Wednesday 25 August 2010

Star Investment Analysts Lose Their Brilliance When Changing Jobs

The publisher's blurb for the new book Chasing Stars: The Myth of Talent and the Portability of Performance by Harvard prof Boris Groysberg says:
"Groysberg comes to a striking conclusion: star analysts who change firms suffer an immediate and lasting decline in performance." Why does this happen? "Their earlier excellence appears to have depended heavily on their former firms' general and proprietary resources, organizational cultures, networks, and colleagues." I wonder if that also applies to mutual fund and portfolio managers. It could form a handy way to filter out future losers.

Kudos to Simoleon Sense where I found the link.

Monday 23 August 2010

Weakness of Fundamental vs Cap-Weight Indexing - The Potash Corp Takeover Bid

Those of us convinced of the superiority of an investment strategy using fundamental index (RAFI) funds over traditional cap-weight funds need to avoid the error of merely assuming that all is well and merely look for positive evidence that it works. We need to be on guard for things that might go wrong. My little one-vs-the-other tracking table at the bottom of this blog recently turned from net fundamental advantage red to cap-weight green and it is almost all due to the effect of the Canadian equity component of the portfolio where the cap-weight iShares TSX 60 (XIU) stands against its RAFI competitor Claymore's Canadian Fundamental Index ETF (CRQ). Why, I asked myself?

Potash Corp Takeover Bid
The buyout battle initiated by BHP Billiton for Potash Corp of Saskatchewan (POT) on August 17th caused a typical leap in the share price of POT (see Google Finance chart below). Guess which fund, XIU or CRQ, did better. Yup, XIU did, because of its much greater holding of POT before the formal takeover bid.

Note how the orange line of XIU jumps above the blue of CRQ the day of the bid. POT's weight in XIU has bounced up and down in the past year but the iShares document store shows weights varying around 3.5% through the past year while the fundamental weight has been much lower. On August 19th, after the takeover announcement CRQ still had only a 1.8% weighting in POT, up from 1.4% at the end of March, while POT jumped to 4.6% of XIU.

The media rumour about a possible takeover has apparently been around a long time, judging by this March 2009 article in the Telegraph and this Andrew Willis article in GlobeInvestor from last October, which may account at least in part for the fact that POT has occupied for over a year in XIU a weight far above what is justified by its profitability and other accounting valuation data, which is what CRQ reflects. (Though one wonders what those smart professional investors were doing bailing out of POT just before the takeover bid - note the big price dip through from March to early July this year.)

The moral of the story is that RAFI will underweight stocks subject to takeover speculation and in a restricted market like Canada's where a fairly small number of stocks occupy much of the index, any takeover will have a much more pronounced effect.

However, not all takeover speculation comes to action and not all takeover bids succeed and this one isn't a fait accompli either. (Hmm, slip of the tongue there folks, didn't mean to say that passive index investing involved being part of the market's indulgence in a stock speculation ... or did I? ;-) Maybe POT's price will fall back down. It remains to be seen whether such takeovers are a factor significant enough to invalidate the RAFI strategy but for now, I'm holding steady.

Tuesday 17 August 2010

Book Review: Investing in Renewable Energy by Jeff Siegel, Chris Nelder and Nick Hodge

Not really a book about investing, this book is an introduction to the various sectors and technologies that make up renewable energy and a polemic that society needs to adopt it and fast. The authors take a highly positive stance to the point of boosterism towards renewable energy, touting all the positives but ignoring or skimming the negatives, citing such as mere impediments that will quickly and easily be solved (e.g. the fact that wind does not blow reliably all the time to generate power when it is needed and the NIMBY view-spoiled opposition it engenders).

The other major missing element to make the book a really useful tool for the investor is to recognize the difference between an important and probably inevitable economic, technological and societal change and the success or failure of individual companies. The inevitable growth of renewable energy does not mean the inevitable profitability of all or even most of the companies investors may be faced with. In fact, I would expect that the energy transition will play out exactly as with other big new technological changes - a small minority, a tiny handful of companies will do extremely well, while a good number will succeed reasonably well and the majority will crash and burn. We have the recent lessons of the Internet and the dot com era to guide us.

In other words, I would want an investor-oriented book to guide me through the factors specific to renewable energy companies I should be paying attention to. What are the revenue ratios and cost factors? What are the special operational factors that make or destroy profitability in the various renewable sub-sectors? None of this is found in the book.

For example, the chapter on geothermal energy mentions Ormat Technologies (NYSE: ORA), calling it " ... the best of breed among the publicly traded geothermal companies." There's even a nice chart showing the rapid rise in share price between 2005 and 2008 (when the book was published). Fast forward to today and look at this Google Finance chart snapshot of ORA below - not so impressive anymore.

The latest Ormat results reported a loss due to "... low generation and high operating costs at the North Brawley power plant". It seems that making money in geothermal is not as simple as drilling a hole in the ground. So, is this the time to snap up Ormat stock? The book doesn't help me at all to decide by giving the tools and techniques to do the proper assessment.

To a minor degree (only, since there is considerable real content on the renewable sector), the book suffers from a touch of infomercial disease - promotion of the authors' website where you can subscribe / pay for all the latest hot news in their investor newsletters, complete with stock tips. One can expect there what can only be called recommendations for speculation, not long term investing, according to this statement: "... we'll be reporting on it [a reference to a solar power project in New Mexico] to all our readers so they can get in early on these, too; this will give them an opportunity to take up an early position, then cash out once the rest of Wall Street catches up and pushes the stock north." (p.51) Hmm, is that like recommending Ormat on March 3, 2009 at $25 with a 12 month target of $41 in 3 Stocks to Play in a Down Market? Siegel is sticking to his guns though, he's still recommending it.

To my disappointment, and perhaps to my friends who installed one of their geothermal heat pumps as described in yesterday's blog post, the book doesn't mention WaterFurnace (TSX: WFI), a smaller company that is still making profits, paying dividends and increasing sales, despite the poor housing market. The stock price has been stagnant for several years. Is this a value play? On the other hand, maybe flying under the radar is a good thing.

Making money on green chip stocks, as they put it in the book's sub-title, requires more than anticipating when fads and psychology will generate temporary emotional enthusiasm to push up a stock price. For the real investor, trying to look years ahead, it requires difficult reasoned comparative analysis of present and near-term alternatives, with number crunching and diving down into the business model of companies, as well as evaluating the skill of company management.

My rating: 2 out of 5 stars

Monday 16 August 2010

Geothermal Home Heating Case Study - Going Green Puts Green into Your Pocket

In the autumn of 2009, good friends of mine converted their Montreal home from oil heating to a system that uses heat from the ground. I asked them to share their experience since the new system is so impressive and unique both for its environmental benefit and its financial payback. What follows is their story.

The Need: We were facing the replacement of our existing air source heat pump as it was well past its expected life time. This would have cost us $ 6,000. An air source heat pump in Montreal provides air conditioning throughout the summer and provides some heat down to -10 C. It is not nearly as efficient as geothermal because the ground, below about 5 ft, at this latitude is a constant 8 C.

The geothermal system and its cost:
The installation of the whole system was approximately $ 36,000. This included the new heat pump, circulating fan, thermostat and most importantly the 2 wells drilled to a depth of 250 feet each. This last point is important since it is the most expensive line item. We had to go with a vertical implementation. If you have enough land, it can be put in horizontally. It makes a mess of your yard, but it is much cheaper. Some installations can use a nearby lake or pond for the heat source and that can reduce costs as well.
See photo showing result of drilling - pipes leading out of the hole to the house

We were able to take advantage of a grant from the government for retrofitting to geothermal. This program (the EcoEnergy program) was abruptly cancelled by our beloved Conservative government. (Note from me your blogger: some provincial governments still seem to offer a grant according to NextEnergy) The grant was worth $ 4,600.

When the heat pump is running below its maximum output, the extra heat is used to pre-heat our domestic hot water.
See photo of heat pump installed inside the basement of the house - looks a lot like a furnace)

We had to make a case for an additional $ 26,000 (i.e. approx. 36,000 - 6,000 heat pump replacement - $4,000 grant).

Financial Justification:
This house averaged 3,000 liters of oil every winter to heat the house and provide domestic hot water. This was in addition to the electricity to run the air-source heat pump which provided heating in the spring and fall.

The cost of oil was 98 cent / liter in 2008, but subsequently dropped to 75 cents / liter in 2009. I expect the price of oil to rise back to at least a dollar / liter within the next 2-3 years.

The increase in electricity costs this past winter was $ 320.

We saved 3,000 * .75 = 2250 - 320 = $1930 this year at 75 cents / liter.

I project we will save 3000 * 1.00 = 3000 - 320 = $2680 per year in the future. This assumes constant electricity rates. I also assume that oil prices will rise faster then electricity in this province.

Another important factor: the efficiency of a geothermal system is 1:4. That means each unit of electricity provides 4 units of heat. We are just moving heat, not creating it. For instance, if someone heats their house with electricity via heating coils, and the cost of electricity goes up, they will have 4 times the increase in heating costs compared to a geothermal system. This is important from the perspective of a retired person as it shields us somewhat from inflationary energy costs.

So how is my return on my investment? I save approximately $ 2,000 dollars this year with my one time incremental cost of $26,000. That is a 2000/26000 * 100% = 7.7 % return (note, even without the government grant, that's a return of 2,000/30,000 = 6.7%). And that is a non-taxable return (they haven't figured out how to tax money not spent!). I feel that my money is working well for me.

Another advantage is the increased value of our house if / when we should decide to sell it. It is hard to say what percentage of my investment we would get back. At the very least, it will make the house much easier to sell. I expect that as geothermal heating becomes more common, the advantages will become more obvious and that we may see a 70 % return from a new value perspective (70/100 * 36000 = $ 25,200).

It just feels good to be green:
I believe the IPCC findings regarding global warming. I recognize that my contributions to carbon dioxide loading of the atmosphere is a mere drop in the bucket, but you can't expect a government to make policies that you yourself will not follow.

Oil produces 2.6 kg of CO2 per liter burned. We have therefore reduced our carbon footprint by 3,000 * 2.6 = 7,800 kg of CO2. That is 7.8 tonnes of carbon!
Electricity in Quebec comes from Hydro, so the resulting $ 320 of extra electricity I consume would have a negligible carbon footprint of its own.

Another way of looking at it: my car averages 8.5 liters of gas per 100 km. I now drive about 15000 km per year and therefore consume 1275 liters of gas per year. Gasoline creates 2.5 kg of CO2 / liter. My driving therefore produces 1.5 * 1275 = 3188 kg of CO2 / year. I save the equivalent of 2.44 years of driving!

Other Options in Comparison
We looked at a couple of different options:

1. A super high efficiency air source heat pump that extracts heat as low as -30 C called the "Acadia" sold by a small Maine company called "Hallowell". Here is a link:
This looked like a less expensive option and we seriously considered it. I had to track down the Canadian distributer of this. It is a new technology and we would have been the first installation in Montreal, the second in Quebec. There were good reviews of this product in the US, but I was concerned about being the first to put it in and the lack of experience, if not expertise, with this product in the local market. I had a quote, and this was going to cost a bit over $ 20,000. It did not qualify for the government grant.
Another concern is that it sits out in the open and would be subject to rain, snow, ice, ice build-up and any bumps by activity around it.

1.5 While we were looking, Mitsubishi came out with a competing product to the Acadia. Link:

2. The brand of heat pump that we went with is the WaterFurnace "Envision" heat pump. Our installation has 4 modes: low power heat pump, high power heat pump, 10 kw electrical heating element and finally it will kick in our existing oil fired hot water system. This last option was never used and we learned to avoid the 10kw heating element by not setting the thermostat more that a couple of degrees lower at night. That runs counter to general advice, but for a geothermal heat pump, it is more efficient to maintain a (nearly) constant temperature.
Here is a link with lots of useful information about heat pumps and specific information about our unit:

3. There are other brands of heat pumps available for the geothermal system. A bigger consideration for us was the company that was going to install and support the system. We had several representatives over to our house to give us their recommendations and quotes. Here are the important considerations:
- One company was going to do the work for less, but not use the correct "filler" around the vertical wells. They were significantly cheaper, but this work would not qualify for the eco-Energy federal grant because a certified system needs to use "bentonite" which acts like a concrete to prevent pollution of the aquifer.
- We looked carefully at using our existing hot water radiators to transfer the heat from the heat pump. This can be done, but would not work as the sole source of heat since heat pumps do not warm the water up to high enough temperature. We would have required a hybrid hot water / forced air combination and would have incurred higher costs, so we did not pursue this.
- The most important consideration was the expertise of the contractor. We choose a local company called "Thermo-stat" because their representative impressed us with his thoroughness. He is also the WaterFurnace technical expert in this market. They contract out the drilling and fitting of the pipes and then install the heat pump themselves. We have been very happy with their work.

4. A final consideration was where to do the drilling! We chose to have holes drilled where our driveway is. The pavement needed replacement as it was. The location was close to the foundation so a long run of pipes was not required. It avoided any damage to existing trees or gardens.

5. Maintenance. Everything is either underground or in our basement. Geothermal systems have actually been around for over 20 years. Failures of the pipes in the ground are extremely rare. They will likely last for 100 years. The heat pump should be reliable because it is not exposed to the weather. The Waterfurnace heat pump has a 10 year labour and parts warranty. The pumps have a 5 year warranty. The heating element also has a 5 year warranty.

From the day of the drilling to the final hook-up of the heat pump was 3 weeks.

It's an all-round impressive project.

Here's a final photo of my friends drilling, turning dirt into dollars.

Update 14 Sept: The Green Building Talk forum has a lot of advice and experience from people in the USA who've done geothermal. They keep emphasizing how important the contractor doing the installation is. The equipment itself seems to be fairly close in efficiency and reliability from one manufacturer to another. Re ongoing maintenance, one post says the pumps tend to wear out and need replacement after about 5 years at a cost of $200-250US but other than that, a well installed system seems to go 15+ years without any attention whatever.

Monday 9 August 2010

Pension Reform: a Comparison of CPP(IB) vs RRSP / RRIF / LIRA / LRIF / LIF

There's been a lot of talk lately in Canada about pension reform, a very necessary and worthwhile subject, but unfortunately most of the analysis is from the viewpoint or from the self-interested position of government, regulators and the financial industry. Herewith I present a modest contribution to the debate by comparing two of the existing major options from the viewpoint of the retiree or pensioner, in whose interest all this reform supposedly is ultimately most important.

The two options:
  • Canada Pension Plan (CPP) and its investment arm, the CPP Investment Board - thus my new acronym CPP(IB)
  • RRSP / RRIF / LIRA / LRIF / LIF - the family of registered retirement plans available to individuals, first to save for retirement, and then to draw income from during retirement
The objective is to determine which best meets the first and highest priority of retirement income, the essential spending needs to maintain a lifestyle. I defined my criteria for this objective in my post of June 15 Pension Reform and What Retirees Need, so now I turn to the comparison evaluation as promised then.

First order analysis: What the alternatives deliver today, as promised and as possible. The CPP is very straightforward - once you are eligible and fill in the form to start payments, you receive a monthly cheque, indexed (increased but never decreased e.g. during deflation) for inflation, for the rest of your life. The registered plans are more complicated and the income must somehow be created from investments. I've assumed that the pensioner will follow what I consider to be the best available method to invest within the plans - a portfolio of passive index ETFs, possibly with annuities purchased at some point.

Below is a table with my comparisons and ratings. I haven't bothered with an overall score because the CPP is clearly and massively superior based on doing what it does now.

Second order analysis: drilling down beneath the surface, how sustainable and sure, and what are the risks of each alternative. Below is the table for those results. Again, the CPP is Victoria to St. John's distance ahead of registered plans.

Third order analysis: what investing challenges must be met, what effort and skills does each require to be successful. Big surprise huh? A pattern seems to have emerged as the CPP is again far superior to registered plans.

One could say that the CPP is the best thing since, and for, sliced bread.

Thursday 5 August 2010

Tax Free Savings Account: a Clever or a Fortuitous Name?

In the book Why Smart People Make Big Money Mistakes by Gary Belsky and Thomas Gilovich, the authors note an interesting quirk - when people receive "bonus" money, they are prone to spend it right away, while "rebate" money gets saved. Another book, Nudge, written by Richard Thaler and Cass Sunstein, recommends that governments exploit such thinking processes to influence people in the right direction (which in itself can be debated, though they follow a reasonable principle that the person him/herself would need to be in agreement that they are being nudged in a way that they themselves think beneficial).

Enter the Tax Free Savings Account (TFSA), introduced by the federal government in January 2009. Its purpose is to encourage people to save. Sounds reasonable for people to save before spending, rather than the reverse. So, I wondered whether the feds got the idea for the name with the intention to virtuously manipulate our behaviour. I asked the Department of Finance and this is what they said: "The name – Tax Free Savings Account – was considered to best represent the nature and benefits of this account ..." i.e. no nudging happened here, just routine, bureaucratic, mundane, literal, factual thinking. To put it in terms of a previous management trend, they were thinking fully inside the box. Or, that's what they are willing to admit, because though they considered other name options, they wouldn't tell me what they were. Governments routinely and deliberately mislead us (in our own best interest, so it is said) but cannot admit to doing so. Guess we'll have to guess whether this was a case of Nudge or Nudge Nudge Wink Wink.

The TFSA has enjoyed rapid uptake. Perhaps some of it has to do with the name itself? First, the word "free" is a sure-fire consumer salivation-inducing tool that works no matter how much it is misused and abused in advertising. Second, savings is a good trigger-word to induce people to put money in and to keep it in. Imagine if they had called it the Tax Free Spending Account.

It would be useful for the feds to track withdrawal rates to see if they stay low, and perhaps to do surveys to ask people what they used the money for when they did withdraw it. If the program works, we should expect to see people withdraw little for luxury consumer spending (the new plasma TV, a holiday trip) and more for things with long term value (house, education).

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