Blessed by the Potato

Krystal Yee weighs in on the eternal savings vs line of credit (LoC) emergency fund debate. I disagree with her on a number of points which is largely just personal preference, but importantly she’s needlessly fearmongering on a few points, and that needs to be cleared up.

To begin, I think of emergency preparedness as having multiple levels, each of which requires its own solution.

The first level is not financial at all: what if you get stuck in your house? A bad blizzard, a quarantine, earthquake, or zombies roving the neighbourhood. Whatever it is, money won’t help you. You need to have a few days’ supply of food and water (and um… q-tips). The government has a site that’s a good resource for basic planning. Remember, it doesn’t necessarily have to be a separate dedicated cache: if you normally keep bottled water in the house, then just make sure your inventory never goes below a few litres; likewise for shelf-stable, easy-to-prepare food.

The next level is for the likely but not severe “emergencies” or “lumpy” expenses you may face, and that’s IMHO best kept in cash (in your chequing/savings account, not literal paper cash). Whether it’s HR screwing up and delaying your pay by a month, getting hit with a car repair, needing to fly across the country for a funeral, or finding a sale on a big item you didn’t properly budget for, there’s a reasonably high likelihood you’ll need a few hundred to a few thousand or so dollars at the ready. But much beyond that and I think it’s more optimal to put the money to work rather than keep it around.

After that comes the less likely but larger expenses. This level, I argue, shouldn’t be kept in cash unless you are very conservative. A line of credit is a good option here, alongside the ability to sell investments and use that cash.

What are the trade-offs? If you don’t keep cash and are hit with an emergency that needs more than a few hundred/few thousand dollars to cope with, you’ll have to find a way to cover that. If you borrow from a LoC you’ll have to pay some interest, if you sell investments you may have transaction fees, you may be forced to sell low and buy higher later when you recover from the emergency, and you may have to temporarily give up some TFSA room. None of that sounds so onerous to me, especially when faced with a rare, expensive emergency.

So, what did I find so objectionable about Krystal’s post? A few points:

Her first point, she says “after your emergency money is gone, you will still be debt-free” which implies that after using a LoC to cover some emergency, you would be in debt if you didn’t keep a cash cushion. But if you approach it from an all else being equal perspective, you see that’s a ridiculous false dichotomy: if you had cash and spent it you’d realistically be no better or worse off than if you had invested the cash and then borrowed against the investments in an emergency. Yes, there is debt, but you’re not in net debt — with the click of a mouse you can sell your (bond) index funds and pay off the LoC if you so choose. And if you’re debt averse, you may be less likely to tap the LoC for avoidable “emergency” spending that might otherwise drain the cash account. In other words, the choice is not between cash and debt, the choice is between cash and investments with a debt option.

Her second point is entirely personal: sure, going into debt is stressful. I had to experience it myself when I went 4 months this summer without a paycheque, and sold off investments and tapped my LoC to make ends meet. But the fact I had debt on my LoC was a trivial, marginal increase to my stress caused by the overall situation. And because I had invested my money rather than keeping $6000 in cash lying around, I made several hundreds of dollars on that money over the years, which was more than a fair trade-off for that marginal stress.

She almost gets the point on the 3rd bullet: the bank controls the LoC. The big risk of the strategy is that the bank could pull your LoC at exactly the moment you need it most (e.g., if you lose your job, or during a liquidity crisis). One way to help ameliorate that is by securing the LoC against your house, if you have one and have enough equity (a HELOC). “If your line of credit is secured by your home equity, you have the added pressure of knowing that you will be putting your house is at risk.” [sic] No. Well, technically, yes. But realistically, no. No one in the history of Canadian banking has had the bank repossess their house over a few thousand dollars on a HELOC. The risk to your house is there from the emergency itself: if you don’t make your mortgage payments, or pay your property tax, or whatever. Not from actually using your HELOC to cover a few thousand for an emergency (the amount she says you should keep in cash instead).

To say it again more clearly, the risk of using a HELOC for your emergency fund is that the line gets taken away, not that the house gets taken away. It’s more risky than holding unproductive cash, but it’s a remote risk that’s not really worth getting worked up over.

So in the end, I think a better strategy is to keep a small (~1 mo) emergency fund, and then have the rest invested, with access to a LoC/HELOC if needed. The choice is not between a large cash emergency fund and nothing to fall back on at all — those investments are available if you need them. And of course, that’s one of the reasons I recommend filling the TFSA first over the RRSP, since you can withdraw from the TFSA if you do hit a bump in the road and need to cash out. Since it may take a few days for transactions to clear, the LoC can help you bridge that time, and also give yourself some time and breathing room to decide if you do need to liquidate, or just borrow and repay the LoC from future savings.

It all depends on your own risk tolerance of course: if you can’t sleep at night without a big metaphorical mattress stuffed with cash under you, then so be it. You’d most likely be better off investing most of that cash, but you do need to take your own psychology into account. Just don’t go out of your way to make up risks to frighten yourself with, the world is scary enough as it is.

Before I get to the rest of the links, an important reminder about the Canada Learning Bond for low-income families to help fund their RESP from MSB. If your net income is below $41.5k, and your child born in 2004 or later, the government will just give you money to help fund the child’s RESP — not even a matching amount like the CESG.

Larry MacDonald reports on more wariness towards stocks by younger investors. Of course, given investor psychology, it’s probably coming at the wrong time.

Spreadsheet fever hits Preet, as he gives mutual fund investors a tool to estimate how much of their return is sucked away by fees…

The housing bubble has started to get a few more mentions, perhaps because it’s a slow news period. Including:

3 of Rob Carrick’s 12 new year tips are variations on “don’t buy a house in this ridiculous market”.

Almost all of Canada’s banks have now also started to publicly fret about the state of the housing market. “There’s no question that the warning signs around the Canadian housing market have been visible for more than a year,” Mr. Downe [BMO CEO] said. The banks have mentioned that they did a stress test of their finances if house prices declined by 25%. Ideally, they should be doing these kind of stress tests regularly for risk management reasons — but the fact that it became newsworthy may be of note.

Plus, 2 segments on BNN on Wednesday, and another on Thursday (11th and 12th of January).

Nelson of Financial Uproar infamy has a guest post (is there anywhere he doesn’t guest post?) that spends a quarter of the word count on non sequiturs and still manages to be an excellent description of how easy passive investing can be (I needed a whole book to get the concept across!).

This is why I’m focusing my job search on non-academic positions, though that hasn’t gone so well so far, either.

Otherwise, not much new with me. Weight’s holding steady (not good, but not terrible). Just barely hitting one job app per week — I really need to quit it with cover letter writer’s block. The 2nd week of flag football went well, with more of our team showing up, and a slower rate of play due to the other team constantly consulting a playbook (I thought having a playbook was supposed to speed up your planning). In fact, I got so many breaks with all our spare players for subbing in/out that I started to question even going: having no subs last week was exhausting, but having enough to only play 50% of the time didn’t feel like exercise at all, and the commute down twice as long as my on-field time.

It’s perhaps far too early to speak of bottoms, but with the news full of stories of the recent Carnival cruise ship-wreck and subsequent 16% sinking in share prices, it may be worth doing a bit of work to see at what level buying in the face of panic may be warranted.

First up, before deciding how much to discount CCL, we should have an understanding of whether it was appropriately valued to start with. At 14X P/E for a discretionary vacation provider, it was perhaps a little rich going into the mess on an earnings basis, but pro-forma book value was $30/share, giving it some support. But if we say $29 would have been a more fair starting place before the ship got grounded, then it’s clearly not bottomed yet — a 16% drop only takes it to that price.

For the current circumstances, to be conservative we should assume no insurance coverage (due to the possibility that it was an at-fault accident) and that the ship will not be able to be repaired, representing a $500M loss. It’s tough to say what the liability will be for each of the passengers (~4000), but perhaps $50k each is a good upper bound, plus another $2k for the next group of ~4000 to compensate them for having to change their trip plans/flights at the last minute, plus $1M for each death (6 confirmed with ~20 missing, call it $25M). $733M immediate hit to book value, or about $1/share.

On top of that, it’s fair to assume that people will be less likely to book cruises for the next few years, so revenue may decline by say 10% for the next 3 years. If costs are fixed (assume that they are, again to be conservative), that goes straight to a decline in earnings. So I’ll plug into my little model $1/share in earnings for each of the next 3 years, returning to $2.40/share afterwards. In fact, that appears to be a much, much larger potential hit to the value than the loss of the ship and liability from the accident, which is a shame since it’s a lot harder to estimate. Add in a healthy fudge factor, and I wouldn’t be interested until it hit something like $21-25 – a 1/3 decline from Friday’s price. Until then I think I’ll just watch.

My record is fairly spotty with this sort of thing: 1-1-1 to date (BP a clear win, the Canadian banks w/ ABCP came out all-right, and TEPCO was a disaster).

Here are my picks for the 2012 Island of Misfit Bloggers Stock Picking Contest:

Poseidon Concepts (TSE:PSN) ($12.45)
Indigo (TSE:IDG) ($7.40)
Superior Plus (TSE:SPB) ($5.75)
Research in Motion (TSE:RIM) ($14.81)

I’ve already done a whole post on PSN.

Indigo was originally a “hidden value” play for me. Now the Kobo division has been sold (though the deal has yet to close), and yet the stock price has been languishing after an initial bump on the news — presently trading at about the value of the Kobo deal plus half tangible book of the bookstore business. Management has said that they won’t be returning the cash from Kobo to shareholders, which means some mad folly may easily destroy the value there. For risk management reasons, I won’t be buying any more in RL unless it gets a lot cheaper, but there’s a lot of potential here if Indigo can shake the impression of being somehow on death’s doorstep (a profitable holiday quarter would help a lot there).

Superior Plus is a long-time holding of mine. A bit of a strange mini-conglomerate with 3 business lines, one of which I like, one of which is mediocre but generates reasonable cash flow, and one of which is just terrible. They took on too much debt building this little conglomerate, and the debt market has recently bitten them. The past few years have not been easy for them, and they spent a long time over-paying a juicy dividend while hoping business fundamentals would turn around faster than they did. When they did finally decide to cut the dividend, the stock tanked (from already-depressed levels), yet the company is still about as cash-generating as it was a few months before; all that changed is where the cash is going. Plus, new management may lead to a promising 2012. The thing to watch will be dilution, as they state they are still looking for tuck-in acquisitions, which will be funded with equity (since the objective now is to reduce debt). That makes me roll my eyes, since expansion by acquisition is in large part what got them into trouble in the first place, and you don’t want to be doing equity raises while the stock price is so depressed.

RIM: there are stocks that are “priced for perfection” which means that so many good expectations are built in that even if the company is profitable and grows but just grows a little less than the market was hoping — anything short of perfection — the stock price can tank. At some point a few years ago, that description may have fit RIM very well; it seems to be the opposite now. RIM is if anything, priced for the worst-case scenario: barely above book value, for what is still a profitable company — though no longer a growing one, in a very rapidly shifting business. At this point though, I think any good news could really drive the stock up, as witnessed by the 10% pop on the mere rumour of a rejected takeover courtship. I don’t own any in RL, but was hoping for some last-minute tax-loss selling to put it into the $12-13 range (it sure looked like it was heading there before the rumour came out). Some big things to watch for include just falling flat on their face: the fabled QNX phones were supposed to be the next big thing for RIM, but they have been much-delayed, and now may not even make it out for the 2012 holiday season. Mr. Market’s pessimism may be overdone in this case, but it is certainly not unwarranted.

I’ve been trying to write this post for a long while, and will likely end up writing several iterations, so bear with me. Basically, I’m caught on the edge of active (value) investing vs passive (index) investing.

There are a lot of good criticisms of active investing out there, which strongly suggest that even if it is possible, it is not easy to beat the market. I was hoping I’d get a chance to read the Quest for Alpha before this post, but I don’t know when I’ll find the time, and I can always change my mind in the future (which is fodder for a second post!). Anyway, one of the things that sticks with me in the active vs passive debate is that much of the evidence against active investing comes from looking at actively managed mutual funds, which fail to out-perform their indexes net of fees to a ridiculous extent. A common (and useful) trope is that mutual fund managers are professionals who eat drink and breathe the markets, so if they can’t out-perform, then what hope do you have? However, that raises the question of whether actively managed mutual funds are the same as actively managing your own portfolio, and I think that there are key differences.

So we know then from all the studies at the very least not to invest like a mutual fund. What are some of their characteristics? High turnover. Being forced to hoard cash at market bottoms to fund redemptions. Chasing performance. Short-term (yearly or even quarterly) outlook. Avoidance of portfolios that are radically different than the index (there’s no point in being a closet indexer unless you have ridiculously low costs — just index). A focus on large, liquid companies. Window-dressing with hot companies.

Another, disciplined, approach might work then. Indeed, there are some investors out there who have consistently beaten the indexes which suggests to me it is possible to do so. I’m a numbers guy and not a people person, so I figure I have a much better chance of being one of the few investors that can beat the market than finding one who’ll manage my money for me. Though I have to endorse Michael James’ view that most people will not be able to do either, so the best option may be to not even try.

Theory aside, how have I actually done as an active investor? The first two years: not bad. I was down in a down market, but less than my benchmark indexes. Then the market came raging back, and so did I — again, a little bit better than the market, but nothing really to brag about. Then in 2010 the market had a decent year, and I had a blow-out one, nearly tripling the market return, though much of that was admittedly luck. All the while I was sticking to my principles: low turnover (~3-4 year portfolio turnover) and low costs (I figured my trading costs were around 30-40 bp, very comparable to index funds — partly a function of concentration, but mostly of a lack of trading). But then 2011 came along.

I’ve made a lot of mistakes in investing this year: TRE, TEPCO, YLO being some of the worst, but I had a few moments of stubbornness and what can only be described as idiocy (one particularly bad case of anchoring). I also had some real under-performers that I don’t yet know how to classify (IDG, SPB, NFI). If you had asked me in the summer, I would have estimated my “alpha” at something like -15% this year — it was looking so bad CC quipped “is there a pooch you don’t own?”. To be sure, I made mistakes in 2009 and 2010 too, but they were offset by some real winners, so overall alpha was positive. This year the last few months helped make up for a disastrous middle, but only a bit: in the end, I was down about 9.3%, vs the Canadian e-series fund down 9.8% and the US one up 2.0%, for a benchmark of -3.9% (I have not accounted for the impact of luck in terms of withdrawals/investments – that’s my IRR vs. a straight annual total return for the index funds). That was a relative under-performance of 5.4%.

“I didn’t do it right” is not a strong defence of active investing — I need results in the real world, so if active investing leads me to make more mistakes and under-perform passive investing at the end of the day, then I should be passive investing, even if active investing “would have” done better “if only” I didn’t make such-and-such a mistake. Would have and if onlys are great for study, but lousy for results. And the hard-and-fast of it is that by attempting active investing, you open the door for more mistakes to be made.

But I also know that even successful active investing has its bad years – partly due to mistakes, partly due to trading off higher risk for more rewards, partly due to just setting up for the future (buying what’s beaten-up only to watch it continue to get beaten up for a while).

I also know that index investing has one thing that’s a little tough to stop thinking about trying to improve: how the indexes are made up. It’s an arbitrary process — one that works great, don’t get me wrong, but no less arbitrary for that. Why does S&P get to choose which companies go in the index and which don’t, rather than say, me? The Dow is a total black box, and the TSX composite is widely regarded as over-weighting some sectors and under-weighting others. Some quasi-passive funds have emerged to put a “fundamental value” tilt on a large index with a simple weighting formula, but those look like they have flaws too (e.g., taking the already poorly balanced TSX composite, and skewing it even further towards financials).

I’ve often thought about the possibility of being “passively active” (or actively passive?) — embrace the passive philosophies of low portfolio turnover, low costs, and broad diversification, but create your own index (one that could be even better weighted by sector than the TSX, for example). Simply attempt to create a representative sample of the universe of stocks. Unfortunately, just as I was drafting a post focused on that idea a month or two ago, Michael James started talking about volatility drag and how that might not work as planned. Drat.

So once again I find myself on the fence about the active-vs-passive debate. For sure, passive investing is all I recommend to beginning investors, and all I cover in my book. Most people don’t have the OCD or emotional deadness or the je ne sais quoi that makes for a decent active investor. I don’t know myself if I’m most people or not yet. But I’m not yet ready to write off active investing as nothing more than futile hubris.

Nonetheless, I have to protect myself from overconfidence, so I do have a passive indexed portfolio to complement my active one. I do track my returns and compare how I’m doing. I use Potato’s Valve to stop myself from throwing good money after bad, and to ensure that an essential core of my portfolio is following the logical passive portfolio, so that at least my minimum goals can be met even if I blow up my active portfolio through mis-management.

Anyway, a rough year for active investing in the Potato household. Lots of mistakes were made, and though I could write many posts on what they were and how to try to avoid them in the future, the simple fact is that attempting active investing makes mistakes possible. Yet I’m still on the fence, and not quite ready to go all-passive. Like Warren Buffett said, sometimes value investing just grabs you, immediately clicks, and you can’t stop thinking about buying a dollar for fifty cents.