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Where do we start? It has been a fascinating year. It ended very different from where it started. It started out looking a little shaky but overall we remained confident, by the end it seems that all you were hearing was doom and gloom. Is it really so bad? Is the world really coming to an end? Well, to quote my sister, "I wish the press would stop throwing gasoline on the fire." If I can add to that, I also wish the politician's would stop throwing gasoline on the fire. All this makes people believe that things are far worse than they really are, this not only worsens things, it leads to governments feeling the need to do something, even though they have a lot less control than they are prepared to admit and even though any action they take, will have a delayed impact of at least six months to a year. So in the end, these actions, many of which will be unnecessary, will in all likely hood be ineffective and in the long run there will be a price tag attached. Let's hope that the majority of the cost will be for infrastructure projects that need to be done anyway and once done will be over, avoiding the continuous structural costs of the past. On a positive note, if I can quote Marian, my wife, when she sent out our annual Christmas letter, "Given how the last few months of 2008 has turned out, 2009 may be a tough year, but we have been through this before when we had far less and we will come out of this again and in a few years have far more than we have today."

So where are we? We use to have a recession every few years; now we have not had one in nearly 20 years. If you had told me in 1990 that we would go nearly 20 years without a recession, I would have laughed at you. Yet here we are. It has often been said that market based capitalism is not a perfect system, but it is the best we have. I concur. It might be nice if we had a system where we all got the same rewards and we would all work hard for the benefit of the world. Yes that would be nice, but we are not ants, and we are not wired that way. Yes most of us believe in doing the right thing, have a high moral character (although our individual definitions of morality may vary) but we are wired to first look out for the interest and well being of ourselves and our families, then those close to us, then those of the same religion, then our country and somewhere down the line maybe the benefit everyone on the planet. For everyone the list and order will be little different, but you get the point. If you do not believe me, ask yourself: Would you sacrifice the five people most important to you to save a hundred strangers who live on the other side of the planet? How about a thousand?

Market based Capitalism has brought the world many innovations. However, it is not perfect and it does need a certain level of checks and balances. The markets greatest weakness is that in the short run it is driven by greed and fear. On the other hand one of its greatest strengths may be that it is driven by greed and fear. As a result, every so often a correction or recession becomes necessary to shake out inefficiencies, realign things and to bring us back to reality.

So what happened? Well, aside from being overdue, a number of things. However, it appears that the most significant was a financial crises brought about by a thing called sub-prime mortgages. As I understand it, it went sort of like this. The economy was doing very well. Governments (especially the U.S. government) believed it would be nice if more people could own their own homes. Their hearts were in the right place. Since interest rates were low and house prices were climbing, at the time it seemed like a good idea to let people borrow 100% of the value of their home (nothing down) and then only require them to make interest payments. Since values were rising, people would accrue equity through the inflated house values. And inflate they did as people who could not really afford to buy their own home entered (maybe flooded) certain markets. Of course this also had to be financed. Some of this came from traditional sources, but then clever financiers decided to package the loans into investment vehicles and sell them as sound mortgage backed securities. Of course most of the investors did not really know or understand what they were investing in and it did not help when rating agencies gave the vehicles high ratings. This might not have worked so well had there not been a lot of investors reaching for yield, something we have discouraged. In our opinion, reaching for yield, or looking for higher and higher returns from fixed income securities has become a problem since the days of high inflation and high interest rates. Investors remember when they could get 10% plus interest on secure investments like government bonds and GIC's etc. They have this misguided idea that they should still be able to get these high rates without risk and go looking for them. Brokers and advisors who want to please their clients then promoted vehicles that we considered inappropriate like junk bonds, income trusts, sub-prime mortgages and hedge funds to name a few, without due regard for risk. Everything was good until the inevitable hick- up and then the whole thing unraveled. Few saw it coming. While we always thought that things like income trusts and hedge funds were ill-conceived, inappropriate for most investors and would burn their investors, we never saw this coming.

So what happens next? Well only time will tell. I recently called the bottom, but as I like to say, it is only about the fourth time I called the bottom, and eventually I will be right. Personally I think that we have seen the market bottom and that sometime in late 2009 the economy will turn too. But it could take longer. The road back might only take a year or so, but it could take a few, but I am confident in the long term future. Globalization, technology, the internet and automation are wonderful things that should ultimately benefit people around the world and in time bring us all closer together. But the road is bound to be a bumpy one. If you strip away the money and financial terms etc. what you have left is a finite amount of resources. By resources I mean work force, infrastructure, buildings, plants and natural resources etc. This is not a physical disaster like the flood's of New Orleans's where physical assets/resources were destroyed. It is an economic recession and it does not change the amount of resources available. What it will do is change how those resources are owned and how and where they are deployed. In the end, that will probably mean that they are used more effectively, resulting in a stronger economy, a better standard of living for more people and hopefully a greener economy as the shakeup will provide opportunities for change.

So what is an investor to do? We believe that our principles are more important than ever. Panicking will only cost you. Hopefully you have a diversified portfolio of high quality stocks. Both quality and diversity are very critical at this juncture. A friend asked me the other day what sectors he should emphasize now. I pointed out that there are more ways to be wrong then right and I believe that being diversified is extremely important, especially right now. More importantly, you need to be sure not to be overexposed in any sector or company. Second, I cannot stress quality enough. Most of the best companies, many of which remain profitable will benefit from the shakeup and eventually flourish. Many of the lower quality ones will disappear. On closing, be patient and remember Marian's words "we have been through this before when we had far less and we will come out of this again and in a few years have far more than we have today."

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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.

January 4, 2009

IFC: Since we spoke a year ago a lot has happened. At the time you spoke of your returns and indicated that while you might lose money in the bad times, you tend to outperform the market during the bad times. So how do your returns look now and would you change your approach?

Heinze: I definitely would not change my approach. It is because of times like these that I stick to my approach. To follow up from last year, for the year 2008 my personal portfolio lost 28%. I believe that was my worst year ever. But that still beats the market and most Canadian Equity mutual funds. Also, to put it in perspective it was equal to giving up the last 3 to four years returns. That may sound bad, but after 30 years of investing it is not really a big deal and it is bound to happen from time to time.

IFC: So that is like giving up some previous gains. Do you wonder if you should have sold high and avoided the loss?

Heinze: If my crystal ball worked, I would be much wealthier than I am now, but it does not. Yes I gave up some gains, but if I got out of the market every time there might be a setback, I would never be in the market and I would not have any gains to give up so I would be a lot poorer today. Reality is that it is three steps forward, one back, two forward, one back, five forward three back kind of thing. But at the end of the day, or decade, my approach provides good returns with minimal losses.

IFC: Last time you compared you returns to Canadian Equity mutual funds. How do you measure up now?

Heinze: I am happy with my relative performance. Of course while I know my numbers, comparative information as at December 31 is not yet available. As of December 31, for the year 2008 my portfolio lost 28%, for the ten years ended December 31, 2008 I had an average annual return of 6.4%. However, we can compare the period ended November 30, 2008. For the 12 months ended November 30, 2008, I lost 26.8%. For the 10 years ended November 30, 2008, I had an average annual return of 6.8%. Based on Globe Investor Gold funds reports, that puts me in the top 22% for one year returns and top 20% for 10 year returns for Canadian Equity funds, which is the best comparison I have. I also want to point out, as I did last year, that is of the funds that survived, as not all the funds in existence at the beginning of the period were still around at the end.

IFC: You talked about funds that disappear last year so we will not rehash it today. If readers wish more on that they can scroll down to that conversation which is reprinted below. In light of the economic times, perhaps we can talk about some economic issues. First, have you ever seen anything like this before?

Heinze: This actually reminds me a lot of 1982. When I look at a log chart of the TSX going back into the seventies, I see striking similarities. The drop is similar to the one that happened in 1982. At around 9000 the percentage drop was almost identical, so we have dropped a little more from top to bottom, assuming we have seen the bottom, but really it is a very similar chart. I lived in Calgary in 1982 and the current housing market in parts of the United States really reminds me of that time in Calgary. I think this is very similar to 1982 and the market recovered and thrived after that. It worked out very well for us, in 1984 we bought our first house and as luck would have it we could not have planned it better. I talked about that in the January 2000 issue of Financial Insight that is reprinted on our web site.

IFC: Are there differences?

Heinze: Yes there are some positive differences. In 1982 we were facing runaway inflation and runaway interest rates. Today, interest rates and inflation are both under control. Also, it appears that most of the economic powers are working together. If they continue and resist the urge for protectionism, then we may be about to witness something unprecedented, global cooperation. The other difference is in the approach of government, or at least in the Canadian government. In 1982, the Liberal government tried to spend its way out of the recession, something we could not afford, especially given the runaway inflation and interest rates of the time. This created huge structural deficits that took years and two different governments to bring under control. Today, inflation and interest rates are under control and we have a healthy fear of deficits.

IFC: Do you oppose Government stimulus at this point?

Heinze: I am concerned. One of the most dangerous things an investor can say is "this time it is different." But there are differences. Inflation and interest rates are under control and there is a very real understanding of how dangerous deficits can be and what they will cost. But yes, I am concerned. However, there is a lot of infrastructure that needs tending to and sooner or later we will have to pay for it. It seems to me that this is the time to do it, while costs are lower and labor is more available. We get the job done, cheaper, get some stimulus and wind up with a better infrastructure that helps position us for recovery. As long as we only do what needs to be or should be done and do not do projects for the sake of doing projects and once they are done we stop.

IFC: How do you feel about corporate bail outs?

Heinze: Fundamentally I oppose them. It has been said that subsidy and government bailout are the Canadian way. I refer to this as pulling everyone down to the lowest common denominator. It is far better to create an environment that encourages competition and rewards success which in the long run will create more jobs and opportunity and pull everyone up to the highest common denominator. That is the Canada that I would like to see and I like to believe it is achievable. Having said that, I am more sympathetic than I normally would be. The financial crises created a situation that no one could have reasonably been expected to be prepared for. However, I am worried that in the long run, we may do more harm than good. Probably the best thing governments can do is to try to grease the wheels of the financial system the best they can and get things going again, this will create an environment for success.

IFC: What about the auto sector?

Heinze: The same holds true for them. It may be necessary to give a temporary life line but in the end the best thing that can be done for them is to get the economy and the money flowing again. At the end of the day, there will be an auto sector, as people will still be buying cars. However, I expect that the sector will be very different then it is today and I hope that by throwing them a life line we are not just deferring the inevitable.

IFC: Well it looks as though 2009 will be a very interesting year. I look forward to seeing what happens. Thank you.

Heinze: I look forward to it too, and you are welcome.

Editors Note: Here is an updated chart in pdf format of the respective performance of $1,000 invested in Dave's portfolio verse the TSX and the DOW from January 1, 1998 to the end of June 2009.

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.

Just because you told your dog to sit, as he was about to sit, does not mean he is obedient.

A friend once told me that the trick to training a dog is to tell them what to do just as they are about to do it on their own. Then you can feel like you are in control. Thanks Alex. So you are probably wondering what that has to do with investing. Well, I must admit it took some thought. You see, I was thinking of this and thinking, what a great rule, I must use it. Then I tried to think of a way to relate it to investments. Then it came to me, like a flash of lightning, a profound message from the sky, like the ultimate …… well okay, it just came to me, but it really is relevant.

It seems investors are always looking for that one special piece of information that will lead to success. Further, it seems that there is no end to advisors and writers who are only too happy to oblige by giving them the shortcut they desire. Those supporting the theories, strategies, rules or whatever, always seem to have some historically proven approach. Their analysis shows that over a specified period of time, whenever a specific condition was met, a certain result happened, or it happened with a very high consistency. So it seems, or is apparently statistically proven that there is a correlation, so as an investor all you need to do is put the approach to work. The road to riches is free and clear. But then maybe you should ask yourself, if it is so easy, why are they telling me or anyone else about it? Would it not be smarter to just quietly profit by applying it? Or is the real money in the approach to be made by the person promoting it, rather than by the one applying it?

You see, it has been my experience that it is never that easy and that these schemes usually result in a parting of the ways between the investor and their money. It also seems that the more guaranteed the scheme, the more sure you can be that it will fail. While it is true that an outcome is a result of certain events. In investing, it is even truer that a result is the sum of numerous events, and rarely does one single event determine the outcome. So the fact that an outcome followed a specific event, no matter how regularly, does not prove the result will follow the event in the future. Put another way, if I am very good at knowing when my dog is going to sit and I only tell it to sit just before it sits, you might assume that it sat because I told it to. Therefore, it would seem logical that if I say sit, the dog will sit. It might even be statistically proven. However, if it was not sitting because I told it to but because it was going to anyway, then it is not reasonable to expect the dog to sit just because I said sit. As a side note, with some dogs, I think it is easier to determine when they will sit than to get them to do as they are told. And there lies the dilemma.

I do not believe there are simple answers and there certainly are not guarantees. A lot of factors effect your investments, and to take any of them in isolation is to ignore that very important fact. I do believe that with a reasonable amount of homework, it is not that difficult to build a sound well diversified portfolio of high quality companies that as a whole, over the long term will provide you with a respectable return, while accepting a reasonable level of risk. However, this requires patience, and the knowledge that some of your decisions will not turn out the way you hoped, but in balance, in the long run, the good will outweigh the bad.

So next time someone shows you a simple way to wealth with an exceptional track record, remember: Just because you told your dog to sit, as he was about to sit, does not mean he is obedient.

You see, there really was a point.

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Details can be found on the Federal government web site at www.tfsa.fc.ca. Essentially they work as follows:

• Canadian residents 18 or older can contribute up to $5,000 per year into a TFSA. The amount will be indexed with inflation in $500 increments.
• Income earned within the accounts will not be taxed.
• There is not a deduction for contributions, however, withdrawals are tax free. The resulting effect is that all investment income earned in the accounts is tax free.
• Unused contribution room is carried forward, similar to an RRSP. However, unlike an RRSP, any amounts withdrawn are added back to your unused room. This will make the accounts worthwhile even if you only have a little short term savings. For example if in 2009 you contribute $ 4000 to the plan. Then in 2010 you will have ($1000 unused and $5000 new) $6000 contribution room. Then say your investments do well and the amount in the plan grows to $8000. Then you withdraw $7000 in 2010 but make no contributions. Then in 2011 you will have (original $6000 unused, plus $7000 withdrawn plus $5000 new for 2011) $18,000 contribution room.
• Essentially any investment eligible for RRSP's is eligible for a TFSA. And yes, self-directed plans are allowed and already available from many brokers.
• Income earned in the accounts and withdraws do NOT effect eligibility for federal income-tested benefits and credits.
• Unlike RRSP's, we believe that TFSA's are eligible to be used as collateral on loans.
• Also, unlike RRSP's that we understand (but ask your lawyer before you count on it) are now creditor proof like other pension funds (except for specific circumstances like recent contributions or contributions to avoid creditors), we doubt that TFSA's will offer any creditor protection.
• There are not spousal plans, however, you can give a spouse or common-law partner the funds for them to contribute and avoid the attribution rules.
• TFSA assets can generally be transferred to a spouse or common-law partner upon death.

These new accounts should be a terrific savings vehicle and we expect that they will be used by many Canadians. How you use them will depend on your circumstances. Essentially they have the same real benefits of RRSP's but with added flexibility. See the article below about RRSP's that explains the benefit of sheltering. If you are a high income earner then you will likely want to contribute to RRSP's first and then put any amounts over your maximum RRSP contributions in a TFSA, or if you do not have extra funds you may put short term money in a TFSA instead of a regular savings account. If you cannot contribute to an RRSP (e.g. you are retired and over 71) then you might put some of your investments in a TFSA. If you expect to be in a higher income group when you retire, you might invest in a TFSA first, then into a RRSP. Many people will use the account as a good place to place savings that they want to keep available for future use. Especially in the first few years until they have built up contribution room. Of course there are many different situations and circumstances so you need to use the accounts in the way that works best for you.

We should point out a couple of other considerations. As with RRSP's, the quality and risk associated with your investments has nothing to do with the tax status, it is a result of the risk associated with the underlying investments. Also, it is worth verifying what service charges the financial institution in question will be assessing, especially while the amounts are smaller. There is no point in saving taxes only to have the savings eaten up by the financial institution. For example, $5,000 at 2.7% will earn $135 in the first year. If you are in a 40% tax bracket, the tax on that is $54. So in that specific situation if you are going to incur an extra $54 in service charges, then essentially the benefit of the shelter is lost. So, consider what the service charges will be.

Why RRSP's Work

It seems that every so often there has to be some discussion on the benefits of RRSP's. Someone will question if equity investments even belong in RRSP's since the tax on Capital Gains is much lower than on normal income. Their premise is that since capital gains are only one half taxed, it may make more sense to leave the investments outside of the RRSP. After all, withdrawals are fully taxed, so you lose some of the benefit that is afforded capital gains. We must admit, a few years ago when the rates were dropped back to 50% of the normal rate, we had our questions too, so we did do some analysis.

On the outside, many of the arguments sound good. However, as is often the case, these discussions fail to grasp the complete picture, so we ran some numbers. We figured that there was some basis to the argument that since the money in the shelter would be fully taxed when it was withdrawn; maybe it should be left outside. Actually, we assumed, wrongly assumed, that it would take some time for the benefits of sheltering to outweigh the benefits of the lower tax rate. What we found was that the advantages of the shelter took effect as soon as there was any, we stress any, realized return on investment. We had to give that some thought, but once we remembered that RRSP's are bought with before tax dollars where other investments are bought with after tax dollars, the answer became clear.

Since the money is going to be fully taxed anyway, either when earned or when withdrawn from the RRSP, it is what happens in the middle that counts. Since the RRSP shelters the income in the middle, it is better. Let us explain.

One of the first things that is often forgotten is that a rear-end load on the final balance has exactly the same effect as an equivalent front-end load on the original balance. For example, say you were investing $1,000 in an investment that would double in five years, and you had a choice of either a 10% front-end or a 10% rear end load. It would not make any difference which option you chose. With a front-end load you would get an original net investment of $900, once it doubles you have $1,800. With the rear-end load you start with the whole $1,000, once it doubles you have $2,000 then you pay the 10% rear-end load of $200 and you have the same $1,800 left over. In this way, RRSP's and TFSA's provide similar tax advantages.

The same principle applies to RRSP's. Outside an RRSP your original income, which is how you got the money to invest in the first place, is fully taxed at the beginning, like a front-end-load. However, if you put the money into an RRSP, the tax effectively becomes rear-end loaded instead. As we showed above, there is not really any difference in the end. However, with the shelter, in a way, the income in the middle is not taxed. Let us give you an example.

Say you are in a 40% marginal tax bracket, and for simplicity sake (and lack of a better assumption) you will always be in a 40% marginal tax bracket. This means that every additional dollar you earn is subject to 40% or 40 cents in taxes. Now lets assume that your employer gives you a $1,000 bonus that you plan to invest either inside or outside of your RRSP at a rate of 10%.

If you put the money into an RRSP, you can invest it all, as it will not be taxed. Also inside the RRSP the income is not taxed either. So at the end of 10 years you will have $2,594. If you then withdraw the money, you will pay 40% taxes on the balance and have $1,556 left over. Or you can invest outside of the RRSP.

In this case, the original tax is front-end loaded instead. That is you receive $1,000 but must immediately pay $400 in taxes. So now you have $600 to invest. Of course this is not a problem, since there will not be a rear-end tax, and we have shown that the effect of a front-end load or tax is the same as the rear-end load or tax. Except for one thing, outside the RRSP, the income is also taxed as it is earned. This means that if in the first year you make 10% or $60 ($600X10%), the government gets $24 of it and you keep $36. So your after tax return is only 6%. At 6%, in ten years your investment is worth $1,075. True there are no more taxes, but the $1,556 (calculated above) that you are left with after withdrawing from the RRSP is significantly better than the $1,075 you get to keep if the money is outside your RRSP. The difference is because in a way, inside the RRSP the investment income was tax free, as you really only got taxed on the original investment (albeit, on the final balance instead of the original balance). Of course the difference is less if you invest in investments that earn capital gains instead.

If you had invested in stocks that only returned capital gains, (no dividends), then outside the RRSP only 50% of the gains would be taxed, meaning an effective tax rate of 20% in the example. Also, the tax would only be due once the gains were actually realized. So if in the example you held the stocks for 10 years, then there would be no advantage to the RRSP. However, if every year you realized the return (presumably because you flipped the stock) then the RRSP has an advantage. In that case, your return would be reduced to 8% (10% less 20% of the return for taxes) and at the end of ten years you would have $1,295. Still significantly below the $1,556 you would have kept by using the RRSP. While we agree that you are not likely to flip the whole portfolio every year, especially if you follow our advise, it stands to reason that from time to time you will be flipping some investments and eventually you will probably be realizing most of an average years return every year. For example, if you turn over 20% per year, that suggest that every 5 years you will flip the equivalent of the entire portfolio, and after 5 years each year's realized income, which will be taxed, will equal one average years income. Regardless, while the difference may be less than what we are showing, the advantage of the RRSP is still there and is still significant.

It is worth noting that while the calculation is different for TFSA's the results would be the same.

It seems fairly obvious from the above that we should use RRSP's and TFSA's as much as possible.

The following table shows the difference in the value of a $1,000, 4% interest bearing investment after all taxes after 1, 5, 10, 20, and 25 years assuming a 40% marginal tax rate. Remember, outside the RRSP the money was taxed when it was earned, so you would only have $600 to invest to start with.

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.

One reason is because you expect your tax rate to go up in which case a TFSA might be a better choice. In an RRSP this 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 but it might be worthwhile to put that money in a TFSA if you have room. You may have investments that do not qualify. 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, and 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. These analysis also apply to TFSA's, so look at your whole mix.

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 and TFSA's as much as possible. If their total investments are greater than the maximum that they can have inside their plans, 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.

Having two out of three of these is not good enough. Having too much debt makes a company vulnerable. Poor management can kill even the best company, and if you do not have something profitable to sell, then you can not make money.

Reasonable Levels of Debt:

This is a critical factor, as too much debt can put a company out of business. In a recession, companies with excessive debt can find themselves unable to meet their obligations, while in a good economy, growth can be restricted.

There are many formulas for measuring debt, but we will discuss two that we like. This preference probably reflects the conservative accounting training and experience in our backgrounds, as well as the fact that we learned our basics in the Seventies. Nevertheless, we are constantly watching the current literature, so that we can embrace better approaches when they arise. So far, we have not seen any arguments to cause us to change our approach. Actually, we believe that these ratios are really more telling than some of the ones being embraced by many of today’s analysts. In our opinion, some of them may hide how high a company’s debt really is.

One of the ratios measures the level of current or short term debt, while the other deals with total debt.

When evaluating current debt, we are really trying to satisfy ourselves that the company can meet its current obligations. To measure that, we use the Working Capital Ratio, (in the past this was called the current ratio). This ratio is equal to current assets divided by current liabilities. Both these numbers can be found on a company’s Balance Sheet.

Traditional wisdom says that this ratio should be equal to two or more. While we like to see this, if total debt and other factors are reasonable, we are usually happy if this ratio is above one, and we must admit, the larger and more established the company, the less we worry about this ratio. But that is our view, not an accepted benchmark.

There are several ratios used to measure total debt. We prefer total debt (generally including all current and long term debt) divided by total assets. Both these numbers can be found on a company's Balance Sheet. This tells you how much the company's creditors have contributed to the company versus the shareholders through the purchase of stock and leaving profits in the company.

For instance, if this ratio is 50% (or 0.5), then it means that half of the assets come from borrowing and half from the shareholders (either directly or indirectly). If it is 25% (0.25), it means that one quarter (25%) is from borrowing and three quarters (75%) is from shareholders.

The lower this ratio, the more secure the company. You will hear different rules of thumb for this one. At one time, the material for the “Canadian Securities Course” put on by the Canadian Securities Institute suggest this ratio should not be over one third, or 33%. While this is nice, we believe that it is not realistic. We think, and we suspect that most experts would agree that debt levels up to one half or 50% are reasonable, in most cases.

Actually, we usually calculate the opposite ratio, that is Shareholders equity divided by total assets. If shareholder's equity is 75%, then total debt is normally 25%. Since the discussion is about debt levels, we felt it would be better to describe the debt percentage ratio, but either can be used.

Debt of Utilities and Financial Institutions: We should point out that if you apply the above to utilities or financial institutions, you might never buy one, even though they are considered to be in fairly low risk industries.

When looking at utilities, you may be prepared to live with more debt, as a monopoly position may guarantee them a steady income. You should keep this in mind, but ask yourself; will the monopoly position continue? What if it does not?

Financial institutions nearly always have very high debt ratios. Debt to total equity is often over 90% and sometimes nearly 100%. This is because money is their product or commodity. They are in the business of borrowing money, then investing and reloaning it. To do this profitably, you must have very high debt levels.

Good Management:

This can be evaluated a number of ways, some qualitative, and some quantitative.

First we will discuss the qualitative. This entails reading the financial news, watching the news and reading reports from investment services. It also includes paying attention to your every day dealings with the company, both personally and when applicable, professionally. If you like what you are seeing, this is good, if not, look for another company.

The quantitative includes calculating some ratios and trends to determine if management has been successful at turning a profit and what they have done with the profits.

Return on Equity: This is a popular ratio, used to determine how effective management is at earning a profit on the owner's equity. It is calculated by dividing Net Income by Shareholders Equity. One premise is that if they cannot get a higher return than can be earned on a low risk investment like Government Bonds, then why be in business. We find that most analysts like to see this ratio over 10%, and anything over 15% is considered excellent.

Do not forget to look at the trend for the last five or more years, as this may tell you more than just the current numbers.

One Dollar Premise: The only place that we have seen this is in the book, “The Warren Buffet Way." The author indicates that, Warren Buffet believes that, over a long time period, if management is looking out for the shareholders best interest, then the value of their shares should grow by at least as much as the earnings retained in the business.

The way we apply this is by calculating the amount of increase in market price per share over a five to ten year period. Then we divide this by income retained over the same period. We calculate the amount retained by adding all the earnings per share, less all dividends per share (and per share value of any share repurchase if applicable). If the result is one or more, we presume that management has acted reasonably.

Ability To Earn Profit:

This too has a qualitative and a quantitative side. On the qualitative side, you need to know something about the business. What does the company sell, is there likely to be a growing or shrinking market. Is the product or service likely to be replaced by new technology, if so, by who, the company or a competitor? How Competitive is the business, can the company hold or increase its market share? What does it spend on research and development?

These are the kinds of questions you should ask yourself. You do not need to be an expert, presumably that is the job of the company's management, whom you as a shareholder have hired to work for you. However, the more you know about these things, the better position you will be in to make a good decision.

On the quantitative side, there are ratios and trends that you can look at. The following are some of the ones that we like. These numbers are reported by many investment services.

Gross Profit Margin: This is mainly applicable to businesses that sell products. It is gross profit divided by the total sales. This ratio, or operating profit margin, will give you an idea how much margin is available to cover other costs and create profits. Here you should look at the trend over the last few years. Is this percentage growing, shrinking or fairly constant? If it is shrinking, it may mean that the company is going to have a hard time producing profits in the future.

Trend of Sales per share: This will tell you if the sales per share are growing. Total sales tells you if the company is growing. However, total sales growth might only be due to things like mergers, etc. For instance, if sales double but the number of shares outstanding also doubles (without stock splits), your investment has not grown, just management’s empire. However, if sales per share are growing, then you stand to see your investment grow. In general, a steady growth trend is good, a steady decline is bad, and erratic behavior may be cause for concern.

Trend of Cash flow per share: Cash flow per share is equal to earnings per share less non cash expenses like amortization (depreciation). The numbers here should be positive and increasing.

Trend of Earnings per share: This is the amount of profit the company made divided by the number of shares. In theory, this is what a share earned during the year. Here again we like to see positive amounts and a steady growth trend. By its nature, this number will fluctuate more than the last two. We do not become concerned if there is one loss year over a five year period, but we do get nervous if there are two or more.

Trend of Dividends per share: This tells something about management’s plans and expectations. We like to see consistent or growing dividends. A decrease in the dividend rate may be a signal of rough waters ahead. However, if the company is growing rapidly, and does not have a history of paying dividends, it is not necessarily cause for concern. Many growing companies use earnings as a means to finance growth. This is okay, however, companies that do not pay a dividend should be considered higher risk than if they had paid a dividend.

A Lot of Information:

The above are a number of the things we look for in a quality company. The more positives the better. However, we do not find many companies with only positive factors. Most have some good, some average and the odd not so good. That is probably all you can hope for. We look for the best combinations we can find, and try to avoid danger signs. By doing this we hope to build a sound portfolio of shares, which over the long haul will weather the bad times and thrive in the good.

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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: Since the Bank of Canada has lowered interest rates charged to the banks and moved more money into the system, why don't the banks pass the lower rate on and loan out the money?

A: This is something that makes great headlines and gives the politicians something to crow about to make themselves look good, but it does not reflect the whole story. First, on the question of why they do not lower interest rates by the full amount of the interest rate drop. If the Bank of Canada rate represented the banks full cost of borrowing, then it might be fair to expect them to pass on the whole interest rate drop. However, this is only a small part of their borrowing. The majority of the funds that the bank's loan out comes from other sources, mainly bank accounts, some of these accounts like GIC's have a fixed interest rate and some fluctuate. So while a cut in the bank of Canada rate does lower a banks' cost of capital, a one point cut in the rate does not mean a cut of one point in the banks cost of capital. It is fair to expect them to lower rates, and they do, but it is not fair to expect them to match a point for a point.

On the second part, why don't the banks start lending? Our information is that despite popular opinion, or what the press are leading us to believe, they are. From what we understand, overall, Canada's major banks are lending and money is available, however, we believe there may be a drop in demand as borrowers and banks are being more careful about the borrowers ability to carry the loans. Also, we understand while money is available from the major banks, there is a major shortage of funds available in the secondary markets that provide a lot of financing to Canadians and businesses, but that is not under the control of the major banks.

Another point worth noting is that Canadian's are being well served by the fact that our banking system is rated number one in the world. This is largely a result of conservative lending requirements. So while we want the banks to keep the money flowing, it is very important that people and business only receive the credit that they can afford. Otherwise both will be worse off. Remember, it was lax credit policies that created this mess in the first place, and both lenders and borrowers are now paying the price, not to mention the rest of the public and the economy.

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