Financial Jungle

Folks, I’m on a quest to nail down a checklist for income trust investing. The checklist itself is an evaluation, and one reason for this post is to solicit your feedbacks and hopefully morph the list into something functional.

The unfortunate reality is that our Canadian common share market is quite narrow when it comes to selections, but the income trust market opens a door to a new dimension of diversification. I maintain a small watch list of income trusts, and it’s quite intriguing watching most of them going against the TSX movements on a regular basis. You know you have a healthy portfolio when all your securities are weakly correlated with each other.

Although I’m not one to stereotype, somehow there’s a stigma and prejudice against income trusts as being no growth businesses that keep chugging steams of cash while draining down their assets. Since I’ve not analyzed every single trusts out there, I can’t confirm if the majority of trusts are indeed decaying businesses, nor would that stop me from investing in this space.

Being a (wannabie) value investor, I believe it’s safer to hold only a handful of high-caliber trusts than buying the entire spectrum, which may potentially include a number of ugly cousins. By high-caliber, I mean trusts that offer at a minimum, the one-two-three knockout punch: sustainable distribution, strong growth profile, and sound fundamentals.

Without further ado, let’s sharpen our process! Please visit Canadian MoneyCentral for financial summaries, but it’s imperative that you peek under the hood by visiting the individual trust’s website. Many of which have an “Investor Relation” link to hunt down financial reports and distribution histories. For this checklist, I’ll reference CML Healthcare Income Fund, which is a leading provider of laboratory testing services in Ontario and the largest private provider of medical imaging services in Canada. (By the way, since the TSX is a Healthcare challenged index, most Canadians should consider opening their arms for home grown Healthcare stocks/trusts like CML Healthcare.)

1. Sustainable Cash-Flow - The trust must generate enough cash to cover both distributions and capital expenditures. This is one hallmark of sustainable trust distributions. If the internal cash flow doesn’t cover its distribution and capital expenditure obligations, the business must seek external funding (debts and share issuance) which is a major warning sign. Looking at their 2006 cash flow statement, the CML earned $98.4M cash from operations. In the process, they depreciated and depleted their assets by $3.28M. They have enough operational cash flow to cover both the $3.28M as well as the $78.81M distribution to shareholders without resorting to debts and share issuance.
2. Strong Growth Profile - The trust must have a strong growth profile. We’re not looking for the “good enough” trusts. To quote my ex-Marketing Director:
   
   

   We’re not in the business of pain-killing. We’re not the Tylenol; we’re the Viagra!

   Just meeting the minimum cash flow requirement isn’t good enough. We want exceptional trusts that not only reward investors with reliable distributions and, but retain the excess to propel and grow the business well into our retirements. CML’s cash-flow didn’t merely meet the depreciation/depletion and distribution, they exceeded them. What are they doing with the extra cash? Their spent $10.9M on “Cash From Investing Activities”, which is more than enough to replenish the $3.28M depreciation/depletion. In addition, they paid back $1.12M in debts and retained $2.54M in the bank. I probably didn’t pick the best example since CML’s distribution is relatively short(since 2004) but they had raisen their distribution twice.

3. Strong Fundamentals - The overall business must be sound. For instance, both the Profit Margin and Return On Capital should be higher than peers, and Debt/Equity should be manageable for the industry. There are always exceptions to the rule. For instance, it’s reasonable for REITs to have higher Debt/Equity ratios, because they can match long-term fixed mortgages with their long-term tenant contracts. CML’s Return on Capital and Net Profit Margin are 13.7% and 34.4% respectively, which are stellar for income trusts. Meanwhile, their 0.36 Debt/Equity ratio is much more conservative than the industry’s 1.39.

I have no doubt that there are gaps in my analysis. Consider this draft one. If I receive enough feedbacks, I’ll post version 2 of the checklist.

Two stock brokers, Jon and James, head out for their usual 18 holes of golf. Jon offers James a $50 bet. James agrees and they’re off. They shoot a great game. After the 8th hole, James is ahead by one stroke, but cuts his ball into the rough on the 9th. “Help me find my ball. Look over there,” he says to Jon. After a few minutes, neither has any luck. Since a lost ball carries a four point penalty, James secretly pulls a ball from his pocket and tosses it to the ground. “I’ve found my ball!” he announces. “After all of the years we’ve been partners and playing together,” Jon says, “you’d cheat me out of a lousy 50 bucks?” “What do you mean, cheat? I found my ball sitting right there!” “And you’re a liar, too!” Jon says. “I’ll have you know I’ve been STANDING on your ball for the last five minutes!”

A young man asked an old rich man how he made his money. The old guy fingered his worsted wool vest and said, “Well, son, it was 1932. The depth of the Great Depression. I was down to my last nickel! I invested that nickel in an apple. I spent the entire day polishing the apple and, at the end of the day, I sold the apple for ten cents. The next morning, I invested those ten cents in two apples. I spent the entire day polishing them and sold them at 5:00 pm for 20 cents. I continued this system for a month, by the end of which I’d accumulated a fortune of $1.37.” “And that’s how you built an empire?” the boy asked. “Heavens, no!” the man replied. “Then my wife”s father died and left us two million dollars.”

Pretty soon when you look up “Vancouver Bear”, you just might find my face on the Oxford dictionary.

Nah, I shouldn’t flatter myself. There are plenty more unpopular Vancouverites in the city claiming the podium; one being Mohican from Langley Financial Planning. Mohican found this hilarious gem on MLS.

MLS®: V643849 $529,000

House on a quiet street. 1/2 block East of Nanaimo. 3 bedrooms up & 3 bedrooms down. New paint on main. Low basement ceiling. Tenanted at @ $1,050/month. Hold and build later. Needs notice to show.

$1,050 a month is quite pathetic when you consider that’s only $12,600 a year, or a 2.38% rent yield, which is barely above inflation.

We’re not done yet. The rent yield is before expenses, which include property tax, water and sewer tax, home insurance and maintenance. All taxes combined should amount to more than $3,000 per year. We ought to set Tax Freedom day on Mar 31st, when all rents collected up to this point are funneled to the government.

Needless to say, the “earning” yield is much lower than 2.38% after expenses, but we’ll be generous and dock only a quarter off to make 1.78%

The recommendation from the seller is to either “hold or build later”, but neither options are sensible. Who would want to hold for a 1.78% yielding property with a scant growth prospect? (In BC, landlords are restricted up to ~4.2% rent increases each year.) Might I add the 5-year mortgage rate is up - again - to 5.79%? Borrowing 5.79% to buy a slow-growth property yielding 1.78% is ludicrous. Some people belittle renters because “rents are money out the window”, but so is paying mortgage interests, taxes and insurance.

The second option of building later will cost dearly. I know a couple of friends who paid a vicinity of $250,000 to build a home in Vancouver due to labour shortage and higher material costs. Add the construction cost to this purchase price, and you’re a proud owner of an $800,000 Vancouver special. Now you really must push the throttle to earn your 5.79% interests back, or $3,860/month. Remember, the interests aren’t the only expense. Tag along another $250 of taxes, insurance and maintenance to round up the figure to $4,110/month.

Wouldn’t it be funny if I get a spanking from the seller? The things I do for my readers.

Being a Telus shareholder, I’m fascinated by the seemingly lopsided skirmish between Telus and 3 other private equity suitors in bids for a BCE takeover. According to Derek Decloet, speed is of the essence for Telus CEO, Darren Entwistle, who is doing everything he can to sweet talk regulators into a swift approval in-time for a concrete bid:

Despite the happy talk from Mr. Entwistle about how a Telus-BCE combo is best for shareholders, bondholders, customers, taxpayers, bankers, brunettes, vegetarians - have we forgotten anyone? Oh yes, kitten lovers - he knows that this scenario could be his undoing. In an interview with the The Globe and Mail on Tuesday, he invoked the Inco name at least twice and, in essence, pleaded for a better deal from regulators than Mr. Hand got. European Union apparatchiks dragged their heels for months on the Inco-Falco proposal, a delay that gave plenty of time for other bidders to plan their (successful) assault.

BCE has a reputation of squandering free cash flow on horrendous acquisitions, but they do have quite a decent wireless division (~28% market share) in addition to their decaying landlines. Is this a case of great assets with bad management? A Ferrari with me behind the wheel? Maybe Darren Entwistle is the Michael Schoemaker that BCE shareholders have been crying for; a new leader to zoom with their assets at full throttle. The word on the street is that a Telus-BCE merger would shave $800 millions to $1 billion off operating costs. To put that into perspective, the Telus and BCE earned $1.1 billion and $1.9 billion last year respectively. This is a substantial saving! In other words, BCE is worth more in the hands of Telus than the other bidders, thus enabling Telus to bid for $44/share, and topping the runner up bid of $42/share. As Ian Nakamoto puts it:

The others can bring financial muscle but not synergies.

Amidst all the merger talks, I’m curious if a Telus-BCE merger would serve as a catalyst to spark a few pertinent securities, namely BCE preferred shares and the Canadian banks.

Since the bidding story broke out, BCE preferred shares have been on a dire streak - falling about 15% - in anticipation of private buyers “loading the company with debt to pay for the buyout and thus compromise its ability to pay its dividends”. Since the glooming prediction is largely priced into the shares, there should be minimal downside from this point. But if competition regulators do give Telus the green light to merge with BCE, wouldn’t this mitigate the need for BCE to load up with debts, as Telus would most likely raise shares to fund this takeover? I’m soliciting opinions here. Of course the worst case scenario is regulators reject the Telus-BCE merger when every bidder has already upped their offer, thus further jeopardizing BCE’s ability to pay its dividends. In this scenario, preferred shareholders would be in a slightly worse situation than before. Nonetheless, it’s worth it to monitor preferred shares’ prices, while watching the events unfold.

Some Canadian banks may benefit as well, especially the ones with lower price/book ratios like National Bank and Bank of Montreal. Each of these banks already offers a superior yield when compared to long-term bonds, but now there’s a catalyst for price appreciation should the government becomes receptive of bank consolidations. In almost all acquisitions, the acquirers tend to fall and the acquirees tend to rise. If one of these banks gets taken out, we have an opportunity to sell at an inflated price, and load up the acquirer at a deflated price, however we are sailing into speculative territories.

I recently came across Invest Skeptically by Thomas Kim. Although Thomas is new to blogging, he’s an affluent investor judging from his initial posts. I’m always on a look out for online mentors, and Thomas fits the bill perfectly. His writing resembles one of my favourite authors, John Lawrence Reynolds, of The Naked Investor.

His About page reads:

Invest Skeptically is an investment blog for the ordinary investor. Retail investors (whether from lack of time, interest, or education) are often at the mercy of savvy marketing and smooth salespeople. The purpose of this blog is to be an advocate for the retail investor by reading the fine print, sharpening my pencil, and bringing in a little bit of the training and experience that any institutional investor has available to them.

Welcome to the blogosphere!

At $68, BMO is a mighty compelling investment despite competing against raising bond yields. Minus the recent hiccup with the derivative trading losses, BMO has done an admirable job over the past 10 years, when they bought back shares, paid back 30% of their long-term debts, doubled their earnings, and more than tripled their dividends. Check out their dividend history:

In this post, we’ll find out how BMO stacks up against the Canada 10-year bond. However, just to be on the conservative side, let’s assume zero growth for BMO over the next 10 years, and that investors can purchase the bond without a spread.

Currently, BMO is sporting an attractive 4% dividend yield and a cheap P/E ratio of 13. In other words, for every $100 invested in BMO, the stock earns $7.70. Contrast that to only $4.68 for the 10-year bond.

Out of the $7.70 earnings, BMO distributes $4 to shareholders in the form of dividends. A Vancouverite in the 30.65% tax-bracket receiving the dividends would pocket the $4 entirely tax-free, and that’s in addition to a modest tax-refund from the dividend tax credits. On the other hand, the same Vancouverite receiving $4.68 from the bond must surrender $1.43 in taxes, and wind up with a paltry $3.25.

What’s more, after rewarding shareholders with dividends, the company still retains $3.70 of earnings. So, not only is BMO yielding higher than the bond after-tax, the company still has the means to stimulate futher capital growth over the next 10 years.

Please realize that I’m not forecasting a surging share price, but merely taking a snapshot of the present valuation. Comparatively speaking, I’m favouring BMO over the 10-year bond if my time horizon is 10+ years.

It’s time for another Jungle Bulletin to share some links.

1. Thicken My Wallet writes a very fulfilling piece on the merit of leverage investing. My favourite part is when he uses a struggling business as an analogy to an under-performing investor. You’ll have to visit his link as I won’t give it all away. Not to be outdone, Canadian Capitalist reinforces Thicken My Wallet’s post by reminding borrowers how swiftly the avalanche of dot-com money vanished in 2002, and investors should thread carefully when considering leveraging.
2. In a two-part series, Ed Rempel, a guest writer at Million Dollar Journey, debunks some common stock market adages, which include “High P/E markets are riskier than low P/E markets“, “rising interest rates are bad for stocks. Falling rates are good”, and “America has way too much debt”.
3. Find out why the likable and down-to-earth Krystal, from Give Me Back My Five Bucks, is getting an adrenaline rush from PayPerPost.
4. I’m giving Four Pillars my pom-pom support for picking BMO as his first leveraged stock. While I don’t advocate leveraging for everyone, from reading Four Pillars’ posts, I’m confident that he’ll manage his debts and invest responsibly. You can also read up on my BMO. A Poster Child For Cash Flow Leverging? post.
5. A picture is worth a thousand words. Canadian Dream demonstrates the art of sleeping through market dips with his patented sleeping pills.
6. Investoid reminds investors that the TSX is too concentrated in three particular sectors, but don’t worry. He has a few tricks in his bag to share.
7. This Money Diva post may be a couple of weeks old, but it has a lasting impression on me. I agree with Money Diva, Ellen Roseman and Krystal that the point of blogging is the personal connections. Anybody can look up facts by reading financial books, but blogging brings a personal touch that the media cannot compete with. Additionally, once in a while, it’s fun to embarrass yourself by revealing some personal goofs, so you don’t set yourself up with unnecessary pressure to always perform at your peak.
8. I always have this itch to snoop inside people’s stock portfolios to spot potential investment ideas. Thank you, Middle Class Millionaire and Money Gardener, for satisfying my craving.
9. I’m participating in a couple of carnivals this week: Carnival of Personal Finance and IBN Festival.

PS. Due to work commitments, I won’t be posting tomorrow.

The market is weird. Every time one guy sells, another one buys, and they both think they’re smart.

Being a stock picker, this is one statement that I dread the most. How do you respond when you’re cornered into a no-win rhetorical statement? Do you pretend snobbishly that you’re smarter than the other guy? Otherwise, why become a stock picker at all?

My typical response is, even though the market is smarter than I, behaviour science teaches us that the market is perpetually stuck in a moody state where traders tend to exaggerate positive and negative news. The idea of stock picking is to avoid the herd mentality, and think independently.

The point of this article isn’t whether the market is efficient. Rather, even assuming all stocks are priced at equilibrium, market participants can still reap tangible value because stocks are priced inefficiently relatively to the individuals’ objectives and holding structures. Maybe a few examples will clarify things.

I picked up 100 BMO shares a few weeks back when they announced some derivatives trading losses. Someone must have sold the 100 shares to me, but I have no clue who that was. Maybe it was an American*, which would make perfect sense due to the lack of preferential tax treatment — BMO is worth more in my hands because Canadians receive the dividend tax credit.

Or, perhaps the seller was a Torontonian. Once again, BMO is worth more in my hands since Vancouverites benefit more from a higher dividend-tax-credit rate than Torontonians.

The seller could also have been a retiree who has a much shorter time horizon and looking to swap his BMO holding to something more conservative like bonds.

How about income trusts that distribute ample of interest incomes? As most know, the government will strip the preferential tax treatment for most income trusts by 2011. In the meantime, income trusts avoid paying the corporate tax as long as they distribute all earnings to shareholders. This delights RRSP shareholders more because the resulting pre-tax distributions are generally higher and tax-deferrable, while non-registered shareholders must report the distributions as regular income for the year.

Once the rule changes in 2011, the opposite is true. Income trusts must pay corporate tax on all reported earnings, however the trusts can distribute dividends to shareholders, who can then claim the dividend tax credit. The new rule favours non-registered holders because the after-tax distributions are essentially the same as prior to the rule change. On the other hand, the new income trusts are worth less in RRSP holders’ hand because the corporate tax reduces the distributable cash, and the dividend tax credit is lost inside RRSP.

As you can see, there are scenarios where win-win transactions can take place, and I haven’t even touched on portfolio rebalancing or hedging yet. The only time when it’s a zero-sum transaction is when it’s between two investors with similar goals.

For my own purchases, I don’t worry about who’s at the other end of the trade, because we can both be right.

* Since BMO is inter-listed on both Toronto and New York, I’m not sure if Americans receive preferential tax treatments if they purchase BMO from New York.

I just met another apex of my blogging career. Larry MacDonald gave thumbs up to Financial Jungle when he introduced a few new personal financial bloggers today. Larry highlighted Financial Jungle along with Ellen Roseman and Four Pillars. In his exact words, Larry said:

Financial Jungle Guy
A nicely written blog with intelligent and amusing posts (e.g. Can Money Really Buy You Happiness?) from a Vancouver software programmer.

This is quite overwhelming that Larry MacDonald would praise Financial Jungle with uplifting words like intelligent and amusing. I’m not only feeling humble; I’m downright embarrassed.

After all, Larry is one of the most well-known and respected investment writers in Canada. He’s the icon of sexy journalism. Women want to be with him. PF bloggers want to be him. I tell you. He can turn those prominent eye-wears into a hot commodity.

I just want to say thank you.

Please check out these links to follow Larry’s exceptional writings:
Canadian Business
Investor’s Digests

Larry didn’t get the opportunity to review all the new blogs, but he made notable mentions to:
The Financial Blogger
A Canadian and Her Money
Re: money
Riscario Insider Blog
Thicken My Wallet
Financial Security Quest
Savings Journey
Moneygardener

Contratulations to everyone!

On the surface, TSX Group appears as a textbook play for a fundamentally sound company with a distinct competitive advantage in the Canadian equity exchange market. The company has a strong cash flow, no long-term debt, and sports an attractive 3.5% dividend yield. It owns the only senior equity exchange (the TSX) in Canada, and is poised to penetrate Montreal Exchange’s lucrative derivate market as soon as the 10-year exclusivity agreement expires.

Back in 1999, TSX Group shook hands with Montreal Exchange (MX) in a deal to gain exclusive rights to equity listing. In return, the TSX handed over all options and derivatives trading to MX for the next 10 years. The 10 years was almost up, and things were looking rosy for TSX, so I picked up a position at a rock bottom price during the 2006 summer correction.

Fast forward a year later, TSX’s outlook doesn’t look so rosy anymore, but I’m still holding on to the position. In early May, a group of Canada’s leading investment dealers announced a plan to launch a new Alternative Trading System to take a bite out of TSX’s trading business. Good for them and lousy for me. To put that into perspective, the trading business represents about 40% of TSX’s total revenue pie in the previous fiscal year. It’s nothing to sneeze at, but CEO Richard Nesbitt predicts the proposed ATS would eat up a paltry $3 million out of the projected $400 million in annual revenue. Assuming he’s being optimistic, I’ll take that as the best-case scenario.

Let’s turn the page over to TSX’s bread and butter, equity listing department. Off the top of my head, I can’t remember the names of the recently consolidated TSX listed companies, but BCE and Alcan are likely the next 2 big boys on verge of getting taken out, and a number of analysts are promising more to come. Amidst all the consolidations, many Canadian companies are also inter-listing their stocks across the border, which makes me deduce it’s a matter of time before TSX’s equity listing revenues growth begins to erode.

Last night, I received a fresh copy of Investor’s Digest. The timing is impeccable, because Larry MacDonald wrote a piece on TSX Group with an exact opposite opinion. Now, Larry MacDonald is a lot smarter than I am, so I’m willing to bow to his wits. Some of his key counter-arguments are as follows:

He said TSX Group is the perfect welcome mat for BCE refugees looking for strong yields. I think he makes a good case, although one would think that BCE shareholders would either go with Telus or Rogers as an alternative telecom play, or Bank of Montreal as an income play.

TSX Group “enjoys a near monopoly on stock trading in Canada. Put another way, the company enjoys pricing power and exposure to the secularly booming commodity market. That would seem to make it an attractive alternative for investors wondering what to do with the proceeds from takeovers of resource companies.”

“TSX Group has a dividend yield of 3.5% that is well supported by ample, steady cash flows and a clean balance sheet with no debt and about $300 million in cash.”

“The new ATS is not expected to be up and running for at least a year.” TSX Group is leveraging a 12-month window to develop a faster and more cost-efficient trading platform, in addition to slashing their trading fees in attempts to keep the ATS threat at bay.

“The New York Stock Exchange was even more outmoded than the TSX, but it still flourished though a decade of competition from electronic and other alternative exchanges. Incumbency is a huge advantage in the stock exchange business.”

I apologize if I’m not offering a definitive conclusion. I take selling very seriously especially when much of the bad news has already been absorbed in the share price. The 3.5% yield should set a floor price, although the 22 P/E is probably steep for a stock facing serious head winds in revenue growth. In the meantime, I’m staying put and watching how events unfold over the next 12 to 18 months.

I’ll give you the famous answer; it depends. Since we don’t live in a binary world where it’s either happy or not happy, I think money can at least buy you some degree of happiness by ridding of financial burdens. Otherwise, your life is constantly saddled with bills, debts, rents, grocery and other necessities. At the minimum, money can relieve you of these headaches, and shifts you toward the happier end of the spectrum.

If you still believe money is irrelevant to how happy you are, try watching The Pursuit of Happyness. Pay close attention to Will Smith’s expression when his character, Chis Garner, was finally accepted to Dean Witter after confronting with a string of financial predicaments in the early part of his life. Chris Garner struggled to contain his excitement on a busy New York street. (I almost cried during that scene.)

I suppose the more interesting question is, can money buy you happiness once you cover all your necessities.

Whoever said money can’t buy happiness simply didn’t know where to go shopping. - Bo Derek

Once again, the answer is… it depends. What would you do if you have a million bucks? What happens when your million dollar journey is over? I’d love to hear some of your thoughts. Personally, I’d spoil myself with a Canon EOS Mark II, and travel around the world capturing breath-taking sceneries. Of course that’s just me. Perhaps it’s too nerdy for some, and others may have different ideas of what make them happy.

Sex is one of the most wholesome, beautiful and natural experiences that money can buy. - Steve Martin

Umm… no comment.

Anyway, for most folks, I think money can buy you happiness, as long as there is something to live for. I’m not talking about squandering money on impulse, but using it to purchase items that enable you to pursuit a genuine dream(s).

I always wonder what sane people would claim that money doesn’t buy you happiness.

Money doesn’t make you happy. I now have $50 million but I was just as happy when I had $48 million. - Arnold Schwarzenegger

Well, if you have $48 million, an extra $2 million is going to be insignificant. There’s an element of diminishing return where the first million will satisfy your inner most wants, and subsequent millions will round up the secondary. Consequently, not every dollar is appreciated equally. Can money buy me happiness? It depends on which million you are referring to.

Just a short post to say happy anniversary to my sweetie. See you tonight at the Japanese steak house. Yummy.

The Two Of Us

Love,
From your Financial Jungle Guy