Q1 2018 Managers’ Commentary and Review

Applying Chaos Theory to the Financial Markets

President Trump likes chaos. Financial markets do not. Those facts became abundantly clear for the equity markets in general, and Amazon shareholders in particular, during the last week of March. As investors, the trick is to keep focus on the longer term while dodging the shorter-term darts hurled from a reckless twitter feed. To do that we need to have a rudimentary understanding about what makes President Trump tick.

On the surface it appears that we are dealing with a man who has a narcissistic personality disorder and is quite willing to engage in self-indulgent payback, even if it means slamming mega-companies like Amazon. In this case, the payback is aimed at Jeff Bezos, the billionaire president of Amazon.  Mr. Bezos just happens to own the Washington Post, which editorially has been one of the harshest critics of the Trump Presidency.

But Trump’s mastery of the get-even psyche only scratches the surface – and it may not be all bad because, underneath it all, Trump is not a politician. His outside voice has no filter and it aligns perfectly with his inside voice. That’s unique because most politicians’ outside and inside voices have never even had a first date.

We also know that Trump’s approach to negotiating is based on a stick and carrot approach. We have witnessed this throw-a-hand-grenade-into-a-room-and-walk-away-strategy play out in the US refusal to endorse the Trans Pacific Partnership (TPP), clashes with NATO about cost sharing arrangements, the tumultuous NAFTA negotiations and, more recently, pressuring North Korea to bend under the weight of sanctions.

The steel tariffs were the most recent volley in this chaotic approach to negotiating. The very notion of such tariffs was enough to send fearful shivers of an all-out trade war through financial markets. That doomsday scenario, however, was never a likely outcome because there is a vast chasm between Trump bluster and realpolitik economic reality.

Hence, the threatened imposition of large steel and aluminum tariffs is clearly a political move and there is no chance that an all-out trade war would ensue.

Trump gains nothing from a trade war especially if the other side targets his base. Notice I said Trump and not the US. Make no mistake – everything we have witnessed is about Trump and has little to do with American domestic interests. That’s important because with his personality, the President is not about to engage in a trade war that provides no political upside.

So why do this at all? In this case, the steel and aluminum tariffs were floated to prop up the chances that the Republican candidate would win a Congressional seat up for grabs in Pennsylvania (America’s steel capital).  More to the point, this Congressional seat is in a solid Republican District that Trump had won by more than 20 points during the previous election. With all the pomp and ceremony of a reality show Trump signed the Tariff order surrounded by steel workers at the White House.

The Democrats ultimately won that seat and, as for the 25% tariffs on steel and aluminum, almost every major trading partner except for China, which was always the primary target, has been granted an exemption effectively rendering the penalties moot.

China has already responded tit for tat with countervailing duties on pork and other agricultural products intended to apply maximum pressure on, you guessed it, States that form Trump’s base. But to me this is likely the opening salvos in trade negotiations that will begin in earnest later this year. The end game will see the US standing firm on the transfer of intellectual property with the quid pro quo likely to be more favorable treatment for Chinese imports. As both sides play to the gallery, likely causing additional volatility in the financial markets, the trick is wading through the mid-game.

There are positives to Trump’s approach. When he came into office he threatened to leave NATO. His rationale was that most of the NATO partners were not carrying their fair share of the costs. Within months the other NATO countries started upping their contributions. Clearly his threat worked.

With regards to NAFTA, frequent threats of cancellation have culminated with invocation of the “nuclear option” (whatever that may mean) with regards to Mexico and immigration.  Yet, at the same time, there is word of real progress and even an eagerness to conclude a deal – on the President’s own politically-shortened timelines.

He also got North Korea to the bargaining table – something that no other President has been able to do. In the lead up to negotiations with North Korea, Trump has maintained the maximum pressure campaign and for good measure appointed two hard line staffers (Bolton as the new National Security Advisor and Pompeo as Tillerson’s replacement for Secretary of State) to act as his supporting cast. I suspect Trump sees a successful North Korea summit as the best chance to turn around his numbers. Because of its importance he likely will get a favorable outcome, which could be good and bad.

Shorter-term, a clear victory would be a positive for the financial markets as it would provide stability in a region that is strategically and economically important. On the downside, it will support Trump’s position that his negotiating approach is spot-on, meaning we are likely to see more of the same in the coming months.

The challenge is to maintain a well-thought-out investment strategy that takes advantage of Trump’s bluster while managing the risk that his altered universe may become reality. Bluster creates buying opportunities in financial markets while an altered reality could traumatize global trade and investment values longer-term.

And there’s the rub! Weighing the probability of taking a simple long or short position based on potential outcomes that are Presidential-personality dependent is almost impossible. But if we enhance buy and sell decisions with options we can exponentially increase the chance of a positive outcome. At a minimum, we get paid to assume the additional risk.

To that point in the current environment many of our portfolios are benefiting from option contract premiums that are about double what we were collecting at the end of last year. Higher premiums provide cash flow for investors seeking tax advantaged income (option premiums are taxed as a capital gain in Canada) and provides a hedge against downside movements, which should benefit investors notably in the second and third quarter of 2018.

Think of this as our strategy to reduce the chaotic fallout from President Trump’s future “nuclear option” threats.

Richard N Croft
Portfolio Manager

 TCG534 Income Pool

In the first quarter of 2018 we increased equity exposure and reduced the allocation to preferred shares the Income Pool, resulting in a significant 24% shift in asset allocation. This shift was in response to the early February market sell off, which brought equities’ valuations back in line with reasonable levels, and to an 80% increase in implied volatility, which made equity option writing (selling) very attractive.

The pool’s overall equities allocation now over-weights the Information Technology and Financial Sectors. The Information Technology sector has strong fundamentals and free-cash-flow valuations are competitive. The Financial Sector is expected to experience EPS growth of 30% due to higher interest rates and improved credit performance.

As of January 1, 2018, we initiated a 5% annual distribution in the pool, paid monthly, which is funded by income derived from interest, dividends, and option premiums. To that end in Q1 2018 we employed the increased equities allocation in a covered call strategy, which capitalizes on the expensive option market and depressed equity prices.

To reduce volatility within the pool, we also increased allocation to gold through select resource companies. Gold typically exhibits a negative correlation to the overall equities market and acts as a hedge against equity risk. To increase cash flow in the pool and reduce the cost of hedging, we are also selling calls on the gold exposure, and we expect to maintain this strategy until the valuation of gold companies exceeds reasonable levels.

The correction and increased volatility during Q1 also provided us with an opportunity to unwind a hedge that we had put in place early in 2017. To address concerns of heightened equity valuations we purchased long-duration SPY (S&P 500 index) puts.   Since most of 2017 was a period of extraordinarily low volatility, these puts were trading at historic lows. After equity markets sold off and volatility spiked In the first week of February 2018, we sold these puts at a significant profit.

Mark McAdam, CFA
Portfolio Manager


TCG531 Equity Growth Pool

After an uncommonly comfortable and profitable 2017, Q1 2018 yielded the first US equity market correction since Donald Trump took office.  While most investors view such corrections negatively, in some ways we welcome the event as both a healthy adjustment and a new investment opportunity. Through January 2018, US markets got a bit ahead of themselves as tax reform materialized and price-earnings multiples became quite stretched.  While multiple expansion is a sign of a healthy economy, valuations must be reasonable if we are to continue to invest.

That’s not to say we were unprepared.  By design, the Equity Pool contains companies with favourable growth prospects, healthy balance sheets and stable price behavior, with which we aim to build and maintain a portfolio that will go down less when markets get rough.  So far in Q1 2018 we have been able to achieve this goal.

However, the volatility that returned to the market in February marked our entry into a new investment regime.  With US tax cuts behind us, many market participants lost their focus and investors started paying attention to other things such as uncertainty surrounding global trade.

Higher volatility also means opportunities to write (sell) options and collect greater premiums for bearing the risk of the underlying stock.  The question most people ask at this point is: if markets are getting riskier why continue to bear that risk and write options?  Fundamentally, it is because we are comfortable pricing that risk (with options) and we don’t think markets will drop much further in the near term.

While there are reasons to believe we are in the mature phase of the macroeconomic cycle, we probably still have a couple of more years to go. Unemployment is low and wage inflation is on the rise.  Further, tax cut savings are supporting a new business investment cycle.  Any money companies have left over is invested into employee compensation and share buyback programs, which are both good for markets and the economy.

Looking out to the rest of 2018, we see broadly-based sales and EPS growth across all sectors, which suggests that bottom-line earnings growth is moving beyond mere tax cuts and is now supported by top-line sales growth as well. While the recent era of steady growth with low volatility is unlikely to resume, we are optimistic about the year in general and stand ready with the necessary tools to navigate what comes ahead.

 Alex Brandolini, CFA
Portfolio Manager

 TCG539 Option Writing Pool
A Tale of Two Periods

Like the great Dickens novel, A Tale of Two Cities, it is both the best and worst of times for the Option Writing Pool, which experienced in Q1 2018 its first quarterly loss since it was launched in February 2016. The Option Writing Pool is designed to provide consistent, tax advantaged income to investors and as such now forms an important component of our new Enhanced mandates. The strategy is to manage risk within the pool by writing (selling) options that expire at different times, benefiting from the time value erosion.

The tale of most of the period since the pools inception was one of low market price volatility, which is the main variable in how options are priced. Higher volatility translates into higher premiums for longer periods – we get more when we sell the option – while a low volatility market has the opposite effect. In a low volatility scenario, the objective is to sell options close to maturity – sometimes within a week of their expiry – to benefit more frequently from the maximum decay of smaller premiums.  This best/worst scenario remained broadly in place through January 2018.

Times have changed since the beginning of the year, introducing us to the second financial market tale. Volatility has increased exponentially, which means this an excellent period for selling options as we are now getting much greater premiums for the options we sell.

In this scenario, as long as volatility remains above the historical norm we tend to sell longer-dated options because we can capture the higher volatility and the resulting higher premium. This works well for managing the income within the pool. However, due to the further out expiration date the time value of the larger premiums erodes at a much slower pace.  So, what we will likely experience through the second quarter is a slower uptick on the value of the pool, but at the same time we have banked significant capital to deliver the monthly income, which is critical to our investors.

Based on the current size of the pool we need approximately $2 million dollars to meet the monthly income requirement. We collect about $1.3 million from dividends on the stocks we hold in the portfolio while the remainder is delivered through the sale of call and put options. Altogether, we have already captured the additional cash flow from the sale of the options to meet our income needs. However, as mentioned, we will not likely see that benefit the pool’s price until the late second or early third quarter of this year.

Richard N Croft
Portfolio Manager

We’re Moving!

To support our continuing growth and serve you better, we are excited to announce that as of Monday,   October 23, 2017, R N Croft Financial Group is relocating to a professional and modern facility located close to the intersection of Highway 401 and the Don Valley Parkway in Toronto.  The move will take place on the prior weekend, with operations recommencing at the new location on Monday. Our contact phone numbers and e-mail addresses will remain the same.


R N Croft Financial Group Inc.
251 Consumers Road
Suite 801
Toronto, Ontario
M2J 4R3
Please reach out to Jason Ayres, Director of Business Development if you have questions on the move.



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.


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.


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.

Read more at www.optionmatters.ca

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.

Watch brief video

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.


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!

Read More at OptionMatters.ca a Montreal Exchange initiative