Last week we published a report on how to assess your portfolio’s performance (How is Your Portfolio Doing?).

Today we’re releasing a supplementary report that uses the framework to assess the performance of the Steadyhand Balanced Income Portfolio, which is a hypothetical model portfolio (comprised of our funds) used by a large number of our clients.

Assessing performance can be an arduous and confusing task. Not anymore.

Early last year we published a report on how to assess your portfolio’s performance. The paper laid out a framework for evaluating your investments, focusing on five areas: gathering the facts, reviewing the market environment, analyzing the numbers, assessing the potential for future returns, and determining when to take action.

The report was well received by investors and won the Best Stewardship Initiative at the Canadian Investment Awards last month (read more).

Today we’re releasing an updated version of the report. All the market returns have been updated to December 31, 2011, and we’ve made a few small refinements.

We’ll also be publishing a supplementary report next week that uses the framework to assess the performance of the Steadyhand Balanced Income Portfolio, which is a hypothetical model portfolio used by a large number of our clients.

Assessing performance is a key element of investing. Our goal is to provide a practical framework to make the task less onerous.

As we start a fresh new year, there’s no shortage of Top 10 Lists (we’re guilty, too). They can get annoying and repetitive, even for a David Letterman fan. But some are worthy of passing on, even posting on the fridge. Here’s one you should staple to the front of your next investment statement.

Top 10 New Year’s Investing Resolutions (by Larry Swedroe).

By Tom Bradley

I was talking with a client last week about portfolio re-balancing and the challenges of volatile markets. I often tell the story of Bob Hager’s shaking hand to illustrate how hard it is to do the right thing when markets are down, but his story is just as good at bringing the challenge to life.

Our client was telling me that he’d read our August 10th blog (What now? Part II) and agreed with it. With markets well down from their highs and valuations getting attractive, he felt it was time to move more money into stocks. The day he planned to do it, however, was a particularly brutal one in the markets, so when he went to pick up the phone, he said it felt like it was “glued down”. His brain was saying one thing, but his emotions were telling him otherwise. As he tried to make the call, he was acutely aware of this internal wrestling match.

As it turns out, he did get the phone to his ear and got the trades done as planned. He stuck to the strategy that he’d laid out last year (with Chris’ help), but it got sticky there for a few minutes.

Tom was on BNN this morning discussing how we think about asset allocation and portfolio positioning in volatile markets. It’s all about being ‘approximately right’ rather than exactly wrong. In other words, you’re never going to pick the top or bottom of the market, so it’s key to stick to your strategic asset mix (SAM) and make modest adjustments when valuations and sentiment are at extremes.

Currently, sentiment is flashing fear, bonds are expensive and stocks are cheap. It’s a good time to lighten up on bonds and buy equities – within the context of your SAM. If you have any questions on how this advice may apply to your situation, give us a call at 1-888-888-3147.

Watch the clip here (6:00 min)

By Tom Bradley

What are the stock market declines telling us (other than we’re temporarily poorer)? Are they signaling the end of the world as we know it or, as a veteran value manager suggested to me yesterday, are we entering “opportunity-laden times?”

In my view, it’s both. The state of the world’s finances is such that we have to be prepared for slower economic growth and more frequent disruptions to markets. The outlook has gotten worse. But as Larry “I’ve been through the end of the world a number of times” Lunn, Chairman of Connor, Clark & Lunn, points out in his latest outlook, the gap between earnings yields (the flipside of a stock’s price/earnings ratio) and bond yields is as high as he’s ever seen it (9% - 2% = 7%). Translation: stock prices are factoring in most or all of the bad economic news and valuations are attractive.

In response to recent developments, we’re revising our recommendation to clients. Up until now, we’ve been advising caution, but with further advances in bond prices and a significant retrenchment in stocks, it’s time to make some moves (see the Grip).

The specifics of our view are outlined below. They’re written from the perspective of a balanced client who has been following our asset mix recommendations, but they apply to all investors.

What now?

Bonds are even more overvalued now. The push to safety has driven down yields to unsustainable levels.

Action:

• Fund manager: CC&L is making adjustments in the Income Fund. In the short to medium term, they’re getting more cautious on interest rates by shortening the duration (sensitivity to interest rate changes) of the bonds. This will help defend the fund from a rise in interest rates.

• Clients: You should consider moving more out of bonds. This can be done by switching some money out of the Income Fund or selling another fixed income investment.

Equity valuations are getting attractive, even if the economic outlook has worsened. It’s time to do some buying. The market is unpredictable and volatile, but one thing we do know is that if we buy securities at cheap prices when investor sentiment is flashing FEAR, we will make money in the medium term.

Action:

• Equity fund managers: In light of the market volatility and changes in relative valuation, it’s likely our managers will be making changes. We’ll provide updates in the near future.

• Clients: We recommend you add to stocks. This would be the first step of a multi-step process (2 or more) because nobody knows when the market is going to bottom. Buying in stages makes economic sense and is more tolerable psychologically (buying now is hard to do). Your purchases can be funded from the bond proceeds and/or by deploying some of the cash on hand. In the case of the Steadyhand equity funds, we don’t have a strong bias to one fund over another, as they’ve all been hit by the market and all own well-capitalized, sustainable businesses.

It’s still a good time to have some cash on the sidelines. The economic fundamentals are poor, political leadership is pathetic, we’re operating without a safety net (i.e. there’s little room for increased government spending or lower interest rates) and we don’t know when the investor sentiment (panic) will improve. There are some positives emerging – share buybacks, lower energy prices, more balanced inventories, improved equity valuations – but we still believe it’s advisable to hold some cash in reserve (5-10% of your portfolio).

As I noted in Part I, long-term investors who are holding cash far in excess of this level should be more proactive in putting it to work. To repeat what I said last week, “You have a long way to go to be fully invested and this is what you’ve been waiting for. GET STARTED!”

To summarize

We recommend you (1) assess your total portfolio from the perspective of your strategic asset mix (SAM), (2) let the Steadyhand fund managers do their thing, (3) hold 5-10% in cash and short-term investments, (4) own a less-than-normal weighting in bonds, (5) be neutral to slightly overweighted in stocks and (6) don’t hesitate to call us (1-888-888-3147) to discuss the specifics of your portfolio.

To illustrate our recommendations, consider a 50/50 client who has modeled her portfolio after our hypothetical Balanced Income Portfolio. Her strategic asset mix (SAM) is 50% stocks, 50% bonds and 0% cash. Her current mix (before the above-mentioned recommendations) would be 5-10% cash, 40-45% bonds and 45-50% stocks. Our recommendation for her now would be to continue to hold 5-10% cash, reduce her bond weighting to 35-40%, and increase her equity weighting to 50-55%.

The steps recommended may be the first of many. We don’t know how the markets will play out from here. (Repeat: We don’t know what the markets are going to do in the short term). We do know, however, that bonds will provide a modest return going forward based on current yields. We also know that stock valuations are attractive again (the S&P 500 is trading at 11-12 times earnings, which is well below the long-term average of 14-16). Further, investor sentiment has swung decisively to the FEAR side of the behavioral spectrum, which means it’s time to pay special heed to Warren Buffett’s words:

“We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”

Safety is now expensive and risk is on sale.

By Tom Bradley

The Grip (see above), which is our tool for expressing our overall portfolio strategy, was a new feature in the June Quarterly Report, but the cautious stance it signaled was not. Since January, we’ve recommended that clients be positioned conservatively and where appropriate, set aside some cash. We’ve been worried about the challenges of a debt-laden economy and the fact that interest rates are likely to trend up over the next few years.

So how are we sitting today? Well, pretty awkwardly I must say. Not because the markets have got us spooked (although it’s been no fun lately), but because we don’t think of ourselves as market timers. And yet, anything we say at this juncture will have a heaping portion of market timing.

In any case, here is what I think is happening and what we’d recommend doing about it.

Current Situation

• We’re going through a particularly bad patch of news right now, but for the most part it’s just another chapter of the same story. The western world has been living beyond its means (way beyond) and now finds itself deep in debt. As a result, this economic cycle will be bumpier and less robust than normal. In my view, we will muddle through the challenges, with growth being driven increasingly by the emerging economies in Asia and South America. The growth will come with lots of drama, however, so we might as well get used to it.
• The flight to safety in recent weeks has pushed up the ‘safe’ currencies (Swiss Franc, Yen) and pushed down bond yields (10-year government bonds in Canada and the U.S. are now at 2.5%). It has been my feeling for a while that yields are artificially low, so to me this current decline looks like a temporary reaction to the recent bout of uncertainty.
• It’s likely that corporations will find it tougher to grow in the next year or two, but Corporate America (and Canada and International) is well capitalized. An accommodating corporate bond market and strong stock markets have allowed companies to build up their balance sheets.

Going Forward

As our name connotes and my investing personality suggests, we’re measured in our actions, particularly at times of crisis or euphoria. Whatever we do, we make decisions in the context of our clients’ long-term plans, specifically their strategic asset mix (SAM). For Steadyhand clients, it’s important to remember that most of the heavy lifting is being done by the fund managers. They’re reacting to emerging risks/opportunities and making changes when appropriate. But at the portfolio level, there may be some adjustments needed too.

• Cash – We’ve had a few calls from clients asking whether they should hunker down further. Is it time to sell stocks and get into cash? While every situation is different (we encourage you to call us if you want to discuss your portfolio), we’re not generally recommending that. We don’t want to sell beaten-up stocks to increase the cash reserve. As for the existing cash, we’d keep it in place for now.
• Bonds – We’ve been recommending going light on bonds. While we’ve been early on that call, we feel even more strongly now that valuations on bonds are extreme (expensive). So we strongly recommend that clients hold a less-than-full allocation of bonds. If some selling is required, the recent run-up in prices is a good opportunity. Whether the money goes into cash or stocks will depend on the particular situation.
• Stocks – For clients who’ve been following our guidance and have a stock allocation in line with, or slightly less than, your SAM, there isn’t much to do just yet. We’d like to see the current crisis play out a little further. Those who don’t have a full allocation should use this weakness to do some buying. Most or all of the bad news has been absorbed into the prices and valuations have improved.

The recent market action has been disarming, but I don’t believe we’re in a situation like 1999 or 2007. The stock market is well grounded in the realities of the day (debt, slow growth, power shifting to emerging economies) and isn’t trading at extremes valuations. Indeed, some sectors may be moving into ‘cheap’ territory.

The Grip is still indicating caution, but it’s time to start thinking about what to buy.

Note: For readers who are substantially out of the stock market, we want to be very clear - Now is the time to take your first step at getting back. You have a long way to go to being fully invested and this is what you’ve been waiting for. GET STARTED!

The larger issue is when and where households will begin to deploy these monies in an unfolding environment of expanding wealth, stronger economic performance, improving equity markets, and an altered interest rate environment. Herein lies the ‘money in motion’ conundrum that will face all market participants in the months to come.”

As an addendum to my post last week (Risk-free? Be Careful What You Wish For), I want to revisit the words safe and Canada.

An excellent reason for investing in Canada is that it’s a safe(r) way to play the emerging markets, specifically China. Our resource stocks in particular will benefit from China’s unquenchable thirst for raw materials.

Why is Canada a safer way to play China? The argument is that:

• Our capital markets are well regulated.
  
• Corporate governance is best of class.
  
• Market transparency and corporate disclosure are good.
  
• And in general, our companies are well funded, or at least have ready access to capital.

All of this is true and Canada may continue to be an effective way to play China, but whether it proves to be safer or not is yet to be seen. I say that because resource stocks are the most volatile way to play any economic trend. Commodity prices are unpredictable, highly cyclical and cannot be controlled by company management. And relying on one big customer is always a risky strategy (as we’ve seen in the past, China can turn the tap on and off without notice).

The key point here (and in my previous column) is that holding a portfolio that is all-Canada all-the-time may be a safe(r) way to play the emerging markets, but it’s not a safe strategy per se. Having exposure to the world’s growing economies is a key piece of any investment strategy, especially with the developed countries being growth challenged, but it’s a more volatile piece and needs to be apportioned accordingly.

If you don’t have a Tax-Free Savings Account (TFSA) yet, get on it. It’s a rare government sponsored plan that encourages the sheltering of investment income and gains from tax. For a primer on these savings vehicles, check out a blog we posted at the time of their introduction.

TFSAs were established in 2009, which means that you now have $15,000 in contribution room (three years’ worth) if you haven’t yet opened an account.

There has been considerable debate in financial circles about whether it’s more advantageous to contribute to an RRSP or a TFSA when saving for retirement. If you have a low income, the TFSA may be the route to go; whereas higher income earners may benefit more from the upfront tax deduction afforded by RRSPs. In my opinion, investors should contribute to both types of plans, if possible.

As for my strategy, I’ve sold some of my non-registered investments and invested the proceeds in my Steadyhand TFSA. I triggered a small capital gain in the process, but the future tax-free growth will more than offset the small tax liability.

All of my TFSA contributions have gone into our Small-Cap Equity Fund. I look at all my accounts (RRSP, TFSA and Investment Account) on a consolidated basis when reviewing my asset mix, and have modified my RRSP contributions to keep my overall mix in check.

While I own all three of our equity funds, the Small-Cap Fund will likely produce the greatest capital gains over time, which is why I’m holding it in my TFSA. This strategy makes sense for me because I don’t intend to tap into my account in the short-term. The other fund that would be a good candidate for the plan is our Income Fund, as it generates a stable stream of income that would be sheltered from tax, but I hold a smaller proportion of this fund in my RRSP.

This strategy may not be suitable for everyone, but it works well for my situation. If you’re grappling with a strategy of your own, give us a call. We’re happy to be a sounding board.

The manager of our fixed income funds (Connor, Clark & Lunn) prepares a Financial Markets Forecast every year that addresses the outlook for the economy, inflation, monetary policy, market valuations and extreme technical conditions in order to set the framework for their portfolio strategy.

The Forecast is a tool that CC&L uses to help guide their thinking. They make it clear that no prognostication will be totally accurate. In fact, CC&L are sure to be wrong in certain aspects of their outlook and stand prepared to adjust their thinking as circumstances change.

I found their commentary on the U.S. housing market particularly interesting. CC&L reports that the market is still a mess, with home sales, building permits, new starts and a heightened level of foreclosures all pointing to a sector of the economy that is still in deep trouble. A scary stat – 25% of all U.S. homeowners (15 million) have negative equity in their homes (i.e., the value of their mortgage exceeds the value of their house). Yikes! To make matters worse, mortgage rates have started to rise (up 0.7% over recent lows) and are forecast to move higher throughout the year.

On the brighter side, the manager notes that housing starts are only averaging half the level required to keep up with population growth, affordability is the best it has been in 30 years, mortgage servicing costs are attractive, and the price-to-rent ratio suggests that owning is preferable over renting.

All said, CC&L expects the U.S. housing market to decline modestly in 2011. This is not to suggest that investors should steer clear of the U.S. stock market, however. CC&L points out that the consumer is slowly making a comeback, the outlook for corporate profits remains good, corporate America is sitting on piles of cash and stock valuations are attractive relative to historical levels.

There’s no denying the mess in the American housing market. Some value hunters would argue, however, that there’s no sector more ripe for the picking. From where I’m sitting in Vancouver, it's hard not to agree. A ‘starter home’ (read: tear-down) on a standard size lot in the west side of the city is regularly fetching $1.2 million (typically with multiple offers). That would buy a whole block in most parts of Arizona. Something seems out of line. For investors with a healthy tolerance for risk, a long time horizon and a good pair of boots, this may be a mess worth getting a little dirty in.

Assessing your portfolio’s performance is a key element of being a successful investor. Yet, it’s also one of the ‘muddiest’ and more overlooked areas of investing. That’s because a proper performance assessment takes time and is hard to do. Also, the wealth management industry doesn’t help matters by providing account statements that are often difficult to read and don’t provide relevant information on performance and fees.

At Steadyhand, we want to change this. By providing a common-sense framework for assessing investment performance, we feel that investors will be better able to make sound decisions and in turn, achieve their investment objectives.

Tom Bradley is passionate about the issue (some of my colleagues would argue that obsessed is the more appropriate word) and has worked hard over the past few months in preparing a practical approach to assessing investment returns. It takes into account the limited time and resources most investors have.

The end product is a paper titled How is My Portfolio Doing … And What Should I do About it. We have also prepared a supplementary report that uses the framework to assess the performance of the Steadyhand Balanced Income Portfolio, which is a hypothetical model portfolio used by a large number of our clients. Both reports are available in the Library section of our website, or you can download them by clicking the links below.

How is My Portfolio Doing ... And What Should I do About It?

Steadyhand Balanced Income Portfolio: A Performance Assessment

Howard Marks of Oaktree Capital Management is one of my favourite market analysts. In a letter published last Friday, he takes on the topic of gold. It’s a wonderful piece and a must read for anyone who is interested in the shiny metal.

There are too many pearls to highlight in this post, but I thought the following passage was an excellent summary of the arguments for and against owning gold.

I have no doubt: gold is the ideal investment. It serves as a reliable store of value, especially in challenging and uncertain times. It’s a hedge against inflation, since its price rises in sympathy with the general level of prices. It exists without the involvement of man-made constructs such as governments. And it’s desired and accepted all around the world (and always has been).

The supply of gold is finite. It can’t be created out of thin air. Thus it’s not subject to dilution or debasement, as is paper currency when governments decide to print more. In comparison, currency can be similarly reliable only if backed by gold.

Finally, gold is tangible, meaning you can take delivery and store it. Most other investment media exist only in the form of figures on a computer screen. But gold is something you can actually hold and know you own. Thus it’s one of the few things you can depend on in an uncertain world. Gold is perfect.

Except, of course, gold is nothing but a shiny metal. Since its real-world applications are limited to jewelry and electronics, very little of its value comes from actual usefulness. Further, the amount put to those uses each year is small compared to the total amount in existence, so its value for those purposes is at the margin and can’t be of much help in putting a price on the world's gold reserves.

There’s little intrinsic to gold that enables it to serve as a store of value and a hedge against inflation. Gold serves those purposes only because people impute to it the ability to do so. It’s self-deception, nothing but the object of mass hysteria like that exhibited in “The Emperor’s New Clothes.” Gold has no financial value other than that which people accord it, and thus it should have no role in a serious investment program. Of this I’m certain.

Our funds paid out their distributions to unitholders yesterday. As a reminder, distributions represent the mechanism whereby the funds transfer to unitholders any interest and dividend income and realized capital gains they accrued over the year.

The Income Fund paid a larger than normal year-end distribution of $0.53/unit, much of which consists of capital gains. This is because the equity and corporate bond components of the portfolio have performed particularly well over the past several quarters and the manager adjusted a few holdings and booked some profits in the year.

The fund’s distribution is equivalent to roughly 5% of its unit price, and the amount that each unitholder received is added to the adjusted cost base of their investment. This can be confusing to investors, as it may appear as if the amount they have contributed to the fund is higher than their actual purchase(s). It can also lead to inaccurate performance calculations if investors assume that their gain (or loss) in the fund is the difference between the market value and adjusted cost base of their holding.

Consider the following example:

Steve purchased $1,000 of the Income Fund on October 1st at a price of $10.6968. He received 93.4859 units ($1,000/$10.6968).

• On December 16th, the fund paid a distribution of $0.5326/unit. Steve received a distribution of $49.79 (93.4859 x $0.5326). This amount is added to his adjusted cost base, which is now $1,049.79.
  
• The pre-distribution price of the fund at the time was $10.6684. The market value of Steve’s investment was $997.34.
  
• After the distribution, the price of the fund dropped to $10.1358, but Steve received an additional 4.9123 units ([$0.5326/$10.1358] x 93.4859). The value of his investment remained the same at $997.34. (93.4859 units + 4.9123 units = 98.3982 units x $10.1358 = $997.34)

The value of Steve’s investment has fallen -0.3% since his purchase. However, if he were to calculate his performance using his adjusted cost base, it would appear as if his investment is down -5.0%.

The takeaway: distributions can meaningfully increase an investment’s adjusted cost base, and this figure should not be used in performance calculations. If you have any questions on the topic, feel free to give us a call at 1-888-888-3147.

My posting last week (A Simple Risk Management Tool to Avoid the Next Bubble) garnered lots of comment. In one of the kinder emails, a reader asked what weaker performing assets I would consider to be an attractive balance to the current high flyers. I gave him a few ideas:

• High-quality foreign stocks – Slow-growing, global franchises with good yields and reasonable valuations.
• Japan – The ultimate underperformers – slow or no-growing, global franchises that are becoming more investor friendly and seriously penetrating the rest of Asia.
• Canada's fallen angels – A package of solid companies that have stumbled - names like RIM, Shoppers Drug Mart, Ritchie Bros, Manulife and Royal Bank.
• Natural gas – Perhaps baby steps at this point.
• Arizona real estate – Was just there … very reasonably priced.
• Cash – Some dry powder when opportunities become more plentiful.

Markets have been riding high lately and the ‘New Low’ list has been sparse, but there are still stocks available that haven’t gone up and represent excellent value.

At the risk of repeating myself, I’m not suggesting that investors should never buy assets that have done well in recent years, but … if that’s all they’re buying, then they’re setting themselves up for disappointment.

To quote Howard Marks of Oaktree Capital Management:

“It has been demonstrated time and time again that no asset is so good that it can’t become a bad investment if bought at too high a price. And there are few assets so bad that they can’t be a good investment when bought cheap enough.”

Last week a friend asked me what his daughter should do with her mortgage. The bank was giving her the option of going with a variable rate mortgage at 2.85% or a 5-year fixed at 3.5%.

Investment professionals get asked this question all the time by friends and family. I’ve come to learn that the askers have way more interest in this topic than anything I could ever tell them about our funds or their portfolio. This is ‘food on the table’ stuff.

So how did this investment professional answer the question?

With regard to the lower variable rate, there is no free lunch here. Research reveals that going variable saves money over the long run (Note: 30 years of declining rates has a huge influence on the numbers), but it comes with the risk that monthly payments will go through the roof if rates rise significantly. A borrower should only go the variable route if she/he has the resources and stomach to absorb a big increase for an extended period of time.

As for the fixed rate mortgage, we have to keep in mind that 3.5% for 5 years is an UNBELIEVABLE rate. Yikes! Knowing you’re going to have low monthly interest payments until 2015 sounds pretty good. We shouldn’t forget that we’re living in an artificially low rate environment right now. It won’t always be like this.

As an investor, I’m always comparing reward versus risk. There is a good chance that a variable rate mortgage will win over the next 5 years, but the potential risk is substantial. It seems to me the borrower has a chance of winning small or losing big. Go fixed.

(Note: With regard to the numbers, I’m simplifying grossly here. Rates and conditions are different in each situation. And I’m told that variable mortgages are available at lower rates.)

David and I have been doing presentations over the last few weeks and we’ve talked about the notion of a ‘steady hand’. The company name came from the belief that for all the good things we can do for clients (good managers, well designed portfolios, fair fees, appropriate service), the most important one is providing a steady hand. We need to help clients stay on track with their long-term plan, keep cool when markets are overheated and take action when markets are weak. And importantly, not flinch when they need us.

Investing is not rocket science, but emotions and peer pressure sometimes get in the way of making sound decisions. Indeed, the psychology of investing is the hardest part. Most of the time, investing is pretty mundane, but at market extremes, it’s anything but.

In James Montier’s book, ‘Value Investing – Tools and Techniques for Intelligent Investment’, he talks about the empathy gap. “When we are in a cold, rational frame of mind we say we will behave in one fashion; when we are smack bang in the middle of a situation with our blood pumping, our previous plans are thrown out of the window.” Mr. Montier suggests that, “we aren’t good at predicting how we will feel in the future.”

So, I ask you the same question we asked our audiences. Who is your steady hand? Is it you? If not, is it your partner? Your Mom? Your investment manager or advisor?

You should know who or where the steadiness is going to come from when you’ve been shaking all night.

(Note: thanks to John DeGoey for the Hip quote.)

Through the market’s ups and downs over the last few years, one area of stability has been dividends (for investors in Canadian stocks at least). With few exceptions, companies have maintained or increased their dividend payouts, providing investors with a steady stream of income. In fact, the income currently generated from a portfolio of dividend-paying stocks is often higher, and more tax-efficient, than what can be generated by holding government bonds – a rare occurrence by historical measures.

With the increasing focus on these securities, we have fielded a number of questions from investors over the last few months. What are the dividend yields of your funds? How much income do the funds generate? What happens with the dividends that the funds receive? Are they automatically re-invested in the same stock? How are they distributed to investors?

Dividend-paying stocks have always been an important component of our equity funds. While our managers do not invest exclusively in these securities, these equities typically comprise a large portion of our funds, given the attractive cash generating characteristics and strong balance sheets of many dividend-paying companies.

For reference, our Equity Fund holds 25 stocks, 22 of which pay a dividend. Our Global Equity Fund holds 38 stocks, 34 of which pay a dividend, and our Small-Cap Equity Fund holds 17 stocks, with 9 that pay a dividend. The equity portion of our Income Fund is comprised entirely of dividend-paying securities.

The dividend yields (pre-fee) of our funds are as follows (as of August 31):

• Equity Fund – 2.2%
  
• Global Equity Fund – 2.9%
  
• Small-Cap Equity Fund – 3.3%

The Equity Fund’s 2.2% yield means that for every $100,000 in assets, the fund receives $2,200 in dividend income on an annual basis. While investors do not “see” this income, it forms part of the fund’s working capital (net assets). The manager typically uses the income to purchase additional shares in existing holdings, but they may also add it to the fund’s cash reserve if they are not finding good value. In essence, this income serves as a source of capital that the manager can put to work (on behalf of unitholders) as they see fit.

The dividend income that the portfolio receives is reported to investors at the end of the year on a T3 slip and is attributed to unitholders in the fund’s annual distribution. As with all forms of income, dividends are taxable (if they are held in non-registered accounts). Note, however, that some of this income may be used to offset the fund’s operating expenses. If this is the case, the distribution and tax liability are reduced accordingly.

Investors and portfolio managers have been frustrated with stocks over the past few years. But those who own dividend-paying stocks and are tolerant enough to see their investment thesis play out are being paid for their patience. As Tom Petty put it, “the waiting is the hardest part.”

We continue to be barraged with negative news. Even the most positive economists are projecting slow growth for the next few years, and the bearish ones, whose names all seem to start with ‘R’, send chills down my spine. One sentence in Connor, Clark & Lunn’s September Outlook pretty much captures the concerns.

“Consumer, business and investor confidence are poor, retail sales are sluggish, credit formation is weak, unemployment rates continue to rise, house sales and prices are falling again, the system is choking on debt and the majority of leading indicators have rolled over and are heading down at an alarming rate.”

Yikes.

In this context, we continue to counsel caution, but we’re not recommending our clients stray too far from their long-term asset mix. I say that because there are some offsetting positive factors that don’t get much press. Rather than wallow in the gloom, we need to keep some perspective. Consider the following:

• Price/Earnings multiples are low. There are plenty of high-quality, well-financed companies trading at 12 times earnings, or less. This compares to U.S. treasuries that carry a multiple of 40 times. As CCL calculates it, the Equity Risk Premium, which factors in interest rates, credit spreads and economic growth, is at its highest reading ever (i.e. good for making money).
• Corporate balance sheets are strong. Indeed, they’re stronger than all but a few countries. This means corporations have money to spend on capital assets and acquisitions. If we do get a pickup in mergers and acquisitions activity, the stock market will love it.
• Negative sentiment usually presages a major investment opportunity. Today equity mutual funds are in redemption and investors are asking why they own stocks at all. Indeed, in recent weeks, there have been a number of articles on “The End of the Equity Cult”. In his July 19th letter, Howard Mark of Oaktree Capital Management phrased it well. He said, “Markets are safer when fear balances greed, and when worry about losing money balances worry about missing opportunity.” We needn’t worry about greed right now and all the worry is focused on losing money.

In my meetings with industry veterans over the last month, the themes have been consistent. Why would I buy bonds yielding less than 3%? Equity returns are going to be modest over the next 5-10 years (because of subdued economic growth). And there are some really good companies trading at low valuations, particularly in the U.S. and Europe.

It doesn’t necessarily add up – low rates and low stock valuations don’t usually go together, nor do cheap stocks and subdued market expectations – but not to worry. What it really means is that there’s opportunity out there and we need to start culling through the negatives to find the positives. I say that not to cheer myself up, but rather to make sure we bring some balance to the discourse.

It was reported this week that millionaires are feeling more bearish. The Spectrem Millionaire Investor Confidence Index fell to -18, which represents “mildly bearish territory”. Prior to the August score, the index had been in neutral range (-10 to +10) for 12 straight months. In response to the number, Spectrem president George Walper said the “decline is particularly troubling since it suggests millionaires, typically more sophisticated than the broader affluent population, are reverting to a bearish frame of mind.”

As readers of this blog know, I learned from Art Phillips to watch market sentiment very carefully. When everyone is bullish, it’s generally a time to be careful. And when everyone is running for the hills, it’s time to pull out the buy tickets. Sentiment is not an exact timing tool, but rather a check against what the fundamentals and valuations are indicating.

I’m not familiar with the Millionaire Index, but it confirms what I’m hearing from clients and people I’ve been meeting with in Toronto over the last few weeks. The sentiment among investors is generally cautious, and at times downright gloomy. One senior portfolio manager went so far as to say that he thought the investor mood is worse now than it was after the market declines of 2008.

I’m not reading too much into the Millionaire Index or individual comments from the street, but I certainly differ from Mr. Walper in my interpretation. When investors – rich, poor, professional or amateur – are wary of the market, it’s a good thing for future returns. The more bearish the better.

RRSP Nightmare: Too Many Funds in Your Basket
Originally published in The Globe and Mail on February 9, 2007
By Tom Bradley

We were driving to Whistler last weekend and out of the blue my wife Lori said “it's RSP season and you still haven't written that column”. It took me a minute to clue in, but what she was referring to was a piece she wanted me to write about a Financial Facelift column we'd seen last summer in the Globe and Mail (August 12th).

Lori got really worked up about this particular column because she just couldn't believe that someone could get themselves into the situation the Canmore couple found themselves in. The featured couple had registered retirement savings plans totaling $170,000 that were spread across 29 mutual funds. “Twenty-nine funds. How does that happen? What were they thinking? Where was their advisor through all of this? Tom, when are you going to do a column about this?”

Because I didn't have any other brilliant ideas for a column this week and do value my marriage, I thought I'd give it a go.

Holding 29 funds is ridiculous whether you're investing $170,000 or a million dollars. It demonstrates that you don't have a financial plan. There's no focus and certainly no commitment to the funds you own. If you're not willing to add money to a core group of funds (5-10), then why do you own them?

Owning this many funds also makes it difficult to figure out what your asset mix is. It becomes a major project every time you want to figure out whether you're still on plan.

But more than anything, owning 29 mutual funds means you're seriously overdiversified. A little math would be useful here. Let's assume that 20 of the 29 funds are equity funds and on average these funds own 60 stocks. We have to assume that there are lots of stocks that are owned by more than one fund. In the case of Canadian equity funds, the overlap may be as high as 60-70% between some funds. Indeed, it is conceivable that you own Royal Bank or Manulife in 10 to 15 funds.

If we assume that there were 45 unique stocks per fund, that's 900 stocks plus the ones that showed up in multiple funds. Let's say you own 1000 stocks. What you really own is a very expensive index fund.

Through exchange-traded funds (ETFs) you could get the same market exposure for an average fee of 0.25 to 0.30 per cent a year on their management expense ratios. I hazard a guess that the couple in the article were paying in the neighbourhood of 2.5 per cent. It is no wonder they were disappointed with their mutual fund returns.

How does this happen? I don't really know, but I imagine it is a combination of things.

Each RRSP season has its own themes. While foreign funds are the dominant sellers one year, it could be tech funds the next and clone, income trust or lifecycle funds in other years. If you are prone to chasing past performance and your advisor is inclined to take the easy road (that is, give you the current best seller), you could easily add two to five new funds a year.

Where was the advisor through all of this? Clearly, he or she never said, “XYZ fund has been out of favour for a while and I think you should put more money in it this year. Think of it as being on sale.” While the Canmore couple continued to add funds, they weren't willing to sell any on the other side because of the redemption fees they would incur.

In general, I believe that patient, long-term investors don't need a lot of advice. It is more important that you keep your costs down. Occasional advice and low fees is a great combination. Having said that, I recognize that some people are in need of more help and that costs money. Unfortunately, this couple was getting the worst of both worlds. They were paying for advice they desperately needed, but they weren't getting it.

The Financial Facelift article that got Lori so worked up is obviously an extreme case, but overdiversification is definitely an issue for many mutual fund investors. In actual fact, holding even half the number of funds this couple owned could still result in an overdiversified portfolio, depending on what kind of funds they were.

If you haven't made a contribution to your RRSP for 2006, or even better, are contemplating what to do for 2007, I'd look first at the funds listed on your quarterly statement. If there was a good reason to buy a fund in the first place and those reasons haven't changed, then you might ignore the “flavours of the month” and show commitment to what you already hold.

And if the one you choose hasn't been doing well in the last year or two, all the better.

‘It Will Sell’: A Tipoff for Bad Investment Products
Originally published in The Globe and Mail on April 4, 2009
By Tom Bradley

As the wealth management industry works through this bear market, investment products that promise certainty and limited downside risk are going to be popular. With guaranteed investment certificates (GICs) offering minuscule yields, stock-market-related products with “guaranteed income” and “principal-protection” will be big sellers.

I think that's unfortunate for two reasons. First, we're now in a favourable environment to take more risk, not less. And second, investors give up a lot of return for the fancy features they're buying. Such things as downside protection, tax deferral or arbitrage and convenience come with a price.

My purpose here is to illuminate some of the tradeoffs investors make when they go beyond plain vanilla.

But first some background. I developed an aversion to complex investment products and packaging about 10 years ago. I was at Phillips, Hager & North at the time and we had a number of investment bankers come through our offices pitching us on their newest creations. They wanted to work with us because we had a good brand name that would lend credibility to the products. At the sessions I attended, I always asked the same question: “Is this good for the client?” I never once was told that it was. There was some diverting of eye contact, hemming and hawing, and on a couple of occasions, the answer was simply: “It will sell.”

We once committed to working with one of the banks on a product that saved high-tech executives taxes when they exercised their stock options. We thought it looked like a reasonable idea, but as we got further into it, we became increasingly uncomfortable. We calculated that the executives could achieve higher after-tax returns without a complicated structure. Fortunately, we were able to escape our commitment honourably when the high-tech bubble burst.

From that point on, I've done research (sometimes vicariously through much smarter colleagues) on many new packaged products and rarely have I come up with a different answer to my question. What I got was a notebook full of issues.

Lack of transparency: We should always understand the basics of what they're investing in, even when an adviser is involved. But products like principal-protected notes (PPNs) and guaranteed income funds are complicated and hard to figure out. Too often investors don't know how they work, what the underlying assets are and how much they're paying.

Misalignment of objectives: A lack of understanding often leads to investors buying products that are ill-suited to their needs. For example, a 40-year-old with a 30-year investment horizon shouldn't be buying short-term stability or principal protection, no matter how appealing it sounds. A bumpy 8 per cent return is what she/he needs, not a smooth 4 per cent.

The marketing imperative: My undergrad degree was in marketing, but when it comes to product design, that area of business should play a secondary role. Sales and marketing departments want things that will sell, which means looking in the rear-view mirror. The easiest sale is whatever worked last year (I recently saw an ad for a “bear-resistant” fund). In general, marketing-driven products encourage investors to “buy high.”

Overdiversification: “One-solution” products, including some wrap funds, are convenient, but tend to be too diversified. By having multiple managers in each asset category, the product (I'm reticent to call it a portfolio) owns hundreds or thousands of stocks. Effectively, it's an index fund with an annual fee that's two percentage points higher than it should be.

Complexity risk: In many packaged products, there are so many moving parts that it's difficult to determine what risks are being taken. That complexity sometimes results in outcomes that were unforeseen by bankers and advisers (liquidity drying up; the worst bear market in 80 years; global bank failures). Other times, however, the risks have been identified, but not communicated. The creators of PPNs (the type known as Constant Proportion Participation Insurance) have always known that their notes were path dependent (i.e. if the underlying asset goes too far down in value before it goes up, eliminating any chance of a positive return). That potential outcome is never openly discussed with potential buyers, even though it reduces the value of the note.

Degrees of separation: It's best if money managers live and die with the performance of their funds. Managers should be invested alongside clients. With packaged products, that accountability gets diluted with every person that gets between the client and the portfolio of stocks and bonds.

Cost: And with every degree of separation comes more fees. When investment bankers, lawyers, traders, money managers, insurers, marketers and salespeople get involved, they need to be paid. As a result, structured products are expensive.

Who's insuring who?: There is a common misconception about fancy investment products. Too often buyers believe that someone else is paying for the insurance and guarantees. Wrong. There is no new source of return being invented. Additional costs come directly out of what is earned by the underlying stocks and bonds.

There are other issues scribbled down in my notebook – poor liquidity, misunderstood by advisers, bad names – but I'll stop there.

I liken structured products to Viagra. The industry is hooked on them because they stimulate sales. They're a specialty product that should be used by few, but are sold to many. And the buyers get instant gratification, but pay for it in the long run.

Interestingly enough, the Canadian dollar today is worth almost the same value against the U.S. dollar and the euro as it was at the time of our posting (see graph).

Looney Predictions
Originally posted on September 21, 2007
By Scott Ronalds

With the loonie hitting parity with the U.S. dollar for the first time in over 30 years, the forecasters are once again coming out of the woodwork with predictions on the future direction of the currency. Some are patting themselves on the back for correctly calling the loonie’s rapid ascent, while others are back-peddling on prior forecasts and coming out with fresh revisions.

The bullish camp points to strong fundamentals driving the currency higher over the short-term: high oil prices (the loonie is viewed by many as a petro-currency, with its fortunes tied closely to the price of oil), continued demand for commodities, low unemployment, etc. While the bearish camp points to an oversold U.S. dollar, a slowdown in global growth, and a probable cut in interest rates by the Bank of Canada as key reasons why the loonie is likely to lose steam.

So which camp are we supposed to believe? How about neither. Short-term currency movements are really anyone’s guess and are next to impossible to predict. If the loonie is closely tied to the price of oil, where is oil going? Who’s to say that it won’t fall to $50/barrel? Or rise to $100/barrel? If its path depends on the strength of the domestic economy and the interest rate environment, will Canada steam ahead or pull back? You get the picture. There’s too many variables at play. Not to mention that movement in the loonie isn’t entirely correlated to these variables anyways.

If you can’t sleep at night because the loonie’s rise is killing your foreign equity returns, you can consider hedging away some or all of your foreign currency exposure (although it may not be the best time to do so, given the substantial short-term appreciation that you’ve already absorbed). A better solution is to ignore the headlines and accept that currency movements are too unpredictable to gamble on, and tend to balance themselves out over the long term. And while it certainly hasn’t benefited Canadian investors lately, foreign currency exposure actually provides a layer of diversification to your portfolio and can boost your returns. Remember the 1990s?

We all like to have fun with predictions (don’t kid yourself, even the big addresses on Bay Street have 'friendly' pools on where the loonie will close at the end of the year), but it’s not so fun when you jeopardize your portfolio by acting on them and making the wrong call on something that’s entirely out of your control (read currency movements).

That said, I couldn’t end this posting without a prediction of my own, all in good fun of course. So here goes: Seahawks 27 – Bengals 21. Now you can take that to the bank.

The Increasing Complexity – and Masked Risks – of Wealth Management
Originally published in the Globe and Mail on April 19, 2008
By Tom Bradley

Purdy, what were you thinking? Didn't you know how complex and convoluted investment products have become? Didn't you know this would become a hornet's nest with many different interests at play and the big financial institutions playing multiple roles?

If only you'd extended your summer in Nova Scotia a week longer and missed the call. Or better yet, listened to your wife.

When Mr. Crawford's committee to sort out the asset-backed commercial paper mess stopped in Vancouver a couple of weeks ago, I went to watch the proceedings. I am lucky enough to not own any of the combustible paper, but was curious to see how the process was playing out.

Very early in the proceedings, Mr. Crawford revealed that he wouldn't have taken the assignment had he known what he was getting into. What it involves is a classic example of how the investment industry has gone overboard inventing new and often inferior ways to sell the same thing - stocks and bonds. We have become intoxicated with our own genius and the marketing hooks that go along with it.

ABCPs are a symbol of how complicated investment products have become. At the Vancouver meeting, we learned that these short-term notes were backed by securitized loans (ranging from autos to immigrant loans), leveraged super senior structures, unleveraged synthetic CDOs, and U.S. residential mortgages. And the restructuring plan adds a few new elements to the mix - master asset vehicles, senior and junior notes, a margin funding facility and, well, don't ask.

Very few people at the meeting could have understood what was said. I've been around a while and I was hard pressed to keep up. This despite the fact that the presenters did their best to methodically take us through what the products are, how they blew up and what the restructuring plan is.

Over the course of Mr. Crawford's esteemed legal and business career, the wealth management industry has come a long way, most of it good. A few decades ago, it was pretty simple. The investor paid a broker to purchase a long-term security for his portfolio - a stock or bond. Commissions were high, but the investor got access to the interest, dividends and capital appreciation without incurring continuing fees.

As we move away from that basic model, each new feature or level of complexity increases trading, legal and administration costs. Investment banking, money management and trailer fees come into the mix. And in some cases there are performance bonuses and additional costs related to currency hedging and principal protection.

That's a lot to put into a package like an ABCP, particularly with low single-digit yields on government T-bills. By the time everyone has been paid, there isn't enough extra return in the product to justify the additional risks that are being taken.

For longer-term products with greater return potential, some of these costs are totally justified. If you want to hire someone who can beat the market, you have to pay a higher management fee, and perhaps a performance fee. Certainly increased trading is done in the hope of adding value.

But the other complexity costs (structural and marketing) erode the attractiveness of a product. They result in investors getting a smaller portion of the additional return, even though they are taking all the extra risk. The investment professionals involved receive the lion's share of the premium (as was the case with ABCPs), but shoulder none of the risk.

Consider a fictitious example. The hot new product for spring - Super Secure Dividend Enhanced XYZP - holds securities that will generate a yield 1 per cent higher than a GIC issued by one of the big banks. This is done by backing the XYZP with a package of higher risk investments (including loans to Third World fish farmers). The cost of bringing this product to market, however, is 0.75 per cent, so the investor is receiving an extra 0.25 per cent return for incurring 1 per cent worth of additional risk.

If the fishing is good and the XYZP doesn't run into difficulty, there is a modestly higher return for the investor. Everyone is happy. If it's good for a long time, the sellers and buyers forget that there is any risk being taken at all.

Despite what you might think, I'm not a troglodyte. I'm not adverse to using advanced methods or hiring someone to do them for me. And I like a marketing hook as much as the next executive, maybe even more.

But in any investment structure, the majority of the extra return, if there is any, belongs to the buyer who is taking the risk.

In too many products today, this is not the case. The current generation of structured products have little or no transparency and, as a result, they mask the risks being taken and how the potential rewards are being apportioned.

As Mr. Crawford's lapse in judgment reminds us, if you don't understand what you're getting into, don't buy it.

Irrational Nervousness = Fertile Soil
Published May 1, 2008

The managers of our funds report to us formally once every quarter.  In the Income Fund report from Connor, Clark & Lunn, there was a chart that is a great indication of what the capital markets are going through.

It shows the extra yield an investor receives from owning a Canadian agency bond (i.e. Farm Credit Corp) compared to a conventional Government of Canada bond.  While these bonds are explicitly guaranteed by the Federal Government, they typically trade at a higher yield – approximately 10 basis points (bps) or a tenth of 1% - because they are not as liquid as Canada bonds.  Big investment managers who are moving a lot of money around prefer to use the more tradable Canada’s.

But as you can see, the nervousness in the markets has led to the spread widening to over 50 bps.  This to me is a huge indication of how nervous investors are.  I may not think it’s rational that TD Bank bonds trade at 150-200 bps above Canada’s (I don’t), but without knowing what’s going to happen in the banking sector, a spread of that size may be warranted.  With agency bonds, however, there is no credit risk.  No credit analysis can justify the current spread.  It’s just plain irrational nervousness.

Our Income Fund is more than 50% invested in corporate bonds at this stage.  CC&L feels very strongly that we’ve been given a once in 10 or 20 year opportunity to buy good quality corporates.  Undoubtedly not all of their selections will work out as they hope, but the agency spread chart tells me they are planting seeds in very fertile ground.

I’ve had a bias to owning higher quality companies since 2007. In a challenging economy with unpredictable credit markets, it seemed reasonable to pay a premium for stable profits, excess cash flow and strong balance sheets. I knew the companies would survive, and possibly thrive, in a tough business environment.

Buying the best sounds like a good strategy, but it can lead to poor returns if you’re not attentive to industry dynamics and stock valuations. We learned that in the 1970s when investors paid fancy prices for leading U.S. stocks known as the “Nifty Fifty” and were disappointed.

Most of my quality favourites continue to deliver profits and are in a better competitive position today than they were three years ago, but a number of them have seen their stock prices lag behind the market. Instead of being stars, stocks like Research In Motion, Ritchie Bros. Auctioneers, Shoppers Drug Mart and Rogers Communications just keep getting cheaper.

The question is, am I holding great companies at bargain prices, or getting caught in a value trap?

If it’s the former and the stocks are screaming “buys,” then it will be because of a double whammy. Earnings will turn out to be better than forecast and sentiment toward the companies will get less negative. The result is nirvana – a better valuation on better-than-expected earnings.

If, on the other hand, they’re value traps, we’ll keep waiting for good stuff to happen, but it never will. Growth will be slower than expected, or negative, and repeated efforts to turn things around will fail to pan out. Meanwhile, the stocks’ valuation metrics – price to book value, earnings and cash flow – will keep getting cheaper.

With the benefit of hindsight, it’s possible to identify some general themes that run through every value trap. There is usually a major trend that turns against the company. The product is being made or delivered in a different way, or customers are looking for something new. The change is secular in nature, as opposed to cyclical, and may bring new competition with it.

Established firms are unable to adapt to the new paradigm because their assets and competitive strengths lie in other areas. In some cases, management is unwilling to adapt. They’ve been successful with their old model and are reluctant to give it up. They don’t want to absorb the profit hit that a major shift will cause.

Of the names mentioned above, RIM is the one being most vigorously debated in Canada’s money management circles today. Only a few months ago it would have been inconceivable to mention RIM and “value trap” in the same sentence, but at a conference I attended recently, a panel of fund managers discussed just that topic.

This is the RIM that’s a world leader in the fastest-growing segment of mobile communications – smart phones. The maker of the iconic BlackBerry, which has a clear advantage in e-mail and texting, and is the most efficient user of bandwidth. The firm that’s done a masterful job of working with wireless carriers and corporate IT departments to dominate the business market. And yes, the same RIM that saw revenue grow 24 per cent last quarter, profit increase 41 per cent and cash on the balance sheet tick above $3-billion (net of debt).

So why is the stock down 40 per cent from its 12-month high and trading at less than 10 times earnings?

There are many reasons of course. The stock market has been skittish and hyper-sensitive to any hint of bad news. RIM is facing off against two of the most powerful forces in the world, namely Apple and Google. But the main issue is that the competitive landscape has changed. After being the technological leader throughout the smart phone revolution, RIM now finds itself playing catch-up. E-mail got the company to where it is today, but the new battlefield is Web access. The iPhone, and various devices based on Google’s Android software, have better browsers and a more appealing array of applications.

In high-tech, where a company’s assets are people and patents, it’s hard to catch up after there’s been a severe change of direction. Redesigning operating systems and rewriting major software takes time. Meanwhile, the competition keeps moving forward. Technology is a sector that value investors usually steer clear of, even if valuations look compelling.

If RIM’s next generation Web-browser is as good as management says it is, and proves to be less of a bandwidth hog than the Apple products, then the stock will make up a lot of ground. If the new version doesn’t get the BlackBerry back in the race, then the bears will be justified in using the words “value trap.”

The smart phone market is going through a jolting change, but I’m not willing to give up on RIM yet. Management has its head up and their team has the right skill set. And importantly, I’m not paying much to wait and see if they’re up to the task. But ah, that’s how we get sucked into value traps.

Who doesn’t love summer? Sunshine, BBQs, lounging, water sports...it’s all good. And then of course, there’s the other summer ritual – reruns. We thought we’d build on the tradition by re-publishing a blog each week from the Steadyhand archives.

For our first posting, we’re digging up a classic from the spring of 2009 where Tom suggests that we have to be careful going too far in declaring that ‘the world has changed’.

The World Has Changed
April 15, 2009

More and more commentators and experts are acknowledging that the world has changed. The framework for the future that Pimco’s Bill Gross laid out recently – namely de-levering, de-globalization and re-regulation – encapsulates what I’m reading every day, as does his resulting caution.

I guess it’s my contrarian blood, but I do think we have to be careful going too far in declaring that the world has changed. As the pronouncements get bigger, more confident and extend further into the future, it is more likely they will be wrong.

No doubt, this downturn is a biggie. It’s the most severe one any of us have seen and will cause serious dislocation. And de-levering will take time. Steps have been taken to address the problems in the capital markets (margin calls made, hedge fund lending reduced, equity capital raised), but consumers have a long way to go to get their affairs in order and governments of course are going the wrong way.

But as the list of concerns expands and the conviction builds (which is a trend I’ve definitely noticed), it feels like we’re piling on. It’s easy to come up with more doom and gloom, but difficult and less topical to seek out the balancing items.

So here are my bold, confident predictions of what’s on the other side of the ‘world has changed’ ledger.

First, I can say without hesitation that not all of the grand pronouncements are going to come true.

Second, in the new world, we will be surprised at how big the gains will be for the strong, prudent players. Well-positioned countries, companies and individuals are going to move up the ladder, maybe a few rungs this time. We’ve focused on the weak so far, which is natural, but the strong will also prove to be a noteworthy feature of this cycle.

This recession will accelerate the shift of economic power to the developing world. Many emerging market countries are sporting a current account surplus and are better financed than in previous crises. I’m not suggesting that they’re ‘decoupled’ from the worldwide recession, but they may weather the storm better and come roaring out the other side. It could be a seminal moment for some of the Asian countries in particular. Canada has a chance to be in that category, although the determination of the Federal government to subsidize the past as opposed to invest in the future weakens our case.

With regard to companies we invest in, think about the opportunity that the Canadian banks now have in front of them. The environment for their basic banking services, both for retail and corporate customers (yes, they still do that), is fabulous. And with a few exceptions, their global competitors are reliant on government funding and unable to do acquisitions. Unless our big five experience further unexpected blowups, their world standing is on the rise.

Individuals with confidence, discipline and a job (importantly) stand to gain as well. Goods and services will be marked down in price and investment opportunities (stocks, real estate, and businesses) will be plentiful. It is a buyers’ market.

And finally, I remain confident that this will be a cycle like all others. The downside will be bad and may last a while, but the excesses will be purged and the next up cycle will occur. The longer and deeper we go, the more powerful the other side will be.

Stocks have halved in price and corporate bonds are trading at depression-like valuations. The markets are telling us the world has changed. But not everyone will be impacted the same way and not all of it will be bad. Indeed, good news and opportunity will become a bigger part of our changing world as we move forward from this point.

Located in Vancouver and being the sports (analogy) junkies that we are, readers would expect us to go crazy with Olympic stuff. Certainly there are obvious connections between Olympics and investing - the value of time; the notion of risk and reward (the topic of my last post); having the right equipment; and getting good help from coaches, mentors and technicians. I could go on, but the analogy that most resonates with me (always) is the unpredictability of investing and sport.

Manuel Osborne-Paradis was a gold medal hope for Canada in the downhill. He was one of the favourites and the spotlight was shining brightly on him. When Manny didn’t win, it was a huge disappointment, but hardly a surprise. The odds of the favourite winning in the downhill are pretty low (with the exception of the Franz Klammer days) given that many variables are at work while even the slightest errors are magnified greatly.

The spotlight often shines too brightly on the favourite athlete or trend while there’s lots going on in the shadows that can impact the outcome. It is often in those shadows that the opportunities lie.

Kristina Groves represents one of those other possibilities lurking in the shadows. She unexpectedly skated to a bronze in the 3000 meter speed skating race. It was not her favourite distance, so she wasn’t expected to medal, but she is one of the best in the world, was skating well coming into the games and was on home turf.

As investors, we too often get locked into a view or trend that influences everything we think and do. More than any other profession I know, success is not defined by where the consensus is pointing or what’s in the spotlight.

In the meantime, let’s go back to the spotlight where it now looks like the Men’s hockey team doesn’t have a chance. GO UNPREDICTABILITY GO!

Tom was on BNN this morning (Feb 8) with Marty Cej and Frances Horodelski. Topics of discussion included:

• What to do at this stage in the market
  
• How to reflect caution in your portfolio
  
• ETFs

The seven minute piece brings together some key messages from Tom’s recent Globe and Mail articles. And as an added bonus, he’s wearing a cool new Olympic tie.

You can watch the segment on BNN’s website by clicking here.

Call it an interesting juxtaposition. A few pages after my column on reaching for yield a couple of weeks back, there was a back page ad for the MINT Income Fund. Since then, the ad has been running constantly in the national papers.

MINT, which is an existing closed-end fund, is doing an exchange offer whereby investors can tender individual securities (stocks, trusts, preferreds and convertible debentures) in return for units in the fund. This is a common way for closed-end funds to grow their asset base.

MINT is an example of aggressively ‘reaching’. The fund is currently yielding an impressive 8.4%. It is primarily an equity fund, although it does hold some cash and convertible debentures. It is 60% invested in energy stocks, with the largest 13 holdings being oil and gas companies. Its distributions have varied widely over its 12-year history and its share price volatility has been reflective of a typical resource fund.

If an investor was to exchange a preferred share or convertible bond into the MINT fund, she would get a more diversified portfolio of income securities and a higher current yield to be sure, but she would also be subject to considerably more risk and volatility.

A fund like MINT reinforces the importance of understanding what a fund is made up of and where the yield is coming from. Its claim of being a “cost effective method of reducing the risk of investing in high income securities” is one that needs to be seriously questioned.

"The lower-hanging fruit is largely gone...but the return profiles are still attractive, relative to the extremely low cost of funding."

This innocuous quote from Peter Schoenfeld is very telling. In an article about the outlook for hedge fund strategies in 2010 in Barron’s magazine this weekend, Mr. Schoenfeld, who is the CEO of P. Schoenfeld Asset Management, and other managers make the point that the opportunities for super returns have all but disappeared. Valuations are more normal now compared to a year ago. Most asset managers I talk to, including our own, feel the same way.

The interesting part of the quote is the last eight words, “relative to the extremely low cost of funding.” The reason we are counseling clients towards caution right now is because asset values in the capital and real estate markets are being driven by artificially low interest rates. The prices on all types of securities are being pushed up by the lack of return from risk-free government bonds.

I don’t think valuations in the corporate bond and equity markets are unreasonable, but we nonetheless have to be careful doing our usual comparisons to government bond yields. There is nothing usual about those yields.

The discipline of writing 800-900 words for the Globe and Mail every two weeks means that stuff gets left on the cutting room floor. But as I’m learning, that’s usually where it belongs.

Having said that, I did want to add an addendum to my last installment about reaching for yield (Don't Let Your Search for Yield Blind You to Risk). A big part of the income product proliferation over the last few years has come in the form of funds or products that offer a set distribution rate, which is usually paid monthly. Every self-respecting institution now offers a monthly income fund and many offer a T-series version of their mutual funds (which have set distribution levels).

In some cases, the distribution rates are set to reflect the income level of the fund – interest and dividends minus management fees and expenses. But increasingly, the yield is based on the expected ‘total’ return of the fund (interest, dividends and long-term capital gains).

These funds can be a convenient way to receive a pay cheque when in retirement, but there are a few things to be aware of:

• Distributions are not guaranteed. If the income potential and outlook for the fund changes, the rate could be adjusted. Hopefully the long-term return exceeds the distribution rate, but if it doesn’t, one of two things will happen. Either the distributions will be cut or they’ll be paid out of capital...your capital.
• Death and taxes. There are tax features to some of these products. In certain scenarios there is a deferral or arbitrage benefit, but don’t kid yourself – a return of your capital is tax efficient because it’s your ‘after-tax’ money being returned to you.
• Balanced funds in disguise. These funds are essentially conservative balanced funds, so they will fluctuate in price along with their underlying securities. In a 3-4% interest rate world, it’s reasonable to expect long-term returns of 5-6%. In that context, a product with a distribution rate above 4% per year needs markets to go up and fees to be reasonable to avoid dipping into capital.
• No escaping path dependency. It’s important to know that no matter what the long-term returns turn out to be, it’s better when the fund zigs up before it zags down. When the zag comes first, securities have to be sold at reduced prices to fund the distributions and less capital is available to earn back the losses. If a market downturn lasts for a couple of years and distributions are maintained, then the fund may be seriously depleted by the time the recovery comes.
• Cash flow management on auto-pilot. Packaged income products definitely are convenient, but they don’t negate the fact that you still need to manage your cash flows – e.g. have some cash and short-term investments available to pay the bills when markets are down and you don’t want to sell your longer-term investments.

Essentially, packaged income products with set distributions are no different than making withdrawals from a balanced portfolio. In both cases, it means that the higher the promised yield, the more you have to understand the product. The higher the yield, the more ‘reaching’ being done. And the higher the yield, the more volatile they’ll be.

There was a table showing the trade and current account balances for all the countries and regions of the world. As expected, the U.S. current account was in a huge deficit ($542 billion annually or 3.1% of GDP), while China (+$364 or 6.1%), Germany (+$144 or 3.8%) and Saudi Arabia (+$134 or 1.4%) were the leaders on the plus side. But the number that stood out was Canada – a modest trade deficit of $1.3 billion and negative current account of $35 billion or 2.7% of GDP.

What’s with that? We are a trading nation. We have an educated population, stable political system and are endowed with an abundance of energy and resources. We are in the middle of a commodity boom and yet we can't keep our trade and current account balances in positive territory. What happens when the commodity cycle goes through a downturn?

I know there is an explanation for the short-term numbers - our strong economy keeps importing while our biggest export customer, the U.S., is down in the dumps; natural gas sales to the U.S. have slowed; and the auto industry is in the tank – but these numbers are appalling. Canada is doing a poor job of selling anything other than resources. And what export sales we do have are totally dependent on the U.S. We have been a laggard in penetrating the Asian and other developing nations (Go Blackberry go!).

Canada is on a roll right now and we’re feeling good about ourselves (which is long overdue). But when we pull back and look at the numbers, we should hold back on bragging too much. We have some work to do.

Maybe the hardest conversations we have today are with prospective investors who got out of equities in 2008 or early this year and did not get back in. What do they do now?

There is really just one answer to the question and then a bunch of execution issues.

The answer is: Make a plan to get your portfolio back to its long-term asset mix and get started.

A plan can take many forms, but in general it should lay out the timing and amounts for re-investment. For example, if you’re going to take a year to get back to a 50/50 mix of bonds and equities, then you might move 10% into equities today and another 10% at each quarter-end.

There are all kinds of factors that will shape what the plan looks like:

• The valuation in the market. We are currently advising caution with regard to asset mix (The Party is Rolling Again, so be Cautious), so we’re recommending clients move into the market at a slower pace than usual. Last year at this time when bond and stock valuations were particularly compelling, we encouraged clients to move faster.
  
• The risk tolerance you have with regard to the funds. Long-term retirement savings that need to earn a return well above inflation should be treated differently than a new inheritance that represents your mother’s life savings. In the case of the former, bolder steps are necessary.
  
• How far from the ideal mix you are. To go back to the earlier example, if you hold zero equities and your long-term asset mix is 50/50, then the early steps in the plan need to be more meaningful. The first step might get you half way there, with smaller increments to follow.

This is one of the toughest situations an investor can find themselves in. It’s gut wrenching and there’s no way to know what lies ahead (investors in this situation know that better than anyone). Which makes it all the more important that you methodically layout a plan as to how and when you are going to get back into the market.

A key part of executing the plan is acknowledging three things. First, this is about looking forward, not back. Second, you’re not seeking perfection. A plan that gradually works you back into the market will by definition be imperfect – the purchases will either be too early or late. Guaranteed. And third, what is the alternative. A week, month or year from now, there won’t be sirens going off telling you “now is the time”. And if there are sirens, they have a good chance of being wrong.

If your asset mix is far from where it needs to be, then it’s an imperative that you get a plan in place and start executing right away.

Interest rates have a profound effect on portfolio returns. The level of rates sets a base for on-going income and changes in rates affects security prices. As rates drop, bond prices rise and vice versa. The 25-year bull market for bonds and stocks that ended in 2007 was fueled by steadily declining interest rates.

Today, we are looking at quite a different scenario. Income generation is low and instead of the tail wind that most of us have experienced throughout our investment careers, we need to prepare for a head wind. Rates are at rock bottom levels and have nowhere to go but up.

As with The Hard Questions - Part I: The U.S. Dollar, I’m not here to take a stand on interest rates and inflation, but rather to address what steps investors can take to protect themselves in the event that rates rise. I lump inflation and rates together because they are inextricably linked. If government spending starts to push inflation up, investors will demand higher bond yields and rates will rise. If, on the other hand, high unemployment and excess capacity in the economy keep inflation pressures subdued, then rates may stay low for a while longer.

How do you protect your portfolio from rising rates?

• Stay short. Longer-term bonds are more sensitive to interest rate changes and will be impacted the most by rising rates. If the yield on a 10-year bond goes from 4% to 6%, the price would drop approximately 15%, while a 3-year would be down only 5-6% if rates rose to a similar extent. High-interest savings accounts and 1-3 year GICs provide good protection.
  
• Corporate bonds. Corporates are also impacted, but rising rates would likely mean that the economy is improving. So while the interest rate impact would hurt, the reduction of credit risk (default) would help to offset it.
  
• Real return bonds. There are some government bonds that are inflation protected. If the Consumer Price Index (CPI) rises, the capital value of the bond is adjusted accordingly.
  
• Companies with pricing power and growing dividends. It’s a bit of motherhood, but owning growing companies that are able to pass on price increases is a good thing. It provides some cushion against the reality that rising rates lower valuations on stocks by pushing yields up and price-earnings multiples down.
  
• Gold. The list wouldn’t be complete without gold. It has always been viewed as a hedge against inflation. It may be, although I find it difficult to determine what drives the gold price at any given time.

Clearly, there is no free lunch here. Owning short-term bonds is defensive, but their income is modest at the current time. A diversified portfolio of corporate bonds and equities (such as our Income Fund) is a good alternative, but it must be recognized that you are taking more risk and subjecting yourself to some short-term volatility. And RRBs provide peace of mind, but yields are modest here too and they are expensive - the purchase price is assuming future inflation of 2.5% while the CPI is currently closer to zero.

Investors need to keep inflation in mind, but to repeat what I said in the U.S. dollar post, you never know what’s going to happen for sure. You can protect yourself against rising interest rates, but you’ve got to balance it off against your long-term goals. Further, keep in mind that fund managers often have an interest rate/inflation strategy that is reflected in their portfolios and they may therefore be duly protecting you from the impact of rising rates. The manager of our Income Fund, for example, pursues an interest rate anticipation strategy when managing the bond portion of the portfolio.

As always, pursuing any of the strategies above should be done in the context of your long-term investment plan.

Chris, Sher and I were out meeting prospective clients last week and there were a few questions/concerns that came up over and over again. For the most part we have discussed them in the blog, but it struck me that we could be more direct in addressing them.

In this post, the U.S. dollar is the topic. There are many investors that want nothing to do with the U.S. The overwhelming consensus is that the empire is mismanaged, burdened with debt and in serious decline. It’s been a decade since anybody made money investing in the U.S. I agree with that assessment, but there are some things investors need to consider.

Like any security, there are two parts to the analysis of the U.S. – the fundamentals and the price. As noted above, the fundamentals don’t look good, but it’s never as one-sided as it seems. For instance, the U.S. government debt levels (debt, not deficit) aren’t as bad as some other countries (the UK and Japan to name two) and there are lots of potential areas for increased tax revenue – cigarettes, booze, gas and/or a value-added tax.

As for price, it would appear that the U.S. dollar already has many of the concerns factored in. The research I see indicates it’s already undervalued against most currencies. But I’m not writing to take a stand on the dollar.

If you want to protect against a lagging U.S. economy and weak dollar, here are some things you should think about:

• Even if you hate it, don’t eliminate it. You can never be sure, so you may want less U.S. exposure than your long-term plan calls for, but not none. The U.S. is a leader in sectors where Canada has few good offerings – technology, healthcare and consumer-related sectors. Every decade has different market leaders and as we flip the calendar to 2010, one or two of these may be a replacement for the current leader – commodities. And a weak dollar will actually help companies that have a majority of their revenue and profit coming from outside the U.S.
  
• Hedge the currency. There are a number of ways to hedge your currency exposure. Many of the exchange traded funds (ETFs) are hedged back to Canadian dollars and some U.S. mutual funds offer a hedged version. These types of products will protect against a weaker U.S. dollar, but there is a cost and they are not perfect, particularly in volatile markets.

To be clear, we are not recommending that you reduce or eliminate your exposure to the U.S. Our fund managers aren’t leaning that way and neither am I when it comes to asset mix. And we all steer away from currency hedging, except in rare situations.

But if you are going that way, we recommend you do it in the context of your long-term asset mix and maintain at least some exposure to leading U.S. companies.

In my recent article, The Party is Rolling Again, so be Cautious, I throw a little cold water on the market rally we’re enjoying. I think it’s important to reiterate how a view like this relates to an investor’s asset mix.

The key line in the article is near the end – “I've sold stocks to bring my equity weighting down to the bottom half of my range.”

As an investor, that means:

• I have no expectation that my timing will be anywhere close to exact.
  
• I haven’t exited the market. I am hoping the market continues to rise because I own lots of equities.
  
• If the market does go up, it won’t mean my caution was inappropriate. It’s all about finding the correct balance between reward and risk.
  
• For illustrative purposes only, if my range for stocks is 40-60%, then I am now under 50%. This compares to mid-summer when I was at the top end of the range, or over.

As we say ad nauseum, we are not market timers. From time to time, we will shade our portfolio in one direction or another, but it’s always based on valuation, done in the context of our long-term asset mix and...executed without emotion (I know we’re boring).

So if you agree with my view, should you get out of the market? No.

Is it time to re-balance? Possibly.

By Scott Ronalds

Housing stocks make me squeamish. It was painful to watch them fall like a rock over the last couple of years as the U.S. real estate market imploded. A number of companies faced bankruptcy or saw their share prices slashed due to stretched balance sheets, huge unsold inventories and weak consumer demand.

Our global equity manager, Edinburgh Partners Limited (EPL), took their lumps on Pulte Homes, a Florida-based builder, which they sold last year after their worst-case-scenario estimates on the company’s book value and earnings were realized. Although the position was fairly small, Pulte was a clear loser for unitholders of the fund (including yours truly; the fund represents 25% of my portfolio). EPL made some strategic moves when the markets were bottoming and has since regained much lost ground, but Pulte sticks with me for whatever reason.

The U.S. housing market is still a pretty ugly place. Especially in places like Arizona, California and Nevada, where speculative activity was the highest during the days of mad flipping. Yet, as the economy pulls itself out of recession, opportunities are emerging. While there are still plenty of foreclosures, there are signs of a floor being reached in many markets, and unsold inventories are winding down. For those with a very high tolerance for risk, an investment property in Scottsdale, San Diego or Vegas may turn out to be a big winner a few years from now.

For more conservative investors, taking a longer term view on homebuilders could prove to be a good bet. As the economic storm passes, the best of the group will return to profitability in a world with fewer competitors and more end-users (i.e., those looking to buy a home to live in, rather than trying to sell it for a quick buck). Edinburgh Partners feels the risk/reward tradeoff is enticing enough to revisit the sector, and they’ve found what they believe to be a good opportunity in DR Horton, a Texas-based homebuilder. They like Horton because the stock satisfies all of their requirements from a valuation perspective (e.g., it’s cheap on a number of measures). The company is also one of the largest homebuilders in the U.S. and their focus is on the lower end of the market with respect to price point. In other words, their homes are affordable and appealing to first-time buyers.

Pulling the trigger on a housing stock right now may not feel overly comforting. Yet, the best investments are often made when you feel the least comfortable. Tom referenced this notion in a recent Globe column where he quoted the late Peter Bernstein, “If you are comfortable with everything you own, you’re not properly diversified.”

I felt pretty uncomfortable eight to twelve months ago when EPL was buying bank stocks, Chinese internet companies and Hong Kong land developers, but those investments have since proven to be very wise. This is what we pay them for. They take emotion out of the game as best they can and buy undervalued stocks, wherever they may be found. And their experience and longer-term track record speaks for itself.

So go ahead, make me squeam.

Quick. It’s February 28th, 2010. The Olympics are just ending and you have to make a last minute RRSP contribution. What would you do?

Five seconds.
Four.
Three.
Two.
One.

Time is up. OK. If you answered:

• Put it in the Money Market Fund and think about it later;
  
• Go with whatever your advisor is talking about;
  
• Look at what’s been doing well; or
  
• I don’t have a clue,

...then you’re not where you need to be. Forget about February 28th. You don’t know where you’re going now. You don’t have a plan...a framework...a road map.

The correct answer?

• Look at every investment, existing or new, in the context of my investment plan;
  
• Don’t let the RRSP deadline determine when I buy or what my mix will be;
  
• Add to my existing holdings in the proportions that I currently have; or
  
• If necessary, use the money to re-balance my portfolio so it’s back in line with my long-term asset mix.

Just testing.

Related reading:
Tackling Uncertainty This RRSP Season
Uneasy About the Market Bounce? Just Stick to Your Plan

Throughout the interview Tom resists the temptation to make short-term currency or market calls, but near the end he falls off the wagon and makes some comments on the economy. It smacked of market timing. What was he thinking? Looks like we’ll have to make some time for media training this week.

I don’t believe in trying to precisely time the market. For our clients’ portfolios, and my own, I strive to be approximately right, as opposed to exactly wrong.

Having said that, last fall and early this year we were as aggressive as we’ll ever be in pushing clients to do some buying, either by re-balancing or making an RRSP contribution. We felt strongly that the market declines were overdone and values were compelling.

So after a huge rise in the equity and credit markets, where are we today? Before I try to dodge the question, let me provide some perspective.

• This crisis was caused by excessive use of debt. The process of correcting that problem has not yet started in any meaningful way. Consumers are still being encouraged to borrow and spend (which they are) and governments are levering up their balance sheets at an unprecedented rate.
  
• Corporate earnings are down, but there are still two directions they can go from here. They could show improvement compared to last fall’s reduced levels, which would please the markets, or they could head lower as the companies run out of room to cut costs and the slow economy grinds on. We shouldn’t be surprised by either outcome.
  
• 15,000 on the S&P/TSX Composite Index (July, 2008) is not a number we should get anchored on. The last two years revealed that level to be a debt-inflated bubble which couldn’t be justified by business and economic fundamentals. We also shouldn’t get anchored on 7,600 (March, 2009). It was an equally false low, this time fueled by concerns of a capital markets meltdown. Comparing today’s market level (roughly 11,400) to either number is not very useful, whether it’s to say, “I’m buying because we’re still well below the old highs” or, “We’re up more than 50% from the lows...I’m bailing out”.
  
• There is lots of talk that investors have a renewed appetite for risk, but I don’t agree. I think professional and amateur investors are still wary of the economy and the potential for a return to volatile markets (read: down). I think investors were just starved (under-invested) and had to eat something.
  
• There will be lots of surprises over the next couple of years. Perhaps China will disappoint as it deals with the hangover from its spending binge. Or the downtrodden U.S. and/or Europe will show more life than people think.

Investors have plenty to consider in trying to figure out which way the market is going from here.

Stocks have moved up from extremely cheap levels, but valuations don’t look overdone. Some stocks are no longer bargains, but the portfolio managers I talk to are finding others with price-earning ratios of 12-13 times. To me, high quality stocks still look to be under-priced – a view shared by most of our fund managers and our favourite analyst, Jeremy Grantham at GMO.

As for corporate bonds, yields have come down a long way (which has translated into great returns), but the gap versus government bonds is still well above historic norms. Further spread reductions would translate into capital gains, but we don’t need that to happen for the returns to be attractive – i.e. we can justify holding corporate bonds based on their yield (5.5-8.0%).

At this point, it feels a lot to me like the Stealers Wheel song from the early 70’s - we’re Stuck in the Middle (With You). We’re in the middle of possible economic outcomes, the middle of the valuation ranges, and somewhere near the middle on the ‘Greed versus Fear’ meter. That’s not to say we couldn’t have some meaningful moves from here. In a market that is still over-leveraged, the range of possible outcomes for equities is still wide (+/- 20%).

If we learned anything from the last six months, it should be that markets are totally unpredictable and impossible to call in the short run. So while there are “clowns to the left of me and jokers to the right” who are making pronouncements about where we are going from here, we’re happy to have our clients in the middle of their long-term asset mix range, focusing firmly on the longer term.

In postings on March 31st and May 14th, I mused that the financial crisis and market meltdown had turned everybody into an economist. We all have a view on how deep the recession will be, where the dollar is headed and when the recovery will come.

In last Friday’s Report on Business, Robert Buckland, chief global equity strategist at Citigroup, shed some light on how this trend has played out in the ranks of professional investors (see Is Good Stock Picking About to Make a Comeback?).

He said, “We still meet too many fund managers who, two years ago, were diehard stock pickers and would never see a strategist. Now they are all over the latest moves in the Shanghai market or the ISM (Institute for Supply Management) index. The bear market has bullied them into becoming much more top down, and their view on the market/economy is often the reason why they are reluctant to get on board the rally in riskier or more cyclical stocks.”

As investors, we all have to be mindful of moving away from what we do best. A top-down approach to investing has always been a tough way to go, but when untrained investors or died-in-the-wool stock-pickers are attempting it, the degree of difficulty goes up.

Clearly, we need to be aware, and wary of, the business environment around us, but our focus must be firmly on buying undervalued businesses.

Again, Mr. Buckland: “Just when the bear market (and subsequent rebound) has bullied us all into being very macro is the time when a good contrarian should be moving micro. At the very least, equity managers should get out of the office and see some companies...and come up with some interesting bottom-up themes instead. It’s time to move on.”

In my last posting, I talked about the questions that money managers should be asking. I focused on three – inflation, the next market leaders and valuation.

There is an additional question that individual investors (and their advisors) should be asking.

Is there a reason my portfolio should be significantly different than its long-term asset mix?

The up and downs of the last couple of years have left many people with asset mixes that are far different from what their plan calls for. Chris, Scott and I have certainly found a disproportionate number of investors holding over-sized cash positions, even though their objectives and time frame call for a large commitment to long-term assets (i.e. bonds, stocks, real estate).

I can’t make a case for such a divergence. A long-term asset mix represents a person’s best guess as to what type of portfolio is appropriate to meet her/his objectives. For investors to deviate significantly from the target mix, they need to have a contrarian view that carries with it heaps of conviction and confidence.

As regular readers know, last fall I found myself holding such a view - “prepare for the other side of the valley”...“this isn’t the RRSP season to miss”. Pounding the table on such a topic is a rare occurrence for a market-timing atheist like me, but I just felt that markets were significantly out of whack.

Today, economic and company forecasts are conservative and the apocalyptic scenarios of last year are no longer realistic (all of which is good for investors). Valuations are at more normal levels after the market rebound. And while the problems and opportunities ahead still point to a wider range of possible market outcomes, I don’t think we’re at either extreme on the reward/risk continuum.

Investors have a plan for a reason. To be significantly out of line with that plan, they need to have good answers to the right questions.

Last week Chris and I met with Scott Robertson, a financial planner from Ottawa. Scott is a veteran and has a straight-forward, no-nonsense approach to his craft. That was clear when we asked him when and how often his clients re-balance their portfolios. He said without hesitation, “When they’re out of balance.”

That makes sense. Nice and simple. Why get hung up on quarterly or yearly. Just do it when you need to. Set a range as to how far the portfolio can stray from its long-term mix (5 or 10%), and then take action when the limits are exceeded.

I would only add that having a re-balancing rule based on the calendar (i.e. annually) requires less monitoring of the portfolio and totally takes the emotion out of it. It’s a crutch we can lean on when the heart is getting in the way of taking action. I think calendar-based rules are more ‘automatic’ than the range-based rules.

In either case, our view is that re-balancing makes sense for most clients given that (1) the long-term, strategic asset mix represents their best guess as to what’s appropriate for them, (2) calling the market in the short term is impossible and (3) it dampens down the volatility of a portfolio. A disciplined re-balancing regiment forces us to buy low and sell high without emotion getting in the way.

People are having trouble with this rally. Indeed, I admitted to being uneasy about the speed and magnitude of the market’s move in a recent post.

What’s spooking people is that it’s happening at a time when the economy is in the dumper and it’s not clear how we’re going to get out. Repeatedly I hear people saying, “The market’s move isn’t supported by what’s going on in the economy.” Indeed, as I write this, an email from Advisor.ca flashes across my screen saying that the economy shrunk 1.4% in the first quarter.

But as investors, we have to remember:

• The market looks forward. The past influences investors’ views, but future profitability drives stock returns.
  
• Very little of a stock’s valuation is derived from current earnings, or losses. When investors take ownership in a company, they are buying a future stream of earnings and dividends. The first three or four years of that stream accounts for about 15% of the value, while the other 85% is derived from what happens in years 4 and beyond. Too often investors get mixed up on their emphasis – 85% of their focus on the next year or so.
  
• The market doesn’t need economic news to move. The recent ride could be explained by the fact that stocks got oversold and were trading at silly valuations...silly cheap. At that point, perhaps, the urgency factor moved from the sellers (who were getting tapped out) to the buyers (who had lots of money to spend).

Then again, maybe there’s another explanation. The reality is that the economic and market landscape is so complex, we can’t ever make a definitive bet on what will happen in the short term.

This market move shouldn’t surprise investors. And nor should another 10-30% move - up or down - over the next X months.

Posted by guest blogger Lori Lothian (Steadyhand Director)

“Fess up, fellows: The masters of the universe have turned out to be masters of disaster. No matter which aspect of the financial crisis you consider, there is a man behind it.”

This was the opening paragraph of an article recently posted in the Wall Street Journal that reinforces our view that women are great investors, and even better clients! Realistic expectations, discipline and patience lead to better returns, and women investors tend to employ all of these hallmarks.

The article was timely because last night we hosted a third Investment Seminar for Women. Our thesis in holding these seminars is that women have all the potential in the world to be great investors, but lack time, information, confidence and/or interest. The aim of these seminars is to demystify the process of investing and, in so doing, show women that what they really need to be savvy investors is what they already are - good consumers. Sounds simple, and it should be!

So why aren’t more women ‘taking the reins’ of their families’ investment decisions? I don’t know the answer, but I did enjoy the somewhat tongue in cheek theory I recently heard advanced by Tracy Theemes, an investment advisor at Sophia Financial Group in Vancouver. Tracy put it this way: Women tend to carry the bulk of responsibility for family matters. It’s not unusual for men to have two jobs around the house – taking care of the investments and BBQing. It’s very difficult for women to say to their partners, “sorry honey – its just BBQing for you.” As with all stereotypes, this one contains a kernel of truth, although it’s interesting to note that when we asked the women at our seminar to identify their main barriers to investing, only one said that it was their partner’s responsibility.

What’s interesting is that the very reasons that hold so many women back from becoming engaged investors are those that make them good at it. For example, many women at our seminars say they feel uncomfortable with financial jargon and the confusing array and complexity of investment products. At the risk of quoting Martha Stewart, “that’s a good thing!” They are uncomfortable for a reason, and it has nothing to do with them. Jargon and complexity mask poor investment products and choices, and every investor should be insisting on plain language, straight answers to all their questions, achieving a thorough understanding of what they are buying, and clear, transparent reporting.

Obviously there are compelling reasons for women as a group to be more engaged in investment decisions. Life circumstances are one. All women, whether young, old or middle aged, will be unpartnered at some stage of their lives, and will simply have no option. Importance is another. Few matters have more significance in terms of women and their families’ quality of life than investment decisions. But the main reason why women should become more engaged investors is, as the article suggests and we believe, they’re good at it!

We are encouraged by the attendance and the feedback we are getting from our seminars and are planning sessions for Calgary, Winnipeg and Toronto. Let us know if you would like to be notified of these events.

In 26 years of doing this, one of the phrases I find least useful is, the market “is range bound” or “will stay in a narrow trading range over the next X months”. I don’t have conclusive data on it, but I believe that these types of predictions are almost never right.

I’ve heard these words used more over the last couple of weeks. It’s not surprising, because they usually come out after the market has had a good run and people are worried that it’s running out of steam.

The implications of those words are that (1) the speaker has an ability to predict the market in the short term, and (2) the market is going to do something it hasn’t been done since...well, I can’t remember when. Certainly not in the last decade or so. What sounds like an innocuous little throw-away comment is actually a very bold statement.

I thought this was important to write about only because there are times when investors base decisions on this kind of analysis. They shouldn’t.

As I pointed out in a recent post (Everyone is an Economist), we all have a tendency to become economists at extreme times like this. Everyone has a view on the economy, the dollar, Ben Bernanke, U.S. consumer debt and Wall Street’s demise. And with our increased focus comes increased confidence and conviction that our view is right.

I read a piece last weekend that reminded me how hard it is for economists, or big picture thinkers in general, to get it right. And of particular importance to me, how hard it is for said thinkers to enhance our investment returns.

In his weekly letter, Tim Price of PFP Wealth Management in the U.K. wrote:

“The essential problem of Traditional Economics is that it assumes a largely closed system of...incredibly smart people but in unbelievably simple worlds. The reality...is that the economy is closer to being a complex, adaptive, dynamic system – not unlike a living organic being, vulnerable to illnesses and other sudden exogenous outbreaks.”

Thinking and talking about the big picture is interesting, fun (for some of us at least) and it makes us better conversationalists. But for those who are charged with generating investment returns for our clients, we have to be careful how we use it.

More from Mr. Price:

“Fundamentally, it makes sense to own up to our lack of complete foresight and conviction. From an economic and investment perspective, a realistic assessment of the limitations of our knowledge may be helpful. Overconfidence – in economic modeling or financial forecasting or the sustainability and durability of previous market relationships – is unlikely to be of much advantage.”

I admit to being down on the big picture stuff lately – this is the second ‘Everyone is an Economist’ and last week I posted on the futility of predicting currencies – because in recessions there is a tendency to make it too big a part of our investment decision-making process.

We can most reliably add value for clients by identifying undervalued securities – stocks and bonds – that have a high chance of generating an above-average return over the long term. There is no denying that we need to know the context in which we’re investing, but when we let ourselves get caught up in the noise, we are distracted from that mission.

We become part of the short-term oriented herd, a herd of economists no less.