Buying a Dividend Machine

Photograph: Cash-Flow Machine.

It's easy to say, but often tough to do: buy something popular, before it's popular. As Yogi Berra was once reputed to have said, "It's easy to make money in stocks; just figure out which ones aren't going to go up, and don't buy them"

However, research has repeatedly shown that buying stocks that return money to shareholders, through dividends and/or share buybacks, consistently outperform the market, usually by a wide margin (2% or more).

The best buys however, are usually those whose cash returns to shareholders are just beginning to turn upwards, and those that operate in a protected or oligopolistic environment.

Cable and cell companies fit the bill in terms of limited competitors, and two stocks whose fortunes appear to be ascendancy are Rogers Communications, and Shaw Communications.

Both trade both in Canada on the TSX (RCI.B and SJR.B) and also on the US exchanges (RCI and SJR) respectively.

After a several decades of infrastructure build-out and crushing debt, Rogers is emerging as a cash-flow machine. According to a survey of analysts, as reported here, Rogers is predicted to increase dividends from $1.00 annually to $1.60 later this year, to $2.40 is 2009 and $3.20 in 2010. Morningstar provides some further information, here (note, however, that the dividend information is out of date, as it has been recently raised).

What is also interesting here, is that if the consensus dividend projections are correct, it suggests that the stock may well also be revalued significantly higher by 2010. Compared to its recent price at around $41 (Canadian) with a 2.4% dividend yield, very few quality stocks in Canada yield much over 4.5%. Assuming that the $3.20 in dividends by 2010 is correct, this suggests that the stock may well be valued by the market in the low $70 range at that time, with the distinct possibility of something higher.

Similarly , according to a story here, Shaw Communications, a cable and telephone provider expects to be able to continue churning out the dividend increases. Morningstar provides some further information, here (note, however, that the dividend information is out of date, as it has been recently raised). Shaw's recent price of $23 (Canadian) is producing a 3.2% yield, and it also appears that there may be room for significant upward appreciation of the stock price if the dividends keep getting raised.

In another story, Shaw was picked by analyst Peter Gibson at Desjardins Securities in his outperforming focus portfolio, as one of eight Canadian stocks with the potential to outperform the market. He also picked Rogers in that same portfolio.

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I expect both of these stocks to outperform the broader market over the next five years, and the current dividends (and expectation of future increases) make that prospect just the more tantalizing.


JW

The Confused Capitalist

EFT Benchmark: Broad Canadian Market "XIU" (on the TSX) - $80.40 (Canadian)

Beating the S&P 500

Back in early 2006, The Confused Capitalist suggested a low maintenance model portfolio that I felt would outperform the S&P500 over the next five years or so. The portfolio was based on certain themes, some of which are ones which have generally proven to outperform over longer periods of time, such as buying value positions and small companies.

Additionally, I felt that commodities and emerging markets would continue to benefit from the world situation, and that the US dollar would continue to be under pressure - thereby adding to investments denominated in something other than US$. I suggested positions in a total of six ETFs, at values of 7.5% to 25% of the portfolio, with most around the 20% range.

To compare, we suggested a suitable tracking comparison would be the S&P500, as represented by the "SPY" ETF which was then priced at $131.47. It closed Friday June 15, 2007 at $153.07, a gain of 16.4%, which is pretty good. Add in dividends of roughly 2% or so, and the total gain is about 18.4%. If you'd gotten this, you would have beaten about 80% of the mutual funds out there, using traditional five year horizons as a guide (only 1 in 5 mutual funds beats the index, when the period is five years or so).

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Let's see how our own simple ETF-based portfolio, which looks like this, performed:

• 20% weighting to a broad-based international ETF - EFV - $64.91 - ishares product tracks the MSCI EAFE Value Index, which tracks European, Australian, and Far Eastern markets. This ETF closed at $78.92 on Friday June 15, 2007, for a 21.6% gain, plus dividends. Advantage: The Confused Capitalist.

• 20% weighting to small company - IWN - $74.99 - ishares product tracks the Russell 2000 Value Index (US small cap). This ETF closed at $85.11 on Friday June 15, 2007, for a 13.5% gain, plus dividends. Advantage: The S&P500.

• 25% weighting to emerging markets - EEM - $105.45 - a broadly-based (for emerging markets) ishares product tracks the MSCI Emerging Markets Index. This ETF closed at $132.42 on Friday June 15, 2007, for a 25.6% gain, plus dividends. Advantage: The Confused Capitalist.

• 20% weighting to the value portion of the S&P 500 - IVE - $70.62 - an ishares product tracking the value portion of the S&P500. This ETF closed at $83.78 on Friday June 15, 2007, for an 18.6% gain, plus dividends. Advantage: The Confused Capitalist.

• 15% Own Ideas (in this case, my belief that commodity-oriented countries will do well for the next five to ten years). I'd equally weight a Canadian ETF (EWC) - $24.86 - and a Brazilian ETF (EWZ) - $44.25. The EWC closed at $30.58, for a 23.0% gain, while the EWZ closed at $62.66, for a 41.6% gain. Advantage both: The Confused Capitalist.

These weightings result in a total gain of 22.0%, plus dividends which, in this case, would add about another 1.5%, so the total would be about 23.5%, versus the 18.4% all in of the SPY ETF.

So not only did the Confused Capitalist beat the S&P500 ETF by five percentage points in just over a year, it did so in 5 of the 6 ETFs selected, showing broadly-based outperformance. The Confused Capitalist feels comfortable continuing to hold these same positions and original weightings going forward over the next year or so, and will check back in 2008 to compare relative performance.

I hope to continue to show that a low-maintenance portfolio, with modest thought given to what the future might look like, will continue to be able to outperform static indices. Those wishing to view some similar simple portfolios felt to have an excellent change to outperform the S&P500, should go here, here and here.

With these increases in value, the weightings have changed slightly going forward, but not enough to warrant a re-balancing. These weightings are now:

• EFV - 20.0%
• IWN - 18.6%
• EEM - 25.7%
• IVE - 19.4%
• EWC - 7.6%
• EWZ - 8.7%

June 18 2007. 12:10PM Pacific time. Correction made to the EEM discussion bullet, which misstated (understated) the current price and percentage increase. Ah, the dangers of using the "cut and paste" function!



JW

The Confused Capitalist

Outperformance for widows .... and others too!

I have written recently about the need to outperform the standard capitalization-weighted indices, such as the S&P500, the DJ Industrial averages and the S&P/TSX Composite. It's not only important for those folks who need to plan their retirement, but also for younger widows/widowers who may not have a grand source of income, but have received a decent inheritance.

Assuming that their home is paid off, and they end up with the tax-free equivalent of 10 years salary, they might want to look at having the equivalent of eight of those years salary invested into the stock market. All at rates intended to protect the principal from inflation (meaning that it continues to grow), but also allows a decent income to be claimed from the portfolio. The balance might be invested in money market and bond issues, and used to draw short-term living expenses from.

Again, I think using ETFs that track some type of fundamental index (in other words, a index that is based on value-type measures [eg price/book, PE ratios, free-cash flow growth, and dividend growth/payments], such as some of the RAFI indexes) offers a much greater chance for outperformance, and with enhanced safety of capital. (See video, here, on why fundamental indexation is a better mousetrap). In other words, having your cake and eating it too. What could be sweeter?

Again, I think that these type of portfolios can be very robust, and also very simple. For instance, if I was advising my wife, I would probably suggest that the stock portion of the portfolio be weighted toward dividend growth/paying ETFs (given the need for income, and the documented outperformance that these types of stocks have delivered over time) and might look something like this:

The Claymore Canadian Fundamental Index (CRQ) ETF has been designed to replicate the performance of the FTSE RAFI Canada Index, which comprises those Canadian companies with the highest fundamental weightings. The index weights constituents using four accounting factors, rather than market capitalization. These four factors include:

• Total cash dividends (five-year average of all regular and special distributions)
• Free cash flow (five-year average cash flow)
• Total sales (five-year average total sales)
• Book equity value (current period book equity value)

This index has produced a return of 13.3% since January 2000, versus only 6.5% for the TSX60 over that same period, suggesting that the ETF would have produced a parallel return, deducting only for the small MER of ETFs (instead of the giant 2.0% to 2.5% most mutual funds charge). I would suggest a 20% weighting for this ETF.

Claymore Canadian Dividend & Income Achievers (CDZ). Weighted to emphasize stocks that both have a relatively high yield, and also have a good track record of raising their dividends. It tracks the Mergent Canadian Dividend Income and Achievers (fundamental) index. Over the past five years, the index has posted a 15.1% annual gain, versus the S&P/TSX Index return of 11.1% annually. Over ten years, it posted an 18.1% annual return, versus an 11.0% return for the S&P/TSX Composite Index. The underlying holdings are around 55-60 stocks typically. I would suggest a 20% weighting for this ETF.

Claymore US Fundamental Index, C$ Hedged (CLU). This ETF also tracks another fundamental index, which tracks the top 1,000 US securities by fundamental value, using the following four factors: cash dividends, free cash-flow, total sales, and book equity. This ETF is also attractive from my point of view, in that I think the US dollar will be lower in 10 years than now, but this ETF hedges against currency changes, meaning that we'll only trap the underlying changes in the index. Over five years, this index has returned a 7.0% rate annually, versus a -3.2% S&P 500 annual return (as converted to Canadian currency). The underlying holdings are around 1,000 stocks. I would suggest a 20% weighting for this ETF.

Claymore BRIC (CBQ) is the final Claymore product, that portfolio manager Roger Nusbaum has also written about. This ETF isn't fundamentally indexed, but is designed to mirror the BNY BRIC Index, which tracks ADRs from Brazil, Russia, India and China, all powerful emerging economies. Over time, this should be a strong growth component, but one which will also be volatile in nature. This index has returned 33.2% annually over the past four years, versus the more widely known MSCI EM Index, which has returned 19.7% annually over the same period. The ETF has 75 underlying stocks with above average concentration in the first ten stocks, with about 53% of the value held therein. This isn't currency hedged or denominated in Canadian dollars, but this could be a plus if these currencies gain strength against the Canadian dollar over the next decade. I would suggest a 20% weighting for this ETF.

Finally, for the fifth ETF, I'll suggest a product that trades on the American exchanges, a Wisdom Tree ETF product that tracks the Wisdom Tree International Dividend Top 100 Index (DOO). This is also a fundamental index, based on dividend yield of large and mega cap international companies. Currently, about 80% of the companies in the index are domiciled in Europe, with about 20% in Australia, Singapore and Hong Kong. The index has returned 16% annually over the past five years, as denominated in US Dollars. Conversion to Canadian currency over that time would have considerably diminished these returns to about 8.5% annually (which is still respectable, although not outstanding). While the currency issue may be slightly negative over the next decade, I don't think it's going to weigh down returns like it did over the past five years, or like it might for an unhedged US stock situation going forward. I would suggest a 20% weighting in this ETF.

Well, that's it. A relatively simple portfolio, with ample geographic representation, and wide corporate representation. The one noteworthy thing about this portfolio is that it's definitely weighted to the financial sector, but I've never considered that a particular problem, since I consider this sector as the backbone of the entire economic system. My theory here is that if this sector suffers some sort of serious long-term decline, so will virtually every other sector of the economy.

Finally, the other noteworthy aspect is the ability of high-dividend paying stocks to resist market downturns, something that might make this particular portfolio even more attractive; certainly, it makes it easier to sleep at night.

Now, the only thing that would need to be done by your proverbial widow, is simply to "re-balance" this portfolio back to the same 20% weightings, about every three years or so. This allows the winners to run for a while, and also to take advantage of longer-term "reversion to the median" and relative underpricing in the portfolio.

Of course, the widow would want to check out other sources of fundamental ETFs, such as Claymore Investments, Wisdom Tree and Power Shares in case she prefers a slightly different weighting using fundamental indexed ETFs. Finally, she should of course take the whole idea to a fee-only financial planner for critique and tweaking.



JW

The Confused Capitalist

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.


JW

The Confused Capitalist

Fundamental Indexes & ETFs

Release the hounds! The hunt for positive alpha [or avoidance of negative alpha]).

I have just finished watching a presentation to the Toronto CFA society by Robert Arnott, Chairman of Research Affiliates. For anyone wanting a complete 60 minute education on new fundamental ETFs and indexes, I suggest that that you link up and watch the following two segments (only if you have broadband access however):

Claymore Investments 1
Claymore Investments 2

Mr. Arnott has many fascinating things to say, and many fascinating Power Point slides, all of which reinforce the superiority of fundamental indexing. For those in doubt, or those who'd just like to know more, I highly suggest this presentation.

Just one of the little nuggets he throws out there (and there are indeed, many), is that simply investing in the S&P 490 (don't invest in the 10 biggest S&P companies), would have produced an average outperformance over the S&P 500 (over the last 80 years), of about 55 to 60 basis points annually.

Even if you're a believer in the strength of fundamental indexes, as I am, there's still lots of good stuff here. Visit once, and you might be on your way to investing products from three of the larger fundamental ETF providers (Power Shares, Wisdom Tree, Claymore [USA or Canada]). Any strategy that produces 200+ basis points better annually than a conventional index, with lower risk, certainly gets my attention!

The one other fascinating thing to me, is the potential for these fundamental indexes to get a short-term boost over their usual outperformance, as more and more capital begins flowing into these companies over the next decade or so. I suspect the outperformance will be even starker over the next while, as this phenomenon unfolds.

John Bogle, thanks for the ride, but move over, the next great investment train is arriving!

JW

The Confused Capitalist

Value matters: Low PE stock returns pummel market averages!

If you needed more evidence or confirmation that stock value matters, i.e. not paying too high a PE ratio for stocks, some late-breaking research confirms, once again, that "value" stocks beat up on expensive "growth" stocks.

A report recently released by RBC Dominion Securities confirmed that a portfolio of the cheapest 20% of the equity universe has, since 1980, far outpaced the rest of the market. This performance contrasts even more markedly with the most expensive 20% of the market.

Total returns for those one-fifth of companies with the lowest price-earnings ratios in the S&P500 beat the index by 3.5% annually, and trampled the 20% most expensive part of that same market by 6% annually.

In Canada, the example was even more extreme, with the S&P/TSX composite index used as the equity universe. There, the cheapest one-fifth of companies soared past the index by 5% per annum, and trashed the most expensive quintile of companies, by 15% annually.

Furthermore, this performance is remarkably consistent over time: every five year period over that time frame saw the cheaper stocks outperform, except for a single five year period (the bubble years of 1995-1999 and only within the S&P500), and even then, this was only minor and only against the most expensive quintile of stocks.

Perhaps this can form the basis for a new "enhanced ETF" product.


JW

The Confused Capitalist

Dividends: Swinging the Odds in my Favor!

In my own investing, I pay attention to signs that the business managers and corporate directors have a "shareholder orientation". One place this is clearly visible relates to dividends; paying and increasing them. The reason I pay attention is because the propensity of dividend-paying stocks to outperform is well-known. As reported over here, dividends have a fabulous track record for indicating outperformance with the underlying stock.

Some have speculated that this is due to the managers having to keep their "eye on the ball", i.e. what produces cash-flow and earnings, and to look to keep developing aspects of the business able to do that. I believe that's true over the longer-term.

Over the shorter-term, I also believe that instituting or increasing dividends has a good record of predicting upturns in that particular business. Basically, when either of those things happens, a group of individuals very knowledgeable about the business (i.e. the company's directors) are telling you that things look pretty good from their perch.

Generally, they're going to have far more knowledge and insight about their business than I do, and when you add that to the obvious shareholder orientation of returning excess capital, this provides me with three positive signs unavailable in many businesses. Just to recap, those signs are:

1. Ability of management to keep their eye on the ball - i.e. business activities that generate cash;
2. A "report" of sorts from the directors, that things are looking pretty good as far as they can see, and;
3. A "shareholder brain", a positive decision to return excess cash to shareholders, rather than spend it foolishly.

I once used a list published in a national newspaper that showed companies that had increased their dividends in the past one, three, and five years (i.e. three sets of companies) by the highest amount over that time frame. I think each list had about 50 companies on it, with some overlap (i.e. a company might have appeared on two or even three of the lists). Many were obviously larger companies with established track records and with very solid, if unspectacular, share price growth too.

However, I used the list in a different way. I speculated that companies appearing only on the one year list (highest dividend raises in the past year) and nowhere else, were signalling a significant upturn in their business fortunes.

I tracked those companies, let's call them Dividend Dynamos, over the course of a year, and compared it to the most appropriate benchmark, the TSX/S&P60.

Even after eliminating those in the oil business (whose fortunes were in a major upswing) from the Dynamos, but not the benchmark, after one year, the 10 remaining Dynamos were up by an average of 39%, compared to just 18% for the benchmark. Also, not a single one of the Dynamos was up by any less than 20%!

Further, a quick and dirty assessment on the benchmark told me that about half of the benchmark rise was due to oil companies. So the true comparison was even starker: about a 4:1 advantage for the Dynamos.

Dividends: a good thing. Look for them.

NB Ammended at 10:04AM to include missing link to prior dividend discussion. Also here.


JW

The Confused Capitalist

Weighing the odds of emerging market outperformance

Well, as sports fans here know, I'm a big fan of many emerging markets, mainly because I consider them to be cheap. For that, you get a good growth profile, better than ever ROEs and current account surpluses - all good stuff. Having said that, all emerging markets are not alike.

A recent UBS report makes many of these same points, suggesting that they offer a good investment profile. As to whether the market continues its' emotional response in the face of further inflationary pressures, or some sort of crisis, is yet to be determined. I suspect that will be the case: in other words, EM market volatility will continue for awhile. I personally hope to profit on this volatility: that in the next plunge, these values will discount at a higher beta than the S&P500.

Yet, the UBS report makes the case that many offer good value, particularly my personal favorite, South Korea.

I suspect that one day off in the not too too distant future (timing, as always Stella, remains the question), the US market and EM market will finally disconnect, with the EM market finally being accorded more respect and lower volatility.

May I suggest you peruse the report?


JW

The Confused Capitalist

Dividend Divas

Ain't dividends grand?

Boy I remember back in the bad old days of the late 1990's, when dividend-paying stock-owners were looked down upon, by their Nasdaq-investing friends. Their stocks seemingly soared, while boring old dividend-paying stocks just kind of coasted along. Time has shown of course, that many Nasdaq-type stocks were destined to crash and burn, while the dividenders did nothing more than produce reliable consistent wealth growth.

A recent study by RBC Dominion Securities show how dramatic that difference has been. They isolated stocks into three silos, one which was stocks that paid no dividends over the past ten years, another consisting of stocks with stable dividends, and the last consisting of stocks that consistently increased their dividend over the period.

In the US market, to May 30, the average annual rate of return was as follows:

1. No dividends: 6.5% annually
2. Stable dividends: 8.8% annually
3. Increasing dividends: 9.6% annually.

In Canada, the difference was even starker, and more remarkable:

1. No dividends: 1.3% annually
2. Stable dividends: 15.5% annually
3. Increasing dividends: 17.2% annually

Just to remind you of exactly what kind of return 17.2% is - that'll double your wealth in just over four years. Please bore me some more!



JW

The Confused Capitalist

Time is on my side ...

Time is on my side, yes it is ... (apologies to the Rolling Stones) ... or at least it's on my kid's side.

I was thinking about this today with my two teenagers, and thought how little money it would take, with decades of compounding ahead of them, to fashion a comfortable retirement, some 50 years hence. Of course, compounding within the confines of a tax-deferred account will make it all the better.

So with that thought in mind, I considered what $5,000 could be worth with a little leverage working for them for a long period of time. Recently, Horizons BetaPro Funds announced two leveraged index mutual funds. Both are levered to produced twice the change as their underlying indices; which are the Canadian S&P/TSX 60 (the largest companies in Canada); or the NASDAQ index. Both funds are designed to mimic their index, except with twice the upward and downward movements. The MER on the S&P/TSX 60 index is 1.5%.

To consider what could become of $5,000 in a tax-sheltered account (IRA or RRSP), compounded for 50 years, I used considered a long-term rate for large companies of 10.5% annual return as reasonable (about 10.5% is a widely quoted number). However, this might be slightly optimistic going forward, so I scaled this back to 8-9%, say 8.5% as a long-term rate. With a fund leveraged like this, it would mean an 17% return over the long haul, less the 1.5% MER charged by the fund. This would leave a net return of about 15.5% per annum.

I then went over here to use the financial calculator, and this indicated that the $5,000, compounded at 15.5% over 50 years (in other words, when my children turn 65), would be worth $6,703,839 at the end.

However, inflation has averaged 3.15% per annum over the past 90 years. Accounting for that 3.15% inflation factor suggests that the $6.7 million will be worth the equivalent of $1.42 million in today's dollars. More than enough to provide a very comfortable supplement to whatever else they have accumulated for their retirement.

Excuse me, I'd like to continue talking to you, but I have to go speak to my wife about an idea I have ...


JW

The Confused Capitalist

Outperformance - some key thoughts

Outperformance in the world of Resolute Growth Fund manager Tom Stanley (there since 1993 inception).

One year return, 91%, five year return 45% p.a., since inception, 26% p.a. Investing principles according to Mr. Stanley:

1. Be a long-term investor - it's easier to spot long-term trends than quarter-to-quarter movements;
2. Be flexible - use whatever works at a reasonable price;
3. Hunt for ideas;
4. Be skeptical of information sources - try to verify important information from a secondary source;
5. Buy your best ideas - last year, Resolute held only 14 stocks in it's fund ("we had 14 great ideas - I don't have 150 great ideas, so I'd rather just buy the 14");
6. Strive for effective rationality - filter out the noise;
7. Outperform by being different - if you really want to outperform the index, you have to strive to position yourself differently;
8. Stay humble - humility breeds an open mind that continually seeks good advice and is willing to listen to others (and is thus open to heeding good advice);
9. Stay in your circle of competence - define it, learn within it, stay in it;
10. Be a contrarian - some of the best opportunities are found in unloved sectors and stocks;
    
11. Be patient - being a contrarian means sometimes underperforming the index, while the long-term trend you've seen fully develops and is more generally realized;
    
12. Apply spiritual principles - a daily prayer for wisdom can help you avoid making investment mistakes.

JW

The Confused Capitalist

Zombies on the prowl for better investing

Well, it's all confirmed as true. Emotionless investors make better returns than us regular humans.

In a study by Professor George Loewenstein last year at Carnegie Mellon University in Pittsburgh, found that those who had suffered brain damage which impaired emotional responses, were better investors in a small study.

The participants, consisting of normal people and those with some neurological impairment, were tested on their ability to invest. Participants were given $20 to invest, and in each round they could either invest $1, or refrain from investing and pocket the $1. The study found that under the circumstances - consisting of roughly 20 rounds of investing - the impaired individuals ended up with an average of $25.70, vs. $22.80 for the non-impaired. They also invested more often, at 84% of rounds, versus 58% for non-impaired.

Prof. Loewenstein found that the non-impaired often became discouraged if they lost money and avoided investing too often after that. Conversely, those who won too often, often took to sitting out rounds, in the belief of not wanting to "press their luck". The emotionally impaired, it seems, were best able to figure out the odds and continued to press on.

Although this isn't really new information to most savvy investors, it does help to clarify my thinking around this point - please refer to my more recent photograph below.

"The needs of the many outweigh the needs of the few" - Spock


JW

The Confused Capitalist

Canada: Hiding out the market downturn in the land of rocks and trees

Canada's stock market has often been referred to as market of rocks and trees, a reference to it's reliance on commodities like minerals, lumber and oil to power its economic growth and stock markets.

I have written recently about the bell ringing in the US, my opinion that the market is near the top for the stock market, based on a number of signs I see, not the least of which is unrealistic expectations of capital gains (note, things have only gotten more speculative since this was written), rising interest rates, booming commodity prices (a harbinger of inflation, something particularly bad for the US market), risky assets becoming more popular (note, things have only gotten more speculative since this was written), while quality assets languish (i.e. big cap's continue to be available for bargain prices). All of this common sense information makes me also wonder if another 1972-1974 drop might be in the offing, and if so, can one "hide out" successfully in the Canadian hard asset climate, as Sir John Templeton is reported to have done in the secular bear market lasting from 1968 to 1981.

Culling through the TSE (Toronto Stock Exchange - Canada's largest stock exchange, now renamed as the TSX) statistics, if you were focused on avoiding the 1972-1974 bear market, the escape to Canada wouldn't have provided much comfort. The Dow fell by about 40-45% over that time, and the TSE also fell, by a somewhat similar amount. In 1972, the TSE index closed the year at 1226 (its monthly high close for the year), and by December 1974, closed at 835, a decline of 32%. So over the short term, the two markets were fairly similar.

However, over a slightly longer period, it was definitely favorable to be in the Canadian market, as by mid-1979 it had rallied to double in value over it's 1974 close, while the Dow took until 1982 to close above the 1000 level at year end; this was a level it (the Dow) first pierced in 1964 and closed at year end above that in 1972. Perhaps because inflation was such a factor, companies involved in hard assets (mining, lumber, oil) were the prime beneficiaries of hard asset inflation, and thus the Canadian market rallied through the mid-to-late 1970s. This is a scenario that I think is could again be replicated when the US market softens over the next while and struggles over the period thereafter.

I had always thought that the Canadian market had fared better than the US market during the brutal 1970s bear market. It turned out I was both right and wrong.


JW

The Confused Capitalist

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PS: Changes made, May 3 06, 3:20PM, to correct grammer and erroneous reference to 1972 TSE "low close", when it should have stated "high close".

Portfolio Construction - Outperformance

If you want to outperform the market, to build a better portfolio, then you have to be willing to do things differently than most of the herd.

First among these is committing to your positions. Today, this is called a "focused" portfolio or if a mutual fund does it, a "focused fund". Recent academic studies have shown that focused funds perform, on average, a couple of percentage points better than the typical fund. This is no surprise really, since you are willing to commit more capital to those positions holding the best promise.

While some diversification has it's place, too much will produce only market performance at best. Think of it like a game of Texas hold 'em poker: If you got dealt two aces "in the hole" to start the game, would you start off with an average-sized bet? If you did, you'd be wasting your huge advantage.

Investing is like that too: you should commit larger amounts of capital to the most promising positions, and less to the ones which are still promising, just less so.

I personally think that no one who wants outperformance should have more than 25 positions, and that the minimum amount of any position should be at least 4% of the portfolio value. Without being willing to commit at least 4% of your capital to a position, shows a lack of confidence in it, perhaps underpinned by a lack of understanding of it, its industry, etc. In that case, you shouldn't invest at all.

In some exceptional cases, you might want to commit 20% or more of your capital to an exceptionally promising situation. Superinvestor Warren Buffett has remarked that early in his career he held over 50% of his net worth in a single stock, and slept like a baby every night (presumably because he felt the stock was remarkably under-valued).

You need to ask yourself a few questions before your undertake your purchase - before deciding on the percentage of your portfolio you're going to commit to it:

1. What are the odds that something could go wrong with this stock, and
2. If something goes wrong, how much damage will it do, and
3. If things go as I foresee, how much upside does this add to my portfolio?

When you can answer these questions to your satisfaction, then you'll have an idea how much capital to commit. Never forget to build a "margin of safety" into all your estimates.

Thinking differently: the first step to outperformance.

JW

The Confused Capitalist

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Prospecting for great stock values

How do you find great stock prospects?

Well, it's easy but it requires work. The easiest way to begin with some sort of specified list - typically, this works best if you've defined an area or areas of the market that you prefer to invest in. That way, when you see a "wonderfully" priced stock (i.e. read "cheap"), you'll know it, and be able to act on it. This is one of the keys to outperformance - being able to recognize value.

Let me give you two examples from my own portfolio - two stocks - very cheap stocks - that I found. The first was Xceed Mortgage Corp., a Canadian sub-prime lender.

At the time I bought it, it was growing its earnings at a 40-50% rate annually, and yet the PE of this "undiscovered gem" was only in the nine or ten range. In situations like this, you're apt to get rewarded very quickly ... like I was ...



How did I find this? Well, I went through a list of about 400 Canadian financial stocks, eliminating ones that didn't fit my criteria (small/micro cap stocks, as it's easier to find undiscovered value in that area than anywhere else). I then researched the more promising candidates in detail. Overall, this took the best part of two weekends, but I was paid very handsomely for my efforts.

Another area I focus on is herbal medicine/businesses. Spending the better part of a weekend working through a list, I was able to find another undiscovered beauty that also rewarded me very quickly. This was American Oriental Bioengineering, and I found it at a PE of around nine, with an earnings growth rate of better than 50% annually. I was rewarded very quickly in this case too ...



But you can see how much better I would have done, had I even found this stock one month earlier ...

In each case, I also found a couple of other stocks I invested in at that time as well, but it was very clear to me that these two were easily the best ones of those lots, and I invested pretty substantially in both. It probably would have been pretty clear to just about anyone, as the value wasn't that hard to see - what was harder was having the patience and discipline to weed out the others that weren't as promising.

As one final benefit, while the "other" stocks I concurrently invested in didn't do as well, they still did OK, because they at least offered reasonable value. The best thing was that going through those other stocks gave me great confidence that those two both did offer great value and therefore I wasn't scared to overload my portfolio with them - and enjoy the benefits thereafter.

Finding great stock values - easier than you might think.


JW

The Confused Capitalist

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