Kivenko Tells How to Check Out Fund Advisors

Want to avoid an Earl Jones nightmare in your life? Do you know whether the person who wants to sell you mutual funds is on the up-and-up? Ken Kivenko of CanadianFundWatch.com gives us the details on how exactly to check out mutual fund salespeople (technically, dealing representatives, self-termed as advisors) in Checking Registration and Disciplinary History. Unfortunately, the dogs-breakfast regulatory system in Canada means that it takes three pages of single-spaced explanation on how to do this and even then it is not foolproof, but hopefully readers will believe it is worth the effort.

There is another solution of course - be a DIY investor. Then you can wrestle with the question of whether you should entrust yourself to invest your own money.

Picking Out Actively Managed Funds that Predictably Outperform

There is an oft-repeated rule of thumb that past performance is no guide to future performance, that picking funds with recent above-average results usually leads to disappointment because their future performance tends to under-perform and revert to the mean. It certainly seems to be true in Canada (e.g. Richard Deaves in the book What Kind of Investor Are You? says there is no historical evidence of persistence in either under- or out-performance). Is that situation necessarily inevitable and immutable?

Along comes Super Fund Performance, a report from the Australian superannuation industry, to say "yes, it is possible to identify with considerable confidence which funds will continue to out- or under-perform". The key differentiator: whether the funds are retail for-profit offerings or not-for-profit (sponsored by public sector, corporate or industry). Not-for-profit has been winning, and by a huge amount - an average of 2% per year for the past 15 years!

Below is a fascinating chart from the study. Especially interesting is that the not-for-profits always did better than the retail for-profit funds. It looks like a sure-fire way for Australians to narrow down retirement fund selection. Too bad the not-for-profit option doesn't exist in Canada and it doesn't look like pension reform via the government's PRPP proposal will change that soon.....

Why the out-performance?

• lower fees/costs - the report doesn't state the difference but a quick search in one comparison website, the Canstar Superannuation Star Ratings, shows MER ranges from about 0.4% at the very low end to 2.5% at the extreme high end. The big not-for-profit funds look to be in the 0.6-0.8% Total Expense Ratio range according to another comparison site, Selecting Super.
• economies of scale, but only among the not-for-profit funds; retail funds don't get any more efficient with size, which the report says is due to governance factors - "... either economies of scale are not available to retail funds, or the benefits are not passed on to members". 
• embedded advice - the for-profit riposte is that their members get financial planning advice much more than clients of the not-for-profits, about twice as often according to Canstar. Investor Daily reporter Wouter Klijin says the not-for-profits are increasingly gearing up to provide advice, which he says will increase their costs and possibly/probably lessen their out-performance down the road. A big question is, of course, how useful the advice is, whether it is merely sales or client-interest-first, depending on the source. From which type of outfit would I want "advice"? That's a pretty easy call I'd say. 

Why Does Mutual Fund Performance not Persist? by Wolfgang Bessler, David Blake, Peter Lückoff and Ian Tonks provides another take on persistence using US data -

• Winner funds keep winning if, a) the fund investment manager stays on and b) there is NOT high fund inflow
• Losers start doing a lot better if, a) the investment fund manager is sacked and, b) there is a high fund outflow

The problem for the investor is of course, that what works on average may not happen for the specific fund selected. 

Equity Risk Premium and Likely Future Returns: Elroy Dimson's History Lesson

Highly recommended: Rethinking the Equity Risk Premium, Elroy Dimson's free (registration required) audio and slide presentation that says investors should expect no more than 3-3.5% annual real returns from equities over the riskless rate aka government bonds, which currently is more or less 0!

Noted academic and equity researcher Elroy Dimson (best-known as co-author along with Mike Staunton and Paul Marsh of the yearly investor treat called the Credit Suisse Global Investment Returns Yearbook, 2012 edition here) has been at it again, producing well-explained, substantial commentary on a supremely relevant topic - how much return have investors achieved around the world and what should one expect from equities in future?

Other notable points in the presentation:

• the equity risk premium has not been constant over time, or from country to country, though equities have substantially outperformed bonds over the past 112 years in every single one of the 19 countries for which they have data (slide 19)
• over the very long run (100 years or so) currency shifts between countries have barely mattered to equity returns for an international investor (using the USA investor as the example) ... though it has mattered a lot over short periods (slide 17 c. 21 minutes along)
• most (or all, in some countries) of long-term real equity return comes from reinvested dividends (slides 20 and 222)

There's more fascinating and potentially useful stuff on such topics as - do higher or lower GDP growth countries give better equity returns, do weak or strong currency countries give better equity returns, do high or low dividend markets foretell better equity returns? Here's one of Dimson's slides that reinforces the idea that "valuation matters", at least in the form of dividend yield (as this post on my other blog showed, the current Canadian yield around 3% is around the the historical average):

There's also a background paper with the same title (likely to be heavy reading; though I haven't yet read it, I'd bet it's worthwhile), also free from the CFA Institute.

WaterFurnace Renewable Energy 2Q2012: Worrying Sales Slide

WaterFurnace (TSX: WFI) has just released its second quarter 2012 financial report. The news is not good.

• Big slide in sales - Sales dropped a big 16.5% vs the same quarter a year ago. Management is now lamenting dropping consumer confidence and belatedly recognizing the competition from low natural gas. Worst news is that CEO's Huntington's claim that WFI is stronger than its competitors and gaining market share looks dubious. LSB Industries reported recently too and its sales drop on the comparable climate control side of the business was only 12.5%.
• Inventory climbing - Inventory is rising fairly dramatically - from 33.5% of sales in 2Q2011 to 41.1% in 2Q2012. Why are managers downplaying this by saying that inventory remains at "historical levels"? The factors behind the sales slowdown aren't likely to reverse soon.
• Warranty costs rising - Warranty provisions continue to rise, even as sales decline. Using note 13, net additional accruals for honoring warranty claims rose from 4.3% of sales in the first six months of 2011 to 5.5% in 2012. The biggest portion comes from increasing claim rates not new units covered following sales. As I discussed in my last post about WFI in April, this cannot continue forever without consequences. If the provisions are correct, future cash flow will suffer when claim repairs or replacements occur. If so, the dividend could be in danger. If the provisions are too high, earnings will shoot up when the liability is reversed.
• Dividend payout looks unsustainably high - Aside from the warranty cost question, the current dividend payout at $0.96 per year looks way too close to the trailing 12-month earnings per share of $1.07 i.e. 90% payout. If sales remain soft and below 2011 in the next few quarters, the ratio will exceed 100%. That 5.8% dividend yield is not sustainable.
• Manager compensation rising out of line - Both salaries and stock allocation to managers rose considerably (10+%). That doesn't fit very well with relative or absolute business performance, nor with WFI's stock price, which has dropped 22% in the past year.

The only hopeful news was the announcement of the joint venture with a Chinese partner to sell its products into China. However, whether that initiative produces renewed sales growth will only be seen in a year or more. And success is not at all certain.

Revised Stock Valuation - Using much more pessimistic assumptions than in the initial assessment of 2010 (see post here) - earnings fall to $0.85 EPS, dividend cut in half, no growth for six years, followed by 3% growth thereafter, with a required return of 5% - WFI is worth around $23. With no growth at all, dividing the 0.85 EPS by the 0.05 required return gives a value of $17, just above where it trades today. FWIW, one broker tracking WFI, Canaccord Adams, has a target price of $24. According to Thomson Reuters, two un-named brokers have 12 month price targets of $21.90 and $23.90. One rates WFI a Hold, the other a Strong Buy.

Though it doesn't look as though there is a high chance of further big price declines, the last quarter's drop in sales was a surprise - even it seems to management - so it will be interesting to see what happens after the ex-dividend date of August 20th. Some investors might stick around to collect the dividend and then head for the exit. For the moment, I'm holding on.

When a Broker Goes Bankrupt Your Securities May Not be Yours to Take

The latest article by Independent Investor What if your investment dealer went bust gave me a fright. Probably like many others, I have gone along believing that since my holdings with my discount broker are segregated and in effect held in trust, I would get my securities back automatically and promptly. Oops, bad assumption, as Independent Investor explains: "... the assets of all customers generally fall into a single, common pool, and the rights of the customers become financial claims to be dealt with uniformly by the trustee. In other words, customer assets that are fully paid for and fully segregated are not separately and directly returned to those customers."

It is true that the Canadian Investor Protection Fund is there to step up and make up any deficiency up to $1 million per customer per dealer but a problem remains - how long will this take? Going through courts and insolvency proceedings is likely to take "some time" as they say. Meantime, what are people who need access to the holdings e.g. for retirement income, supposed to do?

An obvious tactic to deal with this danger would seem to be to split assets amongst several brokers. Another tactic, admittedly harder and more constantly complicated to carry out, is to assess and monitor the solidity of the broker, which for most Canadians, is a subsidiary of one of the big six banks. I look forward to what Independent Investor has to say in his promised follow-up article on who is most at risk and on possible preventative steps to minimize the risk.

CEO Compensation: Jarislowsky Opines, Algoma Central Delivers

It's reassuring that it isn't just me complaining that CEO compensation is way too high these days. Billionaire investor Stephen Jarislowsky recently appeared in this BNN clip saying he doesn't believe it is either wise or necessary to pay CEOs amounts that have gotten totally out of line. Amusingly, or scarily, he admits that he, a highly experienced and sophisticated investor, has a great deal of trouble figuring out the extremely complex pay schemes found in most big publicly traded corporations. He blames the historical out-of-line rise in CEO pay as being due to two factors: the public disclosure of pay, which made CEOs ask for what others were getting and the arrival on the scene of the compensation consultants, who have created all the insanely complex pay structures that magically produce higher pay whatever the company results or stock performance (I think there is probably a rule of thumb that the more opaque a CEO pay plan is, the more likely the shareholder will get taken advantage of). 

Whether pay gets reduced, both in relative and absolute terms, by shareholder "say on pay" or Boards putting the hammer down, it needs to happen. Another BNN clip with Globe and Mail reporter Janet McFarland and Fair Canada (as in, fair to investors) executive director Ermanno Pascutto, talks about the small advances in Say on Pay votes in Canada, which as ever in the hands-off Canadian regulatory landscape is voluntary here in contrast to the mandatory regime in the USA.

One company that caught my eye through this Globe and Mail article as being more on the right track than many others is Algoma Central (TSX: ALC). The description of it as old style with no stock option plan for the CEO, which is what Jarislowsky recommends, made me look up the latest Management Information Circular on Sedar.com to see the pay structure. Indeed, the CEO pay scheme is actually understandable, only a base salary plus an annual cash bonus scheme, half of which gets deferred and paid out only after three years. There are no options, no benchmark peers that automatically drag up pay, no golden parachutes and the pension accrual formula is the same as for other employees (CEO Wight is grandfathered in a very generous DB plan of 2.25% per year while new executives (after the Jan 2010 closure of the DB plan to new employees) go into the DC plan that all employees apparently receive). There is a new twist to the bonus plan for next year - half the cash bonus, instead of merely being deferred for three years, is notionally invested in common shares that vest in three years and are paid out based on the value of the shares then. In other words, unlike options, which have no risk to the CEO, there is downside risk - if the shares go down, the CEO loses that amount of the bonus, just like a real shareholder would. Sounds good to me. The only part of the pay that looks dubious is that the CEO Greg Wight's base pay, on which bonuses are based, rose at more than double the inflation rate in both 2010 (+6.6% over 2009) and 2011 (+5.5%).

Of course, sensible pay doesn't guarantee good stock performance. ALC's stock return has languished in the last five years, doing worse than the overall TSX. As the Globe article says, it might be a buyout value play since it looks quite under-valued (a P/E of 6.3 and a P/B around 1, profitable every year for the last 5 - see TMX here). The controlling ownership structure and the consequent lack of liquidity and analyst coverage seem to be getting in the way of value recognition.

Labour-Sponsored Rip-off

The union labour movement likes to think of and to portray itself as fighting for the common man, for fair dealing, for social justice, for honesty in business and so on. At times it does, witness its support of an expanded Canada Pension Plan.

Why on earth then would it continue to allow its name to be besmirched with one of the unmitigated disasters of investing for the common retail investor, the horribly exploitative abomination known as the Labour-Sponsored Investment Fund (LSIF), also called the Labour-Sponsored Venture Capital Corporation?

The history of LSIFs according to Wikipedia had a naively noble origin - fledgling companies need capital to thrive and grow, so the labour movement pushed the government to give generous tax breaks to average joe retail investors putting money into funds that would invest in these companies. It would stimulate the economy and create jobs. Professional managers in the funds would research and figure out which were the best small companies to choose. So the theory went.

The reality is that putting money into any old small company doesn't work. Many, indeed, most companies don't survive and grow, they unfortunately wither and die. And when the incentive structure is such that the fund managers make a lot more money a lot more easily from collecting high fees than on choosing future star companies, which is hard to do at the best of times, while the managers have none of their own money at stake, putting money into any old company with a cool story is the easy way out. The recipe was set for LSIFs to fund weak companies and provide little or no lasting job creation in the real economy while uniformly losing money for investors and allowing financial managers to systematically strip money through exorbitant fees (like 5, 6, 7, 8% annually).

The proof is in the pudding, and it has been for a long time. Go to Morningstar Canada and pull up a table of current LSIFs. There are seven with a positive 10-year return out of 82 funds, not bad you might say since they outnumber the six with a 10-year loss. It's not so good, however, when we remember that many long term losers disappear through being bought and merged into other funds. Two examples are the Capital Alliance Ventures Inc and Canadian Medical Discoveries Fund, both of which started back in the 1990s and have ended up folded into the GrowthWorks Canadian fund (I traced the history of these funds in this post last year). Here's a telling chart from Morningstar that shows the downward slump of CMDF and of the overall Retail Venture Capital Index compared to the BMO Small Cap index.

The CMDF is now in dire straits. Thanks to Ken Kivenko sending on the news published here and here in the Financial Post, we learn that CMDF is essentially insolvent. Fundholders are caught between the proverbial rock of not being allowed to withdraw funds and the hard place of being asked to approve CMDF taking on a loan merely to pay the managers' fees. It's inevitable that fund investors will lose big time, sooner or later. Yet the show is allowed by government (by the feds and some provinces continuing to offer a tax credit) and regulators to go on.

Why for example, has the Canadian Federation of Labour, the labour sponsor of the GrowthWorks Canadian Fund, not intervened through its majority (it nominates 8 of 12 directors) control of the Fund's Board, to say enough is enough, it's time to liquidate and wind up the fund before all the investors' money is sucked out of it? I'd like to see how differently labour Directors like Joseph Maloney and Edward Power, both of the International Brotherhood of Boilermakers, Iron Ship Builders, Blacksmiths, Forgers and Helpers and both on the Board since 2006, would react if they had more than their share ownership of exactly zero. (None of the labour directors have a big stake in Fund shares.) Of course, if the fund were wound up, messers Maloney and Cole would not collect the $16,000 or so in director fees they got last year.


Though the Canadian Federation of Labour doesn't take a fee from the GrowthWorks fund, in some cases the union itself does collect an on-going trailer fee. For example, the Canadian Police Association and the Association of Canadian Financial Officers are co-sponsors of the Covington Fund II. They collect an annual fee of 0.16% of the fund's net asset value, which turns out to be a tidy $480,000 based on the Fund's $300 million NAV (as of February 2012, per the Semi-Annual Report filed on www.sedar.com). All that for lending their name. Of all labour groups, one would think that police and financial officers would recognize and not want to take part in a rip-off scheme.

Disclosure: I am not neutral on this topic since I owned shares of both CAVI and CMDF and lost most of my investment before I managed to sell out a few years ago.