Monday, November 20, 2006

Outperforming the index - split shares

I recently came across a compelling paper that suggests that the good S&P 500 returns of the past are unlikely to be replicated into the future. I suggested that, for younger investors particularly, outperforming the index would be a matter of prime importance. I'd also suggest that the paper has similar implications for Canadian investors too.

I had also indicated I'd write on some relatively simple methods to outperform the index.

One that I'd like to re-visit is the idea of leveraged share structures, or leveraged funds. (Leverage: see the dangers 1, 2)

For an investor with a relatively long time line, say more than 10 years, many of these types of structures are ideal to enhance returns. They leverage underlying shares or indices and can provide a greater than average return, provided that you have sufficient time to ride out the shorter-term volatility associated with this type of leverage.

For instance, two split-shares available on the Canadian market (TSX), LSC and ALB, provide access to, respectively, the four largest Canadian life-insurers and the six largest Canadian banks. Generally, the banks and insurers have proven to be prodigious wealth-producers over time. These returns are enhanced by the leverage structure of 1.69x and 1.99x on the "capital shares", respectively, so these shares should move up or down at the underlying share rate, multiplied by that factor.

What you don't want to do is buy them when the underlying shares are over-valued. While absolute measures are somewhat subjective as to value in today's market, both corporate sectors appear to be relatively good value.

To arrive at that conclusion, I surveyed three fundamental ETFs, the IShares XCV product, a measure of Canadian value stocks. I also surveyed the Claymore Investments fundamental ETFs, CDZ (dividend-based value), and CRQ (tracks value based on four fundamental factors). In all of these three ETFs, at least four of the six banks hold a weighting in the top eight securities, while the insurers weren't too far behind, with three of the four insurers taking weightings within the top 18 spots in all those ETFs. This suggests that they are relatively cheap in the Canadian market.

Another split share, SNH.U (capital shares), tracks the Health Care portion of the S&P500; its' underlying composition is similar to the SPDRs health-care ETF, XLV. It's largest holdings are in Pfizer and Johnson & Johnson, two stocks that have recently attracted a lot of buying from the guru value set, suggesting that they too, are reasonably priced. Another recent report stated that on a historical-basis, this group is trading in the 3rd percentile of its' historical cash-flow range, indicating that valuations in the health care sector are fairly attractive at this time. But you have to be able to handle the leverage factor, in this case at 2.86x.

Therefore, using a split share structure that leverages the long-term growth and relative cheapness of these various sectors is probably a good thing for long-term performance. Which is one reason why I hold all of the above in my personal portfolio.


The Confused Capitalist

Friday, November 10, 2006

Canada - Hitting the Sweet Spot

A recent Goldman Sachs study reported that Canada topped the rankings for economic growth potential of all G7 nations, surpassing both the US and Germany, and now holds 6th spot of the 170 countries tracked.

The past few years have seen a string of successes for Canada, the roots of which were formed when, in the middle 1990s, the federal government made positive strides to eliminate a seemingly perpetual bugetary deficit. Since then, the federal government has recorded its ninth consecutive budget surplus, as controlled costs and booming commodity prices have led to an enviable situation.

After a tough 1990s, it's nice to be on the right economic track. Now, if we can only do something about our productivity woes, a problem that threatens to plague a future generation.


The Confused Capitalist

Sunday, November 05, 2006

Canada - Income Trusts - No Trust

The Canadian government (a Conservative minority) announced this week that existing income trusts, who pay little to no corporate taxes, would begin paying full corporate taxes in 2011. For those on the block to conversion to income trust status to eliminate paying corporate taxes, the income trust tax of 34% would be applicable immediately.

Two recently announced conversions, BCE and Telus, which themselves would have deprived the government of $1.1 billion annually in taxes, placed this in the government's "must take action" in-tray, despite a recent election promise that income trusts would be left alone. The opposition Liberals had pondered the very same move last fall when then in government, leading to a large drop in the income trust market at that time. The trust market had, however, largely bounced back since then.

A quotation from this story more or less synopsizes why the government, despite it's earlier pledge to leave the trust sector alone, felt it had to act:

Had the entire TSX converted to income trusts, it had the potential to be disastrous not just for government revenues but for Canadian productivity, although many companies would have likely gone back to the market for investment capital.

The action on the part of the government led to a 13% average drop in that sector this past week. However, many have speculated doesn't reflect the underlying valuation change due to having a significant tax burden imposed. Some experts suggest that in the weeks and months ahead, this sector, which now constitutes about 10% of the TSX Composite Index value, is slated to see further weakness.

The howling from trust-owning pensioners has been predictable, given that most trusts were bought for their income yield, typically ranging from 6-11%, which is pretty juicy in today's environment. Many of these pensioners claim to have "lost trust" in the Conservative government.

It is interesting to note that this same structure began to gain some prevalence in the US, Australia and Britain, a number of years ago, before legislators recognized the tax-shift burden that would fall to the middle class, and shut down the advantageous tax rates for them. However, they did this before these structures had gained the widespread popularity, as they have in Canada.

In this regard, Canada is simply following suit, but with many asking the question: Why did it take so long here?


The Confused Capitalist