Wednesday 23 March 2011

Tax Shocker? Rich Pay More than Their Fair Share in Canada

It will no doubt come as an interesting discussion point for those both on the right and the left of the political scene to learn that Canada is right up there near the top of countries in terms of taxing the highest income earners! Canada is far above the OECD average, trailing only four countries in the OECD. Now the ideological left can shorten the slogan for the upcoming federal election - "make the rich pay their fair share" can become simply "make the rich pay".

The USA, surprise, surprise, is the country that taxes its rich the most, repeat the MOST. And the country that has been given the image of socialist paradise, Sweden, only taxes the rich their fair share. Poland and Switzerland are refuges for big earners - they tax the least.

This comes from the Tax Foundation website's No Country Leans on Upper-Income Households as Much as the U.S. The place I found this, William M. Briggs, has a neat graph, where Canada hides under the Czech Republic.

Budget Restoration of EcoENERGY Program - Good and Bad

Yesterday's federal budget restored the popular EcoENERGY home retrofit program, though the government's heart really isn't in it (apparently this is a sop to bribe, oops, accommodate a demand of, the NDP) since the funding of $400 million is only for the 2011-12 fiscal year.

The temporary short extension of the program is bad but at least the program itself is good for homeowners. Home energy efficiency investment is a one-time cash outflow that replaces future constant regular cash outflow on energy bills. It provides permanent inflation protection against energy price rises (see my original post on my friend's actual geothermal home installation for the financials of his situation). For the retiree especially, a cash flow saving that automatically exactly matches inflation on an essential living expense is a great boon. Consider the difficulty of trying to find an investment that even gets close to doing that.

This budget item is also a good thing for investors (of which I am one) in WaterFurnace Renewable Energy (TSX: WFI), a manufacturer of EcoENERGY-eligible ground source home heating and cooling systems whose Canadian sales dropped 14.3% in 2010 per the annual report after the EcoENERGY program was allowed to lapse last year. For a year at least, WFI's Canadian sales should get a boost, though they are at such a low proportion (12.7% in 2010) of WFI's total sales, that won't make a huge difference.

Friday 18 March 2011

Map of Inflation around the World

The Globe and Mail recently published a neat map of inflation in major world economies. Though Canada and the USA still have relatively benign inflation, it is not so elsewhere. When our currency stops appreciating (see RatesFX 1-year chart for CAD), can we be far behind?

Thursday 17 March 2011

Waterfurnace Renewable Energy YE2010 - Trudging Along

The 2010 annual report and conference call (on for WaterFurnace Renewable Energy (TSX: WFI) are now available. What do they tell us (I do own some) shareholders?

The financial results bring no great surprises. Earnings in the last quarter followed the trend of 2010, being down from 2009, which itself was down from 2008. Sales went up a bit, at much lower profitability, as the company only in late 2010 implemented a price increase to try to recoup some of the input price rises, notably copper.

The company has continued its fairly dramatic shift away from the moribund new US residential housing market to the residential replacement and commercial sectors.

Strangely, given the big drop announced today in US housing starts (to 480k in February from 620k the month before and the analyst forecast of 580k) the tone from management on the conference call (yesterday) was quite positive. They said they expect an upside of 15 to 20% in 2011 from residential new construction.

Apart from the upside uncertainty of housing starts, the major downside risk is that US government cost-cutting may remove the 30% tax credit for geothermal home installation that is supposedly in place till 2016. Management said they feel the tax credit is relatively secure based on their lobbying contact with lawmakers.

Another upside uncertainty that would increase the financial attractiveness of geothermal is how much, if at all, natural gas prices will go up.

The acquisition of Hyper Engineering sounds like a reasonable move. Its technology for limiting the inrush current on startup of electric motors can both be integrated into its own products and continue to be sold, even expanded, as a separate business. WFI managers even said that Hyper is a profitable business right now.

Due to the removal of the federal retrofit rebate program, Canadian sales kept falling through 2010 (now under 15% of total sales) and according to WFI management, have now hit a solid bottom. Some provinces continue to support geothermal for residential.

WFI continues to fly under the radar - only two analysts, one for CIBC and another whose affiliation wasn't stated - took part in the conference call.

One of the Board directors, Thomas Dawson, even bought 100 shares in February at $25.25. There have been no sales by insiders for over 12 months so that is positive.

All in all, maybe things will get better in 2011 as WFI management expects, but at worst it is still a waiting game, perhaps another year or two before growth resumes. Other investors in the last two days seem to like the results - the stock is back up over $26. I am comfortable holding onto my WFI shares.

Wednesday 16 March 2011

LSE-TSX Merger - FAIR Makes a Sensible Suggestion to Help Investors

Amongst all the confused and confusing commentary, it is a relief to read a sensible suggestion by FAIR Canada that the merger of the LSE and the TSX be taken as an opportunity to change the regulatory side of the TSX market's operation, a move that would help protect investors a bit better.

FAIR Canada says the TSX's responsibility to set and to police the listings requirements should be moved to an arms-length body (like IIROC) away from where it is now, within the TSX itself in the same group that goes out soliciting listings by companies. That would avoid the obvious conflict of interest and danger that the pursuit of listings and the associated revenue for the TSX might be done at the cost of too-loose control of listing conditions.

The second aspect of listing rules is that the merged LSE-TSX would have to decide how to deal with listing rules - e.g. whether to keep them separate or come up with a single aligned set. Making a single set of stronger/better rules would be a welcome development. The Globe and Mail's In a TMX/LSE merger, whose rules apply? by Dave Milstead explains some examples of differing LSE vs TSX rules.

Looking on the positive side, instead of the prevalent negative blather that seems to predominate these days, the merger is a good opportunity to fix existing TSX deficiencies in a way that helps investors in Canada.

Tuesday 15 March 2011

TSX Market Darlings & Dogs in March 2011

It is always worthwhile to compare the iShares TSX S&P 60 Index ETF (XIU) with Claymore Canada's Fundamental Index (CRQ). CRQ selects and weights its constituents according to historical accounting data while XIU does so based on the market value of companies. As such, the comparison tells us which sectors are popular and where the market expects future excess profitability and growth will come from - i.e. when XIU has more weight in a company or sector than CRQ.

Here's what my comparison table below tells me:
  • Dogs (in Red on the table): Financials are still unpopular (less weight in XIU than CRQ) as a sector and across the board company by company with one exception, the Royal Bank, whose weight in XIU is slightly more than in CRQ. CRQ's 13.5% greater weighting than XIU in Financials and its overall weighting of 45% in that sector makes it extremely dependent on it. Incredibly, CRQ's Financial weighting has even increased since my last comparison. Inklings of popularity amongst banks and insurance companies are beginning to glimmer as most of them have gone up slightly in their weight within XIU from last August to today. Even Manulife and Sunlife, though still way less weighted in XIU than CRQ, have become less doggy i.e. have gained a little ground within XIU.
  • Darlings (in Green, naturally): Energy (as in petroleum) has not only maintained its popularity, it is continuing to rise in XIU, both relative to CRQ, where it was already a heftier component, and to past August within XIU. The biggies are Suncor, Canadian Natural Resources and Cenovus and they have all gotten bigger. They must be making more money than other sectors since they have gone up within CRQ too.
  • Waning Darlings: The Materials sector is still a grossly over-weight in XIU compared to CRQ but some slimming has occurred. Gold companies Barrick Gold and Goldcorp both lost ground as did Potash Corp of Saskatechewan. By the end of the day, uranium producer Cameco (CCO) (not shown on the table as it is too low down the list) might be considerably less as a proportion of XIU (it is down c. 6% as of 11:30am). CRQ has less to lose that way as Cameco is only have the size within CRQ as it is within XIU.
  • CRQ's sector weightings have evolved much more slowly than in XIU. None of CRQ's sectors has changed as much as the 1.5% increase in Energy's weight, or Materials' 1.2% drop, in XIU. Accounting profits, sales and the like do not change as rapidly as market expectations, or should I say, today, market panic.

Wednesday 9 March 2011

Inflation Control Debate Underway in Canada: Why We Need to Pay Attention

Inflation is one of those things where most often the best a citizen or investor can do is not lose ground. Whether it is a salary that does not keep up with rising expenses (just today, Canadian Capitalist was justifiably moaning about huge increases in home insurance premiums) or GIC rates that do not compensate for inflation even before taxes, we always seem to be one step behind or losing ground. The problem is especially acute for retired people where normal annuities are not indexed and a pot of money must suffice for ever longer life expectancy.

That there should be inflation is government policy. The target, characterized as "low inflation", is currently at 2% and allowed to vary within a 1 to 3% range according to the organization mandated to make sure that happens, the Bank of Canada.

Right now, the debate about how much inflation is to be created or allowed is wide open. The reason is that the five-year agreement between the federal Minister of Finance and the Bank of Canada on the target and the system to measure or control inflation expires at the end of 2011.

The most visible part of the debate, though no doubt there is lots going on behind closed doors at the Bank of Canada and the Ministry of Finance, and invisible to us ordinary schmucks, seems to be emanating from the CD Howe Institute in a series of reports. The main issues and/or suggestions include whether to:
  • lower the target rate for CPI increases from 2% to 1.5%, 1.4% or even 1%, about which I ask, why not a zero percent inflation target?
  • replace inflation targeting, which we have now, with price level targeting; "The key distinguishing feature of price- level targeting is that shocks pushing the price level off its intended growth path must be recouped, meaning that a temporary rise in inflation above 2 percent must at some point be offset by future inflation of less than 2 percent. In contrast, with inflation targeting, the same positive inflation shock is subsequently reversed, but not recouped: for the price level, bygones are bygones." (from Precision Targeting: The Economics – and Politics – of Improving Canada’s Inflation-Targeting Framework by Christopher Ragan at CD Howe). In other words, with price level targeting, we don't have a permanent loss of purchasing power that we somehow have to try to recoup on our own under inflation targeting. Why not let the Bank of Canada do the job for everyone through price level targeting?
  • mandate the Bank of Canada to include control of asset price bubbles as one of its objectives in setting monetary policy. That goal does not form part of its mandate right now. Why not have the BOC prevent asset bubbles? In the last ten years we've had the painful High-Tech stock bubble and the USA/European housing bubble. Though the housing bubble that caused the 2008 crash wasn't in Canada and thus would not have spurred BOC action, would not such a policy be worth it for all central banks? Would it not have been less painful to avoid the big crashes? No doubt there would be costs and possible downsides but maybe they are less than the damage of recurring asset crashes. Authors like Robert Barbera in The Cost of Capitalism (my review here) make a reasonable case for central bank control of bubbles.
Do a Google search of the phrase "too important to be left to the experts" and you will find it popping up in any number of contexts - health care, finance, biotechnology, war, science and in general. If we don't say something, inflation will surely be done to us for "our own good" though we may not like the result.

Monday 7 March 2011

Book Review: The Power of Passive Investing by Richard Ferri

If ever there was any question or hope that a person could succeed in beating market returns (or their fund equivalent, market-cap weighted low-fee index funds) through investing in actively managed mutual funds, this book utterly destroys the notion. In The Power of Passive Investing author Richard Ferri presents piles of research results that slice and dice the data backwards and forwards, inside and out, upside and down. Whether it is high- or low-fee funds, past-winners, before- or after-tax, bond or equity funds, foreign or domestic investments, large funds or small, portfolios of funds, manager qualifications, Morningstar ratings, risk-adjustment that is used to select a mutual fund, none of it works better than cap-weighted index funds.

Worse, Ferri gives us the disquieting evidence that individual mutual fund investors get significantly poorer returns than even the average under-performing mutual fund because of bad trade timing.

It is thus difficult to dispute the practicality of his advice that individuals should buy passive index funds and focus their efforts instead on an asset allocation, matched with long term goals and personal circumstances (emotional strength aka risk aversion, age, wealth, job, health etc), that should change infrequently - only when the goals and circumstances do.

Ferri says it is not just individual investors who will be better off following that strategy. He makes an argument that charities, personal trusts, pension funds (especially small ones) and financial advisors should do the same to best carry out their responsibilities.

The referencing, presentation, writing style, grammar, diction and organization of the book is thankfully up to snuff (much better than another of his books that I reviewed).

That's the good stuff. Here is what I didn't like.

1) The big one:
Dismissal of active management and fundamental indexing - Showing that actively-managed mutual funds are, on average, losers, does not mean that active management, the seeking of "alpha", cannot ever work. Ferri indirectly and inadvertently (I think) recognizes such when he quotes (p.149) famed Yale University endowment manager David Swensen: "Low cost passive strategies suit the overwhelming number of individual and institutional investors without the time, resources, and ability to make high quality active management decisions". Or, on page 112, "Most of the great managers aren't for hire by the general public. The truly talented managers like to fly under the radar ... ". Or, again, on page 128 where he discusses where the dumb-money investors' money goes: "Much of it went to brokers, brokerage firms, and their trading desks. Another portion went to a handful of talented money managers who skillfully separate investors from their money". (my bolding)

He might admit that such managers really do exist (eg. Warren Buffett isn't just on a long lucky streak) but in effect says that we small-fry investors cannot tell them apart. Perhaps with active mutual funds that is so, but is it true with fundamental indexing, which he summarily dismisses on pages 75-76 with a stream of invective instead of looking at evidence? The historical performance evidence, along with the theoretical dissection of why fundamental indexing makes sense, presented most notably by Robert Arnott (whose book The Fundamental Index I reviewed here) deserves more attention than that from a smart guy like Ferri. The fact that some high-powered and neutral researchers like the EDHEC Risk Institute have effectively been trashing the value of market cap-weighted indexes for practical and theoretical reasons, suggests strongly that we, including Ferri, need to pay attention to this particular innovation, especially when it comes offered in reasonably low cost funds. The big question is whether the higher fees or tracking error of such funds (e.g. the US equity ETF from PowerShares PXF's 0.39% MER vs the classic S&P 500 ETF SPY's 0.0945%) offsets any alpha they might generate. That question is why I have the little practical side-by-side experiment going at the bottom of this blog (so far, fundamental is winning).

2) Minor annoyances:
  • the mysterious 1:2 winner to loser ratio - all through the dismemberment of mutual fund performance, Ferri keeps emphasizing that the ratio of winners to losing funds in various studies settles around 1:2 (except even more mysteriously, that the bond fund ratio is even worse at 1:4), but he never explains why. There must be a Dan Brown novel in this!
  • the big-5 lifetime financial liabilities in chapter 10 misses health costs - especially in the USA, and less so in Canada, health care costs, most likely in retirement, need to be a prime financial factor to be dealt with somehow
  • the suggestion that it is too difficult to implement passive investing on one's own (page 191 chapter summary) - "The mechanics for prudent asset allocation and investment selection are more involved than how they are presented in this book. More reading is required to a portfolio is much easier said than done. Do-it-yourself investors often do not complete the process or maintain it well." Ok, here goes: US investor - 50% VTI (or PXF), 50% AGG; Canadian investor - 50% XIC (or CRQ), 50% XBB. Rebalance annually, or never, if you are really lazy. Add money by topping up the one below 50%. Withdraw money by selling off the one over 50%. Is that simple enough? It's only a good enough, not nearly optimal solution, but it should be possible for anyone to follow.
In short, this is a very good book with one significant flaw that is more of a missed opportunity than a damaging omission, as individual investors would not go wrong following the author's advice.

My rating: 4 out of 5 stars.

Disclosure: Thanks to the author's firm Portfolio Solutions for providing a free review copy.

Wednesday 2 March 2011

Perils of Procrastination - Missed Stock Opportunity

Looks like I missed the boat from delaying looking at two companies suggested by a commenter on a post about Waterfurnace Renewable Energy's (TSX: WFI). "Anonymous", also a WFI shareholder, had asked whether I had looked at Computer Modelling Group (TSX: CMG) and 5N Plus (TSX: VNP). Prices of both companies are up considerably since that post. 5N has just announced an acquisition per this GlobeInvestor article, boosting its price 17% in a couple of days, which brings it to c. plus 50% since my post! CMG is up over 40% since October! Got any more stock analysis suggestions, Anon?

WFI has its conference call March 15 and full year results release March 14, which I will be reviewing. The company has already authorized and paid the quarterly dividend at the same rate as the previous one. I'm not expecting much sales or profit rises given the continuing bad state of the US housing market. The rise in energy prices is making the value proposition of its product - geothermal heating - increasingly attractive, however.

Tuesday 1 March 2011

Global Investment Returns Yearbook 2011 from Credit Suisse

The 2011 edition of the Credit Suisse Global Investment Returns Yearbook is out ( free download here). It is again full of fascinating material that gives a long term (111 years of data from 1900 to 2010) perspective on investment returns of stocks and bonds across 19 countries, including Canada, which again looks rather good compared to just about anywhere else. It also has three excellent topical articles, two by principal authors / data compilers Elroy Dimson, Paul Marsh and Mike Staunton, and one by Credit Suisse analysts David Holland and Bryant Matthews. These are my highlights:

Stock-Bond Drawdown Extremes, Correlations and Inflation Impact
  • Equities outperform bonds over the long run ... "Yet that superiority [of equities] has been dented by the striking performance of bonds over intervals that exceed the investment horizon of most individuals and institutions." e.g. 1980 to 2010 (31 years)
  • "Historically, bond market drawdowns have been larger and/or longer than for equities. ... UK government bonds were underwater, in real terms, for 47 years until December 1993. While bonds appeared less risky in nominal terms, it is clear that their real value can be destroyed by inflation" [Drawdown = the difference between the portfolio’s value on a particular date and its high-water mark] Look at figure 2 (USA) or 3 (UK) for visual proof of how unsafe bonds can be.
  • The drawdown of a portfolio 50% stock 50% bond portfolio has been much less pronounced and much briefer - see figure 4 - i.e. a balanced portfolio really reduces risk.
  • Correlations between stocks and bonds have been negative for the last few years. That has been great for diversification in regularly rebalanced portfolios but the correlation is likely to rise so the risk reduction effect won't be as strong.
  • The past decade has been brutal for equities. Here is what they write about the US, which is more or less the case for every country: "After the tech-bubble burst in March 2000, equity prices also collapsed and, by October 2002, the real equity index was down in nominal terms by 48%, and in real terms by 52%. While the nominal recovery took only 47 months, in real terms the market remains underwater to this day."
  • "It is sheer fantasy to expect bond performance to match the period since 1982. Yet expecting bond returns to be lower than in the golden era is not the same as asserting they will enter a protracted period of negative performance." Bond returns might simply remain low but positive.
  • High inflation is to be feared. All sorts of bad things happen - bond prices have their worst drawdowns. Stocks experience big losses too. And the correlation between stocks and bonds increases, lessening the risk reduction achievable from diversification.
  • Real returns on bonds are higher [not lower, as one might think] in high inflation countries but they find that only reflects greater risk in the form of volatility and uncertainty
Dividends and Dividend Yield Investing
  • "... long-term returns are heavily influenced by reinvested dividends ... the total return from US equities, including reinvested dividends, grows cumulatively ever larger than the capital appreciation ... the longer the investment horizon, the more important is dividend income. For the seriously long-term investor, the value of a portfolio corresponds closely to the present value of dividends"
  • "... historically, investment strategies tilted towards higher-yielding stocks have generally proved profitable ..."
  • Stocks with high dividend yields provide higher returns, even after adjustment for risk: "... an equity investment strategy tilted towards higher-yielding markets would have paid off handsomely"
  • "... our research indicates that portfolios of higher-yielding stocks (and countries) have actually proved less risky than an equivalent investment in lower-yielding growth stocks". They lay out the long term evidence for 21 countries in the chart below which plots the risk-adjusted return metric known as the Sharpe ratio compared to high- vs low-yielding stocks. It sure looks like investing in high dividend stocks pays off. It also looks like investing in no-dividend stocks will greatly under-perform.
  • Similarly, investing in countries with high dividend yields e.g. through a market index, has paid off handsomely. "... the high-yielding countries outperformed the low-yielding countries by an appreciable margin. The results are not therefore period-specific. Nor are they attributable to risk."
  • However! "... there can be extended periods when the yield premium goes into reverse and low-yielders outperform ... there have been extended periods when even the rolling five-year premium has remained negative. These include the early 1980s, much of the 1990s, and the present time"
Expected Future Equity Returns
Holland and Matthews use a model to assess what current market expectations are for future equity returns of industrial firms based on analyst forecasts of future cash flows.
  • As of mid-January 2011, the required rate of return on industrials in the USA was at 5.1%, which is less than the historical median of 5.8%, implying a market where investors are willing to take on risk. The current figure is just at the dividing line they label overheated. But the premium of equity to Treasuries, the equity risk premium (ERP), is still attractive, so stocks looks good in that sense. "We would caution bullish investors that the risk premium will only stay high so long as Treasury yields remain low. A robust global recovery would stoke inflation and long-term Treasury yields."
  • "We estimate the ERP for key regions in Figure 6, and see that the ERP for developed markets is far more attractive than the ERP for developing markets. This prompts the question of whether equity investors will be compensated for the extra risk they are taking in developing markets."
  • Canada has been one of the best countries in the world to invest in over the past 111 years. "Canadian equities have performed well over the long run,
    with a real return of 5.9% per year. The real return on bonds has been 2.1% per year." On equities returns, that ranks it behind only Australia (7.4%), South Africa (7.3%), Sweden (6.3%) and the USA (6.3%) amongst the 19 countries listed. Resource-rich countries have done well.
  • It seems to continue to be a good place to invest - falling in the middle of the over/under heated charts (see Figure 5 on page 29)
  • Canada's stock market was the world's 4th largest as of the end of 2010. I wonder if Bloomberg will ever notice and start displaying the TSX on its TV channel streamers.

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