The Bottom for Canadian Banks?

I had an interesting conversation with an investing peer Thursday evening about the unexpected change in activity this week in the preferred share and debt markets.

Experienced investors will often make a reference to the fact that, "The Debt Market Knows All."

What is suprising is not the fact that TD Bank (TD), Royal Bank (RY) and CIBC (CM) chose to issue new series of 5-Year Rate Reset preferred shares, but instead the terms of those issues. While many companies have struggled to raise cost effective capital in this difficult economic environment the Canadian banks have been able to raise preferred equity with relative ease.


See Full Spreadsheet

If you took the time to examine the preferred issues over the past 10 months or so there are a few interesting observations:

• TD and RY have each raised over $1B in equity
• RY has continuously issued preferreds at a discount to its peers
• Each 5-Year Rate Reset issue has progressively increased either the initial yield or subsequent reset yield as the cost of capital has increased

The trend, of progressively rising reset yields appeared to have stopped with the most recent three issues with TD, RY and CM's reset yields dropping dramatically from their previous issues.
These "less lucrative terms" as my friend Scott pointed out might be marking the bottom for Canadian banks as they report quarterly earnings and could be raising capital not because they need to, but because they choose to. All of them touched new 52-week lows and quarterly earnings, as of yet, haven't been disastrous.

Only time will tell if this is the bottom, but with valuations tumbling and yields near the historically high end for many of the banks I took the opportunity to increase my positions in RY and Bank of Nova Scotia (BNS) on Tuesday.

Disclosure: I hold shares in BNS, TD & RY

Vote for the Canadian Bank you want to read about in a future stock analysis!

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Canadian Stock Analysis:

Taking Stock in Pfizer (PFE) is now in its final editing stage and will be E-mailed out to SAML subscribers in full on Sunday March 1st, 2009 with a condensed free public version published on TMWTFS on Monday March 9th, 2009.

Earlier this month I placed a poll along the right sidebar of the site asking readers what industry I should choose a stock from to analyze for my first Canadian stock analysis of 2009. Not surprisingly the overwhelming response (52%) was for a Canadian Bank Stock.

I've placed a new poll at the top right of the site where readers can vote for their choice of what stock will be analyzed in the next SAML post. The poll will close on March 31st, 2009 and the company with the highest number of votes will be chosen for the next stock analysis.

The Choices:

• Bank of Montreal (BMO)
• Bank of Nova Scotia (BNS)
• CIBC (CM)
• Royal Bank (RY)
• TD Bank (TD)

Notice: Any blog authors who mentions my poll in a post (with link) will receive a free full analysis on the Canadian Bank chosen by readers when it is published (including all historical data).


Looking for more information on becoming a Stock Analysis Mailing List subscriber? Read the reviews submitted by readers and independent investors on some of my stock analyses.

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C-Suite Survey Reveals Difficulties:

While many individual consumers might not have felt the pinch of a recession in Canada top executives who run some of Canada’s largest corporations have a much different view.

The most recent quarterly C-Suite survey interviewed 150 top executives from Canadian corporations and was conducted between January 29th and February 12th, 2009 by the Gandalf Group and sponsored by KPMG on behalf of CTVglobemedia Publishing Inc.

My interest in the C-Suite surveys are two-fold:

1. As an owner of a business that provides consulting services to small-medium sized businesses I look to utilize resources, statistics and raw data of much larger companies to reveal current trends that individual business owners are facing in any economic climate.
2. As a Do-It-Yourself (DIY) investor I am keenly interested in the behaviour of a broad group of corporate executives in order to gain a sense of opportunities or threats to the operations and profitability of the businesses I own shares in.

There was some very interesting data that the most recent C-Suite survey collected on how executives view the current economic environment, the challenges they are facing and what behaviours/actions they anticipate taking over the next 12 months to better position their businesses for future success.

As I outlined in a few recent posts (I & II) the ability to access credit and the cost of capital is a prohibitive barrier many executives are facing in their daily operations with two-thirds stating it is now more difficult to access credit than ever in their careers. Of the 150 executives who responded to the survey when asked what the biggest challenge facing their company currently they responded:

Access to capital: 35 (23%)
Market fluctuations: 29 (19%)
Economic conditions: 20 (13%)
Organizational challenges: 9 (6%)
Human Resources/Labour: 5 (3%)

With reference to access and cost of capital respondents stated that financing is not only expensive, but the terms and conditions on the loans are restrictive when compared to only six months ago.

An additionally important point I took from reading the survey was the goal of corporate survival with 53% of respondents stating they were concerned about their company’s ability to survive versus only six months ago. What startled me was the candid response of executives that they are conscious that this focus on corporate survival over the short-term will directly impact their ability to perform over the long-term. 40% stated they will be cutting staffing levels over the next 12 months to cut fixed costs and additional cuts to spending, hiring and marketing are already being initiated.

The Impact:

“In response to the worrying economic environment, more companies are trimming their sails by curtailing hiring, or even cutting staff. Almost 40 per cent are planning reductions. And executives are expecting a long siege - almost half say it will be one to two years before they are able to rebuild their company's market value. To hold on, many are also cutting capital spending, marketing, training and R&D, and some may resort to bankruptcy protection.”

85% stated in the survey that they expect rebuilding the market value of their companies to take longer than six months.

Investors should create their own impressions from this data and form opinions on whether it should/should not affect your investing activities. What is clear to me is that there are clear hurdles facing many Canadian companies, public or private, that will impact returns on investment for individual investors.

If you want more information on the C-Suite survey Marty Cej will be presenting more information tonight on the Business News Network (BNN) at 8:30 pm (ET) on Monday evening.

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Sustainable Dividends:

This article originally appeared on The DIV-Net on February 15th, 2009.
Last week I wrote a post titled Leveraging Dividends where I provided tips for using conservative leverage in a dividend growth portfolio. This week I want to expand on what I deem to be conservative income for any investor looking for companies that pay dividends.

There have been a number of dividend cuts announced over the past 12 months and many investors are speculating on who could be next or how far further dividend cuts could go. As a dividend investor you have to develop a discipline that prevents you from chasing yield and allows you to look at the operations of the company with an unbiased view. There are a number of public corporations whose operations aren’t sustainable and neither is their dividend.

How does an investor identify what is a sustainable dividend?

You need to look at the operations of the business, examine the business model, assess their earnings strength and determine the payout ratio of the company.

Yield isn’t the sole factor that should set off alarm bells in the minds of investors; the payout ratio is more important. The payout ratio is the amount of earnings that are paid out as dividends to investors; the higher the payout the less sustainable a dividend potentially becomes.

For a company with high growth and a capital intensive business the payout should be relatively low; below 50%. The reason for this is because the company needs to re-invest earnings back into the business in order to continue growing and maintaining their strong financial position. For a company with low growth and limited capital requirements the payout can be slightly higher; above 50%. The reason for this is because the company can afford to pay out more in dividends to investors since its operations don’t require the majority of earnings to be re-invested back into the business. A company always needs to retain some portion of earnings, but determining what is appropriate depends on the business model and life-cycle of the business.

Many investors have chased yield over the past year and been burnt badly when the company’s dividend has been subsequently slashed.

What companies have sustainable dividends?

I’ve included a list of 25 companies whose payout ratios range from a low of 14.4% to a high of 66.5%. They include companies from different industries, with different business models and different demands for re-investment of their earnings.



I consider each to have sustainable dividends and each should have the ability to endure this difficult economic period with their dividends intact or higher. They aren’t the most exciting companies, but they provide something that many investors lack in their portfolios at this time: consistency & sustainability.

Disclosure: I own shares in BAX, BDX, KO, CL, GIS, SJM, JNJ, KMB, PG, SNY, WMT, CNR, ACO.X, ENB (via ENB.PR.A), FTS, RCI.B, SJR.B & X.

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The Dividend Express II

Photo courtesy of Canadian National Railway.

As valuations of equities continued their uninterrupted slide this week The Dividend Express kept chugging along. Despite being down 8.87% YTD Canadian National Railway (CNR;CNI) made an announcement on Wednesday that quietly flew under the radar of investors and the broader market. When cashflow is king and the cost of capital becomes prohibitive companies who are able to secure cheap financing benefit from an important competitive advantage that places them in a position to continue operating without impairment through any economic crisis.

On Wednesday (February 18th) CNR announced it would issue $550M of 10-year bonds priced at 295 basis points above a 10-year US treasury bond. The bonds carry a coupon of 5.55% with a maturity in 2019 and carry a control clause that if CNR were ever taken over bondholders could redeem the bonds at a premium price.

Why is this announcement significant?

There are a lot of companies looking to raise capital that are finding a difficult environment for affordable financing. It's easy to overlook these important activities of business with analysts touting their buy or sell targets and pundits on TV talking about BUY BUY BUY or SELL SELL SELL, but the basics of business are pretty simple in this economic environment: borrow cheap and spend smart.

Let's examine a few other financing activities to shed some light on how important CNR's recent financing really is to me as an investor who owns shares in the company.

On February 3rd Harley-Davidson (HOG) priced an offering for $600M of senior unsecured notes in order to secure financing for its lending activities. Davis Selected Advisors and Warren Buffet (through Berkshire Hathaway) each committed to purchase 50% of the financing with the notes due in 2014 and providing an annual coupon of 15%.

On February 13th Tiffany & Co. (TIF) priced an offering for $250M of debt all going to Warren Buffett (through Berkshire Hathaway). The issues of $125M of 8-year debt and $125M of 10-year debt will each yield 10% on an annual basis.

On February 19th Precision Drilling (PD.UN) planned a bond offering for 10-year debt worth $250M to replace short-term bank loans in an attempt to strengthen its balance sheet after last year's acquisition of Grey Wolf. With the prospects of having to pay a 12-15% coupon on the bonds in what the company called "unfavourable market conditions" and announced its closure of a $172M sale of equity.

I do acknowledge that these are only three recent examples of companies issuing debt at a restrictive cost of capital, but it demonstrates the clear disadvantage that many companies are experiencing when others, such as CNR, can issue debt at only 5.55% over a 10-year term.

If you owned a company and had to pay investors 2.7 times the cost of what your competition could raise money at you stand at a substantial disadvantage regardless of your business model. Whether you intended to use the proceeds to pay off short-term debt or buy assets such as equipement or inventory no advantage in pricing, branding or operations will dramatically offset the high costs of financing.

Another strong bond offering came from Honeywell (HON) on Friday (February 20th) when they announced a public offering of senior notes worth $600M with a coupon of 3.875% due in 2014 and $900M with a coupon of 5.00% due in 2019.

The cost of capital is providing an important lesson to companies who took on too much debt or ignored the importance of developing a strong credit rating during the past few years when debt was cheap and easy to come by. As lending continues to constrict more and more companies will find that financing can be prohibitive and put them at a serious disadvantage versus their competitors. Investors should take the time to look beyond the commentary in the markets and get back to analyzing the basics of companies they are considering for investments.

When companies such as CNR or HON can issue debt at such substantial discounts to their peers they can directly benefit from this strengthened capital position now and in the future. Over the short-term the noise of fear may drown out these debt offerings as investors look to more exciting developments and speculation, but the fundamentals remain that any competitive advantage has the potential to accelerate a business forward versus their competition if capital is properly allocated within the business.

Disclosure: I hold share(s) in Canadian National Railway (CNR) and Berkshire Hathaway (BRK.B)
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The Return of Capital II:

Two weeks ago I wrote an article titled The Return of Capital that talked about the role of fees in the financial services industry.

Fees aren’t anything new to investors and are virtually impossible to avoid. Yet minimizing your exposure to fees can have a significant long-term effect on your returns when you have the proper information and perspective to avoid excessive fees when possible.

In The Return of Capital I introduced DSC (deferred sales charge) fees that are often hidden in managed mutual funds as a deterrent for fund holders to sell or switch out of a specific mutual fund or group of funds. These fees can run from 4-6% of invested assets and are a serious hindrance to investors who wish to pursue a different strategy for their investments.

I had the opportunity to sit down with a new DIY investor who agreed to conduct an investor interview about his experiences with mutual funds, budgeting, DIY investing and the financial services industry.


Thanks for taking the time out of your schedule to conduct this interview John,

It is my pleasure to do this actually. I have been surprised and grateful about the number of helpful and patient people that I have met on forums that have helped me learn and understand investing better. If I can give information back to the community and help other beginner investors it would be the least I can do.


Can you take a moment to introduce yourself and tell readers more about you?

I am a 32 year old married educator. My gross income is $60,000 I own a $280,000 house that has a mortgage of $174,000. The mortgage difference is more because of the increase in value of the real estate market than aggressive payments, but that is changing. My spending habits are fairly frugal, but occasionally they do build up and a rare impulsive buy happens. I try to concentrate on being content, separating wants from needs, waiting seven days before making a purchase, and realizing how small purchases can impact the big picture. My wife and I do not agree on everything but, I am happy to say that we have both compromise and really try our best to work with each other.


When did you first become interested in investing?
How did you find a financial advisor and select your funds?

I first became interested in investing when I was 19, I knew it was something that I needed to understand and I read The Wealth Barber during a trip to Thunder Bay. The good news is that I started early the bad news is that I didn’t learn much after that until recently. At 19 I thought I knew it all, you paid yourself first and bought mutual funds and retired. Although this is a good start I should have paid myself more and spent more time on budgeting and fund selection.

I have a relative that is an investment agent, so I never really thought through the process of selecting the best agent. In fact, I trusted the relative’s judgement so much that I never took any real responsibility for my present or future finances. It is embarrassing to admit that I invested with my relative for 13 years and I never selected or researched any of my funds.


What did you understand about the fees that were involved in investing when you first started?

Nothing. You can applaud the industry for being very smart with hiding their fees. I always knew that real estate agents and car sales people had fees, but I never really thought about how the investment industry got paid. I see it now; at work I have now noticed people getting birthday cakes and entertainment tickets from their financial advisors.


What motivated you to change your investments at this present time?

My motivation came from MoneySense. I am not sure why but during the summer of 2008 I bought a copy and then I started reading their free back copies on their website. The Couch Potato and Pay Less, Get More articles made me start asking questions about my own situation. At the same time the economy started to turn and I could see that professionally managed funds were suffering despite being professionally managed. If the Canadian economy stayed stable it would have been more difficult for me to become motivated, but all these factors created a perfect storm for motivation to learn more and examine my personal situation.

The Mark vs Nurse article (Part I, II & III) on the TMWTS website helped me see the impact that initial losses can have on final results. Emotionally, I would really like to start in a fresh direction and be finished with my current situation, but I will wait. Expensive lesson learned!


How much in DSC fees would you be charged if you pulled out all your money today?

If I was to transfer everything into a couch potato portfolio there would be a total penalty of approximately $1700. The RRSPs are between two different fund companies who both charge a declining percentage of DSC over six years. Presently, I do not think it makes sense to pull the money out so, I will wait a year at a time and pull out whatever amounts no longer have DSC charges on them. When I get down to the final two years I will see if it makes sense to be charged lesser DSC fees or not. Either way it is a long painful process to get my money out.

I had no idea that it would be so much, in fact I almost pulled the money without checking. The investment industry is so good at hiding fees that I may have never noticed.


Has your advisor been supportive of your decision to change to an investing strategy that meets your needs?
How have they helped or harmed this process for you?

My advisor indicated that he is not overly familiar with index funds and then gave me four reasons not to do it:
1. Questioned if I really knew what I was doing
2. Stated that I should wait until the market rebounds to regain my losses
3. Stated if index funds were so good everyone would be doing it
4. People come up with new investment ideas just to sell books

Also, I noticed that my advisor took a long time or did not get back to me with some questions, like are there any penalties, I think he thought I would just eventually lose interest.

In the short term the above did slow my progress and put doubt in my mind, but in the long term it helped show me what the industry is really like and motivated me into taking control of my situation. I am no longer doing anything through the agent and just getting my required information from the head office 1-800 numbers.


What has been your experience with the amount of education you have received from your advisor?
Is it adequate?
Inadequate?
Why?

I recall asking about some specifics in the past and I was given a 20 page booklet on the fund or company, I don’t really know because I never read it. The booklet was technical and not designed for a beginner investor. Also, I was told it was best not to worry about funds as they are part of a long term strategy and not something to be checked regularly. Although, the advice/education may have been inadequate, it is still my responsibility to understand my situation.


What has been your biggest challenge trying to educate yourself on investing?

There is not one perfect solution for all investors, but when you are starting out this is what you want and it is hard to create your own solution with limited experience.

I also struggled with grasping the actual how to. I agreed with the theory, but what are the actual steps to make it happen. I look back and laugh some of it is very obvious now.


What resources have you used or sought out to receive educational material on investing?

Magazines:
· Moneysense
· Canadian MoneySaver

Websites:
· http://www.nurseb911.com/
· Moneysense – every back issue is available, excellent beginner resource
· Moneysense forums
· Globefund
· Morningstar
· Webring forums
· There are some other blogs that I have subscribed to but I don’t have the time to read them much – frugal dad and million dollar journey


Can you tell readers a little bit about your new budget?
What is your new focus?
Where have you trimmed costs or focused your additional savings?

I always had the belief that I did not have to budget because I really only purchased things that I needed. I was wrong. Can you believe that I found out that we spent $1,400 on groceries one month, how is that even possible, but it is true!

I tried quicken first and I am unsure if it is because budget software and its functions were new to me or if it was just quicken but after two months of aggravation I switched to Microsoft money. Although money is not as flexible it is much more simple and straight forward to start with.

Recently I have trimmed some costs on increasing deductibles and reducing monthly payments on house and car insurance. I have never made a house claim and have not made a car claim in over six years, when I did the math I felt sick. Back to the grocery budget, we are trying to hit $800/monthly and it is still not happening, so what we are trying now is to spend $200/week. Over a month the goal and the expenses are not present, but over a week they are. So far this micro/mini budget seems to be working out. Even if we don’t stay under $800/month we are spending less and I put the savings into extra mortgage payments.


What is your definition of financial freedom?
Where would you like to be at 55?

Over the next 23 years I am certain that I will have different answers to this question, so I simply want to build enough to cover my current expenses as early as possible.

I read the MoneySense article, Retirement: A number you can live with, that you should multiple the amount you need by 25 to give you your retirement goal, 25 x $45,000 (approximate expenses) = $1,125,000. The article goes on to say that I can take 4% of my savings each year so 4% of $1,125,000 = $45,000. This is another area that the created a budget helped me examine and plan my future.

$1,125,000 is shockingly high to me and may not be right, but it does give me a concrete number and huge motivation to examine what I am doing today for tomorrow.


What is your understanding of how fees affect returns now in retrospect?

In retrospect, I view my previous financial situation as parasitic. I was silently losing small amounts of money in many different areas. Over the long term I can see that making small adjustments will have a large impact. It amazes me to say this because only a year ago when I heard someone mentioning budgeting or retirement I thought I had it all under control, now I have become more detail orientated and thinking about the long term effect time has on money.

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Want to learn more?
Visit the New Investor Index for more articles, links and helpful tools on investor education.

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Mail Bag: Manulife (MFC)

Jeff asked in a recent email,

“Now that MFC is below $15.00 what are your thoughts? I began investing in MFC when they purchased Hancock and until recently had a beautiful chart. What's going on with this well run company?”

Jeff is referencing the US traded listing for Manulife (MFC) on the NYSE which closed at $14.15 US on Friday and $17.53 CDN on the TSX.

I published a stock analysis on this company, Taking Stock in MFC, in November where I published the following comments,

“Segregated funds have been a major concern of the equity markets in recent weeks and put Manulife and other insurers in the spot light. Segregated fund products in recent years have been very attractive to insurance companies and aggressively sold to investors seeking capital preservation of their investments with the potential benefit of upside as markets appreciate. As equity markets have declined significantly in recent months questions have been raised about these products and whether additional capital needs to be raised in order for companies to meet these longer-term obligations. In my situational analysis one significant internal threat for my investments in insurance companies has been the increased affinity for these products. While they offer lucrative fees and an incentive from the issuing company’s perspective the explosive growth of these products has been concerning and likely something that will be appropriately managed in future years. One benefit is that although segregated products have been sold by Manulife in all their major markets many of these products do not require repayment for another 7-30 years and the potential costs of these products are within the stated resources of the company. Manulife continues to operate above any regulatory minimum for their capital ratios and have not yet taken significant losses attributed to these products.”

Segregated funds are guaranteed investments that Manulife and other financial services companies have sold to investors over the past decade as an incentive to bypass the risk of investment losses. One example is Manulife’s Guaranteed Investment Funds (GIF) where investors make a deposit over a 10-year period and in return receive at the end of the term a guarantee of 75% of their investment or the market value, whichever is higher.

In recent years these products have been very attractive to investors and lucrative for the companies offering them. With equity markets tumbling more than 40% in some markets Manulife and other financial services companies selling these products have come under pressure because of their future obligations to repay investors back their principal at a potentially higher price than their market price. If equity markets were to stay at current levels Manulife would have to begin paying out more than it received on some of these products in seven years.

The insurance business of Manulife has been improving both in scale and profitability, but the investment side of the business has obliterated the stock over the past six months. Management didn’t adequately hedge their exposure (or hedge at all) to investment products as they should have and are currently paying the price as the market concerns grow over future repayment obligations.

In the past two quarters Manulife has been forced to commit equity to these products to ensure that they maintain a regulatory minimum for asset coverage of them. This has hurt profitability at the company even though the insurance side of the business posted impressive results in fourth quarter operations.

Even the best group of mangers make mistakes, whether small or large, and a company suffers because of that. This illustrates the importance of a company’s management to identify future risks and act appropriately to protect operations and their shareholders. This will be an expensive lesson for the company and many others, but likely one that they will learn from as they look to offset future risk with these segregated products. An investor shouldn't discount this exposure as it poses real risk to the company now and in the future. A long-term investor needs to weigh the future prospects of this company and evaluate whether the price today offers value for the company's operations and performance in the future.

For readers interested in more specific details I would advise you to read Manulife's fourth quarter news release and information package provided on their investors relations website.

Disclosure: I own shares in MFC

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Always Coca-Cola:

The Coca-Cola Company (KO) released fourth quarter and full year 2008 results yesterday that continued on their path of achieving predictable, sustainable and enduring value for their shareholders.

Some highlights from the report:

• Strong worldwide unit case volume with 4 percent growth in the quarter and 5 percent growth for the full year.
• International operations delivered 6 percent unit case volume growth for both the quarter and full year.
• Global volume and value share gains continued across key markets and categories.
• Solid cash generation continued, with full year cash flow from operations up 6 percent.
• Fourth quarter reported EPS was $0.43. Comparable EPS up 10 percent to $0.64, reflecting nine consecutive quarters of double-digit comparable EPS growth. Full year reported EPS was $2.49 and comparable EPS up 17 percent to $3.15.
• Operating income growth of 12 percent on a reported basis and 10 percent on a comparable basis in the quarter. Full year operating income grew 16 percent on a reported basis and 17 percent on a comparable basis.
• Productivity program initiatives accelerating and are on track to deliver $500 million in annualized savings by year-end 2011.

I published a public and private stock analysis titled Taking Stock in Coca-Cola (KO) last month where I presented very clearly the competitive advantages that this company enjoys versus its global peers and the investing prospects of the company in the future. After reviewing the most result results, analyzing the numbers provided by the company and gauging the confidence exhibited by CEO Muhtar Kent I’m glad that I’ve added to my equity position in recent months. When readers compare the most recent numbers with the historical data provided in both versions of Taking Stock in Coca-Cola (KO) a clear trend emerges of continued operating success.

One paragraph that caught my attention came from Kent himself,

"Our highly skilled management team is assertively addressing the challenges posed by the current global economic crisis. Working in close collaboration with our bottling partners, we successfully accelerated actions, refocused investments and intensified our disciplined execution to drive results. We also made significant gains in realigning our organizational structure to generate greater productivity and in rewiring our business for sustainable results.
While certainly not crisis proof, as no company is, I do believe our global business model is relatively resilient, as we bring simple moments of pleasure to our consumers, nearly 1.6 billion times a day, for cents at a time. We recognize that 2009 will bring many unique challenges to us and our consumers, customers, and bottling partners. Yet, I believe that our solid brand and business fundamentals – together with a fundamentally sound balance sheet, robust cash generating model and strong global bottling system – provide a sound foundation for our management team to continue driving long-term sustainable growth."

Regardless of the economic climate in 2009 for many companies Coca-Cola stands to benefit from their strong financial position to self finance growth through free cashflow and remain focused on doing what they do best.

I cannot stress enough the importance of a solid strategic focus in uncertain times by management and Coca-Cola has demonstrated an ability to continue to move forward in a measured manner that sets the company on the road for success for decades to come.

With the stock trading below $45, at less than 15x 2009 earnings, a rock solid dividend yielding 3.4% and stability not found easily in many global corporations Coca-Cola continues to grow the premier brand in the world.

I own shares in KO directly and indirectly through BRK.B
Read more about Coca-Cola by purchasing the full stock analysis available to SAML Subscribers.


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Leveraging Dividends:

This article originally appeared on The DIV-Net on February 1st, 2009.

A Leveraged Dividend Strategy

Leverage Killed companies in 2008 and investors need no other indicator of the success that leverage played in the demise of so many companies than to look at their investment returns from the past year, those of the broader market and at companies continuing to have problems right now with heavily levered balance sheets.

There are clear lessons that can be learnt from how leverage poisons companies but borrowing money to invest under the right conditions can be a prudent investment decision for an individual investor.

I certainly don’t advocate that investors eager to invest in the current market go out and do so blindly with borrowed money but for the long-term investor an adequate amount of leverage can enhance returns if properly allocated and managed. Not only is the amount of leverage used important to consider but how that capital is allocated into investments to best position an investor for success.

An obvious strategy for using leverage when investing is to focus on dividends. Dividend paying stocks are often sought after with a leveraged investing strategy because of an investors’ ability to pay down interest and/or principal of borrowed funds with the cashflow provided from monthly or quarterly cash payments. The danger is that many inexperienced investors look at dividend paying stocks that yield 5% and with borrowing costs as low as 3-4% come to the immediate decision that borrowing to invest in such a company is a no-lose situation or risk-free.

I utilize leverage in my dividend investing activities because under the proper conditions and with a conservative approach I believe that borrowing to invest offers a disciplined investor an ability to accelerate returns over the long-term. What I don’t do is ever lose focus of the risk I expose myself to and consistently monitor the amount of risk I’m taking versus the perceived reward of my activities.

I want to provide four key concepts I use for any investor who might want to use leverage or is considering leverage for a dividend growth portfolio.


I – Conservative Amount

For an investor considering leverage I would first advise you to identify a sustainable amount of leverage for your investing strategy. There is speculation in the market that some hedge funds and investment banks were leveraged as much as 30:1 (or higher) entering into 2008 and this was clearly not sustainable under any market conditions. Borrowing $30 for every $1 committed to an investment strategy is sheer insanity and how this was sustained for any length of time goes beyond simple logic. To put this type of leverage into perspective: would you buy a $600,000 home with only a down payment of $20,000?

Fiscal mismanagement should not be tolerated and I certainly don’t advocate it for the individual investor. While only you know the amount of leverage you can handle I would politely advise that whatever your intended target (10%, 20% or higher) you first start with half. The threshold for my portfolio isn’t a percentage, but a dollar amount which I will touch on in section IV.

The important lesson is that whatever amount you intend to borrow, start with half and work from there. You might not find a happy medium right away but it’s always better to start from a conservative footing than finding yourself out too far on a cliff without anything stable beneath your feet. It’s only after you begin losing money when investing that you realize your risk tolerance is well beneath what you originally thought it would/should be.


II – Conservative Stocks

For an investment strategy where you intend to leverage your returns you want to be diversified against all types of risks. If you intend to create a leveraged portfolio of stocks for a medium to long-term portfolio try to include a balance of financials, consumer staple/discretionary, utilities, energy, real estate and industrial stocks in the portfolio.

I would initially target companies who aren’t leveraged heavily because this helps an investor avoid double leveraging your investments (your leverage plus theirs). Companies with solid business models, strong cashflows, fiscally conservative management teams and products/services in sustainable demand are key candidates for a leveraged investing strategy. If you have an opportunity to add stocks with distinct competitive advantages in their operations I would strongly consider those as primary investments.


III – Conservative Income

A collection of low yielding stocks likely won’t pay your bills and a collection of high yielding stocks may spell disaster for your portfolio in short order. Achieving a balance of income produced by the stocks in your portfolio goes a long way to making your strategy viable in all market environments. Stocks with high dividend yields above their historical average may be at risk for dividend cuts. For balance target a collection of low yielding companies who increase their dividends consistently at a high rate and medium-high yielding stocks who increase their dividends consistently at a conservative rate.

Conservative leverage in the beginning is key for the success of your strategy in the event of unexpected events. If you start with an amount of leverage beneath your targeted threshold and one or two of your dividend stocks cut their payout by 50% you haven’t over extended yourself on the basis of risk. It’s much easier to go up in leverage than down.


IV – Conservative Payment

Each investor should have a specific target for the amount of leverage they want to use in their portfolio. Some of my peers use anywhere from 30-45% as their basic benchmark for the amount of money they borrow to invest; for every $1.00 in their portfolio they use $0.30-0.40 of borrowed money to invest. My approach is slightly different since I take the ultra-conservative approach of using borrowed money when I invest and anticipate a worst case scenario.

The basic principle is this: Can my internal cashflow from the portfolio cover my costs?

When an individual or institution provides you with borrowed money they expect it back with certain terms and a timeline. Often a line of credit, loan or margin has a minimum requirement to repay over a set time period. This can be solely interest or interest and principal depending on the terms of your agreement and it is very important to understand these terms prior to investing borrowed funds. If you’re using a margin account this is a little different, but for this example I’ll simply use an investment line of credit (which I use).

My belief is that internal cashflow from my portfolio should cover my interest and 2-3% repayment of the outstanding principal in any given month. That’s my threshold for how much I will borrow in my leveraged strategy.

My reasoning is very straight forward: if I don’t have enough money coming in from my investments each month to pay the interest and repay a portion of the principal I owe I feel that I am taking on too much risk for my individual tolerance.

Example:

If my monthly cashflow is $200 in dividends and my interest rate is 4% I want to know how much leverage I can use to repay the interest plus 3% of my principal.

In really simple math if I were to borrow $6,000 I would pay approximately $20 in interest and my repayment on the principal (3%) would come to $180. On a $48,000 portfolio yielding 5% ($2,400 per year in dividends) this would put my leverage ratio at only 12.5%. I would be borrowing $0.12 for every $1.00 invested and able to manage the leverage adequately without committing any new money of my own on a monthly basis.

Obviously if you are adding savings to the portfolio on a regular basis you can afford to borrow more, but setting a target threshold for your monthly payment (interest + % of principal) helps you to stay conservative in your investing strategy and not overextend yourself with unnecessary risk.


Leveraging Dividends Review:

• Understand how leverage can enhance/diminish returns
• Understand the risk
• Begin by using a conservative amount of leverage
• Target a diversified group of stocks with higher margins of safety in their operations and financial health
• Target safer sources of income
• Set a payment plan that targets repaying both interest & a certain percentage of your outstanding balance from your monthly cashflow

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The Return of Capital:

Fees

Experienced investors cringe at the sheer mention or sight of this word and for good reason. Many investors realize that fees eat into their returns and few investments come without them. Exchange traded funds (ETF’s) and low cost trading commissions are available to investors, but even if your invested assets are of a reasonable size someone always seems to have a hand in your pocket as you try to make money in the markets.

2008 taught investors very important lessons and many are still feeling the pain as they re-evaluate their risk tolerance, portfolio allocations, investing objectives and attempt to access their capital for new changes in 2009.

I’ve wanted to write a post on this topic for quite some time but only recently in conversations with a few new investors did I feel compelled to put my pen to paper.

I have a saying when I educate new investors about mutual funds which goes something like this,

“This is your money that is being professionally managed – it shouldn’t be professionally stolen.”
In my opinion many mutual fund companies, money managers and financial professionals commit robbery with reference to their fees. Two percent (2%) might not seem like robbery when you examine your returns on a year to year basis, but consider this: 2% each year over a ten year period results in 20% of your potential investment lost to fees. That goes for both up markets and down markets.

The difficulty I have with fees is...well...it’s your money. I don’t advocate that a professional managing a portfolio should work for free but fees should be proportional to performance and the hands on approach of your specific advisor.

The concern I have today is with regards to your return of capital which is far more important than the return on capital.

I’m not talking about return on capital or return on invested capital; those are completely different concepts in business. I’m talking about the return of your capital when you ask for it, make a decision to change how your money is invested or choose to simply walk away from a professional you’re not satisfied with.

Questions: (feel free to put up your hand)

Who reading this has paid DSC fees before?
Who has paid DSC fees without knowing what they were?
Who has no idea what DSC fees stand for or if the mutual funds you own charge them?

DSC (deferred sales charge) fees are often hidden gems of the mutual fund industry that require investors to pay a fee (often substantial) on a declining yearly basis to have their capital returned to them if they choose to sell. These are of course on top of the yearly MER’s (management expense ratios) that a mutual fund manager will charge an investor and trailer fees your advisor receives from those fund companies.

Right now these gems are turning out to be landmines when investors seek to sell their funds in order to switch strategies, investment advisors or mutual fund company altogether. Investors are receiving a reality check when they’re informed that 4-6% of their invested assets are now eligible for these fees and investors’ angered responses aren’t very polite for obvious reasons.

I’m not attempting to place blame on advisors or mutual fund companies although they do deserve most of it. Investors themselves hold a responsibility to ask questions about how their money is managed and those who handle your money have a responsibility to fully disclose fees so that you understand their impact.

What I want to bring to the attention of readers is how I believe the financial industry does a horrible job of returning your capital to you when you request it. In all fairness to the financial industry this is your money. You should be able to do with it what you please within a reasonable time period. The purpose of these fees is not to necessarily rip investors off, but provide a serious disincentive and discourage you from moving your money away from a fund or manager.
The lack of transparency and education in the financial industry is literally appalling and very few individuals hold themselves to a high and respectable standard.

Little investors aren’t the only ones hurt by the features of DSC fees as many wealthy investors who invested capital in the hedge fund industry are now finding out. Gating is a provision placed on many hedge funds that limits a specific amount of money from being withdrawn from the fund during a period of time. Many investors were unaware of this provision and during the selloff in the market in 2008 many who asked to have their capital returned to them were swiftly denied. The gates closed on the fund and are now unavailable to shareholders.

I think of this as the money bin from a childhood cartoon I watched (Duck Tales) with Scrooge McDuck at the helm of his town’s finances. Wealthy investors gave Scrooge their money to invest because of his miraculous wealth and historical financial returns. When the markets went south investors started demanding the return of their capital and Scrooge let his investors take out 15% of assets and then promptly shut the gates preventing investors from pulling out their money.

It’s important to note that whether the hedge funds go up or down in value over the gated time period individual investors are now forced to watch this money sitting beyond their reach. They could make 20% or lose 60% of their invested assets and legally have no way to force the hedge fund to repay them their capital.

In Part II of The Return of Capital I will be sitting down with a Canadian investor who recently learnt some important lessons about his finances when he decided to make some changes to his managed portfolio. In this investor interview we’ll discuss DSC fees, mutual fund selection, budgeting tips, resources for new investors and important insights on the financial services industry.


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