Preet from Where Does All My Money Go and I had so much fun in our initial insider’s conversation about investing that we decided to go head to head again to muse about surviving and investing in bear markets, high-dividend yield stocks and the best exchange traded funds on the market (by the way, to be clear, Preet is not my investment advisor). As usual, neither Preet nor I are offering investment advice. Our conversations are purely informational in purpose and not a recommendation to buy any product mentioned herein. Please conduct your own due diligence. (What a cop out- Preet :P)

We have changed things up this time around: the conversation starts here and continues on Preet’s blog. Hope you enjoy our conversation. My comments in bold; Preet’s in Italics.

UPDATE

Preet, let’s get an update on you. How is the RRSP Book doing and what are you up to next?

The RRSP Book did very well in February. Strangely, sales were slow in the US.

That’s because you had too many “eh?” in the book and spelt too many words with the letter “U”!

But seriously, the sales did drop off after the RRSP deadline as to be expected. I’ve had a two library wholesalers pick up some small bulk orders and it should be available on-line soon through more recognized sites like Amazon and Chapters. Proper distribution set-up is painstakingly slow. In the meantime, people can still only buy it directly from http://www.theRRSPbook.com.

I’m almost done my next book (more of a booklet really) on Charitable Giving in Canada. This one will be free for everyone electronically, and I’ll probably print a small run of physical books with all profits going to cancer research and care. I’ll also be making the e-manuscript available to any charitable organizations that would like to print their own copies and will allow them to customize it.

The blog is going well, we continue to grow at 25-30% per month and I’m finding that a lot of financial advisors are subscribing to the email updates which is pretty cool. It’s also really handy to refer clients to when they have questions on anything we talk about.

Thanks for the update. Let’s get the show on the road shall we?

SURVIVING THE BEAR MARKET

Let’s start with separating the stock market from “real life.” If you read personal finance resources, you would think we are in the middle of a depression. But the U.S. Department of Labor reports the unemployment rate at the end of February 2008 to be 4.8%. [note to readers: this conversation occurred before the March unemployment numbers were released]. An unemployment rate of 4.8% is quite healthy and, setting aside the traditional manufacturing sector, there is actually a shortage of workers in industries like healthcare, construction and engineering. Are we placing too much emphasis on the stock market as an indicator of what is happening in the rest of the world?

To a certain extent I would agree that. When I look around me I see that nothing has really changed in my little world. By that I mean the neighbourhood I live in, the businesses I see on the way in to work and the people at the malls, movie theatres, etc. But of course if you watch TV and read the paper you would think it is time to build a bunker to fortify yourselves for the impending doom and gloom. Not only will everybody be defaulting on their homes, they will be losing their jobs, contracting skin and lung cancer, running out of gas, become sterile, etc. Not only is fear a big motivator – it sells a lot of advertising in its dissemination.

That’s not to say there is no link between the capital markets and the world we live in. I do believe that earnings drive the markets in the long run and that economic cycles of various nations/industries are linked with capital markets. I also believe that over the long term GDPs goes up – and that’s largely due to the ingenuity of people. There’s always something to be improved, technology to harness, and as a future trend: failing infrastructure to repair (not to mention new infrastructure to create). Infrastructure now plays a long term role in my portfolios.

I looked long and hard at infrastructure stocks. In particular Brookfield Asset Management (BAM) and all of the Macquarie products. BAM was once the darling of Jim Cramer and he publicly stated he was wrong (he’s been doing a lot of that lately…) and the Macquarie limited partnership structures had some structural issues to them (priced way high and really benefiting Macquarie more than the investor). Where is the infrastructure play besides just buying materials?

There are two infrastructure ETFs, but they are not pure plays on the space. You can track the S&P Global Infrastructure Index through IGF or Macquarie’s index through GII. I use IGF as it is more diversified. GII is over 80% utilities, whereas IGF is 40% utilities with broader exposure to railroads and highways, oil and gas storage and transportation, marine ports etc. A lot of exposure to industries that may have more government regulated contracts which tends to keep the income, earnings and stock prices buoyant in otherwise dark times is nice for the correlation matrices of the portfolios.

What are you generally telling your clients?

I’m lucky I suppose, as for the last 4 years I’ve kept harping on the fact that returns are above the average we should expect long-term. Less than 10% of my clients have had any questions or concerns about the markets that I hadn’t addressed ahead of time or during a regular meeting. I did make it a point to meet face to face with as many clients as possible during Q1 – these are the times that will make or break your investing success if you make the wrong choices.

But what I always tell people whether they are prospective clients or current clients is that very few people seem to really grasp the relationship between risk and return. We know that markets correct from time to time and that if you just buy and hold you will be fine. According to Peter Lynch and the Fidelity research team, between 1940 and 1992 (a span of 52 years) the S&P500 corrected (had a decline from peak of 10%+) 31 times. That’s around once every 20 months. Get used to it.

But to be more specific, I explain the nature of the sub-prime problem and its origins and possible outcomes. Then we put it into context of past financial crises, and develop a short term game plan that fits with our long term game plan. For example, if they have a large deposit to make we would think twice about blindly deploying it and look more at putting it into something safe that we systematically switch over into the long term investments over time. Some choose to buy on this dip.

As an advisor it’s my job to explain the advantages and disadvantages of each possible strategy, so that the investors make the choices themselves.

Every client has different objectives and risk tolerances, but I have not sold any positions as a result of the sell off for a single person.

Do you believe there is a natural reaction to do something in bad times when, in certain circumstances, the right response would be to sit on our butts and wait this out? I read a lot about shift your assets from this industry to that industry or reallocate your assets from equity into bonds. However, setting aside the disadvantage of increased transaction fees and the tax hit of frequent selling, by the time someone says to shift money from one sector to another the investing trend is basically over or you are getting in at less than good value. For example, my Dad reads Fortune Magazine. One day, he asks me about Potash stocks. I suspect from the time that article was written to publication potash stocks most likely went up quite a bit.

I absolutely believe that the natural reaction of many investors is the worst possible thing you could do (sell during a decline and buy after the market makes back the losses and then some). I know an advisor who actually has clients fill out a simple one page document that only requires one check mark and a signature. It asks them to check if they would either like to A) Buy Low and Sell High or B) Buy High and Sell Low. While most would laugh at it, he gets them to fill it out and keeps it on file. The odd time a client will call during a market decline wanting to sell and he faxes them this sheet and asks them to change their answer and fax back.

I also remember meeting with someone who showed me a multi-decade history of mutual fund transactions. His portfolio was flat over 20 years and all the funds he held had returned between 8% and 12% individually over those 20 years (i.e. if you just sat on your hands the whole time). But since they move in cycles, obviously some holding periods would be negative and some would be above the long term returns. Well, this poor guy had successfully managed to switch between funds based on emotions and past performance data such that he was always a step behind. He basically fell into the trap that most do: invest in a fund because it’s been on a tear (on an absolute basis), experience poor performance for the next year or two as it reverts to the mean and then switch into something that did better during that time. Of course what he switched into then started reverting back to its mean.

Really, everyone should have an Investment Policy Statement (IPS) that their advisor creates with them, or you create yourself if you are a DIY investor. You should address Strategic Asset Allocation, Dynamic Asset Allocation and Tactical Asset Allocation strategies (and know the difference between these and market timing). You’ll never worry about your portfolio ever again (within reason).

Probably the key if you are a DIY investor is to write it out and then post it somewhere you can see it every single day and then co-op your spouse or a friend to remind you of your investing goals every time you get antsy.

The more thought out your IPS, the less likely you are to get antsy.

The U.S. markets are obviously in trouble right now-most likely the recession started late last year and we won’t know it until the summer of this year. Are you a believer in the de-coupling theory that what happens in the U.S. will be largely contained? I am not. Capital moves too quickly cross-borders now a days and too many of these exotic financial instruments had counterparties which spanned across borders. As some of these contracts become unwounded or mature, I believe you could sell the subprime flu give other countries colds?

The “Decoupling Theory” has a nice ring to it, but I haven’t seen enough evidence of decoupling to believe it either. I think you hit the nail right on the head with as to why. But let me ask a question for the readers to ask themselves: When the “new world order” countries like India and China experience double digit growth in GDPs, isn’t it convenient that developed economies are “re-coupled” and stand to participate in that growth in the future?

Not only are developing world countries not decoupled they have their own structural issues; the Chinese and Indian stock markets have suffered more than North American markets this year (the Shanghai exchange is down 34% this year compared to a loss of 7.5% for the S&P 500). In exchanges still in their growth phase, there continues to be a lot of “junk” trading in it; some stocks are junk, financial disclosure can be a bit murky at best and regulators don’t want to crack down for fear of killing the golden egg (hmmm… sounds like the Vancouver Stock Exchange in its hey day…). These are additional risk factors no one wants to talk about.

This gets back to my earlier point that people really don’t understand the true nature of risk and return. Additionally, the volatile emerging capital markets are in their infancy compared to developed nations – and they will go through some of the same mistakes and headaches that we’ve been through over time with respect to regulatory matters, overheating, etc.

HIGH DIVIDEND YIELD STOCKS

Many bank stocks have historically high dividend yields. I believe BMO’s dividend yield went above 7% for a short period of time. When is a high dividend yield stock a value trap?

First we’ll define a “Value Trap” for those unfamiliar with the term. It’s quite simply a stock that has declined in price enough that it may now appear to be a good value stock that is just temporarily under-priced for no good reason. An investor would buy a value stock in the hopes that the market will accurately price it in the future (i.e. the stock’s price will increase). A Value Trap is when you mistake a stock for a value play when in fact the business or fundamentals have deteriorated (in other words, the market is accurately pricing in the decline).

I suppose that answers the question. A high dividend yielding stock is a value trap when the business or fundamentals have indeed deteriorated. Time will tell what is in store for certain banks. Of course hindsight is 20/20 as always, but what clouds the issue is that the sub-prime mess has indeed affected the banks – the question is how much and is the market accurately pricing it in?

Given that there may or may not be value traps in high dividend yield stocks is now the time to employ a dogs of the Dow strategy (you buy the top 10 dividend yield stocks on the Dow Jones Industrial Average)?

Only as long as the investors understand the trade-offs, and really it is a long term strategy as any proponent of the strategy will certainly point out that it can underperform during short timeframes (as with most strategies), as well as long timeframes. Historically the Dogs have beaten the Dow by 3% per year for the last 50 years. I’m pretty sure that the next 50 years for the U.S. will be different than the past 50 years – I have no idea in what ways though. I’d be more comfortable using the Dogs for part of my US equity exposure as opposed to for my entire portfolio.

I would look at high dividend yield stocks and value traps by trying to answer this question- is the dividend safe? The best way of answering that question is how quickly does a sale become cash (I believe they call this cash velocity in i-banker speak)? We never think about it this way but when we visit an ATM to deposit money, it is a “sale” where the cash is made instantly by the bank. That’s why I do not like tech and construction stocks- it takes too long for the cash to come after the initial sale (with notable exceptions).

I would look at other things as well, such as the payout ratio. If it was high to begin with and there is some business or fundamental problems, the dividend may become unsustainable, it may be a hindrance to operations and these would make it more likely for the cut. Even if the payout ratio was low, a debacle could necessitate cutting the dividend. Ultimately, the question is “Is the dividend safe for a long time?” which can be estimated more prudently if you take into account the fundamentals, the business prospects and the business model (including looking at cash velocity). I suppose what I’m trying to say is “Yes Virginia, you still need to do your homework.”

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Part Two of this conversation where we speak about the future of ETF’s, PPN’s and fun investing can be found here.