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BMO Is Feeling The Heat On Derivatives Losses


The market has a magnifying glass over Bank of Montreal’s recent confession on its commodity trading losses, which will likely cut second quarter earnings by $350 million to $450 million, or around $0.50 per share. BMO has traditionally been a more conservative bank, so this news came as a surprise to shareholders. Credit Suisse analyst Jim Bantis explained:

Profit growth at its bread-and-butter Canadian consumer banking operations has lagged its rivals, and that’s likely what led the bank to take on extra risk in its commodity trading business as it hunted for other ways to boost the bottom line.

On the bright side, the new BMO Chief Executive Officer Bill Downe reassured investors:

The commodity trading losses were the result of decisions that did not adequately recognize the vulnerability of the portfolio to changes in market volatility. We are conducting a thorough review and actions have been taken to address the current situation and reduce the likelihood of a recurrence. The commodity trading losses are particularly disappointing as our company continues to experience good operating momentum. We remain committed to providing the high level of service that our clients in the energy sector have come to expect from BMO Capital Markets.

BMO’s stock fell by $1.58 to $69.69 as a result of the negative news, which improved the dividend yield to 3.9%. BMO had traded roughly between 2% to 4% over the past decade, therefore I’d classify $70 as cheap, though not necessary a bargain. I think the $1.58 drop is an over-reaction, since the pre-tax $0.50 is a one-time paper loss, and Mr. Downe is taking steps to mitigate derivative risks. The best time to buy banks is when they’re down and out. It was 2004 when Royal Bank was struggling with its US operations, 2005 when CIBC was taking 10% haircut with the Enron scandal, and now possibly BMO with it losing market shares, and getting their hands slapped on derivatives trading. Since I already have a position from the summer of 2006 correction, I’ll hang tight for now, but will accumulate more below 68 bucks.

Table: BMO’s five year dividend history

Ticker 2006 2005 2004 2003 2002
BMO $2.26 $1.85 $1.59 $1.34 $1.20



Further Reading Materials

Financial Jungle Blog Updates


  • The Money Diva will feature Financial Jungle along with 14 other blogs on the second Canadian Tour of Personal Finance Blogs. I missed the deadline for the original tour, but I’m glad to be in the lineup this time. I have a few possible topics in mind, but I’m leaning toward something on the lighter side.

    Canadian Tour of Personal Finance blogs.

  • The first calendar month for Financial Jungle is nearly over. Here are the latest stats for April, and thank you for your support:
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Jungle Bulletin


New Deep Value Investor On BNN


Value investors will be pleased to learn that Pat Naccarato, manager of the successful AIC Value fund, is now sharing his value wisdoms on the Market Call segment of BNN. Okay, I can hear some people giggling. BNN guests are often stereotyped as talking heads by many investment forums, but I believe each guest should be evaluated on his own merits.

Deep value investors are a rare breed, because they’re natural contrarians who go against the crowd. It is the ability to think independently that helps them hunt for out-of-favour gems when no one is looking. There are plenty reasons to like Pat Naccarato. It is not because he outperformed S&P 500 13 out of 15 years, or that I’m holding many of his current recommendations. :D It is the way he rationalizes his investment philosophies. Pat puts capital preservation as his number one priority. He emphasizes one way to keep your risks in check is to buy companies at or near their book value, because book value is a more stable yardstick over earnings. Try avoiding companies with high Price/Book ratio such as the old Nortel, which managed to fall by 90% twice! Pat doesn’t spend much time worrying about returns, because you can’t worry about what you cannot control, but everyone can always manage their risks.

Despite having Dows and S&P hitting new highs, Pat is still able to find many bargains out there. During the segment, he commented on homebuilders, financials and furniture makers. Although he didn’t mention one specifically, one homebuilder off the top of my head is DR. Horton. Over the past 10 years, DHI traded between 0.93 to 2.11 Price/Book. It is now trading at 1.09, which is both near its historical low and its book value. DHI also sports a handsome 2.65% dividend yield, the highest among the major builders, as well as a low Price/Earning of 10.10. Pat is also excited about Internet bank, IndyMac Bancorp, whose stock tumbled for no apparent reason except that it’s in the same general sector as sub-prime lenders. IndyMac is yielding 6.50% backed by a healthy payout ratio of 38%.

The $250 millions AIC fund started gaining traction since Pat took over as the portfolio manager sometime in 2005. I might consider investing a small portion inside my RRSP to receive his quarterly and annual commentaries.

To learn more about Pat Naccarato, check out the following links:

CMHC Fee Reduction


I just learned homebuyers are finally getting some relief in the overheated real estate market. Effectively immediately, buyers with at least 20% down will not longer pay a dime for the CMHC insurance premium.

“We believe that a great number of home buyers will benefit from this change and we are delighted to be able to take a leadership position in making this new option available immediately,” said Cid Palacio, Vice President, BMO Bank of Montreal.

Ms. Palacio noted that based on an average home price of $300,000, a home buyer with only a 20 per cent down payment can now save an average of $2500 in insurance premiums.

To the best of my knowledge, the new fee structure will look as follow. Since the news is so recent, I can’t find official confirmations of these numbers. Not even CMHC’s own website is updated as of this writing. I’ll update this post as I learn more.
[Edit: Just gotten words from my mortgage broker that the only change is the elimination of 20-25% bracket. Everything else stays the same.]

Down Payment
 New Fees
 Old Fees
21% - 25%
 0%
 1.00%
16% - 20%
 1.75%
 1.75%
11% - 15%
 2.00%
 2.00%
5% - 10%
 2.75%
 2.75%
Flex Down
 2.90%
 2.90%


The intention is obviously to alleviate the burden to come up with 25% down, but I’m not convinced that it will be the buyers who reap the benefit. The market has a way of offsetting any money left on the table. I believe the cheaper premiums will drive up demand, causing buyers to bid up prices in the mist of an already tired real estate boom. Consequently, what you gain on the insurance savings, you give back in higher prices. I guess we will have to wait and see.

On a related note, existing home owners can now access up to 80% of their home equity instead of 75%. This is good news for owners looking to tap into their equities for such things as the Smith Manoeuvre or renovations.

“Now, with refinancing at 80 per cent, we’re making an extra five per cent equity available to our clients for their financing needs,” said Catherine Adams, RBC Royal Bank’s vice-president, Home Equity Financing.

Resources

If you want to get overview of banking system you can consult many journals or websites relating to banks. The bank charges on the credit card vary from bank to bank. The bank closing information is normally provided on the banks website you can also get other bank related information from there. Now online credit card application forms are available and you can apply for the travel credit card through the websites.

Do You Get What You Deserve?


Not according to my real estate mentor, Ozzie Jurock, “In life, you don’t get what you deserve; you get what you negotiate.” In the end, I concede that real estate isn’t my real calling, but one can easily relate this marvelous quote to other aspects of personal finance. Salary comes to mind, but the less obvious is investing. We don’t realize this, but buying and selling stocks is a constant negotiation with the market. When you look at a stock like Scotia Bank, even though the intrinsic value of the bank doesn’t change much over the course of days, weeks or months, the share price swung widely by nearly 10% over the past two months. Luckily for us, negotiating with the market doesn’t require a thick skin. Just make a note of what you’re willing to pay, and wait for the right offer to come along. To quote Warren Buffett:

There are no called strikes so you can watch stocks come by and wait and wait until the right pitch and no one is going to call a strike.

That begs the question: how do you decide what price to pay? Well, I don’t have the secret formula. It’s often said that stock picking is more of an art than science. Some people accept good deals, but others may chance it by waiting for the real bargains. To help you develop a price target, let me share a neat little tool called the Big Charts. You can enter Scotia Bank, and pick various fundamental indicators such as Yield, Rolling Dividends and P/E. Looking at the 5 and 10-year graphs, you find that BNS normally trades between 2.75% to 3.25% dividend yield. Since the current yield is near the lower end of this range, the indicator suggests the market’s offer is too pricey.

Astute investors may criticize that valuing based on yield alone is always folly or too rudimentary. Most investors will develop their own process over time, but for now, I’d add Big Charts to your bag of tricks. Have fun!

Claymore S&P/TSX Canadian Preferred Share ETF


I recently came across a Claymore Canadian Preferred Share ETF article written by Rob Carrick of the Globe And Mail. Although I’m by no mean a preferred share guru, I can’t help but feeling leery about the impeccable timing of this release. Just a few months after our finance minister derailed the income trust gravy train, income-seeking investors are now crying for second best options. There is one important lesson I learned during the dot com era: the financial industry creates new products for investors who are too late in the game. This trend never fails. You have technology in the late 90’s, resource and income trusts in early 2000, and now preferred shares. Who knows? Maybe this time is different, but James Hymas from Hymas Investment Management doesn’t think so. To quote Mr. Hymas, who is a formidable force in preferred share:

This construction difference is apparent from the release. The top three constituents are GWO.PR.X, BCE.PR.A and BCE.PR.C. You know what I like? I like indices that are easy to beat, that’s what I like. I might even be able to earn my fees just by avoiding those things and closet indexing the rest of the portfolio!

Unlike common shares, the preferred share world is complex, illiquid and inefficient. This is one of those rare cases, where I believe active management by a preferred share veteran like James Hymas can add value. Too bad I don’t have the net worth or minimum income required to buy his funds.

The preferred share index that the ETF is tracking is yielding 4.66%. In theory, if you subtract the 0.45% MER from the yield, you net around 4.21%. In other words, the ETF gobbles almost one tenth of the dividends before distributing the rest to you. That’s sounds like a lot to me, but I’m not sure if it’s the going rate. Having said that, I’m still interested in adding a preferred share ETF/mutual fund as part of my diversified portfolio, although I may want to proceed after the frenzies cool off.

Folks. Do you have a suggestion or two for me? Feel free to write me a few comments.

Model Portfolio: ETFs


For investors who don’t have the inclination or time to study the stock market, there is a terrific alternative that is easy, cheap and tax-efficient: buy a basket of low cost Exchange Trade Funds (ETF). An ETF is a security that tracks an index, such as the TSX 60 and S&P 500. You can trade them just like regular stocks through your brokers. Many studies cite the vast majority of actively managed mutual funds have under-performed their passive counterparts. Personally, I’m not a believer in the Efficient Market Hypothesis, but ETFs have other merits. For one, you can easily diversify across the entire globe with a few simple mouse clicks. Secondly, ETFs are many times cheaper than actively managed mutual funds. Thirdly, ETFs’ low turnover rates allow your portfolio to compound tax-efficiently.

Just for fun, I assembled this passive model portfolio consisting of 100% ETFs. The weighted average Management Expense Ratio (MER) is a rock bottom 0.1535%, instead of 2%-2.5% for most other actively managed mutual funds! I’ll be using Morningstar.ca to track and report the portfolio return once a month or so.

ETF MER Purchase
Price
(C$)
 Shares
 Current
Price
 Market
Value
 Weighting
iShares S&P/TSX 60 (XIU) 0.17% $77.800 642 $77.800 $49,947.60 50%
Vanguard Total Market (VTI) 0.07% $164.083 151 $164.083 $24,776.47 25%
Vanguard Paicific (VPL) 0.18% $78.364 127 $78.364 $9,952.29 10%
Vanguard European (VGK) 0.18% $83.574 119 $83.574 $9,945.28 10%
Vanguard Emerging Markets (VWO) 0.30% $93.004 54 $93.004 $5,022.24 5%
Portfolio 0.1535% n/a n/a n/a $99,643.88 100%

Some awesome links on ETFs:

Don’t Overpay That Hotdog Stand


Suppose you are in the market for a hotdog stand business, and a vendor is offering to sell his. Making sure no rocks are left unturned, you do your due diligence like any sensible businessman would. You ask for the previous financial statements. After crunching the numbers, you conclude that the hotdog stand is worth $5,000.

Here are 3 possible outcomes:

  1. The vendor asks for $5,000. Although it’s a fair offer, you negotiate anyway in case your calculation is off.
  2. The vendor asks for $3,000. You contain your excitement, and accept the offer promptly.
  3. The vendor asks for $8,000. You walk. It’s pointless to maintain a dialog, because you don’t have enough wiggle room.

It’s funny. When it comes to investing, many of us don’t think like businessmen, even though when you buy a share, you become a part-owner of a company. During the dot com era, I was buying and selling concept stocks strictly by price movements. In fact, I was doing the complete opposite of the hotdog stand example; buying when the price jumped, and selling when the price fell. Needless to say, I was traipsing the financial jungle until the wolves finally got to me during the infamous NASDAQ calamity. The lesson was harsh, but hey, better learn it while I’m still young.

My attitude is different nowadays. Nothing gets my tail wagging than watching my favorite dividend paying stocks tumble. The lower the price, the more shares I get, and the more dividends I receive. Conversely, I shun at stocks that soar to new highs. That would be like paying $8,000 for the hotdog stand. A key ingredient in keeping my emotions in check is to stick with boring, tried and true Canadian blue chips, most notably banks, insurance, mutual funds, pipelines, telecom, exchanges, railways, big integrated oil and gas companies. They’re predictable, profitable, and have long track records. The only action on my part is to wait for the right asking price.

Battle Between GIC And Mortgage


A lot has been said of asset allocation, but can we do better than bonds or GIC’s for our fixed-income asset class?

The best current 5-year GIC rate is 4.40%. After paying for taxes, you only keep 3% depending on your tax bracket. That’s barely above inflation! A better option may be to pay down your mortgage. The going rate for a 5-year fixed mortgage is 5.1%. Since a dollar saved is a dollar earned, saving 5.1% on your mortgage is a better deal than earning 3% from bonds or GIC’s. After all, why lend your money to the financial industry just to re-borrow it back at a higher rate?

Jungle Bulletin


Smith Manoeuvre - Hidden Treasure In Your Mortgage


A growing number of Canadian homeowners are making their mortgage interests tax-deductible.  Last year alone, my wife and I received a $1,613 tax refund, simply by following the Smith Manoeuvre to rearrange our financial affairs.

Our US cousins down south have it easy; not only do they benefit from lower income taxes, but their mortgage interest is also tax-deductible.  This is significant when you consider a typical person pays 72% of the first year’s mortgage payments toward interest.  Unfortunately, Canadians do not receive this tax advantage.  We do get a break on investment loans.  To remedy this tax drag, Fraser Smith popularizes a technique to convert mortgage debts into tax-deductible investment debts. 

The gist of it is to actively pay down your mortgage via cash surplus, and re-advance the principal to fund your investments or businesses.  The benefit is the interests on the converted loan are now tax-deductible, which means you’ll receive tax refunds each year, enabling you to pay down your mortgage even faster. At least this is the high level goal. The nuts and bolts of the Smith Manoeuvre are different depending how your finances look today and your investment risk profile.  Picture the Smith Manoeuvre as going from point A to point B. We know point B is to make mortgage interests tax-deductible, but everyone has a different starting point A.  I’ll go over some common scenarios later on, but first, a little background on Home Equity Line of Credit.

In almost all situations, the Smith Manoeuvre works best by opening a Home Equity Line of Credit (HELOC) secured by your home. A HELOC gives you the flexibility to re-advance your mortgage principal, therefore making your debts more tax-friendly. In our case, we used the President’s Choice just because we have a joint account with them. I have yet to find one lender that offers less than prime.  If you know one, feel free to post it here.

Alas, there are a few caveats with HELOC. Firstly, the homeowner must cover the legal and appraisal fees.  Secondly, to qualify, you must have more than 25% of equity in your home.  The equity over and above the 25% is your credit limit.  For instance, if the market value of your home is $400k, and you have $250k left on your mortgage, then you can qualify for ($400k-$250k) - ($400k x 25%) = $50k.

Below, I’ll outline a couple of common scenarios:

Flintstone Flip

This is the situation that we were in several years back.  We had a lump sum of investable cash, but needed to deploy it in the most tax-efficient manner. Suppose you have a $50,000 investment portfolio.  Assuming it has little embedded capital gains, you can unload the portfolio, pay down your mortgage, re-borrow $50,000 from your HELOC, and re-purchase the same investments.  At the end of the day, nothing really changed.  Your overall debt level remains the same, and you still hold the same investments. The only difference is you’ll start receiving tax-refunds, because the interests on the $50,000 are now tax-deductible.  You have just transformed $50,000 of bad debts into good debts.  The actual refunds depend on the loan interest rate and your tax bracket.  Assume the interest rate is prime rate or 6%, and you’re in the 40% bracket, the tax refund works out to $50k x 6% x 40% = $1,200. 

Cash Flow Dam

Similar to investment loans, converting your mortgage debts into business debts means more money in your pocket. This applies to homeowners with an existing unincorporated business that has revenues and expenses.  It works with an unincorporated business, because the tax department treats the business and you as one entity.  Consequently, the tax department treats revenues from your business identically as your employment salaries. If you can make mortgage payments with your pay cheques, you can make mortgage payments with your business revenues.  The next step is to withdraw cash from your HELOC to pay the business expenses.  Since you’re borrowing the money to pay business expenses, you’ll receive tax deductions on the HELOC interests.
For a more in-depth look at cash flow dam, check out this document from Fraser Smith.

As some of you already know, I’m a die-hard dividend investing fan.  Although I don’t remember Fraser Smith mention this specifically, I should be able to apply the Cash Flow Dam concept against a leveraged dividend paying stock; the revenues are the quarterly dividends, while the expenses are the loan interests.  Say I borrow money to buy BMO today, the dividend yield is 3.7% and loan rate is 6%. Every year, I pay down the mortgage with my 3.7% dividends, then re-advance 6% to cover the interest expense, provided that the HELOC account has available credits.  Since the 6% is tax-deductible, I’ll get 2.4% back if I am in the 40% bracket.

As always, don’t take advice from a guy on the Net.  Talk to your accountant if you’re interested in the Smith Manoeuvre. You can read more about it here: