Wednesday, July 8, 2015

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

Tuesday, May 26, 2015

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

Tuesday, January 20, 2015

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. 

Tuesday, January 13, 2015

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.  


Friday, August 8, 2014

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!

Thursday, July 24, 2014

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!

Sunday, January 5, 2014

What Does the Investor Need to Know About Financial Statements? The Cash Flow Statement

They say that "cash is king," and indeed, cash forms the lifeblood of any business. For the Intelligent Investor, it is cash that is used to pay dividends, buy back stock, and fund daily operations. When companies experience a cash squeeze, they find themselves at the mercy of lenders and often find it difficult to concentrate on their long-term corporate goals. This can lead to hurried and poor decision making. Healthy levels of cash lead to the flexibility corporation's need for continued success.

So how can the investor examine the cash flows of a potential business opportunity? They should start by referencing the "Statement of Cash Flows" found within a companies financial statements. The Statement of Cash Flows should be publicly issued every three months with the quarterly reports, and can be found in the Investor Relations section of most publicly traded companies' websites. 


Whereas balance sheets present a snapshot in time for a companies overall financial health, the cash flow statement shows activities over a period of time. Because the ever important earnings per share numbers are not found within the cash flow statement, this statement is often overlooked by investors. However, it is crucial for properly understanding the health of any business. 

What does the Cash Flow Statement commonly look like and what does the investor need to know? At its most basic level, the cash flow statement is segmented into three parts:

Section # 1) Operating Cash Flows
+
Section #2) Investing Cash Flows
+
Section #3) Financing Cash Flows
=
Net Cash Flows

Each section can have a positive or negative balance, and the sum total of these three sections will result in a number titled "Net Cash Flows." Generally, a negative number is displayed in brackets. Net cash flow helps the investor to identify whether or not the business had a net inflow or outflow of cash during the period of time being measured. It is very important for the Intelligent Investor to remember that a positive or negative net cash flow is not necessarily good or bad, it all depends on HOW the inflow or outflow of cash was realized. This can be understood by examining the three sections highlighted above. 

The investor must act like a detective to discover the story behind the net cash flow number. You can begin doing this by asking some basic key questions:

1) Is the Operating Cash Flow positive or negative? Why? 2) Is the Financing Cash Flow positive or negative? Why? 3) Is the Investing Cash Flow positive or negative? Why?

By examining the information listed below for a hypothetical corporation, we can see the following: 

1) Operating cash flow is positive, primarily due to large income levels experienced during the period, there is not excess depreciation being added into this equation. This is a good sign. 

2) Financing cash flow is positive, and this is primarily from a share issuance. As an existing investor, you generally do not want there to see more shares issued, as this decreases your stake in the company. This could be a warning sign... especially if these funds are needed to pay off debt or to pay dividends. 

3) Investing cash flow is negative, and we can see that this is due to the purchase of new fixed assets. If these assets contribute to increased profits in the future, this may be a worthy cash outflow, and not a negative sign. If, however, there are large inflows of cash from asset sales... you should investigate why. Sometimes it is a sign that a company may be experiencing trouble and selling existing assets to raise money to cover other obligations. 

Hypothetical Statement of Cash Flows for Acme Corporation

Operating Cash Flows
Income for the period +$64,795
Depreciation +$2,000
Equity Income -$5,000
Minority Interest +$2,000 
__________________

Net Operating Cash Flows = + $63,795

Financing Cash Flows
Proceeds from a Share Issue +$10,000
Repayment of Debt -$2,000
Dividends Paid -$1,000
__________________

Net Financing Cash Flows = +$7,000

Investing Cash Flows
Acquisition of Fixed Assets -$15,000
__________________

Net Investing Cash Flows = -$15,000

__________________
__________________

Total Increase or Decrease in Cash (Net Cash Flow) = +$55,795

The Intelligent Investor must always look for warning signs within the cash flow statement, such as: 

1) a business continuing its operations through the use of debt and equity financing (borrowing money or issuing shares), and using that money to fund losses highlighted at the start of their Operating Cash Flows. 

2) a business that is essentially "borrowing from Peter to pay Paul," which may appear as outflows of cash in the form of dividend payments, but inflows of cash in the form of share issuances or the issuance of new debt. This might be evident by seeing new shares being issued and/or new borrowing happening, while at the same time relatively large dividends are being paid.  

3) a business that is experiencing higher levels of depreciation than it is investing in new assets. This might result in positive cash flow numbers for a period of time because decaying assets are not being replaced with new ones, but eventually this might cause trouble as technology becomes obsolete or assets need to be replaced to maintain day to day operations or keep attracting customers. 

An interesting cash flow statement to examine is the one issued for Exxon Mobil (NYSE: XOM), which generally experiences positive levels of Operating Cash Flows, and negative levels of Investing and Financing Cash Flows. This means that the company is taking large positive influxes of cash from sales to its customers (Operating Cash Flow), and utilizing that cash to heavily invest in new assets (Investing Cash Flow), and return profits to shareholders via share buybacks and dividend payments (Financing Cash Flow).

Below you can see a graphic illustrating this activity from 2008-2012.   


As with the Balance Sheet, you can dig deeper into the Cash Flow Statement, and I encourage you to do so. Please ask if you have any questions, and Happy Investing!

Cheers, 

Matthew.

Wednesday, December 11, 2013

What Should the Investor Look for in the Financial Statements? The Balance Sheet.

The first section to tackle when examining the financial statements of any investment enterprise is the Balance Sheet.  The balance sheet shows the company's financial situation on a certain date, and is like a snapshot of a company's financial health.

There are three primary sections of the balance sheet:

1) Assets: what the company owns and has owing to it from others. 
2) Liabilities: what the company owes to others. 
3) Shareholders Equity: the net worth of the company, or the shareholders' interest in the company. It will always equal the Assets minus the Liabilities.  

The reason it is called a "balance" sheet is because both sides of the balance sheet equation must always be the same. 

Assets = Liabilities + Shareholders Equity

Often, the Shareholders Equity will be referred to as the Book Value of the company, and can be thought of theoretically as what the value of the company would be if it sold all of its assets and paid off all of its debts. 

In reality, for a variety of reasons, the business could be worth more or less than its Shareholders Equity or Book Value. This is primarily because the company will either have a certain degree of earning power to generate more assets in the future, or lack earning power, and its assets may decrease in value over time with future losses and depreciation. 

Also, sometimes the real value of a company's assets may be difficult or hard to determine, and an example of this might be the value of a patent on a new technology that a company owns. 

Assets, Liabilities, and Shareholders Equity can be categorized into a wide number of different items, such as: 

Assets: Cash, Temporary Investments, Accounts Receivable, Prepaid Expenses, Inventories. 

Liabilities: Current Liabilities, Future Income Taxes, Non-Controlling Interest in Subsidiary Companies, Long-Term Debt

Shareholder Equity: Share Capital, Contributed Surplus, Retained Earnings

There are additional categories to be explored later, but the crucial thing for the Intelligent Investor to understand is the importance of a "healthy" balance sheet

A healthy balance sheet is one showing ample assets to cover any future liabilities, and no warning signs that would indicate limited amounts of cash or "liquid" assets to fund ongoing operations.

A number of seemingly great businesses, upon further inspection, are buried in liabilities that seriously limit shareholder gains over time, and can pose a serious risk to shareholders during a tough economy or business environment. 

To highlight an example of a poor balance sheet, below is some information on Wynn Resorts Limited, (NASDAQ:WYNN):


The current balance sheet of Wynn highlights $7.3 Billion in Assets and $5.8 Billion in Debt... if all Liabilities are included, the number rises to $7.5 Billion. Therefore, the following is true for Wynn:

Assets ($7.3 Billion) = Liabilities ($7.5 Billion) + Shareholders Equity ($-0.2 Billion). 

As a shareholder, this would not be a positive situation, and for the Intelligent Investor, in general should be avoided. 

In future, we will examine more characteristics of the Balance Sheet, and in particular the Earnings Statement and the Cash Flow Statement.

Cheers, and Happy Investing.  

Matthew. 

Tuesday, July 30, 2013

Investing in the Future of Natural Gas: Making Money Reducing the Carbon Footprint.

America's current plan for tackling climate change is less than stellar... or even all that existent in reality. But of particular note has been some recent comments by President Obama in a speech at Georgetown University

President Obama declared that America would reduce its annual carbon pollution by 50% over the next 20 years. To achieve this, he plans to empower the Environmental Protection Agency to create carbon emission standards for new and existing power plants. 

Why should this news be relevant for the Intelligent Investor?

If electricity producers have to limit the amount of carbon pollution that they emit, a strong and natural incentive will develop to shift from coal to natural gas. Natural gas has been an alternative for years, but in the last few years the price has dropped to such a level to make it increasingly more attractive when compared to coal, especially if emissions become a concern.

Natural gas reached its lowest level in a decade last spring, but there is a very long lead-time from when a power plant is planned, and when it actually begins buying fuel for production. This means that the low price point reached last spring, could be the start of a very long up-ward trend in natural gas prices as large scale buyers of natural gas, such as power plants, finally start utilizing the fuel in their completed operations. 

Other key demand drivers for natural gas are: transportation fuel, LNG exporters, and residential and commercial heating.

People have long been declaring the growth of natural gas utilization for transportation, but there is now increasingly more evidence that predictions are finally coming to fruition. Major companies such as Waste Management and UPS have already made the commitment by buying fleets of natural gas trucks, while other key transportation players in the rail-road industry, such as Norfolk Southern and Union Pacific, are seriously considering converting many engines to natural gas. 

Right now, supply for natural gas in North America is very high (especially from recent shale gas production), and for an investor, that means prices will remain low right now and profit margins may not currently be as high as investments in oil, but once demand for natural gas increases, and price comes up to an equilibrium, a lot of the investment money will already be made by those in on the ground floor. 

Where can the Intelligent Investor find an investment in natural gas?

Encana is Canada's largest natural gas producer, and easily one of the markets purest ways to invest in natural gas production. Second quarter operating profit at the company increased 25 percent recently as volumes at the company soared.

Capital spending at Encana for the year is expected to be in the $3 billion range, which will be above current cash flow levels. This means that the company will have to sell some assets or borrow money in the short-term, but as natural gas prices rise, or capital expenditures decline, free cash flow at Encana will leave shareholders with plenty of money leftover for dividends and share buybacks.

Cheers and Happy Investing.

Matthew Clarke. 

(Full Disclosure: Matthew Clarke's clients and family may own or hold shares in Encana)

Thursday, March 14, 2013

Fee-Only Financial Planning: How do Most Canadians Pay Their Financial Advisors?


Today’s Globe and Mail sheds light on the industry of fee-only financial planning. Most Canadians are completely unfamiliar with the concept of hourly-rate financial planners, but as the Globe and Mail notes, a small shift is beginning developing within the financial consumer’s mindset.

How do Most Canadians Currently Pay for Financial Advice?

Most Canadians pay for financial advice in one of two ways: 

  1. A commission on the dollar amount of investments being managed. Most often this is reflected as a percentage of a particular financial transaction. For instance, if John and Jane Smith invest $100,000, they would pay a commission of anywhere from about $1500 to $2500 for the service. Some investment companies may charge as high as 5%, or $5000, but that is getting increasingly rare. 
  2. A percentage fee charged annually on the amount of money invested. Most often, this charge is hidden within a wide range of investment and/or mutual funds fees and charges that is simply deducted from the investment returns of the customer. For instance, if John and Jane Smith invest that $100,000 in a balanced mutual fund at the bank, they would most often pay about $2,000 to $2,500 per year in mutual fund fees. Now, if the bank actually showed those charges to the customer, there would be an outrage… so they simply hide them in the prospectus and reports. How do they do this? Let us imagine that John and Jane earn 5% on their investments valued at $100,000, or $5000. In order to pay their fees of 2% per year, the bank or financial institution would simply show them a net return of $3,000 or 3% (Their $5,000 actual investment return, minus 2%, or $2,000 in fees).

There is, however, a third, and much more transparent way that Canadians can pay for financial advice: 

3.  Hiring a fee-only financial consultant or planner. This method generally involves the individual financial consultant billing the customer an hourly rate for the advice that they give. For instance, if the advisor charges $75 per hour, and the customer seeks an hour of advice, the bill would be $75. Plain and simple, with no hidden charges or secret fees buried inside the prospectus or report. Obviously, this method would not earn as much for the planner or financial institution, so it is less common and little advertised.

Why don’t more Canadians use fee-only financial planners / consultants? It is easy for the population to be manipulated by the financial industry into thinking that they are not “paying” their advisors or planners when they do not get an obvious bill for services rendered. Of course, the truth is that they are often paying more than necessary. Perhaps it is time for a change!

Cheers, and Happy Planning and Investing!

Matthew.