Weigh House Blog Returns!

We just wanted to send out a short note to confirm that our blog will once again be active. Our goal remains to initiate discussion and to provide a perspective that reflects our thoughts and concerns with regards to the current investment industry.

Our new blogs will be authored, for the most part, by myself, Mike Macdonald, and will reflect the content released simultaneously on the blog “unbiasedadvisor.blogspot.com” which is written under the name “soismike” ( a throwback to our corporate roots as Second Opinion Investor Services”).  While our posts will be less frequent than we previously published, we hope each posting will help engage our readers in the investment world, financial planning, and our current markets.

mike macdonald

Chasing yield

Dividends, dividends, dividends … You can’t watch CNBC without seeing another expert pitching another high-yielding dividend stock. From a personal point of view, I’m as guilty as the next investor and have built up my own meaningful dividend portfolio.

We live in strange times. Where retirees are forced to chase yield (and risk) to supplement their pensions. Where governments punish savers with low rates to the benefit of debtors. My only consolation to lower rates is that the government will get lower tax from my lower interest income.

I was fortunate to have escaped the financial crisis unscathed. Moreover, I knew with low interest rates that it made sense to buy dividend stocks. Still, I get no pleasure now from watching my dividend portfolio rise in value. That’s because with interest rates down to all-time lows, and escalating fears of a Japan-style future, I’m wishing I had bought more.

But chasing yield is not without its risks. Stocks have risen a lot since the crisis bottom. The catchphrase on CNBC is to keep buying dividend stocks because their yields are higher than government bonds. That’s a red herring in my view. The only reason bond rates are at emergency lows is because of the dire state of the patient. If that patient gets better, rates go up, which could have an adverse effect on share prices, particularly for leveraged dividend plays. If the patient stays the same, rates might stay low and dividend stocks might still be a good buy. And if the patient gets worse — can we be certain that dividends won’t be cut or that share prices will hold up on the back of yield alone?

It’s a tough call.

In March, I wrote: Don’t shoot for the stars. The main message being: investors should avoid targeting returns that are too high, otherwise they risk taking more risk than they can handle. It’s why I won’t sell my dividend portfolio even as prices rise exponentially. It’s also how I resist from buying (too much) more — (I’m not perfect).

For retirees who live off their investment income, it can be hard to resist chasing yield. These individuals would do well to carefully consider all the risks and ask themselves if they can better afford to tighten their belts now, or risk being forced to tighten them later.

What scares me (and 70-year old retirees)

That Japan happens here.

The problem with low interest rates is that once you’ve cut them to zero, you can’t cut them again. Your ammunition, your firepower, your ability to excite the market is gone. Nor can you raise rates — not if the economy doesn’t gain traction.

Years of near-zero interest rates. That was Japan’s  reward for not dealing with their bubble. And it made life very difficult for the country’s retirees and savers, who saw their post-retirement fixed income dwindle to nothing. Nor did it help equity holders, with the stock market today still 70% below its 1989 peak.

Japan’s experience taught Asia (which went through its own  financial crisis in 1997-98) that sometimes the best for cure for a boom is a bust. Investors will never invest when they think there’s more pain to come. Sky-high interest rates in Asia forced bankruptcies and flushed the crap out of the system, paving the way for recovery.

Is the US doing the right thing with zero interest rates? One thing I know for sure right now — there’s got to be something seriously wrong with an economy when at zero interest rates, borrowers don’t want to borrow, and lenders don’t want to lend. Bank lending has continued to contract in the US in recent months.

But it’s not the US that scares me. Canada has been piggybacking off US interest rate policy. An interest rate policy that may have been inappropriately low for us. So our asset prices have not adjusted downwards, just the opposite.

At least when this is all over, and US rates start to rise, the United States will have adjusted. It will be globally more competitive with a markedly lower dollar and property prices some 30-50% below peak levels. But what about Canada? When interest rates start rising, the Canadian economy may be in a world of pain. And it won’t just be the recent home-buyers who get burnt with 30-40 year mortgages, but all the retirees who’ve taken on excessive risk because they could no longer live off their GICs.

Another way to value your home

For most Canadians, their home is by far their largest investment. That said, most new home buyers don’t actually do much in the way of valuation analysis to ascertain whether they should buy this largest investment.  Instead they focus on “affordability” and the ever popular “hardwood floor-to-crown molding” ratio.

Imagine if your broker used affordability as a reason to buy a stock. Imagine this conversation:

Broker:  “Ahhh. I just picked up 100,000 shares of Acme stock for you at five dollars.”

You: “Really?  That’s $500,000! I’ve only got $50,000 in my account. And this stock has risen so much! What’s the valuation look like?”

Broker: “Huh? Valuation? What do you mean by this word “valuation?” I never heard such a question. The stock trades at five dollars. I bought your shares at five dollars. Five dollars is the valuation. Right now. But it’s going higher. The  price has been rising for years and analysts, banks, politicians, property agents & taxi drivers expect it to continue to rise. Particularly if people like you continue to buy. Don’t worry about the price. I arranged a $450,000 loan for you to cover the difference. Don’t worry about the loan either. You and your wife earn good incomes and can afford the loan payments. Especially if we assume that interest rates remain at all-time lows — for the next 30-40 years.”

When an  investor looks at an investment — any investment —  as part of their due diligence, they should value it against its alternatives — both alternatives within the same industry and alternatives in other industries/asset classes. After all, greed knows no boundaries — it’ll eventually chase out the best returns.

When investors evaluate stocks, a popular valuation tool is the Price/Earnings ratio (P/E), which measures share price relative to earnings per share (EPS).  For example,  a stock with a share price of  $40 and an EPS of $1 would have a P/E of 40x. The corollary of P/E is earnings yield (EPS/Price), which in this example works out to be  2.5%.  Is an earnings yield of 2.5% atttractive? It depends on several factors: the growth of the earnings,  the dividend payout, and of course the alternatives.  An earnings yield of 2.5% might be attractive relative to other stocks in the same sector. But if risk-free government bonds were yielding 10%, then 2.5% on a risky company might not look so good.

Which brings us to property valuation.  Professional investors’ favorite valuation metric for commercial property is “cap rate” which (not unlike earnings yield) measures  a property’s net operating earnings relative to the price.*  Property cap rates tend to be correlated to interest rates and vary across sector. For instance. according to Colliers International’s latest report, 1Q10 Cap rates for Toronto Grade A office ranged from 6.75-7.75% while multifamily low rise apartments ranged between 5.75-6.5%.

I bring this up, because even though I have found no reliable data on housing cap rates, all anecdotal evidence suggests that Canadian housing cap rates are far lower than commercial cap rates. In Toronto, based on my own observation, I’d put them at no more than 3-4%. Obviously, there are tax savings and considerable intangible benefits, but do they really justify cap rates lower than apartment buildings, Government bond yields and the dividend yields of property-exposed bank stocks and REITs? Especially if interest rates do indeed go up.

The fact that most home buyers don’t look at cap rate or buy a home with the intention of renting it out is beside the point. Whether  you choose to live in your house or rent it out is irrelevant. You are saving rent by living there, and your property is implicitly earning the rent that you would otherwise have received, were you somewhere else.

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* You might argue that it’s more akin to dividend yield than earnings yield, but that’s a different conversation.

Clickworthy: The active/passive red herring

While it remains to be seen whether the recent weakness in the markets proves to be a turning point, one fact remains constant. Whether you are invested in passive ETFs  or in active mutual funds you will be effected by the direction of the markets. That’s because, mutual fund managers — despite their “active” approach — are typically required to stay fully invested. They can’t short or go to cash even if they believe the market is headed off a cliff. This latest commentary by Arrow Hedge Partners sheds an interesting perspective on the so-called active/passive debate. Key point for me:

… We believe the active/passive debate is asking the wrong question. The question should not be: do active funds outperform passive? The question should be: why aren’t actively-managed mutual funds more active, when it comes to protecting investors from bear markets? …

… The average mutual fund manager knows that there is little they can do to protect you in a falling market. That’s why they harp on about their performance relative to the market. So when the market falls 40% and their portfolio falls 38%, they’ll brag to investors about how they did a good job. To that end, perhaps the active/passive debate should be renamed the passive/slightly-less-passive debate …

An easy way to increase your inheritance

It’s only been two months since I started blogging for Weigh House and I’m already numb to the issues. Every day there’s another blog or newspaper that essentially says the same thing: you’re paying too many fees for your mutual funds, mutual funds underperform, your advisor is not your fiduciary, bleah, bleah, bleah.

Today’s forum in the Globe & Mail is a case in point. The issue of financial advisor regulation is — once again — probed, dissected and blathered about. There’s a lot of smart people making a lot of smart comments — but we know nothing will likely change.

Now why is that? Why does nothing ever seem to change?

Perhaps it’s because the investors who take the trouble to read investment blogs and the personal finance section of the newspaper already deem the system a joke. It’s their friends and idiot cousins who have no clue what’s going on, mostly because they make no effort to educate themselves.

While the greedy capitalist in me loves the idea of strangers losing money — it makes me feel richer — I thought I would put together a simple email template that you could forward to your own relatives. After all, what is left of their retirement savings may one day be yours.

Dear xxx,

Hope all is well. It’s been a while. I heard from Auntie xxx that you’ve been having a bit of a rough time what with your  recent surgery. She also told me that your bladder is acting all funny again. So sorry to hear that.

I’ve also been thinking a bit about your investment portfolio. After all with all your health problems you certainly don’t need to be worrying about your retirement income.  I know that you don’t understand the high-flying world of finance, but here are three easy things you could do right now, that will save you money:

1. Transfer your mutual funds to Questrade. You will still own the mutual funds — nothing will change there. But from that simple transaction, you could receive cash in your pocket of $1,000 for every $100,000 that you transfer. That’s not a one-off payment. That’s $1,000 per year — minus some minor fees.  Click here for details.
2. Switch your money out of mutual funds and into portfolio managers. You could save up to 1% per year in fees by switching. Click here for details.
3. Switch your investments out of  mutual funds and into ETFs. This will be a little more labour-intensive but you could save up to $2,000 in fees per year for every $100,000 you switch. If you don’t know what an ETF is, or how to do this, contact Weigh House Investor Services and they will teach you.

That’s it. I really hope you get better and I hope to see you soon. Unfortunately, I won’t be able to make your birthday party next Sunday. It sounds like it will be a blast though. Give my best to the nurses, the therapists and all the other residents.

I love you so much!

xxx

The Canadian stock market — it’s not up to us

Most conversations about the markets are a waste of time. They usually go something like this:

Person #1 (lurking in doorway):
“So what do you think about the market?”

Person #2 (making eye contact):
“Oh, I’m bearish.” or “Oh, I’m bullish.”

Person #1 (nodding seriously):
“Ahhhh, why?”

Person #2 (nodding back seriously):

“On the back of a strong commodity market, growth is blah,blah,blah.” or “Economists still expect Canada’s housing market to blah, blah, blah.” or “Canada’s banks are the most blah, blah, blah”

And so on….

This blog does not give investment advice. I am never going to attempt to predict the future. However, what I am going to do is show you a chart which I believe illustrates a crucial point for any Canadian investor. It’s not up to us.

This chart shows the five-year performance of  the Australian All-Ordinaries Index and the Canadian TSX. The blue line is the TSX. Not that it makes a difference — the two indices are virtually indistinguishable.

And why are they so similar? I imagine it’s because both our economies are highly dependent on commodity exports. Roughly 2/3 of the world’s incremental demand for commodities comes from China and India. So perhaps Canada’s housing/economic/stock market resilience is not because we’re particularly talented or more conservative than the US. Perhaps, like Australia, we’ve got stuff in the ground that Asia wants. Which is why I’ll pick the Asian Wall Street Journal over a Canadian newspaper any day of the week.  Because Asia’s bubble boom has been our boom — and so might be their bust.

Not that this makes it any easier to predict the future.