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! 


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!