that are registered with the federal government enjoy certain benefits that other non-profit organizations do not. In exchange for being compliant with multiple government regulations, they have the ability of issuing tax receipts which equates to a refund of income taxes of 20.06% for the first $200 donated, and 43.7% for anything above that, using BC rates.

One of the items that a registered charity has to comply with is reporting to the Canada Revenue Agency so there is a degree of transparency where people can see where money is raised and spent within a charity. You can access this on the CRA Charities Listings site.

It is very important to know when an executive of a registered charity says that “We do not receive any government funding” that you check lines 4540 to 4560 on the return; if you see revenues there, the management is lying to the public. In addition, they are implicitly receiving government funding due to the value of the tax refund from charitable contributions. For example, if you were to donate $1,000 to a charity, your after-tax cost is actually $610.28. The federal and provincial government are essentially donating the other $389.72 in the form of an income tax refund.

Also there is the well-known issue of having a high percentage of money wasted on administration expenses. If line 5010 (Management and Administration component of total expenditures) and 5020 (Money spent to raise more money) are high compared to total expenditures in a charity, I would look at it as probable that they are not being efficiently run.

My advice would be to donate only to registered charities that you know at least one of the directors of, and your opinion of the director is positive. At least if they incompetently squander your money, you’ll be able to grill them in person and keep them accountable.