If you believe the media, oil has now hit a price point where it is beginning to change our behavior: we drive less, buy smaller cars, car-pool etc. which means less consumption and a return to some semblance of more normal pricing (one hopes). But the general public continues to pour money into oil stock, having lost its confidence in bank stocks. However, below the surface, the mega-rich are already moving to the next great energy play: wind power. As reported recently, Boone Pickens, who made his billions in oil, has ordered over 600 wind turbines to commence his $10 billion wind farm in Texas. What is particularly interesting is that Pickens hasn’t even secured the right-of-ways for the power lines that will deliver electricity to the grid. That is some bet on wind power when you buy before you obtain government approval.  Warren Buffet is also betting on wind power buying up shares of GE (who produce the wind turbines).

The advantages of wind power are pretty obvious. Wind is ubiquitous. Solar power has limitations if there isn’t a lot of sun. Bio-fuel solves one problem but creates another (have you seen the price of bread lately?). Nuclear is very expensive and what do you do with the waste? Wind power from a business perspective allows the capital costs to be amortized over a long period of time.

Wind power is still a relatively new concept in North America. In Europe, there are large wind farms in-land as well as off the coast. Despite this fact, wind power still continues to constitute a small but growing portion of energy output. As an investment, wind power is one of those “invest early in the trend and wait for it to explode” investments; the rich are patient so they are betting early in the game while prices are still low.

Wind power has its challenges: finding large barren tracts of land is difficult, there are obvious regulatory hurdles (in England, it takes approximately 30 months to bring a wind farm on-line), it is expensive to build out power lines to plug into the grid (remember that wind farms are far away from urban regions so you have to run a lot of power lines a long distance) and the industry doesn’t have the same tax breaks as bio-fuel or oil (yet) to encourage further production.

But, you know what? They said the same thing about the Alberta oil sands 15 years ago and now Alberta is awash in cash.

If you want some ideas for investing in wind power, Jim Cramer gives you some wind power stocks to consider (you know the drill, not a recommendation, please do your own due diligence).

Have a great weekend.

I ended up having some drinks with a friend of mine who has moved from the bank to an investment counsel firm. An investment counsel, in plain English, manages money for rich people (their legal standard of care is higher than an investment advisor and, with such higher exposure to liability, they charge higher fees; hence, their fee structure tends to cater only to well-off individuals). Before we had too much to drink and started waxing nostalgia about a more innocent time, we somehow started talking about mutual funds. His firm does not sell mutual funds: the first reason being is that rich people don’t want to be offered the same product as the mere plebeians like you and me (yeah, it is snobbish but its how the world works however unfair) and second reason is that the mutual fund model is simply broken.

It is always interesting to hear the view of insiders about certain investment products and his criticism of mutual funds serves as a reminder why we should not buy mutual funds and why the investment industry has recognized the model is broken and trying to sell new product instead (I have often thought that the ABCP fiasco became a larger problem than it should have because people became frustrated with mutual fund performance and were pressing their advisors for something different).  For the record, I started selling my mutual funds earlier this year and moving into ETF’s.

In no particular order, here’s what is wrong with mutual funds:

1. Most mutual fund managers are employees and not owners and have no incentive to beat their peers. Most mutual fund managers at large mutual fund companies are employee, albeit well-compensated employees. Think of your work-place; if you are an employee, you put in a professional effort but, as long as you collect your pay cheque, you are pretty much ok. Think of the owner of the business; they do well if their business does well. Thus, they have an extra incentive to go the extra mile. Financial Jungle did point out that mutual fund managers who are also owners of their fund tend to out-perform the market but this class of mutual funds is few and far between. Most mutual funds  are managed by employees which tends to mean they make safe choices and try not to rock the boat to keep their job (as the saying goes, no one ever got fired hiring IBM).
2. Most mutual funds are basically closet index funds. My friend point this out. The larger the mutual fund, the more likely they are buying stocks which consist large indexes like the S&P Industrials, the TSX 60 or the MCSI.  Why do you need to pay fees for someone to do this for you. An exchange traded fund (ETF) will do the same thing. But here’s the kicker as astutely pointed out by my friend: most mutual funds have to keep approximately 5-10% of their assets in cash to pay out redemptions so it is a closet index fund but not using 100 cents on your dollar.  A mutual fund could only be using 90 cents of your dollar to invest in a de facto index. That’s a lot of wastage for doing what you can do easily buying a ETF. 
3. The prime business of your mutual fund is not to manage your money but to sell more mutual funds. Eric Sprott is a bit of a local legend. His mutual funds do not hold any bank stocks or traditional blue chip stocks. Instead, he invests based on large macro-economic trends. His most recent successes being an early bet on gold and more recently on food. In a recent feature on Sprott’s management company, the article made an observation that Sprott Asset Management employs a lot of analysts (who research and make recommendations on stock to buy for a mutual fund) rather than on sales staff which apparently is opposite of the mutual fund industry. I scratched my head over this observation- you mean to tell me that the mutual fund industry is top-heavy on sales people rather than financial analysts? The obvious implication being the mutual fund is using our funds to sell more mutual funds rather than manage our money.
4. The fees are a killer. This dis-advantage to a mutual fund has been beaten into the ground: mutual funds charge high fees compared to performance, fees are paid if the mutual fund performs well or poorly etc. etc. But here’s some more food for thought- why are fees consistent no matter how much you invest? For example, why does a mutual fund charge 2% MER even if you invest, $500, $5,000 or $50,000 into a fund? Isn’t there an economy of scale if you invest $50,000 that should be reflected in lower fees? The conclusion being you are worse off the more money you invest in a mutual fund since you do not have any economies of scale (whereas in a stock purchase the commission is the same no matter how many stocks you buy).
5. You are not being sold the best mutual fund but the fund paying the best commission structure to the investment advisor or with the largest marketing budget. This is pretty self-explanatory.

If the rich don’t buy mutual funds, why should you?

Many see the fire sale of Bear Stearns to JPMorgan Chase as the first horsemen of impending financial apocalypse but, more than a week since these events, it may be prudent to look at Bear Stearns and financial stocks in a discerning light and removing the sheer panicked tones that surrounded the reporting of the event.  Lest one stock up on military rations believing our stock market will send us all into ruin, let’s remember a couple of things.

• Bear Stearns couldn’t get out of its problems because it wasn’t a deposit taking bank. I am not going to admit to knowing in precise detail the collapse of Bear Stearns but its fundamental problem wasn’t a lack of money; more precisely, it was they didn’t have any short term money lying around. All their money was tied up in either bad commercial paper or financial commitments which could not be paid back fast enough. Think of Bear Stearns as a trust fund kid who owes a lot of money to the wrong people but the trust isn’t going to give him his trust entitlement until he’s 25- and he’s 23…which means he’s about to have his knee-caps broken. Deposit taking banks can at least rely upon the fact it can use deposits to fend off any short term cash crunches. The investing lesson? As I blogged about before, invest in banks that have good retail operations. Think of banks like Wells Fargo, RBC, Bank of America (not a recommendation; for disclosure, I own RBC). At the very least, they can use our deposits to buy their way out of their stupidity.
• Banks don’t go under. We keep them afloat. Regardless of whether central banks have private interests or non-private interests sitting on the board, the results are the same. At the end of the day, the government will always bail out the banking system and the damage will always contained- something that cannot be said for every industry. Whether it is through nationalization (England and Sweden) or other relief (what the Federal Reserve is doing now), the central banks will use taxpayer money to maintain the integrity of the system. Yes, the risk has shifted from the banks to the taxpayer and, while the banks may have averted disaster, the cost to you and me is most likely government induced inflation and less money to fight deficits or pay for programs (makes you wonder if you might as well buy bank stocks since the central banks are taking money out of your pocket and indirectly putting them into the banks; at least with a dividend from a bank stock, you get some of your money back).
• A lot of babies got thrown out with the bath water. There are banks who have little to no exposure to subprime or ABCP that are collateral damage to the selling of financial stocks in the market (exhibit A: TD which I own). Insurance companies and mutual fund companies, with little to no exposure to subprime or ABCP, have been swept up in the selling of bank stocks. Remember not to paint the entire industry with the same subprime brush when looking in the bargain bin. Look for stocks with little subprime exposure that have a history of timely and full disclosure to shareholders.
• Its not over…this is a multi-trillion dollar problem and billions are being thrown at it (an analyst wrote earlier this week that subprime may take 2.5 years to completely unwind itself). Plus… the banks got off too easy. The Federal Reserve bailed them out relatively quickly so I am not sure if they learned their lesson. They may go back and think of some new exotic financial instrument to shoot themselves in the foot (never under-estimate smart people to be too cute by half). As I said above, look for banks that adhere to the KISS principal in order to ensure some safety cushion.
• Nature abhors a vacuum. One of the more interesting phenomenons occurring is that non-financial stocks are raising their dividends to attract money that once went to the financial stocks (look at General Mills, Encana, Rogers and Harley Davidson(!) raising dividends in higher than historical fashion as examples). The good thing about the financial melt-down is that other companies are rushing into the breach as alternatives for investors to put their money.

If you believe that now is the time to buy financial stocks (and I am not going to predict whether it is or not- just remember even an “expert” like Jim Cramer has put his foot in his mouth recently over financial stocks), look for fundamentally sound companies- good cash flow, good deposit taking institutions, management committed to full and timely disclosure, lots of revenue streams (retail banking, credit cards, M&A, wealth management) and the dividend payout ratio is relatively low (under 40% ideally)- to let you sleep at night. For specific stocks, some other bloggers have looked at:

• Citigroup by See Me Get Rich
• BMO by the Money Gardener
  
• Bank of America by the Dividend Guy
• A collection of research at Canadian Banks and Insurance

There’s an old saying in the law: “the big print giveth, the small print taketh” and no where is this truer than when buying insurance. Buying insurance is like buying a car now: the base model is attractively priced but you really need to buy quite a number of upgrades to really make it work for you. In insurance lingo, an upgrade is called a rider. Keep this in mind when you obtain an insurance quote- the initial price may not get you what you need.

Last week, someone showed me a quote for critical illness and disability insurance and I was shocked but how little you get in a base policy; the insurance is cheap but how much are you really getting without the appropriate riders? Insurance is more about what you are not getting then getting now a days. If in doubt, ask for an insurance quote with all the bells and whistles on it and get your broker to sit down and explain everything to you. Remember that in some cases, you cannot add riders to your insurance policy after it is issued.

Given the amount of fear and paranoia on the street now, I suspect insurance will be aggressively pitched by the industry to provide piece of mind but do your research carefully before you buy since you are worse off paying for a bad policy than having no policy at all. The issue is that insurance quotes are so full of lingo and finance terms, it really makes your head spin something (when I looked at the quote last week, I scratched my head a lot and had to look up a lot of things). Thus, here’s a quick and dirty on critical illness and disability insurance, the problems with base policies and the common riders to consider.

CRITICAL ILLNESS INSURANCE (”CI”)

WHY DO YOU NEED IT? If you contract a critical illness (see below for what this means), the insurance company will give you a lump sum of money to pay for medical costs/loss of income/expense coverage (usually either $100K, $250K, $500K, $750K etc depending on the amount of coverage you buy). The amount of money given to you will obviously depend on the amount of your policy premium. Payment is usually made within a set period of time after you are diagnosed with a critical illness. CI can be thought of as emergency health care insurance.

WHO IDEALLY NEEDS IT? Those not on health care plans (whether individual or group plans) or the health care plan is quite limited (it does not provide a lot of coverage if you are on medical leave, the coverage is quite short in time, the coverage is quite low monetarily etc.) and those without the support network (monetary or otherwise) to protect themselves in the event of prolonged illness (i.e. those without family to help them through an illness etc.)

WHAT ARE YOU COVERED FOR IN A TYPICAL BASE POLICY? Increasingly, little. Base CI policies cover the following critical illness: heart attack, life-threatening cancer (emphasis on life-threatening. Thus, it does not cover “minor” cancers) and stroke and…that’s it. The list use to be a lot more but the cost of insuring an aging population is resulting in decreasing insurance coverage. If you contract any of these three illness, the insurance policy will pay you a certain lump sum amount upon satisfactory proof until you turn 65 (typically). The insurance company does not care what you do with the money; if you, and let’s hope this all happens to us, have a fast recovery then you can pocket whatever money they gave you after you pay for medical expenses, replacement income, fixed costs etc.

In other words, in most basic policies I have seen, your CI will cover you for little.

WHAT RIDERS MAY BE APPROPRIATE?

• Enhanced Cover: You can add other critical illnesses to coverage such as blindness, coma, MS, Parkinson’s and loss of limp. The suitability of this rider depends on your family history, the environment you live in (are you exposed to a lot of chemicals and toxins?) and your age.
• Return of premium: This comes in various options now: (i) a return of part or your full premium at designated time (5 years, 10 years etc.). A full return of premium means you cancel the policy; (ii) a return of your full premium at the expiry of the insurance policy (typically 65 years old unless you buy another rider to increase coverage); or (iii) return of premium upon death.
• Fixed/Guaranteed premium: You pay the same amount to the policy even if the costs of insuring you are increasing. Typically, the policy is more in the beginning but evens out over the years as inflation catches up.

The biggest weakness of a base CI policy is that you become ill for illnesses other than for heart attack, life-threatening cancer or stroke, you are healthy for the life of the policy (strange to describe this as a weakness) and your premium is never returned (although it is not typically indexed to inflation) or the industry is just poor at risk management and the premiums go up without corresponding additional value. Thus, concentrate on riders that address these concerns or you could be sending your money unwisely.

DISABILITY INSURANCE (”DI”)

WHY DO YOU NEED IT? DI is an insurance against income loss. If you become “disabled” (as defined by the policy but generally meaning you are not able to work and generate income; there are exceptions if the disability is caused by mental breakdown or substance abuse), the policy will pay you a set amount of money monthly (as a replacement to your pay cheque at the time you obtained the policy and NOT when you become disabled) for a period of time as stated on the policy. Most policies are sold as payment until 65 although you can pay less and get less coverage. Coverage stops when you resume working. DI is income replacement insurance.

WHO IDEALLY NEEDS IT? Sole bread winners in families. People who have little to no workers compensation insurance/government provides poor disability benefits/employers have poor disability coverage. Those, for whatever reason, are highly leveraged in their lives (whether through bad financial planning or by circumstances- most entrepreneurs have be highly leveraged to capitalize their business) and would not have sufficient cash around to pay for fixed costs.

WHAT ARE YOU COVERED FOR IN A TYPICAL BASE POLICY? Payment of set payments monthly (determined by your monthly income when you obtained the policy) after the “elimination period” (which is the time between disability and when the cheques comes) until the coverage expires.

WHAT RIDERS MAY BE APPROPRIATE?

• Future Increase Option: A DI policy typically will pay you a set amount of money based on your current income when you obtain the policy. For example, if your take-home monthly salary is $3500/month when you obtain a DI policy, you will not be entitled to more than this amount, even if you are making more later, unless you buy this rider. If you are young, your income is increasing or you are making little, the initial coverage may not be adequate if you become disabled down the road. This rider allows you to up the payments payable to you (with an appropriate increase in premiums of course). Ideally for those who are younger and who’s potential income will increase substantially over time.
• Cost of Living Adjustment: the amount paid to you is indexed to inflation. More ideal for younger policy holders since the effects of inflation are greater than their older counter-parts.
• Non-Cancellable and Guaranteed Renewable: Basically, the insurance company has to pay you the agreed upon rate of coverage even if your income goes down or you change jobs. Ideal for those who may want to “down shift” in their careers/become part-timers/go free-lance.

The biggest weakness of a base DI policy is that it is not indexed to inflation or your income and life-style are significantly better after you obtain the policy. In such a case, if the policy has to kick in, the amount of money received is less than what is required when you first obtained the policy. Thus, if you are young or have large income earning potential, focus on riders that will match your earning power over the years and mitigate against the effects of inflation. Otherwise, you could pay a lot for little protection.

____________________________________________

Insurance is a very complicated financial product. Thus, educate yourself accordingly; just don’t take the first thing given to you or the cheapest insurance quote since the policy could not provide to you adequate coverage. If you have to squeeze the most for limited dollars, keep in mind the limitations of base CI and DI polices and buy the riders that cover up the biggest holes in the policy in the context of your life. Good luck.

…if I wrote “priceless” who would be madder, Visa or Mastercard? (I am in my hotel room on business travel mucking about so I though I would add a bonus post this week.) The final price for the Visa IPO is $44/share which is $2 more than the initial maximum share price. Public trading starts today. Following up on my initial post last week on the Visa IPO, this would push the p/e to close to 30. This is an extremely high valuation (can you think of any mature company this size growing 30% a year?).

Who is one of the lead underwriters in the VISA IPO? JPMorgan Chase. Who is the largest bank shareholder of Visa? JPMorgan Chase (who pocketed a reported $1.25 billion). Who has the biggest slice of the underwriters’ estimated $500 million pie? JPMorgan Chase. Who just paid hundreds of millions to bail out then buy Bear Stearns (albeit with very cheap money from the government and at 1/15 the market value)? JPMorgan Chase. Hmmm…..someone needed to increase the pricing of Visa shares to pay for some recent expenses.

I read into this pricing jeux casino gratuibonus de casino en lignejeux de planche a roulettejeu gratuitesvideo poker en lignecasino jeucasino achat en lignefree crapsjeu baccarat en ligne gratuitesjeu de hasardloterie en lignejouer stud pokerle meilleur poker en ligneseven card studjeu poker gratuijeux frle poker téléchargement gratuitesapprendre texas holdemtélécharger le jeu de poker gratuitesregles poker ouvertjeu poker macstrip poker virtuelapprendre a jouer au pokerla règle du jeu de pokerregles du poker texasjeu poker internetcomment jouer au pokerjeu de poker gratuitstournoi de poker gratuitespoker en ligne gratuites texastelecharger poker texastournoi poker gratuitespoker a telechargergagner poker onlineworld poker tournamentsites poker en lignejeu flash gratuitesplay 7 card studpoker texas holdem en lignejeu video pokerpoker en ligne gratuitesjouer poker tour gratuitespoker holdemregles du jeu du pokerjeu poker freewarejeux tour de pokermalette de jeu de pokerjouer poker en ligne gratuitespoker tour reglesjeu online poker tour that the IPO market will be flat to non-existent this year and Wall Street grabbed with both hands with the only sure-thing IPO this year (not to mention that a lot of brokers could be laid off after public trading commences today- the VISA IPO could be the last kick at the can for a lot of traders, not that I am shedding any tears). Probably another reason to avoid the hysteria today.

I wanted to end my post today with a mea culpa. You may have noticed I inadvertently posted both guest posts on the same day. I seemed to have lost the ability to count this weekend when I was posted both contributions with the same time-stamp and didn’t catch it while traveling. Apologizes to both Expat and Mom2KG; both excellent pieces should have been posted separately for the readers to enjoy. I hope to get them both to post again in the near future.

Bank stocks are in a total free-fall (notwithstanding this week’s temporary relief where billions were thrown at a problem in the trillions) and, with it, much handwringing given that most of us hold one, if not multiple, bank stocks in our portfolio. It seems like stodgy bankers decided to become derivatives traders and, lo and behold, they managed to wipe billions of dollars off in their companies’ values and sent bank stocks in the gutter (now that’s a trick not even the most sophisticated of derivatives traders could have pulled off!). What do heck do we do now?

In a larger sense, and as preserve as this may seem, this blood-letting is good. It lets us see who really runs the best bank since they cannot rely on financial slight of hand and off-balance sheet transactions to report millions in profits. Banks have to make money the old fashion way- finding ways to attract and keep our money; a low-margin but fundamentally necessary way for the bank to leverage its way into higher leverage businesses such as wealth management, wholesale banking and insurance.

One of Warren Buffet’s favorite bank is Wells Fargo. Why? The bank has a reputation of being a strong “retail bank” (short-hand in the industry as a bank that knows how to attract your money and mine). At the end of the day, Wells Fargo knows how to attract money into its coffers no matter what the economic conditions are. Good banks know how to keep our money; bad banks rely on financial gimmickry.

Here is another example, the following is a list of mutual fund sales by the banks during RSP season as reported by the Investment Funds Institute of Canada (from largest number of sales to smallest):

1. RBC- $3.9 billion (even if you add in all the other financial institutions, RBC is first in sales by miles)
2. TD- $1.2 billion
3. CIBC- $795 million
4. Scotiabank- $352 million
5. BMO- $153 million

Since mutual fund sales are front-line sales products (they are sold in-branch, they are sold by investment advisors and the human face of any bank) sold to the retail market, it tends to be a good litmus test of which banks continue to do its core function well- getting money out of our wallets into their safe.

The sales numbers tend to match the strongest to weakest bank of the Big 5 and reinforces Big Blue’s reputation as the undisputed leader in Canada (not to mention a growing presence in parts of the U.S.). The anomaly in the group is Scotiabank which can be explained quite easily: anyone who follows the banking industry knows that Scotiabank’s Achilles’ heel is its wealth management section and its mutual fund division. They are huge challenges in Scotiabank breaking the grip of the “Big 2″ no matter how many foreign banks it acquires. Lest I be accused of selection bias, retail banking growth among the Big 5 follows a similar pattern with RBC and TD eating into the competition.

In looking at banks this year, I have avoided looking at dividend yield altogether (as Dividend4life writes, focusing on current dividend yield can be a fool’s game) and started looking at sales numbers. In a worse case scenario, every single one of these exotic financial instruments have to be written down and the bank goes back to its original function- keeping your money and mine “safe”. Thus, I have concentrated on who does retail banking the best since, in the long run, these are the banks I want to own.

The best way to do that is simply to look at who is opening new branches in your city and ask your teller if they are opening a lot of new accounts- yes, I am not even looking at balance sheets now (not that they disclose much these days) and doing some plain old observation. One banking analyst wrote this week that we should take a price to book rather than a price to earnings analysis to banks now- hard to do when you don’t know how much the book is really worth. Bank analysis has to be with our eyes and ears in the short term in addition to the traditional financial statement analysis.

The other thing to do is simply read research notes about market share growth in the retail sector of the bank (interestingly, BMO’s recent stumbles were preceded by warnings by observers that it was letting its retail operations slide…). Now to the $64,000 question…. no, I am not buying any banks now. I waiting for the other shoe to drop and have some mid-tier financial institution go under; every bubble seems to have some semi high-profile causality which usually marks the bottom.

(For full disclosure, I own both TD and RY.)

I finally made my way through the monster known as the Visa IPO document. The VISA SEC filing to register the initial public offering can be found here. I consider the Visa IPO financial pornography- most of us will not be able to participate in the initial offering, other than buying after the market opens at, most likely, more than the initial price. Most, if not all, of the shares are spoken for by institutions, hedge fund, pension funds etc. The Visa IPO is expected to open sometime mid-month (March 20 is the date being cited by several sources) on NYSE with the proposed ticker symbol of “V.”

I have attempted to do a Q & A on the highlights of the Visa IPO with some of my own commentary. As usual, please do your own due diligence. This is a long post so bear with me (it is also from the February 25 filing so there may be some amendments to the IPO by Visa).

WHAT IS VISA?

This sounds like a stupid question but Visa is not a card credit company. The credit cards and debit cards with Visa on it are issued by financial institutions. To quote the IPO: “Visa operates the world’s largest retail electronic payment network and mangers the world’s most recognized global financial services brand.” In other words, Visa operates the electronic transfer of funds- it is the clearing house for all the credit card and debit card transactions for the banks that issue the cards (non-payment of credit cards are the banks responsibilities and not Visa) and merchants that have accounts.

It makes its money from two major sources: “data processing fees” and service fees- the fees charged to banks and merchants. Essentially, it is the middle person between the merchant and the banks. Every time you and I use the card, it makes money.

Visa, before the IPO, was “owned” (I use the term loosely) by financial institutions that license the cards around the world and manage the system in various territories (this becomes important as described below). Thus, Visa U.S.A. had a series of financial institutions that administered and managed the network in the U.S.

By total transaction (44.4 billion in 2006), it is almost twice as large as its closet competitor (Mastercard).

HOW MUCH MONEY IS IT RAISING AND AT WHAT PRICE?

406,000,000 shares are being offered with an over-allotment of 40,600,000 of class A common stock (the underwriter is allowed to issue these in the event the shares are full subscribed). There are 277,035,213 Class B shares outstanding which are held by the financial institutions that are members of Visa U.S.A. There are 203,885689 Class C shares outstanding owned by financial institutions outside the U.S. (keep the Class B and C shares in mind). These are non-voting.

The maximum offering price is $42. Only the Class A shares are being offered meaning that the Visa IPO should raise over $17 billion. Most observers indicate that the price will be somewhere in the range of $37-$42.

IS THIS AN EXPENSIVE STOCK TO OWN?

YES. THE STREET GOT GREEDY. At a maximum share price of $42, the price to earnings (p/e) ratio will be approximately 27 or, in other words, you are expecting Visa to grow at 20% plus per year to make it a reasonably priced.

A key metric to measure the performance of any credit card companies is transaction growth- after all, it gets paid every time someone uses a credit card. The IPO states that credit card transactions will grow at a rate between 11% between 2006-2012 which is a decrease from annual compound growth rates of 14% from 2000-2006. THE CREDIT CARD INDUSTRY IS PROJECTED TO SLOW DOWN. Even in emerging markets, the projected growth rates will be between 17-20%- well below the p/e of 27. The problematic statistic is North American projected transaction growth for this period is 8% (a 4% decline in the U.S. from its 2002-2006 transaction growth rate)- good but not great and certainly not worth a p/e of over 20 even at the lower offering price of $37/share.

The bottom line: the proposed p/e is above Visa’s current growth rate and the industry’s growth forecast meaning the underwriters added a significant premium to the price. By comparison, Mastercard’s p/e is approximately 24 and American Express p/e is approximately 13.

WILL A DIVIDEND BE PAID?

It is anticipated that a dividend of $0.42 per share/year will be paid commencing June 30, 2008. This represents a 1% dividend yield on an offering price of $42.

WHY WOULD I BUY?

(a) Good financials: Operating revenue of $15.9 billion in 2007. Removing allowances for a litigation fund (see below) and expenses are only $2.23 billion. There is $4 billion cash on hand which suggests an ability to increase dividends in the future. The company is massively profitable once you strip out short-term litigation concerns (see below).

(b) Cash-Flow Rich Business: Visa gets paid first in any transaction. It makes money even if card holders default on their debt. Good cash flow + limited risk = great business model.

(b) Dominant market share and brand: Visa is the world’s largest retail electronic payment network by any financial measure- by miles (total volume of business as of 2006 was $3.23 billion vs. Mastercard (no. 2) at $1.9 billion). But did Visa gain this position through uncompetitive practices and deception (see below)? Now that its hand have been caught in the cookie jar by regulators (several of the lawsuits are not settled and there is no admission of liability by either side), will an even playing field erode its market position?

WHAT ARE THE PROBLEMS?

(a) Poor use of IPO funds. It is anticipated that Visa will use $10.2 billion of the initial offering to redeem the Class B and Class C shares. In other words, the financial institutions will be cashed out using our money. I am sure that many of the financial institutions will keep their shares but there may not be the same incentive to manage and expand the Visa brand now that the original “owners” are cashing out (some of the banks booked this revenue already).

(b) Litigation. The VISA IPO lists a wide variety of lawsuits and government actions underway over uncompetitive conduct (Visa use to bar its merchants from using other credit cards as a condition of supply), to deception (unclear currency conversion policies) and competitors suing over the same issues (there is a lawsuit with Discovery that, based on the information provided about the trial so far, does not look good for Visa). The lawyer in me say “uh oh” reading the status of some on-going actions. Thus, $3.0 billion of the initial raise is being used to create a fund to pay out various litigation and/or penalties to be paid pursuant to regulatory settlements.

These are short-term problems and a good chunk of change was used in the Mastercard IPO to pay on-going lawsuits. These are not structural issues which will slow its future growth.

But that’s $13 billion dollars NOT used to expand the business. $13 billion to make banks and lawyers richer.

(c) Its biggest customers are in trouble and may not necessarily be loyal after being cashed out: Visa makes 22% of its operating revenue from 5 customers (7% from JP Morgan alone). All of these customers are not bound by exclusivity agreements to Visa; they can walk away at any time. Banks, to say the least, are in trouble. Banks may have to consolidate to get themselves out of these problems. Larger customers have more bargaining power which means it can cut a better deal and Visa’s historical pricing power could be cut (remember since the banks don’t own Visa exclusively anymore, it has no real loyalty to it).

(d) The industry is slowing down: As stated above, credit card transactions are projected to slow down to a healthy pace but nowhere near the valuation proposed in the Visa IPO. Growth in emerging markets cannot keep pace with the frenzy of spending Americans did from 2002-2006 and the American consumer is spent. Many emerging markets have cultures which have real aversion to debt; one wonders whether projected growth in these markets takes these cultural factors into account?

CONCLUSIONS?

Good business with some short-term problems but is the VISA IPO priced too high for you and I to make money? (assuming pricing is towards the $42 range) Don’t use the Mastercard IPO as a precedent: different context/better timing, a no. 2 in the industry with clear room to grow and the banks did not have issues at that point in time.

I love the business but the longer term play may be to let Visa settle down at some more realistic valuation after the IPO and monitor the situation then. Given that the VISA IPO may be the only major offering this year, Wall Street has a natural incentive to be greedy and I would want to avoid the hype being created to feed the greed. Just my 2 cents.

Do your own due diligence and, if you are happy, beg someone to sell you some shares.

Here are some other blogs which address the Visa IPO

Million Dollar Journey

Chris Perruna

Investing Blog

You know this is the prime selling season for the investment industry. All the silly products are being sold on the street promising great returns, no risks, early retirement and the utterance of “trust me, its a good product…” in brokerage offices all over the land. What has made this frenzy greater is that the markets are either falling or unpredictable. And, here comes inflation! Unpredictability for the average investor is reason to panic but, for their savvy counterpart, an opportunities to buy (although Buffet insists that a shrewd investor should park themselves on the nearest lazy boy and do nothing for now).

PPN, ETF, MIC, IPP, ABCP, GIC, M-O-U-S-E! What are we to make of all these products? There’s an old saying in the investing world- don’t buy what you don’t understand. If you don’t know what these acronyms stand for, don’t buy them. And always KISS- KEEP IT SIMPLE STUPID when it comes to investing. It sure sounds fantastic telling your friends you bought some derivative structured product at lunch but, if she’s holding a plain old blue chip dividend yield stock that keeps increasing its dividend every year, guess who has the money to pay for the bill?

My advisor has a “do not pass go” list of things we never discuss. Here they are with a short reasoning. Remember this is my list only. Feel free to invest in the products of your own choice after conducting your own due diligence.

PRINCIPAL PROTECTED NOTES (PPN)

In a nutshell, a PPN is a product which guarantees your principal if you hold onto to the note until maturity. This constitutes one part of your investment. The other portion is used to invest in other investment products such as a certain basket of securities, mutual funds or hedge funds.The gain in the other portion is capped to some % gain as a compromise to protecting your principal. For example, a PPN could invest in a basket of tech stocks and, after 5 years of holding on to the note, you are guaranteed your original investment back plus a portion of the gain on those tech stocks.

I avoid PPN like the plague. We, collectively, should take it as an insult that the investment community believes we are so uneducated that we could not protect our hard-earned money for 3-5 years (the typical maturity date of a PPN)? Putting my money in a high interest bank account would protect my principal and, depending on the interest rate, protect against inflation. There is no inflation protection in a PPN- at the very worse you get your principal back but inflation has eaten into the purchasing power of that money. Thus, in a worse case scenario, you have eroded the purchasing power of your money.

Fees are high, the upside on the note is capped, it is so confusing that the government has stepped in and is going to require greater disclosure rules to be given to investors. Here is the direct quote from the Finance Department when it issued the proposed new rules: “The complexity of such products can make it difficult for the average retail investor to fully understand the risks, fees and potential returns.” This is not exactly a ringing endorsement of the product- and this is from our government!

Reviews of PPN range from saying no to PPNs to PPNs give you the worst of both worlds (and this from a member of the investment community). And You can construct your own PPN without lining the pockets of the investment industry.

MUTUAL FUND OF FUNDS

I am not a big fan of mutual funds but really hate these variations. These are basically mutual funds that invest in other mutual funds. So…you can look at the marketing material, find out what mutual funds this fund is buying and do it yourself without paying higher fees. OR you can be lazy and lose tens of thousands of dollars in fees over the years for the manager’s skill in picking other funds which isn’t much of a secret since it has to be revealed in the offering documents.

Basically, the mutual fund manager is too lazy to actually pick stocks to buy and you decide to reward him for this laziness. Sounds like a great deal for the manager and a bad one for you.

I compare a mutual funds of funds to nightclubs that charge cover at one door and let people in free in the other door. Why exactly are you paying cover if you can get in for free?

SEGREGATED FUNDS

These are basically mutual funds which are offered by insurance companies. The funds are insurance products so they have the advantages of creditor proofing (creditors cannot attack insurance contracts in most cases but there are exemptions), estate planning (no probate is paid by the estate) and principal protection (if the funds are held for a certain period of time). Million Dollar Journey gives a more detailed summary on segregated funds.

Segregated funds suffer from the usual problems -fees are extremely high. Why would one want to pay such high fees to protect your principal when you can do it yourself (see my discussion on PPN)? If creditor proofing is a concern, the cost of a good lawyer to maintain and establish vehicles, such as family trusts, will be much less than the fees paid out over the life of a segregated funds (MER can be in excess of 5% in some segregated funds). It is a penny wise and pound foolish philosophy to purchase a segregated fund for creditor proofing purposes without paying for a professional’s time to discuss less costly alternatives over the course of one’s life- remember a professional’s cost may be a one-time occurrence but fees are constant.

Having said that, some people may be ideal investors for segregated funds. However, most employees, who have minimal liability risk, and those without massive tax liabilities at death (i.e. massive capital gains without an insurance policy to pay out taxes), would not fit into this category.

TIME-SHARES AND VACATION PROPERTIES AS “INVESTMENTS”

A time-share used primarily for vacation is great. But I would never buy it as an investment. All real estate suffers from liquidity issues- I can’t exactly sell my house on 1 day’s notice but I could liquidate my stocks tomorrow. Most time-shares I have seen have no liquidity; the contracts are quite tight as to what circumstances you can sell a time-share and many time-shares have veto rights even if you fall under one of the limited circumstances. Basically, you have to die before you can sell a time share. In other circumstances, time-share contracts assign the duty of selling the time-share to the management company who have no real incentive to sell the unit so it does nothing while telling you that it is trying oh so hard to sell your time-share.

Thus, even if the time-share was increasing in value, how exactly can you sell it if the terms and conditions conspire to lock you in for life? It is all a paper gain and it is hard to use it as collateral since, you guessed it, the contract prohibits you from doing that too.

Having said that, there are some great time-shares that are more investor friendly. You have to shop around and you have to read the fine print. The devil is in the details.

I also want to differentiate a traditional time share from these hotel-condo investments going up in large cities. These are functionally different products.

ANY PRODUCT DESIGNED PRIMARILY AS TAX SHELTERS

These come in varies shapes and sizes- from flow through shares endorsed by the government to invest in mining and exploration companies to “traditional” tax shelters. They all share one basic characteristic-to save me tax and not to experience appreciation. Most of these are not eligible for your retirement account so the high selling season was before year end and not now.

I like saving tax but there are other ways to do that than buy a product which may not appreciate (most flow through shares are designed not to make you money). Considering we use on average 7% of our retirement contribution room (that is not a typo), the statistics seem to indicate that we focus too much on overly sexy and complicated products to reduce tax and ignore the fact that an average person had 93% contribution room left in their retirement account to reduce tax.

The regualtory risk on these types of products is also quite high. Putting aside the government endorsed products, there are a lot of tax shelters which get challenged by the authorities and the claimed deduction may be denied years later with interest and penalties accruing during that time (which, in some cases, is double the actual denied deduction).

Products designed primarily as tax shelters are too cute by half for my own liking.  There are much easier ways to reduce taxes like contributing to your retirement fully annually. Simple and elegant.

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This is my terrible 5 list.  Let me know what you avoid buying.

Warren Buffet holds approximately 6.5% of his portfolio in Burlington Northern Santa Fe (BNSF), the U.S. biggest railway based on 2006 EBITDA. Bill Gates’ foundation owns a little under 6% of the common shares of Canadian National Railway (CNR). Before the private equity bubble burst, a syndicate of institutions, including Goldman Sachs, contemplated purchasing Canadian Pacific Railways (CPR). Why are all these really rich people and institutions buying up, or contemplating buying, railways? Aren’t railways a relic of a by-gone era?

Not necessarily. The world is a funny place and what goes around comes around and railways are back for several reasons and have become, for some sophisticated investors, a good place to invest. As usual, what is good for some may not be suitable for you so, as per usual, please do your own due diligence before you consider investing in a railway stock.

By railway stock, I am speaking of what the Association of American Railroads classify as U.S. Class I Railroads- these are rail companies with operating revenue equal to or greater than $346.8 million (2006 figures) and include two Canadian railways (CNR and CPR) who, even counting only their U.S. operations, would nevertheless classify as Class I Railroads in and of themselves. In other words, Class I Railroads are the major players in the industry. There are publicly traded stock of smaller railways but I am focusing on the big ones that the Buffet’s and the Gates’ invest in. The Class I Railroads are in order of 2006 EBITDA (expressed in millions):

1. BNSF (NYSE: BNI): $4,625
2. Union Pacific (NYSE: UP): $4,121
3. CNR (TSE: CNR): $3,680
4. Norfolk Southern (NYSE: NSC) $3,318
5. CSX Corp. (NYSE: CSX) $2,837
6. CPR (TSE: CPR) $1,564
7. Kansas City Southern (NYSE: KSU) $459 (KSU is so small, relative to its Class I Railroad counterparts, that it is often excluded when people speak of railway stock)

Why exactly are rich people buying the choo-choo train stocks?

• FEW COMPETITORS, HIGH BARRIERS OF ENTRY = PRICING POWER: Six major railways serve 300 million people in the United States (in practicality five since KSU is so small). Two major railways serve 30 million people in Canada with operations in the U.S. as well. These are not a lot of competitors serving a lot of people and the railways tend to have regional dominance rather than an all out free for all nationally. For example, Norfolk Southern is concentrated mostly in the north-east of the USA while BNSF serves mostly west of the Mississippi River. This means they have real market power on their home turf. It also costs a lot to become a major player in the industry- it is not easy to build track, labor costs are high, there are long established ship to train relationships etc. etc. This does not even count the regulatory barriers to enter the industry or buying a competitor. It is not exactly an industry where price wars occur a lot. This results in railways having pricing power which translates to healthy profit margins.
• ESSENTIAL SERVICE: Yes, railways are essential services. Last year, the perfect storm happened in central Canada: a refinery in Ontario was shut down because of a fire and a rail strike occurred which stopped the flow of oil to Ontario and Quebec from Western Canada. There were periodic gas shortages for approximately 2 weeks. We needed the trains to transport gas from the west to east. Most electricity plants run on coal (An often overlooked fact. We continue to burn a lot of coal- the “traditional” energy choices are still coal fueled electricity plants or nuclear). What was the leading commodity transported by railways? Coal. Railways keep economies going by transporting commodities and goods from one part of the continent to the other. Without this mode of transport, goods would be dramatically higher or we would have shortages. I will point out, however, just because it performs an essential services does not necessarily mean that stock prices will be stable as the market goes down.
• STABLE BUSINESS MODEL: A railway train for industrial use has not changed much in the last 20-25 years. Compare that to other modes of travel. There also isn’t a technological revolution that will fundamental change the industry unlike how hybrid vehicles are changing the production patterns of the automotive industry.
• PEAK OIL: Railways have become cheaper transportation options relative to other forms of transportation since the price of oil has increased so much. Rails do run on diesel but there are a certain economies of scale which railways have that trucks or jets do not.
• INTERNATIONAL TRADE: A lot of rail traffic occurs when the goods originating from abroad is picked up from a major port (such as L.A.) and transported into the interior. International trade has become such a large component of railway business that CNR built, with its own money, a port in Prince Rupert, British Columbia as a means to accommodate the flow of goods coming in from Asia and the transport of commodities out. The demand was that great that a railway got into the shipping business.

What are the risk?

• EXPANSION IS LIMITED: North America is densely populated in certain clusters. It is not easy to build more track without infringing on major urban centers. Track is also expensive to build since you have to assemble a lot of land, secure right of ways, buy a lot of material, ask the government for consent and hire a lot of mostly unionized labor to lay trade.
• UNIONS: CNR became a success story by basically breaking the union. Labor strife is always going to be an issue since the work-force is primarily blue collar, older and unionized. Unionized labor also increases costs which makes expense control harder to achieve.
• THEY ARE NOT EXACTLY GROWTH STOCKS: Stable does not equal exciting. If you disregard KSU, the price to earnings ratios of the Big 5 in the U.S. and Big 2 in Canada ranged between 13 on the low end and 20 on the high end for the end of 2006 (price to earnings is how much an investor is willing to pay for $1 worth of earnings/profit, the higher the p/e the more investors believes it is a growth stock) and the p/e estimates are in the 13-15 range for 2007/2008. These are comparative low compared to the S & P 500.
• DIVIDEND YIELDS ARE COMPARATIVE LOW: The average dividend yield for the industry is between 1.4%-2.2% excluding KSU which does not pay a dividend. Railways are capital intensive businesses which require a lot of cash (a railway’s capital spending budget can be 50% or more of its revenue). This results in less money being returned to shareholders in the form of dividend increases. Dividend payout ratios are in the mid-teen’s to low twenties.

The key industry specific financial ratio to focus on is operating ratio (which is determined by dividing operating expenses into operating revenue; the lower being the better since it means you are doing more with less). CNR currently has the lowest in the industry by about 10% (the range is in the low 60% to high 70%).  Given that railways are very cash intensive businesses, a even slight increase in the operating ratio can cost the business millions in profit. In case you haven’t notice from this post, CNR tends to be regarded as best in class leader in the industry (but, again, do your own due diligence).

Rail stock are also bellweather stocks. Slower rail business means a slowing economy so watch these stocks as indicator of where the economy is going. As an industry, they are not exactly going to light your portfolio on fire with appreciation or dividend payments but they have a steady-eddie, stabilizing quality to them (not to mention the business is easy to understand). They are not for everyone but the above may be some of the reasons why Buffet and Gates bought rail stocks. Despite my intellectual curiosity, I do not own any rail stocks.

I have had a hard time finding bloggers who have blogged about railway stocks in depth (which are not out of date). If you know of any, kindly share. Thanks.

…and, drum-roll please! The winner of our contest is Rick T. A copy of the book will be on a train to you. Thanks to everyone for entering.

There has been a lot of recent attention paid to dividend yield stocks on two different fronts: (a) as a safe haven to invest in during 2008; and (b) whether the dividend payment of any particular stock will be safe regardless of whether the stock price is declining or not. I wanted to address the latter since it focuses on some of the fundamentals of dividend investing.

What is a dividend? In the simplest sense, a dividend is payment made to the shareholders from free cash/profits on hand; it is surplus cash returned to shareholders. In most jurisdictions, you cannot pay a dividend if a corporation, after the payment of the dividend, “would be unable to pay its liabilities as they became due.” In other words, you have to pay the bills before you pay the dividend (keep this important point in mind). By law, a corporation cannot borrow to pay a dividend.

If you like to invest in dividend paying stock, there is always three things to keep in mind: (i) dividend yield; (ii) dividend increases; and (iii) dividend payout ratio. If you want to know whether your dividend is safe, you concentrate on (iii) primarily. A dividend payout ratio is the % of free cash/earnings/after-tax profits paid to shareholders. A dividend payout ratio of 50% means a corporation is paying 50% of its profits back to shareholders. Does this mean you want to find a stock with a high dividend payout ratio since, as a %, it would put the most money in your pocket? Not necessarily.

Companies with high dividend payout ratios are also the most vulnerable to a dividend cut. These companies are using a lot of its free cash to paying dividends. If there is short-term problems, one of the ways to get out of trouble is to cut the high dividend and use the cash saved to pay the bills. Think of dividends as your household’s “fun money.” In times of trouble, it is the first fund to be cut. Thus, high dividend payout ratio stocks are more vulnerable to a dividend cut. The Dividend Guy found a study which supports the fact that dividend stocks with high dividend payout ratios are not necessarily good stocks to own.

What is a high dividend payout ratio? It depends on the industry. On a quick and dirty analysis I also found the following (this is not an exhaustive analysis and there are exceptions):

• retail stocks tend to ratios under 30% (retail is a terrible cash flow business);
• mature tech stocks (i.e. IBM) tend to be in the 20%’s (they need cash for R&D);
• bank stocks are historically in the 30-45%’s (the current payout ratios are not representative of historical ratios);
• consumer staples (i.e. Procter & Gamble) tend to be in the 40%’s; and
• tobacco/alcohol are over 50% (they are mature industries and has no need to reinvest cash).

My rule of thumb is that I avoid a dividend payout ratio above 45% (except for tobacco/alcohol) or where the ratio is well above its competitors; anything more than 45% or that is not industry-norm means there may not be enough cash to weather hard times or raise the dividend. With obvious selection bias, Citigroup and Washington Mutual both have dividend payout ratios over 70%; many are speculating that the former will have to cut its dividend after running into sub-prime mortgage/bad commercial paper issues and the latter has cut its dividend.

Thus, if you are wondering if a company can maintain its dividend, do the following:

1. Go to Yahoo Finance/MSN Money or another financial website that will provide dividend payout ratios for you.
2. Find the stock you are interested in. Look under financial ratios and find the dividend payout ratio(sometimes referred to as just “payout ratio” under the dividend section)
3. On some sites, there is a “competitor” button that allows you to look at the financial ratios of competitors. Look these up as well.

Assuming the company is not in a mature industry, if the dividend payout ratio in excess of 45% OR well above its competitors (which I define as more than 10% more), then be a little worried; it may not be able to keep up the dividend payment or keep increasing it. I always believe that a safe dividend payout ratio should be between 35%-45% since the company has enough cash flow to meet an emergency, has room to increase the dividend and is probably growing since it is using 55%-65% of its profits to reinvest in the company.

As always, do your own due diligence before you buy. My 45% rule is a personal one. Everyone has their own investing goals so assess yours and proceed accordingly.

I am on business travel the rest of this week so the remainder of the week will be guest week with posts from an author of a personal finance book that addresses generation debt, frugality and love among other topics, a personal finance coach and a soon to be regular contributor who writes about their new year’s resolution to be financially responsible. Have a great week.