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TSX Group, A Bad Apple In My Portfolio.


TSXLogoOn 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’m A Guilty IGM Shareholder


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.

Investors Group

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.

BMO. A Poster Child For Cash Flow Leverging?


I’ve been noticing that a number of bloggers - including myself - are topping up their BMO positions as the stock is rattled by commodity trading losses. Money Diva initiated 400 shares of BMO earlier in the week. My own BMO position grew to 250 shares last week with a new adjusted cost base of $63.20. BMO, to me, has the best balance of high yield and dividend growth. At $68.69, the stock is yielding a cool 3.99%, while its dividends surged from $1.20/share to $2.26/share over the past 4 fiscal years. At this price point, I think this is a window of opportunity for aggressive investors to snatch up some BMO with leverage, and still maintain a positive cash flow.

Continuing with my dividend tax calculation post, a BC resident in the 30.65% bracket wouldn’t pay any dividend taxes. If you leverage to buy BMO, you’d receive 3.99% in dividends tax-free and a small tax refund. The loan interest rate would be 5.75% from Interactive Brokers, but the interest is tax-deductible. If your tax bracket were 30.65%, your after-tax cost would be 3.99%, thus canceling the dividend yield. In other words, it’d cost you nothing to invest in BMO with borrowed money.

The reward is in the dividend growth. Granted that part of the recent growth came from rising payout ratio, but even with a modest projection of 6%/year growth, the yield can still overcome the interest rate by 1.35% in 5 years. The beauty of this setup is that you’re never forced to sell. Leveraging alone isn’t dangerous, as long as you can afford the interest.

Jungle Bulletin - Cheap Canadian Stocks, Free Will, Universal Life Insurance and TSX Group


TSX Group


Just a quick update on my portfolio. I accumulated more shares to my existing TSX Group position today. The stock is down recently, because first-quarter profits of $0.53/share miss the consensus estimate by 3 cents.

I don’t mind it as long as revenues are up 15% on stronger listing and market data revenues. The drop in profits is attributed to raising costs, but it is not wasted money:

Expenses jumped 29 percent to C$47 million, due in part to additional employees taken on after the acquisitions of Shorcan Brokers Ltd. and certain fixed income assets from Scotia Capital last year.

Also boosting costs were advisory fees related to joint ventures TSX entered into with the International Securities Exchange Holdings Inc. and IntercontinentalExchange Inc. during the first quarter.

“While we continue to aggressively manage our cost base, we’re not going to hesitate to invest in initiatives that we believe will grow the business over the long term,” TSX Chief Financial Officer Michael Ptasznik said on a conference call.

TSX Group is the operator of Toronto Stock Exchange and TSX Venture Exchange. TSX Group has a consistent history of rising dividends, and is one of the few non-financial companies with 3+% yield.

BMO Is Feeling The Heat On Derivatives Losses


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

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

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

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

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

Table: BMO’s five year dividend history

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



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Jungle Bulletin


New Deep Value Investor On BNN


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

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

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

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

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

Do You Get What You Deserve?


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

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

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

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

Top 10 Reasons For Dividend Investing


Every investor has a style.  I am a dividend-investing fanatic.  Here are my top 10 reasons for dividend investing:

 

 

1)      Dividends set a floor price – Dividend stocks tend to trade within their yield range.  For example, last summer I purchased Bank of Montreal at $60.50 when it was trading near the historical high yield of 4.1%.  The dividends kept the stock from falling more than a couple of bucks before storming back to $71.  BMO also distributed another $1.89 worth of dividend/stock and 2 dividend increases since.

 

2)      Dividends account for over half of the long-term real return – If you own 100 shares of BMO and receive 4% of dividends by year’s end, you can DRIP your dividends to buy another 4 more shares.  If you keep up the DRIP for 20 years, you’ll have a handsome 219 BMO shares in your portfolio.  Even better, some Canadian corporations offer 5% discounts through DRIP.

 

3)      Companies with long-term track records of stable and raising dividends show quality of the managements – Managements show commitment to shareholders by improving fundamentals and sharing profits.

 

4)      Dividends cannot be manipulated like earnings – Dividends are real hard cash in your lap.  Earnings can be faked by creative accounting.

 

5)      A stable stream of dividends reward investors even during market down turn – Management pays you to wait even during market setbacks.

 

6)      Dividends are more tax efficient than regular incomes and capital gains – In British Columbia, you can make $66,000 in dividends and pay no tax.  For regular incomes, you pay $16,880 in taxes.  For capital gains, you pay $5,097.

 

7)      You can safely spend your dividends without harming your portfolio – If you think in terms of income streams instead of portfolio size, you can consume 100% of your dividends without hurting your portfolio.  If instead you go for capital gains, consuming your capital during a depressed market will hurt your portfolio.

 

8)       Receiving dividends are passive – Dividends and increases are given to you each quarter or year automatically without any action on your part.  On the other hand, to receive capital gains, you must monitor the share prices continuously. 

 

9)      High dividend paying stocks have historically outperformed low-yield stocks – In David Dreman’s Forbes column (April 2004), he cited that between 1970 and 2003, the top fifth highest yield stocks returned 14.5%, while the lowest fifth returned only 8.8%.

 

10)  Dividends are more predictable than capital gains – Suppose BMO averages 10% over the long term with 4% in dividends and 6% in capital gains.  In a given year, you can count on seeing the 4% in your brokerage account, but the 6% capital gain is less dependable.