Investoid

The big news on the Canadian financial stock front is that TD Bank (TD: TSX) has agreed to buy Commerce Bancorp, a regional US bank. As the Financial Post article indicates, TD is taking advantage of our historically high dollar to leverage their buying power in the US. Our banks have become relative minnows as financial institutions around the world have consolidated since the early 1990s. The big 5 in Canada have not participated in this wave due to federal regulations restricting mergers within our domestic banks as well as regulations limiting the amount of foreign ownership in Schedule 1 banks.

While Canadian banks have not kept up with global competitors in terms of size, they have exceeded the typical global financial conglomerate in terms of profitability and shareholder return. Since our banks face little competition on the retail banking side, they have been able to milk consumers for high profit margins. Meanwhile, global banks have faced stiff competition around the world as they begin to tread on each other’s turf. As a result, large firms such as Citigroup and Royal Bank of Scotland have underperformed our little banks to a large extent. Overall, our financial sector has outperformed similar US firms over the medium term.

While having Canadian banks eat up smaller US and other global firms may give shareholders and management a good ego boost, I wonder about the long term affect on the bottom line. Most Canadian banks have mixed records of integrating foreign assets into their operations, and rarely have any such assets ever met the same rates of return on capital that domestic operations have. Such acquisitions invariably reduce short term earnings, which may never become accretive. That said, I understand the trepidation that such banks face, seeing how small they have become.

Nonetheless, I am more interested in firms who are looking for higher growth areas than the US. For instance, Scotiabank (BNS: TSX) has a much more emerging market-oriented strategy, which I believe can produce similar rates of return (or at the very least similar absolute earnings growth) to domestic operations.

Make sure you evalute your Canadian financial holdings when they make foreign acquisitions. Depending on the size and scope of the deal, it may materially affect their performance for years to come.

The Wall Street Journal has reported that PIMCO is starting a $2B fund to purchase distressed debt on the cheap. To me, this is a very good sign that the capitalists are coming out of the woodwork and are taking advantage of the collective fear out in the credit markets. I expect we’ll hear more such announcements in the coming weeks.

Hopefully the Fed is looking at such actions and will take into account the vast financial sums still on the sidelines, which can do a far better job of fixing the issues out there than a rate cut would. For years we’ve been hearing how much cash has been sloshing around looking for investments to fund. For awhile the private equity groups were receiving this money, but now that cheap credit is drying up I suspect that distressed debt funds and other vulture funds will start to get attention. The market will work through this, provided the structural monetary issues are handled by the Fed. Hopefully they will tighten money supply and keep the dollar from collapsing by holding rates steady.

Let’s see what Tuesday brings!

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!

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.

Larry MacDonald from Canadian Business has wrote an article on “Lazy Active Portfolios”. I appreciate the mention of my article on the subject and the use of the term I coined a couple of months back. I suggest you take a look at the article, as it’s full of good information on how to construct market-beating active portfolios based on the efforts of the best in the business. He also mentions on his blog how Stockpickr is an excellent resource for evaluating US-listed companies.

I have one additional comment to Larry’s article - be aware of the quality and how up to date the information you’re gleaning from the pros is. Typically most pros are in a regulatory environment where they have to provide public updates quarterly, but for some funds and private investors, the period can be longer or even non-existent. So it’s important to know where the source of the information is coming from, be it EDGAR, news reports or elsewhere. If the information is from published public reports, determine reliable news sources that you can use to track what movements the pros are making in between reporting periods. You don’t want to be stuck with the best investment Buffet had last year.

I was reading an Edmonton Journal article on Saturday that contained some Q&A from the recent Berkshire Hathaway AGM. Warren Buffet and Charlie Munger had some memorable quotes during this session and I thought I’d share a few with you:

“There are more problems with having the wrong managers than having the wrong compensation system.”

The nature of private equity activity is that the score doesn’t get put on the scorecard for a number of years, so the investors won’t leave. What will slow down the activity is if yields on junk bonds became much higher than yields on high grade bonds.

“Investing on paper and investing with real money is like the difference between reading a romance novel and doing something else; there is nothing like having a real experience in investing.”

“It isn’t the derivatives themselves (that will cause a bubble). But the usage of them on an expanding basis in more and more imaginative ways introduces more and more leverage into the system.”

“If we’re in an oil stock it’s because we think it offers value, not because we think the price of oil is going up … We like best those businesses that require very little capital, because you can’t have a business with huge capital expenses year after year and end up with a high return business.”

I think this last quote is the most relevant to helping amateurs with investment selection: Berkshire’s magic formula is based on finding low capital intensive, high cash flow businesses. Typically these types of business will have high dividends and/or stock buybacks and/or strong acquisition growth.

I recently bought The Tao of Warren Buffet for a friend’s birthday and found that there were many good quotes in it about business, investing, and life. While some of the quotes in it are already well documented, there were many that were interesting views on Warren’s overall worldview. If you’re looking for a quick read with profound meaning, I suggest you pick it up.

David Dodge has gone on record to suggest that companies should be offering defined benefit pension plans over defined contribution plans. Mr. Dodge is suggesting several changes to the private pension plan structure to improve their efficiency and ensure that employees of smaller companies can also benefit from employer-sponsored retirement plans.

While I agree with Mr. Dodge’s specific recommendations, I do not intrinsically believe in defined benefit plans. Ostensibly, defined benefit plans are the ideal for employees, since they provide peace of mind for them in retirement. This is definitely an alluring proposition for employees - all they have to do is have $x automatically removed per month and when they retire they will receive $y in return, sometimes until they die.

However, defined benefit plans are not without their issues. For instance, when employees leave an employer, they are faced with having ‘orphan’ retirement funds. Some companies will pay out these amounts, depending on how long you’ve been there, while others will actually pay you small amounts at retirement. It would be to the employees benefit if these funds could travel with them, at the very least to reduce administrative overhead in retirement.

Secondly, employees still face risks associated with their return on investment, although these plans simply shift the risk. Your contributions are not only dependent on your retirement picture, but also the overall picture of all past and current employees. As a result, when defined benefit plans fall into trouble, current employees pay the price while retired ones do not. This can be especially tough on younger employees, who potentially face many years of additional premiums that are doing nothing for their retirement.

Thirdly, the expenses involved with such plans can be opaque, yet quite costly. Defined benefit plans require sophisticated financial engineering to remain solvent, and are based on continually changing estimates of lifespan, employee retirement rates, the overall economy, wage inflation, etc. Not only do the costs of managing a portfolio come into play, but the actuarial expenses are something that you would otherwise not have to account for.

Philosophically, I do not believe in defined benefit plans. Each individual should be responsible for all aspects of their life, retirement included. I do not expect everyone to manage their own retirement finances, but I think they should have the privilege and responsibility of deciding who manages their funds and how.

Personally, I would like to see employer-sponsored personal retirement accounts that are mobile with the individual over time. Employers would provide matching funds up to some amount, and individuals can choose to put in more money if they wish. The individual can choose to direct the investments themselves, have a company or advisor manage the funds, and pool them with other employees and even companies to be able to improve their diversification and asset mix. In the worst case I could seeing this being another opportunity for the financial services industry to rip off retail investors, charging high fees for such services. But at least the person would have the choice to determine how his funds will be managed.

Of course, this type of solution only works with transparency in fees, hopefully more options for retail investors, etc. I would hope that if our country set up the right structure and reasonable cost services would emerge, but you never know.

The shift towards defined contribution plans is a step in the right direction, but I would like to see employees more empowered with their plans.

On a sad note, Yahoo! is reporting that Jim O’Connell has passes away. The BNN Market Call and morning business news anchors was one of the original hosts when the then-ROBTv launched.

I always enjoyed his programs and thought his personality was a perfect fit for business tv. He had a straightforward approach that was very effective and yet not too stodgy.

My thoughts go out to him and his family.

The Bank of Montreal (BMO: TSX) has reported over $350M in losses related to energy trading. Seems like they took heavy losses on natural gas speculation. This will likely cut their quarterly earnings by at least a third. The stock has dropped about 2.3% at the opening on this news.

While I’m not a day trader, I do like to pick up good stocks on weakness when news like this breaks. Some of these losses are unrealized, so the cash losses are lower than what is being reported. Overall I like the bank stocks, and think that if you like BMO then this is a good opportunity to pick some up. It’s not my favourite bank stock (I like National and Scotia better), but it’s definitely worth taking a look at today if you’re looking to add banks to your portfolio.

I’ve been asked here and elsewhere what my thoughts on technical investing are. To be brief, I think that the simple mathematical formulae espoused by traditional technical traders is mostly smoke and mirrors. However, a lot of solid mathematical development has occurred in the past two decades to advance quantitative investing as a real science.

I was reading VentureBeat yesterday and came across an interesting company called FatKat. They just raised a Series C round of $2.4 million (venture capitalist speak for the third round of financing from heavy duty sources) to continue development on their proprietary trading algorithms. On their site they have a good overview of the development of quantitative investing strategies, which I think is worth a read for all investors.

I think it’s important for do-it-yourself investors to be aware of the fact that a sizable portion of trading today is done by algorithms, not humans. This can materially affect how the market swings in both directions, as algorithms are intent on capturing as much statistical market-independent returns (otherwise known as alpha) as possible. These algorithms can be quite complex and require some major computing power to work, but the potential payoff is huge.

While it may seem daunting to be up against legions of Math Ph.D’s and their computers, it’s important to note that most of these strategies are focused on generating short-term, market independent gains. This can lead to more volatility and sizable short-term shocks. The upshot is that if you are a value style investor such shocks lead individual stocks and even whole markets to be oversold quite quickly, thus leading to good buying opportunities.

Quantitative investing has taken out the human element for many of the world’s largest investing institutions on at least a portion of their assets. Meanwhile, casual investors are by and large left to their own devices and the talents of mutual fund managers. Don’t fret though - academics have postulated that there is only so much alpha to go around, and all these quant shops are chasing the same scarce resource. As a result they have to spend more and more energy (both brainpower and literal) each year just to maintain their share of the pie.

To me, this means that an equilibrium will be reached whereby quantitative investment methods will always have to continuously adjusted to be of any value, and thus there will be no net growth in their share of the market. As a result, I think that the long term dynamics of markets will maintain their current and historical statistical properties, meaning regular investors will still have opportunities to have solid returns.