Investing: Part 2

The second obstacle to successful investing is knowing when to buy a stock.  The truth is there is no such thing.  All one can do is to assess the company, industry, and the economic climate at the time of investing and predict what the future looks like for that company.  Assessing is nothing but an estimate which is the toughest skill to become successful at. But, thankfully you are reading this publication and we will list a few factors to look for when it comes to putting ones money to work.

Type of asset:  Avoid any mutual fund, ETF or any other investment vehicle created by Bay Street. These instruments rarely outperform the stock market and are designed to generate excessive commissions at the expense of your returns.  Stick to individual securities. 

History of profitability:  One can waste his or hers life savings trying to find a successful start-up that will become the next Microsoft.  Therefore, it is almost always preferable to invest in a company that is mature and has a lengthy history of increasing profitability. Even if the stock does very little, the risk of losing some of one’s capital decreases significantly.

Dividend Yield & History:  Dividends often account for more than half of a stocks return over time.  This is why the dividend yield is so important.  For example, a company with a lengthy history of paying a 2% dividend will return ones investment in 50 years, assuming there are no dividend increases.  Similarly, a share that offers a 4% yield will return the investors’ money in 25 years.  Again, this assumes there are no dividend increases.  A dividend increase will decrease the time needed to recoup ones invested capital.  Therefore, one should always look at the dividend history of a company and favor companies that have a history of increasing the dividend.

Valuation:  We use the dividend yield and price-to-earnings ratio (P/E).  If the dividend yield is below its long term average and the P/E high, it usually means the stock is overvalued and one should wait on the sidelines for both to revert to their long term averages.  Obviously, one wants to invest in the company when both are below the long-term norms.

Cashflow: Cash comes into the business (cash inflows), mostly through sales of goods or services and flows out (cash outflows) to pay for costs such as raw materials, transport, labour, and power. The difference between the two is called the net cash flow. This is either positive or negative. A positive cash flow occurs when a business receives more money than it is spending. This enables it to pay its bills on time.  A company can have a loss; however, if it is still generating a positive cash flow that is most likely sustainable, the stock is worth a look.  A perfect example is (for paying subscribers only)  were it released negative earnings for many quarters but continued to generate a positive cash flow and bank $100m quarterly.  Further investigation into the company found that the majority of losses where paper losses derived from the write-down of assets and amortization.  In this scenario, a stock is worth the gamble as long as the company can maintain a competitive advantage in an industry that has a positive outlook.

Industry outlook:  Does the industry have a long-term horizon?  This is important because the majority of wealth is realized by the law of compound returns over time.  Specifically, if a company can grow its earnings over time, the share price will most likely follow.  For example, if $10,000 is invested in a stock that generates a 15% annual return, it will grow to $20,000, then $40,000, and $80,000 after 15 years.  Most stock markets are lucky to average 7% annually. 

Economic outlook:  This is pretty much self-explanatory.

Our system of buying, holding and, collecting dividends is the easiest and cheapest way to invest.  It is also a method that generates returns that outperforms 99% of investment professionals.  But at some point in the future these shares will have to be sold. 

...to be continued

Investing: Part I

"Twenty years in this business convinces me that any normal person using the customary three percent of the brain can pick stocks just as well, if not better, than the average Wall Street expert."                                                  …Peter Lynch

Every investor has three issues to contemplate when it comes to putting ones savings to work in the stock market. The first is finding someone whose ideas and guidance you can trust and who has a proven track record; the second is knowing when to buy; and third, when to sell a security.

The first problem is much harder than you think.  The main reason it is so difficult is because the majority of professionals in the industry are employed by companies whose self-interest in generating commissions trumps that of the clients.  One of the main principals of investment advisors is the “know your client” rule (KYC).  This rule basically stipulates that as an advisor you must collect the important facts and financial objectives about a client.  The second specifies that any recommendations the advisor makes must be suitable to the client's objectives. The KYC rule is humorous and the most two-faced principal of any profession because profit of the broker and the institution they work for comes first.  The majority in the investment business are told what to buy, and occasionally, what to sell for their customers.  In many cases, a brokerage house will issue shares for a company and it is then responsible for the release of the shares into the open market in order for the issuing company to raise as much capital as possible.  More often than not, the brokerage house is paid in shares of the issuing company at a discount to the issue price. Once the shares are ready to be released into the market, the brokerage house will issue a buy recommendation and its brokers will disperse the shares onto their clients.  The brokerage house will profit by its own shares realizing an instant capital gain and by the commission it charges for purchasing the shares for its clients even if the stock is not suitable for client.  This is contrary to the KYC rule. Another common practice that goes against the KYC rule is a firm will load up on a security at a lower price and then get their sales force to recommend those shares to their clients.  The sales force would then receive bonus commissions for placing clients’ money into those shares regardless of whether it suited the needs of the client.  Most of the sales people, sorry, “Investment Professionals”, could only see a bonus commission.  This was common at the firm that my father once worked at.  He left after a few weeks because he was, and still is, against this type of business.  Fortunately, as my dad put it, “luckily, in about a year’s time, the firm disappeared”.  Breaking the KYC rule runs rampant in this industry.  Obviously a mutual fund salesperson will only sell the products created by the company they work for.  The same can be said about most ETFs and life insurance professionals.  As a result, it is rare for a client to receive a product that fully suits their investment needs. An investor, if they have the time, can spend unlimited hours searching for an advisor they can trust.  With a bit of luck, they will cross paths with an individual that makes sense and gives honest opinions and suggestions on their financial wellbeing.  However, finding that individual is rare and we hope our readers and our clients find Sacola fills this need. We have found about a dozen of these people (David Rosenberg, Jim Rogers, Patricia Croft and Warren Buffett, to name a few) whose opinion we truly respect.  While we may disagree with them at times, it is obvious they have done their own research and given serious thought to their conclusions.  Unfortunately, the truth is that the majority of people in the investment business do little research and understand very little about investing.  Yet, it is these people who most investors end up with. ...to be continued

Stock Markets - May 2013

          Six years ago, almost to the day, the Dow Jones Industrial Average (DJIA) traded at 18.3 times earnings and the S&P 500 index at 16.7.  Today, the DJIA is at 16.75 times earnings while the S&P is at 18.55, probably it’s all time high.  During 2007 the DJIA set 27 new daily record highs.  This year there has seen over 20 already.  The S&P set 5 new daily highs in 2007.  So far in 2013, the count is at 12.

          If history is to repeat itself, then we are either at the top, or within a few weeks of it.  Our reasoning is that corporate earnings are not growing as fast as the stock markets, nor will they for the rest of 2013 and 2014, and the markets are in expensive territory.  Furthermore, a good chunk of the growth in profits is paper, realized by share repurchases, rather than organic revenue growth. 

          When a company repurchases its shares it is spreading the profit over fewer shares, resulting in higher earnings per share (EPS).  For example; company A earns a profit of $100, and there are 10 shares outstanding.  As a result, the earnings per share is $10.  The company then decides to use some of its profit, or borrow funds, to purchase 2 shares.  Assuming the company made the same amount of profit, the earnings per share would be $12.50, or 25% higher.  Share prices usually increase as a result of the increased EPS.

          The Baltic Dry Index is off 14% from its 2012 high.  The index has been flat for most of 2013, a signal the world trade is doing very little.  In April 2010 the Index was trading around 3096.  For almost all of this year the index has been under 900, with it recently trading at 841.  This is a bad sign as it confirms what we have been reporting for months; there are surpluses of just about everything we produce. 

          The CRB Index has been flat for the past year which accurately foreshadows the world economy.  This is probably the best gauge for the world economy and how it is performing.  The CRB indicates the world economy is going nowhere for the rest of this year.

          Stock market gains this year are based on the attraction of some high yielding shares, low interest rates, as well as the hope that the American, European, Japanese and the Canadian governments will get their acts together and finally tackle what is destroying their countries’ economies. 

          Real estate is too expensive even with zero interest rates.  Plus, around the world there remains a surplus in all forms of real-estate.  Mutual funds are always a disaster for the investor.  Have you ever met someone who got rich holding mutual funds?  Hedge funds are too expensive.   Hedge and mutual funds are designed solely to transfer one’s wealth into the manager’s coffers.  With money market funds, one is lucky to break even after taxes.  After-tax wage gains are slightly positive, but probably less than 1%.

          Sadly the stock markets are the only game in town.  This alone is a negative because it is luring the inexperienced and the desperate hoping to make a little extra.  History proves these people make poor choices and end up losing because they buy horrible companies, and they panic sell, adding further downward pressure to sell offs.

          Dividends have saved us, but only because we bought at the right time and held the shares for years.  If we had not, we would be lucky to get a 4% yield today.  Most good quality companies yield 3% or lower.  Our recommendations are returning over 10% annually based on our purchase prices, one of the highest returns in the world for investing.  Some subscribers have told us they made over 10% last year.  My father’s Tax Free Savings Account, holding only this newsletter’s recommendations is up 92% in just over 4 years.

Poland announced their gas fields, believed to be the largest in Europe, will not be developed for some time due to cost and competition from Cyprus’ reserves.  Between the two countries they will be fighting for market share, along with Russia, the biggest supplier.  Russia is trying to take over the Cyprus field, so they control Europe’s needs for years to come.             However, today Russia is worried.  They have decades of reserves already (probably over 200 years worth), but the gas would end up staying in the ground for decades if Poland and Cyprus both develop their fields.  We suspect Russia has bribed Poland not to develop their field for a few decades, because Russia and their mafia are in desperate need of cash flow.  Russia’s elite have robbed their country for years and continually need a fresh source of money, which shale gas provides in sales to Europeans.            If gas prices hit $1.50, which we believe will happen, it will be a financial disaster for Russia.  As a result, they will do everything in their power to keep the price from falling further.  Unfortunately for the corrupt nation, they will be unsuccessful at this because of the growing glut of reserves across the globe.  Continue to avoid the Natural Gas market.

          There are no buying opportunities available today.  In my father’s 48 year career, he has never sat on the sidelines for so long and held so much cash.   We do not believe in buying at the peak of the market, which we feel is where we are at today.  Stock markets are in expensive territory.  By the numbers, all stock markets are vulnerable to a sizeable correction.  Today we must wait for the stock market to come to us, which they will.  It might be a week from now or 6 months away, but it is coming.  The coming sell-off will be quick and substantial.   In the meantime we will be collecting all those lovely dividends each month and know we have X amount locked in safe money market vehicles.

Keep cash in money market investments, with no term longer than one year.

The RRSP

          It is time for our annual reminder to not contribute any money to a Registered Retirement Pension Plan (RRSP).  There are so many negatives and only a handful of positives when it comes to them.  These plans are promoted to the public as a tax shelter, when in fact it is a tax deferment plan.  Specifically, the money grows tax free until one retires or reaches the age of 69, at which time the money becomes fully taxable at the individual’s tax rate once the funds are extracted.

          True, there are some positives to the RRSP, however, we believe the negatives outweigh the positives.  Below we have outlined the good and the bad  about RRSP investing:

• It is important to realize that the need for an RRSP depends on the individual.  Most people lack the discipline to save, so for many, the RRSP is the only method of saving as the individual is unable (I should say, not supposed to) to touch these funds until retirement.  Unfortunately though, this is rare.  A recent article in the Globe and Mail stated that 76% of RRSP’s are collapsed prematurely, resulting in penalties and loss of tax deferment status.
• For an individual who will be receiving around $32,000 from a pension plan in retirement, depending on the amount of money in the RRSP, the forced income from the RRSP will most likely push the individual into the next tax bracket, forcing him/her to pay higher taxes.   
• RRSP’s are huge revenue channels for all financial institutions which is evident in the large number of advertisements on the radio, TV and in newspapers.  Specifically, every RRSP plan charges an administration fee. In addition, if one is not using a self-directed RRSP, the financial institution managing the plan will always be investing your money in their financial instruments.  These instruments, mainly mutual funds and ETF’s, then charge numerous fees on top of the ones from the RRSP.  As we have discussed before, these fees come at the expense of profit.
• The laws surrounding a RRSP are complex at best and often require advice from a tax specialist.  Any breach of the laws and one will be heavily penalized. This is one of the main reasons I will never register my money in a plan. The best investments are always simple.
• Do you know what the tax rate and structure will be 10-15 years from now?  Based on the largest demographic shift in Canada’s history around the corner, more people will be leaving the work force than entering.  Because of this, it is safe to bet that taxes will be higher 10 years down the road as there may be fewer payroll tax receipts going to the government and more people drawing down government services.  As a result, it is beneficial to pay lower taxes on the money once it is earned today, rather than at a higher rate later down the road.
• Use a self-administrated RRSP.  A small yearly fee is cheaper than pouring large sums of money into expensive, poor-performing mutual funds.  Depending on one’s age, invest a portion in market funds (T-bills), and the rest in blue-chip companies that have a solid record of increasing dividends each year.

          While we will not recommend RRSP’s, there are some benefits to having one.  Specifically, the proceeds towards an RRSP are a tax benefit.  In addition, if one is fortunate to work for a company that contributes generously to an employee RRSP plan, I would recommend that the individual takes this opportunity, because it is an extra form of pay.  But, keep in mind this is a taxable benefit. Furthermore, companies that offer this will more than likely offer non-registered benefit plans as well.  If you choose to invest in RRSP’s, make sure to do your research and proper planning.  Failure to do so can end up costing you a lot of time, money, and grief. 

           If you have the ability to save on your own without touching the funds, I would not recommend investing inside a RRSP. When you do the math, there is no tax savings. If an investor saves $1m in an RRSP, once the individual collapses the plan he would have no choice but to purchase an annuity which will tie up his/her money. Failure to do so can cost the investor roughly $400,000 in taxes.

          By investing in these plans, all one is doing is creating long-term tax obligations.  Sacola feels that it is better to pay the tax when income, interest or capital gains are earned.  Only when one pays these taxes, does the money become truly tax free.  In addition, for the serious investor it makes no sense to tie-up ones money as you do with an RRSP.  Investing is about taking advantage of opportunities and registered plans limit a large number of them. 

Dividends

     Warren Buffett once said "the stock market is designed to transfer money from the active to the patient."  This is holds true in today’s market on so many levels.  One of our rules to investing is to let the market come to you rather that you chase the market.  This takes patience, but, it will eventually prove to be more profitable over the long run.

     Today’s market takes time to create buying opportunities.  In the meantime, we are constantly rewarded with cash dividends and a nice tax credit (if one qualifies) while we wait for bargains.  It is these dividends that end up creating a large chunk of ones overall returns.  This is evident on page 6 of our publication.

     There are a number of factors to look at before choosing a dividend paying stock.  Dividends are measured by yield, and are calculated by dividing the dividend into the share price.  The yield will tell an investor if the stock is properly valued, or if the dividend is at risk of being cut.

     A stock with a dividend that is at risk of being reduced, or cut all together, will trade a lower price causing the current yield to be abnormally high.  The price, at which the stock will fall to, tends to be the level the market believes the new dividend will deliver a competitive yield.  If the dividend is eliminated, the stock price tends to realize a substantial decline.

     As the chart of $25,000 invested below clearly highlights, the benefit realized by waiting for a higher yield is tremendous.  An investor who waits 4 years for a nice yield (5% in the chart) will make nearly 40% more than the investor who jumps right into the market in order to earn a 2% yield.

     Using the chart again, one who is able to wait for a severe market correction, which tend to occur nearly every 7 years, and gain a 7% yield will nearly double the gains in two-thirds the time compared to settling for the lower yield.

     When researching a company’s dividend, an investor should look at the following:

1.  Are dividends paid from earnings?
2.  Does the company have sufficient financial resources to cover liabilities as well as dividends?
3.  Is there a lengthy history of increasing the dividend?
4.  Is the company in an industry that offers price stability and low competiton?

     ***** has raised its dividend by 3 cents a share quarterly.  The company started paying dividends in 2006, and since then has raised the payout at least once every year.  Its financials today are rich enough that there could be another increase in 2013.  With over $50b in the bank, it is nearly a guarantee an increase will occur.

     ****** announced that it predicts its profits will grow by roughly 10-to- 12% a year for the next 5 years.  As a result, it will most likely increase the dividend each year accordingly.

     ****** is the major shareholder of *******.  In this relationship, ***** usually realizes part of their dividend increases from the subsidiaries.  This means that ***** will be increasing their payouts.  It has done so for 7 of the past 8 years.  ****** oilfield operations should be in full production within the next 3-6 months, meaning higher profits in the future, leading to more dividend increases.

     We have strongly recommended buying dividend paying shares since the inception of this publication.  More importantly, we tend to concentrate on companies that increase the payout on a routine basis.  There are plenty of these companies around.  Bay Street never recommends these stocks because it equates to only one commission since there is rarely any reason to ever sell them.

     Sometimes it becomes a hard decision to know when to sell.  Before the recent credit crunch and the collapsing real estate market, ******** and ********** had the best dividend growth record in the industry with 15 years of increased payouts.  We did not suggest selling ******** because we believe in the future of Canada.  Plus, the yield is still respectable.

     Both companies, as did others, have raised their payouts in 2012.  Will ***** and ****** be back in a race for the best record?  Let’s hope so.  It is worth noting that ******* has one of the best records in the world for paying a dividend, over 110 years.

     A key point to our system is that, based on our purchase price and after numerous dividend increases, our portfolio yield grows.  For example, ********* yields 12.1%; ******* 11.8%; ********* 6.5%, and so on.  Plus, these shares have made huge capital gains.  The 3 mentioned above have gained 136%, 100%, and 148%, respectively.

     Even companies that do not raise payouts on a regular basis hold up due to reasonable yields.  *******, ********, and ******** fall under this category.

     ****** used to have one of the better TSX dividend growth records.  However, they have stopped increases because, along with most companies in the industry, it is being hurt by the zero interest policy.  These company profits will increase with interest rates.  Once this occurs, the dividend increases will follow.

      Nobody knows the future, but history helps to guide us for tomorrow. It is telling us that we are in for a sustained period of flat growth.  As a result, most stock markets profits will be via dividends.  It has been proven, time and again, dividends must be part of any investment portfolio if it is to grow.