Blessed by the Potato

I’m really not much of a negotiator, and usually roll over after the first refusal. I do try though, and I know that it can work sometimes. Of course, in retail the sales drones really don’t have much flexibility in pricing, but in other matters, discounts can sometimes be had. What brought this to mind was thinking about my budget recently, and how when we moved in to the house, we managed to get the landlord to agree to keep the rent fixed as long as we were here (instead of increasing it 2-3% per year). It’s the sort of small thing that was pretty easy to get her to agree to, but which does make a difference in the long term for me. I mean, grad students in my department haven’t had a raise in the better part of a decade (probably longer, since who knows how many years before I arrived the last stipend increase was), yet rent and food and gas keep going up year after year. Not having a rent increase will save us over $400 this year, and something like $850 the year after. Contrarily, in the old apartment rent went from ~74% to ~78% of my stipend over the course of my MSc (all the while quality of life there went down the shitter as increasingly noisier and messier neighbours moved in).

Unfortunately, I still have another few posts under money to come over the holidays; apologies to those of you bored by this already.

I know I just got through talking about diversification and mutual funds, and how I had parked some of the cash I was sitting on in my high interest savings account into a few low-cost index funds from TD. I warned against the hazards of trying to pick individual stocks to beat the market — since only a minority of investors do manage to beat the market. But my dad calls the stock market “the great casino” and of course, every now and then there is the great urge to gamble.

So shortly after becoming “fully invested” my beloved Trans-Alta (TPW.UN) has been bought out and my shares were forcibly redeemed. That’s left me once again with cash to invest somewhere. I could follow my earlier reasoning, and buy some more index funds and just hold on for the next decade. Or, I could look at the signs of dreary economic forecasts coming in and say to myself that this might be a good time to have some cash, and to not worry about buying anything for a while. Or, I could gamble.

I’ve been watching the bank stocks for a while now, and they have been hit fairly hard by this subprime/ABCP fiasco. And they deserve to be: there’s billions of dollars of debt at stake, and their loosey-goosey lending/accounting/risk management may pull the whole continental economy down into a recession. However, if any industry can turn it around in the long term, I’m sure it’s the banking industry. So, if the current crisis makes bank stocks a good value for a long term hold, then I’m going to look into that.

One bank I like is TD: they have quite good customer service including extended branch hours, and were the only ones conservative enough to stay the hell out of the ABCP mess. They’ve been fairly flat for the last few weeks and are probably close to their fair value. TD is probably the least risky Canadian bank at the moment for both the near and long term, but since it looks like a lot of other investors see it that way as well, it’s also not “value priced” at the moment.

Going to the other end we have CIBC. While I love PC Financial, which is offered through CIBC, I’ve never been a direct customer of theirs and have heard of customer service problems from other people that have been long-standing. They’ve also managed to dig themselves into the deepest pit of any Canadian bank with this subprime mess. Will they lose a billion dollars? TEN billion dollars?! It’s not going to be pretty whatever happens, and there’s still a lot of risk and uncertainty there. However, they’ve also had the ever-loving shit kicked out of their stock, down 20% in the last month, about 8% in the last week alone. So with a stock like this, at what point is the price low enough to reflect the losses and risk factor? At what point is there a potential over-reaction and thus a potential value buy? When I was first looking at what to buy a few weeks ago, I read through a lot of information available on CIBC, and jotted down a quick note: “Don’t touch till $75”. Well, today it’s crashed through that point, closing down at $73.60.

Trying to value something like this is a skill I do not really have. I tend to rely a lot on people like my dad and stock analyst reports. Unfortuantely, my dad says that the risk is too big with CIBC at the moment, since they keep saying that they’ve released their bad news, just to have another batch of bad news come out the next week. No matter how cheap it may seem he’s not interested in touching it, so he’s not going to walk me through how he values companies. And I think the analyst reports I’ve read are wrong, overly optimistic, or at least out of date. So I’m going to have to wing it on my own.

There are a number of ways to try to put a value on a company’s stock, and I’ve probably never heard of the ones that actually work well, but here are two very amateurish methods I can try to apply to CIBC. First, we have price-earnings-ratio. This is the ratio between a stock’s price and the earnings per share. For instance, CIBC has about 335 million shares, and made about 3 billion dollars last year, or about $9/share. Many bank stocks typically trade at about 12X earnings, so to put it very simplistically you expect to buy about 12 years worth of earnings with your stock purchase. If there’s anything that might upset the forecast for future earnings (such as massive losses from a subprime mess), then you have to adjust your stock value accordingly. So if we imagine that over 12 years, CIBC might stand to make 12*3 = 36 billion dollars, but might also have 10 billion in losses from bad investments or an economic downturn, then we might project that the 12-year earnings would be $26B, or $77.60/share, and then we say that’s what the stock should be worth. If the losses are “only” 5 billion, then we might be looking at $92/share. Of course, things are more complicated than that, since the losses wouldn’t be averaged out evenly over the 12 years like that, they would happen soon, and things that happen soon are worth more (in this case, more of a hit) than things that happen later. There’s also still so much uncertainty about what’s going to happen, and uncertainty and risk carry a price penalty as well. This little analysis also started from the current year $9/share earnings, but that might be an optimistic start point, as that’s a pretty high earnings figure for this bank. The 5-year average looks to be more like $5.40/share/year. Using that to find 12-year earnings (~$22B), taking a subprime hit ($5B), and then finding the share value gives me something like $50/share. I think that might serve as a good “floor” price.

Another simplistic valuation is to look at the share price relative to the book value. The book value is about $33/share (about $11 billion total when you multiply that out). Take off a $5B subprime hit (and how arbitrary these numbers can be in the face of uncertainty) and that book value comes down to $18/share. The stock had been trading at something like 3X book value, which would put the new, adjusted price at $54. If the hit to book value is only $2B, then we’re looking at $81/share, which we’re already below.

From all this you can plainly see that I am not at all qualified to be doing this kind of value analysis without further training. However, I think that some point between $50 and $75/share, CIBC might be a good long-term buy. “Calling the bottom” is a very difficult thing to do, but I think if CIBC drops any more (below, say $70/share) I might buy some, though I’ll probably wait until it starts to turn around, possibly months from now. One complication is that the share price is quite high, especially compared to TransAlta, so I don’t have enough money to buy a “board lot” of 100 shares. Normally, I’d stay away from odd lots, but for big bank stocks there is so much volume, so many shares being traded every day, and so many dividend reinvestment plans producing odd lots that I think it’s pretty safe to not worry about getting a block of 100 shares and just investing what I can (and as always, only what I can afford to lose).

I’m in favour of nuclear energy for Canada. While it does have a history of delays and cost-overruns, the delays are often a result of making sure that we implement it safely. Plus even at double the cost, nuclear power is still one of the very cheapest forms of energy available to us, and the only large-scale carbon-free source we can count on for the medium term. There are hazards with nuclear power. The risks are very remote, but when things go wrong, they have the capability to go very wrong (whereas with other sources of power, the risks associated with them occur more frequently, but usually are more minor). However, Canada has a reactor design that is inherently safe, and a strong history of keeping things above-board and putting safety as one of the highest priorities (which is part of where all the crazy budget overruns come from).

…until the Harper government decided to thwart the nuclear regulator in order to bring the NRU reactor in Chalk River up sooner. The NRU shutdown has had a big effect on nuclear medicine scans across the country, and in fact, across the continent. Somehow, this one reactor had come to be the dominant source of molybednum-99 for much of the world, with no backups, anywhere. The shortage has turned the nuclear medicine corridor at my hospital into a ghost town, with the tiny bit of remaining isotopes used strictly for emergency patients. There was a stockpiling process before the reactor went off-line, but since the isotopes break down so quickly that could only last for a few weeks, and as the shutdown stretches on still…

Personally, I think the reactor probably could be turned on for at least a short while to do another round of stockpiling, and then upgrades can be made over the next year a week or two at a time as necessary, while keeping the medical isotopes flowing.

But I must strongly disagree with what the Harper government is doing here. Politicians do not have the expertise necessary to say with any degree of confidence things like:

“There will be no nuclear accident,” Prime Minister Stephen Harper asserted in the House of Commons, saying the government has received independent advice indicating there is no safety concern.

“On the contrary, what we do know is that the continuing actions of the Liberal-appointed Nuclear Safety Commission will jeopardize the health and safety and lives of tens of thousands of Canadians. We do have the responsibility to demand that Parliament step in and fix this situation before the health of more people is put in jeopardy.”

The Harper government has a nasty habit of closing up and relying on “independent advice” without ever sharing its sources with the public, and this is absolutely not the time for that kind of bullshit. Likewise, it’s not time to throw in nasty, probably untrue snipes at the Liberals (Hey, “Canada’s New Government” you’ve been at it for well over a year), especially as the spendiest government in our history has found billions for Quebec, arctic patrol routes, etc, but didn’t bother to throw some money at the new Maple generators until a crisis hit.

This is not an issue that should be politicized: in fact, that’s the sort of thing that makes nuclear reactors dangerous. Design them well, operate them meticulously, listen to the careful watchdogs, and spend the money it takes, and then we can all benefit from nuclear reactors (whether for energy or isotope production).

Ben asked a question about mutual fund fees. That’s somewhat fortunate, as that’s something I just did a bit of research into. It’s somewhat unfortunate since it’s a slightly advanced topic to jump into with “part one”, so I’ll drop my numbering scheme now :)

To briefly cover the background, mutual funds are a collection of stocks, bonds, and cash (sometimes a mixture of all 3, sometimes just stocks) that an investor can buy into. Stocks generally have the best returns over the long term, but can be quite risky. One of the best ways to try to reduce the risk is to diversity into many different stocks, both amongst different individual companies and in companies in different sectors. There are many different rules of thumb about how much diversification one needs, but generally 10-25 different stocks are recommended. I haven’t seen anyone recommend more than 30, since beyond that there isn’t much risk reduction (at that point you should have enough companies and sectors sampled that the only way you’d face significant loss is if the market crashed as a whole), and there becomes a nearly unmanageable amount of data to follow. In addition to the administrative task of following all those stocks, it requires a lot of money to do: each purchase will have a broker fee, and to not have those fees eat up any potential profit, one needs to invest a fair bit in each stock (and that’s not even getting into issues like odd lot trades).

Mutual funds can pool the money from a number of investors and buy a whole crap load of stocks (and bonds, and hold cash). This can free one from the day-to-day stress of watching the market as well as providing a decent amount of diversification.

However, mutual funds often charge a number of fees that can sap their potential returns. There are “front-load” and “back-end” fees, which are basically transaction fees when you buy or sell, respectively. Many back-end fees are for a limited time only, designed to punish early redemption, and to keep people from trading in and out of a mutual fund too much. Of course, “early” can be subjective: some of TD’s mutual funds only have a 90-day lock in period, whereas others can be up to 7 years. Some funds don’t charge these fees (“no-load funds”), but all funds (even no-load ones) will have some sort of recurring expense to cover the cost of administering the fund, paying the managers to select stocks/bonds (if applicable). Advertising, kickbacks to salespeople/advisers, and legal fees are also included in this recurring expense. These recurring fees are called the Management Expense Ratio (MER) and are given as a percent of the fund’s value. The transaction fees/commissions to buy/sell stocks when the fund’s portfolio changes, or when more people buy in (or leave) are another factor, but according to the OSC’s site, aren’t included in the MER.

These MER fees are compounded annually, and you don’t get an invoice or a line-item breakout to see how much they’re costing you each year. They’re simply a negative added on to the fund’s overall growth rate. If the fund’s underlying portfolio of stocks, bonds, and cash went up 7% over the year, but the MER was 1%, you’d see a 6% increase at the end of the year. Likewise, if it was a bad year and the fund just broke even (0% growth in the portfolio), that 1% MER would actually cause you to see a decrease in the fund’s value of 1% at the end of the year.

Canada has some of the highest MERs on mutual funds around, with an average up around 2%. 2% on its own might not sound like much, but when “the market” goes up something like 10% a year in the long term, a 2% hit can be brutal. A mutual fund with a 2% MER, just to keep up with the market would need a gross appreciation of 12% per year (that is, they’d have to beat the market by 2%). It can be done, but usually it’s done only by luck or by the very best investors. I believe the statistic is that only 20% of funds manage to beat the market (or rather, the index they’re compared to) — the rest are either no better, or of course, worse. Also keep in mind that the power of compound interest applies to MER fees as well, though it’s negative in this respect (cutting your compound interest rate from 10% to 8%).

So, there have been some good arguments suggesting that rather than pay 2% to a mutual fund that will likely not end up beating the index it’s measured against, one should instead just buy the index. Some low-cost funds do just that, including the TD e-series funds. These funds are not managed: they simply blindly follow the index (S&P 500, Dow Jones, Scotia Bond Index, etc.) and have a minimal cost (MER of about half a percent — as low as 0.31% for the Canadian Equity index). These low-cost funds can be a great way to get some diversification for a larger portfolio, or form the beginnings of a small one (especially since the TD ones have a low minimum investment of $100).

There are reasons sometimes to pay higher fees. If you genuinely believe a fund will outperform the market (and some do) then that’s a good reason right there. For example, despite the fact that the energy and natural resources sectors are quite hot lately, I think concepts such as peak oil are only going to drive them up further in the future. However, TD doesn’t have a low-cost energy or resources sector fund available: both of those cost 2%. I think for those sectors, I might take the hit since they would be a bit of a gamble to begin with. Also, some RRSPs will only offer a limited selection of mutual funds, all at higher fees. To go out on your own might incur a cost of $100/year for a self-directed RRSP account, which for any portfolio under $5000 would be over the 2% the mutual fund would hit you up for. In those cases, the tax savings of an RRSP might save you.

Getting diversified into foreign stocks is also a great place for mutual funds to shine. Canada is only a small part of the overall world economy, so the argument goes that only a small part of your money should be in Canadian equities. But if you thought it was hard to research and monitor Canadian stocks, doing so on an international scale might well be impossible. So let a mutual fund do it for you. There are some low-fee ones (such as the 0.5% ones at TD) to track European, Japanese, or more broad-based global indexes. Otherwise, this might be a place where it would be acceptable to pay a little bit more.

Don’t however, get suckered into paying a high MER on a mutual fund just because the person at the bank or your financial advisor recommended that fund (or a list of funds). Often, these people will get commissions or kick-backs for selling mutual funds, so they may face a conflict of interest. Likewise, don’t pay it just because a fund is “popular” (you may just be paying for advertising then), or because it’s had good performance in the past. It’s difficult to predict the future, and sometimes past trends carry on… but it could also be that a fund just capitalized on a fad and is about to tank. You’ll need to do a little more research…

A final note is that exchange traded funds (ETFs) typically have very low MERs, it’s sort of their specialty. I’m still researching those after seeing Canadian Captialist talk about them, but I’m a little more in favour of the TD e-series funds. Partly because there’s no transaction fee, whereas I would have to pay a commission for buying/selling an ETF. Partly because the ETFs I looked at (some of the iShares ones on the TSE) were very thinly traded, so the funds were trading a fair bit above what their value would be in terms of holdings. And partly because it’s easier to buy in to the TD ones with very small amounts of money, incrementally. There’s no strict minimum (except for 1 share) for an ETF, but generally when buying shares one wants to go with a “board lot” or 100 shares, which can be a little pricey to start with, and difficult to add to over time. The $100 minimum (which can also buy fractional shares) for the TD funds is much more attractive.

Links:
Investopedia, diversification.
Ontario Securities Commission, mutual fund fees.
InvestorED Mutual Fund fee calculator
Canadian Captialist “Mutual Fund Fee Debate: The Industry Response”
Canadian Captialist “Top Five Reasons to Index Your Portfolio”
Canadian Captialist “Reasons to Avoid Actively Managed Funds”
Canadian Captialist “Two strikes against active management”

Disclaimer: I am not a financial advisor, and this post (or any other) is not to be construed as financial advice. In fact, I’m a graduate student, and thus have obviously made one of life’s worst financial mistakes and you shouldn’t listen to a thing I say. Seek the advice of a professional, and only invest what you can afford to lose in equities.

Sorry for all the talk about money and finances lately, I know it’s boring to some people. I promise to get back to hybrid cars, nuclear plants, copyright, and general all-out ranting and raving craziness soon. But first, a question: how much do you know about finances? I realize that most of the people who read this (at least, those who I know about and who comment) are students or young people in the beginning of their careers and moving-out-on-their-own lives. Thus they might not be (or feel that they are not) in a position to have significant long-term savings, and thus aren’t worried about how to manage those savings.

Nonetheless, knowing this stuff can be quite important, especially as our cohort comes to the age where savings is both possible and easily overlooked in favour of shiny things.

I take a lot of this stuff for granted, after all, my dad was an accountant/financial consultant, and passed a lot of it on to my brother and me (though I don’t know if he’s been teaching my sister). So I’m sometimes amazed at how little a lot of the general public knows about saving, investing, and finances in general. One example was a new student in our lab who, despite living on her own for years and being in university, did not have a chequing account for us to set up direct deposits for her. I had to explain why she needed to open an account, how cheques could be useful, etc. To be fair, she did have a bank account, an old one where she could go to the bank, in person, and withdraw or deposit money, and have the tellers pay bills. Why one of them never set her up with a more modern account I’ll never really know.

Similarly, there was some discussion recently about mutual fund fees, and how unaware many people are of them. That made me wonder how many people were aware of mutual funds at all? So I figured I’d put together a little list/quiz of sorts. Feel free to give your answers in the comments, or keep them to yourself… but please feel free to ask me if you’re not familiar with anything. I’d be happy to follow this post up with a blog entry on each, but don’t really want to waste my time if everyone already knows this stuff or will run off and learn about it somewhere else before I write it up :)

Are you familiar with/have:

1. A chequing account?
2. Online bill payments?
3. Savings accounts? (Especially high interest savings accounts)
4. GICs?
5. Bonds?
6. Mutual funds?
7. A brokerage account? (Online discount or otherwise)
8. Stocks?
9. Do you know about the power of compound interest? The exponential growth function? [Aside: I highly recommend that video series at least to part 3: At what point do you realize there’s a problem?]
10. Limit orders?
11. Risk? (Not the boardgame, though bonus points for people that do have the boardgame and want to play)
12. RRSPs?
13. Inflation?

There’s probably a lot of other things that could be added to a list like that (like “debt”), but that should do for starting discussion now…