Normally, I don’t quote sports columnists on this blog but I am a regular reader of Gregg Easterbrook’s Tuesday Morning Quarterback on ESPN. Gregg mostly writes on football (and very well at that- too bad he didn’t help me draft my fanatasy football team. Oh the humanity!) but he’s also an astute observer of the economy. To end the week, this week’s nugget of wisdom by a member of the media to the media was very timely (emphasis is mine):

…Just last winter, gas at $4 a gallon was said to represent a super-ultra emergency, and ExxonMobil profits were said to be obscene. Now gas is $2 a gallon and this is bad, according to CNBC economics bobbleheads, who last week warned the lower pump price will depress oil-company profits. Just last winter, rising consumer prices were said to represent a super-ultra emergency — now that consumer prices are falling, that’s supposed to be bad too, owing to the possibility of deflation. But innovation and rising labor productivity are supposed to drive down prices. Lower prices are a core goal of capitalist economics!

Oh no, the price is falling! Oh no!

These points should serve as reminders that the mainstream media always present all economic news as bad. Higher interest rates? Bad for borrowers. Lower interest rates? Might cause inflation. Normally, the media’s penchant for spinning all economic news as bad doesn’t matter — but right now it does, as pessimism more than logic seems to be driving the weak economy… Pessimism is driving the downturn, and that pessimism is advanced by relentless media negativism.

Even the Wall Street Journal is spinning events in the most pessimistic light. A page one story declared, “Investors in the U.S. stock market have lost more than $9 trillion since its peak a year ago.” But there is a distinction between a decline and a loss. The paper value of U.S. equities has declined $9 trillion since the peak in October 2007, but many investors have suffered no loss because they haven’t sold. Many people’s houses have declined in value in the last two years, but most people haven’t lost a dime because they haven’t sold — just as many people’s houses rose in value from 2002 to 2006 but most people did not gain, again because they did not sell. Doing nothing can be the smart move in a bear market, and those investors, individual or institutional, who have cleverly done nothing have incurred no losses and are likely to come out ahead in the long run. Yet some insist on claiming $9 trillion has been “lost.” Exaggerating the negative only worsens the economic-confidence picture.

Have a great weekend.

I do not believe anyone is taking what is happening in the economy lightly. But there also needs to be a matter of perspective and context factored into the equation. If nothing else, what appears to be unfolding is actually a return to historical normalcy after a decade of bubble economies, unrealistic expectations and an entitlement to spectacular returns. To wit:

• Yale economist Robert Shiller, who’s become the god of bubble economics (he of the “I told you so” when it came to the real estate market), recently looked at price to earnings ratios historically. From 1890 to the late 1990’s, the average p/e was 14.6 before consistently being over 20 (in other words, $1 invested in a stock would take 20 years to return). As of early November, after the two of the worse months in the S & P 500’s history, it is back down to slightly over (yes, over) historical norm at 15.7 (here’s the full article on Shiller’s price to earnings analysis).
• From 1960-2006, corporate profits represented 4.9% of America’s income. In 2006, it represented 6.4% of American’s income- a 30% increase over historical norms (another Morningstar stat).
• This has been posted many times in other blogs but home values are abnormally high even with the correction in the last 12 months. The chart suggests a very long correction before real estate even approaches historical pricing norms (strangely, housing values actually rose during the depression).

Finally, more anecdotally, I read an article last week indicating that small business’ largest concern was readily available access to capital quoting a member of a small business association that members were feeling the squeeze at prime plus 3% and prime plus 4% business loans. I almost spit out my tea reading that.

If an entrepreneur had to rely upon that cheap of capital to stay in business then it shouldn’t be in business. Cheap cost of money should not be why someone should stays in business.

…my point being, even with prices on everything plunging, we are only still at or near historical norms. So are we in a free-fall to a depression or has the weight of history finally asserted itself on a market drunk on a mixture of entitlement, greed and hubris?

My regular columnist, Mom2KG, returns this month perplexed about her financial advisor. You have any advice? Please feel free to share. If you are new to this blog, please visit the Mom2KG section to catch up. Thanks.

It may not come as a surprise to anyone that the market meltdown has paralyzed us with fear. Mostly my husband, of course, who sees money draining away with every move I make. I even use too much toilet paper, apparently.

We’re doing a few things differently.

First, we increased the mortgage payments again. If we stick to our plan, we’ll have the whole damn thing paid off before the term is up, which means we won’t have to worry about the anticipated soaring interest rates. Second, I created automatic deposits into my RRSP account, but instead of spreading the deposit among different investments, I’m just putting it in cash for now.

Perhaps the best thing we’ve done is have me responsible for a large, fixed portion of the credit card bill every month. I have to admit this has made me pause once or twice before making a purchase. The account I pay out of is now a joint account, but until recently was only in my name. Even now I’m the only one using it, and I rather like seeing the cash balance.

Oh, I also finally got the President’s Choice Master Card, and we’re going to say bye-bye to the stupid Aerogold Visa. It costs $200 a year (for the primary cardholder plus a secondary card), and points do not seem to accumulate fast enough for us to be able to purchase flights. In addition, certain charges are not covered by the points, and so flights end up costing a few hundred dollars anyhow. Then we’re also stuck with Air Canada, which is not known for point flexibility. The program does offer merchandise as well, but we had really wanted the flights, and we don’t need more stuff. The PC card will allow us to set off the cost of groceries – always an issue with us.

One last thing – we are reviewing our choice of financial advisor. It’s a one-stop shop kind of place. I recently purchased term life insurance there. The original estimate turned out to be wrong, by close to 50%. It was a simple oversight – the broker had all the information but gave me the wrong info when we first spoke. I was pretty irritated, but signed the contract anyhow, because the final price was still acceptable, the contract is non-binding, and I’ve been trying to get this done for almost a year. But it’s just one more thing that’s rankling with us. We know everyone has lost money in the last several weeks, but were our portfolios properly diversified? Why had the advisor never mentioned REITs? Why did we have to push on getting an explanation about ETFs? Why is there so much redundancy in the portfolio? Why has no one talked to us about short, medium and long-term planning? We have very specific goals – isn’t that what we should be talking about?

What do you look for in an advisor? We need someone who will actively inform us of the greater implications of our investments, at least quarterly (right now we’re getting two calls a year, though we did get calls and e-mails around the time of the market frenzy). We want someone to educate us in the variety of investment possibilities, not just stupid mutual funds. We want someone to take an interest in our life and family goals and think about, and tell us, a strategy to get there.

As a post-script on yesterday’s post about Canadian banks and dividends, TD announced it is issuing $1.2 billion of common shares for the primary purpose of boosting its capital adequancy levels (this refers to the amount of money a bank must set aside). A good, bad or indifferent sign? Only time will tell…

Last week was a pretty bad week for the Canadian banks. Scotiabank and TD Canada Trust, viewed by most as two banks least tied up to bad assets in the credit market, both reported larger than expected credit losses in its last quarter (a credit loss is a loan that cannot be collected). This has lead some to worry about whether Canadian banks will fail.

I wanted to address more the safety of the dividend in Canadian banks but, as a side-note, we really have short memories. TD, now seen as a leader in the industry, almost ran out of money in the 1990’s after some really bad bets in telecom. CIBC seems to be in trouble, oh, every 5 years or so (as I wrote before, its one of those businesses with trouble in its DNA based on its history). Everyone lost their shirts when Olympia and York went under in the 1990’s. So, in the much larger historical context, its a different day, different mess but its business as usual.

Having said that, I am one of those people who believe bank stocks are going sideways for 2 years and they are better cash flow generating vehicles via dividend payments than appreciation stocks. I also work under the assumption that no Canadian banks are going on an acquisition spree soon- valuations on banks are nearly impossible to predict and we are entering into an era of big government again where the idea of a foreigner company buying a major American financial institution isn’t going to go over that well.

Thus, the question becomes how safe is the dividend?

Historically speaking, the dividend payout ratio of the S & P 500 was 53% between 1960-1994 (in other words, 53% of profits were being paid in dividend). From 1995-2006, the dividend payout ratio fell to 42% which is very explainable since earnings went well above historically norms beginning in the late 1990’s (stats courtesy of Morningstar).

Now, if you assume that the word of investing is returning to some pre-dot com era of modest returns and reasonable valuations (p/e in the mid-teens and not 20’s), one would assume that dividend payout ratios would begin to creep back up.

Here are the dividend payout ratios of the Big 5 banks as of the opening of the market November 24 (keep in mind only BNS and TD have reported their earnings at the time of writing):

• BMO-63.49%
• BNS- 42.52%
• CIBC- n/a (CIBC is at a net loss for the last two fiscal quarters)
• RBC- 42.26%
• TD- 37.95%

It appears that you a have and have-not world. BNS, RBC and TD still have a ways to go before hitting historical dividend payout ratios. BMO and CIBC- well, the former may have to cut its dividend (if historical payout ratios are a guide) and the latter is eating into cash right now to pay out its dividend.

It would be safe to say that dividend increases are not happening any time soon. The question for BNS, RBC and TD are whether any future shocks are great enough to knock its payout ratio above 50%. For BMO and CIBC, the question is becoming how long can it hang on.

As usual, this is not a reccommendation to buy. Please do your own due diligence. And, please, please, don’t panic.

p.s. if you are wondering about dividend yields, here is an older musing about whether dividend yields are ove-rated (as usual, the comments from my readers are more interesting than my post).

In a previous life, I use to meet a lot of people with start-up businesses. They are absolutely great people to meet because they possess so much energy and passion. It is like having a bolt of energy walk into your office.  But, alas, you also become good at figuring out which start-up businesses will make it and which ones won’t. It, sadly, becomes a bit of a bad re-run.

What I have noticed is that a lot of the mistakes that start-up businesses make are the same that many people starting to invest make:

1. Why are you doing this? It sounds simple but why start a business or why invest? If its only to make money, the business will die a quick death through a lack of passion. Same thing with investing. Making money for money’s sake is a soul-less endeavor. If you are starting a business to solve a problem or investing to give your kids opportunities you did not, there’s a true purpose driving you on those nights when we are all down and asking ourselves “why?”
2. What is your niche? Business and investing are tough subject-matters to grasp. There are so many experts and the rules change all the time. So have your knowledge be an inch wide and mile deep rather than a mile wide and an inch deep. I have very rarely met a successful investor who was good at stock investing and real estate investing. They were great at one and did it well over and over again. Same thing applies to business. Find a niche and do it well. Most small businesses simply don’t have the band-width to sell to 1 million people like the business plans say. Sell to a small, defined market and focus on it.
3. Don’t reinvent the wheel. People have been starting businesses or investing for centuries and doing it quite well. What makes one special enough to reinvent the wheel? Money Gardener boils down financial security in simple elegance. I would add don’t chase the exotic financial products. Same thing with business. Take something someone has done well at and copy it but make it better.
4. Work hard. The book The Millionaire Next Door states that one of the keys to financial independence is that those who have work harder than those who don’t. Sounds simple right?
5. Don’t use do it, plan it. The big failing of entrepreneurs is that they spend so much time in the business, they don’t spend time to plan the business. Same thing with investing. The investing plan set 3 years ago may have to be altered to meet your changing circumstances. Quarterly net worth updates or business planning sessions also allow you to get a big picture on what is going on and adjustments that need to be made.

I have recently switched jobs/businesses and, with that, I have shifted from supervising middle-aged and experienced employees to younger employees (under 30).  Coupled with that, some of my former employees were owner-managers, which attaches with it pride of ownership, and my new employees are plain-old 9-5ers. I freely admit I am having a hard time adjusting.

Fundamentally, if you don’t have enough time under your belt, you don’t know instinctively what to do in the work-place. So I am having a lot of heart-to-heart discussions with my employees about expectation levels and how to make the boss (me) happy. This is what I am saying:

1. Learn to prioritize. Bosses, especially me, are notoriously bad at giving an employee an assignment and then not telling the employee when it is due. Then another supervisor gives the employee an assignment. Which one does the employee do first? The key is to ask what the priority is on the work given. If both supervisors say its “urgent” ask them to speak to each other to fight over the employee’s time.
2. Be pro-active. School is, in many respects, a passive environment. The student sits back and waits for the assignment, is told what to read and when to write the exams. Most office environments I know are not like that. You have be pro-active. Tell people you want work. What type of work you are looking for. What your interests are. If you don’t, you will disappear at work and become expendable.  No one baby-sits you in busy offices.
3. Follow-up, follow-up, follow-up. This is related to #2. Tell your supervisor when you are done an assignment, that you are having trouble with it (see below) and you need feed-back on your work. If you do the work and then wait for the supervisor to find you to see how you have done, the supervisor thinks you are too passive.
4. Don’t be afraid to ask for help. When an employee gets an assignment they are having trouble with, they can do one of two things: (i) be seized up with fear and do nothing; or (ii) ask for help. The supervisor isn’t going to do the assignment for you but ask for a precedent to copy or a direction you should be going. Asking for help implicitly communicates you want to learn and you are interested as well.
5. Don’t pick and chose the “fun” jobs. Of course, you want to the fun jobs. Everyone does. But here’s the key to work. You get paid for the grief and not the work. Ever wonder what your boss does? They sit in the office mediating office politics, dealing with the Denise the Menace of the work-place and calling clients to collect the unpaid bills. Fun eh? Your boss got to be the boss by dealing with the grief. Show a positive attitude by volunteering to do a wide variety of things- the good, bad and ugly- and you will be respected by co-workers and thanked by supervisors.

Anyone care to share any advice for first time workers?

For those job seekers, Squawkfox has a great series running on resume writing this week (I post the first part).

Imagine you worked with a co-worker named Roger. Roger runs a small fiefdom at work with a lot of employees under him. But, Roger has been unproductive for a very long time. His work-product is generally mediocre. He can’t motivate his employees; even worse, they cause a lot of trouble every 3 years about his troubled managerial rein. Roger biggest redeeming assets is that he was great employee way back when and made a lot of money and trained a lot of good employees. But, for the last little while, Roger has contributed little to the bottom line and there are better managers than him more motiviated and who cost less.

In an economic down-time, the question becomes who goes and who stays in the bloated managerial rank. Does Roger deserve preferential treatment because of seniority and his name recognition in the elevators or hallways of your workplace? Or do you let Roger go and keep more deserving employees?

… I feel that this is the trouble with bailing out GM. You are bailing out a name of yester-year (yester-decades? When was the last time GM was relevant in the automotive industry?) when the money could go elsewhere. And, what exactly, are you bailing out? A business uncompetitive with bloated bureaucracy, a reputed massive pension shortfall and products not known to be environmentally friendly.

A bailout for GM is a bailout for an almost begone way of life: industrialized and unionized giants with a feet of clay (or the Emperor with no clothes).

I am sympathetic to the jobs lost and unfunded pensions but a creative politician (an oxymoron) could arrange for the government to create a body to manage the pensions (although the CAW is already assuming those functions in the near future).

My preference would be to let GM file for Chapter 11 (a reorganization as opposed to full-blown bankruptcy), have the government guarantee some vital contractual obligations and then let GM break up into the useful parts and let the unuseful parts die the death they deserve. It sounds cold but the choice to me is do you save the few for political points or use the money to help us all?

Any thoughts? Would you bail out GM? Or do you think it should go the way of the Doo-Doo bird?

My friend, a commercial real estate agent, insists that real estate investment trusts (REITs) will be the next pillar of the real estate industry to correct.  And, sure enough, in one of those “I told you so” moments, H & R REIT, who are constructing Encana’s new HQ in Calgary (aka the Bow), announced last week it would have to sell assets and cut back costs in order to obtain construction financing to finish the project.

However, others think that REITs have hit historically low prices relative to the value of underlying assets and rental incomes and now is the time to buy REITs as a value play.

So which is it? A value trap or a value play?

Every REIT is built a little bit differently. I have been looking at REIT’s lately as purely a cash flow vehicle.  My analysis is two-fold:

Can a REIT maintain its distributions?

In a typical dividend analysis, you would look at the dividend payout ratio of a REIT (recall that a dividend payout ratio is annual dividends paid per share/annual earnings per share). If it was approaching or above 100%, then you have an issue since you have a very small margin of error to work with in a down economy. However, you cannot apply a conventional dividend payout analysis when looking at a REIT;s ability to maintain its distribution.

Real estate companies write down a great deal of depreciation which is an expense for accounting reasons, reducing earnings, but a non-cash entry (in other words, it is a paper loss and not a cash loss). As a result, earnings tend to be dragged down which, in turn, artificially increases the dividend payout ratio. Thus, you see REITs with dividend payout ratios over 100%.

The more accurate measure of a REIT’s ability to maintain its distributions is determing funds from operations (FFO) which is an industry agreed upon term (but not GAAP approved). FFO is calculated by taking net income and adding back in non-cash items (primarily depreciation and amortization); again, the reason why you do this is that depreciation and amortization are accounting losses and not cash losses and you want to compare cash in to cash distributed. Then divide FFO by the number of shares outstanding and you have FFO per share.

Once you have FFO per share divide that number by distributions paid and you have a FFO payout ratio which is the REITs’ version of a dividend payout ratio. If this sounds confusing, don’t worry, Every REIT publishes its FFO per share in its quarterly reports so you don’t have to do this calculation.

For example, RioCan REIT reported that its FFO for the first 9 months ending Sept. 30 are $1.09/share and declared distributions of $1.015/share for the same period (the September distribution is paid in October but I have assumed it as part of the calculation). This gives RioCan a FFO Payout ratio of 93% (1.015/1.09) (this is not a recommendation to purchase RioCan).

Morningstar, the publisher of all things investing, recommends that a FFO payout ratio should ideally be no more than 85% (if you are wondering why this ratio is so high it is because REITs by law have to pay out most of their cash to maintain their REIT status; the % of cash to be paid out varies according to jurisdiction but it is typically quite high).

Is the REIT overly sensitive to leverage?

This point is contextually obvious. With the financial institutions not willing to lend freely, REIT’s have an issue as their debt becomes due- who will renew their debt obligations and on what terms (remember that loan to value is based on appraised value of a falling asset group; REITS have to worse of both words- unwilling lenders and falling asset base to borrow on)? If a REIT can’t refinance, it has to divest of assets which reduces FFO and endangers a payout to investors.

The analysis on debt is two-fold. The quick back of a napkin analysis is to simply look at quarterly reports and see when long term debt is coming due (this is usually found in the notes to the financial statements). If a majority is maturing in the next 12-24 months, there is an issue.

The quantitative analysis is to look at interest coverage ratio. This ratio measures operating profit/interest expense. The higher it is, the better since the higher the ratio, the more cash a company has to service debt. Even if interest costs increase due to higher costs of borrowing, a high interest coverage ratio indicates that a company can absorb these costs with undue hardship.

Again, most REIT’s report interest coverage ratio in their financials and MSN Money calculates it for you as well. Morningstar recommends an interest coverage ratio of at least two (i.e. profits are at least twice the costs of interest expenses) to maintain sufficient financial flexibility (this applies for all stocks other than financial stocks).

To use the same example, RioCan reported that its interest coverage ratio is 2.6 which means its operating profit is 2.6 times their interest expense. Its good but not great.

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Underlying both of the above are the obvious factors you have to look at in a REIT: who are the tenants, what type of tenants (commercial or residential), how long are rental revenues locked in for, what is the default rate on rental income, how quickly is it turning over property (many REITs made money flipping commercial properties quickly during the boom; this business model is probably dormant for the next couple of years).

But to determine whether a REIT is a value play or a value trap, one has to dig into the financials and determine whether the distribution is safe and whether the REIT is overly exposed to leverage and debt.

A lot of my friends ask me what I think of this credit crisis and my reply has been, over time, it will mean a return to some level of normalcy in the economy. Cheap money allowed a lot of unfavorable things to happen: unnatural appreciation in real estate, a lot of businesses survived that should have gone under if cost of money was closer to historical norms and short-term valuations in stocks that were unsupportable.

If a loss of 20%-50% in your portfolio in less than a calendar quarter jars one to a “back to the fundamentals” approach to investing, what are some things one should be looking for? Firstly, and this is subject of a future post, principal protected structured finance products tend to make the investor and, in some cases, the issuer poorer over time. For a great analysis of how investors may be worse off buying the exotic, I would refer you to Canadian Capitalist’s eye-opening piece on annuities (it’s a three parter- I only linked the first part).

It appears fundamentally, if one believes in stock investing, the majority of a stock’s return relies upon the payment of dividends. Jeremy Siegel, revered in many circles as the investing academic of choice, found that in the last 204 years, the average real return on equities (real return factors in return after inflation) is 6.8% of which 5.1% consists of dividend yield.

To give you some sense of the consistency of dividends as a pillar of stock return, consider dividend yields in both the best period and worst period for equity returns in the post war period that Siegel studied:

1966-1981 (a period characterized by run-away inflation and stagnant growth): Real Return on equity: -0.04%, dividend yield: 3.9%

1982-1999 (inflation is tamed and generally a period of great prosperity): Real Return on equity: 13.6%, dividend yield 3.1%

In other words, dividends tend to be the steady eddie of investing. They mitigate losses in bad times and augment gains in good times; they are a constant portion of a return on equities.

I use to be in a fantasy basketball people. One of the other fantasy owners was the son of a lawyer and was destined to be a lawyer (and he actually did become one during my 5 year stint in the pool). He never ever made the first trade offer. He would always start with “I am interested in [insert player here] on your team. Why don’t you make me an offer?” or “I hate [insert player] on my team. If you want him, make me an offer.”

It was a very clever tactic on his part because he was letting the other fantasy owners set a valuation for a player which allowed him to counter-offer. If your opening offer was too high, you just set the floor too high for yourself. If it was too lower, he could withdraw without ever showing what he thought a player was worth.

In essence, he was following a rule that all good negotiators adhere to- never throw out the first number. Whoever throws out the first number always sets a valuation and basis of negotiations and allows the person to counter-offer based on that. If you have negotiated against yourself and gave a too high/low number, it just may be taken.

In non-fantasy pool life, think about how this works. Most car dealerships teach their salespeople to ask customers “how much do you want to spend?” The trick in the automotive sector is to tailor monthly payments to how much you say you want to pay even if the loan ends up being unusually long and detrimental to the customer. But, in the heat of the battle, the customer thinks they got a good deal since the salesperson got them a car at the price they told them to.

Or, to turn the tables, I have seen this done a lot to salespeople in the business world. The salesperson gives a quote and a shrewd potential customer says: “Well, I got a quote for lower than that. Can you do better?” The key is to not tell the salesperson how much lower the quote is (if you got another quote at all- you sly bluffer). What a lot of inexperienced/bad/desperate salespeople will do is to undercut their price without even asking you how much lower the other quotes where.

The other example you see is a lawyer saying: “well, that offer is utterly insulting to my client”… and then not make an counter-offer. They want you to negotiate against yourself and lower your offer without them doing anything.

Now, if you meet a shrewd negotiator, you end up in this strange dance where no one wants to throw out the first number. Then you basically become Job and become super-patient and outwait them or you know you are against a good negotiator and walk away. If you have to make an offer, make sure you do your research carefully.