Investoid

Most people are familiar with passive Exchange Traded Funds. They typically have the lowest MERs available and can be purchased during any trading session. These are what attracted me to them a few years ago and they are still my preferred investment vehicle for the passive equities portion of my portfolio.

But could index mutual funds be a better choice? After all, they have a couple of seemingly big advantages over ETFs:

• It is easier to put in small amounts (both when initially investing and with subsequent purchases), since ETFs require whole share purchases (and preferably board lot purchses). The minimum initial investment can be as low as $500 and subsequent investments as little as $25.
• If you purchase the mutual fund through your self-directed RRSP, it’s unlikely there are any transaction fees.

With this in mind, I set out to determine which passive investment vehicle is better for an average family who is planning for retirement.

Here’s how I defined my typical family:

• $10,000 initial money to invest
• $200 savings each month for retirement

With the mutual fund, the family would put all $10K in at the beginning and all $200 each month for 30 years. With the ETF, the family would buy as many whole shares possible at the beginning and subsequently make purchases once they have ‘sufficient’ funds to do so. I deemed the RRSP account to have sufficient funds when the brokerage fees would account for less than or equal to 2.5% of a transaction. The brokerage fee is set to $29 per transaction and the cash accumulates in a non-interest bearing account.

To make things (possibly) more realistic, I assumed that the ETF would split its stock once its share price reached $150. I don’t know if any iShares or other ETFs have ever done this, but I believe that they would at some point if the share price ever got too large (much like the banks do to keep the per share price ‘accessible’ to regular investors). This makes purchasing the ETF a little less frequent towards the end.

In both cases, I took off the MER at the end of the year. I assumed that the growth of the underlying index is 8% annually. For the ETF, the MER resulted in a lower share price. For the index fund, I used an MER of 0.88% (which is the MER on TD’s Canadian Index Fund) and 0.17% for the ETF (which is what XIU has).

The results were a little surprising to me (you can see all the calculations here):

• Mutual fund account end value: $312,112.28
• ETF account end value (cash + stock value): $356,302.41

I didn’t think that the mutual fund account would underperform by nearly 12.5%. This just goes to show you how even a half a percentage point in MER makes a big difference to your retirement account. The underperformance is even greater if

• You start off with a larger initial investment
• The index returns higher annually
• The brokerage cost is lower

Note that because I have used a constant growth rate I am ignoring timing effects. It is likely that the ETF strategy will be more volatile since you are not purchasing every month. This could have a material impact on returns, since you may be purchasing at bad (or good) times more frequently than you would be with a steady monthly mutual fund deposit. Also, I see two other drawbacks:

• As far as I know, you can’t easily set up a stock purchase plan like this through a discount broker. That means you’re more responsible for making sure you purchase the ETF when you have sufficient funds.
• You may be more tempted to time the market, since you may not wish to buy the ETF if the market is dropping. While this may sound good, you’re not likely to be a good judge of when the market will hit bottom (and if you are, why are you reading this? Go out and make millions). So this method also requires more discipline.

Despite their hassles and potential drawbacks, I’d stick with the ETF strategy.

Related reading:

ETFs: the new Canadian investment idols

John Bogle Is Wrong About ETFs

Funds with a cost advantage

China’s stock markets dropped substantially in the past 24 hours, and the global markets have taken notice. Right now, the TSX is down about 1.5%, while the Dow and S&P 500 are down just under 1%. I thought these drops would be a bit larger, but I think it demonstrates how optimistic investors still are about the unending growth machine that is China.

As the article indicates, the Chinese market and economy have been relatively volatile recently. With growth rates not seen since 1995, the Chinese government is worried about overlending as well as excess capacity.

Is this a buying opportunity for Emerging Markets ETFs, or for our indices as well? While this pullback is attractive, I’d be hesitant to buy on this drop. It could be a harbinger of things to come. I suspect there will be a relatively quick rebound, but I think that it’s prudent to wait and see if any other negative news comes out before diving in. Chinese stocks have had so much of a runup that there could be significant downside. Still, it’s worth keeping an eye on these markets and look for a good buying opportunity.

When an investor is trying to generate consistent above market returns, they need to find a way to get an advantage. For the professionals, this may mean having close connections to managers, or having algorithms created and tested by an army of Math and Economics PhDs. It can be tough to compete, so what can an average investor do? One way to get an edge is to invest locally.

By investing locally, I mean looking for companies that have their headquarters or do a large chunk of their business in your area (city, town, or even province/state), but do not have a national profile yet. This does not necessarily mean that they don’t already do business national or even internationally, but that the market as a whole is not aware that they really exist yet.

One way to check out the (inter)national profile of a company is to do searches on national newspaper and business archives. Secondly, look at the local media in financial hubs (in Canada’s case Toronto, and to a lesser extent Vancouver) - assuming the company isn’t located there. If you’re coming up with no stories of substance in the past few years, chances are the company isn’t really high on the radar screens of investors at large. Thirdly, check out the company’s analyst coverage. If there are no analysts (or maybe one or two independent analysts from small research firms), then this is another indicator of a company that’s flying underneath the collective radar. Lastly, check to see if there’s any fund ownership. If there’s none or very little, then the company may currently be too small for managers (who typically have certain liquidity/market cap restraints).

So, if the world is not looking at the company yet, how do you find them? Typically local business magazines and newspaper sections will highlight up and coming businesses. Usually the local media will run something on a company that won’t make national headlines. Sometimes local papers will have a ‘local index’ of companies trading on exchanges that are based in your area.

If the company’s overall story sounds promising, then delve a bit deeper and look at the market opportunity. If the growth opportunity is good and there’s large upside, take a careful look at the quality of management. Have they done this type of business before? How successful were they at it? How have they been financed so far? How much more financing do they need to get to market or grow? If you can’t find this information on SEDAR or on the company’s website, see if you can talk with management or their investor relations department. Typically smaller companies are more willing to field questions from everyday investors, and you’re less likely to get the run-around. Finally, decide how long you think it will be until the company will break out with a story that will attract attention.

You also need to take a look at current valuation and possible dilution, in the context of the market opportunity. If the market opportunity is $1 billion/year in sales in 5 years, and the market cap is already $2 billion, then the stock might have already gotten ahead of itself and all the excitement and market potential is already prices into the stock.

There are definitely risks associated with this type of strategy. The stock’s liquidity will obviously be an issue if you are looking at getting a sizable position in the firm. Thin traders can often be the target of short sellers, who use the light volume to push down the stock price between earnings release and other major news items. Lastly, the company’s execution may falter, particularly if management is inexperienced or if the company is facing barriers due to the location of their operations (I’ve seen cases where issues arise when management was too far away from their customer base).

I’ve done this a couple of times with some successes and some failures.

Fabrice Grinda has wrote a good article on the current state of the world economy, and its current implications on investment. Here are some highlights:

• The US account deficit is being primarily financed by China and the Middle East
• Asset valuations have reached historical highs as a result
• There is a potential for a major correction in the mid term unless oil prices go down or Chinese consumption (as a percentage of income) goes up

I agree with most of his analysis, but I do think there are possiblities that could affect his potential outcomes:

• I agree that oil prices could stay high for an extended period of time due to demand, geopolitical instability, etc., but I could see prices being dramatically reduced if China’s economy overheats. With so many entrepreneurs attempting to capitalize on China’s growth, I could see a scenario where overinvestment leads to a stagnation in their economy.
• It is possible that some Middle Eastern countries will shift their wealth out of the US for political motivations, which would affect the fiscal balances around the globe.

Assuming that Fabrice’s scenario plays out, what does this mean for regular investors? First, the TSX (with its high energy and materials weightings) is likely to continue to do well. Secondly, yields on bonds, REITs and the like will remain depressed from historical levels. On a risk-adjusted basis, many of these assets will be inferior to short term government t-bills. Third, it will make sense to take profit on investments if they’ve appreciated to a point you feel they are fully valued or overvalued. Lastly, do not chase the current ‘hot sector’ with a material amount of your portfolio. If you’re looking to juice your returns with some exotic investments, then by all means if you feel comfortable with such risks, go for it. But as long as this global fiscal imbalance continues, there is a good probability that things could blow up on you. Keep the majority of your investments in solid long term assets.

Disclosure: As of February 26, I hold a long position in DVT.

I came across DivestCo (DVT:TSX) while doing some value screens. After doing some more detailed analysis on the company, I must say I believe the stock is quite undervalued. Below is a more detailed analysis on the stock.

Business Background

• DVT is a diversified oil & gas services company specializing in seismic data and related services
• The company focuses on supplying data for sites in the B.C. and Prairies regions.
• DVT is growing through a combination of acquisitions and organic growth (primarily acquisitions)
• DVT wants to be the largest acquirer of seismic data in the 2006/2007 period for the Western Canadian Sedimentary Basin
• The company has four main business segments: data, consulting, software and services
• All businesses are profitable, except for the consulting division
• The company has a good track record (4+ years) of profitability
• Revenues have increased 108% on average each year since 2002, earnings have increased by 138% on average each year since 2002
• The company does not issue a dividend, nor is one apparently on the horizon

Business Environment

• The company is in a relatively competitive field
• Competitors include IHS, Pason Systems, Petroleum Geo-Services, Pulse Data, CGG Veritas, and Seitel
• Currently the company is relatively small compared to some of its competitors.
• The biggest macro factor for this company’s success is climate for oil & gas exploration (which is in turn driven by oil & gas prices)
  • Corporate execution is also a major factor. Specifically, their success depends on selecting appropriate locations to complete geological surveys. If they over invest in an area that has little value to their potential customers, their revenues and earnings will be significantly affected
  • The ability for the company to acquire companies at reasonable prices is another factor. As management has stated their intention to continue growth through acquisition, this will be a major determinant in their future returns.

Company Analysis

• Insider ownership is over 30%, according to their most recent investor relations presentation
• According to the 2006 Q3 Financials, several of the senior executives of the companies which were bought were issued forgivable loans to purchase shares as part of their buyout terms. The prices for these shares were in the $4.50 range, and the loans are forgivable based on employment milestones. To me this is a good indication that management of these firms believe that the company’s share price has a fair bit of upside remaining.
• The company announced a Normal Course Issuer Bid (NCIB) last month to repurchase up to 5% of current shares outstanding. However, the company did not repurchase any shares during their last NCIB. Note that they have little cash on hand to currently purchase a material amount of shares.
• The average weighted price of stock options that were issued in 2005 was $5.11. Since this average is currently out of the money, the managers and employees receiving these options have incentive to have the company’s performance improve.
• Their acquisitions have been financed by a mixture of debt and equity, as well as cash from operations. They are demonstrating good fiscal responsibility, as they are not overleveraging the company to fuel top line growth.
• Management revised 2006 revenue and earnings upward in June.
• Despite breaching loan covenants by having negative working capital in Q3 2006, their lenders simply acknowledged this breach and did not enforce any violation terms. This demonstrates to me that their lenders are comfortable with the company’s status and are confident in the company’s ability to rectify the situation.
• The company has been consistently operating cash flow positive during the current acquisition spree. This shows me that the company is purchasing solid assets with good operating performance.

Given this company’s growth potential, this company seems extremely cheap at only 10 times trailing earnings. Even if their earnings were flat for the foreseeable future, this company seems to be undervalued. Their Q4 2006 financials are expected to have record revenues and earnings, due to the backlog that occurred after a slowdown in Q3.

In my opinion, DivsetCo is a buy at the current closing price of $4.00.

Note: This is my personal opinion and not a recommendation for anyone else to buy this stock. This site does not purport to tell people, or suggest to people, what they should buy or sell for themselves. Please see my full disclaimer for all the details.

While perusing Google, I came across a site called CommunityLend. Juding by their splash site, they will use the peer to peer lending model that Prosper and Zopa use.

I applaud this type of service coming to Canada, and have been eagerly awaiting someone to bring this concept here. I see benefits for borrowers and lenders alike. For those with solid credit, you can build a nice carry trade business in such marketplaces.

I look forward to seeing what features will be available at CommunityLend, including what type of credit and income verification schemes they will have, as well as if there will be any portfolio management solutions for lenders.

I find the earnings season is an interesting time. The equity markets seem to react swiftly to earnings hits and misses, changing the market cap of companies by billions in a few short hours. I personally think that the markets focus too closely on quarterly and year over year earnings, which is part of the reason there is currently a private equity buyout binge (less pressure for managers to consistently hit steady growth targets each quarter).

Earnings surprise occurs when actual earnings (or sometimes revenues or margins) are materially different than what was projected by the analyst consensus. Typically the consensus is calculated as the arithmetic average of estimates by all analysts that cover a stock and the metric in question (eg. earnings, revenues, etc.).

If this seems silly to you, it is. Treating all analysts equally is like having an equal amount of money in each TSX listed company, from the penny stocks to the EnCanas. Some analysts are better at what they do and others are worse.

A company called StarMine developed a rating system for individual analysts back in the late 1990s. They ranked all analysts that were covering a stock and came up with their own weighted estimate. Their estimates were helpful in identifying potential earnings surprises. When their estimate is significantly higher or lower than the regular average, there is a good chance that the company will surprise on earnings. For short-term investors, this type of tool is great for getting into a stock before an earnings announcement and take advantage of the price swing that usually occurs on an earnings surprise.

Unfortunately, StarMine is no longer available to retail investors (they shut down their retail side sometime last year). However, Yahoo! Finance still provides StarMine’s top ratings for analysts on a given company for U.S. listed stocks. Here’s a sample with Intel.

If you have access to the individual analyst’s forecasts (through I/B/E/S or your brokerage), you can still attempt to forecast an earnings surprise by seeing if the top analysts’ forecasts are significantly different from the consensus.

When analyzing a company, I typically take the consensus estimate with a grain of salt. Creating accurate estimates is extremely hard. When thoroughly analyzing a company, I’ll create my own earnings estimates under various growth scenarios. But I do not treat them as gospel, only as a guide as to where the company’s stock price could go (and should be now) based on what might happen in the future. I also balance these figures against several other measures of valuation (both tangible and intangible), so I am not overly reliant on any one factor when determining my investment decisions.

Earnings estimates can be helpful, but I would not use them exclusively to figure out where a company is going.

The Canadian Financial DIY blog wrote an article on banks recently, similar to my last post, entitled “If you can’t beat ‘em, join ‘em”. I have a similar mentality to this, and is part of the reason I like Canadian banks as investments so much (see points 1 and 2 in my last post).

So, can you go wrong in this industry and pick a bank that will underperform? I think so. I have a quick rule of thumb about the banks (and other financial companies) that I use for investing - if I use them, then they’re probably not a good investment.

Like most personal finance bloggers, I try to minimize my personal expenditures, particularly the ones that I derive little or no pleasure from. So when it comes to banking, I use President’s Choice Financial. I moved to them from my Alberta Treasury Branches youth account, and thus have never paid a cent for personal banking services. And as long as such services exist, I don’t plan on ever doing so.

PC Financial is a great service, but it’s definitely a loss leader for CIBC. But most people who would use such a service are unlikely to be ‘upsold’ in my opinion. Thus, I think CIBC is the last bank I’d own (outside of its weighting in XFN).

All my business banking services and brokerage accounts have been through TD, so they’re another one I would avoid.

Keep in my this is by no means a hard rule and just my long term investment view on these banks. From time to time they may be good investments (like CIBC has been because it was undervalued after the Enron writedowns). But more often than not, if the frugal use a company’s services, their margins are lower than a competitor.

Update: TD announced strong earnings and a 10% hike in the dividend. Their stock was up about 1% on the news.

I am currently overweight financials in my retirement portfolio and will likely remain that way over the long term. I get my exposure to financials two ways currently:

1. Via the approximate 35% weighting financials have in the TSX/S&P Index, which I replicate using the TSX/S&P Index Capped iShares (XIC)
2. Via the TSX/S&P Financials iShares (XFN)

I like the Canadian financial stocks for several reasons:

1. Barriers to entry: the banks in Canada enjoy some level of barriers for their core services in Canada, from retail banking to investment banking and corporate services. While some small progress has been made by multinationals (such as ING) on the low end of financial services, their limited success only highlights how tough it is to break into this country.
2. Willingness to accept fees: as is currently being highlighted by the NDP, Canadians accept a lot of fees with little resistance. Whether it’s ATM fees, regular account fees or high mutual fund MERs, we seem to accept them all in stride, even when they increase (insert whatever cliché you wish about Canadians and our ‘nice’/passive personalities; it seems to apply here). This factor pads the profit margins of financial firms and is quite stable regardless of the economic cycle (less so for the mutual fund companies though).
3. Yield: in today’s low yield environment, it’s nice to get an extra 2-3% annually in a stable dividend. When government long term bonds are currently yielding only about 4%, you can really see the advantage to owning financials.
4. Currently, there is little to indicate that interest rates will be increasing in this country. Inflation (ex-housing) is pretty stable and low, while the economy is not growing that strongly. If anything, I see a rate decrease if the US housing collapse ends up affecting enough resource suppliers in Canada and depressing our GDP figures further.
5. Outperformance: since January 1, 2002 the financials have outperformed the capped iShares by 3% annually in terms of total return (all figures calculated based on figures available at Yahoo Finance Canada). Note that this does not provide any diversification away from the market risk associated with the TSX. The correlation between the XFN and XIC over this time period is 0.989, meaning you are not reducing your market risk in any meaningful way.

In the past 5 years financial stocks as a whole have risen steadily with only a few brief pauses or drops. In my opinion, you can’t go wrong buying XFN at nearly any time. But, if you’re already invested in XFN and are looking to get some additional return, here are a couple of tips.

1. Wait until there’s a slight pullback (4% or more) to purchase more. You may get a chance in the near future if Finance Minister Flaherty acts along the lines of his current comments and does something to restrict ATM fees or some other bank profit machine.
2. Pick the specific stocks which have consistently outperformed the financials index. Of the large banks, the two that pop up in terms of 5 year historical performance in Bank of Nova Scotia (BNS) and National Bank (NA). Both have outperformed XFN by at least 2.5% annually since January 1, 2002 on a total return basis. Of the two, BNS is less volatile, while NA has outperformed BNS by about 0.8% annually since 2002. Both offer solid yields in the 3.3% range.

I’ll update these to outright long-term buys if there’s a pullback on any of these three stocks in the near term without material news which affects their long outlook.

I went over to an acquaintance’s house last night to play a game of Cashflow with him and his family. He’s had the game for a long time and took its message to heart – he’s been investing in real estate for nearly 5 years and works on it full time.

I’ve played CashFlow once before and in general I like what it teaches people from a personal finance perspective (review your expenses, pay down high interest debt when possible, look for ways to augment your regular income, etc.). I do take issue with a few of its features though:

1. It has defined trading ranges for stocks. While the stocks can go outside of these ranges, I think it gives players too much insight into whether a stock is a good deal or not at the given price. I know it’s hard to replicate the complexities of stock analysis in such a game, but I still think there could have been better ways to have players determine whether to buy a stock or not.
2. The goal of the game is all about getting passive income. While this is what many people dream about, I am skeptical of its portrayal of real estate net revenues as the ultimate cash flow available to everyday people due to the low initial outlay versus stocks or businesses, thanks to the miracle of mortgage financing. As any landlord will tell you, rarely is this true passive income (maintenance, dealing with tenants and the like are all time consuming).
3. Nearly all the real estate deals were ‘undervalued’ at purchase time, making it easier to obtain high percentage capital gains on real estate in a short amount of time due to your leverage. This seems a little convenient and skews the game even more to real estate investing.

I never really bought into this type of investing, but many people in my province have and have done quite well for themselves over the past 7 years. The unprecedented growth Alberta has had in the new millennium has definitely made such opportunities available to a large number of people.

Time will tell if this is a sustainable way to make a very good living over the long term. I believe we can look to the United States (and its record year over year national price decrease) as an indicator of what happens if too many people become mini real estate moguls. This average masks the pain that is happening in several markets which have declines of well over 6% (see here for more detail).

Here’s a couple of articles I think are instructive about the perils of flipping property or hoping for positive cash flows from real estate assets.

• Stung by the slow market
• House Flipping is In