Financial Jungle

This post is a continuation of my original analysis on Keynote Systems.

The wait is over. I finally scooped up a few shares of Keynote Systems this morning after a stunning 25% tumble — courtesy of a downgrade by Ferris Baker Watts from buy to neutral. *

Their latest quarterly results are out and they look pretty sharp. Revenues are up 12%, and net income is break-even compared to a loss of $369 million a year ago. (Note that my calculation of net income is Non-GAAP net income minus stock-based compensation.) The company just repurchased about 1.5 million shares since November 2007, and the board authorized, yet, another 2 million shares.

Keynote Systems now only has 17.8 million shares left due to the company’s aggressive repurchase program. Who can blame them? At $9.74 (after-hour trading), it’s a highway robbery.

The stock is cheap, and I believe the arithimatic is very simple. In theory, you can go to the open market and buy the entire company for a mere $173.4 million. But, this debt-free company is worth so much more. Strip away all their employees. Strip away all their intellectual properties. Strip away all their software and computer equipments. Nevermind goodwill and intangible assets. You’re still left with:

• An empty mortgage-free headquarter that’s worth $135 million**
• A bank account with $99 million in it

That’s a total of $235 million backed by hard assets, or a case of buying one dollar for 74 cents.

Who else is saying “yes” to free money?

Another value investor, Brad from Triaging My Way To Financial Success, sent me a heads up on the bargain and picked up a few shares himself.

* Couldn’t google any explanation on the downgrade. In general, I take these ratings with a grain of salt anyway. Keynote has a potent balance sheet that enables them to buy back tons of shares; a characteristic that most analysts hate because they tend not to receive a lot of underwriting businesses from corporations who are too rich to ask for more capital.

** Estimate based on $85 millions purchase price and 6% annual appreciation since 2000.

Sometimes, we just need a hero. This is even more so in the universe of dividend investing, which by nature is a contrarian style. Let’s face it. Dividend investors are always pooh-poohed in a cocktail party because they never share your misery in a market slide, nor your pizzaz in a market frenzy. Want to become a successful dividend investor? Forget about winning the popularity contest.

Instead, follow Warren Buffett’s proverbial mantra:

Be fearful when everyone is greedy and greedy when everyone is fearful.

So, does dividend investing really work? Are there real people who manage to pull this off? Of course we can always point to the foremost Stephen Jarislowsky, author of Investment Zoo, and Tom Connolly of The Connolly Report. But that’s not fair, you may quibble. They are one of a kind. How about someone a little less celebrious? Someone a little… umm… like us?

Folks, meet the retired run-of-the-mill dividend investor, bunyip, whom I met from the Canadian Business forum. Bunyip is a relatively quiet dividend investing veteran, but when this low profile investor speaks, enthralling words flow out of his mouth.

I’m delighted that he gave me the opportunity to interview him three weeks ago, just before leaving for his Central America vacation. Inquisitive readers should hang on to the lessons from his 20-year investing experience.

1) Bring us back to your foray into investing. Did you experiment with various types of style? How did you stumble into dividend investing? What appealed you?

I started investing in the early seventies and made all possible mistakes (never twice). I changed strategies several times and it wasn’t until 1992 that I invested exclusively in dividend stocks and even used to sell half when a stock doubled. Now I rarely sell anything, just reinvest all dividends. I’m retired (freedom 55) but have pension so I probably won’t use non-registered account for anther 10 years. I could have retired earlier but I enjoyed my job and after all debts were paid we had a lot of money to put into stocks.

I bought my first shares in the seventies (20 shares of Simpson-Sears @ around $40). They split 4 for 1 soon after and I used to get a dividend cheque for $10 every few months. I kept them for several years until I bought my first house and sold for a small profit. My next foray into the market was in the late seventies when I was buying small cap mining stocks on the Vancouver exchange and gold coins. Did well with the gold but rather indifferent results with the speculative stocks. It was during this period that I started to read everything I could about the markets and created a starter list of dividend yielding stocks that I wanted to own. By 1992 my mortgage was paid off and I was able to start working my way through the list. It wasn’t until I got a computer and joined TDW that I really developed my own style. At that time I would still sell half of any stock that doubled, a carry ever from the junior resource days, a strategy I came to realize didn’t make any sense. For the last 3-4 years i haven’t added any new funds as I have reach all my targets and average $3000 per month in dividends that i reinvest, mostly in stocks in which i already have a position. Now I rarely sell anything and don’t care about the size of the portfolio, just the year over year increase in the yield.

2) What personal traits are best suited for dividend investing?

Patience for sure, especially in the beginning when increases come so slowly. It is always tempting to go for a “home run” but to build a large dividend stream requires discipline, pick a strategy and stick to it. There are many stocks that have more than doubled their dividends in the last 5 years such as the major banks, ENB, FTS and IGM. I also manage the portfolios of two very old relatives and in one of their accounts it is interesting to note that the dividends paid on several stocks are now higher than the original purchase price. So start young and have patience. I was driving across N. Ontario a few years ago and looking for a radio station to help keep me awake and the only one I could receive was a CBC affiliate doing a phone in gardening show. One of the questions was “when is the best time to plant a tree”. I think the person was looking for an answer like spring or fall. The expert replied “twenty years ago”. That answer could also apply to when is the best time to buy stocks.

3) How do you research your stocks, and what characteristics are you looking for? How do you determine your entry prices? Do you sell after a strong run-up? Do you average down?

Mostly annual reports as I mostly only buy stocks in which I already have a position. Also read both National papers and Globe’s website. I look for a history of dividend increases, ideally a payout ratio of less than 60% and increasing revenues. Entry price? I don’t try and time the market, I buy when dividend revenue is sufficient to buy the next stock on my list. That being said, I’ll buy more if the stock or the market overall drops. I virtually never sell anymore and a strong run-up works against me, it makes everything more expensive. I buy all stocks at market price because all stocks I buy are very liquid and would prefer not to miss a dividend or end up paying a higher price just to save a dime.

4) What stocks are in your portfolio?

Agf.B, Aco.X, Bmo, Bns, Bce, Cm, Ema, Enb, Fts, Igm, Mbt, Mfc, Pow, Pwf, Roc, Ry, Rus, Sap, Slf, Tck.B, T, Td, Ta, Trp, Fap. Trusts- Aet, Apf, Bfc, Cix, Cos, Cne, Cwi, Eit, Mpt, Npi, Pif, Pgf, Prg, Rei, Ylo, Ep. There are several of these that wouldn’t meet my criteria today- Mbt Rus and Tck.

You may have noticed that I hold no mutual funds, just mutual fund companies. I don’t spend any money on MER or even pay for ETFs. They will eat your profits over the long term. My total expenses for a $650,000 account last year were $89.91 representing 9 trades. If this were mutual funds (well you do the math). Mutual funds have to trade often to show gains that they use in advertising, a retail investor in dividend stocks has a huge advantage. A stock that regularly increases it’s dividend and is held for the long term will come out ahead of most mutual funds in the long run.

5) What were some of your best and worst moves? If you were to travel back in time, would you do anything differently?

Best moves- Buying a lot of trusts right after Flaherty’s announcement. TRP@ 11.45 in 2000 after a dividend cut (since restored and then some). Worst- After reading a book on demographics I bought Extendicare and Louwen Group(2nd largest funeral Co in N.America). Both companies were involved in very expensive lawsuits in the US. Exe. survived but Louwen went from $40 to zip. Be diversified.

6) What are you thoughts on investing with borrowed money to enhance return?

Or enhance losses? I think it is human nature to want things to happen faster but it goes back to an earlier question. Patience. Hey but if you are successful, you’ll look like a genius.

7) How do you define financial freedom, and are you financially free?

I am financially free and have been for many years. I probably worked a few years too many because it is very difficult to say when one becomes financially free. I stayed longer so I would have a cushion but realize I don’t need that big a cushion.

I am also a jungle guy and am leaving Friday [FJ: that was 2 weeks ago] for a jungle lodge on the Costa Rican/ Panama border for 2 weeks. No phones, no computers, no stock market. I’ll probably be in withdrawal for a couple of days.

8 ) What stocks appeal you these days? What are you avoiding?

The next three I’m adding to are Fts, Td and Pwf. I’m avoiding anything to do with medicine or aviation, I have never made a cent on either though I tried often enough.

9) Any good books or websites you recommend?

I was impressed with your website. I do a lot of reading but nothing pertaining to the market as my portfolio is becoming less hands-on all the time.

Sure, you can invest in this 3-bedroom Vancouver old timer yielding a meager 3.5% to 4% CAP, but why torment yourself? Instead, you can indulge yourself with an 8.2% yield by owning these sexy office towers within H&R REIT’s portfolio:

As you may recall, the market has been punishing the Real Estate Income Trust (REIT) sector for much of 2007 and into early 2008, while the average yield is inching up each day. No one knows how long the spanking will persist, but as of this moment, the whole sector is roaming into bargain territory as many REITs are yielding well above 7%. That is far more attractive than the 3.74% offered by Canada 10-year bond, a popular yardstick to judge how attractive the REIT sector is relative to a guaranteed income investment.

I have taken an interest in H&R REIT - the largest Canadian office REIT and the overall second largest Canadian REIT behind RioCan. Today, HR.un is distributing an annualized $1.44 or 8.2% based on closing price of $17.49. That looks pretty cheap to me, and insiders agree. CEO Thomas Hofstedter and directors collectively scooped up $3 million worth of units in Nov & Dec at prices above $19. I picked up half a position at $18.05, but if we’re lucky enough, the trust will trade below $16 for a 9% yield. Otherwise, I’m happy to hold on to the half position for the long haul.

Back in 1999 when euphoric investors were dumping REITs while flocking to the ecstasy of dot-com land, HR.un traded briefly above a 12% yield at a time when 10-year Canada bond was yielding 6.25%. Outside of this anomaly, HR.un’s yield was around 10%, or a 4% premium above Canada bond. Today, the market is giving us a second chance to own this REIT at a 4.5% premium above Canada bond.

HR owns a portfolio of 35 office, 125 industrial, and 142 retail properties across Canada but principally in Ontario. Some of their well known creditworthy tenants include Bell Canada Inc., TransCanada Pipelines, Bell Mobility, Telus , Royal Bank, Public Works of Canada, Nestle, Canadian Tire, Finning International, Circuit City, Rona, Lowe’s, Shell Oil Products, Home Depot, Wal-Mart, Chapters, Famous Players, Walgreens, Sobey’s and Shoppers Drug Mart.

The trust has steadily bumped their distribution over the years, rising from $1.03 in 1998 to $1.44 today, or an annualized 3.8% growth. (They just increased distribution by 5.1% this month.) Together with the 8.2% yield, that’s a total return of 12%. Not too shabby for a hard asset class that’s traditionally weakly-correlated with the stock market. And if you’re into DRIP, HR offers a 3% bonus if you reinvest the monthly distribution to buy more units.

Real estate, by nature, is a highly leveraged asset class. HR’s average mortgage term is 10.4 years, but this is paired with an average tenant lease duration of 12.2 years with only 12.8% of leases expiring by the end of 2012. Nothing is bullet proof, but mortgage payments appear well covered. Nimble management was quick to snap up cheap buildings in a hot real estate market. New properties acquired during the first 3 quarters of 2007 cost the REIT a weighted average mortgage interest of only 5.67%, giving them an expected levered return on equity invested of 12.1%.

The only thing peculiar about HR is that their payout ratio actually exceeds 100%. The portfolio released $133.2 million of cash during the first 3 quarters of 2007, but distributed $133.7 to unitholders. This practice appears normal judging from other landlords in the REIT space. For example, bellwether REIT, RioCan has a shocking 116% payout according to a TD Waterhouse report. My only explanation is that REITs with a deeper pipeline can afford to over distribute in the short-term; RioCan has 10 properties in the pipeline versus HR’s 3.

** This is not a recommendation to buy. I’m not a REIT expert. If you have an opinion on HR or REITs in general, I’d love to hear about it.

For more info, please visit www.hr-reit.com.

There are different debt management companies, which want you to free from debt. You can learn from different websites that how to pay debt easily and can provide you every type of debt help. Now you can get online insurance leads by different companies and also online mortgage services. Low bank home loan rates are being offered by a number of banks. The home insurance is also available at cheap rates making it easy to pay installments.

Telly recently left a comment on my Top 5 Reasons Why Dividend Investing Over ETF post expressing her skepticism that anyone can build a diversified portfolio yielding over 4% “without loading up on some income trusts which are not favourably taxed or becoming less diversified by owning only high yielding dividend companies.”

I figure it would be a fun exercise to build this high-yielding diversified portfolio, although I wouldn’t shy away from income trusts. In my opinion, income trusts are an absolute key ingredient to sprinkle over a diversified portfolio. Just because some our best Canadian cash cows are structured as income trusts doesn’t mean we should place them in the penalty box:

• Canadian Oil Sands - a 33 year life reserve of tarsand with no exploration risks like most other energy trusts.
• Consumers Waterheater - Torontans take warm showers recession or not.
• CML Healthcare - a highly profitable diagnostic, laboratory testing and medical imaging services business that is pouring out distributions from its opearational cash, and while paying back debts at the same time.
• InterPipeline - a stable and low payout ratio pipeline trust that’s not sensitive to commodity prices. I covered IntePipeline in a previous post.
• H&R REIT - any diversified portfolio must include real estate. With H&R REIT, you get a little bit of office, a little bit of retail, and a little bit of US. I’ll cover this particular REIT in a future post.

I put this hypothetical 20-stock $100,000 portfolio together based on Friday’s closing prices. I started initially with a list of 30 stocks, and then painstakingly chopping it down to 20, although I’m the first to admit that investors should stick with 30 or more just to spread the eggs around.

As many know, the TSX composite is uncomfortably concentrated in the financial, energy and materials sectors. So, one of my main objectives is to diversify away from these them and place heavier emphasis on real estate, health care, consumer and pipeline stocks/income trusts.

Incidentally, I purposely left out Russel Metals, Manitoba Telecom, CIBC, National Bank or Bank of Montreal as I’m sure many were anticipating. The only high yielding dividend stock is Rothmans, which has a tradition of raising payout and occasionally rewarding shareholders with special dividends. Not to mention the business is recession resistant. But given the portfolio’s lofty 4.69% yield, we still have the buffer to add other lower yielding stocks like Talisman, Shoppers, Research In Motion and Potash without falling short of the 4% target.

I could be tweaking this portfolio all week long, but without further ado…

*** This is just a fun post. Do not interpret this as a recommendation to buy.

The current market tailspin probably doesn’t make you very rich, but at least you can be famous. Gavin Adamson, a personal finance columnist for The Globe and Mail, is looking for a DoItYouself investor for his upcoming article. The only prerequisite is that the investor must have an online RRSP account and makes use of the research materials and tools available on the brokerage web site.

How often do you get an opportunity to appear on a national paper? If you’re opinionated and can tolerate a little stardom, please leave a very brief comment below telling us which online brokerage site(s) you use and also your assessment on the service. Remember to include your email address.

Please submit by this Sunday evening at 6pm EST, after which I’ll pass along the comments to Gavin.

Here are a few samples of Gavin’s work:

• ESTATE PLANNING: A little trust goes a long way.
• Empty nesters: Health-care insurance. ‘We’re all invincible, until we’re not’
• Want to save money for your kids’ future? RESPs aren’t the only option
• Child-free, with a portfolio to nurture

ps. don’t forget to continue visiting Financial Jungle when you become famous.

All right, that’s it! Those ETF bullies have tormented us dividend stock pickers long enough. I’m retaliating. My headgear is on. My gloves are strapped. Give me your best shot.

1. Less MER - In fact, buy-and-hold dividend investors pay no MER at all. Regrettably, iShares CDN LargeCap 60 ETF (XIU.to) and TD Canadian Index eSeries seize 0.17% and 0.31% respectively. Which means, dividend investors have a 0.17% to 0.31% head start each and every year.

2. More Diversified - Most investors refer to the other types of diversification: by sectors and by geographical locations. This is a non-issue for investors with 30 or more stocks. As long as your eggs are properly spread amongst different baskets, the portfolio will achieve similar volatility as the general market. At least one study found that 90% of the unsystematic risk can be diversified away with as little as 12 stocks.

Sure, diversification does alleviate uncertainties in a portfolio due to particular sectors or countries, but there is a much bigger monster in the room, and that is market sentiment. No matter how much you slice and dice your portfolio, all sectors are still subject to market sentiment. The past few months are a testament of how every sector limps along while the market is howling over its PMS. No one can escape the carnage. The way I see it, dividend investing is the only remedy to help us cruise through the turbulence while remaining fully invested in the stock market. Just look at Bank of Nova Scotia. It’s basically the same old boring bank as yesterday, last week, last month, last quarter and last year, but its 1 year chart resembles 6-flags roller coaster. All that while, their distribution policy is steady as she goes.

So, dividend investing offers you another dimension of diversification by easing reliant on market speculations, and rewarding you with real hard cash straight from the operations of your high-caliber businesses.

3. More Tax Efficient - A $35,000 salaried British Columbian profiting from a $5,000 capital gain must pony up an extra $615 in taxes. The same British Columbian receiving a $5,000 dividend would pocket a $175 tax refund. (That’s almost enough to pick up 4 more BNS shares!) So, ETF investors must overcome both the MER and the tax refund every year.

4. Extended Investment Horizon - Due to market sentiment described in point 2, ETF investors must gradually shift their equity exposure toward bond to protect their nest eggs from market volatility. Consequently, a 25 year old ETF investor may only have a 30 to 35 year weighted investment time horizon before reaching 65. This is a double whammy for them: the investments have less time to compound, and the turnovers create tax-drags against the portfolio return. And don’t forget that bonds are taxed as regular income.

On the other hand, dividend investors can prolong a carefully crafted portfolio because dividends are never at the mercy of market turbulence. By sticking to stocks with a history of rising dividends, or businesses that provide essential goods and services, you can afford to hang on to the portfolio longer. I think the best defense is the best offence. If anyone can prolong a dividend portfolio for 40 years, the dividend compounding coupled with the preferential tax treatment will deliver enough capital cushion to hold to the stocks forever.

5. Less Market Timing - Contrary to popular belief, a thoroughly hands off approach to investing is an illusion. Eventually, a retired ETF investor will have to live off his equities. Unless he turns over 100% of his portfolio to bonds (I smell capital gain taxes), the 4% withdrawal rule is going to pinch during bear markets. If hysteria sinks the market down 15%, can he afford to devour another 4% and erode his already undervalued capital? If euphoria drives the market up 15%, should he take out a little more in anticipation of a trend reversal? You see? There are so many crucial market timing decisions. Doesn’t sound to me like a relaxing golden age.

A retired dividend investor doesn’t need to fiddle with his portfolio whether the market is sad or happy, because the dividend stream is more dependable even when the market is tumbling. And courtesy to points 1, 3 and 4, a dividend portfolio should enter retirement with a much larger base and yield, and be able to outpace inflation and cushion any unforeseen dividend cuts.

Further reading: A brief history of high yield stocks

Being an author of a personal financial blog, isn’t it embarrassing that I’ve never heard of The Financial Forum & Wealth Management Expo? According to their website:

The Financial Forum & Wealth Management Expo delivers Canada’s premier financial event where investors, advisors and exhibitors meet to exchange ideas, and benefit from a robust program of financial education, expert advice and timely information. It is all about money matters!

Gail Bebee, author of No Hype – The Straight Goods on Investing Your Money, first brought this event to my attention. As an introvert type, my ideal weekend doesn’t typically involve springing off the comfort of my own jungle to mingle with other investors. But, what the heck. Maybe I’ll have a blast yakking with like-minded individuals. Since most of people in my circle don’t even know what a P/E ratio is, this event will be a fresh experience for me.

Oh, and don’t worry. I’ll be on my best behaviour. E.g. no interrupting a whole life insurance or a closet index fund sales pitch.

So, Saturday, Feb 9th is marked on my calendar. BTW, Gail Bebee is presenting on this day as well. BTW2, if you’re a RBC Direct Investing client, your Winter 2008 newsletter should include an invitation code for a free register to the event. I’d post my code here, but better be safe than sorry as I don’t have the financial means fight an onerous battle against Royal Bank.

For those who are coming, see you at the conference.

Psst! Did you know a British Columbian couple can earn as much as $99,200 in dividends and not pony up a dime for income tax? Legally?

BC is truly Canada’s most exhilarating province where the government begs you to splurge on mountain hiking, skiing, fishing, sailing, golfing and urban living, at least in Vancouver. Best of all, you can do all that tax-free with passively generated dividend income from qualified Canadian corporations.

What’s the secret to this tax-free nonsense?

Everyone, please hail to the power of dividend tax credit. Simply put, dividend tax credit (DTC) reduces the amount of tax you pay to the government. You can calculate this tax credit by following my post on How To Calculate Dividend Tax Credits. In a nutshell, all dividend incomes are “grossed-up” to 145% of the actual dividends received. In the eyes of the taxman, you earned 145% of the received dividends for the year. This sounds terrible, because the more money you earn, the more tax you pay. However, the DTC turns around and slashes your tax bill based on a combined federal and provincial rates. The federal DTC rate is fixed at 18.97%. On the other hand, the provincial DTC rate ranges anywhere from 6.65% in Newfoundland to 12% in British Columbia and New Brunswick.

If you’re like me, these calculations make you cross-eyed. To skip this dividend gobbledygook, surf to this online tax calculator from TaxTip.ca. To calculate your total tax payable, simply select your province at the top, and punch in the dividend amount at the “Cdn dividends eligible for enhanced div tax credit (public companies)” field.

I used to believe the first $66,000 in dividends is tax free until confronted with the sneaky Alternative Minimum Tax, which targets high earning individual awash with certain tax advantages. Some web sites are still quoting ~$66,000 as the maximum tax-free dividend earning in BC, but I’d be more than ecstatic if anyone can provide proof.

Probably the most hostile criticism to dividends is the how the 145% gross-up amount robs seniors from certain government supplements, most notably the Old Age Security. Seniors (over 65) can receive up to $502.31 per month from OAS, but problem is the government starts to hold back certain amount for seniors earning above $64,718, and the entire OAS payment vanishes completely by $104,903. The dividend gross-up amount is a real concern because it’d only take $44,634 in dividends to enter the $64,718 territory.

Despite the warning, I believe the pros outweigh the cons. Policies change from year to year, so you never know if OAS is sustainable amidst the dramatic aging population shift over the next few decades. Even then, the prudent course is to clasp the guaranteed tax-savings today, reinvest and compound the profits for years to come.

Reference:
How to optimize dividend tax income by Million Dollar Journey
The other way to retire by Canadian Dream

It seems everyone is busy writing down his/her New Year’s resolutions these days. This is a fabulous idea, and I’m not about to get left out of this party. I’m going to succumb to this boisterous bandwagon, only because publicizing one’s goals and signing them with blood is an effective way to hold oneself accountable, and accountability is what empowers us to make great strides through out 2008 in achieving our goals. I urge everyone to do the same either by conveying your 2008 resolutions to someone other than yourself (or your pets). Hey, be my guest if you’d like to announce them right here at Financial Jungle.

As long-time readers, you may have guessed this year’s theme is dividend investing. For 2008, my goal is to boost our monthly dividend income by $300 — from $1,560 to $1,860. $300 may sound miniscule, but in the context of 1 year, that’s a $3,600 raise, not to mention it’s passive and recurring. This figure is possibly more than my salary raise this year.

What’s my action plan? I anticipate attributing half of this increase to organic growth of dividend increases and smart dividend reinvestments. The other half will come from the sheer power of disciplined saving and investing. I figure the recipe to achieving this goal is to turbocharge our saving rate up from 36% to 43%. This means we must adhere to the following rules:

1. Brown bag our lunches once a week. (Too much of a shock to my system to brown bag every day.)
2. Sniff harder for vacation deals without sacrificing quality.
3. Target those “one-time” discretional expenses that contribute little to the quality of lives.
4. Top up the new RRSP contribution room with tax-inefficient income trusts from non-registered accounts.
5. Pray for decent salary increases.

If 2008 is anything like 2007, this year will again flash by before our eyes. If I squint hard enough, I can almost see the $300 hovering on the horizon. How is that to keep motivation sticky? Yes, living within your means still rocks!

Signed by Financial Jungle Guy, January 8th, 2008.

Let’s round up a few New Year’s resolutions from around the blogsphere.

• Where does all my money go - A New Year’s Resolution for 2008 if you carry high-interest debt
• Thicken My Wallet - 2008 Financial Goals
• Canadian Financial Stuff - Belated Happy and Prosperous New Year
• Million Dollar Journey - Financial and blog goals for 2008