Canada’s Banking Albatross

And How to Benefit from it.



Deathly afraid to enter the stock market, Canadian retail investors are keeping their money in low-yielding GICs and bond funds - if they are investing at all. Mortgage and refinance business has collapsed. The self-employed have entrenched. Business is slow.

With mortgages newly dead and rigor mortis setting in on investing, there is nothing to sustain the currently high stock prices of Canadian banks. As an investor, what can you do to protect yourself, and perhaps make some money in the process? The Frost Report states the case in black and white.

First off, sell your Canadian bank stocks, as well as your Canadian dividend mutual funds (which usually contain 50% bank stocks). In order for stocks to drop, banks don’t need to have a disastrous quarter; they just need to have a quarter that is less spectacular than the last one.

Secondly, sell your Canadian REITs (Real Estate Investment/Income Trusts). There is no point holding on to REITs to generate income when you know that income from real estate will soon drop, and the price of REITs along with it.

Thirdly, buy distant at-the-money put options on Canadian banks, so that you can make a profit on the coming stock price decline. If you don’t know what an at-the-money put option is or how it works, completely ignore this piece of advice, for now is not the time to be learning.

Alternatively, you can buy Inverse financial ETFs, such as the Horizons BetaPro S&P/TSX Capped Financials Bear Plus ETF 2X, (symbol HFD). Again, if you just read this description and have no idea what any of it means, don’t even consider buying HFD. For those who understand, read the full prospectus.

Lastly, Canadians should start paying down debts and building cash reserves. While everyone else is experiencing a crisis, you can be comfortable. Cash gives you a sense of control & security, and, when things start to pick up again (which they always do), you can take advantage of the bargains that will be everywhere.

The Bank of Canada shot the albatross with its low interest rates months ago, and for a while the results looked good. Now, however, the storm is approaching. As with any other impending disaster, preparation is crucial.
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Bank of Montreal reports Tuesday Aug 24th. Analysts expect third-quarter share profit of $1.21, up from $1.05.

Canadian Imperial Bank of Commerce reports Wednesday Aug 25th. Analysts expect third-quarter share profit of $1.53, up from $1.36.

Royal Bank of Canada reports Thursday Aug 26th. Analysts expect third-quarter share profit of $1.02, down from $1.21.
National Bank of Canada also reports Thursday Aug 26th. A third-quarter share profit of $1.52 is expected, down from $1.79.

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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.
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“Instead of the cross, the albatross / About my neck was hung”

The Rime of the Ancyent Marinere, Samuel Taylor Coleridge.
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Socially Responsible Investing

Nice concept. Stupid, but nice.

Socially responsible investing is the art of investing in companies that are morally upright: no arms manufacturers, no tobacco companies, no companies that have questionable labor practices or pollute the environment, nor companies whose employees surf pornography at lunchtime.

The problem with investing in socially responsible companies is that they don’t actually exist. Medium to large companies, no matter what their field of interest, eventually end up with some kind of litigation against them. Human nature says that if you have 500 employees, not all of them will be angels.

Years ago, when I was in the military, I remember the surprise we all felt when we saw the manufacturers of our equipment: “Don’t they make Barbie?” asked one soldier when examining a trademark on his machine gun. “Hey!” said another, “this landmine is the same brand as my cell phone!”

Since the terms “ethical,” “moral,” and “socially responsible” mean different things to different people, the investment choices of your moral mutual fund may not provide you with the peace of mind you were looking for. In the top-ten holdings of your socially responsible mutual fund you will likely find oil & gas companies, pulp & paper manufacturers, mining companies, banks, breweries and property developers. Wal-Mart famously sells semi-automatic rifles but not pornography: which, if either of these do you consider ethical?

The other major issue with socially responsible investing is, of course, the returns. Finding nice companies that stay nice takes a lot of time and effort, and therefore a lot of stock switching (causing high taxation) and high management fees. My $200 socially responsible mutual fund, purchased when I was in high school, has yielded an annual return of about -.02%. The only reason I don’t sell it is because I couldn’t be bothered to pay the transaction fee. And besides, it amuses me to see it there, performing pathetically.

My recommendation is to stop trying to find “clean” companies, and instead choose your vices carefully. If you drive a car, consider purchasing oil stocks. If you wear jewelry, consider a gold or diamond mining company. If you use a computer, consider an electronics manufacturer. If you use fertilizer in your garden, consider a chemical manufacturer.

You are directly supporting these companies anyway – you might as well make money with them.
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“If you pretend to be good, the world takes you very seriously. If you pretend to be bad, it doesn't. Such is the astounding stupidity of optimism.” Oscar Wilde

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.

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!