High Liner Foods (HLF.TO) – August 2016

It has been over 3 years since I last reviewed High Liner Foods Ltd. To date, HLF.TO is still one of my favourite companies as it was as the first that I truly analyzed, and over the years it has been an impressive performer in my portfolio. At a high level, High Liner Foods is a supplier of quality seafood dishes and supplies to both the retail and commercial markets, here and in the US. They have operations throughout North America, and have grown over the years both organically and through acquisitions. Their own corporate snapshot best summarizes the firm:

High Liner Foods is the leading North American processor and marketer of value-added frozen seafood. High Liner Foods’ retail branded products are sold throughout the United States, Canada and Mexico under the High Liner, Fisher Boy, Mirabel, Sea Cuisine and C. Wirthy & Co. labels, and are available in most grocery and club stores. The Company also sells branded products under the High Liner, Icelandic Seafood and FPI labels to restaurants and institutions and is a major supplier of private label value-added frozen seafood products to North American food retailers and foodservice distributors. High Liner Foods is a publicly traded Canadian company, trading under the symbol HLF on the Toronto Stock Exchange.

Source: 2015 Annual Report

Analysis

From an analysis standpoint, HLF is an interesting company.  The company is headquartered in the maritime provinces, and pays and reports its dividend in Canadian Dollars, but since 2012 they have reported their financial statements in US Dollars.  This requires us to make some minute adjustments to EPS and Cash Flow per Share calculations, to ensure we factor in the appropriate exchange rate.  Moreover, this can swing the YoY growth metrics, since a shift in the USDCAD exchange rate can have a drastic effect on their bottom line due to foreign exchange gains or losses.

Below are the key evaluation criteria for HLF:

Category Criteria Threshold Current Value Pass?
Strong financial condition Current Ratio 2.30 1.50 YES
Earnings Stability Number of most recent years of positive EPS 9.00 3.00 YES
Earnings Stability Number of consecutive years of negative EPS 1.00 1.00 YES
Dividend Growth Compound Annual Dividend Growth 0.21 0.02 YES
Share Price Growth Compound Annual Share Price Growth 0.12 0.03 YES
EPS Growth Compound Annual EPS Growth 0.23 0.03 YES
Moderate P/E Ratio P/E 16.20 15.00 NO
Moderate P/BV Ratio P/BV 2.39 1.50
Moderate P/E*P/BV Ratio P/E * P/BV 38.72 22.50

And here is some of the fundamental data underlying the above evaluation criteria:

Year EPS Dividend per Share Dividend Payout Ratio (EPS) Dividend Payout Ratio (FCFS) ROE P/E Ratio Book Value Price to Book Value (P/BV) Net Income (000s) P/E × P/BV
F2005C ($1.9639) $0.1000 (5.0918%) 30.2774% (60.5188%) (2.3168) $6.4903 1.4021 ($41505.0000) (3.2483)
F2006C $0.1531 $0.1000 65.3106% 21.0671% 4.4303% 28.5734 $6.9121 1.2659 $3156.0000 36.1710
F2007C $0.2910 $0.1000 34.3585% 19.0414% 4.6450% 16.5780 $12.5316 0.7701 $6079.0000 12.7659
F2008C $0.4400 $0.1100 25.0003% 13.8824% 8.5031% 7.9547 $10.3490 0.6764 $13252.0000 5.3805
F2009C $0.5370 $0.1350 25.1377% 17.0828% 12.5713% 8.6120 $8.5439 1.0826 $19747.0000 9.3236
F2010C $0.6208 $0.1650 26.5784% 10.3864% 13.5665% 13.0878 $9.1520 1.7756 $19985.0000 23.2383
F2011C $0.6016 $0.1950 32.4117% 12.9113% 11.2551% 13.5880 $10.6909 1.5293 $18180.0000 20.7806
F2012 $0.0725 $0.2100 289.7152% 7.9876% 1.4365% 217.4934 $10.1433 3.1085 $2203.0000 676.0686
F2013 $0.5491 $0.3500 63.7394% 26.1210% 16.9814% 43.5613 $6.0805 7.8678 $31356.0000 342.7317
F2014 $1.1463 $0.4100 35.7677% 16.4163% 15.3827% 19.7682 $6.4234 3.5277 $30300.0000 69.7371
F2015 $1.3284 $0.4650 35.0042% 20.7587% 14.7522% 11.7057 $6.5064 2.3900 $29581.0000 27.9761

 

HLF’s share price was on a bit of a tear up until 2014, and it has been dropping since then.  I don’t necessarily see this as a bad thing – in 2014, they were trading at more than 3.5× book value, so a pull back from that price provides more buying opportunities.  Another important point is that in December 2013 HLF was added to the S&P Canadian Dividend Aristocrats Index.  The addition to this index would theoretically increase trading volume as the any ETFs based on the index would be buying and selling shares of the underlying companies, HLF being one of them.  This addition was short lived how however: it was removed in February 2015 because it did not meet the average daily value traded criteria1.

High Liner Foods - 10 Year Stock Price - 2005-2015

High Liner Foods – 10 Year Stock Price – 2005-2015

As a long term investor who is more interested in the continuous passive income from holding the company in my portfolio, rising or falling share prices do not necessarily spook me. Falling share prices are a good thing, since they give me more opportunities to add to my portfolio, provided the underlying fundamentals remain strong. That said, I am more interested in the company’s dividend, its dividend growth, and the margin of safety for the dividend vis-à-vis the ability of the firm to consistently pay that dividend.

HLF.TO - 10 Year Dividend, EPS, and Free Cash Flow per Share

HLF.TO – 10 Year Dividend, EPS, and Free Cash Flow per Share

HLF.TO - 10 Year Dividend Payout vs EPS and Free Cash Flow

HLF.TO – 10 Year Dividend Payout vs EPS and Free Cash Flow

2012 is one year that stands out when examining the  historic fundamentals for HLF.  Their EPS over 2011/2012/2013 went—on a split and currency adjusted basis—from $1.20 in 2011, to $0.14 in 2012, and back up to $1.10 in 2013.  The main reason for this was due to one time write-down charges due to some of their acquisitions in 2011 and 2012, which reduced their net income from $18,180,000 in 2011 to $2,203,000 in 2012.  This one time charge drastically reduced EPS, and helps to explain the huge spoke in the P/BV × P/E value for the same time period, illustrated in this graph:

High Liner Foods - 10 Year P/E × P/BV

High Liner Foods – 10 Year P/E × P/BV

Notice how in 2012 the P/E × P/BV spiked at almost 700, but then dropped down to ~350 in 2013, before returning back to more realistic levels in 2014 and 2015 of 69.7 and 28.0 respectively.  All that aside, if we were to naively look only at the dividend payout ratio relative to EPS we would be very worried; dividend as a percentage of EPS was 289.7% in 2012!  However, if we inspect dividend payout ratio to the free cash flow per share (green line in the Dividend Payout Ratio (vs FCF) graph), we see that the dividend has consistently been below 21.1% since 2006 (it was marginally higher at 30.3% in 2005).  Moreover, notwithstanding the drop in 2012, the EPS on a year over year basis has been generally trending upwards; 2012 was the exception, not the norm.

Recommendation

Over a 10 year time horizon, HLF has had positive dividend growth, EPS growth, and share price growth, with compounded annual growth rates of 15.0%, 27.1%, and 11.8% respectively.  Even taking into account the pull-backs since 2013 in the share price, and the EPS drop in 2012, the stock over a longer time horizon (e.g. 10 years) has been very strong. My recommendation criteria would place HLF as a HOLD, primarily because the P/E × P/BV multiplier is very high at 28.0, which is higher than our threshold of 22.5. However, given the relative strength of the dividend, and HLF’s impressive 15.0% compound annual dividend growth over the past 10 years, I would consider purchasing it even today, unless there were more suitable companies to buy on the open market. Either way, I would purchase on dips: purchasing at any price strictly than $13.95 on the open market would push us below the magic 22.5 threshold for P/E × P/BV, based on the F2015 EPS and Book Value.

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1. As per an email exchange with S&P Dow Jones Indices. Email me for more information or for a copy of the exchange.


Minimizing investment friction

Over the years, I have started to pay more attention to friction in my portfolio, which I define as any charges, fees, or penalties, which ultimately deter from my earning potential. When I am making decisions to buy/hold/sell investments, there are three primary types of friction I pay attention to, and try to avoid: Tax Friction, Rounding Friction, and Commission Friction.

1. Tax Friction

Taxes are a reality, and ultimately the tax man (or woman!) always gets his (her) due. In Canada, there are three key types of taxes to pay attention to with your investments. The first, is the capital gains tax, which is applied on any capital gains (i.e. profits) from your investments when you sell them. Following this, is taxes on dividend income; and finally, there are taxes on interest income.

There are a number of ways to reduce tax friction with your investments. The most obvious one, is to keep your investments in a tax free account; in Canada, this would be your TFSA, otherwise known as a tax free savings account. Any capital gains, dividends, or interest, you receive in the TFSA are received tax free. The reason for this is that any contributions you make to a TFSA (i.e. money or investments transferred into the TFSA) are made from after tax dollars, so you have already been taxed on the inflows to the account. The one downside to using a TFSA is that you cannot use capital losses incurred in the TFSA to offset capital gains outside of your TFSA.

The second vehicle at your disposal is to keep your investments in a tax deferred account, e.g. your RRSP. Similar to your TFSA, any gains, dividends, or interest, or not taxed in the account (well, not immediately; see the second key difference below). Moreover, any losses cannot be used to offset gains outside of the RRSP. That being said, there are two key differences between a TFSA and an RRSP. The first difference is that contributions to your RRSP lower your taxable income in the year in which you make the contribution1. As an example, say your salary in 2016 is $45,000, and you contribute $5,000 to your RRSP. This lowers your taxable income to $40,000, which means that your income tax for the year is on $40,000, not $45,000. Taking this even further, if you review the marginal tax rates for your province, you may actually move yourself into a lower tax bracket. In the example we just cited, in the province of Ontario, at $45,000 your marginal tax rate is 9.15%, but at $40,000 your marginal tax rate is 4.05%!

The second difference is that you are taxed when you take money out of the RRSP. The theory is that when you take the money out however, you will already be in a lower tax bracket. So while you may be in a $45,000 tax bracket today, when you take the money out when you retire, you will likely be in a lower tax bracket. Again, by forcing yourself into a lower bracket, you are ultimately paying less tax (and keeping more money in your pocket!).

The third way to reduce taxes is to leverage your capital losses against your capital gains. This option is only available to you in a non-registered account (e.g. not a TFSA and not an RRSP). With this reduction, you reduce the amount of tax you pay on your gains by your losses in that year. For example, if you sell a stock for a profit of $10,000, and you sell another stock at a loss of $4,000, you will only pay tax on $10,000 -$4,000 = $6,000. In general this applies provided you claim the gain and loss in the same reporting period (or carry forward any losses and/or gains to future years); seek advise from a tax professional for details.

2. Rounding friction

Rounding friction is exactly what it sounds like: losses due to rounding. As an example, assume we are able to trade stocks with no commissions, and with no tax friction (e.g. in our TFSA). For our example, say there are two companies, A and B, and we wish to sell company A and purchase company B, because the yield on B is higher:

Line # Company A Company B Notes
A # shares 100 20
B share price $12.34 $59.80
C total value $1,234.00 $1,196.00
D dividend yield 5.00% 5.10%
E dividend $ $61.70 $61.00

After we have completed all of our trades, our absolute dollar return is less even though Company B is the higher yielding stock. The reason for this is that we cannot trade fractional shares. When we sold Company A and took the proceeds of $1,234.00, the proceeds divided by the price of Company B would have had fractional shares: $1,234.00 ÷ $59.80 = 20.635 shares. But, since we can only trade in whole shares, we lost out on 0.635 shares. Even if we take into account the residual cash from selling Company A (i.e. the cash leftover from the trade), our net value is still less. Note that this is only in Year 1, however in subsequent years your net dividend income would still be lower as well with Company B due to the loss of 0.635 shares.

Line # Company A Company B Notes
A # shares 100 20
B share price $12.34 $59.80
C total value $1,234.00 $1,196.00
D dividend yield 5.00% 5.10%
E dividend $ $61.70 $61.00
F Cash in Lieu n/a $38.00
G Net Value $1,295.70 $1,295.00

The only way to get around this is to either luck out and fund companies where the net proceeds of the first will exactly pay for the net cost of the second, or to purchase fractional shares. Luckily, there are ways to perform the latter. If one uses Optional Cash Purchases for companies that allow it, you can purchase any number of shares, and the the total shares purchased will be exactly equal to the amount of capital divided by the going price for the shares.

3. Commission Friction

The most common type of friction, and often one of the hardest to avoid, is friction caused by commissions on your trades. As investors we are all familiar with commissions, and they are a cost of doing business when investing.

Other than choosing a (discount) brokerage which has very low commissions (Personally I use BMO InvestorLine, which charges $9.95/trade), to my knowledge there are really only two ways to get around commission friction.

The first, is to use Optional Cash Purchases for those companies that allow it, and that do not charge commissions on OCPs. Not all companies that offer OCPs do so commission free. For example, the McDonald’s OCP program charges $6.00 per share, whereas the Emera OCP program does not.

The only other way to reduce commission friction is to trade in larger quantities of stock, thereby reducing the average commission. For example, if you purchases 100 shares of a stock at $9.95 commission, your average commission per share is only $0.0995. But if you were to purchase only 50 shares, your average commission would be $0.1990. While you are not completely eliminating the commission, you are reducing it on an average basis.

Onward and Upward!
-pmp
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1 This isn’t exactly true. See a tax professional, but you can may be able to defer your contributions to a later year, hence reducing taxes in a later year.


My recommendation criteria

One of the key elements to being a successful investor is to have a repeatable, quantifiable, investment process, which makes recommendations to buy/sell/hold based on sound fundamental values.  This removes any emotion from the stock picking process, and allows you to easy trace your decisions, when reviewing your portfolio holdings.

As part of my research process, I have built up a number of models based on various books I have read, as well as courses I have taken on investing.  The lion’s share of my criteria are actually taken from Benjamin Graham’s The Intelligent Investor, and have been tweaked to fit my own investment style. Specifically, when I am looking at an investment, I review six quantifiable tests, and make a recommendation for Buy/Hold/Sell based on how many of those tests pass. As of August 2016, here is my recommendation matrix:

Recommendation Financial Strength Earnings Stability Dividend Growth Share Price Growth EPS Growth Undervalued
Strong Buy Pass Pass Pass Pass Pass Pass
Buy N/A Cond1 Pass n/a Cond1 Pass
Hold N/A Cond1 Pass n/a Cond1 Fail
Sell Fail Cond1 Fail n/a Cond1 Fail
Strong Sell Fail Fail Fail n/a Fail Fail

In the above, Cond1 means any of those tests pass. As an example, for a stock to receive a Buy recommendation, it must pass the Dividend Growth test, the Undervalued Test, and at least one of the Earnings Stability or EPS Growth tests.

But, what do each of those tests mean?

Financial Strength

Financial Strength is driven by the current ratio for a stock, which is defined as the Current Assets divided by the Current Liabilities. This measurement is always based on the most recent year of analysis, and a company will pass this test if this ratio is less than or equal to 1.50. The test is meant to ascertain whether a company can make its current liability obligations (e.g. short term loans, accounts payable, etc.).

Earnings Stability

This test is made of up two sub tests: the most recent number of years of positive EPS growth, and the number of consecutive years of negative EPS growth.

Realistically speaking, a company may experience negative EPS growth for any number of reasons. For example, they may have faced currency headwinds which had a short term (negative) affect on their bottom line. Or they may have wound down a division, and experienced an abnormal charge for severance pay to employees of that division. However, over a lengthy time period (>= 10 years), negative EPS growth should not be a recurring theme for any firm. This test is designed to examine how many years in a row we have had consecutive negative growth. If a company has had more than one year of negative growth, this indicates that there may be other underlying issues leading to that growth, or that the company is not learning from its mistakes.

The number of recent years of positive EPS growth is another indicator of a companies ability to build on its mistakes. For this test, I look for firms where the most recent three years of EPS growth have been positive. Passing this test shows that (i) a company hasn’t had negative growth in the past 3 years, and that (ii) the company has been in an upward trend for the past three years.

Dividend Growth

Dividend Growth by itself is not a key metric referenced in The Intelligent Investor, but since my personal investing style is on dividends, it is one which deserves a test on its own. For this test, we look for a compound annual growth rate of at least 2.00% over the past 10 years. Designing this test this way has two key benefits:

  • It removes growth only (i.e. those who do not pay a dividend) companies. I am a firm believer that if you are to hold a company, you should gain some current premium for holding it, and dividends are one of the only ways for a company to give you a current return for holding their stock.
  • It smooths out periods of slow or flat growth. Depending on the dividend investment methodology being used (e.g. US Dividend Aristocrats, Canadian Dividend Aristocrats, dividend achievers, etc), you may subject yourself to rules such as “increasing dividends every year, but one year of no growth is acceptable.” Because I am looking to invest for the long term (e.g. 10+ years), I expect the total dividend payout (in absolute dollars, not yield), to grow at a rate of at least inflation. Right now, that means I am using a target of 2.00% growth per year, compounded annually. By taking the CAGR over a 10 year horizon, we do not inadvertently screen out companies which have not had stellar dividend growth over the analysis period (10 years).  For example, High Liner Foods Ltd. had zero dividend growth for four years, but still has a hefty 14.99% dividend CAGR for the past 10 years.

Share Price Growth

All things considered, we still want the share price to be going up over time. For this test, I am looking for compound annual share price growth of at least 3.00%. This also indirectly screens out chasing after yields: if my dividend growth threshold is 3.00%, and my dividend growth threshold is 2.00%, then I am asking for my share price to grow faster than my dividend. This forces out high yielding firms (i.e. dividend remain high or stable while share price falls), since I am explicitly screening out firms whose share price may be falling, yielding to increasing dividend yields.

EPS Growth

One could include this test with Earnings Stability, but I prefer to separate it out, since there are also separate tests for share price and (absolute) dividends. EPS growth also has a minimum threshold of 3.00%. This builds an at-a-glance screen to ensure that dividend payout ratios (i.e. dividends divided by EPS) do not outpace EPS: since my EPS must grow faster than dividends, this ensures that our dividend payout ratio does not become too unwieldy.

Tied with the earnings stability, this gives a fuller picture of EPS: we are checking that companies have consistent growth, are recovering from bad periods, and have a minimum allowable EPS growth over time.

Undervalued

All things being equal, I would rather buy a good stock for a good price, and a great stock for more than it is worth. Leveraging two classic criteria, the P/E ratio and the P/BV (BV=Book Value), we can build a simple screen of P/E × P/BV. In this test, I check that P/E is less than 15, P/BV is less than 1.5, and that their combination is less than 22.5 (i.e. 15 × 1.5). This allows us to reduce the universe of stocks which are too expensive, but still allowing for stocks which may be too expensive on only one metric (e.g. if a stock has a high P/E ratio, but it is trading at less than book value, all things being equal it is likely still a good buy; by applying P/E × P/BV, we can handle these situations).

Caveats

The tests are meant to be a simple way to quickly quantify a recommendation, however they should not be taken as gospel. Even when evaluating firms, I challenge myself if a company looks like a good (bad) prospect, but my model tells me to not buy it (or to buy it). For example, a company may have more than one year of negative EPS growth, but this could be due to a string of restructuring or spinoffs from the beginning of a 10 year analysis window; and since then, they have had nothing but positive growth.

Future considerations

This model is a work in progress, and as I am focused on dividend investing, it still ignores some key criteria:

  • Dividend Growth Trajectory. Looking at dividend CAGR of 10 years is meant to smooth out periods of no growth. However, it also allows periods of negative growth. All things being equal, we want a company who has had positive or flat dividend growth, but not one which has cut dividends in its 10 year history, and made up for the cuts at a later date.
  • Dividend Payout Ratio. This model does not check for our dividend payout ratio. While my analysis inspects this in general by (visual) inspection of the dividend payout graph, the model itself does not test for it. This means that some companies may pass all of the tests, even though they have dividend payout ratios in excess of EPS or Free Cash Flow.

This year I will be re-tweaking the model as I become more involved in my investing again. Stay tuned!


Reset button.

It has been a little over a year since my last post, and there have been a number of changes occurring personally, professional, as an investor, and with this site, all of which are intertwined.

The biggest event was that I was displaced in June 2015 due to downsizing at my former employer.  This was a massive hit professionally and financially, as I saw my defined benefit pension fly the coop, and I took a drastic paycut.  The summer of 2015 was a rocky one: instead of going to the beach, enjoying the weather in a park, or drinking on a patio with my mates in Toronto’s downtown core, I was hunkered down at home applying for jobs all summer.  Towards the end of August 2015 I landed a contract position, and from there started up my new life as an independent project management consultant.  So, in the end, things worked out, but it was still a bit of a professional roller coaster; and I will miss the defined benefit pension.

Personally, my family purchased a home earlier in 2016, just ahead of the massive Toronto Housing Bubble.  We lucked out; similar properties in the neighbourhood we moved into have gone up about 10% since we purchased our house earlier this year.  Needless to say, the market is hot, and I am certainly glad not to be part of that fire!

Which brings me to the changes as an investor.  The majority of my investments were being saved for the next big purchase, or retirement, whichever came first.  Needless to say, retirement is a far way off, so I ended up liquidating a number of my holdings to help pay for the house.  While the sting of selling off those holdings is still wearing off, I am happy that overall my previous investment decisions were good ones.  The biggest sale I had which contributed to the house was my long position of CCL Industries, which netted me a tidy return of 517.8%; I had purchased a while back in the high $30 range and sold in the $220 range.  I had some other big gainers (e.g. High Liner Foods returned in excess of 200%), but CCL was definitely my big winner!

Which brings us to today.

With the cashing out of my defined benefit pension, and the selloff of a number of positions in my portfolio, my portfolio has taken a net hit of about 17%.  Moreover, the tax distribution in my portfolio has changed drastically: before all of these major changes, 45% of my portfolio was taxable (i.e. non-registered), and 55% was in non-taxable or tax-deferred accounts, such as an RRSP or a TFSA (i.e. registered).  Now, the mix stands at 10% in the taxable portion, and 90% in the non-taxable.

This split is both good and bad.

The good, is that the majority of my US investments are now in my RRSP – this means I save an instant 15% of withholding taxes, since Canadians do not pay withholding tax on dividends from US corporations if they are in an RRSP.  Moreover, having 90% of my portfolio “locked away” means that I truly am saving for retirement: taking the money out of the registered portions of my portfolio would result in an immediate tax hit.

The bad, is that only 10% of my investments provide present day disposable income.  So, if I need to use any dividend income to offset present day purchases, I am unable to do so.

From a salary perspective, I am not yet at the point where I can pay myself the same salary as before I was displaced, since I have to build up some capital in my corporation.  My salary today is 17% less than one year ago, not including  any short-term bonuses, the losses of which may be even larger.  Contrary to popular belief, independent consultants are not rolling in cash!  Due to this change in salary, I am not able to invest as aggressively as before, which means my portfolio growth will be seriously constrained until I can increase my net cashflow.

As investors, diversification should be one of the primary objectives of our investment portfolios.  I’m happy to report that during the ups and downs of the past 24 months in the markets, my portfolios have done relatively well, all things considered.   With that in mind, the irony of the situation is that my income streams were not diversified.  While I received some income from dividend investing (in 2015, dividends attributed approximately 3% of my net cashflow), like most normal people, the majority of my income came from my place of employment.  So when your job changes, your net income could take a massive hit; such was my case.  With that in mind, I am looking at diversifying income streams as well.

I have moved this blog from a WordPress.com hosted site, to one hosted on my own servers.  This will give me more opportunities for revenue generation through the site; what that means, I am not quite sure, but at least the option is there.  You may see some ads on the site going forward, and clicking through to those will help me in keeping this site on its feet.

I started off by noting that it has been over a year since my last post, and I have a whole slew of ideas and things to write about.  While the original focus of this blog was on dividend investing, I will be branching out into new areas.  From an investing perspective, dividends are typically the payouts a shareholder receives from the profits of the company in which they own shares.  However, a broader definition is “anything received as a bonus, reward, or in addition to or beyond what is expected.”  That said, future posts will also focus on other methods of generating net positive cash flows: this could either be from hard inflows of cash (i.e. income), or cost avoidance, which ultimately results in more disposable income to use in other investing activities.

One thing is certain: I am certainly glad to be back here blogging and sharing my views and ideas, and I look forward to receiving criticism and feedback from my readers.

Welcome back.


Investing Roadmap Part 2: How much do you need to retire?

In my previous post, I spoke about having goals for investing. My goals fall into the second category, Investing to achieve some target and/or goal, and that goal is to not have to work.

Now, most people don’t want to work. Given the choice, I would rather sit on my balcony all day sipping an espresso reading books, researching companies, or in the living room watching a good film. However, work is a reality of life: we have to pay the bills somehow (how will I buy the espresso?). So, to be able to get to the point where I don’t have to work to make money, I need to have some inflow of cash which handles all of my regular expenses. This is a fairly mechanical exercise:

  1. Identify your monthly expenses, and multiply by 12 to annualize
  2. Add in any annual expenses (e.g. property tax on your residence, if you own a home)
  3. Add inflation up to the point that you wish to retire
  4. Factor in personal taxes

After the four steps above, you’ll have your required annual pre-tax income for when you wish to stop working.  Here is an example:

Monthly Expenses
Rent $1,500.00
Groceries $300.00
Entertainment $400.00
Insurance $100.00
Utilities $200.00
Transportation $200.00
Pet care $75.00
Mobile phone $85.00
Internet $50.00
Netflix / TV $10.00
Computer / Technology $100.00
Maintenance Fees $350.00
Emergency Funds $200.00
Total Monthly $3,570.00
Annualized $42,840.00
Annual Expenses
Vacation $5,000.00
Property Taxes $3,000.00
Total Annual Expenses $8,000.00
Total Expenses $50,840.00
Implied Tax Rate 40%
Total Annual (Gross) $84,733.33

From the example above, if I were to stop working today, I would need ~$84.7M ($M=000) in annual income to maintain my current lifestyle.

However, there is a small wrinkle in that this is in today’s dollars, and we need to factor in inflation (step #3 above).  For example, if we assume 2% inflation (i.e. on average costs will go up 2% next year), our pre-tax income shoots up to ~$86.4M.  And to further complicate things, inflation is an unknown: we don’t know what inflation will be.  Say for example I wish to stop working in 10 years, in 2025.  What inflation rate do I use for 2016, 2017, 2018, etc.?

My own workplace uses a 2.25% inflation assumption for each year.  I would prefer to account for some variability, and one way to account for this variability is to run a simulation, using a range of acceptable inflation values.  Specifically, a Monte Carlo simulation, wherein I have run 100,000 trials using an inflation assumption of 2.25% +/- 1.00% per year for the next 27 years.  One iteration of the simulation gives results such as the following:

Year Pre-tax income
(Jan 1)
Inflation Assumption Pre-tax income (Dec 31)
2015 $85,000 3.21% $87,729
2016 $87,729 3.13% $90,474
2017 $90,474 2.68% $92,899
2018 $92,899 1.29% $94,098
2019 $94,098 1.89% $95,876
2020 $95,876 2.56% $98,330
2021 $98,330 2.13% $100,425
2022 $100,425 2.67% $103,106
2023 $103,106 3.15% $106,354
2024 $106,354 1.39% $107,832
2025 $107,832 1.87% $109,849
2026 $109,849 1.93% $111,969
2027 $111,969 2.64% $114,925
2028 $114,925 1.67% $116,844
2029 $116,844 2.60% $119,882
2030 $119,882 3.24% $123,766
2031 $123,766 2.79% $127,219
2032 $127,219 2.88% $130,883
2033 $130,883 1.88% $133,344
2034 $133,344 1.91% $135,891
2035 $135,891 1.79% $138,323
2036 $138,323 2.36% $141,588
2037 $141,588 2.85% $145,623
2038 $145,623 2.85% $149,773
2039 $149,773 2.67% $153,772
2040 $153,772 2.89% $158,216
2041 $158,216 2.17% $161,649

As you can see, by the time we hit 2041, to live at my current lifestyle, I would require $158.2M in annual income.  The inflation also bounces around a lot, as each year the inflation is estimates to be somewhere between 1.25% and 3.25%.

Now, if we run this simulation 100,000 times, we get the following for the required income in 2041 (only first 10 entries shown):

Sequence # 2041 pre-tax income
1 $158,216.33
2 $160,945.75
3 $142,668.57
4 $160,712.46
5 $160,133.85
6 $160,235.08
7 $146,449.32
8 $150,616.91
9 $161,482.05
10 $152,456.35

But, what do we do with those numbers?  The answers is to perform some statistical analysis on each year, and come up with what we feel is a reliable number.  If we focus on 2041 as our example, here is the histogram:

Histogram of Required Income in 2041

For the above, we have a median required income of $154,922.16, and a mean income of $154,991.19.  However, the median and mean are the mid-point and average required incomes respectively.  Whilst the median is $154,992.16, there is a chance that it will be above that.  What I am interested in is the required income with a certain level of confidence.  If we do some more analysis on the histogram, we can break up all of the salary ranges into buckets, and from there interpolate the expected required income in 2041 with 95% confidence:

Bucket # Low High Count Cumulative Probability
1 $134,510.51 $135,685.09 1 0.0010%
2 $135,685.09 $136,859.67 0 0.0010%
3 $136,859.67 $138,034.25 1 0.0020%
4 $138,034.25 $139,208.83 6 0.0080%
5 $139,208.83 $140,383.41 12 0.0200%
6 $140,383.41 $141,557.99 55 0.0750%
7 $141,557.99 $142,732.57 156 0.2310%
8 $142,732.57 $143,907.15 338 0.5690%
9 $143,907.15 $145,081.73 682 1.2510%
10 $145,081.73 $146,256.31 1296 2.5470%
11 $146,256.31 $147,430.89 2098 4.6450%
12 $147,430.89 $148,605.47 3325 7.9700%
13 $148,605.47 $149,780.05 4653 12.6230%
14 $149,780.05 $150,954.63 6419 19.0420%
15 $150,954.63 $152,129.21 8000 27.0420%
16 $152,129.21 $153,303.79 9048 36.0900%
17 $153,303.79 $154,478.37 10070 46.1600%
18 $154,478.37 $155,652.94 10061 56.2210%
19 $155,652.94 $156,827.52 9678 65.8990%
20 $156,827.52 $158,002.10 8773 74.6720%
21 $158,002.10 $159,176.68 7376 82.0480%
22 $159,176.68 $160,351.26 5833 87.8810%
23 $160,351.26 $161,525.84 4249 92.1300%
24 $161,525.84 $162,700.42 3006 95.1360%
25 $162,700.42 $163,875.00 2057 97.1930%
26 $163,875.00 $165,049.58 1224 98.4170%
27 $165,049.58 $166,224.16 721 99.1380%
28 $166,224.16 $167,398.74 453 99.5910%
29 $167,398.74 $168,573.32 214 99.8050%
30 $168,573.32 $169,747.90 126 99.9310%
31 $169,747.90 $170,922.48 43 99.9740%
32 $170,922.48 $172,097.06 14 99.9880%
33 $172,097.06 $173,271.64 7 99.9950%
34 $173,271.64 $174,446.22 5 100.0000%
100000 100.0000%

Based on the above, our required income, at 95% confidence, is $162,647.28.  In other words, I can say with a degree of confidence that my required income in 2041 will always be at, or less than, $162,647.28; put another way: there is only a 5% chance that I will need more than $162,647.28 in annual income to live comfortably in 2041.

However, that is only for the year 2041.  It would be nice to see a bunch of years, say, from 2026 to 2041.  I won’t display all of the histograms and such, but here is the summary table:

Year Income Required at 95% confidence Mean Income Required Median Income Required
2026 $114,667.71 $111,013.30 $110,991.02
2027 $117,397.60 $113,512.43 $113,484.70
2028 $120,183.67 $116,061.47 $116,037.66
2029 $123,019.43 $118,672.26 $118,654.49
2030 $125,975.59 $121,345.28 $121,319.06
2031 $128,935.52 $124,077.19 $124,044.14
2032 $131,995.18 $126,871.97 $126,845.13
2033 $135,073.08 $129,724.75 $126,845.13
2034 $138,286.34 $132,644.87 $129,688.96
2035 $141,521.77 $135,624.14 $129,688.96
2036 $144,833.57 $138,672.78 $138,639.86
2037 $148,260.68 $141,794.27 $141,765.55
2038 $151,705.86 $144,983.10 $144,948.96
2039 $155,291.29 $148,242.42 $148,193.00
2040 $158,933.22 $151,579.05 $151,517.82
2041 $162,647.28 $154,991.19 $154,922.16

At the outset of this post, I said that my goal was to not to have to work.  From the above, I now know how much income I need in any given year, to maintain my current lifestyle, while factoring in inflation.  So, if my investments happen to generate at least $114,667.71 in income in 2026, I know that I can then quit my job and not have to worry about anything.

In one of my upcoming posts, I’ll talk about forecasting my expected income, which is the flipside of this discussion.


Why do you invest?

A few people may stumble into financial security. But for most people, the only way to attain financial security is to save and invest over a long period of time. You just need to have your money work for you. That’s investing.

Simply put, you want to invest in order to create wealth. It’s relatively painless, and the rewards are plentiful. By investing in the stock market, you’ll have a lot more money for things like retirement, education, recreation — or you could pass on your riches to the next generation so that you become your family’s Most Cherished Ancestor. Whether you’re starting from scratch or have a few thousand dollars saved, Investing Basics will help get you going on the road to financial (and Foolish!) well-being.

Now that the markets are showing signs of life, the pundits and financial writers are pumping out investing articles of all kinds. Gold is prominently mentioned as are a wide variety of stocks, mutual funds, and exotic ETFs. More so than ever, when I read these articles I ask myself this question: Why should I invest in that? Or taken one step further, the question becomes: Why do I invest?

I actually struggled for a long time on how to open up this post, but taking a page from Finding Forrester, sometimes it is easier to let someone else write the intro for you.

It should come as no surprise that many folks have asked the age old question of, “why?”.  In fact, everything that I say in this entry, has likely been written in greater detail, depth, and clarity, by someone else.  However, it is a necessary step in my overall roadmap of investing.

So, the question as it stands, why do you invest?  And as an extension to that, how do you know that you did it well?

The three quotes cited above contain a wealth of information on the how and why of investing.  At the end of the day, If we ignore the mechanics of investing (e.g. compound interest, “buy low, sell high”, “long time horizons”, etc.), the reason that any of of invest is a deeply personal one.  However, in my view the reasons for investing can be broken down into one of three categories:

  1. We invest for personal gain
  2. We invest to achieve some target and/or goal
  3. We invest for someone else

Fundamentally, these three reasons cover pretty much every scenario.  Saving for retirement?  That is #1 or #2.  Helping a relative?  That is #3.  Saving for school?  #2.

The reason that I have broken everything down into three categories, is that the why of investing is useless without some type of barometer as to how well you are investing . If you are saving for school, you know if you are successful if you have enough for your tuition.  If you are saving for retirement, then you have enough if you know that you can be financially secure after you stop working.  If you are saving for personal gain (e.g., “I just want to be rich”), you are successful if the personal decisions you make in your investing are better than those that would be made if you paid someone else to handle your money (e.g. a financial advisor).

There are really only two ways to monitor your performance: absolute, and relative.  In absolute measurements, you have some fixed, quantifiable goal against which you are measuring yourself.  If you are saving for your child’s education, and you know that the total cost will be $50,000 with tuition, books, and residence fees, then you have an absolute target against which to work.  Contrasting this are relative measurements.  These measurements are typically against some benchmark, and fundamentally reflect the opportunity cost of investing relative to some other means.  For example, if your benchmark is one of the couch potato portfolios, the performance of your investment decisions shows how much better (worse) you have done by managing your own money, instead of following the couch potato formula.

With the above in mind, the question should not be “Why do I invest?”.  Rather, it should be, “Am I meeting my investment goal?”  Defining your investment goal will lay the foundation on which you base all of your future decisions.

-10d


Portfolio Update – September 2014

September was a brutal month for returns, but I did manage to fix the asset allocation a little by going long some CBO.TO in my TFSA. Reviewing the results, using traditional methods my returns are down -2.44%, however if we use the Modified Dietz method, I am actually up 2.00%. This just goes to illustrate how the timing of your trades in a given period can greatly affect your perceived returns (in this case, I gained 4.44% due to the purchase of CBO.TO, all things being equal).

2014-09 Monthly Performance

2014-09 TTM Performance

The benchmark was down as well at -1.25%, and this month has put a drag on my Sharpe ratio, which dropped from .45 to .38.

As I said, I also purchased some CBO.TO (250 shares to be exact), which has improved my weights a little. Last period my fixed income was 5.6% (target range 20.0%-30.0%), and this month it is up to 8.0%. Only a 2.4% bump, but more than I had before.

2014-09 Asset Mix Allocation by Asset Class

These short-term fluctuations in the market don’t worry me too much — I am still making good progress overall, at 19.82% for the last twelve months.


Portfolio Update – August 2014

Once again, we are up over the benchmark, clocking at at 1.65% for the month of August vs. the benchmark’s 1.30%, giving us a sharpe ratio of 0.45.

The biggest drag in this reporting period was High Liner Foods, which has a 5.78% weighting in the portfolio, and which suffered a 14.53% loss due to lower than expected earnings (see this link). The biggest gain was from Brookfield Asset Management at 6.81%, which has a weight of 7.31% in the portfolio. The gain in BAM-A.TO was likely due to improved confidence due to higher net profits in the quarter.

On to the graphs!

2014-08 Monthly Performance

2014-08 TTM Performance

2014-08 Asset Mix Allocation by Asset Class

2014-08 Asset Mix Allocaiton by Geogrpahic Region

No change from last week with respect to weightings, but I am at the point where I can sink some cash into fixed income. The fixed income component should be up by 2.00% by next reporting period, if all things go to plan.


Portfolio Update – July 2014

The year continues to be a good one, and July was no exception. Sharp Ratio was 0.44, which is better than the last reporting period. Month over Month was up 1.82%, beating the benchmark return of 0.43% by over four fold! TTM is still north of 20.00%, although it has dipped isnce last period, coming at 23.09% vs. 23.45% in June.

The biggest losers this period were Front Street Growth Fund, which last 8.36%, and the biggest gain was in Intel, up 12.04%.

On to the graphs!

Monthly Performance 2014-07

TTM Performance 2014-07

Asset Mix Allocation by Asset Class 2014-07

Asset Mix Allocation by Region 2014-07

Observing the above it is clear that my weightings are still an issue. I am not losing sleep over it, and I still haven’t reached my $5,000 minimum before pulling the trigger on a new investment. As I get closer to that target though, I am looking for some fixed income ETFs to round out the portfolio.


Portfolio Update – June 2014

Skipped the May update, but the results are baked into here.

Overall I am still happy with the way that things are going. Sharpe ratio for this period is just south of 0.40, and I am still consistently exceeding my benchmark portfolio. May and June were up 1.49% and 1.37% respectively, vs. the benchmark of 0.76% and 0.23% for the same months. The S&P/TSX (using XIC as a proxy) was down 0.09% and up 3.32% over the same periods.

I am still concerned about my asset allocation, since I am not making any of my targets. I will be re-balancing when I have a minimum of $5M to work with though..

On to the graphs.

201406_Monthly

201406_TTM

201406_Asset Mix Allocation by Asset Class

201406_Asset Mix Allocation by Geographic Region