Inflation and Corporate Earnings

How inflation can destroy shareholder value in the latest McKinsey Quarterly (free registration required to get access) brilliantly illustrates with a simple easy-to-follow example how inflation can surreptitiously erode real profitability in a company and thereby undermine its shares. The point made is essentially that when inflation jumps up, it is not enough for earnings to rise by the inflation amount. Unless cash flows do too, the company and the shareholder lose ground. Earnings must appear to rise by a much greater amount just to keep pace (it is worth pondering that if that were to happen, there would be public outcry about corporations gouging ordinary people, whereas they would actually be losing ground). The driver is that depreciation, a non-cash flow item, does not rise as fast as inflation and this skews profitability ratios and hides loss of real earnings.

The piece also includes a neat graph showing how returns on invested capital during the high inflation 1970s did not move outside their remarkably constant band of 8 to 11%, whereas they should have gone up to 25 to 30% to maintain real profitability during that decade. Accordingly, stocks did very poorly.

The lesson of inflation during the 1970s is worth noting. If inflation reignites, stocks / equities are not likely a good place to be.

Book Review: Winning the Loser's Game by Charles D. Ellis

Call this book A Random Talk About Wall Street. That is both a compliment and a criticism.

It is a compliment because comparing this book to Burton Malkiel's famous A Random Walk Down Wall Street puts it in a special category. Indeed much of the message is the same in the two books - valuable and sage advice on how to survive and prosper as an individual investor in a financial world filled with many predators and some good guys. Ellis pushes many familiar themes: diversify, buy index funds, trade seldom, take a portfolio view, re-balance to maintain asset allocation, adopt a long-term perspective and ignore short-term market fluctuations, consider inflation and real return bonds, market timing futility, avoid excessive mutual fund fees, take account of how various risks work.

The "Random" comparison is also a criticism in that I found the book meanders quite a bit. A chapter topic is begun, and part way through, the text diverges onto a peripheral topic. Ellis' method of exposition feels like a fireside chat from wise old uncle Charley as one idea spurs another. Maybe some readers like that style but I found myself muttering "stick to the topic, will you?" The epitome of this is Chapter 20 Endgame, at once the best chapter in the book and the worst. Endgame talks about leaving the world a better place after you are done, through using your money wisely so that it is a positive force and not a negative force, as it can end up being. There is much text that I found to be inspiring e.g. "Investors who have enjoyed substantial financial success should give careful consideration - no matter what their hopes or intentions - to whether the amount of wealth they can transfer to their children might do real harm by distorting their offspring's values and priorities or by taking away their descendants' joy of making their own way in life." Every parent must think of their money actions with kids from a very early age even if they are not rich e.g. giving a child an allowance to spend or save and considering how to guide the child into using it wisely. Ellis quotes another author who suggests people should give younger family members as much responsibility as they can manage as soon as possible. So true, I experienced that myself and wish I had done it more with my own kids. Suddenly Ellis switches gears. On the next page, there begins a series of numbered paragraphs on IRS limits for IRA accounts, tax-free gift limits, compounding rates, personal residence tax exemptions, trust concepts and the like. After four pages of too-general-to-be-useful such info on tax nitty-gritty, he goes back to the original theme and philosophical level of discussion. He could simply have said at the end of the chapter, "once you have decided what you want do, go talk to a good accountant to make it happen."

The informal presentation does have its benefits - short, easily read and digestible chapters. There are lots of good quotes and anecdotes to illustrate his points. I got lots of ideas for blog posts! e.g. on why this statement is wise in the sense he means it, and silly in another sense - "Never risk more than you know you can afford to lose."

Overall, this book does deliver on its sub-title promise to provide "timeless strategies for successful investing". It is definitely worth reading.

My rating: 4 out of 5 stars

Thank you to publisher McGraw Hill for providing me with a review copy.

Institutional Investors Lose Money Just Like Individual Investors

Absence of Value: An Analysis of Investment Allocation Decisions by Institutional Plan Sponsors by Scott D. Stewart, John J. Neumann, Christopher R. Knittel and Jeffrey Heisler in the Nov/Dec 2009 issue of the Financial Analysts Journal tells us that pension plans, endowments, foundations and other large pools of assets ($10 trillion in 2006) make exactly the same mistakes and get the same poor results as individual investors. "Much like individual investors, who seem to switch mutual funds at the wrong time, institutional investors do not appear to create value from their investment decisions." In fact, the study shows they lost money and lots of it.

This is despite the fact that "Pension plans, endowments and foundations are typically staffed with professionals with years of experience and advanced degrees."

Index investing with a fixed asset allocation seems more sensible every time a new study comes out.

I am left with this question - if individual investors lose money on average over extended periods and the pros do too, who the heck IS making money?

PS - acknowledgement to Index Funds Advisors whose excellent newsletter included the link to the study.

PPS just realized that I've been doing this blog for three complete years now. It is a sort of full circle in that my second post on Feb.1, 2007 was about a paper on the same subject as today's. The 7 Deadly Sins of Investors seems to apply as much to institutional investors as individuals.

New Data on TFSA vs RRSP and Canada's Rube Goldberg Tax System

Cartoonist Rube Goldberg was famous for his drawings of incredibly complex, convoluted machines. That's Canada's income tax system. A new paper from the CD Howe Institute Saver’s Choice: Comparing the Marginal Effective Tax Burdens on RRSPs and TFSAs (kudos to Don Cayo of the Vancouver Sun on whose blog I found the link) reveals the gory detail of the complexity created by the interaction of all the start and stop levels of tax credits, tax brackets, tax surcharges, rebates and clawbacks. The table they show for an Ontario taxpayer has no less than 33 income levels at which tax rates either go up or down. Contrary to popular belief, the tax you pay on your next dollar of income, the marginal rate, does NOT go up constantly and smoothly. It bounces up and down by more than 100% for very small rises in income. These tax items are not special rules for individuals in unique circumstances, it is what everyone faces.

What's more, and what is important for the average person trying to decide whether to put savings into a TFSA or an RRSP, as a result the better choice flip-flops back and forth between TFSA and RRSP. The answer varies by: Province, by income in retirement compared to during working life (the replacement rate) and by working life income level.

CD Howe's Findings

• $20-30,000 or so working income, TFSA always is better and by a massive amount, the GIS clawback being the primary cause as TFSA withdrawals are not included as income for the calculation while RRSP withdrawals are included.
  
• $35-45,000 or so working income, RRSP is better but not by nearly as much as the TFSA advantage in the bullet above
• the boundary between TFSA and RRSP shifts higher as retirement income replacement is lower e.g. in Ontario, at 80% retirement replacement, the TFSA is better up to around $30,000 working income but at 60% replacement, the TFSA is better up to about $39,000
  
• TFSA is better across most of the working life income spectrum for Alberta and Quebec and most income replacement levels
• most surprising, TFSA is everywhere best for the highest income earners of $110,000+ even when their income replacement is only 60% - one would have thought they would end up in a much lower tax bracket and thus conform to the general principle that RRSP is best when your tax rate is less in retirement.
  
• above low income levels, the advantage for TFSA or RRSP is not enormous (less than 10%+/- in marginal tax rate), except for huge spikes up or down in Ontario
  
• a change of only a few thousand dollars in working income can shift the balance, sometimes drastically, from TFSA to RRSP or vice versa, especially in the band $35,000 up to about $80,000 in Ontario (which leads me to conclude that Ontario residents face the most uncertain, difficult and chaotic tax system as far as TFSA vs RRSP planning goes)

Ontario residents in the income range from $35,000 to about $90,000 probably need most to hedge their bets about where their retirement tax rate will end up and to contribute to both their TFSA and RRSP. At least both benefit from the powerful advantage of tax-protected compounded growth while funds are in the plan.

Unfortunately, CD Howe only looked at the numbers for Ontario, Alberta and Quebec, so taxpayers in other Provinces must be wondering where they stand. Don Cayo got preliminary data from CD Howe about BC, which he says is similar to Ontario.

The Federal government could do us a favour by expanding TFSA contribution room to make it equal to the RRSP, or make it a combined total that people can divide between the two as they choose.

McKinsey deflates another bubble

Those who think that now that the recession is over, everything is fine and happy days are here again might think a second thought after reading strategic consulting company McKinsey's The Looming Deleveraging Challenge (free registration required for access to the report). We Canadians might be especially over-confident given the minimal harm our banks suffered during the 2008 crisis.

Despite having the lowest total of public and private debt amongst the 14 countries studied, Canada still likely faces deleveraging in the household sector according to McKinsey. The BRIC (Brazil, Russia, India, China) countries are all much less constrained by debt. The USA, Spain and the UK are more likely to have deleveraging in more sectors than Canada.

McKinsey says deleveraging countries face prolonged belt tightening and lower economic growth for two to three years. Given Canada's strong economic ties to the USA and their even worse state, I'd guess we are in that boat. Ssssssss is the sound of the slow leak in the hope bubble.

The good news is that GDP growth, based on past examples McKinsey studied, likely resumes strongly after that. It will again be time to take a deep breath and start inflating a new bubble.

Live Online Investing Q&A with No Hype Author Gail Bebee

Gail Bebee, author of the investing book No Hype - The Straight Goods on Investing Your Money will answer investing questions online today January 29th from noon to 1pm on the Globe Investor website. It's a good book so she should provide sensible unbiased answers. Click here.

Bank Shenanigans: Post-Dated and Stopped Cheques

Did you know that post-dated cheques and stopped cheques can cause you considerable grief?

Yesterday, I discovered that my (current) bank, the Bank of Montreal, had processed and withdrawn funds from my account despite the fact that the cheque I had written was post-dated for about a week later. When I called the customer service line expecting some sort of redress for what I perceived to be BMO's negligence, I was told that they would do nothing, that they had done nothing wrong or negligent in any way, since the bank is under no obligation to prevent funds from being withdrawn early. If sufficient funds are in the account, then it is paid no problem. What if sufficient funds are not in the account I asked, would there not be NSF charges incurred? The answer unfortunately seems to be yes, I would be on the hook. If a had a problem I should speak to the cheque recipient who had presented the cheque early. Conclusion: the date you write has no significance and is no protection. Post-dated cheques are not a reliable or trustworthy hassle-free method of managing bank account cash inflows and outflows.

A Google search uncovered this Canadian Payments Association FAQ on Cheques that confirms the optional, non-obligatory, one might say at the convenience of the banks, nature of the usual practice to tell the recipient that it is only to be presented on the due date. Note the red highlighted weasel words should and may.

Relevant quote:
" Under CPA Rules, a post-dated cheque is not eligible for clearing and therefore should not be deposited before the due date. However, given the large volume of cheques and the degree of automated processing, some post-dated items may inadvertently slip through. Under Rule A4, Section 6(b), a payment item may be returned through the clearing by a CPA member financial institution for the reason "post-dated" up to and including the day prior to the due date."

Even granting there might be some unstated necessity to exempt the banks from the legal responsibility for their incompetence in providing the service a post-dated cheque is intended to do, the symptomatic attitude "if we at the bank screw up, it's you the customer's problem to fix" is, shall we put it politely, annoying. Unfortunately, I see no solution but to either harass the bank if material losses like NSF charges occur, or not to write post-dated cheques at all.

Paying electronically is just as fraught with uncertainty and bank freedom. You must pay a couple of days in advance since the banks do not guarantee even then that the payment will occur instantaneously on the due date - BMO's blurb from the Agreements for Everyday Banking states its huge leeway in the section on automated services: this
"However, we may require up to five banking days:
- to process any deposit, including any transfer between Accounts;
- to act on bill payment instructions."
and on the website, BMO gives itself this liberty:
"For future-dated bill payments, please ensure you have sufficient funds in the account you have selected at least 1 business day prior to the payment date." i.e. they may withdraw the payment a day early as I have seen happen. Not very impressive in the computer age I'd say.

The other problem I came across while looking for information on the above. When you put a stop payment on a cheque, you are still exposed to it being cashed and having to pay anyway. The simple version explanation of how this can happen is in Before you write a cheque, take note of this little known law that appeared in the Vancouver Sun. A more complicated nuanced explanation is Lost and Stolen Cheques, Bank Drafts and Trust Cheques: Some Modest but Partial Solutions in the March 2009 Advocate. As the title of the article states, problems can arise from cheques that are lost or stolen. The basic though not perfect solution is to a) cross all cheques, that is, draw two parallel diagonal or vertical lines across the cheque; b) add the words, "for deposit only by payee - non negotiable"; c) add the words "not payable more than X days after date". Or they suggest using a wire transfer since that puts the bank on the hook.

I wish it were possible to get protection by adding the words "not payable before date" to counter the prematurely expectorated post-dated cheque but I guess the Bills of Exchange Act that created this reality seems not to have contemplated the value of enabling people to pay with certainty only on a due date and not before.

You also have to the crossing by hand since it seems there aren't any companies in Canada offering cheques pre-printed with the crossing done. Surely the banks and cheque printing companies know the advantages. Why don't they begin offering pre-crossed cheques? In the UK, such cheques are commonly available.