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The markets have gone through some turmoil over the last few months. While many investors are feeling skittish, we see this as a normal adjustment that will soon be over and just another blip from a long term point of view. We find it interesting to note that in the first half of the nineties, investors could not wait to get their money out of Canada. Now they cannot wait to get it out of the United States and into Canada. However, we think it is worth noting that the low American dollar will make American firms more competitive and that ultimately should increase their sales and profits. If anything, we see this as a good time to top up our U.S. positions. Years ago when investors were wanting out of Canada, we wrote that for a Canadian who planned to retire in Canada, moving too much money out of Canada could have a devastating effect if the Canadian dollar were to significantly recover. We recommended then, as we do now that you follow our IFC Investment Principles and that Canadian's who plan to retire in Canada, place approximately 30% of their investments in foreign stocks, preferably American (and Canadian) Multinationals that do business around the globe. We see no reason to change that advice.

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1. Balance your investments according to your personal circumstances.
2. Always diversify your investments.
3. Invest in quality.
4. Invest regularly and gradually.

October 22, 2007

FI: Tell us about your investment performance.

Heinze: Probably the most relevant is the performance on my own portfolio, as it resembles a Canadian Equity mutual fund. For the 9 years ended December 31, 2006, my portfolio had an average annual return of 11.5%. This beat the TSX composite and the Dow Jones Industrial Index's that had average annual returns of about 9.3% and 7.0% respectively. Here is a chart in pdf format of the respective performance of $1,000 invested in all three to the end of September 2007.

I only have records that can be used to get these numbers for the last nine years. However, from the information I have, chances are my ten year return would be slightly better than my 9 year performance at the end of 2006. Based on GlobeinvestorGold information, compared to the funds that survived the last ten years, 11.5% per year average return would be in the top 7% of all mutual funds in Canada and the top 13% of Canadian Equity funds. If I deduct 1.5% for management fees, my return puts me in the top 14% of all funds and the top 35% of Canadian Equity funds.

Editors note: January 23, 2008: For the ten years ended December 31, 2007, Dave's portfolio returned 11.07%. Based on the GlobeinvestorGold information, this put him in the 10% of all funds and top 15% of Canadian Equity funds.

FI: What do you mean by funds that survived?

Heinze: Well a lot of funds have disappeared over the last 10 years. I cannot seem to find good information on how many funds disappeared, however, it appears that in Canada there were around 2,000 funds over ten years ago. As of December 31, 2006, there are over 6,000 funds listed on GlobeinvestorGold, of those only 1060 funds were over 10 years old. For Canadian equity funds, there were 617 funds listed, yet only 104 were over 10 years old. It is evident that a lot of funds that existed 10 years ago, perhaps even the majority did not survive, and those funds are not included in any comparisons.

FI: So what happened to the ones that disappeared?

Heinze: Good question. I suspect that while some dissolved, the vast majority were merged with other funds. But lets be fair, very few, if any of the new merged funds would have taken on the name and record of the poorer performer. So the question is, if you bought a fund 10 years ago and held on to it through whatever mergers etc., what is the chance that you would have realized a return as good as the top 50%. You might assume that there would be a 50% chance that you would hold a fund with a 10 year track record in the top 50%, but I suspect that the odds are more like 25% that you would have realized that return on your fund.

FI: What about your shorter term performance?

Heinze: Well that depends on the period. I had a very good year in 2006 with a return of 19.0%, and I beat the TSX that year. But this year while I should make money, I expect that my return will be a little less that the TSX, mainly due to currency losses. All portfolio managers have good years and bad years, I am no different. If you meet one that thinks they will not have bad years, or bad years relative to the indexes, run away.

As a general rule, I do well during the good times, but not exceptionally well, I do better than average in the average times and very well relatively in the bad times. I must stress the word relatively. In other words, I may still lose money in a down market, but I usually do a fair bit better than the indexes during those times. I am happy with that mix as it is reasonable and should be fairly sustainable.

FI: You mentioned Currency Losses this year?

Heinze: Yes, the Canadian dollar had an exceptional year. This can be and is both a blessing and a curse, but that is a whole other discussion. In terms of portfolio performance, like any portfolio holding U.S. stocks, while the U.S. stocks might have made money or stood still in U.S. dollars, they may have lost ground in Canadian dollars. Of course, the TSX is all Canadian, so it would not be affected by this.

FI: Okay, so back to your performance. You seem to have pretty sound returns, is there a secret to your success?

Heinze: No secret, no magic, no great insights. I do not know the future. Well maybe that is the secret; I know I do not know the future and that I will make mistakes. I also do not expect to make a lot of money fast. That could be an advantage.

What I can do is build a well diversified portfolio of high quality stocks that I intend to hold for years, maybe decades. You see, I do know how to pick a good high quality company with a good earnings history and good potential, and, I can be right about that most of the time. Not all the time, but most of the time. I can also calculate a reasonable intrinsic value for a stock. This will not help me time the market, but will help me satisfy myself that I am holding good value overall. Finally, I can build a good well diversified portfolio of these stocks. The rest should be no more then tinkering. My approach is not a secret, but you could say it is a sound formula.

FI: Where do you get your ideas about companies to pick?

Heinze: A great person once said that everyone needs a hand from time to time. Or maybe I said it, but I am sure I was not the first. There are many publications readily available; the trick is to find the good ones. Obviously I believe those are the ones that think like I do. I will not say they are the best, but two major sources that I follow are The Investment Reporter, put out by MPL communications and Pat McKeough's The Successful Investor. Actually, I get all of McKeough's publications, and he is my favourite. Both of these publications have followed a similar philosophy for years. The Investment Reporter has been around since the forties. McKeough used to write for them, I believe in the eighties.

These publications give me sound ideas, help me stay abreast of current affairs regarding my companies without overreacting, and in general give sound investing advise. Then I do my own analysis and make decisions that I believe are most suited to the circumstances. It is worth noting that I do not always agree with these publications, hell, I do not always agree with anyone, not even my wife. For that matter, I may not even agree with myself sometimes. Also, just like me, these publications are not always right. But, their information and recommendations are generally sound and their philosophy is very similar to mine. Or maybe my philosophy is similar to theirs, who knows.

FI: Are there other references you use?

Heinze: Obviously there are the financial statements of the companies. Also, there are lots of places (including broker research) where I can get information. In those cases I pay attention to things like the financial statements, historical numbers and general information, but put little reliance on the opinions.

FI: Why is that? I would have thought that the opinions are the important part?

Heinze: Well, as a general rule I do not feel they are that reliable. This can be for a number of reasons; like being too close to the action, over reacting, the all to human inclination of trying to outsmart the future, fear of being wrong, inflated egos, short term emphasis, and even conflicts of interest. I am sure that this does not apply to many sources; the trick is to find the ones you can trust. So I use these mainly for the factual information, mainly the numbers and sometimes the news.

FI: What is your thought on investing in trends?

Heinze: Have fun and count me out. Personally, until I get my crystal ball working, I will ignore trends. If anything I would invest against the trend, but that is probably my contrarian nature poking through. Or maybe I am just negative.

FI: Are you generally negative?

Heinze: I do not think so. My mother used to say that I was the last of the great optimise. I think that was and is true. I am a glass half full kind of guy. I would not be where I am today if that was not true.

FI: How does that effect investing?

Heinze: I think it has served me well. I build a well diversified portfolio of high quality companies with good prospects that I can hold for a long time. And I do hold most of them for many years, sometimes decades. Most years I only turn over about ten percent of my portfolios. You have to be an optimist to do that, especially during turmoil and negative events. There is almost always some reason to panic, but these events, even the worst of them like Black Monday and 911 for example, nearly always turn out to be blips from an overall long term economic point of view.

FI: Is that Optimism or steady nerves?

Heinze: Probably both. You have to be able to sit through the inevitable bad times and to some extent use them as opportunities when you can. That takes steady nerves, but if you are not optimistic, then I do not see how you can do that.

FI: So to sum it up, you're an optimist whose approach is to build a good portfolio of high quality companies that you can hold for many years, or even decades. It is that simple.

Heinze: Yes it is really fairly simple. If I were to add anything else, it might be to avoid the popular and fancy investments, especially ones with special bells and whistles. In the end holding hot or fancy stuff, flipping investments or regularly changing approaches will probably kill you, investment wise. But you might make your broker rich.

FI: Thank you.

Heinze: You're welcome.

When I picked this rule, I also considered the rule, "It is hard to do nothing." I suppose this makes me sound lazy, but it is one of my favorite comments, and in my opinion, one of the most important rules of investing. I do work hard. I spend a lot of time following my investments, reevaluating them, evaluating potential new investments and following economic and political news. All of this takes a lot of time, but is important if I am to stay apprised. However, because I build solid well-balanced portfolios of high quality companies that I intend to hold for years, perhaps decades, the majority of my decisions are to do nothing.

Sure, from time to time I add things, top up others, reduce some positions and get rid of some mistakes. This is a necessary process to continually improve a portfolio, but in reality it amounts to tinkering, not to major change. Sometimes I add new stocks, or stocks that I have been following where there appears to be a good opportunity to add them. Sometimes when favorites go out of favor I get an opportunity to top up a position. On the sell side, when a good company does well its position sometimes gets larger than I prefer, in which case I take the opportunity to trim it by selling some of the position. Then there are the inevitable mistakes, in which case it is best to sell and move on. I still tend to be a little slow at that. Regardless, it is really only tinkering.

I also noted that it is hard to do nothing. This is true; the temptation is to keep selling and replacing, moving to better and better opportunities and making more and more money. Alas, if you could really do that successfully for a continued length of time making yourself and your broker rich, instead of just your broker. Yes it is hard to do nothing, but truly if you have built a sound portfolio of high quality investments then doing nothing is usually the best thing to do. Come to think of it, the more I trade, the worse job I must be doing and the less I trade the better job I must be doing. So hopefully, I do work hard at doing nothing.

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The following table shows the difference in the value of a $1,000, 10% capital gains type of investment after all taxes after 1, 5, 10, 20, and 25 years assuming a 40% marginal tax rate resulting in 20% taxes on the Capital Gains. Again, remember outside the RRSP the money was taxed when it was earned, so you would only have $600 to invest to start with.

As you can see, even after a year there is an advantage to the RRSP. There are cases where you do not want to use an RRSP however, but you should examine them carefully before you decide. As we noted above, the first is to increase foreign exposure. However, we are now allowed 30% foreign content in our RRSP's. Our recommendation is that you have about 20% to 30% of your investments in foreign investments. If you follow our advice, plus keep in mind that many of Canada's best companies do business all over the world, then this should not be an issue. Another is because you expect your tax rate to go up. This certainly is a risk, although maybe less than it used to be. However, unless you expect a pretty significant increase and do not expect to leave the money invested for a long time, we think that the value of the shelter will probably more than make up for any difference. So do some analysis.

The investment may be of a short-term nature, as you have plans for it. In this case the money should be kept outside of your RRSP's. You may have investments that do not qualify to be in RRSP's. Obviously these investments must be held outside your RRSP's. Another reason is because you want to keep your high-risk investments out of your RRSP's. This makes sense, as it is wise not to gamble with your retirement funds. On the other hand, if you hold these investments anyway and you have additional room to put them into your RRSP, then it might be a good idea. It could be argued that if they go bad then you lose the ability to deduct the loss. However, we note that until you take the money out, it is in fact 100% written off inside the RRSP, which beats only being able to deduct 50% of it from other capital gains. On the other hand, we would recommend that if there is any chance that this high-risk investment is using RRSP room that you might one day want for another investment, then it is probably best kept outside your RRSP. Also, you might be surprised at how much money you will have to contribute one day, especially after the mortgage is paid and the kids are gone. This leads us to the last reason that came to mind. No more RRSP room. If you are investing more than what you can contribute to an RRSP, (which we would encourage), than something will have to be outside of your RRSP's. And that leads us to the question of which investments to place inside your RRSP's.

Which Investments Go Into an RRSP?

There are continuing debates on this issue. As we have pointed out, it is usually wise to use the RRSP shelter as much as possible. However, if your investments are larger than what you can have in your RRSP's, then some will have to be outside. The goal is to have the most money after all taxes at the end of the day. Sort of like; “He who dies with the most toys wins.” There are two common positions on this. The first is that you should shelter the investments subject to the highest taxes first. For example, interest income is taxed at a higher rate than dividends and capital gains, so under this argument, you should put your investments that make interest income into your RRSP first. The other argument is that it is better to shelter your highest returns. Until recently, we mainly agreed with the second argument, as our analysis had shown that the value of the sheltering of the larger return outweighed the difference in the tax rates. This was assuming a long-term return of 10% on equities and 4% on fixed income securities plus the tax rate on equities was about 2/3's that of the rate on interest. We found that after about 20 years, the benefit on the equities was so good that the RRSP made sense even if there was not a deduction for the original contribution. However, with the tax inclusion rates of capital gains being lowered back to 50%, the balance has shifted.

The following table shows the value of two investments, added together, after 5, 10, 20, 25 and 30 years. In each case the investor invested $1,000 in stocks earning (and realizing) 10% capital gains per year and another $1,000 in an interest bearing investment returning 4% per year. The investor's marginal tax rate is 40%. In the first instance the stocks are in the RRSP while the interest investment are outside. In the second case, the interest investments are inside the RRSP's and the stocks are outside.

As you can see, it takes almost 30 years before it is better to have the stocks inside the RRSP instead of the fixed income securities. Of course the changeover point changes depending on what assumptions you make regarding returns, tax rates, amount of dividend income, how much natural sheltering you get from a buy and hold strategy and so on. But it seems safe to say that it now takes some time before it is better to have the stocks inside the RRSP with the fixed income securities outside. Therefore, unless you expect to have the investments in your RRSP for over 30 years, it is probably best to but the fixed income, or interest bearing securities into your RRSP first then add the equities until your room is used up.

Conclusion

Based on our analysis, there seems to be little doubt. Even with the lower capital gains rates, a Canadian investor should use RRSP's as much as possible. If their total investments are greater than the maximum that they can have inside their RRSP's, then there are issues about which investments should be inside versus, which should be outside. However, it is clear that RRSP's still work, and even better than you might have thought.

Value and Growth Share Selection

Normally, a value investor is considered to be someone who tries to find shares that are undervalued, and then buys them for a bargain. The reason for the share being undervalued could be an industry that is not currently popular, some recent bad news or just market neglect. The investor believes that due to this current unpopularity, the shares can be bought at a bargain, and one day their true value will be realized. The most successful value investors are prepared to wait years for this true value to be realized, as long as they believe that the economic value is still there.

Growth investors are investor’s who are looking for shares of companies that are growing and expanding. Their belief is that the current price is not that important, as by expanding and growing, these companies are constantly increasing their economic value, which will translate into increased share price. It is often their position that if you wait for a lower price, you may miss the ride, because, as the companies grow, so will their price. Consequently, today’s price which may seem high, will be considered a bargain when compared to tomorrow’s. The most successful of these investors are also prepared to hold onto a share for a long time. After all, as long as the company is growing, its value should continue to go up.

The above two styles both have merit, and when exercised correctly, they also emphasize quality.

As indicated above, while it may sound like you can use one of these approaches, or the other, but not the two together, we do not believe this. We think that quality shares can be chosen for a number of reasons, one being growth, but once you have selected a quality share, there is no need to run right out and buy it. The next step should be to value it, to see if it can be purchased for a reasonable price. After all, market hype can cause even the best companies to be overvalued. This is true of all companies, especially fast growing ones.

We should point out that this does not mean buying the share at the best price, or the bottom, it means satisfying yourself that the current price is economically justified. If you wait for the bottom, you will miss it nearly every time, or may never invest, as a better price may be coming. This could cause you to miss most of the best opportunities. On the other hand, if you value a share, then you will have the comfort of knowing that you have purchased some economic value, which should eventually be realized. You will not always be right, and your evaluations should be redone fairly regularly, but on the whole, this should add significant stability to your portfolio. Also, when your shares do drop, it will be easier to hold on to them and sleep at night, knowing that your investments still hold true economic value, if not market value.

Finally, from a purchasing point of view, valuing the shares, makes the decision easier. Presumably, you will be adding to your portfolio over time, so when you have new money to invest, you can review the companies in which you would like to increase your holdings, and add to the ones that are well priced at the time.

When it comes to pricing, there are two main approaches. One uses empirical methods that use market prices to calculate ratios. The ratios are then used to determine the reasonableness of the share's price. The other calculates the intrinsic value, by determining the present value of the future cash flows generated by the share. Both of these approaches have merit, and will be discussed in the next two issues.

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In this issue we are going to focus on the Non-Valuation parts of the Analysis page.

Using either the Pro version or the Shareware version, you can select to view the Analysis page by selecting the Analysis tab.

Current Information: Half way down the left hand side of the page there are a number of ratios etc. automatically calculated or brought forward. Some that are lesser known and may require extra mention are:

Book Value: In theory, but not necessarily in practice, if you folded up the business, this is what the shareholders would get for each share.

Price/Book Value: This tells you how many times the price is greater than book value. The higher the number the greater the concern, but a high number may not be a concern at all. You need to understand the business.

Price/3 yr avg. EPS: This gives you a smoothed price earnings ratio. That is, the price divided by the average earnings of the last 3 years. Sometimes earnings act irregular, in these cases, this ratio might help put things back into perspective.

Equity - Goodwill / Equity: This tells you how much (what percentage) of the shareholders equity (book value) is backed by real assets.

Book Value - Goodwill: If all goodwill were to be written off, this is what the book value would become.

Some Questions for You:

About half way down the right hand side of the page are a number of questions that need to be answered. They include questions about earnings stability, quality of the industry, diversity and other related matters. You should fill these in. They all require a judgment call, so use terms that have meaning to you. The main purpose of this section is to make you stop and think about these items during your analysis.

One Dollar Premise:

This is a ratio that we found in a book on Warren Buffet. The theory is that for every dollar of profit that management keeps, the shareholders should see at least a similar increase in share value, otherwise management is not acting in the best interest of the shareholders. A value of over one suggests that management is acting in the best interest of shareholders. We do not pay a lot of attention to this ratio, but it is worth a note.

Your Questions

Q:I would like your thoughts on a couple of rules. One was the January rule that says that if the market is up in January it will usually be up for the year. The other says that since 1930 there has never been a loss year when the year number ended in 5.

A: Put simply, we ignore these rules and nearly all similar rules. They make great copy for the financial press and nice party talk, but they have no real basis of support and in the end are bound to do more harm than good. Let us deal with these two rules.

For the January rule, we are not sure the actual numbers but the approximate history is that when January was up, about 80% of the time the whole year went up. When it went down, 50% of the time the year went down. However, there are a couple of flaws. First, over the last 80 years, the market went up about 70% of the time. Second, the rule does not say the next 12 months, it is for the year including January. Well if January goes up 5%, then the market would have to drop over 4.75% over the next 11 months for it to be a loss year. Similarly, if January drops 5% then the market must rise over 5.25% in the next 11 months for it to be an up year. Since the market rises about 70% of the time, it seems that there is always about a 70% chance of it rising over the next 11 months and probably about an 80% chance on it rising above where it started from before January if January goes up. So we do not see that this rule tells you anything useful.

Now that other rule. We are not sure the details, but we did hear a technical analyst the other day say something to the effect that they had data going back to the 1930's and that in that time for calendar years ending in 5, there has not been a loss year. At first glance this sounds impressive, as we are talking about a 75 year period. But wait a minute, since 1930, there have only been seven years where the calendar year ended in 5. And if we assume that the market goes up 70% of the time, then it should have gone up for 4.9 of them. Maybe we have the rule wrong, but based on this, we cannot see how you can draw any kind of statistical or other conclusion based on 7 years. Especially when you consider that the market should have gone up for 4.9 of them. If this is the rule, then it is actually drawing a conclusion because over the last 75 years, 2 years out of a specific group of 7, the market did not do what was expected.

Again, these rules make fun party talk and may make some people look bright to someone, but we believe listening to rules like these is more likely to harm your portfolio then to help you.

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