Book Review: Benjamin Graham on Investing, ed. by Rodney Klein, commentary by David Darst

Job ad ... Value Investor: must be highly skilled in dissecting financial statements, especially reading between the lines and uncovering what management may be deliberately or unwittingly concealing; must have great patience and diligence in calculating and estimating data; must be able to separate wheat data from chaff data; must combine internal financial data with external market psychology and national or global economic forces; must have the courage and confidence in one's conclusions to go against the flow of popular and/or professional market opinion or prices; must have the judgement to know when to hold 'em or fold 'em.

Those are some of the thoughts coming to my mind while reading this collection of original writings by the seminal value investor Benjamin Graham. We can see how the master thinks and assembles data into a cohesive analysis. The big question for the individual investor - could I do the same?

Graham speaks for himself in the book through the articles. I wish the editor Klein and commentator Darst had done more to enhance their teaching value by drilling into Graham's analysis, as for example, Jason Zweig does in the Graham classic The Intelligent Investor. For instance, in this day of information overload, it easy to get swamped by irrelevant or misleading details. Could Klein/Darst not have reconstructed the moment in time to say what Graham left aside, or even better to say what he missed? I was asking myself, "so no one is perfect, how good were Graham's analyses in retrospect?" After all, one feature of good investing is to learn from one's mistakes.

Further to that line of thought, I made a small effort to delve into one article, that comparing American Agricultural Chemical (AGR) and Virginia-Carolina Chemical (VC). In the book, Graham says VC is the better buy. Was he right? There's not much to be found through Google for those companies, neither of which exists today (more on that in a minute). From what I did find, Graham was correct, sort of. As of Graham's writing around September 1918, AGR's common share price was $100 and VC's $53. A scant four years later at the end of 1922, their prices were: AGR $32, down 68% and VC $25, down 53%. The Dow Jones Index had moved up from the low 80s to the mid 90s. VC was thus better than AGR in a relative sense but neither was good in an absolute sense. What was Graham's mistake? This, I believe: "... the particular strength of both companies lies in the benefits they will experience from the return of peace. (p.70) ... They have more to hope and less to fear from the future than perhaps any other industry (p.73) ..." In fact, the US suffered a severe postwar recession during 1920 and 1921, not a peace bonus. As fine as was Graham's backward looking analysis, he got the forecasting bit wrong it seems. I did not trace AGR's and VC's history to know whether Graham's conclusion would have made money at any point - that's what Klein and Darst should have done, instead of waxing lyrical about the Aeneid. (It's a bit over the top to say that Graham's writings, well crafted as they are, rank on the same level.)

As for disappearing companies, it is remarkable how few of those mentioned in the book exist today. Capitalism sees companies rise and fall quickly. The mighty of yesterday are gone today. To some degree the foundation of value investing is that the future will be like the past and/or present for a company, e.g. when we buy companies with a record of steady dividend growth, we assume that will continue. For those who don't pretend to know, there's passive index investing.

As a result, this book has no direct investing value relative to today's markets and companies. It is of some pedagogical value for value aficionados, since it is always worthwhile reading the original of any sector's leading mind, like Graham is acknowledged to be.

My rating: 3 out of 5

Watching the UK Get Older - What Effect on Government Finances?

Found on the BBC website Maps chart UK's ageing population this brilliant animated map (compare the map to Statistics Canada's yawn-inducing text Population Projections for Canada, Provinces and Territories) that shows the steady ageing process as the years roll on. Starting from 1992 and projected to 2031, the inexorable slow ageing process is visually striking as the map gets more and more of the darker coloured areas indicating the ageing. Whether the measure is median population age or 65 and older, the pattern is the same. Increasing longevity is evident too as the over 85s triple their share of population.

One interesting phenomenon is that there was not much change through the 1990s but suddenly around 2002 the phalanx of those of State Pension Age or older begins to rise from 18.3% of the population to 19.5% by 2010. That's over 730,000 extra people potentially drawing State Pension. It surely doesn't help government finances. Just as a period of negative market returns is a bad time to start drawing on one's retirement portfolio, so it is for a country, except that the UK government has no choice.

McKinsey Says Emerging Equity Markets Will Grow Faster

A few weeks ago, I noted research results which concluded that there is no automatic, direct relationship between GDP growth and equity market performance, and I cautioned against jumping too fast into investments in China, India and Russia.

Now along comes global consulting firm McKinsey & Company with its annual Global Capital Markets review (summary here with link to full report, which is free upon registration) with the view that Emerging country Equity Markets will grow considerably faster than major developed markets like the USA, the UK, Eurozone and Japan (Canada is too insignificant to merit much of McKinsey's ink). Notable quote: "... asset classes in mature markets are likely to grow more slowly, more in line with GDP, while government debt will rise sharply. An increasing share of global asset growth will occur in emerging markets, where GDP is rising faster and all asset classes have abundant room to expand." Equity is one of the asset classes they discuss.

McKinsey cites several reasons for thinking that equity in emerging markets will do better:

• high savings rates in those countries mean a lot of money is available to invest and equity is better placed than debt to be the investment vehicle
• these countries have great needs for infrastructure construction
• financial markets in emerging countries are still quite small compared to GDP and thus have much room for growth
• many state-owned enterprises have yet to be privatized

Along with the big constraint of the government and private debt burden in developed economies, McKinsey see higher inflation as a risk. They see little hope of big gains in equities: "These projections give little support to the hope that corporate earnings and valuations will rise again to significantly and sustainably higher levels in mature markets ."

It seems that McKinsey may not be alone in coming to such conclusions. The rebound in Emerging Markets has been much stronger since January 1st, as the iShares' Emerging Markets Index Fund (EEM) has outstripped such developed market ETF indexers such as SPY (S&P500), VGK (Europe) and XIC (Canada) in the Google Finance chart below.

Admittedly, Emerging Markets did fall off much more drastically during the crisis last fall but they have still outdone the developed ETFs from just before the worst moments of the crash, between August 1st last year and today, as this second Google chart shows.

Reasearch Results on Whether Financial Advisors Help or Hinder

Sadly, the answer is that financial advisors hinder according to Do financial advisors improve portfolio performance?, a just-released study of German investors at Vox by university professors Andreas Hackethal, Michalis Haliassos and Tullio Jappelli. The reason is the old bugaboo - costs and fees.

Advisors add value but ... "Even if advisors add value to the account, they collect more in fees and commissions than they contribute." Apparently the authors found that richer, older people tend to use advisors more which accounts for a preliminary gross conclusion that "Investors who delegate portfolio management to a financial advisor achieve on average greater returns, lower risk, lower probabilities of losses and of substantial losses, and greater diversification through investments in mutual funds." They note that the financial industry would love to grab that statement for publicity. However, the net truth is completely opposite: "Once we control for different characteristics of investors using financial advisors, we discover that advisors actually tend to lower returns, raise portfolio risk, increase the probabilities of losses, and increase trading frequency and portfolio turnover relative to what account owners of given characteristics tend to achieve on their own."

Of course, that does not mean that all advisors are bad for your financial health. It does mean choosing carefully, however.

So, DIY investors, take heart. Follow sound investing practices and you too will succeed.

Bad Stuff: Harmonized Sales Tax and Sprott Clampdown on Questrade Trailer Fee Rebates

There has been a nose-to-nose yelling match going on between the mutual fund industry and the Ontario government about the extra costs that will result from the Harmonized Sales Tax. But that's not all the HST will affect.

Financial author of No Hype–The Straight Goods on Investing Your Money and speaker Gail Bebee sent along a good commentary, excerpted below, about several other consequences that will hurt individual investors. Grrr!

"There are many investing-related services that are currently subject to the Goods and Services Tax (GST), but not provincial sales tax (PST). These services will probably be subject to the HST, a combined PST/GST tax that effectively increases their cost by 7% in BC and 8% in Ontario. Here is a partial list of services that will likely be impacted:

1. RRSP, RESP or RRIF administration

2. Setting up and holding your mortgage in your self-directed RRSP

3. Transferring securities to another institution

4. Mutual fund and portfolio management

5. Financial, tax and estate planning

6. Changing the beneficiary in an RRSP, RESP or RRIF

7. Searching records and providing copies of account statements.

Concludes Bebee, “Investors should lobby their investment dealers for price reductions to compensate for the pending HST increase. Businesses can afford to drop prices because the new tax regime will significantly reduce business costs.”

For more information or to arrange an interview, please contact:

Gail Bebee

Canada’s Independent Voice on Personal Finance

Tel: 416-733-0221 gbebee@gailbebee.com"

***********************************************
Another frustrating development comes from Sprott Mutual Funds for clients of Questrade. Questrade PR person Lynn Suderman sent along the following blurb with which I can only concur. (Note, I do have an account with Questrade but don't own any Sprott funds)

"As you may recall, Questrade launched a Mutual Fund Maximizer service (with trailer fee rebates) in January. As of yesterday, September 16^th, Sprott Asset Management decided to block the purchase of any Sprott fund by Questrade clients and will no longer be paying the trailer fee rebate. Why? We’re not entirely sure – their reasons are vague. No other mutual fund company is blocking sales of funds or trailer fee rebates.

Attached is a bit of background on the issue. Questrade will be pursuing all available avenues to reinstate Sprott funds and Sprott trailer rebates to our clients. In the meanwhile, I thought you may be interested in this turn of events. Note that Jonathan Chevreau wrote about it in his blog today:

http://network.nationalpost.com/np/blogs/wealthyboomer/archive/2009/09/17/sprott-blocks-trailer-fee-rebates-to-questrade-clients.aspx

I’m hoping to encourage people to lodge complaints with Sprott, the Competition Bureau, OSC, etc – see if we can get this overturned!

This is part of the email sent to our clients who own Sprott:

If you would like to show your support for Questrade and our trailer fee rebate program, we invite you to contact Sprott and the regulatory bodies that oversee our industry. Their contact information is below. Please remember to copy (cc) your letter and emails to marketing@questrade.com.

Sprott	invest@sprott.com	http://www.sprott.com	Toll Free: 1.888.362.7172
The Competition Bureau of Canada:	To fill out a complaint: http://competitionbureau.gc.ca/eic/site/cb-bc.nsf/frm-eng/PJSH-6X9KQY	http://www.competitionbureau.gc.ca	Toll free: 1.800.348.5358
The Ontario Securities Commission	inquiries@osc.gov.on.ca.	To fill out a complaint: https://www.osc.gov.on.ca/Contact/ct_cat-form.jsp	Toll free: 1.877.785.1555

Book Review: Conserving Client Portfolios During Retirement by William P. Bengen

Big bucks but big bang. Conserving Client Portfolios During Retirement costs $65 USD but does it ever deliver value. Both the content and the presentation are superb. Bengen applies his experience as a financial planner working with real individual people to thoroughly cover the many aspects of making investment money last through retirement. He does the work of an author brilliantly, which is to be clear about assumptions and methods, state caveats and limitations but then to digest and distill the data. The result is a compact 165 page small format large print volume with dozens of tables and graphs. Those illustrations are the condensation of what he says believably are thousands of hours of calculation work. The prosaic title (the chapter headings are the same) characterizes the writing style - plain and direct but crystal clear. There is nothing fancy about the book - no jokes or coy titles, no famous quotations, no hot tips or investor alerts, no sidebars or key points summaries. You could say that it is all steak and no sizzle, except that the content itself sizzles.

The Content: Bengen's book is about the narrow but critical topic of how to get the most withdrawal cash out of an investment portfolio without exhausting it prematurely. His fundamental assumption is that the past is the best guide for the future. Using US index data for stock, bond and Treasury bills from the Ibbotson yearbook from 1926 onwards, he systematically tests how well all sorts of portfolios and strategies would have fared. The key metric is what he calls SAFEMAX - the maximum annual withdrawal as a percentage of the portfolio at start of retirement that would have ensured portfolio survival no matter what year retirement started.

The Bengen Variations (somewhat akin to Bach's Goldberg variations): these are all the conceivable options taken in turn to see what effect each has on the base case withdrawal rate of 4.15% (yup, he states two decimal points - is it obvious he started his career as an engineer?)

• asset allocation - varying proportions of asset classes - large company stocks, small company stocks (can boost SAFEMAX up to 4.55%, a 0.4% gain), intermediate term US government bonds, long term government bonds (don't help at all) and US Treasury bills (can substitute for the intermediate bonds)
  
• time horizon - in five year increments from 10 years to 50 years (a forever portfolio can sustain 4%)
  
• reduction in safety (frequency that portfolio would not have survived and shortest longevity) from higher withdrawal rates up to 8.75%, where he cuts off around a portfolio has only a 50-50 chance of surviving the target duration
• alternative withdrawal strategies - 1) withdrawing more during early active retirement years instead of a constant inflation-adjusted amount throughout (not very attractive as the later year penalty is too great); 2) fixed percentage of the portfolio every year (looks unattractive due to large variations in withdrawals); 3) floor and ceiling withdrawal amounts to take less during bad years and more during good times (looks pretty good)
• active investing out-performance and under-performance by + or - 2% per year (really gives pause to think whether any but the passive index approach is worth pursuing)
• how much to lower withdrawals in order to leave a legacy
  
• value of reducing equity allocation during retirement (not worth it)
• making adjustments to withdrawal rate during retirement (it's essential to monitor and adjust if things get too bad and it's possible to boost the safe rate as you get older and life expectancy declines) but ...
  
• bear markets "... the intervention of a major bear market does not have to undermine a client's previous plans for withdrawals during retirement, assuming he initially planned to withdraw at SAFEMAX."
• taxation of the account - using accounts whose effective tax rate was zero (the base case, like a RRIF), 20%, 35% and 45%; the tax Engen computes would be coming from inside the account, taken out of the portfolio before withdrawal
• historical fall in dividend yields from rates above 5% up to the 1950s to about 2% in recent times (don't worry, makes no difference)
• withdrawing once a year or every quarter
• retiring date and withdrawal start at beginning of year or at beginning of various quarters - " ... a difference of only one quarter in the date of retirement can have a major effect on the longevity of a portfolio"
  
• rebalancing frequency from every three months to almost 12 years (about every four years seems best)
• whether or not to shift asset allocation (e.g. more fixed income) in anticipation of upcoming retirement (read it and find out!)

The final chapter sets out three case study scenarios based on Bengen's experience dealing with his clients, showing the actual application of the principles. Due to quite different life goals, like travel, donations, inheritances, the recommended initial withdrawal rates vary considerably from and seem to be appreciably higher from the base case 4.15%. Yet Bengen obviously thinks these would work ok since he insists on the importance of leaving a substantial margin of safety in choosing how much to withdraw. There is one improvement to this chapter I'd like to see: instead of calculating a future model portfolio value using average past returns for every year, Bengen should show what happens in the worst case scenarios of past markets. People who see a projected portfolio that continues to rise in real terms with steady 8.3% in returns every year might scale back their initial withdrawal rate considerably if they see that a severe bear market combined with high inflation, such as happened in the 1970s, could bring them close to portfolio exhaustion.

Another caveat is that actual investment returns modeled on indices such as the Ibbotson data used in this book, cannot and will not be achievable. Bengen does not name any mutual funds of ETFs an investor could actually buy. Though the costs of running the mutual funds and ETFs will theoretically lower their returns by that amount and cause them to systematically under-perform the index, it seems that some funds like the Vanguard Small Cap ETF actually outperform the index (see Seeking Alpha's Indexing: Mutual Funds vs. ETFs and Beating The Benchmark). So it's hard to say absolutely that using index returns is an error.

Many mutual funds, especially those in Canada with outlandishly high fees, are wont to seriously and continuously under-perform. Bengen's chapter 7 on chronic under-performance from active management gives us a way to estimate the penalty - e.g. a 60% equity portfolio with a 30-year horizon would have to reduce the withdrawal rate by 0.3% to compensate for a 1% decrease in average stock returns.

A Canadian investor trying to emulate the same investment approach with the TSX index and Canadian bonds might not be able to achieve exactly the same returns. We could not thus expect to set a sustainable withdrawal rate quite as high as Bengen describes for US investors since Canada's real returns on equities and bonds have been slightly less than the USA's over the period 1900 to 2008 per the Credit Suisse Global Investment Returns Yearbook 2009 by Elroy Dimson, Paul Marsh and Mike Staunton.

Another limitation, which he admits freely in the book, is that other asset classes now available were excluded from the analysis due to lack of long term historical data. He does say that he believes those additional types of assets probably would benefit retirees' portfolios but they are not modeled.

A final caveat is that the scenarios assume that other sources of income, notably annuities, are taken as a given, but in fact, a key choice for a retiree is how much of a retirement account to annuitize, as Moshe Milevsky points out in his recent book Are You a Stock or a Bond? A portfolio does not stand alone as a source of returns, inflation protection or reduction of income variability.

The book is addressed to financial advisors but every individual intending to manage their own investments in retirement will benefit enormously from buying it.

My rating (à la Bengen): 4.83 basic plus 0.17 boost for the many blog post ideas it gave me = 5.00 out of five stars

Postscript: Bengen is a fee-only advisor. When I sent him an enquiry form on his website to ask about some aspects of the book, within an hour he sent an email saying I should phone, which I did and lo and behold, he was there and took my call. If he does that for a lowly blogger I bet his clients are happy, not to mention well-served by the application of the knowledge in this book.

The Perfect Investment Storm for Retirees

Ever wonder what was the worst possible time to retire? Most people might guess that it was around the time of the Great Depression of the 1930s. That's wrong. The generation of retirees hit hardest since the 1920s was that starting retirement in the mid to late 1960s, just before the perfect storm of the 1970s, which combined a severe bear market in 1973-74 with a period of high inflation. The double whammy of lower equity values along with higher withdrawals to maintain a lifestyle would have depleted a 60% equity 40% bond portfolio about 5 years faster than the worst possible quarter to start retirement during the late 1920s. It wasn't just one or two quarters of retirees that suffered, it was a whole generation of those retiring from about 1962 to 1972. I came across this surprising fact in William Bengen's book Conserving Client Portfolios During Retirement (see figure 5A on page 58). Jim Otar's new book Unveiling the Retirement Myth available at his Retirement Optimizer website shows the same result (page 115 of the green online version, in the chapter on inflation).

It's a reminder to retirees to be concerned about inflation. The last dozen years or so, inflation has been very stable and low - around 2% per year. But will that continue? Certainly it is a central objective of governments but will they be successful in containing inflation if government deficits and borrowing grow out of control?