Interest Rates Beginning to Settle. What's Next for Your Portfolio?

With the Bank of Canada holding the policy rate steady this month at 5% (Financial Post), it might be time to reconsider some of the interest rate sensitive securities that have been beaten down in the marketplace. 

Since reaching a low of 0.25% in 2022, rates have been steadily rising as the Bank of Canada combats inflation (CTV News). With inflation now starting to turn lower, and consumers showing some signs of fatigue, policymakers at The Bank have let off the gas, indicating that there might be some relief (or at least no new pains) in sight for rate sensitive borrowers.

What does this mean for your portfolio? Utilities, REITs, Preferred Shares, and other rate sensitive assets might start to look a lot more attractive on a real return basis. Canadian Utilities (CU.TO), Riocan (REI-UN.TO), and George Weston Preferred Series A (WN-PRA.TO), are down 15%, 17%, and 7% respectively Year-to-Date. Fear of further rate increases have pushed these assets lower. Now that rates have paused, investors might start taking another look. 

Is the Bank set to lower rates soon? Likely not, at risk of stoking further inflation. However, Canadian households are heavily indebted, which makes further rate increases a particularly risk proposition for the Bank of Canada, which is tasked with promotion financial stability. In a report by the CMHC: ""Canada's very high levels of household debt — the highest in the G7 — makes the economy vulnerable to any global economic crisis... When many households in an economy are heavily indebted, the situation can quickly deteriorate, such as what was witnessed in the U.S. in 2007 and 2008" (CBC News). 

This also might mean the return of the 60/40 investment portfolio, which has been a bit of a pariah as of late. This portfolio allocates 60 percent to equities, and 40 percent to bonds, and was popularized by financial gurus of the past, including John Bogle at Vanguard (New York Times). With bond yields rising over the last year, bond prices were getting hammered, and this was leading to poor returns for many 60/40 investors. With yields starting to stabilize, and even turn lower, you have seen much more positive returns for the 60/40 balanced portfolio. 

Remember, don't put all your eggs in the same basket, and maintain caution. 

Happy investing everyone. 

- Matthew. 

With the Bank of Canada announcing another interest rate hike, it’s a great time to revisit your investments that are more sensitive to fluctuating interest rates.

Canada’s central bank has raised its key benchmark rate another 50 basis points (0.5%), to 4.25%. This is bad news for those holding variable rate debt (such as adjustable-rate mortgages and lines of credit), and those holding investments that are highly sensitive to changes in borrowing rates (such as longer-term bonds).

When investing in bonds, there is an inverse relationship between bond prices and interest rates. This means that when interest rates rise, bond prices fall, and vice versa. This occurs because the present value of future interest and principal payments falls as the opportunity cost of tying up your money rises (you could invest your money into other assets now paying a higher rate of interest if given the opportunity – this makes your existing fixed rate investment assets less attractive). Preferred shares, which often have fixed dividend payments, also experience this problem.

When investing in stocks, the present value of any future cash flows also falls as rates rises. These future cash flows could be dividends, or the anticipated value of earnings that new projects might bring. For this reason, as well as more than a fair share of economic uncertainty on the horizon, we have seen many stock prices fall in tandem with bonds year-to-date. Often, those stocks most sensitive to declines of this nature are those with fixed payments coming from their customers, such as utilities, or those with cash flows only coming far into the future, such as some in the technology space.

On the bright side, the Bank of Canada might be nearing an end to the rate tightening cycle. Perhaps even just another 25-basis point, or 50-basis point move coming down the road in January. The housing market is showing signs of weakness, and inflation pressures are easing. These are both good sings for those waiting for lower rates.

Thank you.

Matthew Clarke

 

Some additional reading:

https://financialpost.com/pmn/business-pmn/bank-of-canada-makes-big-rate-hike-hints-it-may-the-last-one

https://www.bankofcanada.ca/2022/12/fad-press-release-2022-12-07/

https://www.ctvnews.ca/business/what-the-latest-bank-of-canada-rate-hike-means-for-inflation-consumers-1.6184636

Don’t let investment costs ruin your retirement plans.

In Common Sense on Mutual Funds (2009), John Bogle clearly and methodically articulates the importance for investors to maintain a simple and low-cost investment strategy. Throughout his book, Bogle demonstrates how high-cost mutual funds siphon off vast amounts of investor wealth over the long-term. He uses American statistics, noting that many popular mutual funds charge investors between 1-2% per year in management fees, in addition to other portfolio transaction costs associated with frequent portfolio turnover and trading activity. These fees may not seem like a lot to a typical investor, but over-time they consume a significant amount of the total investment return. For instance, if a stock mutual fund's portfolio returns 6%, and 2% is charged in fees, this equates to 1/3 of the total investment return. With many bond mutual funds currently yielding around 2-3%, even a 1% management fee is quite burdensome. In the long-run, this could mean many more years spent working until you can enjoy retirement.

In Canada, the situation is worse for many investors. According to Morningstar data, the average Canadian management expense ratio (the management cost of the mutual fund per year) is around 2.35%. On a million-dollar portfolio, that amounts to $23,500 per year in management fees. Of course, what should matter to investors is not just the cost, but their net return. Essentially, if higher investment performance compensates investors for higher fees, then the cost may be warranted. However, evidence completed by Vanguard clearly indicates that low-cost passively managed index funds continue to outperform most actively managed mutual funds (2018).

What’s the solution? A well-disciplined investment strategy that limits costs and emphasizes a sensible long-term asset allocation. John Bogle recommends the use of passively managed index funds (stocks and bonds), but he does note that a well-designed portfolio of actively managed mutual funds could do the trick (though perhaps not as well). The caveat to going with actively managed funds being that they must have reasonable fees, relatively low portfolio turnover, trusted management, and consistency. Finding all of that in a common mutual fund is no easy feat. 

Thanks for reading, and happy investing.

Matthew.

References

Bogle, John. (2009). Common Sense on Mutual Funds. Hoboken, NJ: Wiley & Sons.

Vanguard Research. (2018). The case for low-cost index-fund investing. Retrieved from, https://www.vanguardcanada.ca/documents/case-for-low-cost-index-fund-investing.pdf

A few important things to consider when looking for a mortgage loan.

The right down-payment:

Home buyers in Canada are required to make a down-payment of at least 5% of the purchase price of the property. But remember, anyone that has less than 20% down-payment is required to pay a CMHC Premium, which is the cost of insuring your new mortgage against default (non-payment of the loan). With only 5% down, the CMHC Premium will be 4% of the total loan amount. For a $300,000 mortgage, that would be a $12,000 premium (https://www.cmhc-schl.gc.ca/en/co/moloin/moloin_005.cfm). So, what’s the upside of paying for this premium? It usually results in the home buyer having a lower interest rate on the loan, which could save them money over the long-term.

The right type of mortgage:

When speaking about mortgage rates, most people in Canada refer to the 5-year fixed rate. Currently, the Bank of Canada quotes the 5 year mortgage rate at 5.14% (https://www.bankofcanada.ca/rates/daily-digest/), even though most Canadians can negotiate lower rates than this from a lender. Borrowers are free, however, to negotiate a range of mortgage terms, including anywhere from an “open” mortgage, which allows the borrower to pay off the balance of the loan at any time, to a 10 year mortgage, which locks in the client’s interest rate for 10 years, but with the consequence that should the client choose to pay off the balance of the mortgage before that time is up, they would have to pay a penalty. For borrowers that believe market interest rates might stay the same, or even drop, a variable rate mortgage might be appropriate. Variable rate mortgages allow borrowers to borrow money at a lower rate than the current 5 year fixed rate, but with the condition that if market rates rise, so will the interest rate of the client’s mortgage.

The importance of an underwritten pre-approval:

With all of the recent changes to mortgage rules in Canada (https://globalnews.ca/news/3897942/new-mortgage-rules-2018-canada-guide/), it is important for home buyers to carefully obtain the right pre-approval before agreeing to buy a home. An underwritten pre-approval means that a professional took the time to ask for, and validate, several key documents that lenders and the government require from borrowers before they can grant them a mortgage loan. These documents might include employment letters, pay-stubs, credit reports, savings account statements, and even Notice of Assessments from Revenue Canada. These documents are meant to ensure that borrowers have consistent and stable income, that they can afford the mortgage over the long-term; they now even seek to ensure that the borrower could continue to pay the mortgage if interest rates rose a couple of percent. Many lenders will issue pre-approvals without asking for key documents, and this could leave the client open to the risk of not actually being able to obtain the mortgage later in the process once the key documents are properly reviewed.   

Matthew Clarke.

BA (Hons.), B.Ed., MBA.

Mortgage Agent and Financial Consultant serving Ontario since 2007.

www.ygkmortgages.com

matthew@limestonemortgages.com

Debt Levels on the Rise Provincially and Federally: First Ontario's Credit Downgrade, Then What?

Debt levels continue to increase in Canada's most populous province. Recently published reports by both Fitch and S&P, international bond/debt rating agencies, explain that Ontario's government debt will reach $289.9 billion in fiscal year 2015-2016. This figure alone doesn't tell us much unless we compare it to another measure, the provincial GDP, or gross domestic product.

Much like a home-owner compares their mortgage debt to how much their home is worth, known as a loan to value ratio, or LTV, a government compares their debt level to how much economic output the province achieves in a given year, known as GDP. For a home-owner, the maximum loan to value allowed, unless we buy CMHC mortgage loan insurance, is 80 percent. For a government, there is no easy rule of thumb, but for most developed economies 80 percent would be seen as reasonable.

Ontario has a relatively healthy GDP of $721 billion. At first glance, this would seem like Ontario is in fine shape compared with most other developed economies. So why are the rating agencies concerned about Ontario? Because Ontario's citizens are also responsible for the federal debt, kind of like being responsible for two somewhat related but distinct mortgage loans. We are heavily mortgaging future generations both federally AND provincially, and this will cost us dearly.

Canadian federal government net debt reached $688 billion in 2014, which is an increase of over $170 billion since 2008. Combined, Canada and the provinces now have over $1.2 trillion in debt! That is a staggering amount for a population of only 35 million people, many of whom are children, seniors, unemployed citizens, and students with poor job prospects. Sadly, this does not even include personal debts, such as mortgages, credit cards, car loans, et cetera, which are also rising to record levels for Canadians.

The only provinces showing signs of improvement since 2008 are Saskatchewan and Newfoundland, which managed to pay off a combined $3 billion dollars in debt by 2015. All of the other provinces are in worse shape. There are two broad solutions being proposed to improve the situation for Canadians. Firstly, to grow the economy, or GDP, through investments in infrastructure, new trade deals, and other ways of creating jobs and economic activity. Secondly, there is austerity, or cutting back spending to start paying down the debt.

The first solution is being attempted by the governing Liberal party in Ontario. They are proposing billions of dollars in transportation infrastructure that is being promised will improve economic activity in Ontario, and thus reduce the provinces debt / GDP ratio.

Austerity is being practised in many American states, such as Wisconsin, and within many government agencies at home as well. Austerity practices are evidenced by layoffs and wage freezes for many public sector workers, and cutbacks and outsourcing in many government departments. Essentially, the idea is to reduce the overall overhead and operating costs of government, and use any savings to pay down debt.

Why is this so important to think about? Interest rates are currently low, which means the cost for Canadians to finance their debt is relatively low by historical standards. A 5 year fixed rate mortgage can currently be obtained in Ontario by those with good credit at a rate of below 2.6 percent. The federal government can currently borrow for a 5 year period at a rate of below 1 percent. This means that interest costs are relatively low for both your average Canadian, and their governments. However, when interest rates rise so to will the expense to carry the debt, and we may find this crippling due to the high overall levels of debt that we have become addicted to in a low rate environment.

Rising interest costs will mean less money for health care, education, and other government programs. In addition, much like a typical borrower has a credit rating, so too does the government. Right now Ontario's credit rating is relatively high, at A+ according to Fitch, but should our debt situation get worse in Ontario the rating can decline, as it did this month. All else being equal, a rating downgrade means higher borrowing costs and more taxpayer dollars that need to be devoted to interest instead of social programs.

It is time for Canadians to start taking our debt seriously by encouraging governments to not only get spending under control, but also find new and inventive ways to increase revenue and GDP. The Ontario government is trying to boost GDP through infrastructure investment, but they are going to pay for that by selling part of Ontario's crown power assets, which will reduce our future revenues and ability to pay for public services. The federal government, for their part, is promising new international trade deals with European and Pacific countries to boost GDP, but it is notoriously difficult to measure their benefits to Canadians. We must do more, and Canadians themselves can practice this at home by borrowing less and living more within our means. Wages have stagnated in North America, but our spending has not.

Thanks for reading, 

Matthew. 

__

References

The CBC - http://www.cbc.ca/news/canada/toronto/ontario-credit-rating-downgraded-by-s-p-fitch-over-budget-underperformance-1.3140921

Ontario Ministry of Finance - http://www.fin.gov.on.ca/en/economy/ecupdates/factsheet.html.

The Fraser Institute - http://www.fraserinstitute.org/uploadedFiles/fraser-ca/Content/research-news/research/publications/cost-of-government-debt-in-canada.pdf

The Bank of Canada - http://www.bankofcanada.ca/rates/interest-rates/canadian-bonds/

The Kingston Rental Market

According to the Spring 2015 report published by the Canada Mortgage and Housing Corporation (CMHC), the vacancy rate in Kingston remains low. The most  recent data shows a vacancy rate (or percentage of rental units that remain empty) of only 2%! In addition, average rents have been increasing. In 2012, the average rent received for a 2 bedroom apartment in Kingston was $1,005. By 2015, the average rent for a 2 bedroom apartment in Kingston has risen to $1,095 per month.

The above news, of course, is great for existing landlords, which is partially why we are starting to see an influx of new units onto the market. There are some large proposals for the construction of more condo and apartment units in Kingston, especially to help satisfy some of the demand in the down-town area surrounding Queen's University. Indeed, a new proposal in Kingston calls for a large multi-unit residential building to take over the site formerly occupied by the Famous Players Cinema. This new development is expected to be well over the current height restriction in the down-town core, and offer a healthy number of new 2 bedroom units.

With mortgage rates still very low, investor demand for borrowing to finance the purchase of new rental properties is still quite strong. It is important, however, for any new investors to carefully consider if the property will still remain profitable should mortgage rates rise in the future. I would advise to calculate the break-even point for your new rental property, and carefully evaluate if you can still earn an income should interest rates rise 2-4 percent.
If you have any mortgage or financial questions, feel free to send me an e-mail.

Thanks for reading : )                    

Matthew Clarke BA (Hons.), B.Ed., OCT.
Mortgage Agent & Financial Consultant 
275 Ontario Street, Kingston 
matthew@limestonemortgages.com
www.limestonemortgages.com

Inflation and the Investor: Keep a Close Eye on Your Real Returns.

Inflation, or the increase in general price levels over time, slowly erodes the purchasing power of investors. Inflation is not always a constant, as there have been periods of deflation, or a general decrease in the price level, but periods of deflation are fewer and farther between. In Canadian history, the harshest and most prolonged period of deflation was during the Great Depression, when general price levels declined by more than 20 percent over a four year period. Inflation, on the other hand, is a regular and much more pervasive problem for the investor. In the early 1980’s, the Canadian rate of inflation was over 12 percent, but it has since fallen to a level within the Bank of Canada’s prescribed rate of 2 percent per annum. For the investor, this means that any asset you own must appreciate in value, or return to you in dividends or interest, a minimum of 2 percent per year. However, should inflation increase, which it will at some point, you must be careful to increase your minimum required rate of return.

In simple terms, investors or owners of wealth face the danger that their money will purchase less and less goods and services over time, while borrowers of money actually benefit from being able to pay back their loans with money that is actually worth less and less over time. Should inflation be higher than expected, the loaners of wealth suffer, and the borrowers of wealth benefit. Typically, the average investor loans money by investing in fixed income securities, such as Canada Savings Bonds, Corporate Bonds, GIC’s, etc. And in return, the borrowers promise to pay back the loans with interest. Determining what the interest rate should be can be very complex, but to start with, we will discuss why inflation is such an important component of this decision.

Fixed income (investments that promise to return a fixed amount) investors must be particularly attuned to the ever present threat posed by inflation because it will have a major impact on their overall returns. Since most conventional fixed income securities return your principal (the amount you invested) at a future date, you want to make sure that your principal still has a certain measure of value once you can re-invest or spend it at maturity (the date when you are scheduled to receive your principal). For instance, should you purchase a 10 year, $5,000 bond, when you go to redeem your bond in 10 years, if inflation has ran at 3% per year, it has eaten away almost $1700, or 35 percent of your purchasing power. Now, if your bond had been paying you 3% per year to own it ($1500 in total), you have limited the danger that inflation has on your portfolio by achieving a real return (or return after deducting for inflation) of about 0%, assuming that you re-invested any interest payments. If you spent the interest money, you would have actually lost $200 in real terms.

Note the uncertainly present in the above discussion of owning the 10 year bond. What if inflation is more than you expect? What if you purchase the 10 year 3% bond and inflation over the 10 years is an average of 5%? You essentially have a fixed income investment losing you 2% per year in real terms. To help mitigate the risk of higher than expected inflation, investors can do a few things: 1) you can buy bonds that mature (pay back your principal) sooner rather than later, 2) you can stagger when your bonds mature so that you can re-invest your principal at different times, 3) you can purchase a fixed income security called a real-return bond, which adjusts its return based on the inflation rate. Of course, the reverse of higher than expected inflation could occur, and you could experience a period of lower than expected inflation. In this scenario, your bond investments would result in a higher than expected real rate of return, and in some cases, you could even sell your bonds for a capital gain before they mature.

          In contrast to bonds, equities (partial ownership in a business, or most commonly called stocks) provide the investor with a more natural way to protect themselves from inflation. There are a number of reasons for this. To begin with, equities (excluding preferred shares), do not provide the investor with a fixed rate of return. Should the business increase its profits over time, shareholders should experience an increase in the price of their shares, their dividend payments, or both. An effective and well-run business in the right industry will also be able to increase its prices and pass the costs of inflation on to the consumer rather than its investors. This should result in higher revenues to help compensate for any increased costs that the business might face. This is common for many businesses in food retail and processing, such as Loblaw (TSE: L), Metro (TSE: MRU), and Hershey (NYSE: HSY). Should their cost of inputs rise by 4%, they often pass those costs on to the consumer through higher prices over time.

          Additionally, an investment in a business with tangible assets, such as land and buildings, gives you ownership in things that increase in value over time as inflation eats away at the value of everyone’s money. For instance, a corporation such as CN Railway (TSE: CNR) owns large tracts of land, another such as RioCan Real Estate (TSE: REI.UN) owns an array of retail properties. Both investments hold assets that generally increase in value during periods of inflation. As the value of a company’s assets increase over time, share prices should follow, which helps provide the investor with the capital appreciation that they need to keep ahead of inflation.

          Other popular investments available to help protect the investor during periods of high inflation might also include gold, silver, and other minerals, or even commodities like oil and natural gas. Typically, when investors fear that the value of money is going to decline, gold acts as a “safe-haven,” or place where people store the value of their money for a certain period of time. Investors can purchase physical gold bullion, or they can buy shares in gold producers, such as Goldcorp (TSE: G); in both cases, returns often vary wildly, and they can be very hard to predict. There are many supply and demand factors and other risks to consider when investing in metals and mining, or oil and gas. However, there is room within a well-diversified portfolio for many of the above mentioned ideas. These include fixed income, equities, metals, and commodities. As mentioned in the last article concerning Investment versus Speculation, be careful to always do your research on any and all investments, develop a well coordinated plan for buying and selling, and stick to your plan. 

Happy Investing! 

Matthew. 

Investment versus Speculation: Don’t Be a Money Loser.

As a “value-investor,” I follow the teaching primarily of Benjamin Graham. Graham wrote the definitive book on value investing, “The Intelligent Investor,” and in the following series of articles I will discuss and synthesize Graham’s core lessons, as well as relate and apply them to our contemporary investment climate.

A primary theme often returned to by Graham in his writings is that of Investment versus Speculation. An investment is noted as something that “upon thorough analysis, promises the investor safety of principal and an adequate return.” Of course, that sounds perfectly clear and reasonable to most, but the sentence does require some unpacking.

Many people that call themselves investors are actually speculating, which means they are basing their decisions on market graphs, emotions, investment fads, and inadequate analysis of the securities or assets that they buy. Sometimes “speculation,” or buying and selling assets without doing your research, can be fun, but it should never be confused with true investing. And never, and I mean NEVER, should it occupy more than 5% to 10% of your total portfolio.  

So what is considered “investing”? Firstly, a true “investment” is made upon thorough analysis and research. What does thorough analysis involve? At its basic level, it would involve evaluating the financial statements of a company for at least a 5 year period, and preferably more. This would include their balance sheet, cash flow statement, and income statement. What exactly one is looking for in each of these statements will be covered in a later article, but at the present, keep in mind that, at a minimum, this needs to be done by yourself, or by whoever you pay to look after your investments, on a regular basis.

A thorough analysis must also include an examination of the current competitive position and atmosphere for the company. For instance, does the company dominate its industry? Or does it have a veritable barrage of competition in the marketplace? Does the company need to keep inventing products to stay profitable in the foreseeable future? Or does the company possess a “durable competitive advantage” in the marketplace? Does the company appear to be on the right side of the blowing social and political winds? Or is it about to face massive lawsuits that might cost billions? These, and many others, are questions that need to be asked by an “investor.”

Secondly, an investment must have a certain “safety of principal.” This in no way means that GIC’s or Canada Savings Bonds are a great investment, what it means is that an investor must be assured that the business they are investing in has a certain degree of insulation from competition, and a safety net or bottom for the share price. Let’s say that XYZ Corporation has shares selling for a market capitalization (the value of all outstanding company shares) of $500 million. If the company has buildings and land valued at $400 million, those assets (something a company owns) provide the investor with a safety net, or some safety of principal if the market value of the shares fall below $400 million. Why? Because it is possible for the company to sell its assets and return to the shareholders the proceeds from the sale.

The reverse side of the above discussion is a warning against investing in companies that do not contain a “safety of principal,” or assets that help limit your “downside risk.” Even worse, there are many companies that actually owe more than they own. Large manufacturing companies that sink a lot of borrowed cash into inventory and equipment can easily run into this trap (think General Motors circa 2008). Financial companies that hold large values of loans on their books, for which they might not actually get re-paid, are also a cautionary tale. In the case of financial companies, however, “the assets” are often the loans and the “liabilities” are the customer deposits. The many risks associated with investing in financial companies will make for an interesting future discussion.

Thirdly, an “investment” must provide an adequate return. The obvious nature of this rule leads people to not delve into it in as much detail as they should. What is an adequate return? Of course, it depends on the individual investor, but at a bare minimum, it should be more than inflation so that you are not actually losing money in real dollars (after removing inflation). Inflation will be discussed at length in a later reading, but for now, suffice it to say that whatever the current rate of inflation is, we need to beat it.

In order to stay ahead of inflation and consistently earn an adequate return, it is important for investors to demand a future stream of cash payments from the assets that they own. We can all try to earn our returns through capital gains, (selling our assets for more in the future than we paid for them), but they can swing wildly from one year to the next and be hard to predict with any degree of certainty. For simplicity, we should buy assets that provide a stream of payments in the form of dividends or interest. Dividend and interest producing assets provide us with evidence, in cash, that our investments provide a real adequate return.

Does the above discussion regarding what constitutes an adequate return imply that we can never rely on capital appreciation or capital gains for our returns? Absolutely not! What it does mean though is that we want to rely on dividend and interest payments first as the base for our investment recipe, and then capital gains as the icing on the cake.

In order to be intelligent investors, we must look at each investment and calculate what kind of adequate return we should be able to expect. In this case, we will use the example of Bell (TSE: BCE) ß (Exchange: Ticker/Symbol). Around the beginning of 2015, Bell paid its shareholders a dividend of 4.50% on an annualized basis. If inflation at the beginning of 2015 was 2.0% per annum according to the Bank of Canada (http://www.bankofcanada.ca/), then we can assume that our investment in BCE will provide us with the minimum adequate return we need, as long as they continue paying this cash to shareholders. Beyond this, BCE could experience earnings growth, and increase our dividend, which could result in higher share prices and capital gains if we sell our shares.

Could earnings in the above example decline? Or could something else change that eliminates our dividend? Of course, but that is where the first two principles of thorough analysis and safety of principal come into action. The intelligent investor only invests in companies after assuring themselves of all three: 1) that they have completed a thorough analysis of the company, 2) that the company provides them with a certain degree of safety of their principal, and 3) that the company provides them with an adequate return. Should the situation with their investment change, the investor must then undergo a re-examination to see if their capital is more useful elsewhere. “Buy and hold” doesn't work if your original investment thesis no longer holds true. 

Happy Investing! 

Matthew.  

Glittering Goldcorp: How do you evaluate a gold miner and its earnings report?

Gold and precious metals are a perennial favourite for many investors and speculators. It is often viewed by many as a hedge against the risk of inflation destroying our wealth, and the business model can often be relatively clear to understand.

The primary determinant of price movements for many gold stocks is, quite understandably, the price of gold. To recognize whether or not a gold miner is operating effectively, however, you must pour through the quarterly and annual earnings statements. In this article, we will look at Goldcorp's recent earnings release for July 31, 2014 to help understand how to evaluate a gold producer's performance.

According to the company, Goldcorp (TSE: G, NYSE: GG) is "one of the world's fastest growing gold producers. Its low-cost gold production is located in safe jurisdictions in the Americas and remains 100% unhedged." This statement illustrates a number of important points that should be examined more closely when evaluating a gold company for investment:

1) Production levels is one of the primary performance indicators for a gold mining company. The vast majority of a mining company's value lies trapped within the Earth. Unlocking this value is a very expensive and complex process. Increasing or decreasing production levels gives an investor some indication of operational growth in the company, and helps the investor track whether or not the company is on target for any growth plans. 

In the quarter we are examining, Goldcorp notes production of 648,700 ounces, compared to production of 646,000 ounces in the second quarter of 2013, which is a positive sign as production is increasing slightly.

2) Reserves are the metals a mining company still has trapped in the ground for future production. If reserves are declining quarter after quarter, the company will have to start building up reserves so that production does not hit a stand still or eventually decline as existing reserves become more difficult to reach. 

There are a couple of primary ways that mining companies increase reserves: 

1) They can do it the old fashioned way, by discovering and developing their own mining opportunities. This becomes increasingly more expensive over time as the easier to find deposits are developed and exhausted. 

2) They can acquire existing discoveries or developments from other companies. This method tends to be more common for massive multinational gold miners like Goldcorp or Barrick. The significant danger with this method is overpaying for developments that do not pan out, and then the company has to "write down" or essentially take an accounting loss when they admit their mistake. 

Mineral reserves are expected to have economic viability, which means an actual likelihood of being developed in the future, whereas "mineral resources" do not necessarily pass this economic viability test. It is important to note the distinction between the two in a company's reports. Goldcorp's reserves are broken down by mineral type, and it is essentially up to the investor to decide whether or not there appears to be significant value located there. 

3) Geo-political risk is important to examine for all investments, but with mining companies it tends to be particularly relevant. Gold mining operations that exist in stable and developed economies often have less risk of being shut down due to political concerns, and their value is generally easier to determine. Operations in Canada, the United States, and Australia, therefore, deserve a premium to those produced in less stable countries, such as those located in South America and Africa. 

In the image below, we can see the geographical distribution of Goldcorp's 2014 production levels. Note the strong presence in Canada, Mexico, and the United States. This is a positive sign as these areas are generally investment friendly environments for miners. It is important to keep an eye on the location of production, as it can shift over time as companies seek new reserves to replace declining ones. 

4) All-in-costs, or essentially the total costs that the company calculates it takes to produce one ounce of gold, is important to look at when examining a mining company because it helps us to determine something like a break even point for the company. These costs may vary between mining companies as the metric is not completely standardized, but for Goldcorp these costs include: by-product cash costs, sustaining capital expenditures, corporate administrative expense, exploration and evaluation costs and reclamation cost accretion and amortization.

Essentially, all-in-costs are the miner's way to help define the total costs associated with producing gold. For Goldcorp, the all-in-sustaining cost is estimated to be $852 per ounce of gold. By product costs can be a little confusing, but essentially if a gold mine is also producing copper, the money that the company earns from selling the copper is deducted from the costs of production, and it lowers the all-in-sustaining costs of producing gold. 

5) Gold prices are often the primary factor determining the price fluctuations in gold company stock. The difficulty here for the investor is that gold prices act relatively independently of the decisions made by company management. Gold prices can swing wildly from year to year, and company management can try to limit the effects of price changes in the price of gold by implementing hedging strategies. 

Hedging strategies primarily sell certain amounts of future production levels (futures) for an agreed upon price. Hedging bets can make a company money if they sell future production at say $1500 per oz and gold prices on the global market decline to $1000. On the other hand, hedging can lose significant amounts of money if future production is sold at a price lower than the actual market price that materializes in the future. In the case of Goldcorp, they have decided to not hedge their sales, which indicates they they are very bullish, or confident that gold prices will rise in the future.

Below is an image illustrating gold prices in U.S. dollars. It highlights prices inflation adjusted and in nominal dollars. Gold prices, though often seen as a natural hedge against inflation, or something that will naturally keep pace with rising prices, are often unpredictable. Because of this, gold mining companies will experience large swings in their share prices as the price of gold rises and falls with changes in investor sentiment and concerns about inflation over time.  

The information above provides a good introduction to understanding some key information to look for when examining the earnings report of a gold mining company. Remember, as for any investment, it is important to consider other factors, such as earnings per share, dividends, investment alternatives, et cetera. 

Thanks for reading, and Happy Investing!

Loblaw: Losses never looked so good. Understanding Adjusted Earnings and Free Cash Flow.

Loblaw (TSE: L) announced earnings recently (Loblaw Press Release), opening with the statement by Galen Weston that "the second quarter of 2014 marked the opening of the next chapter for Loblaw, combining the number one food retailer in Canada with the number one pharmacy and beauty retailer."

The acquisition of Shoppers Drug Mart by Canada's largest grocery chain marks a clear avenue for future expansion by the retailer, and millions of dollars in synergies as it combines the operations of the two companies into a more efficient Canadian corporate behemoth.

Including the results from Shoppers, Loblaw announced revenue of $10,307 million, an increase of 37.1% over the second quarter of 2013. Adjusted basic net earnings per common share were also up 17.2% to $0.75 compared to $0.64 in the second quarter of 2013.

The headline numbers, however, highlight that the company lost $1.13 per share in the second quarter of 2014, due primarily to costs associated with the purchase of Shoppers. This distinction provides us with an important lesson in "adjusted earnings," which can be used regularly by a number of publicly traded companies.

Adjusted earnings figures are used when a company believes that earnings for a particular financial period are distorted either positively or negatively by "one-off" or unusual events. In this case, the distortion is the artificially high loss caused by costs incurred due to buying Shoppers Drug Mart. Since Loblaw will not be incurring those costs regularly in the future, it does not believe that those costs reflect the company's true performance in the last quarter. To help shareholders better understand the company's true operational performance, it reports what the company would have made if you exclude the irregular costs. In this case, the difference is quite large, from an actual loss of $1.13 per share, to a profit of $0.75 per share.

Intelligent Investors should beware of adjusted numbers, and investigate why the adjustments were made, and if they seem reasonable. In this case, it is clearly understood that the costs are associated with the purchase and integration of another major Canadian retailer. This will not be a standard or common occurrence for Loblaw in most quarters, so the adjustment is most likely reasonable.

Many investors, such as Olstein, are calling for an end to adjusted earnings, as they think it misleads investors. However, the Intelligent Investor simply needs to investigate why the earnings are being adjusted, and how often the company utilizes adjustments. If the company regularly adjusts earnings by a large margin, be careful, but otherwise, the practice can be perfectly reasonable.

To help better understand how the company is performing, it is always helpful to look at Free Cash Flow during the quarter. Free Cash Flow represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. This can be calculated by taking operating cash flow, and subtracting capital expenditures. In the case of Loblaw, the company had Free Cash Flow of $801 million for the quarter, a very healthy number.

Loblaw now has its fingers in a number of very profitable business pies. It is engaged in the financial business through its thriving credit card division (PC Financial now has over $2.5 billion in credit card receivables), the clothing business through Joe Fresh, the real estate business through Choice Properties, the drug business through Shoppers Drug Mart, and of course, the good old fashioned grocery business through entities such as Loblaws, No Frills, and Real Canadian Superstore.

For those Intelligent Investors looking for portfolio diversity, a decent dividend, and strong Free Cash Flow, take some time to look at Loblaw.

Happy Investing!