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Sunday, January 31, 2010

Two Stocks I Like - Oil and Gas Industry

When it comes to stocks, I’m of the Peter Lynch School, which says that you shouldn’t purchase a stock unless you can, a) rationalize your purchase in few sentences, and b) draw what the company does with a crayon. These companies fit the bill.

I have no idea whether these stocks will go up or down in the next 6 hours, days, or weeks, and don’t know anyone who does. My intention is to hold them (I own both) until at least the peak of the next market cycle, or until the company proves to be something other than what I thought (for example, the dreaded words, “accounting irregularities.”)

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Tidewater (TDW) – Tidewater is an offshore oil and gas drilling support-company that owns a fleet including 126 new vessels, making it one of the youngest fleets in the industry. Its ships have low downtime and an excellent safety record. The company has almost no debt, great return on equity, and the stock price is cheap – single digit P/E and close to book value. The company has been buying back shares.

Because Tidewater’s worldwide fleet is mobile, they can sail to wherever the work is. This company is also a manly man stock, with photos of oceangoing vessels all over the annual reports. While this latter point isn’t actually a reason to buy, I enjoy it nonetheless.

Barack Obama recently expressed an interest to expand offshore drilling in the United States: this is not a sufficient reason to buy Tidewater. Buy a stock because the company is great -- not because of a politician, the weather, interest rates, or any other transitory reason.

TDW Statistics (as of writing):
Price $46.81
P/E 6.67
Return on Equity 16.75%
Dividend Yield 2.12%

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Chevron (CVX) – one of the world’s largest and most recognizable energy companies. Chevron owns assets worldwide including Australian natural gas, Canadian oil sands, offshore sites in Brazil, and sites in Nigeria, Kazakhstan, and Tahiti, amongst others.

Recently, Chevron announced that its earnings had declined due to losses from weak refining prices in 2009: something I believe is unlikely to be repeated in the foreseeable future. Chevron’s debt level is low (lower than most energy companies), it has actively been buying back shares, the stock is reasonably priced, and its return on equity is excellent. In addition, its international operations help prevent currency shock.

CVX Statistics (as of writing):
Price $72.80
P/E 11.83
Return on Equity 13.86%
Dividend Yield 3.69%

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Disclosure
Do not buy stocks, or take this or any other financial advice without doing your own analysis; including, but not limited to: reviewing business models, financial statements, management style and philosophy, recent developments, market macroeconomic analysis, and chart analysis. If you do not know how to do these things, you shouldn't be buying stocks in the first place. Seek the advice of professionals, as appropriate.

Monday, January 25, 2010

“Reverse Attribution” – What the News Doesn’t Know



On Jan 21st 2010, President Barack Obama announced that he would limit the amount of “gambling” (i.e. high-risk leveraged trading) that banks would be allowed to do using client money. Traders worried that as a result of this announcement, future bank earnings may not be as high as they’d anticipated, and so stocks dropped. Pretty straightforward, isn’t it? Not really. Investors should be aware that the market is understood via “reverse attribution” (also known as “post hoc ergo propter hoc”). That is, after a market event has occurred, analysts try to determine why it happened and report it as news. In reality, there are limitless reasons for market moves: some simple, some complex, and others masterfully planned.

In 1929, millionaire trader Jesse Livermore sensed a change in the public. After weeks and months of positive news, he sensed that people were getting bored with the “prosperity” story. Livermore knew that a well-known economist, Roger Babson, was going to give a speech the following day, saying that markets were overpriced and due for a crash. Livermore knew that this would be the speech because it was the same speech that Babson had given the previous two years! Recognizing the opportunity, Livermore sold short vast quantities of stock (meaning that he would make a profit if the market declined), and then had his staff of secretaries call every major new agency in the U.S. and alert them to an “important speech” that was about to take place. When the press conference took place, it took place to a packed crowd of eager reporters. The following day, Babson’s dire predictions made front-page headlines, and the market took a frightening dive. This was the beginning of the end for investor confidence in 1929. The infamous” great crash” occurred less than two months later, with many blaming Livermore’s orchestrated press conference as the catalyst that started it.

The market decline that began on Jan 21st 2010 may have been caused by Barack Obama’s pronouncement, as explained in the opening paragraph. Or, it may have been caused by opportunistic traders. For weeks prior, traders had been saying that the market had gone too high and was due for a correction. These traders, upon hearing Obama’s speech -- and seizing the opportunity -- started short-selling bank stocks like mad. The short-selling led to anxiety on the trading floor, causing stocks to drop further. George Soros calls this “reflexivity”: that cause and effect make things that were not previously a reality, a reality. Or, I could be completely wrong, and it could be that a wealthy Arab, for no particular reason whatsoever, decided to sell his bank stocks that day.

A few years ago, a mutual fund manager told me the story of when his mutual fund decided to sell a certain company’s stock. The day they started selling just happened to coincide with an announcement by the same company, saying that they were changing some of their board members. The next days’ headline: “X company stock drops after appointment of new board members: investors not pleased with changes.”

In the book Wall Street Meat, Andy Kessler tells the story of a German banker who decided to have some fun at the bank’s annual Christmas party. The inebriated banker called in a buy order for a massive number of shares in pharmaceutical company Eli Lilly. As the whole party watched the computer monitor in anticipation, the share price ticked higher and higher and higher due to the onslaught from the huge order. When the Dow Jones newswire reported “heavy buying” by a foreign investor, the partygoers screamed with delight. Finally, the New York Stock Exchange halted the buying on rumors that this was a takeover attempt. Disappointed that the fun was over, the partygoers went back to their steins and punchbowls to continue their Christmas celebration. The following morning the large purchase was quietly sold off.

When news agencies simply have no idea why markets are moving, they employ common expressions, most notably “profit taking” (to describe a drop) and “bargain hunting” (to describe a gain). For instance, “the markets went up today on bargain hunting,” is a convenient way to describe an increase in the market on a day with no substantial news. “Profit taking” and “bargain hunting” are your clues that in fact no one has a clue.

On any given day, no one knows exactly why stocks move. Sometimes guesses are (probably) accurate. Sometimes they are dead wrong. Sometimes they cite a single reason when in fact there are several. It’s up to you to dig further than people watching from their sofas. It’s up to you to know that sometimes people manipulate the market for fun or for personal gain, even if it kills grandmother’s retirement plans.

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“Heavy selling out of the Middle East was an old standby. Since no one ever had any clue what the Arabs were doing with their money or why, no story involving Arabs could ever be disputed.” Michael Lewis, Liar’s Poker.

Thursday, January 21, 2010

Barack’s Reforms make Big Banks Cry



Being that I own hordes of bank stocks in my personal portfolio -- and that I work for one -- you might expect me to decry President Obama’s recent pronouncement that big banks will no longer be allowed to engage in certain high-risk trading. On the contrary, I think it’s a perfectly acceptable idea, one that Wall St. professionals have known the practicality of for years.

In 1987, when markets crashed and big banks were “saved,” many thought that this set a dangerous precedent. It was believed that banks, confident that they would be bailed out no matter what their level of gambling, would start acting like hedge funds and go for broke. And they did.

So, while I am dismayed that my annual investment returns may decline a few points due to the proposed changes, I am also grateful that I won’t come back from the bathroom to find my stocks down 80%. In short, I expect my U.S. bank stocks to become more like the banks themselves: large, boring, and immensely profitable.
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“If we bail out this one (Penn Square Bank)…then the markets will know that, no matter what risks they take, the government will bail them out. Eventually, it’s going to lead down the road to nationalization of the banking system.” William Isaac, FDIC chairman, July 1982.
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“CMO equity is a particularly slippery mortgage investment. The CMO stands for Collateralized Mortgage Obligation, but bond salesmen call it ‘toxic waste.’” Michael Lewis, The Money Culture
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“I would confidently predict that most of the derivative books of major banks cannot be liquidated for anything like what they’re carried on the books at. When the denouement will happen and how severe it will be, I don’t know. But I fear the consequences could be fearsome.” Charlie Munger, Poor Charlie’s Almanac, 2005
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The Canadian Housing Market



The bubble is back.

Not content with a single housing bubble, Canadians have apparently decided to ignore reality and give it a second go, especially in Vancouver. Just a few days ago, my mortgage broker confirmed that, just like in the bubble years, multiple bids on properties are back with a vengeance. A typical, two-bedroom bungalow/rancher in the West Side is now priced at 1.3 million dollars, right back to where it was at the peak in 2008.

A few different factors are responsible for this brutal overpricing. First is the typical Vancouverite’s belief that theirs is the greatest city in the world. Granted, Vancouver is a nice place. But, everyone seems to believe the city is so spectacular that Olympic visitors will return to London, Paris, Tokyo etc. and immediately put their homes up for sale so they can move to Vancouver.

Second and more important is the Asian factor. In Vancouver a substantial number of immigrants, mostly from China, are buying residences primarily or completely in cash. Cash purchases are a big factor in propping up high prices; however, they are an even bigger factor in the decision making process for local buyers. Vancouverites are convinced that because of immigration, prices cannot drop; therefore, any price is justifiable, as one will always find a buyer at that new higher price (in economics, this is known as “greater fool theory.”)

Finally, the average Canadian is making a mistake typical for those who know little about finance: they are concentrating on monthly payment amount instead of amount of debt owed. To the financially naive, owing $500,000 at a 2.25% variable interest rate with a monthly payment of $1718 is better than owing $400,000 at a fixed rate of 4% with monthly payments of $1763. More importantly, people are not aware that today's 2.25% variable interest rate, and the resulting barely-affordable monthly payment, will soon be going up.

The governor of the Bank of Canada, Mark Carney, is trying his best to send out the warning ("It is the responsibility of households now to ensure that in the future, when the recovery takes hold and extraordinary measures are unwound, they can service their debts”), but it’s largely falling on deaf ears. While Americans have spent the last two years paying down their credit card and mortgage debt, Canadians have been busy racking it up. The Bank of Canada estimates that by the 4rth quarter of 2011, Canadian personal debt payments will reach record-breaking levels (shattering the previous record set in 2000).

Of course, after the housing bubble bursts for the second time, we’ll probably hear a chorus of, “It’s the fault of the banks. They shouldn’t be approving these loans in the first place!” As a banker, I can say without hesitation that trying to tell a customer they can’t afford to buy their dream home is like telling a child they can’t have ice cream: they throw a tantrum, threaten to run away (take their business elsewhere), and frequently do exactly that. If the next bank doesn’t approve them, they will keep trying until someone does, eventually lying about their assets or income if necessary. People don’t seem to realize that when your banker (who wants to give out loans) tells you that you can’t afford it, maybe you should listen.

And so, the bubble grows…

Mutual Fund 101 - Part II



This is the second post in the series of how to choose mutual funds for investment. Part I covered the very basics (what is a mutual fund) and common terms needed for this article. So now, on to the types of funds themselves and when to buy them…

Money Market Fund – These are very safe, low yielding funds that primarily invest in short-term government bonds and established companies. They are so safe that on financial statements they are considered “cash,” not “investments.” They are not a place to put your money for a long time since returns are low, and may not even beat the rate of inflation. Time Horizon: 6 months-2 years; Best time to buy: growth phase to bubble phase; Worst time to buy: Post-crash (since interest rates are low); Volatility: very low

Bond Fund – “Bonds” are essentially loans that you give to a company. In return, these companies pay you interest. A bond fund is a nice mix of short- and long-term bonds of good companies that pay a rate of interest beating inflation. Almost everyone should own at least some bonds in their investment portfolio.
Time Horizon: 2-3+ years; Best time to buy: growth phase to bubble phase; Worst time to buy: Post-crash (since interest rates are low); Volatility: low to medium

Short-term bond fund – These funds invest primarily in short-term bonds (generally loans that mature in less than 3 years). Short-term bond funds fluctuate in value less than regular bond funds, but also pay less interest. They are a good short-term investment.
Time Horizon: 1-3 years; Best time to buy: growth phase to bubble phase; Worst time to buy: Post-crash (since interest rates are low); Volatility: very low to low

World/International Bond Fund – These bond funds invest in companies all over the world. Since keeping track of the world takes more work, MERs are higher, and world bond funds thus generally under perform. World bond funds tend to fluctuate in value more than regular bond funds.
Time Horizon: 2-3+ years; Best time to buy: growth phase; Worst time to buy: Post-crash (since interest rates are low); Volatility: medium to high

Long-term bond fund - These funds invest primarily in long-term bonds (generally loans that mature in more than 5 years). Long-term bond funds fluctuate in value more than regular bond funds, but also pay more interest. They are a good long-term investment.
Time Horizon: 2-3+ years; Best time to buy: growth phase to bubble phase; Worst time to buy: Post-crash (long-term bond funds lose value when interest rates begin to rise); Volatility: medium to high

High-Yield Bond Fund – A bond fund that intentionally invests in low-quality companies that may be close to bankruptcy. In theory, by investing in many low-quality companies, any losses will be offset by their higher interest rates, resulting in a good overall gain. In reality, most high-yield bond funds under perform regular bond funds due to high MERs and losses. Time Horizon: 3-5+ years; Best time to buy: recovery to growth phase; Worst time to buy: boom and bubble phases (a good economy can hide mediocre business performance); Volatility: high to very high

Equity Fund – An equity fund is any fund that primarily buys company stocks. Generally these funds have a name, such as “US Equity fund” or “Emerging Markets fund,” that tell you where the companies invested in are located. In an equity fund, you pay a manager for choosing the stocks for you, and pay a management fee to do so. Usually these managers do not beat the market, so you are better off buying an Index Fund with a lower MER (ex. buy a US S&P 500 Index Fund instead of a US Equity Fund)
Time Horizon: 3-5+ years; Best time to buy: post crash to growth phase; Worst time to buy: boom and bubble phases; Volatility: high to very high

Equity Index Fund – This is a type of equity fund that, instead of having a manager that chooses the stocks, simply follows a stock market index. For example, many index funds follow the “S&P 500 stock market index,” a list of 500 of the biggest companies in the United States. By owning an S&P 500 index fund, you will own a small portion of 500 different companies. The advantage of index funds is that since there is no active manager, the MER is very low (below 1%). And, because you are only buying large, respected companies, returns are good. For investors with a long time horizon, index funds should form a substantial portion of your total portfolio (50%-80%).
Time Horizon: 3-5+ years; Best time to buy: post crash to growth phase; Worst time to buy: boom and bubble phases; Volatility: high to very high

Dividend Fund – This fund is a type of equity fund that invests in stable, generally older companies that make more money than they need for their internal growth, and so they pay out their extra earnings as dividends. Dividend funds largely consist of old-school companies like banks, insurance companies, and railroads. Though they can fluctuate in value, dividend funds make excellent long-term investments.
Time Horizon: 3-5+ years; Best time to buy: post crash to growth phase; Worst time to buy: boom and bubble phases; Volatility: medium to high

Asset Allocation Fund – This fund is an equity fund that attempts to “time” the market, adjusting to buy the best performing companies at each phase in the market cycle. For investors, these funds usually under perform, due to the high amount of turnover (fees and taxes for buying and selling) and higher MER fees.
Time Horizon: 3-5+ years; Best time to buy: never, in my opinion; Worst time to buy: boom and bubble phases; Volatility: high to very high

Guaranteed Funds – These funds, which go by various names, all have a common feature: if you leave your money in for a certain period of time (usually several years), your principle is guaranteed. That is, if you invest $10,000, you are guaranteed to have your $10,000 returned to you by the maturity date, even if the stock market drops terribly. As compensation for this insurance, these funds typically charge a high MER, or allow you to keep only a percentage of the overall stock market return. Since the maturity date is far in the future, there is very little risk to the issuer that the final level will be below the initial investment; essentially, you are paying for peace of mind. If you have any tolerance for volatility, it’s better to simply own an equity fund with full participation in the market. Guaranteed funds are good, though, for those who are psychologically unable to tolerate volatility or declines. Time Horizon: specific to each fund; Best time to buy: post-crash to growth phase; Worst time to buy: boom and bubble phases; Volatility: guaranteed principle

Income Trust Fund – An income trust is a fund that invests in companies with generally stagnant growth (such as sugar refiners and telephone book printers), but that make a steady income. Income trusts also invest in oil and gas companies, or real estate (known as a REIT). The income trust pays out regular dividends. In a sense then, an income trust is in-between a bond fund and an equity mutual fund. The holder receives regular payments (like a bond fund but with higher interest), but is also subject to higher volatility (like an equity fund). Income trusts are a nice addition to a portfolio.
Time Horizon: 3-5+ years; Best time to buy: post-crash to growth phase; Worst time to buy: boom and bubble phases; Volatility: medium to high

Hedge Fund – To “hedge” means to reduce risk. In the old days, the goal of a hedge fund was to generate a reasonable rate of return, regardless of whether the stock market went up or down. These days, hedge fund refers to a fund that uses large amounts of debt to fund ultra-risky purchases, hopefully providing a great rate of return. Hedge funds typically make spectacular rates of return for a few years, only to lose everything in a single season. Hedge funds are only open to investment by “accredited investors,” meaning either finance industry professionals, or those who are wealthy enough to lose their entire investment and not be destroyed.
Time Horizon: 3-5+ years; Best time to buy: never, unless you know enough about investing to make your own hedge fund; Worst time to buy: boom and bubble phases; Volatility: extreme

A good portfolio should consist of a mix of funds. Generally speaking, the longer the time horizon, the more should be invested in high and medium volatility funds; the shorter the time horizon, the more should be invested in low to medium volatility funds. There is nothing worse then seeing your portfolio value decline just days before you need the money: good time horizon and volatility selection will make sure your funds are available when you need them, yet still get a good rate of return. Good luck and happy investing!
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“Risk is the possibility that the holder of an investment may have to sell it at a time when the price is below cost (including inflation since purchased). ‘Risk’ is often wrongly used to describe cyclical or temporary declines in stock prices, even if the holder need not sell at that time.” Benjamin Graham, The Intelligent Investor.

Tuesday, January 19, 2010

Mutual Fund 101 (The Basics) - Part I


A good friend of mine called recently to ask for advice about what to do with an inheritance. During the call, I realized that while there are many books that describe mutual funds, few actually give it to you straight: here was a gap that needed to be filled. This advice, then, explains the major types of mutual funds, who should buy them, and when. First, you will need to know a few essential terms.

Mutual Fund –A mutual fund is simply a collection of items that you can purchase as a single unit. Say for example, that you have $5000 that you would like to invest in oil and gas companies. One choice would be to buy $5000 worth of stock from a single oil company; however, if that company has financial problems you will lose money. A second option would be to diversify by purchasing $500 worth of stock from 10 different oil and gas companies; however, the purchase fees would be high and the stocks hard to keep track of. The easiest option is to simply buy $5000 worth of “ABC oil and gas fund,” which contains stocks from 10 or 20 companies. Your money is pooled with that of other investors, so that you can diversify while spending a minimal amount of money. And, there is no need to keep track of all the companies, since the mutual fund manager does that for you.

Time Horizon – The number of years before you will need the money you are investing. Misjudging time horizon is probably the most common error that investors make. Every year I ask people, “How soon will you need this money?” All too often I hear, “I probably don’t need it for 10 years or so. But I want to put it in GICs, because I don’t like the market, and I don’t want to lock it in for more than 2 years in case I need it.” This is fear talking. Fear causes you to make stupid financial decisions (such as, in this case, repeatedly buying 2-year GICs that pay a low interest rate). Do yourself a favor. Set aside 3 month’s worth of salary in a savings account, and label it “emergency money.” There. Now, any additional money that you have, you can invest according to your real time horizon without excuses.

Market Cycle – the predictable up and down waves of the economy and market sentiment that drive stock prices. The market cycles are: Post Crash (“have we hit bottom?”), Recovery, Growth, High-growth/Boom (great economic headlines), Bubble, and Crash. You can roughly determine which area of the economic cycle we are in by watching the evening business news, since they will use these phrases exactly. For example, in the recovery phase, you will hear things like, “some analysts say the economy is recovering, but so-and-so disagrees.” During the bubble phase, analysts will be arguing about whether or not there is a bubble. It’s all quite obvious, once you start looking.

MER – Management Expense Ratio. The MER is the fee you pay your mutual fund manager, as well as costs for advertising and administration. Simple funds that don’t take a lot of work to manage will have a low MER (less than 1%), while funds that are more complex will have a higher MER (more than 2%). MERs make a big difference to long-term gains. Say, for example, that you invest $10,000 in each of two funds, one of which has a low MER of .80% (Fund A), and another that has a high MER of 2.00% (Fund B). Both funds make a 10% return every year before expenses, and are otherwise identical. At the end of 10 years, your $10,000 investment in Fund A will be worth $24,111, while your investment in fund B will be worth only $21,985 (a $2126, or 9.6% difference). The longer the time invested, the bigger this gap gets. Generally speaking, high MER funds do not outperform low MER funds. In other words, you don’t get what you pay for.

Volatility – Volatility is the degree to which your investments will fluctuate in price. In the long run, investments trend toward an increase in value. But, they will go up and down, regularly, like the seasons. Retail Investors (non-pros) are infamous for having no tolerance for any decline in the value of their investments. Partially this is due to ignorance (being unaware of market cycles, and thinking that their investments have suddenly “gone bad”), and partially due to fear (“Now I’ll never retire!”). If you invest in stocks, they will be volatile. True professionals don’t always avoid volatility; they just don’t mind it when it happens. The greatest professionals love it and take advantage of it.

Loads/Deferred Sales Charges – Front-end loads are fees that you pay for the “privilege” of buying a mutual fund, while deferred sales charges or back-end loads are fees that you pay when you sell your funds. If you sell your funds too soon -- say within 7 years -- you have to pay a clawback penalty. Depending on the size of your investment, these charges can be hundreds or even thousands of dollars. Back-end loads are called “rear-end loads” by pros to express their effect on clients, which pretty much says it all. Since there are so many great funds available without charges (called no-load funds), simply don’t buy funds that have them. Always ask, “Does this fund have any front- or back-end loads, or deferred charges of any kind?” If the answer is “yes,” you are about to be screwed.

Well, now that you have a foundation for understanding mutual funds, the next step is to review the types of mutual funds and when to buy them! Part II awaits!