Leaving Money on the Table

I spent Sunday helping out my brother in organizing his finances. He joined a major Canadian corporation a little over 11 months ago, and is approaching the point of vesting for his defined contribution pension plan. Within this context, vesting means that his employer will start matching any pension contributions he makes, subject to certain rules and maximums. This is a very common investment vehicle available to Canadians: many companies do not have Defined Benefit (DB) pension plans anymore, opting to provide Defined Contribution (DC) pensions instead. As an incentive for employees to save towards retirement, companies that offer DC plans often provide a “match”. A “match” is a provision wherein the employer will match any contributions an employee makes, subject to certain conditions. For example, one company I know of offers this match structure:

  • Match 100% for the first 2% of contributions
  • Match 50% for the next 2% of contributions
  • Match 25% for the next 2% contributions

In the above, the “2% of contributions” means 2% of the employee’s salary. A more concrete example would be as follows: Assume an individual makes $40,000/year, and wishes to maximize her employer match. The numbers would add up like so:

Employee contribution %

Employee contribution $

Employer match %

Employer match $

2.0%

$800

100.0%

$800

2.0%

$800

50.0%

$400

2.0%

$800

25.0%

$200

As you can see above, the employee contributed $2,400 of their salary, but the employer contributed $1,400. This means that the employee received an instant 58% return for doing nothing! This is quite literally free money: your employer is giving you an instant top-up as incentive to save for your own retirement. Let’s take the example a little further: assume someone starts working at age 30, works for 35 years to age 65, and maximizes their contributions every year. Moreover, assume they get a 1% raise every year. If we plot this example over the duration of the person’s employment, the difference—while still a 58% gain—is even more pronounced.

By the end of 35 years, the employee would have contributed $103,000 on their own, if they had contributed 6% of their salary. But, thanks to the employer match, their effective contribution was $164,000! They have received an additional $61,000 all for doing nothing.

However, when an individual contributes to a plan such as the above, they don’t just save the money; they typically invest in mutual funds which are made available to them through the DC plan. We can modify the above graph to show the theoretical balance at retirement, assuming 2%, 4%, and 6% returns on the investments.

Again, there was a 58% gain when you compare the Employee only to the Employee and Employer Match:

Employee Only

Employee + Employer

2% returns

$146,188.44

$231,464.99

4% returns

$194,337.71

$307,701.37

6% returns

$322,391.14

$510,452.58

The astonishing thing is that many people don’t take advantage of the employer match that is offered in their pension plans (here is an interesting read from the Financial Post). This means that there are people who are literally giving up free money. Often some people say that the reason they don’t do this is that they can’t afford to contribute money to their company sponsored pension plan, because that means that they will have less money paycheque to paycheque. To that, I have a couple of comments:

  • If you are truly living paycheque to paycheque, then there are more systematic issues at hand that you need to look at; you really need to sit down and plan out a proper budget for yourself.
  • You really can’t afford not to take advantage of a pension plan: if you don’t save now, then you will ultimately have to work longer later.
  • Contributing to your pension plan is a tax-advantageous activity: meaning that if you wish to contribute $500 to your DC pension plan, your effective contribution is lower because your taxes will be lower; I will be writing about this in a future blog post.

So there really is no reason not to contribute. Imagine this: you are walking home and there is a fork in the road to go around a building. Both roads from the fork lead you to the same place at the opposite end of the building. From your vantage point, you can see a $20.00 bill lying on the ground up ahead on the road to the right, and on the road to the left, you can’t see any money lying around. Would you take the fork to the left? Of course not, you would be foolishly ignoring money that was just lying around. Your pension is the same: don’t take the road of no contributions, but take full advantage of the free money your employer is willing to give you.

Onwards and upwards!


The CART Model

One of the greatest challenges in investing in individual companies is in identifying which companies to invest in. There are literally thousands of stocks to choose from, and trying to find great value is like looking for a needle in a haystack at times.

One of the easiest things to do is to use a stock screener, of which there are several. A stock screener will let you filter through all of the stocks on a particular exchange, based on preset criteria. For example, you could do a screen on the common shares of stocks listed on the TSX, with a P/E ratio of less than 30, that pay a minimum annual dividend of $0.50/share:

Your screener would then output a list of companies that match that criteria.

Often, some screeners have pre-built screens, such as the one at Yahoo:

However, a stock screen is only the first step. The challenge with screens is that they typically only show the most recent year’s worth of data. For that reason, you often have to dig a little deeper. That said, pulling the past ten years of fundamental data to drop into a spreadsheet is not a trivial task: you often have to collect the data directly from a companies annual filings found on SEDAR or Edgar, which takes a considerable amount of time. However, often service providers such as BMO InvestorLine or The Globe and Mail have the most recent few years of data available.

Historical Data from BMO InvestorLine

Historical Data from BMO InvestorLine

Globe and Mail

Historical Data from The Globe and Mail – Globe Investor

To that end, I have created the CART model:

  • Cursory
  • Analysis
  • Research
  • Template

I’ve already covered a few companies using the CART model on Seeking Alpha:

The CART model provides me with a template for doing a high level analysis of a company by importing data from BMO InvestorLine. This high level analysis:

  • Looks at the most recent 5 years of data (vs. a standard analysis of 10 years)
  • Gives a quick view of underlying fundamental data such as:
    • Revenue
    • Balance sheet
    • Earnings and Dividends
  • Provides a quick view of how under or overvalued the stock is

The resulting template then lets me make a decision if I should go forward with a deeper analysis, which usually covers a wider timeframe (e.g. 10 years), and goes into more fundamental comparisons with competitors, a more detailed SWOT analysis, etc. All of this allows me to maximize my time in searching for value dividend payers, to help improve the returns on the overall portfolio.

Onwards and upwards!


Cursory Analysis: Richelieu Hardware Ltd. (RCH.TO)

The following is a brief summary of an analysis note that I posted to Seeking Alpha. The full article may be found at this link.

Richelieu Hardware Ltd. (RCH.TO) was brought to my attention by a colleague when he was searching for stocks that he found that met Peter Lynch’s stock selection criteria. Upon first hearing about Richelieu, it seemed to hit on some of the key levers I look for in a stock:

  • Small/medium capitalization
  • Dividend paying, with increasing payments
  • Canadian based
  • A boring industry
  • Focused on a tangible product/service (e.g. they make/sell things that you can “hug and hold”)

Headquartered in Montreal, Quebec, Richelieu Hardware Ltd. is an importer, distributor, and manufacturer of specialty hardware and related products, focused on the North American Markets. Its primary customers are split amongst retail customers vis-à-vis the residential and commercial woodworking industry, home furnishing and office furniture manufacturers, and hardware and renovation superstores (e.g. Home Depot, Lowes). In performing a cursory analysis of the past five years of Richelieu’s fundamentals, the company has a strong balance sheet, great profitability, and a compelling dividend. However, it is presently overpriced.

A cursory analysis shows that Richelieu appears to be a strong company based on the past five years of fundamentals. Richelieu’s fundamentals have some intriguing characteristics, but based on the most recent fiscal year it is overvalued. Based on this cursory analysis, I would rate this company a hold, pending further analysis into the fundamentals, over a larger window (e.g. 10 years vs. the 5 years used for my cursory analysis). That said, Richelieu certainly deserves a deeper analysis to establish if it is a company which should be placed on long term watch-lists, to purchase on dips.


SNC-Lavalin (SNC.TO) Analysis

A copy of this article originally appeared on Seeking Alpha.

Thesis

With respectable profitability over the past 10 years, and an incredibly strong dividend history, SNC-Lavalin (SNC.TO) would be a worthwhile addition to any dividend growth portfolio. However, its current valuation measured against its price-to-book, and price-to-earnings ratios, as well as when compared to its peers, demonstrates that even with strong dividend performance it is still overvalued. Investors would be better off putting this stock on their watch list, and adding when the price drops below C$40.00.

Background

SNC-Lavalin is a Canadian based engineering firm, which derives its income from six key streams, outlined below.

Collectively, the Mining & Metallurgy, Oil & Gas, Power, Infrastructure & Construction, and Operations & Maintenance, are referred to as the Engineering & Construction segment. Running parallel to this is the Capital Investments segment, which enters long term agreements which use either fixed cost or equity method accounting to record revenue.

Profitability and Stability

Beginning in F2013, SNC started reporting its revenue broken down between engineering revenue and capital investment Revenue. Except for F2009 and F2013, year over year (YoY) revenue growth has been positive, with the most recent year’s revenue coming in at +16% at over $9billion.

The share price has generally trended upwards over the past 10 years, with minor dips in F2008, F2012, and F2014:

The F2008 dip may be attributed to the Kerala Hyderoelectirc Dam Scandal, and the F2012 and F2014 dips may be attributed to the Libya business probe. Of course, this is speculation, but given the negative press it is a plausible explanation, especially since the underlying fundamentals relating to revenue remained consistently strong during that period.

One other financial stability figure to review is the current ratio. Typically, one would hope to see a current ratio of at least 1.50 (i.e. current assets more than covers current liabilities). As of the most recent fiscal year, the current ratio is 1.02 when comparing net current assets to net current liabilities. However, this number quickly climbs to 1.54 once you consider the ratio of short term assets to short term debt (i.e. vs. aggregate short-term liabilities). This is illustrated in the below chart, which breaks down short-term liabilities into its components of debt vs. de-facto liabilities.

Condensed Balance Sheet

Condensed Balance Sheet

Dividend

Dividends are an interesting metric when compared to share price. Provided the dividend payout ratio (i.e. the portion earnings paid to dividends) remains low, and the dividend remains consistent or increasing, a drop in a company’s share price often represents a buying opportunity. It is for this reason that I feel dividends can be observed separately from share price: whereas share price represents capital appreciation, dividends represent (immediate) realized gains to shareholders. That said, over the past 10 years, SNC’s dividend has risen from $0.23 in F2005 to $1.01 in F2015, representing a 14.40% compounded annual growth rate of dividends.

Overall, the dividend payout ratio has been consistently below 50% since F2010, and prior to that, it was consistently below 40%. Overall this indicates that there is still plenty of room for SNC to continue to raise dividends, even in the face of revenue headwinds.

Valuation

SNC’s current valuation is where it falls short in my view, based on the following:

  • Trailing-twelve-months (“TTM”) EPS of 2.03/share
  • Book value of $25.03 based on the most recent fiscal quarter results
  • Current share price of $56.52 (as of February 3, 2017)

Given these numbers, the stock has a price-to-earnings of 27.8, and a price-to-book of 2.2, yielding a Graham number (i.e. P/E × P/BV) of 60.8. SNC’s meaningful peers (Aecon (ARE.TO), Bird Construction (BDT.TO)) have an average P/E × P/BV of 25.0 for the most recent fiscal year, illustrating that SNC’s Graham number is more than twice that of its peers.

What this translates to, is that SNC is trading at much more than it should be at this time, when compared to EPS and/or book value. At the current TTM trailing EPS and book value, I would expect to see a price of no more than $33.81, if we have an upper limit of 22.5 for our Graham number. This puts SNC’s current price at roughly 1.7× what it should be, based on TTM EPS and book value based on the most recent quarterly results. This isn’t quite as bad as the Graham number multiple compared to peers (SNC’s 60.8 is 2.4× that of the peer average at 25.0), but it is still considerable.

Closing Remarks

Fundamentally, I like SNC. Its historical performance, even amidst two scandals, is stellar, and its dividend growth is spectacular. However, the valuation concerns me; as much as I don’t mind paying an “okay price for a good company”, at the current valuation it is no longer “okay”, just “bad”. I would consider buying on dips, and will re-review after the F2016 results are out to see where the valuation sits vis-a-vis its updated fundamentals.

Notes

All figures are reported in Canadian dollars.


Exco Technologies Ltd. (XTC.TO) Analysis – F2016 Update

I last reviewed Exco Technologies earlier this year, and at the time had recommended them as a buy. Exco recently announced their audited financial results for the 2016 Fiscal Year, so now is a good time to update the analysis to see if this recommendation holds.

Let’s take a look at the aggregate recommendation criteria:

Criteria Value Threshold Pass?
Strong financial condition Current Ratio 2.03 1.50 YES
Earnings Stability Number of most recent years of positive EPS 6.00 3.00 YES
Earnings Stability Number of consecutive years of negative EPS 2.00 1.00 NO
Dividend Growth Compound Annual Dividend Growth 16.57% 2.00% YES
Share Price Growth Compound Annual Share Price Growth 10.59% 3.00% YES
EPS Growth Compound Annual EPS Growth 35.25% 3.00% YES
Moderate P/E Ratio P/E 10.81 15.00 YES
Moderate P/BV Ratio P/BV 1.84 1.50
Moderate P/E*P/BV Ratio P/E × P/BV 19.93 22.50

We can review the EPS, dividend, and free cash flow metrics first, since these speak to some of the fundamental cash flow attributes of the firm:

10 year Dividend, EPS, and Free Cash Flow per Share Growth

Compound annual dividend growth for the trailing 10 years has increased from 14.88% in F2015 to 16.57% in F2016, which was accompanied by an increase in the quarterly dividend to $0.07/quarter earlier this year. EPS compound annual growth has dropped a little: in F2016 the growth is now 31.23%, down from 33.03%, using F2007 as a base year. This does not concern me, as growth is still on an upward trajectory, and as you can see from the data, free cash flow per share is growing at a healthy pace.

As an aside: in F2015 when calculating CAGR of EPS growth I used a reference year of F2005, which gave me a CAGR of 12.32% between F2005 and F2015. However, because F2006 had a negative EPS, this makes comparables difficult. For comparison purposes. I have used a CAGR from F2007-F2015 vs F2007-F2016 when comparing EPS growth rates.

The other reason I am not concerned about a minor drop in EPS growth is the dividend payout ratio:

10 Year Dividend Payout Ratio vs EPS and FCFPS

In F2016, the dividend payout ratio against EPS and free cash flow per share was 24.13% and 26.80% respectively. F2015 had a payout ratio against EPS of 23.86%, and a payout ratio against free cash flow per share of 45.78%. Even though the payout against EPS has gone up in F2016 (because the dividend rose faster (17.39% year over year) than EPS (16.10% year over year)), at 24.13% there is still ample room for dividend increases in the long run. In other words: I am not concerned about the dividend being impacted in the foreseeable future.

I remain neutral on my views of overall profitability strength:

10 Year Profitiability Strength

Revenue has been going up year over year, however the growth in that revenue has dipped somewhat in F2016 (YoY growth in F2015 was 35.31%, while it was only 18.20% in F2016). Profit margins have remained consistently above 8.00%, which is a positive sign: Exco has managed to keep profit margins above this support level for the past three years. But, with the acquisition of AFX (discussed below), I expect revenue growth to match or exceed F2016 by this time next year.

From a valuation perspective, the company is still relatively cheap:

Graham Number as of 2016

The Graham number is sitting at a very healthy 19.93, which is below our threshold of 22.50. If you recall, when I analyzed the company based on F2015 financials the Graham number was 37.87, but at the time of my review it was sitting at 13.72 based on forward EPS at the time. So it has gone up relative to my last valuation, but is still cheap in my eyes. In fact, I doubled my position earlier this week when there was a dip to the low $10.00/share range.

Reviewing the annual report, the company came in under the consensus F2016 EPS: actual EPS was 1.12, vs. a mean forward estimate of 1.14. However, even at 1.12, this was a 16.10% increase over the previous year. Exco completed the acquisition earlier this year of AFX Industries LLC which added significantly to its revenue streams on a go forward basis, to the tune of 11.40% for their consolidated sales revenue for the year. This acquisition also saw the overall debt load of the firm go up: net debt went from $21million in F2015 to $110million in F2016, $100million of which was related to the acquisition. Overall however, I feel that this is a positive story for Exco since it has already added to their overall sales revenue.

Two other points to consider for Exco are the currency exchange rate, as well as the effects of president-elect Donald Trump. A weakening Canadian dollar has been very favourable for Exco:

Over the year, the US dollar averaged 7% higher ($1.32 versus $1.24) against the Canadian dollar contributing $15.2 million in sales to the current year. Similarly, the Euro averaged 5% higher ($1.46 versus $1.41) against the Canadian dollar contributing $5.7 million to sales.

Source: 2016 Annual Report

With regards to the president-elect, if he does go through with moving more jobs into the US and/or increasing duties (or completely eliminating NAFTA), I am not sure what this will do to Exco exports from Canada to the US: as the US is a key trading partner, there may be a material impact on the quantity and dollar value of goods shipping from Canada to the US. That said, Exco is making serious movements in other parts of the world:

  • AFX is a key supplier to BMW, giving them access to European markets
  • Operations in Thailand are giving them a launchpad to better penetrate the Asian market

Activities such as this lessen my worry about impacts of the president-elect at this point: even if there are material changes to NAFTA, with Exco’s Canadian customers, and access to other markets such as Europe and Asia, will mitigate any effects.

With the above in mind, I maintain my recommendation of buy for Exco Technologies Ltd.

Disclosure: Long XTC.TO as of December 9, 2016.


Cost Avoidance: The Indirect Dividend

Earlier this year I was helping my brother out with his financial planning, and one key element of the planning was to cut expenses. Cutting expenses is an important factor of any planning session, since any reduction in expenses boosts your disposable income by an identical amount: save $5.00, and you suddenly have $5.00 to redeploy elsewhere. At the time, he was paying $14.95/month in banking fees at a major Canadian bank, which equates to $179.40/year. When I asked him why he paid the fees, he really didn’t have an answer. Like many individuals, he took fees as a given–albeit a horrible one–and paid them every month. With some nudging, we managed to move all of his accounts to Tangerine, and he now has an extra $14.95 every month in his pocket. By the way, if you decide to open up your own account at Tangerine, please use my referral key: 16176076S1 .

Of course, it is not always possible to move all of your banking. I have the lion’s share of my accounts at Tangerine, however I also have an account at BMO because my mortgage is with them, I have a US Dollar Chequing account there, and I use BMO InvestorLine as my discount brokerage. Having an account there just makes things easier. But, even having an account, there are ways to avoid the monthly fees. For my own plan, if I keep a minimum balance of $2,500 in the account, the fees are waived.

Now, I gave that bit of background, because Bank of Montreal is increasing the minimum balance you require to waive fees as of December 1, 2016. Here is a snaphot (as of November 29, 2016) of the proposed fee increases:

Plan Current minimum balance New minimum balance Difference $ Difference %
Practical $1,500 $2,000 +$500 +33%
Plus $2,500 $3,000 +$500 +20%
Performance $3,500 $4,000 +$500 +14%
Premium $5,000 $6,000 +$1,000 +20%

As with everything, the need to pay for fees is all about opportunity cost. As a consumer, I have two choices:

  1. Pay a monthly fee, and use the minimum balance as I see fit.
  2. Do not pay a monthly fee, and lock up the minimum balance with BMO.

Let’s look at the annual banking fees, relative to the minimum balance to avoid paying those fees:

Plan Monthly Fee Annual Fee Minimum Balance (Old) Cost Yield (Old) Minimum Balance (New) Cost Yield (New)
Practical $4.00 $48.00 $1,500 3.2% $2,000 2.4%
Plus $10.95 $131.40 $2,500 5.3% $3,000 4.4%
Performance $14.95 $179.40 $3,500 5.1% $4,000 4.5%
Premium $30.00 $360.00 $5,000 7.2% $6,000 6.0%

In the above, the Cost Yield column represents the percentage cost based on the minimum balance, to avoid paying the fees. So, for the Plus Plan, by keeping $2,500 in the account, I am avoiding $131.40 in fees per year, or 5.3% of the locked in money. Put another way: if I can find an investment that pays me at least 5.3%, I would be better off taking the $2,500, investing it in the investment, and using the proceeds to pay off the monthly fees. However, that 5.3% doesn’t take into account taxes. My marginal tax rate on dividends is 25.38% according to the tables on taxtips.ca, so in reality I need to find an investment that yields at least 7.0% (since 7.0%, less 25.38% taxes, would yield me 5.3%).

Now, years ago when I was faced this decision, it was hard to find an investment that would guarantee me 7.0% return (with an acceptable level of risk). The other wrinkle was that many ETFs or companies pay dividends quarterly, which means the income stream from the investment would be “lumpy” relative to the frequency of payments. But with the increase in BMO’s minimum balance, things change. Here are the updated tables using the December 1, 2016, minimum balances:

Plan Monthly Fee Annual Fee Minimum Balance (new) Cost Yield (new) After Tax Cost Yield (new)
Practical $4.00 $48.00 $2,000 2.4% 3.2%
Plus $10.95 $131.40 $3,000 4.4% 5.9%
Performance $14.95 $179.40 $4,000 4.5% 6.0%
Premium $30.00 $360.00 $6,000 6.0% 8.0%

My specific plan is the Plus plan, so I now have two choices: find an investment which gives me a guaranteed 5.9% return on $3,000 (which would give me $177.00, or $132.07 after taxes), or keep $3,000 locked at BMO, and avoid $131.40 in annual fees. Given that this $3,000 is a good place to stash emergency funds, and I wish to preserve safety of principal, at this point I feel it is still safer to keep the “ransom money” with BMO to avoid the fee. It is because of the savings that I call this the “indirect dividend”: I can either claim a dividend by investing the capital, or I can save the fee by locking the money away. Either way, I am “making” money off of locking away a fixed amount of capital.

Of course, there are ways to improve the above analysis. For one, if I purchased the shares in my TFSA, then there would be no tax implications, so I could focus on the Cost Yield, not the After Tax Cost Yield. Another possibility is preferred shares, which I spoke of in an earlier post. Over the next few weeks I will continue this analysis to see if there is a better way to obtain overall higher returns.

Onwards and upwards!


Leveraging the Work of Others

I am often asked where I get my information, where I start, and what my process is.

The first thing for any investor, regardless of how s/he invests, is to have an Investment Policy Statement, or an IPS. I’ll touch more on IPS’ in a later post, but in a nutshell it describes your investing goals, strategy, how to meausure success, and risk tolerance. Overall, it measures the how and why you invest. I mention this, because one’s investing process is driven by their IPS, and the process in turn drives how and where you start.

As a dividend investor, I try to work smarter, not harder. There are a plethora of information sources out there. The universe of dividend paying companies is huge, and grows even larger when you expand this to income trusts (e.g. REITs), mutual funds, and ETFs. Because the universe is so large, it is challenging to find companies to invest in that meet my specific criteria:

  • Companies with strong dividend growth
  • Companies which are cheap (by cheap, I mean in terms of valuation, not the actual cost per share)
  • Companies which offer a decent yield
  • Companies which will help to diversify my exposure to different industries (i.e. not being overly concentrated in one type of company, such as “all banks”)

With that criteria in mind, there are a number of tools that one can use to help whittle down the universe of available stocks to invest in. And once this universe is whittled down, you can start focusing on which companies to take a deeper look at, before pulling the trigger and investing your hard earned dollars. That said, here are some of the tools I use to help in identifying companies to analyze, and hopefully purchase.

  • Blogs. I try to read a lot of blogs, but as most readers know, there are many, many blogs out there. It helps to be able to have a shortened list of blogs to peruse on a regular basis. My primary source of blogs is The Div-net, as it is composed of blogs focused on dividend investing. This makes sense, as there are several great bloggers who have already done a fair bit of research on companies to invest in (or not to invest in!). Beyond that, these blogs are a great source of inspiration for my own investment activities, and often help to push me to invest that one extra dollar into my investments.
  • Podcasts. I listen to three (four) bogs on a regular basis. These blogs are not all about investing, but they do act as a great source of inspiration for managing money. Moreover, they make the listener really think, which helps when you are doing deep analyses on companies to invest in.
    • Market Foolery / Motley Fool Money. These blogs are published Monday-Thursday, and Friday, respectively, and are the podcasts of fool.com. The show features a rotating list of speakers who work at fool.com, and is great for a daily recap of financial events, and an hour long recap on Friday. The host and speakers are great presenters, and I’m often left laughing under my breath on the streetcar home when I’m listening to them.
    • Planet Money. While not an investment podcast, Planet Money is a great source of things about, well, money. They cover a breadth of topics, everything from the full process to selling oil (right from pumping it out of the ground, to selling it to a gas station), the odd case of a shopping mall with two different minimum wages, and the investor of the Self-Checkout Counter (who knew that the inventor was a local Torontonian???).
    • Freakonomics. I’ve saved the best for last. I love the Freakonomic books, and the podcast is great for a weekly dose of diverse topics on economics. They cover everything to do with incentives, right from why belts are the worst invention ever, to the history of the Nobel prize.
  • News. Newspapers, and newspaper websites, are a great source of information. Regrettably, many newspapers how have “pay-walls” around them, so some of the more premium content is unavailable without a subscription. Frequent sites to visit? The Business and/or Investing sections of The Globe and Mail, Yahoo Finance (Canada), and Bloomberg.
  • Daily Email News Digests. I subscribe to two daily news digests, which typically deliver an email before 7:00 AM EST so I may read it on my way to work.
    • CFA Financial Newsbrief is put out by the Chartered Fianncial Analyst Institute, and is a great roundup of financial and economic events that have occured in the last twenty four hours (or over teh weekend in the case of the Monday edition). Within the email, there are short paragraphs describing the event, and links to longer articles on 3rd party websites such as Bloomberg, or Wall Street Journal.
    • Bloomberg Briefs. I actually subscribe to two Bloomberg digests, but they are both different versions of Bloomberg Briefs. If you go to the site, there a variety of daily digests which you can sign up for, for various financial products (ETFs, Bonds), different industries, and general financial and economic news.
  • DRIP Investing Centre. The DRIP investing Centre is the heavyweight of all information. On this site, you’ll find the Money Market Dividend Champion lists for both Canada and the US, available in Excel and PDF format. These lists are invaluable to the dividend investor, as they have information going back several decades for each company that pays a dividend in the Canadian and US markets. For my own criteria listed above, I was able to whittle the universe of 700+ stocks down to 15 stocks in less than 5 minutes, just playing with some filters in the spreadsheets. This has saved me countless hours of filtering and searching other websites for the same information. Importantly, it also lists an extrapolated Graham number, which is one of the key metrics I use for measuring the value of a company (e.g. to determine if it is cheap enough to buy). This in itself is a great time saving tool, since it avoids me researching a company, only to find that it is too expensive to invest in!

No investor is an island, and it helps to leverage the work of others! After all, the majority of us are retail investors who are trying to carve out the biggest piece of the pie that they can — and thanks to resource such as those listed above, we can eek out an even larger piece over time.

Onward and upwards!


A Risk Free Rate for Retail Investors

The risk free rate is one of the key inputs to measuring your portfolio performance. It is a fundamental element of two key measures, those being the CAPM (Capital Asset Pricing Model), and the Sharpe Ratio. The CAPM is a basic measurement which is central to many aspects of present day portfolio theory, and states that the expected return on a portfolio (or equity) is equal to the risk free rate, plus some variance against the excess return of the market over the risk free rate:

\bar{r_e} = r_f + \beta_e(\bar{r_m} - r_f)

Where \bar{r_e} is the expected return on our equity (or portfolio), r_f is the risk free rate, \bar{r_m} is the return of the market, and \beta_e is the beta of our equity (or portfolio). A deep dive of CAPM is beyond the scope of this blog post, but for more information you can check out Investopedia.

Another measure is the Sharpe Ratio:

s_e = \frac{\bar{r_e} - r_f}{\sigma_e}

Where s_e is the Sharpe Ratio of the equity (or portfolio), \bar{r_e} is the expected return of the equity (or portfolio), \sigma_e is the standard deviation of the equity (or portfolio) returns, and r_f is the risk free rate of return, as with our CAPM above.

Both the CAPM and the Sharpe Ratio are great indicators of how well you, as an investor, are performing. Of the variables above, the expected return and standard deviation of returns on your own portfolio (\bar{r_e} and \sigma_e respectively) are easy enough to calculate, since you should have the historical returns of your portfolio already. The expected return on the market in the CAPM is easy enough to proxy—you can easily use the expected return of an ETF such as the iShares XIC—but the risk free rate takes a little more effort.

Conventionally, theory dictates that we use a truly risk-free asset such as a treasury bill yield (Canadian T-Bills or US T-Bills for North America), since one would hope that treasury bills issued by Canadian or American governments are relatively safe. However, as a retail investor, this presents some challenges:

  • T-bills are not necessarily readily available to us in the conventional sense. It is pretty difficult for us to go out to our investment brokerage and ask to buy a t-bill. The reasons for this are varied, but for the most part it boils down to availability, and minimum purchase required. E.g. the minimum t-bill purchase may be $5,000 or $100,000!
  • T-bills, by definition, mature in less than one year. To position this in practical terms for the retail investor, we would have to buy a new t-bill every year for the duration of our investment, which means we would have to build a yield-curve based on the expected future prices of those future t-bills. This simply isn’t practical for our needs.

Ignoring the theoretical risk-free instrument, there are a number of practical options which are available to retail investors, including real bonds, bond funds, GICs, and high interest savings accounts.

Real Bonds

Real bonds are just as they sound: bonds that you would purchase from your brokerage, backed by governments or companies. Theoretically, since real bonds are backed for corporations or smaller governments (e.g. municipal governments, provincial governments), there is still a degree of risk involved in the backing body defaulting on the bond. The inherent default risk aside, the key reasons I do not consider real bonds a suitable substitute are:

  • Availability. Depending on your brokerage, there may or may not be sufficient inventory to fill your needs.
  • Minimum purchase. Depending on the bond, the minimum purchase could range anywhere from $1,000 to $10,000.

Bond Funds

Bond funds would include ETFs such as iShares’ XBB or Vanguard’s VAB, which hold bonds as their underlying securities, usually in the proportion of some known bond index. ETFs such as these would fall in the fixed income category, which I wrote of previously. However, the key reason I would not consider a bond ETF as a risk-free investment, is that with a bond ETF you are still exposed to loss of capital, and the actual distributions are not necessarily fixed. For loss of capital, a quick look at the 10 year share price of XBB should suffice:

XBB 10 Year Price History as of October 10, 2016

XBB 10 Year Price History as of October 10, 2016

Inspecting the 10 year history, depending on when you had invested, you may have lost your initial investment. This is evidence of a bond ETF not being truly risk-free, even though it is composed of “risk-free” assets.

High Interest Savings Accounts

Just as they are named, high interest savings accounts (“HISA” for short) are savings accounts you can open at your local financial institution, which offer higher than average interest rates. Typically, a HISA is a very safe option. Being offered by major financial institutions, your deposit should be insured by the CDIC up to $100,000. Moreover, because it is a regular savings account, you have virtually instant access to the capital when you need it.

The biggest risk with a HISA is that the “high interest” may not be guaranteed. Here is a snippit of historical interest rates for Tangerine Bank:

Effective Date New Rate
July 24, 2015 0.80%
February 3, 2015 1.05%
March 6, 2014 1.30%
March 29, 2012 1.35%
August 5, 2010 1.50%
June 30, 2010 1.30%
December 15, 2009 1.20%
September 9, 2009 1.05%

Since 2009, Tangerine (formerly ING Direct) has changed their rate 8 times! Hardly risk-free!

Guaranteed Investment Certificates

I consider a Guaranteed Investment Certificate (“GIC” for short) the closest approximation to a truly risk-free asset.

  • You can select the term you wish to invest for, and the interest rate will be locked in for this term. Terms may range from 30 days to 6 years at most institutions.
  • The rate is guaranteed, with some exceptions as listed in the terms and conditions of the GIC (e.g. there may be an early redemption penalty).
  • Your investment is most likely insured, up to $100,000, by the CDIC, provided the institution is a member of the CDIC.
  • Depending on the GIC you chose, you can select one with an early redemption clause, giving you access to your capital if you need it in an emergency.

Selecting the Appropriate Vehicle

There are undoubtedly other options available to retail investors for risk-free investments. I know that some brokerages offer money market funds and other term-deposit vehicles. Moreover one could argue that, given the paltry returns available on some of the options above, you may be better off putting your money in a REIT or other high yield “low risk” vehicle. However, investing in conventional equities often entails risks, illustrated by the use of a bond fund: ironically, the fund is made up of riskless investments, yet the capital itself is subject to depreciating market values depending on overall market conditions (e.g. change in interest rates). This risk exposure is counter to the entire notion of selecting a risk-free rate: a risk-free rate is meant to minimize risk, not maximize returns.

Moreover, you have to select the best vehicle to use as the risk-free rate. If you are deciding on an investment with a one year time horizon, the 5-year GIC may not make the best sense to use for the risk-free rate. For example, as of October 10, 2016, the best 5-year GIC rate on rate hub is 2.50%, and the best 1-year GIC rate is 2.00%. Lets crunch some numbers:

  • You have an opportunity for a 1-year investment with a guaranteed return of 4.00%; you invest $1,000 today and receive $1,040 exactly 1 year from now.
  • The 5-year GIC rate is 2.50%.
  • The 1-year GIC rate is 2.00%.

Using the 5-year GIC rate as your risk-free rate, the investment has an NPV of $14.63; meaning you would make $14.63 with the investment, vs. investing in the 5-year GIC. Using the 1-year GIC rate as your risk-free rate, the investment has an NPV of $19.61. All things being equal you may pass up on the investment if you use the 5-year GIC rate as your risk-free rate, even though your absolute return would be better when compared with the 1-year GIC rate.  Realistically, you would select the 1-year GIC rate as your risk-free rate, since the duration of the GIC matches the duration of the investment opportunity.

When I look to purchase an investment, I typically look at the 5 or 10 year horizon. For that reason, I typically use the 5-year GIC rate or 10-year bond rate of a bond currently available at my brokerage as the risk-free rate. By doing this, I have a full understanding of the opportunity cost of my investment decision: I can either invest in the 5-year GIC or 10-year bond, or in the investment at hand.

In summary:

  • HISAs and GICs present two of the more effective vehicles available to retail investors for approximating a risk-free rate of return, when determining the performance of your portfolio.
  • You should pick the risk-free rate that best suits the time duration of your calculations.

Onward and upwards!


Ryder System Inc. (R.N) Analysis

Summary

Ryder Systems Inc. (R.N) is a solid dividend performer, but has weak cashflow and a neutral balance sheet due to its business model. Nonetheless, when measured against EPS and overall revenue fundamentals, the comapny seems solid. With strong dividend performance, and revenue fundamentals, I rate this a Buy.

Background

Ryder System, Inc. (Ryder) is a provider of transportation and supply chain management solutions, with operations in three key business segments:

  • Fleet Management Solutions (FMS). Their FMS offering is “comprised of longer-term full service leasing and contract maintenance services; shorter-term commercial truck rental; flexible maintenance services; and value-added fleet support services such as insurance, vehicle administration and fuel services.” Moreover, Ryder makes use of old inventory (trucks, tractors, and trailers) through sales network, providing old inventory for sale through their used vehicle sales program.
  • Dedicated Transportation Solutions (DTS). The DTS unit provides a dedicated transportation solution vis-a-vis full service leases with drivers, additional services (such as scheduling, safety, and regulatory compliance), and equipment, maintenance, and general administrative services.
  • Supply Chain Solutions (SCS). SCS provides supply chain management and general logistics services.

Analysis

Fundamentals

Ryder’s cash flow is terrible, and their current ratio does not meet the minimum threshold I look for of 1.50; their F2015 Current Ratio is 0.65. Moreover, the firm carries a lot of debt, evidenced by their overall financial strength, below. Overall Total Liabilities to Equity, and Net Debt to Equity, are exceedingly greater than 1.00. I differentiate between Total Liabilities and Net Debt, the former including all liabilities on the balance sheet, such as debt, leases, accounts payable, etc., and the latter being pure debt, e.g. debt owed to creditors. On the flip-side of this, Debt to Tangible Assets is consistently less than 1.00, which means that overall the tangible assets exceed total debt; in a sell-off situation, according to the balance sheet, Ryder would still be in an okay position (albeit barely).

Financial Strength

Financial Strength

This weak financial condition had me worried at first, but when you peel back the layers it is not as bad as it seems. For one, the current ratio has spiked in F2015 due to a large amount of long term debt coming due. Second, the nature of the business is that Ryder has long term liabilities vis-a-vis long term leases with suppliers. They take the products from long term leases, and in turn lease those products back to their customers. This is important: they are rotating debt to pay for long term revenue generating property, plant, and equipment (PPE), AKA trucks, tractors, and trailers. Moreover, revenue generating PPE are classified under capital leases; this makes sense, as it reduces the risk of Ryder owning the equipment outright. Within this context, the high debt levels are not concerning, as it is one of their core operating strategies: capital leases, which they then lease out through their various business segments, and finally sell through their FMS used vehicle sales program.

Reviewing key operating metrics, if we look forward from the last financial crisis, revenue, gross, operating, and net profit margins have all been on an upward trend:

Revenue, ROE, and Margins

Revenue, ROE, and Margins

This is reassuring: increasing revenue and increasing margins means that top line income is going up, and bottom line income is going up faster vis-a-vis increased margins. From a dividend perspective, this means that EPS as a whole is going up as well. All things being equal, even with a consistent dividend payout ratio, if EPS is rising, the dividend rises with it. But more on that in the dividend analysis below.

If we look at our key criteria, six out of seven tests pass:

Criteria Value Threshold Pass?
Strong financial condition Current Ratio 0.65 1.50 NO
Earnings Stability Number of most recent years of positive EPS 10.00 3.00 YES
Earnings Stability Number of consecutive years of negative EPS 1.00 YES
Dividend Growth Compound Annual Dividend Growth 0.08 0.02 YES
Share Price Growth Compound Annual Share Price Growth 0.03 0.03 YES
EPS Growth Compound Annual EPS Growth 0.06 0.03 YES
Moderate P/E Ratio P/E 9.84 15.00 YES
Moderate P/BV Ratio P/BV 1.51 1.50
Moderate P/E*P/BV Ratio P/E * P/BV 14.86 22.50

Dividends

Ryder’s dividend has been stellar. While it yields a relatively low 2.68% based on the Oct 3, 2016, market price of $65.58, its compound annual dividend growth rate is 8.44% since F2005. Moreover, the payout ratio based on EPS has been consistently under 40%, breaking that limit only during the financial crisis when EPS was significantly hit due to a drop in revenue during that period.

Dividend, Earnings, and Free Cash Flow per Share

Dividend, Earnings, and Free Cash Flow per Share

Dividend Payout Ratio vs EPS, Dividend Payout Ratio vs FCFS

Dividend Payout Ratio vs EPS, Dividend Payout Ratio vs FCFS

I would normally be concerned that the free cash flow is "wavy", but taken into context against their business model, and how they operate, this does not concern me for Ryder. In this case, the measurement against EPS is appropriate.

Valuation

10 year share price

Ryder 10 Year Share Price ending F2015

Share price is the weakest of our seven criteria metrics, eking out a measly 3.01% over our threshold of 3.00%. The biggest drop has been F2014-F2015, which coincides with the valuation returning to normal levels: in F2014 the P/E × P/BV was a staggering 60, but in F015 it has dropped to the sub-20 level.

P/E, P/BV, and P/E × &P/BV

Graham Number for R.N

As of October 3, 2016, using a mean consensus F2016 EPS estimate of $5.97, the valuation gives us a Graham number of 20.067, indicating that the company is undervalued at the moment.

R.N valuation as of Oct 3 2016
Current Price $65.58
Current Dividend $1.76
Mean Forward EPS $5.97
Dividend Yield 2.68%
Forward P/E 10.98
Historic mean P/BV 1.83
P/E × P/BV 20.067

Closing Thoughts

I like companies such as Ryder, mainly because I love big machinery, and easy to understand companies. One could look at Ryder and say that there is a significant amount of financial engineering to balance leases, etc., but it works in their favour. When I have some free cash, I will likely pick up some shares of this company in the near future.


The Case of Misleading False-Negative Returns

Summary

Total returns since inception may be artificially low (or negative), due to early losses which have far reaching effects on total compounded returns over the life of a portfolio. For this reason trailing N year returns should always be considered, when looking at the "true" performance of a portfolio.

Background on Time Weighted Returns

Returns are the key indicator as to the performance of your portfolio, and the the investment decisions you have made. In the simple case, with no external cash flows, the return for any given period as a percentage is defined by:

Return=\left(\frac{Ending Portfolio Value}{Starting Portfolio Value} - 1\right) \times 100

When you introduce cash flows into the equation, you would measure the value of the portfolio immediately before the cash flow, and apply that to the numerator:

Return=\left(\frac{Ending Portfolio Value}{Starting Portfolio Value + External Cash Flow} - 1\right) \times 100

Your total return is then obtained by linking the individual period returns together. Others have written about this much better than I have, and two good articles may be found on Investopedia and Wikipedia. In summary though, the key formula to understand is the following, which measures the true time weighted return:

Return = \left(\left(\frac{M_1}{M_0+C_0}\times\frac{M_2}{M_1+C_1}\times\cdots\frac{M_n}{M_{n-1}+C_{n-1}}\times\right)-1\right) \times 100

Where in the above, M_n is the value of the portfolio at period n, and C_n are any cash flows occurring in period n (conventionally the cash flow is measured "immediately before" the valuation before period n+1).

False-Negative Returns

One key point to make is that when you are looking at returns, all things being equal, your return after a loss must be greater than the loss itself, to get back to where you started, on a percentage basis. For example, if your portfolio drops from $100 to $90, that is a 10% loss. However, to get from $90 to $100, you need an 11.1% gain. To further explore this example, consider a portfolio which is valued at $100 on Jan 1, $90 on July 1, and $100 on December 31. The return on the first period is -10%, the return on the second period is +11.1%, and the total return by linking those returns is 0%. So even though you did extremely well in the latter half of the year, your net return is still 0% overall (since you finished where you started).

So, for better or for worse, the TWR measures the true performance of your portfolio over time, reflecting every investing decision you have made. But when you are reviewing your total returns over time, you may have misleading results. Consider the following hypothetical portfolio from Jan 2000 to Dec 2002. In this portfolio, I have invested $100 on Jan 1, 2000, and the company I invested in tanked completely, losing me $98 on my $100 investment. Then on Jan 1, 2001, I heard of an even better opportunity, and invested another $1,000. Unlike the initial $100 investment, the second investment performed extremely well, more than doubling by the the end of 2002, after which point I closed off the portfolio. Overall, I have invested $1,100, and at the end of it all I have walked away with $2,260.33, a tidy profit of $1,160.33, or 105.48%; more than double my initial investment! But, if you look at my total time weighted return since inception (i.e. Jan 2000)—which includes every trade, both good and bad—my investment decisions show that I am actually down in excess of 95%!

Period Closing Portfolio Value Cash Flows during Period Period Return Return since Inception Total Invested Total $ Gain
Jan 2000 $0.00 $0.00
Feb 2000 $100.00 $100.00 $100.00
Mar 2000 $93.00 $0.00 (7.00%) (7.00%) $100.00 ($7.00)
Apr 2000 $81.00 $0.00 (12.90%) (19.00%) $100.00 ($19.00)
May 2000 $69.00 $0.00 (14.81%) (31.00%) $100.00 ($31.00)
Jun 2000 $57.00 $0.00 (17.39%) (43.00%) $100.00 ($43.00)
Jul 2000 $48.00 $0.00 (15.79%) (52.00%) $100.00 ($52.00)
Aug 2000 $39.00 $0.00 (18.75%) (61.00%) $100.00 ($61.00)
Sep 2000 $30.00 $0.00 (23.08%) (70.00%) $100.00 ($70.00)
Oct 2000 $19.00 $0.00 (36.67%) (81.00%) $100.00 ($81.00)
Nov 2000 $9.00 $0.00 (52.63%) (91.00%) $100.00 ($91.00)
Dec 2000 $2.00 $0.00 (77.78%) (98.00%) $100.00 ($98.00)
Jan 2001 $1002.00 $1000.00 (98.00%) $1100.00 ($98.00)
Feb 2001 $1057.00 $0.00 5.49% (97.89%) $1100.00 ($43.00)
Mar 2001 $1117.14 $0.00 5.69% (97.77%) $1100.00 $17.14
Apr 2001 $1176.24 $0.00 5.29% (97.65%) $1100.00 $76.24
May 2001 $1207.94 $0.00 2.70% (97.59%) $1100.00 $107.94
Jun 2001 $1195.88 $0.00 (1.00%) (97.61%) $1100.00 $95.88
Jul 2001 $1194.69 $0.00 (0.10%) (97.62%) $1100.00 $94.69
Aug 2001 $1276.98 $0.00 6.89% (97.45%) $1100.00 $176.98
Sep 2001 $1322.88 $0.00 3.59% (97.36%) $1100.00 $222.88
Oct 2001 $1355.91 $0.00 2.50% (97.29%) $1100.00 $255.91
Nov 2001 $1434.43 $0.00 5.79% (97.14%) $1100.00 $334.43
Dec 2001 $1516.08 $0.00 5.69% (96.97%) $1100.00 $416.08
Jan 2002 $1503.97 $0.00 (0.80%) (97.00%) $1100.00 $403.97
Feb 2002 $1585.07 $0.00 5.39% (96.84%) $1100.00 $485.07
Mar 2002 $1654.73 $0.00 4.39% (96.70%) $1100.00 $554.73
Apr 2002 $1735.71 $0.00 4.89% (96.54%) $1100.00 $635.71
May 2002 $1838.00 $0.00 5.89% (96.33%) $1100.00 $738.00
Jun 2002 $1894.92 $0.00 3.10% (96.22%) $1100.00 $794.92
Jul 2002 $1980.10 $0.00 4.50% (96.05%) $1100.00 $880.10
Aug 2002 $1980.10 $0.00 (96.05%) $1100.00 $880.10
Sep 2002 $2073.07 $0.00 4.70% (95.86%) $1100.00 $973.07
Oct 2002 $2104.14 $0.00 1.50% (95.80%) $1100.00 $1004.14
Nov 2002 $2192.43 $0.00 4.20% (95.62%) $1100.00 $1092.43
Dec 2002 $2260.33 $0.00 3.10% (95.49%) $1100.00 $1160.33

Clearly, this is misleading: I have walked away with more than double what I invested in overall, however due to a single bad decision at the outset, my total returns are dragged down completely. In fact, to gain ground from a 98% loss requires a staggering 4,900% return over time!!! The nuances of this are tied to the fact that time weighted returns take the geometric average of your historical returns: they multiply everything together, and due to the way the math works itself out, you are virtually never able to get back to where you started after a devastating failure.

Fortunately, there are ways to paint this picture in a different light. Observe what happens if we position the portfolio this way:

1 year return 2 year return 3 year return
49.1% 125.6% -95.5%

By breaking up the returns into tranches, the results look dramatically different.

The point of this is to illustrate that a single bad period can drag down the total return of a portfolio virtually forever. Similar to how when I review a firm I am typically only looking at 10 years of historical data, there is value in truncating the window at when one evaluates their returns as well; we learn as we move forward, and as long as on a historical basis we are increasing our returns, then we are doing relatively well. The final point is that while the "true time weighted return" is "true", one must review it with a grain of salt. True, on a percentage basis, the above example is still down 98%. However, overall the total return based on absolute dollar terms is in excess of 100%.

For the record, the above is a simplified version of my own portfolio. When I started investing in 2005 I followed “hot tips” from my coworkers who were “good friends” with traders on the trading floor, and I invested in two firms, First Calgary Petroleum (FCP.TO), an Alberta based refinery, and Paincare Holdings (PRZ.N), a US healthcare provider. Luckily I had only invested ~$1250 at the time: 50 shares of FCP.TO at $18.40/share, and 50 shares of PRZ.N at U$5.00/share. FCP.TO tanked, no pun intended, when one of their exploration operations did not pan out as expected. FCP.TO was eventually bought out by a foreign interest at $3.60/share, netting me a loss of 80%. Paincare Holdings was victim to a lawsuit, and the company eventually de-listed except for over the counter pink slips, and is now a private holding. The shares of PRZ.N virtually went to $0.00; they are actually still “in” my portfolio at BMO InvestorLine with a market value of $0.005, or U$0.0001/share, netting me a loss of 99.998% on that trade. As these are the first trades in my portfolio, they have been a constant drag on my true TWR. Since then, I definitely regained the original $1,250 investment in dividend income alone from other investments, so on an absolute (i.e. actual dollars profit) I am well ahead. So, if we carve out those outliers, every other investment I have completed has performed relatively well, something I hope to continue doing as time moves forward.