Tuesday, 25 January 2011

Investing in Utilities - Individual Stocks vs Funds

Our recent post on Electric Power Utility Stocks for the Income Investor? drew the comment from reader Richard that ETFs or other funds offer a diversified alternative to someone interested in the sector. Fair comment, interesting idea! We've therefore decided to compare those stocks against the Canadian fund choices.

Finding the Funds
This required some rooting around since the range of possible fund structures could include mutual funds, ETFs, closed-end funds and split capital shares. We had to check various filters and research tools like GlobeInvestor's Funds page, FundLibrary.com and TMX Money, whose down-loadable list on the Structured Products page turned out to be the most useful, as it included all our candidates below. It seems that there is not a single Canadian mutual fund specialized in Utilities stocks at the moment. The comparison is still something of a challenge, comparing not just apples and oranges but grapes and bananas too. That's the messy reality we investors face!

1) Utility Split Trust - This is a split capital corporation, with the same structure, features, pros and cons as described in two recent posts on split preferreds and on capital shares. We list both the Capital shares and the Preferred Shares below as possibilities since an income oriented investor might want either. One concern is that the corporation is due to close down in December 2011, with holdings liquidated and Net Asset Value returned to shareholders at that time. If the managers First Asset Funds Inc think investors still want it, there could be a proposal to extend its life beyond the intended five-year lifespan.
- Capital Shares (TSX quote: UST.UN)
- Preferred Shares (UST.PR.A)
2) Utility Corp (UTC.C) - This is a closed-end fund (see our previous post on CEFs) due to mature and wrap up in May 2013, though this looks unlikely as the managers Scotia Capital issued warrants in September 2010 to double the size of the fund.

3) Canadian Utilities and Telecom Income Fund (UTE.UN) - It's a brand spanking new closed-end fund, just out of the Initial Public Offering December 17, 2011. There is no track record, so the only comparisons we can make are based on the prospectus.

4) BMO Equal Weight Utilities Index (ZUT) - This ETF has the best-sounding stock symbol but that isn't necessarily a reason to invest. It is only one year old, so again we must infer from available information.

Dividend / Distribution Yield and Value (click to enlarge table)

The current payout of the funds, per the Dividend Yield and Value table above, exceeds that of the individual companies rated top quality in our previous blog post individual company analysis (green highlighted rows), except for that of TransAlta. That would be fine except that dividends are only part of the return, especially for the long term hold investor.

Past Returns - Individual Stocks Outshine Funds
The five year share price graph below, taken from TMX.com, shows how much UST.UN fell behind the TSX Composite. UTC.C more or less kept pace with the TSX while our top three stocks - EMA, CU and FTS - to make a bad pun, "powered" ahead of the TSX and UST.UN. The management fees (MER) of the various funds drag down net returns for the investor. Individual stocks do not have any on-going management fees. There is a price to pay for the diversification gained by a portfolio and the MER is it. UTC.C and UST.UN both have MERs over 1%. A key stated objective of UTC.C's warrant issue is to reduce the MER by spreading costs over a larger asset base. Doubling the UTC.C asset base probably will not reduce the MER by half but it should help a lot.

In the past year UST.UN has done much better, second behind EMA, and UTC.C has fallen well behind the others since its warrant announcement in September. Which will do better in future? That is ever the unknown factor.

The UST.PR.A preferred shares look to be a poor investment at the moment. The yield to maturity in December this year, is a paltry 0.1%. As opposed to the current dividend yield of 5.7% (dividend /stock price), the yield to maturity calculation takes account of the fact that the stock price at $10.59 is above the December redemption price of $10, i.e. a capital loss will occur.

DRIP - For investors who wish to plow back their dividends into shares, the best individual stocks, with both a free DRIP program and a discount on such new purchases, such as EMA, FTS and TA, are clearly better the funds. BMO's ZUT at least offers a free DRIP.

Distribution Tax Types - There is little to mark funds or individual stocks as better for an investor's taxable account since the distributions are mostly all dividends, though for the moment UST.UN is handing out only Return of Capital (ROC). The funds, especially the active funds - UST.UN and UTE.UN - may distribute capital gains in future. In contrast, with individual stocks, it is the investor him/herself who decides when to sell stock and realize capital gains. Within a registered account, none of this matters of course, as tax is only applicable when funds are withdrawn from the account.

Liquidity - The funds are weaker than the individual stocks in terms of trading costs, as measured by wider bid-ask (sell-buy) quote spreads, and trading volumes, which determine how easy it is to set up a holding or sell out as needed. ZUT is best of the funds with a low bid-ask spread. UTC.C's bigger capital base should help it after all the warrants are exercised in the next few months. For a long term hold investor, this factor is not a major consideration.

Safety and Stability - On what is probably the most important dimension to the income investor, the individual stocks, especially the top companies in our previous ratings, look much better than three of the funds, though UTC.C comes out looking reasonably good.

Three of the four company stocks - EMA, FTS and CU and one fund, UTC.C, survived the 2008 crash with much less of a price decline than the TSX Composite as the graph below from Google Finance shows. That's the stability we seek. UST.UN fared even worse than the TSX Composite.

The situation is the same on dividends. Whereas all four of the top stocks have had at least one dividend increase, and no decreases, UST.UN went through two significant chops in 2008 and 2009 before an increase in 2010. UTC.C did what one would hope. It increased dividends in all three of the most recent years.

Another measure of stability is how closely the funds sell for what they are worth, in other words the Net Asset Value of the holdings within the fund. As is typical of Closed-end funds and Split shares, these funds are all trading at a considerable discount - UST.UN (-9.6%), UTC.C (-5.3%) - or premium - UTE.UN (+11.4%) - to NAV. The ETF ZUT is working as intended and typical for ETFs, trading very close to its NAV. Some might consider this a trading opportunity to buy a fund for less than it is worth, but suppose the fund is at a discount when you want to sell, is that helpful?

UST.UN adds risk through the use of leverage (borrowed money, through its split share structure), while UTE.UN's prospectus says it may borrow. UTC.C is totally passive and never trades, not even to rebalance, which is contrary to the usual fund risk management principle of rebalancing regularly.

The preferred share UST.PR.A is quite safe according to the investment grade DBRS rating of Pfd-2 (low).

Holdings - Three of the Funds Look More Speculative (click on table to enlarge)

When we look inside the funds at their holdings, we discover that in addition to the top companies, ZUT contains most of the companies we judged to be of middle and lower quality. If you agree with our assessment then perhaps unstable income will be mixed with possible big capital gains, or losses, in ZUT. UTC.C in contrast, holds only the top electric power companies and a broader mix of large well-known firms in other utility sub-sectors. Though we have not assessed these other holdings, they are more reassuring than worrisome for UTC.C.

UST.UN and UTE.UN both lack transparency. We cannot really tell what is inside since neither reveals the entire portfolio. Both appear to contain companies in our middle quality group and other smaller cap companies. In addition, both are actively managed so we must put our faith in the managers.

Bottom Line
From an income investor's viewpoint, despite the lack of diversification gained from multiple holdings, the best company stocks, even held individually, seem to have done as well as the best fund currently available in Canada - UTC.C - in terms of reliable increasing income and stable safe capital value. The other funds appear more suited to those who seek a combination of fairly reliable income and possible though not assured capital gains with greater volatility along the way.

Maybe we are discovering the meaning of legendary investor Warren Buffett's words (from Wikipedia):
"The strategy we've adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it."

A possible course of action, for the investor who has sufficient capital to buy large enough holdings, would be to buy and hold all the top four electric power utilities - FTS, EMA, CU and TA. However, this is not the end of the story or necessarily the moment to buy in. We have not delved that deeply into the companies to pretend that we know the business in the way Buffett means.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Tuesday, 18 January 2011

2011 Calendar Checklist for the Canadian Investor

Most everyone starts a new year by buying a wall calendar or a personal agenda to mark key dates and appointments throughout the year. We are all organized by time and the investor is no different. To help readers we therefore offer an annual calendar with key dates that will affect most investors, along with a set of links to previous posts or other Internet resources where how-to help is available on the various topics in the calendar.

The 2011 Canadian Investor Calendar

January Tactical Stock Trading – exploit January effect

TFSA additional $5000 contribution room for new year starts Jan.1

ETFs/Mutual Funds – year-end distributions paid in during first few days of month; consider reinvestment of cash

Planning – 1) review portfolio goals, performance and rebalance as required; 2) plan tax strategy

February ETFs - calculate adjusted cost base for ROC, reinvested dividends; data from ETF providers available by approx. mid-February

RRSP contribution deadline March 1st

March Tax Preparation – gather tax slips, capital gains data; pick best software

April ETFs/Mutual Funds – quarterly distributions paid in during first few days of month; consider reinvestment of cash

Income Tax – deadline April 30 for filing and paying tax owed

May RRSP tax refund to reinvest or pay down loan

June Real Return Bonds – interest payment June 1

July ETFs/Mutual Funds – semi-annual distributions paid in during first few days of month; consider reinvestment of cash



October ETFs/Mutual Funds – quarterly distributions paid in during first few days of month; consider reinvestment of cash

Canada Savings Bonds – sale begins early October


December Canada Savings Bonds – deadline for purchase Dec.1

Real Return Bonds – interest payment Dec.1

RESP contribution deadline Dec.31

RRSP – deadline of Dec.31st in the year you turn 71 years of age is the last day you can contribute to your own RRSP

RRSP/RRIF – deadline of Dec.31st the year you turn 71 years of age for RRSP closure (RRIF conversion, annuity, withdrawal options)

RRIF/LIF/LRIF – deadline of Dec.31st to withdraw annual minimum amount

Trading deadline of Dec.23 (Canada) / Dec.27 (US) to settle in 2011

Tax Optimization – tax loss selling

TFSA – deadline of Dec.31st to withdraw funds and get the corresponding contribution in 2012

Monthly Income ETFs/Mutual Funds

Variable Bonds – semi-annual interest payment date unique to each bond e.g. TERASEN 5.56%15SEP14 pays twice yearly on Sept.15 and 6 months later on March 15 till it matures and the face value principal is paid back on Sept.15, 2014.

Stock & Preferred Share Dividends – payment after quarterly financial results, i.e. one of 3 cycles – J(anuary) A(pril) J(uly) O(ctober), FMAN, MJSD. Most companies are on January cycle. Check company website Investor section for exact dates of past payments and future schedule

Note Deadline date is the day on or before which something can or must be done e.g. income taxes filed May 1st are late

Links to Topic Resources

January Effect http://howtoinvestonline.blogspot.com/2010/11/investment-climate-change-mysterious.html
TFSA Basics http://www.cra-arc.gc.ca/gncy/bdgt/2008/txfr-eng.html#q1
Canadian Income Tax 2011 Dates http://www.taxes.ca/info/dates-deadlines.php
Canada Revenue Agency Important Dates for Individuals http://www.cra-arc.gc.ca/tx/ndvdls/tpcs/ll-dts/menu-eng.html
Planning – Review Goals & Performance, Rebalance http://howtoinvestonline.blogspot.com/2010/01/annual-investment-review-part-1-review.html
Planning – Tax Matters http://howtoinvestonline.blogspot.com/2010/01/annual-investment-review-part-2-tax.html
Planning – RRSP vs TFSA vs RESP vs Non-Registered Account http://howtoinvestonline.blogspot.com/2010/02/rrsp-vs-tfsa-vs-resp-vs-non-registered.html
RRSP Loans http://canadianfinancialdiy.blogspot.com/2008/01/rrsp-loans-what-to-do-and-not-to-do.html

Tax Preparation Resources http://howtoinvestonline.blogspot.com/2010/03/income-tax-season-resources-to-help-you.html
Tax Preparation Software – check website for update this year; last year at: http://canadianfinancialdiy.blogspot.com/2010/04/review-and-ratings-of-canadian-online.html

RRSP Refund http://cmawealthmgmt.com/educ_tax-strattips.html

Tax Loss Selling http://howtoinvestonline.blogspot.com/2009/12/tax-loss-selling-explained-what-why-and.html
ETF Adjusted Cost Base http://howtoinvestonline.blogspot.com/2009/01/etfs-and-mutual-funds-calculating.html
ETF Providers for Distributions, Data to Compute Adjusted Cost Base
Barclays Capital (iShares) http://ca.ishares.com/home.htm
Claymore Canada http://www.claymoreinvestments.ca/en/etf/
Horizons BetaPro http://www.hbpetfs.com/pub/en/Default.aspx
BMO Financial Group http://www.etfs.bmo.com/
TD Canada Trust http://www.tdcanadatrust.com/mutualfunds/tdeseriesfunds/

Our goal in presenting this calendar is to enhance your efficiency as an investor, so that things are done promptly at the right time. Or, in the words of a man who succeeded in many spheres of life (see this Wikipedia bio),
"Dost thou love life? Then do not squander time, for that is the stuff life is made of."
--Benjamin Franklin (quotation from theotherpages.org)

Disclaimer: this post is my opinion for information only and should not be construed as investment advice. Readers should be aware that while every effort has been made to ensure accuracy, the above dates and information may contain errors and as such, the article's accuracy is not guaranteed. Do your homework before making any decisions and consider consulting a professional advisor.

Wednesday, 12 January 2011

Electric Power Utility Stocks for the Income Investor?

Income-seeking investors are in a bind with bonds. Low interest rates have reduced bond yields to minuscule levels. Furthermore, the possibility that interest rates could start to rise would hit the capital value of bonds. It is natural for an investor seeking steady income to look around at other options.

Could electric power generating utilities offer an option? After all, everyone needs power so it should be a stable business. Perhaps attractive reliable dividends are on offer and hopefully the stock price would be less volatile than that of most stocks too. Unlike bonds, if interest rates rise, the companies can adjust power rates to compensate, though perhaps slowly through a regulatory process. Finally, when the stock is held in a taxable account, the fact that dividends are taxed at a lower rate than interest increases the attraction. So let's have a look at the main contenders in Canada and see how these ideas pan out.

1) Finding Steady Profit Makers
The first step is to find strong reliable performers and to weed out weaker companies that cannot make profits year after year who will not be able to sustain and grow dividends. Merely assuming that electric utilities will automatically be profitable is a too-risky leap. We identify the companies within the industry sector by going to GlobeInvestor's Stock Filter and selecting Electrical Utilities in the Industry scroll box. The resulting list contains a number of preferred share issues and companies with operations mainly outside Canada so we put them aside. There are sixteen companies left, which are all listed on the spreadsheet table below.

Next we hop over to the Toronto Stock Exchange's TMX Money website to do the manual and repetitious (since the automated stock filters don't provide this information) but revealing task of checking the profit record of the sixteen initial candidates. Some electric utilities seem to generate more losses than power, so we've highlighted them in red and remove them from further consideration. (click on comparison table for details)

2) Separating the Really Good from the Middling
When we then look at a series of financial indicators to form an overall assessment, the field divides into a set of strong companies (highlighted in green in the comparison table) and another set of middling stocks.

Stocks That Don't Quite Make It
The middling stocks all have several significant deficiencies that make us cautious despite what is an enticingly high dividend yield in several cases. The dangers include past dividend cuts, declining earnings, unsustainably high dividend payout rates, a significant net loss within the last five years, no dividend at all, too high stock price relative to earnings (P/E ratio) and high stock price volatility as reflected in the high stress 2008 period. Many are relatively small companies - as reflected by the quarterly revenue column - which would mean greater impact from any problems in a less diversified operational base.

Algonquin Power & Utilities Corp (TSX quote: AQN) almost makes it to the top category. Its significant loss and dividend cut in 2008 may now be merely history and its recent indicators like payout ratio, interest coverage, debt to equity level, quarterly profits, per share profit growth and P/E ratio appear to show dividend stability and potential stock value. Certainly one of our top companies - Emera Inc - seems to think so as it has just increased its stake in Algonquin.

The Cream of the Crop
Four companies fit the desirable stable image we want through such characteristics as: profits year in and year out, rising profits (though to much varying degrees), dividends that not only are sustained but rising over time, stock prices that survived the 2008 crash much better than the TSX, conservative financial ratios for debt levels and interest coverage. Three of four have the welcome and useful bonus of offering DRIP (dividend reinvestment) programs that allow purchase of more shares at a discount.

Canadian Utilities Ltd (quote: CU) - This stock demonstrates the error of judging a stock only by its current dividend yield. It has the lowest dividend yield at only 2.8% but it has raised it twice in the last two years. The low dividend payout ratio and healthy recent profit growth (3-year EPS) suggest room for more dividend rises. Its P/E at 15.8 is still well below that of the TSX Composite's 19.7 and within the range of 15 or less that professional analysts use to judge fair value for utilities.

Emera Inc (quote: EMA) - This company, and its stock, has been on a tear recently. Very strong profit growth and dividend increases in each of the last three years have pushed stock price appreciation far ahead of the TSX. The DRIP discount of 5% is at the high end of any offered. Its dividend is still a relatively high 4.1%. From the looks of the company news its expansion plans continue. The key question is whether it will be successful in doing that profitably.

Fortis Inc (quote: FTS) - The biggest of the utilities, it personifies the image of a conservative, solid performer - steady unrelenting rising profits, stock price that blipped downwards very little during 2008, regular dividend increases but a modest dividend yield. If there is still such a thing as a widows and orphans stock, this is probably it.

TransAlta Corporation (quote: TA) - There might justifiably be doubts about this company's dividend stability. Its payout is currently significantly more than its profits. The market seems to think so as the stock price has actually declined in the past year (see chart below) while the overall market has gone up. As a result its dividend yield is the highest of the top group at 5.5%. An investor is well advised to start reading the company financial reports to figure out what is going on before buying in.

The overall impression the data leaves with this blogger is that currently one gets what one pays for amongst electric power stocks.

What About the Future?
One big question is whether these companies' stock prices are liable to languish since three of the four have far outstripped the one-year price rise of the TSX Composite Index (blue line in chart) as shown in the chart below from TMX Money.

The professional analysts seem to think that's the case as only Canadian Utilities is rated a BUY while the others are given a Hold recommendation in our Returns Market Sentiment table (click on chart image below for details).

The other key issue is whether - as for any stock and company - past performance is likely to be sustained and whether we investors are about to purchase a piece of a business on the upswing or the downswing. The usual essential step of due diligence imposes itself: reading company reports, analyst commentary and investigating other news to form an opinion about those prospects.

Other Resources:
TMX Stock Screener - also has a Utilities selector to cross-check lists of potential companies
DRIP blog list - Canadian companies' dividend reinvestment program details with links
Wikipedia list of Canadian electricity companies

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Thursday, 6 January 2011

Investing Success: More is Less, Less is More

Do you have nagging doubts whether you've made the right investing choices? Do you feel over-whelmed and confused by the huge number and variety of investment options? The reason for these feelings may not be anything you have done or failed to do at all.

The Tyranny of Choice: You Choose published in the December 18th edition of The Economist magazine, describes many ways in which the proliferation of choice in modern society can go too far. Whether it is a decision facing a person to buy a shampoo or an ETF, the benefit of a wider range of products to suit the circumstances and desires of individuals eventually reaches the point of diminishing returns and value. To understand the potential for investor over-load, consider that the main Toronto Stock Exchange lists 1498 securities according to Wikipedia and GlobeInvestor Fund Filter tells us that there are 13069 ETFs, mutual funds and closed-end funds in Canada alone.

Too wide a choice manifests its negative effect two ways. First, more choices often means less and less technical difference between products so that expending a lot of effort to see the differences may not be worth it.

But there are also a harmful effects on the consumer through psychological influences. A multitude of choices often causes people to avoid making any choice at all, an effect explained in such studies as When Choice is Demotivating: Can One Desire Too Much of a Good Thing? by Sheena Iyengar and Mark Lepper. With investments, a pertinent example is that people do not start saving if they cannot figure out the right way to invest, or if they do make a contribution to a TFSA or RRSP, the money simply sits as cash gathering dust. As has been shown and discussed many times, the sooner one starts saving for retirement, the less one needs to contribute in total to achieve goals as the effect of compounding has more time to work.

Another harmful effect is that people faced with too many choices will simply pick the first one at hand instead of taking time to choose using proper criteria. The potential time and effort required to weed through so many choices is so daunting that spinning the wheel or picking a nice sounding name becomes the decision method. Despite professional management, funds are not all the same! A variant of this effect is that people pick the fund that did best in the past on the erroneous supposition that fund success will be repeated, despite even the mandatory warnings imposed by regulatory authorities that past performance is no guide to future performance.

What to do - A (Very) Few Ways to Reduce Investing Choice Problems
We'll try to avoid the fault by keeping our list ultra-short.
  1. Keep your portfolio small, no more than 10 holdings - In our previous post Simple Portfolios Compared we looked at eight (that's still a manageable number to choose from, right?) portfolios with a balance and mix of types of assets. None of these portfolios contain more than five holdings. As we noted in the post, they perform quite acceptably.
  2. Look for low fees amongst funds and ETFs - Funnily enough, low fees reliably equal good performance for the investor. As recounted by McMaster University finance professor Richard Deaves in his book What Kind of Investor Are You? (see review here by CanadianFinancialDIY) and recently again re-confirmed in a Morningstar report various studies concluded that investors get the best net results from mutual funds with low fees, even amongst actively managed funds where the portfolio managers supposedly aim to justify higher fees with better results.
  3. Seek out a trustworthy advisor - When the investing world gets to be too much consider going to a professional who can guide and narrow choices by having worked through it before. Of course, you need to choose the advisor too! The key is to be able to satisfactorily answer this question - "Is this potential advisor worth listening to?" In other words, does he or she know what they are talking about and will he/she be guiding me for my benefit, not his or hers to my detriment? Your head / logic and your heart / instinctive feeling should both be saying the same thing to make a good decision. See this Globe and Mail article or Blue Collar Financial Planning for more detail on how to choose an advisor. Though not on a personal, formal basis, the aim of this blog is to offer impartial information and trustworthy practical analysis to individual Canadian investors.
Best wishes to blog readers for health, happiness and investing success in 2011.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comments are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.