Investoid

Here are some talking points for this weekend.

• Is the private equity binge over? With debt yields increasing, can PE firms continue to buyout companies at such rich prices? With big deals like the Chrysler one on hold due to lackluster debt markets, it may be that the ‘put on equities’ is expiring.
• Will the market continue to swoon from its recent top? ThickenMyWallet has mentioned that the Dow is up greatly in a short period of time, can it only go down from here?
• Is the Alberta real estate boom about to become a bust? While there are conflicts over the outstanding inventory figures, there are tons of for sale signs in town and no one is buying. Can this inventory be sucked up in the fall or will prices start to drastically decline? I think it depends on the amount of speculators in the market. If it’s relatively small percentage (say under 25%), then I doubt prices will fall that much.

Have a great weekend everyone!

Sorry I haven’t posted for a while, I have been busy learning about options trading and risk management. It is definitely a different mindset compared to my long term buy and hold strategy, as well as my medium term stock picking. I’ve been learning about what it takes to be an effective trader, particularly from a psychological perspective. I have read several articles on the mistakes that traders typically make, and have read many personal accounts from people who had their habits and fell into the same trap over and over again.

One of the most important disciplines a trader needs is to be able to follow his or her trading rules. Most of the time, these trading rules involve some aspect of the trader’s investment strategy. However, since I have not decided on a trading method yet, my rules focus on overcoming the psychological barriers that I face when trading.

1. Accept profits when they present themselves. Despite the fact that people typically ‘leave money on the table’ by selling profitable positions too early, I think it’s important for traders to take profit once a position has turned out as expected. This may involve a combination of having a profit target as well as an informational target (eg. I expect XYZ to announce a new deal in the next two weeks, and for the stock to go up as a result). These have to be soft targets though, or else you may wait too long and lose your profit.
2. Take losses immediately when things don’t turn out as expected. This can be the hardest thing to do, but it’s paramount to ensuring that you can continue to trade the next day. If you were expecting a particular event to occur and it doesn’t, or if the stock/future/whatever reacts differently than you expected, get out now. Something has not gone according to plan and you can easily be wiped out if you continue to hold onto losers. Some options strategies will allow you to adjust to the new information and mitigate your losses. If you feel adept at making these adjustments, you can do this instead of pulling out of your position entirely. I would only recommend you start doing this once you’ve learned to take losses though. It’s the hardest thing to do but the most important piece of long term success.
3. Sell a losing leg before a winning leg. Many options strategies involve multiple options, which are often used as hedges against one another. This means that you typically have one or more options losing money even though the overall strategy is profitable. When you’re going to exit a position, you may be tempted to sell the winners and see if the losers will rebound so you can increase your gains. While this may work out in your favour, you may have fallen into the losing position trap, which will hurt you in the long run. As a result, you should always sell your losing legs first, which will compel you to sell your winning legs immediately as well so you don’t have realized net losses. Ideally, if you have a trading package that allows you to sell all the legs at once, you would use that to avoid any temptation.
4. When your asset/underlying asset becomes very volatile, sell. Unless you’re specifically attempting to capitalize on higher volatility, it’s important to realize when the market is in an adjustment period. This can happen when new information is being assimilated, such as when earnings are released. Based on my experience with the current earnings season, some stocks will ‘gap’ up or down significantly, and then could go either way. Some will continue to go up, while others will start to move in the opposite direction as people take profits. When volatility increases substantially in a very short time, it’s best to exit your positions and be satisfied with the profits you’ve made.
5. Live for the execution. Also known as ‘don’t count your chickens before they hatch’. When you’re trading, it’s important to stay on top of what is happening to your positions as they develop. The shorter term your trades are, the more concentration they require. Don’t ever expect a particular trade to go your way, and don’t think about what you’re going to do with all your profits. It’s important to think of each trade as sticking your head out of a trench in the middle of a firefight. Keep alert at all times and follow your rules to a tee. Try and block out all other influences while you’re trading, so you can stay focused on what’s at hand. Lastly, don’t simply set a limit order and expect it to get filled.

While investing in general takes quite a bit of discipline, trading takes even more. I think it’s important for traders to start small but use real money, so they can learn from their mistakes and study how they react when things don’t go according to plan and they’re facing real losses. Disciplined trading is the key to long term success in the field.

MoneySense put out an article in their latest issue chronicling the ‘Top 100 Income Stocks’. The list is divided into income trusts and dividend paying stocks, with 50 companies in each section. Here are some interesting picks that receive an ‘A’ grade.

• Canetic Resources Trust (CNE.UN: TSX): this trust had a horrible performance in the past twelve months (down over 23%), but it’s still listed as an ‘A’ income firm and has recovered nicely from its lows due to the Halloween massacre. Despite its lofty 13.3% yield, the company has only an 80% payout ratio and modest debt/equity. This company is 60/40 oil/gas, so some of its weakness is due to the continuing slump in natural gas.
• Mullen Group Income Fund (MTL.UN: TSX): this is an oil & gas services company that focuses on specialized transportation. It currently yields 8.5% and has a relatively low payout ratio of 63%. This is one company that might not be affected by a slowdown in exploration activity, since their transportation business revolves around more than that. I do not know what proportion of their business is related to ongoing activities, but it is another interesting firm.
• Bank of Nova Scotia (BNS: TSX): is my favourite Canadian bank from an investment perspective. It has a solid 3.4% yield, a strong history of dividend growth (19% last ), and the best 5 year return of any of the big banks. They have less drama (read: exotic investment exposure) than CIBC, and a fairly strong retail network. They will undoubtedly experience some weakness in the current interest rate-hike environment, but are a solid long term hold.
• Teck Cominco (TCK.B: TSX): I was surprised that such a cyclical company could be considered a good income play. The company has been a solid performer over the past 5 years, and they have increased their dividend by quite a bit in the past year (58%). They currently yield about 1.9%, which is about average in terms of the income stocks listed. I personally wouldn’t consider this a long term hold, but it could be a solid stock to have while commodities continue their boom.

A lot of the stocks listed are worthy of inspection, particularly if you’re looking at beefing up the income equity position in your portfolio. As you age and get closer to retirement, these types of stocks will take up an increasing amount of your portfolio as your risk tolerance becomes lower and your need for steady returns increases.

Here are some tidbits to chew on this weekend. I look forward to reading about what you think in the comments below.

• According to EDC, the Loonie is expected to fall to 83 cents US or so by the end of next year. Do you think it’s going in that direction, or heading up?
• Lululemon has stated that they will offer about 16 million shares in their IPO, down from earlier estimates of 18 million. The majority of these shares are through the sale of existing shares. Is this a bad sign for the company’s prospects? If they’re supposed to be expanding globally and have great growth opportunities, why the massive insider exodus?
• How many of you watch BNN Market Watch and follow their picks? I’ve always wondered if anyone is comprehensively tracking their longtime performance using the database from mid-2005 that’s available on their website. I wouldn’t mind doing it at some point provided I can get a historical data feed at reasonable cost.

Have a great weekend everybody!

Volatility plays an important part in the long term performance of our portfolio. At times, I find that volatility is erroneously considered as ‘downside risk’ or ‘value at risk’, which are quite different. Volatility is simply the standard deviation of returns, typically in an annualized format. In of itself, volatility is a neutral measure. It does not mean that stocks are more likely to go up or down, but rather how much they go up and down. Skewness (the third moment of deviation of returns), is what measures whether period returns tend to be more positive than negative.

On an individual stock basis, volatility can be a good thing. Value investors actually like some volatility, or else they would never be able to find a stock that was undervalued. Short term investors are looking for stocks which can appreciate quickly, and thus they are looking for volatile stocks as well. But when it comes to portfolios, volatility is a bad thing.

You don’t want your portfolio to be bouncing around for one simple reason: it hurts your long term performance. One of the co-founders in my last company put it this way (he’s a math guy):

“A squared (A^2) is more than (A+B)*(A-B)”

This is simple to check: (A+B)*(A-B) = A^2 - B^2. In every possible value for A and B, A^2 >= (A+B)*(A-B). Furthermore, (A+B1)*(A-B1) > (A+B2)*(A-B2) when B1 < B2.

So if B is your portfolio's volatility, the lower it is the higher your compounded returns are. It may seem great if you make 20% one year and 10% the next, but you would have been better off earning 15% annually.

What does this mean? Look for uncorrelated assets to fit into your portfolio to minimize volatility. I talked a bit about some assets uncorrelated to the overall market in my inflation post. Larry MacDonald also discusses what big pension funds are using to minimize volatility.

Maximizing your retirement portfolio is all about steady, stable growth. It is definitely not the assets you want to be chasing the hot stock or sector de jour with. By keeping an eye on the long term, you will ensure that your retirement portfolio reaches its potential.

The US earnings season is upon us, and corporate profit growth is expected to be markedly lower this time around. Expect it to be a volatile period: some companies will likely disappoint while others will go beyond expectations.

Right now US growth has slowed down considerably, meanwhile all sorts of inflation measures are running above central bank targets (in Canada and many other countries as well). The Federal Reserve is in a predicament: they cannot raise interest rates because any hikes will only worsen housing price (and related industry) conditions, but at the same time inflation is at its highest point in many years.

While some may view the good news in employment a positive sign, I believe that such hiring is primarily due to a lack of productivity growth. When productivity growth diminishes you require additional labour to grow operations, which increases inflation and depresses profits. To me, this is the biggest threat facing the US economy at the moment. While emerging markets can continue to leverage their cheap labour for some time to come, without a catalyst global productivity will eventually stagnate. The information technology revolution was the last great productivity boon - what will come next?

What does this mean for investors? For right now, long term investors have little to concern themselves with. The biggest issue they will face in the coming years will be geographic asset allocation, as emerging markets ride high growth while remaining relatively risky. Short term traders should be looking for companies that are going to blow out earnings expectations, both in terms of results and guidance going forward (a la RIM). Taking a look at the upcoming earnings calendar will help you decide what companies to take a deep look at. As I’ve talked about before, reviewing StarMine’s star analysts can help you with identifying potential earnings surprises.

While I’m no short-term prediction maven, I suspect the major US indices to remain relatively flat in the coming months, since most large caps will likely meet reduced profit expectations in the next few weeks. However, with so much private equity money still out there, expect smaller cap companies to continue to be buyout targets in the next few months. Technology will also likely continue to be a hot sector, basking in RIM and Apple’s strong performance.

Thicken My Wallet has mused about the increasing popularity in infrastructure firms. He indicates that companies like RBC are investing in the sector now and that it may become the new fad sector.

I think the infrastructure sector has a lot going for it at the moment. The continuing development of the BRIC countries as well as Eastern Europe has lead to increased demand for new capital projects to meet the needs of the increasingly wealthy populations of these nations. As a result the sector is in a cyclical growth period, one that will probably last for several years, if not a couple of decades, since most of these projects take many years to build.

One way to play this sector is to look at infrastructure services firms. I believe these companies will also benefit from this cycle, but are better value since they typically have higher margins than the actual bricks & mortar developers and/or operators. Much like oil services firms, they benefit greatly from the rush of new development, but will also be faced with reduced revenue earlier in the cycle than the actual developers.

One holding I have in this area right now is IBI Income Fund (TSX: IBG.UN). The fund owns 50% of the IBI Group, which provides consulting, planning, design, implementation and analysis for urban land, facilities, transportation and systems projects. They have done everything from designing Alberta’s SuperNet to venue planning for the 2010 Olympics. The other part of IBI Group is owned by a management partnership, whose payouts are tied directly to the payouts IBG makes to unitholders.

Financial Analysis

IBI has been growing steadily over the past few years, through a mixture of organic growth and acquisitions. The company has been buying up small, mature firms with a solid client base around the world as they increase their global presence. While the company still has a heavy reliance on North American revenue, they have been making inroads in China and other emerging markets.

In the most recent quarter, revenues were up 17.4% Y/Y, with organic growth of 13.8%. Their net margin has been increasing as well, although their cash flow decreased slightly due to one-time capital improvements.

For an income fund, distribution cash and payout ratios are of utmost importance. The payout ratio is currently around 80%, which is quite a bit higher than last year. The company has increased distributions twice in the past year, which partially accounts for the higher payout ratio (the capital project costs is also a factor).

Stock Analysis

The company’s float is rather illiquid – the bid/ask spread can be as much as $0.90 at times and the daily volume is quite low. Despite these facts the stock has had a pretty solid appreciation in the past year, mainly due to the increasing distribution.

The company still yields over 8%, which is fairly solid for an income trust with strong growth potential, high cash flows and a good payout ratio. IBI is a relatively small firm (only $144M Cdn market cap), and is only covered by one analyst. This is a company that’s pretty much under the radar, which is part of the reason I like it. In order to reap substantial capital gains on top of the income distribution, its profile will have to be increased. See my comments on investing locally for more details on what I think about under the radar firms.

While the eventual taxation changes to the firm will diminish its income potential in 2011, IBI will still reap a pretty good yield in the future. I think this is a solid medium term holding if you can set a bid at a price you like and be patient for it to be filled.

As I mentioned at the beginning, I think that services firms are a great way to play the infrastructure sector. They typically have better margins and generally do not face cost overrun issues that could materially affect profits. But their performance will lead the sector, since most of their work is done prior to actual development. Thus it’s important to keep an eye on the announcement of future projects and assess when the cycle it nearing its peak.

In order to get into short term investing, you need to understand what human traits causes people to act irrationally. The field of behavioural finance is dedicated to this topic. In this straightforward introduction to the subject, Jay Ritter provides us with the common faults that human investors/traders make. While there are many failings highlighted, the ones that I find most influential are:

• Overconfidence: people tend to overestimate their abilities (for instance, ask them if they are better than the average driver), while underestimating what they are up against. This can lead to under-diversification as well as continuing to employ a losing strategy.
• Representativeness: people tend to underweight long term behaviour and averages in favour of near term trends. This is one of the main factors behind asset price bubbles, as people only see the upside and forget about the eventual reversion to the mean.
• Disposition effect: people are known to take profit too early and hang onto losing positions for far too long. This is because people think about paper gains/losses differently than realized gains/losses. As a result volume is typically higher during bull markets than bear markets. Ken Fischer calls this effect ‘mental liquidity’.

This paper indicates that most short-term deviations in asset value away from the theoretical ‘fair value’ are hard to capitalize on due to a lack of short-term mean reversion, while more systemic and/or long term deviations (eg. tech bull market, 1987 market crash) can be taken advantage of.

I don’t necessarily agree with this conclusion, since most stocks have a pretty wide 52 week range that does not coincide with material changes in their underlying value (eg. earnings, dividends, etc.). As Joel Greenblat observes, do most companies report 100% changes in earnings each year? If not, then why do their prices behave as such? Earnings and financial performance have only a partial influence on a stock price.

My theory behind such volatility is the continual change in assumptions as to what the stock price will be in the future. Other informational influences such as economic news, rumors, buyout activity, etc. all play a part in the daily variation of stock prices.

Knowing what basic human characteristics inhibit your success in the markets is quite important. I plan on keeping a list of all the potential pitfalls I could fall into close at hand and review them every week to ensure that I am managing my positions appropriately.