Financial Jungle

One man’s garbage is another’s treasure. Sometimes it’s quite fruitful to snoop around other people’s dumpsters salvaging disgraced stocks.

Lo and behold, I may be gaping at the rottenest of all: Homebuilder stocks. The S&P Homebuilders index has been nailed and hammered over the past couple of years, and is already plummeting 20% six-months into 2007. Many Homebuilder stocks are teasing their historical low price/book ratios, but who can blame the market when you consider:

• The National Association of Realtors is reporting a nine-month worth of home inventory waiting to burn through. This is a 15-year high.
• The sub-prime fiasco is forcing lenders to tighten their mortgage lending practice, thus reducing housing demand.
• Homebuilders are lowering their prices and enticing buyers with perks in order to clear the excess inventory.
• Homebuilders are expiring and writing off their land options.

I know this may sound counter-intuitive, but bad news is good news for value investors, because the stocks have already absorbed much of these glooming expectations. (For full disclosure, I purchased a half position in DR Horton, which I’ll get to later.)

On Monday, Citigroup slapped nasty downgrades against many Homebuilder stocks:

Analyst Stephen Kim downgraded to “Hold” the shares of D.R. Horton Inc., Hovnanian Enterprises Inc., KB Home, Lennar Corp., Pulte Home Inc., Toll Brothers Inc. and Ryland Homes Inc.

What happened to the DR Horton stock? It dusted off a miniscule 1% over the next 2 sessions. Shareholders are so accustomed to pessimistic forecasts that they barely flinched after the downgrades. When the stock is already priced for disaster, the low expectations along with a higher dividend yield bolster the current price point.

Since homebuilding, by nature, is a cyclical sector, price-to-earning and price-to-sales are deceptive valuation matrices due to the fickle earnings and sales figures. A more reliable valuation matrix for cyclical stocks is the price-to-book ratio, assuming the company can hold its book value steady. Please visit MoneyCentral to appreciate how DR Horton vigorously maintained a modest equity growth even during these difficult times, and then compare what it’s trading now in relation to its historical price-to-book ratios.

Current P/B = 0.96

The question now isn’t if a recovery is looming, but when. Most of the industry experts are projecting a revival of the housing sector within the bottom half of 2008, so securing a HomeBuilder stock at this time may appear premature. However, the market tends to factor in future expectations into today’s price. Accordingly, the stock should rebound ahead of the sector. To quote Brett Arends from TheStreet.com:

[The current valuation] is a fraction of where the stocks usually trade. The last time we saw valuations this low was in late 1990, and that was in the depth of the last real-estate crash. And that time around, the shares quickly rallied — even though the housing market itself took years to get back in the swing.

There are two ways to participate in the Homebuilding sector. The diversified approach is to buy an ETF, such as XHB. The other approach, my preference, is to bypass the MER and snap up a stock directly, since Homebuilders tend to swing in lockstep with each other. DR Horton(DHI) is a reasonable choice because it is the largest US Homebuilder, and the company is buying you beer (3% dividends) while you wait for the inevitable vengeance.

DR Horton traded as high as $42 before tumbling down to $19.75. I haven’t decided when to double-down yet, but I suspect the next cyclical peak will likely surpass the previous high.

Disclaimer: I’m an amateur investor. This is not a recommendation to buy. I welcome any constructive feedback.

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.

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.

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.

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.

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.

Recently, I received requests from readers asking for some advice on finances. One of them being a Vancouverite who is feeling a little lost in the investment jungle. Please realize that I’m only blogging for fun, and I have no official training in financial planning. Therefore, always consult your independent financial advisor prior to any investment decisions.

To protect the reader’s identity, we’ll refer to him as “MJ”. You can view the full letter here, but here are the highlights:

All my RRSP holdings (which don’t exist anymore for reasons not worth mentioning here) were just some dumb mutual fund that made me negative 2 frickin percent. Anyways, got rid of those. A few months ago, I started off with Credential Direct for 1000 loonies and then jumped ship and took all my holdings to questrade where I had to purchase another 1000 loonies. I started off with Activision which just recently lost me money but am holding Apple and Microsoft. Apple is doing well. Problem is.. I have no idea what I am doing really. I am just going by gut instinct and learning what I can about company activities..etc… I am also thinking I should look into IPOs and signed up yesterday to a fool.com insider’s tips.

Help! I feel like a small tuna in the wrong fish tank. I need tools and education before I end up drowning myself. O so many questions!

Don’t feel bad, MJ. Most of us are in the same boat. As hard as it is to imagine, I think you’re making great progress by realizing that investors traipse when they don’t have a set of principles to adhere to. Sooner or later, you’ll have to decide what type of investor you are. Are you a passive, fundamental or technical investor? Draft up your own investment philosophy, and sign it with your blood. In investing, it’s rarely profitable being the jack of all trades and master of none. Similar to how Derek Zoolander having the patented pose, Blue Steel, every investor should have a circle of competence as coined by Warren Buffett. Stick to the one thing and do it well. Without this contract, it’s too easy to succumb back and forth between the various investment styles.

The contract doesn’t have to be fancy, since the only audience is you. I started my clean canvas over 2 years ago, and till this day, I’m still augmenting it with new tools and concepts that embrace my guiding principles. It’s worth the effort, as it crystallizes your thinking.

I don’t want my own biases to sway you toward one particular investment style, and perhaps one day you’ll return and challenge my own investment philosophy. But, to get you started, I recommend reading the following books and websites:

• The Four Pillars of Investing
• A Random Walk Down Wall Street
• The Investment Zoo: Taming the Bulls and the Bears
• Contrarian Investment Strategies
• The Five Rules for Successful Stock Investing
• Money Chimp
• Investment Strategies for the 21st Century

Regarding the Fool.com Insiders’ Tips, I know nothing about it. Rather than squandering hours and dollars experimenting with the different investment newsletters out there, I recommend checking out the Hulbert Financial Digest, since they’ve done the leg-work for you already.

Please take a moment to browse through my Favourite Blogs widget to the right. Many of these financial bloggers (including Canadian Capitalist, Investoid, Yaser Anwar and SteadyHand) have ample investment experience, and I have no doubt you’ll find their insights quite gratifying.

Investors are licking their wounds as the TSX is struggling over the past 2 sessions and finishing off 3.1% lower. I’m not much of an economist, but word on the street is that south of the border, Treasury yields and mortgage rates are edging higher. Higher rates mean less borrowing, which slow the economy. That’s economy 101 for you.

Predicting the direction of interest rate movement is an impossible job as evidenced by the volatile bond pricing. Since my own performance has been mediocre at best, I’ll persevere by sticking to the buy-and-hold strategy, in good and bad times.

No one can predict the correction’s debut, duration or magnitude. One can only tell when the correction is already here, but by then it’s too late, and selling will not send him back in time to recover his losses. There has never been a correction not followed by a rally througout the the stock market’s history. By having the will power to stay invested, investors improve their odds of making a come back.

Yes, I know. It’s easier said than done, and I’m still haunted by the dreadful memory of the dot-com calamity, but I have something to prove.

The measure of a man is not where he stands in moments of comfort and convenience, but where he stands at times of challenge and controversy.

The challenge is here. This is my moment. I know I’m worthy of becoming a contrarian investor, instead of fleeing along side of the herds with my tail between the legs. In this article, I’ve compiled 5 simple reminders to resist the urge to sell. Of course, I love to know what you think.

1. Dividend investors crave for yields, not capital gains. A correction is a terrific time to accumulate more high-quality dividend paying stocks and income trusts at attractive valuations.
2. Over the short-term, the market price does not represent the intrinsic value. Behind the scenes, it is still the same business with the same working capital and earning power.
3. I’m a long-term investor. Volatility is part of the routine.
4. Most investors cannot time the market successfully. Selling would be an attempt to time the market.
5. History proves that the market always compensate those who stay invested during market setbacks.

There’s absolutely nothing that tastes better than a deferred capital gains tax. Many investors consider investment loans as good debts because the interests are tax-deductible, but the deferred capital gains tax is even sweeter. Never mind tax-deductibility; it is interest-free!

If you double your $10,000 investment to $20,000, you owe Canada $2,000 in capital gains tax assuming you’re in the 40% tax bracket. (Only half of the capital gain is included in your taxable income.) By being a buy-and-hold investor, you defer the tax indefinitely until you liquidate the investment. Effectively, you’re borrowing money for free. The fruits of your patience also grow over time. Due to the compounding effect, the longer you hold the investment, the faster you accumulate interest-free debts.

The deferred capital gains tax is much friendlier than margin loans because it has no margin calls, so you’re not forced to sell a piece of good business at the cheapest possible price. Furthermore, the capital gains tax acts as your first line of defense during market setbacks; the government generously forgives the loan before you start to lose money. On the other hand, when you borrow money on margin, it is your equity that fortifies the lender. Market correction is not the time to be brave.

When you have an embedded capital gains tax in your investment, think hard before trading it with another investment. In the above example, such a swap will trigger a capital gains tax and shrink your capital by 10%. Think about what you’re giving up. You’re losing a layer of cushion that absorbs the price volatility, and you miss out on future compounding on the 10%.

In investing, it’s rare to uncover a value stock compelling enough for you to abandon 10% of your capital, and hope it will catch up to the stock you just sold. Note the difference; the 10% loss is guaranteed, while the new purchase is an educated guess, but still a guess.

If the government offers to subsidize your investment, don’t be rude. Accept the gift graciously by holding on to your investment. As Charlie Munger puts it:

Just sit on your ass!

This is probably the most abused Warren Buffett quote I’ve read in many financial forums:

Wide diversification is only required when investors do not understand what they are doing.

For one reason or another, investors seem to interpret this as an excuse to concentrate. Let me rephrase the quote a bit.

If you don’t know what you’re doing, you ought to diversify.

Even Buffett, arguably the most astute of all investors, relies on 42 stocks to cut risks. Granted that the high stock count is probably necessary given his enormous wealth. However, if you don’t know what you’re doing, concentrating your stock portfolio will not turn you into an astute investor. Since no investor is omniscient, s/he can cushion any unforeseen blows from company-specific risks, such as strikes and natural disasters, by spreading your eggs to different baskets.

In my own portfolio, I have about 27 core holdings, a number of smaller positions, a couple of ETFs and a handful of mutual funds. Admittedly, the number of holdings seems excessive, but certainly not enough to qualify as diworsification. I don’t have plans to scale down at the present. Being primary a quantative investor, I find the current portfolio quite manageable.

Reduce volatility without sacrificing return
One of my favourite theories is the Modern Portfolio Theory, which goes something like this: when you construct a collection of high-risk, high-reward and uncorrelated stocks, it reduces the volatility of the overall portfolio without sacrificing the expected return. The key is to pick businesses that don’t correlate with each other. That way, individual stocks may oscillate violently around the expected return, but due to the low correlation, the oscillations cancel each other out, and you benefit from a smoother and more consistent return.

Reduce unsystematic risk
Diversification also reduces company-specific risks, also known as unsystematic risks. Examples include strikes at railway companies, broken oil and gas pipelines, and natural destructions by fires and hurricanes. This one goes along the line of not putting all your eggs in one basket. By diversifying, you can improve you odds of hatching most of your eggs.

I’ve been told that investors cannot diversify away from systematic risks, which include inflation, interest rates, recessions and political instability. Even though we can’t eliminate systematic risks, I’m open to the possibility of at least minimizing systematic risks by investing in companies with these characteristics:

• Ability to pass inflationary costs to the customers
• Clean balance sheet to insulate from rising interest rates
• A lineup of consumer stables including essential products and services
• Diversified international revenues

Further readings on diversification:
- Modern Portfolio Theory by Investopia
- Systematic Versus Unsystematic Risks by Investment Review
- How Many Stocks Diversify Unsystematic Risk? by Morningstar

If it looks like an index, quacks like an index and charges you 2.5% in MER, it’s a closet index fund.

A closet index fund describes a mutual fund that’s a copy-cat, look-alike, mirror image, carbon copy or whatever you call it, to the underlying benchmark. Typically, these funds hold remarkably similar stocks under the hood. You’ll find little differentiations between buying a closet index fund versus a vanilla index fund, but there is one big dirty secret that fund companies won’t tell you; closet index funds charge you about 2.5% in management expense ratio for doing practically nothing. When the portfolio looks virtually identical to the market, the manager has a daunting task of consistently overcoming the 2.5% disadvantage every year. It’s in investors’ best interest to stay away from closet index funds.

Here is one example of a closet index fund. Compare the top holdings between RBC Canadian Equity and TD Canadian Index. It’s bad enough that RBC Canadian Equity fund managers imitate the TD Canadian Index fund, but the fund also trails the benchmark by 3.14%/year over the previous 15 years.

TD Canadian Index

RBC Canadian Equity (a.k.a. closet index fund)

Here are 3 methods to spot a closet index fund:

1. Repeat what we just did. It’s less scientific, but looking under the hood works reasonably well. Visit www.globefund.com or www.morningstar.ca, type in the mutual fund name, and compare the top holdings with an index fund, such as the TD Canadian Index e-Fund. If they look similar, then it’s a potential closet index fund.
2. Another easy way is to compare the charts between the fund and the benchmark. Here is an example of comparing RBC Canadian Equity with the benchmark, and another example with ABC Fundamental-Value . Make sure you select “S&P/TSX Total Return” from the Compare vs. Benchmark drop down.
3. The advanced method is to get the R-Squared value, which reveals how much of the price movements are due to fluctuations of the underlying benchmark. It’s a number between 0 and 100; the greater the value, the closer the fund follows the index. I’m typically suspicious of R-Squared values greater than 90. Unfortunately, FundScope is the only site that I know of which offers R-Squared information, and there’s a $39.95 annual fee. If you know of a free site, please share.

Further readings on closet index funds:
- Closet Indexing by Canadian Funds Watch
- Closet Index Funds, Investors Don’t Ask, Funds Don’t Tell by Will McClatchy
- Beware of the Closet Index Fund by O’Reilly

The Dividend Guy is rightfully scolding IGM’s Investors Dividend fund for milking $291,117,000 a year in mutual fund fees. I’m both proud and guilty of being an IGM Financial shareholder. I’m proud because IGM has been steadily increasing revenues, profit margins, earnings and dividends, while maintaining Return on Invested Equity above 20%, and decreasing debt levels. I’m guilty because the prosperity rides on the backs of investors’ ignorance. Let’s face it. By analyzing Investors Dividend’s top holdings, one can easily conclude that the Investors Dividend fund is nothing more than a closet index fund with a tilt toward dividend paying stocks. Even an amateur like myself can assemble an index look-alike portfolio. Heck, pay me 1/100th of $291,117,000, and odds are favouring me to beat this fund over the long-term.

Not only is the Investors Dividend the largest mutual fund in Canada, the MER is also a whopping 2.88%. So much for economies of scale. To appreciate just how much investors are forgoing with the MER, let’s compare the performances between Investors Dividend and the TSX total return. The 5-year compounded returns are 9.71% and 12.43% respectively, or a difference of 2.72%. Peculiarly similar to the MER, the point is investors are better off buying cheap index funds and ETFs, rather than enriching IGM Financial with a jumbo MER for inferior performances.

Here is a totally unoriginal idea. Don’t buy this mutual fund. Buy the company that operates the fund. Buy IGM Financial. At 400 shares, this position is spoiling me with $684 worth of dividends per year, and this money is coming out of the $291,117,000 pot. I’m a guilty IGM shareholder, and you can give me some virtual spanking.