The Value of Good Advice

The following is an excerpt from our Q1 2017 Commentary and Review

In a recent CNBC interview, Warren Buffett made mention of the fact that investors were overpaying for advice. The thrust of his position was that investors were paying high fees, which penalized their portfolio, effectively preventing them from reaching their goals. His focus was on mutual fund fees and fees paid to hedge funds that were as high as 2% of assets plus a performance bonus of 20% for returns above a certain threshold. Being in the business of providing investment advice, these comments hit home from a couple of perspectives. On the one hand, I agree that mutual fund fees are too high. Investors with at least $100,000 in assets should probably graduate to separately managed accounts with transparent fees that scale down based on the size of the individual’s portfolio.

Secondly his comments on the fees associated with hedge funds were spot on. Investors who invest in hedge funds with a 2 and 20 fee schedule are grievously overpaying. The performance bonus alone provides significant advantages to the fund manager with virtually zero benefit to the unitholders. In fact, you could argue – which I have done in the past – that performance fees are a net negative to investors because they lead to risk taking that is rarely in the investor’s best interest. I think of the over-weighted losing position that Pershing Square Hedge Fund manager Bill Ackman took in Valeant Pharmaceuticals as a case in point.

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Portfolio Diversifiers

I assume that all investors understand the value of diversification. It is all about developing a long-term portfolio strategy that will deliver performance within a tolerable level of risk.

Bonds are typically used as a portfolio diversifier. The fixed rate of interest delivers critical cash flow to the portfolio to offset the principal risk associated with equities. However, that fixed payout can cause fluctuations in the bonds’ price particularly in a rising rate cycle. When rates rise, the value of the bond declines and the longer the term to maturity the greater the impact that has on the price of the bond. In the current rising rate environment, bonds may be the highest risk asset in the portfolio.

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Are Equity Markets Overvalued?

Are the global equity markets overvalued? Given an eight-year bull run where equity valuations have more than doubled, one could argue that markets are… pick the colloquialism of choice; frothy, extended, in a bubble, in correction territory.

While I understand heightened levels of anxiety given the 2000 tech bubble and 2008 financial crisis, one should be cautious about establishing a line in the sand drawn from a period following a major market meltdown. While it is true equity markets have more than doubled since the financial crisis, valuations on a longer-term basis do not look nearly as fearsome. For example, the Dow Jones Industrial average is currently at 21,100 – give or take a few points. Since 1999, when the Dow crossed 10,000 for the first time. This represents a 4.69% annual return over that the last seventeen years. Hardly irrational exuberance!

And what about sentiment? Bull markets typically end when investors are euphoric. Believing that stocks have no where to go but up. When stocks rally after less than favorable earnings results, you want to worry. When you are offered investing advice from a taxi or Uber driver you might want to hedge your bets. But, in this environment, I see none of that. If anything, just the opposite.

Investors are worried as stocks continue to climb a wall of worry. Companies are punished for missing their quarter and rise within normal standard deviations when earnings top expectations. That tells us a couple of things; 1) analysts seem to have a good handle on current trends and 2) investors are guarded about making decisions based on short term data.

After a generation of sub-par returns and regulation overkill, valuations are moving higher, albeit at a measured pace. Expectations about the pace of economic growth remain sanguine and fiscal stimulus, tax cuts and de-regulation while on the horizon, do not seem to be driving sentiment. None of this is what you would expect to see at a market top.

But that’s sentiment which is, by definition, fickle. The real worry is when investors make decisions in a vacuum. On the surface one could argue that, price to earnings, price to book or price to sales are well above average levels. But without having a baseline on which to compare, such analysis only tells half the story.

To accurately reflect valuation, one must examine fundamentals on a relative basis against competing assets. For example, how do current price to earnings or more appropriately its’ reciprocal, the earnings yield[1], measure up against interest rates on ten-year US government treasuries. We cite ten-year US government treasuries because that’s one of the baselines institutional investors use to allocate capital between fixed income and equity assets.

To add a bit of meat to that skeleton, it’s important to understand that institutional investors which represent 70% of the current market value, hold a mix of equity and fixed income assets. The choice of where to deploy new money reflects the potential return and risk of one asset class versus the other. Managers allocate new capital based of the yield they can get on equities (i.e. earnings yield) versus fixed income assets (i.e. current interest rates) adjusted for risk. Risk adjustment reflects the fact that equities are more volatile than fixed income assets. The idea is to buy equities when the earnings yield provides a positive risk adjusted return relative to the yield on ten-year treasuries.

One caveat is that the earnings as defined represents historical numbers. There can be major differences between the historical earnings yield which is calculated ex-ante based on numbers from the preceding four quarters versus the forward earnings yield which is based on expectations for earnings over the ensuing four quarters. If you think that US GDP will grow at 2% per annum, which is the baseline consensus number, that would cause earnings to grow at some multiple of that based on historical precedence. Forward earnings are a key driver professional investors use to assess equity risk versus fixed income potential. But that’s a story for another day.

Keeping with the interest rate baseline theme you can see how it is used in virtually every financial decision we make. For example, if one were to look at the median value of property in the city of Toronto, you could argue homepricesthat we are in a bubble. According, to statistics from the Toronto Real Estate Board[2], the median price for residential real estate in Toronto – including condos, townhouses, semis and detached homes – is just shy of $750,000. In 1990, the median price was around $450,000, which was just before the market crashed
some 30%.

Historically, the cost of a five-year fixed rate mortgage in 1990 was 12.01%. Today that same mortgage can be had for about 3.25% (depending on the credit quality of the borrower). If we are to compare apples to apples, the interest cost of carrying the average Toronto property in 1990 was about $4,500 per month, versus about $2,000 per month to carry the same property at todays price. In that sense, the housing market does not seem nearly as inflated as it was in 1990.

How much interest we pay to purchase an automobile or any large ticket item follows along the same lines. In short, interest is the anchor on the end of a teeter-totter sitting opposite the price of the asset we are considering for purchase.

So much for the metrics that support how investment assets are valued. Armed with that basic data, we need to turn our attention to the fundamentals in today’s economic landscape and compare these to fundamentals that existed prior to the tech bubble and the financial crisis.

The tech and financial crisis were both preceded by flaws in the economy. Tech stocks were fetching valuations that were not supported by earnings. In some cases, tech companies were purchased based on forward earnings more than a generation away. In its purest sense, it was euphoria supported by greed.

The financial crisis was a real estate debacle fueled by dishonesty and Wall street manipulation. Both of which have been muted by a more stringent regulatory environment. And while you could argue that President Trump is seeking to hone in regulation, any changes would require Congressional and Senate approval which at present, requires a 60% majority. The Republicans do not exert that much control in either house.

What you want to focus on are the positive initiatives being promoted by President Trump. Lower corporate taxes and massive infrastructure spending, both of which have a good chance of passing. As mentioned, I don’t think either of these scenarios have been underpinning the current move in equity prices. I believe current valuations have more to do with the earnings trajectory – yes… we have real earnings – and the fact government will be more supportive of business.

In fact, I think that the major anchor weighing on business is the potential for a border tax. My guess is that the border tax may never come to pass, and if it does, will be less punitive than a worst-case scenario. More likely this is a bargaining chip, sort of an opening salvo in renegotiating trade deals, right out of Trump’s book; The Art of The Deal.

Another consideration is higher interest rates. No one doubts that rates will rise. But it really comes down to the number of rate hikes and the degree of each hike. If we get three rounds of 25 basis point hikes in 2017 – that’s the current consensus – we end up with a 1% Fed overnight rate and long term mortgage rates around 4.5%. Neither of these should have much of an impact on GDP growth if, at the same time, wages are rising and unemployment remains below 5%.

In terms of the unemployment rate there has been much talk about the number of individuals who have left the labor force because they could not find gainful employment. They simply gave up looking which tends to skew the employment data. However, I would argue that most of those leaving the labor force are retiring baby boomers. That’s very different from someone who cannot find a job because retirees receive income from their pensions and continue to contribute to economic growth.

Another consideration is credit which remains vibrant. That’s key to economic growth. US banks have been reluctant to loan given the credit quality of the borrowers. But over the last eight years that’s improved significantly as Americans de-leverage. If we get a friendly lending environment – i.e. less regulation – that too will spur activity. Again, not necessary to support higher prices, but if it comes to pass, the so-called Trump rally may be only the beginning.

With all that said we will have a correction at some point. I think there is a 100% chance we will have a 5% correction in 2017. But that’s normal and does not by itself, imply a change in the long-term trend in equity valuations. In fact, a 5% correction historically occurs about once a year no matter the trend in the market which is why every investor should develop portfolio strategies that temper downturns.

The Portfolio Approach

Having laid out a thesis that markets are not overvalued does not imply one should hold a portfolio of 100% equities. A portfolio must include a balance of equity and fixed income assets where the weighting applied to each asset class reflects the objectives and risk tolerance of the investor. The challenge in my mind is holding fixed income assets in an environment where interest rates are expected to rise.

When you think about bonds understand that the price of the bond floats while the interest rate remains fixed. When rates rise, the value of the bond declines and the longer the term to maturity the greater the impact that has on the price of the bond. From my perspective, bonds may well be the highest risk asset within a portfolio. One way around this is to look for bond alternatives such as preferred shares and good quality real estate investment trusts.

I am suggesting good quality preferred shares as a fixed income substitute because I believe they are undervalued relative to bonds. Prior to the financial crisis good quality preferred shares (rated P1 or P2) typically traded at a yield that was 80% of the yield on the same company’s ten year corporate bonds. The yield differential reflected the tax advantages of earning dividend income versus interest income. In short, the after-tax yield in a non-registered account from a preferred share was slightly higher than the after- tax yield on the company’s corporate bonds. And prior to the financial crisis most market participants believed that good quality preferred shares were not that much riskier than the bonds on the same company.

The financial crisis changed all that. Many good quality US preferred shares stopped paying dividends because management could do so without fear of plunging their company into bankruptcy. While the interest payments on bonds are mandated through the bond’s indenture no such protection exists for preferred shareholders. Unfortunately, many Canadian preferred shares got painted with the same brush though most continued to pay dividends throughout the financial crisis. The result, Canadian preferred shares are currently yielding about 120% of the yield payable on the company’s ten year corporate bonds. That change in valuation makes these instruments an excellent alternative to bonds.

If you want further protection, consider buying so-called reset preferred shares where the dividend is adjusted based on either the prime rate or the current rate payable on government bonds. With interest rates expected to rise, these preferred share payouts will increase which will support their price. One security you might consider is the iShares Canadian Preferred Share Index ETF (TMX: symbol CPD, recent price $13.90) which is over-weighted in reset preferred shares. CPD also pays a monthly distribution of 5.122 cents per share which yields 4.584%.

In terms of real estate investment trusts (REIT), I prefer to focus on quality which leads me to the RioCan REIT (TMX: REI.UN, recent price: $26.35). RioCan also pays a monthly distribution equal to 11.75 cents per share for a yield of 5.351%.

[1] The earnings yield is simply a reciprocal of the price to earnings metric. For example, at the end of February, the S&P 500 composite index was trading at 2364. The previous year’s earnings were $92.56 (US Dollars). If we divide the current value for the index by the earnings, we get a price to earnings multiple of 25.54. We calculate the earnings yield by dividing the price to earnings multiple (25.54) into 1. Based on that calculation, the current earnings yield on the S&P 500 index is 3.92%.
[2] See http://www.torontohomes-for-sale.com/4a_custpage_2578.html

Synthetic Stock Positions

By Richard N. Croft

As the name suggests, a synthetic stock position is equivalent to a long stock position. Similar risk reward parameters but with some structural advantages for investors who want to utilize the strategy within registered accounts.

In this column, we will focus on Canadian bank stocks. What else is new! Like it or not banks are in a sweet spot. Expect higher interest rates which improves margins and if we get a stronger Canadian economy, more loans.  De-regulation is also a possibility which will have the greatest benefit for Canadian banks who do business in the US. That said, I am not suggesting these positions with de-regulation in mind.

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Time Weighted vs. Money Weighted Rates of Return

By Alex Brandolini CFA
Portfolio Manager

Time Weighted vs. Money Weighted Return

The time-weighted rate of return is appropriate when calculating the performance of broad market indices and mutual funds because the effect of contributions and withdrawals are not taken into account in the calculation methodology.  This is because contributions and withdrawals can impact performance but are not under the control of the portfolio manager.  When comparing the general performance of your portfolio or of your portfolio manager against benchmarks, the time-weighted rate of return is the most appropriate method.

The money-weighted rate of return represents the average growth rate of all funds in the account over a given time period.  Both the timing and amounts of contributions and withdrawals have an effect and are taken into account when calculating performance.

To illustrate with an example, if a client makes a contribution right before a significant increase or decrease in portfolio performance, the money-weighted gain, or loss, will be higher than that of the time-weighted rate of return.  Conversely, if a client makes a withdrawal right before a significant increase or decrease in performance, the money-weighted gain, or loss, will be less than that of the time-weighted rate of return.

Since portfolio managers normally compare their own performance to benchmarks most, including Croft, have used time-weighted return reports exclusively to make comparisons exclusive of each client’s individual cash flows. However, given the industry’s move toward transparency (new, industry-wide CRM 2 reporting requirements) and the need for an investor to be able to judge where they are at with respect to their costs and personal financial plan, money-weighted rate of return is now required for all Canadian investment account reporting.

Beginning with current Q3 reports, Croft has chosen to present both time-weighted return and money-weighted return performance numbers for comparison at both the Relationship (combined portfolio) and individual Client Account levels.

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After Trump?

By Richard N. Croft

AFTER TRUMP? Surprise!!! To say that Trump’s ascension to the Presidency caught the markets off guard would be an understatement. Consider the overwhelming evidence! Leading up to the election the S&P 500 index experienced nine straight down days. A sell-off directly related to FBI Director James Comey’s letter re-opening the Clinton email probe citing possible new evidence that came to light in an unrelated investigation. As the polls tightened, the market sell-off continued. On the week-end prior to the election, Director Comey sent a follow-up letter to Congress in which he closed the investigation having found nothing in the subsequent email review. Following the election driven script, markets perked up on Monday November 7th and by the close of trading, had erased most of the losses from the previous nine-day swoon.

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Great Expectations?

The following is an excerpt by Richard N. Croft from our Q3 Market Review & Managers’ Commentary

In response to a cryptic question about his expectations, the Le Chiffre character in Casino Royale stated; “I believe in a reasonable rate of return.” Whether in a James Bond movie or today’s financial markets, the challenge is to determine what return is reasonable in order to avoid disappointment …or worse.

Professional money managers recognize that performance expectations rarely jive with reality. That’s a concern because unrealistic expectations usually cause investors to stretch their risk appetite in search of higher returns.

When we look at investor surveys there is a prevailing view that double digit returns are possible over the long term—likely because that is what we have seen since the equity markets bottomed in March 2009. Unfortunately, the performance metrics associated with that short glimpse of history are not supported by return data since the “dot com” bust at the turn of this century.

With all due respect to the industry-wide caveat that historical returns are not necessarily indicative of future performance, we cannot ignore long term trends if doing so results in unrealistic expectations. And the previous 16+ years of data comes nowhere close to current expectations about future growth!

Consider iShares S&P/TSX 60 Index Fund (symbol XIU) which is an excellent proxy for Canadian equity markets. On a price basis, XIU returned approximately 0.85% per annum from its high in early September 2000.

If you add back dividends the numbers look better, approximating 3.15% compounded annually over the same period.

In our view, it is better to develop reasonable metrics on which to forecast future growth and then adapt a portfolio to operate effectively within the constraints of the model. That’s why our Investment Review Committee has been so engaged in discussions around performance metrics for the global equity markets. If we can paraphrase Bob Dylan, the numbers, “they are a changing!”

 So… what’s a reasonable rate of return?

Reasonable expectations begin with an assessment of the economy in terms of its potential and pitfalls. Since the Canadian economy is influenced by exports to the U.S. as our largest trading partner, the potential and pitfalls are one in the same.

From our perspective, despite “Trumped” up criticisms (pun intended), the U.S. economy looks like a decent house on a bad street. Unfortunately, the homeowners are powerful, angry, divided and frustrated – a combination that could have dire repercussions for the neighbors. We believe over time that cooler heads will prevail because of the United States’ resilient middle class and predisposition to innovate.

In that light we see the Canadian economy as certainly not bed ridden and, despite the collapse in oil prices, with some room for optimism. That said, the Canadian economy functions between a rock (central bank largesse) and a hard place (a tepid global recovery). The implication being tepid growth for Canadian GDP, which will likely finish 2016 between 1.0% and 1.5% rather than the 2.0% to 3.0% range that approximates historical norms. Let’s say, few headwinds but walking slowly up a slight incline.

On the other side of the coin we have low interest rates and no evidence that rates will rise significantly or any time soon. We expect a quarter point hike in the US Federal Funds rate at the December meeting with perhaps another quarter point in 2017 and again in 2018.

Low rates are positive for borrowers, but not so much for income seeking investors. Low rates also lead to asset bubbles such as we see with real estate in Vancouver and Toronto, and as some would say, with overvalued equity markets. There lies the rub!

So, the objective is to build an investment thesis that optimizes returns in a low-rate, non-inflationary environment with toned-down growth expectations and equity and other asset prices at or near all-time highs. No small task!

A good place to start is to re-think the role dividends play in a portfolios’ total return. If you believe, as we do, that mid-single digit returns are the new long term norm, then mature blue chip dividend paying stocks should anchor every portfolio. If we add option writing to this mix, the combination of dividends and premium income should deliver returns in line with the new norms but with less overall risk.

Consider as a case in point BCE Inc., which is trading around $60.50. BCE is a blue chip Canadian company paying an annual dividend of $2.72 per share, which equates to a 4.52% yield. Further, BCE has increased its dividend every year since the financial crisis. As a standalone investment, BCE meets much of our criteria.

Now add options to the equation. If we sell covered calls on BCE, which is what we do in our CPC Option Writing Pool, we can enhance our return while reducing our risk.

For example, at the time of writing the BCE May 62 options were trading around $1.35 per share. By selling the BCE May 62 (covered) calls we have taken on an obligation to sell the BCE shares we hold at $62 between now and next May.

We receive $1.35 per share as compensation for assuming that obligation.

If the option is exercised at the May expiration, we would sell our BCE shares to the call buyer for $62 and retain the $1.35 per share premium we received when we sold the call option. That generates a net seven-month return of 4.71% not including the dividends.

Add in two quarterly dividends over the next seven months and the total ‘holding period’ return jumps to 6.96%.

Even if the stock remains unchanged between now and May the net return including dividends and the option premium is 4.48%. Moreover, the premium received from the sale of the option reduces the cost base on the stock to $59.15. That being the downside breakeven for the position.

From our perspective this type of strategy offers a reasonable trade-off between risk and return. When implemented as part of a diversified portfolio we believe it has a high probability of delivering returns in the mid-to-high single digits without requiring a large upside move in asset prices from current levels.

Perhaps the financial markets seem to afford less than great expectations for now, but our view is that there is always a way to do a bit better than just a reasonable rate of return!

Covered Call Horror Stories

By Richard N. Croft

In the late 1990s I sold a covered call on, let’s call the security, XYZ. A “nom de plume” to protect the guilty… or innocent, depending on your point of view.

In any event, XYZ was a particularly volatile technology company trading at $21.75 per share in January 1998. I bought the shares for myself and clients and immediately sold January (1999) 22.50 calls at $4.75 per share. Looked pretty good when I entered the trade. The one year return assuming XYZ was called away, came in at 32.3%.

A much better return than the TSX composite index with significantly less risk as it turned out. To be fair, I need to qualify what I mean by less risk. Investors do not view risk in terms of volatility but rather focus on downside risk which equates to the likelihood of losing part or all of one’s initial investment. At least initially!

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Is Volatility Gone…or Just Forgotten

By Richard N. Croft

In an environment where we see sluggish growth among industrialized countries, global deflation, weak oil prices, political indecision in the US and negative interest rates, one could argue we are living in the worst of times. Add to that mix company specific events like missed earnings and questionable government regulation and we have a classic tug of war between bulls and bears. More worrisome to me is the undue influence that company specific events are having on the broader market.

I say that because one would think in such an uncertain environment that option writers would be generating well above average returns. No so much! Mainly because uncertainty in the broader markets and even among the sectors, is not being translated into higher option premiums. Leading one to ask, is volatility gone, or just forgotten?

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The Doubling Strategy

By Richard N. Croft

This week, rather than looking at short term trading opportunities, we will examine a longer term strategy that is not dependent on a directional bet for the underlying stock. What it comes down to is positioning. Is this a stock you would be willing to hold longer term, what role will it play in your portfolio (i.e. risk reduction, return enhancement, etc.), what cost is reasonable? Assuming you are comfortable holding the underlying stock and have a rudimentary understanding of the role it will play in your portfolio, options can address acquisition cost.

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