Thursday, 27 November 2014

Which Stocks and ETFs are Safe and Secure per the Dispersion of Analyst EPS Estimates

As promised last week, today we review the stocks that look most or least attractive according to the degree of dispersion of professional analyst EPS estimates. The lower the dispersion between the highest and the lowest EPS estimate, the better; those are the most attractive stocks. We had previously done this in 2012 and the results two years later have turned out quite good as we showed last week.

The method
We use the same methods as in 2012. First, we gather a list of stocks by taking all the holdings of three popular Canadian equity ETFs with quite different strategies:
Not only does this give us a reasonably complete list of leading stocks, it also allows us to compare the ETFs in terms of analyst EPS dispersion.

The second step is to find and calculate the percent difference between high and low EPS estimates for 2015 in Yahoo Finance - e.g. Royal Bank. For a few companies not available on Yahoo (pale yellow cells in the tables), we obtained the data in our broker BMO InvestorLine's website.

Third, we add various bits of data that show stability, consistency and attractiveness, or the opposite:
  • number of years of profits (positive earnings) in the last five from
  • profit surprise vs analyst estimate last quarter, return on equity, total stock return (dividends plus capital gains) for the trailing one- and five-years, price-to-earnings, price-to-book, all from Globe's WatchList;
  • number of women directors, from our recent post;
  • place in our 2012 post EPS dispersion list - low (L) EPS dispersion category; medium (M) dispersion category, or high (H) dispersion group.
The attractive lowest dispersion stocks - More reward than risk
(click on image to enlarge)

There is a preponderance of good green and a lot of consistency across the table amongst the stocks with the lowest dispersion between the highest and lowest EPS estimates.
  • beta - volatility of stock price relative to the market average of 1.0 - is almost always low, and the worst stock, Finning International (TSX: FTT) has a beta (1.86) nowhere near the highest betas in the bottom group
  • profit surprises, both positive and negative, are not very large, except for one company Valeant Pharma (TSX: VRX), which is a decided outlier on several other metrics as well
  • profitability (ROE) is good across the board, as is consistency of profits and total market returns; P/E and P/B ratios seem restrained almost universally too
  • women directors are more numerous on average - 2.9 per company - compared to the higher dispersion stocks
  • half the lowest dispersion stocks are repeats from 2012
Middle EPS dispersion stocks - Potential reward but more risk too
(click on image to enlarge)

The rising range of EPS estimate dispersion, from 113% to 141% in this group, is accompanied by slightly less green and slightly more more cautious orange across the various indicators. There are higher average P/Es and fewer women directors per company.

Our surprise comparing this set of results to 2012 is that there seems to be much less differentiation from the top group. Beta seems about the same as the lowest dispersion stocks. There are not many cases of poor profitability (ROE) or inconsistent (5 yr history) profits.

A number of stocks moved down from the 2012 top group but not one moved up from the bottom group.

High EPS dispersion stocks - More risk than reward
(click on image to enlarge)

As in 2012, there is plenty of bad red and cautious orange and not much good green in the bottom group. Stocks where the high vs low EPS estimate spread exceeds about 150% look truly risky. There are many companies with volatile profits and negative market returns. Most companies are repeats from the 2012 bottom list. A handful have dropped into the bottom list from the middle but not one fell from the top list to the bottom. These companies also have a much lower average number of women directors.

Comparing the ETFs - BMO's ZLB is decidedly the least risky and most attractive
(click to enlarge image)

ZLB wins by a long shot over XIU and PXC by holding a lot less of the bottom group with the highest EPS dispersion. Only 10% of its weight is in the bottom group vs around a quarter for both XIU and PXC. ZLB has an appreciably lower weight in the top group stocks but that doesn't matter. It is not surprising that its one-year total return of 26.9% far outstrips the gains of the other two ETFs given the poor overall track record of the bottom groups stocks.

Will that continue or will XIU and PXC experience a surge to catch up to or leap ahead of ZLB? It all depends on the future of the energy companies and miners, especially gold, whose stocks dominate the listings in the highest dispersion part of the table. XIU and PXC hold them, ZLB mostly doesn't. Who knows if the tide will turn, the professional analysts certainly don't agree as their EPS estimates demonstrate.

Bottom line: Meantime, the safe route is to focus on the top two groups or ETFs like ZLB.

Disclosure: This blogger owns shares of stock symbols REF.UN, BEI.UN, CUF.UN, REI.UN, RY, CNR, NA, NWC, CU, FTS, EMA, MRU, BNS, BMO, BCE, SJR.B, ACO.X, TD, HR.UN, TRP, IFC, EMP.A, POT, IMO, SU, FCR, TCK.B as well as the ZLB and PXC ETFs that own virtually all the stocks in the tables.

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Friday, 21 November 2014

How Effective is Using Dispersion of Analyst EPS Estimates to Assess Stocks?

Two years ago our post applied the "wisdom of the crowds" principle, made famous by James Surowiecki, to analyst future Earnings Per Share (EPS) estimates to try to differentiate attractive safe Canadian stocks from the not-so-attractive companies. The academic research we uncovered at the time suggested it should be effective but it's always important to check actual results against the theory, so now let's do an update and see what has happened.

As before, we took our 2012 list of the best - the stocks with the lowest dispersion between high and low analyst next year (2013 in the 2012 post) EPS estimates - and the worst - those with the widest spread - and plugged the numbers into a GlobeInvestor WatchList to get the trailing one- and five-year total returns (the sum of capital appreciation plus dividends). Our benchmark for success is the mainstream large company ETF the iShares S&P / TSX 60 Index Fund (TSX symbol: XIU) whose holdings along with the BMO Low Volatility Canadian Equity ETF (TSX: ZLB) and the PowerShares FTSE RAFI Canadian Fundamental Index ETF (TSX: PXC) we had used to assemble 110 candidate stocks.

Low EPS dispersion stocks performed impressively well
In our comparison table below of the lowest dispersion stocks in 2012, green is good, indicating substantially better performance than the benchmark XIU. The one- and five-year total returns of the stocks with the lowest dispersion of EPS estimates in 2012 is very consistently green.
(click on image to enlarge)

In the five-year column, not a single stock under-performed XIU or had negative returns. Only three did only as well as XIU, everything else was miles ahead.

In the one-year column, only two stocks, IGM Financial (TSX: IGM) and North West Company (TSX: NWC), had a negative (red) return. Eight stocks (highlighted in orange) had positive returns, though less than XIU's +15.2%.

High EPS dispersion stocks performed remarkably poorly
Our second table below showing the 2012 highest EPS dispersion stocks is filled with ugly red. There is very little good green or minimally acceptable orange. Only one stock - Franco Nevada Corp (TSX: FNV) - had benchmark beating returns over both one- and five-year periods.
(click to enlarge)

... and the middle EPS dispersion stocks are in between
The returns for the middle group are generally positive, more like the top group than the bottom, but display a larger amount of red and orange in the table below.
(click to enlarge)

BMO's Low Volatility Canadian Equity ETF (TSX: ZLB) in 2012 held a lot more of the low EPS dispersion stocks than either XIU or PXC as the left-most column shows. It is thus little surprise that its 26.9% one-year total return (neither ZLB nor PXC has been around five years so five-year return is not yet available) handily beat that of both its rivals.

Why picking low EPS dispersion stocks might not work as well in the future? The low EPS spread stocks are mostly in the financials, real estate and consumer sectors. Those sectors have done well. On the other hand, the high EPS spread stocks tend to be in energy and materials, both of which sectors have taken a beating in recent years. If those sectors rebound (the price of oil, gold and other commodities being such crucial uncertain variables), their returns could easily leap well ahead of the safe and steady stocks. That wouldn't necessarily mean the safe stocks would have negative returns; more likely they would under-perform.

Bottom Line: The method is not foolproof but looks darn good. Taking note of the dispersion of analyst EPS estimates appears to be an extremely useful factor to consider in stock selection. Low dispersion = good, high dispersion = risky.

This being the case, next week we'll review the current list of attractive and un-attractive stocks. We'll also compare the ETFs and their holdings.

Disclosure: This blogger owns shares of stock symbols REF.UN, BEI.UN, CUF.UN, REI.UN, RY, CNR, NA, NWC, CU, FTS, EMA, MRU, BNS, BMO, BCE, SJR.B, ACO.X, TD, HR.UN, TRP, IFC, EMP.A, POT, IMO, SU, FCR, TCK.B as well as the ZLB and PXC ETFs that own virtually all the stocks in the tables.

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Monday, 17 November 2014

Women on Boards: Pleasing Progress

A few years ago, we explored whether the presence of women on boards of directors was something investors should pay attention to. The indications we found in research and our cursory look at performance was that, yes indeed, companies with women fared better. We were curious to see how things have progressed since then. What we found looks pretty good.

Plenty more women on boards!
In 2012, the slow progression of women into the boardroom caused some controversy, e.g. the "Glacial Progress" Globe and Mail article by Janet McFarland. Corporate Canada seems to be changing fairly quickly, based on our analysis of the 100 largest companies by market cap that are publicly traded on the TSX (extracted using the TMX Money stock screener).

In November 2012, the top 100 companies had 167 women directors. Today the number is 200,a 20% increase. (We assembled this data ourselves by looking at the bios of directors under the Insiders tab of company listings on - e.g. for Royal Bank of Canada, which surprisingly is one of only three companies which have fewer women - one each - on the board than in 2012 ... but we shouldn't be too harsh on the Royal since it still has four women on its board and is thereby still in the upper echelon of the women director count as our comparison table below shows).

Though we don't show it in the table, the 15 companies that already have women are adding more than those with none at all in 2012. Seven of them added women. In contrast, only five companies went from zero to one, Catamaran jumped from zero to two, while eleven stayed at zero.

As an interesting aside, the financial sector which dominates the top of our table seems also (our impression from reading bios- we didn't count) to be the source, in the form of retired executives, of many women board members for other industries.
(click to enlarge image)

Companies with women directors score better on governance
We again took the scoring from the independent Clarkson Centre for Business Ethics and Board Effectiveness of the Rotman School at the University of Toronto (2013 scores since the 2014 update is not yet available). The results in the CCBE columns on our table for the 15 companies with four or five women directors are better than the 15 companies with no women.

... and their stock performance is generally better too
As we found in 2012, the one- and five-year total returns of companies (performance data is from the GlobeInvestor WatchList tool) with the most women directors at the top of the table look much more impressive on average, with positive returns that more often exceed our benchmarks, the TSX Composite (embodied in the iShares ETF that tracks that index with stock symbol XIC) and the large cap TSX 60 index (tracked by the iShares ETF with XIU symbol). Dividends are higher on average and five-year dividend growth is almost always positive and more often in excess of the benchmarks.

Board diversity is greater in other ways too - with the inclusion of academics.
We were a bit surprised to come across Professors in the Boardroom and Their Impact on Corporate Governance and Firm Performance by Bill Francis, Iftekhar Hasan and Qiang Wu (acknowledgement to Alpha Architect blog for the reference) that found a positive relationship between company performance and the presence of academics on boards. The paper sums up that profs are often "valuable advisors and effective monitors".

We scanned the director bios for the profs too and lo and behold, though few companies seem to consider academics at all (only 16 out of the 100 largest have even one), several of the companies that do are at the top of our table, while there are none in the bottom. Mere coincidence of no significance? Probably not, board diversity helps sound decision-making by bringing together different perspectives and ways of thinking about issues.

Bottom line: The conclusion is the same as two years ago - women directors do not absolutely ensure a profitable investment but it is a positive factor to include in the analysis of a company and its stock.

Disclosure: This blogger directly owns shares of stocks mentioned with symbols BMO, BNS, CU, EMA, IFC, NA, POT and RY at the top of the list and HR.UN at the bottom, along with ETFs that contain more or less all the stocks. In addition, he has a stake in the futures of four daughters who might well one day be considered for board membership somewhere somehow.

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Friday, 7 November 2014

Currency and Inflation Effects on Model Portfolio Performance

Almost five years ago we reviewed how a broadly diversified international portfolio would have fared in the period from 1992 to late 2009. There's been more water under the bridge so let's update and expand the original analysis. We can add nine more years of data - the five from 2009 to 2013 and those back to 1988 - because Norbert Schlenker at Libra Investment Management has performed the excellent favour to investors by continuing to update the annual investment returns for a range of asset classes and making it available for free as a downloadable spreadsheet. In the intervening years we have also written about various model portfolios so we'll test those that we can to see how they might have performed (the main gap is those portfolios that invest in real estate since the spreadsheet unfortunately does not include that asset class).

The International Portfolio still performs very well
The diversification benefit of additional equity holdings in the USA, developed market countries (abbreviated as EAFE - Europe, Australasia, Far East) and Emerging markets (such as India, China, Russia and Brazil), continues to be felt, primarily by boosting returns, while the T-Bill and bond holdings dampen portfolio swings, as our chart below shows.
(click on image to enlarge chart)

Inflation continues to steadily reduce returns ...
On the chart below inflation continues to take a chunk out of returns, though at a lesser rate in recent years than the long term average. Inflation is highly unlikely to go away since it is Bank of Canada policy to target an inflation rate in a range of 1 to 3%.
(click on image to enlarge)

... and currency swings often have quite substantial effects, sometimes boosting, sometimes hindering, returns of foreign equities, which also confirms what we noted in the first post five years ago. As the Canadian dollar (CAD) declines vis-a-vis foreign currencies, the same amount of foreign currency buys more Canadian dollars. That boosts returns. When CAD appreciates, the reverse happens. Thus, in our chart, CAD gains/appreciation are shown as a negative effect on returns (of the foreign holdings) and CAD losses/depreciation have a positive effect. In the early 2000s, for example, the Canadian dollar was gaining in value and that undermined returns of foreign holdings for six years in a row as the chart shows.

Note that the currency exposure for holdings such as developed countries and emerging markets is to the currency of those countries and not the US dollar when, for example, holding ETFs that are traded in USD on US exchanges. CanadianFinancialDIY explained how and why this works in this post.

In the 26 years covered by 1988 to 2013 almost exactly half - 12 years - currency movement helped returns for a Canadian investor. The mean of the yearly gains and losses over the period is slightly negative, just under 1%. That seems to add further evidence to the conclusion we presented in a 2012 post that hedging foreign currency holdings is not really necessary in the long term.

The International portfolio grew more, with less volatility, than a similar domestic-only balanced alternative
The following comparison chart was compiled from results of the Stingy Investor Asset Mixer tool that uses the data from the Libra spreadsheet.
(click on image to enlarge)

As the table shows, the international portfolio performed better than a domestic-only portfolio with the same basic structure (35% cash & fixed income and 65% equities). This was true both during a savings accumulation phase of life or during a retirement withdrawal phase. In each life phase the international portfolio also experienced fewer down years and a higher reward (return) to risk (volatility) ratio . International diversification showed its value.

The international portfolio also gained more than either the Lifelong portfolio and the Permanent portfolio. However, both these portfolios experienced considerably lower volatility, no doubt due to the 50% allocation of both to T-Bills and bonds.

The Permanent portfolio in particular looked much less attractive during a retirement phase of 4% annual withdrawals as it had a lot more down years and minuscule total growth. The stats reinforce the idea of the Lifelong portfolio as a "good-enough" compromise, never the best but never the worst.

Finally, by way of interest only since few would advocate such an unbalanced portfolio, we include stats for the 100% domestic equity (TSX Composite) portfolio and the 100% Canadian bond portfolio. Neither grew as much as either the Canadian balanced or the Lifelong portfolio, a surprise especially with respect to equities which have the image of higher eventual growth despite higher volatility. Regular annual rebalancing (which is what the tool models) provided the returns boost (see our post Portfolio Rebalancing - What, Why and How). On the bond side, the surprise is the higher number of down years during retirement. The lower returns from bonds are more susceptible to turning negative, closer to the line between positive and negative, when withdrawals are also happening.

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Monday, 3 November 2014

Testing the Ultra-Safe ARVA Retirement Portfolio Withdrawal Method

The 4% constant inflation-adjusted rule we posted about in 2009 is the standard advice for setting a retirement portfolio withdrawal rate that is not expected to run out of money, simply because the strategy always worked in the past. But future success depends on the future being like the past. As we recently wrote, there are strong indications that future investment returns will be lower with the consequence that a safe withdrawal rate is closer to 3.5%.

Suppose we don't want to mess around and want an iron-clad guarantee, or as close as is practically achievable, that our portfolio will never run out of money before death while withdrawing the highest amount possible. Step up Barton Waring and Laurence Siegel, whose paper The Only Spending Rule You Will Ever Need, proposes such an approach. The principle under-pinning their proposal makes sense - match assets (portfolio cashflows) with liabilities (spending / withdrawals). Level, guaranteed, lifetime spending with inflation-protected purchasing power most closely matches up with an inflation-indexed annuity, or with a ladder of real return bonds extending out to your expected lifespan.

However, such annuities are difficult if not impossible to find in Canada at the moment (there are annuities which have a set ratcheting increase of 1 / 2 / 3% but none that explicitly adjust to CPI so you have to correctly guess the inflation rate). They also lock in money irreversibly - there's no liquidity or capability to cash out for unexpected needs.

An RRB ladder of Canadian government bonds provides the best possible AAA credit security and direct CPI protection but they are extremely tax inefficient in a non-registered account, As well, the current limited range of issues maturing 2021, 2026, 2031, 2036, 2041, 2044 and 2047 make cash flows lumpy and hard to match with regular even spending. Plus, the furthest maturity is only 33 years away while maximum possible life expectancy is about 40 years, or 105 at age 65, according to the authors. RRB yields are extremely low, at their historic minimums these days, so many investors might still be tempted to keep their portfolio of volatile but higher potential return assets.

Spending must adjust to portfolio fluctuations
For those investors who want to keep their volatile investment portfolio but protect it from exhaustion by respecting the annuity asset-liability matching princple, Waring and Siegel propose doing a simple annual recalculation of how much can be safely withdrawn, which they call annually recalculated virtual annuity or ARVA. Every year after portfolio returns are in, they calculate what income would come from the purchase by the retired investor of a perfectly structured annuity to figure out the maximum withdrawal. The withdrawal fluctuates according to three varying parameters: current average yields on a ladder of RRBs, remaining lifespan aka time in retirement and latest portfolio net balance.

Our Historical Simulation Test - What were amounts and fluctuation of maximum spending?
The authors don't show what would have happened in the past by following their rule. Would the withdrawal fluctuate too widely, especially on the downside? How would the amount compare to the standard 4.0% rate, or 3.5% per today's outlook? For any portfolio size, which factor matters most - interest rate, remaining years? We decided to have a look using available Canadian data.

  • Balanced portfolio - containing passive index tracking ETFs, made up of 50% Canadian broad bond, 50% equity (30% TSX Composite, 10% US S&P 500 equity, 10% developed market MSCI EAFE) rebalanced annually; translated to Canadian dollars with real returns, from Libra Investment Management's free download excel spreadsheet. We applied a 0.3% annual MER cost to the portfolio as if it was composed of low cost ETFs, which doesn't really represent what was possible historically, but we are trying to guesstimate what might have happened if investment opportunities were similar to today. We generously gave ourselves a portfolio worth $1 million at the start of retirement.
  • Life expectancy / retirement duration - 35 years (i.e. to age 100 for a retirement start at age 65) in the base case charts below.
  • Retirement start year - 1992, which is the first year Canadian government real return bonds were issued
  • Real return bond yield rates - the Bank of Canada benchmark rate for a long term RRB at the end of each year; this doesn't really match the average for a ladder of RRBs since shorter maturity issues would most often have had a lower yield and thus reduce the overall average ... but we have to take what we can get and it took quite a bit of Googling to dig up even the benchmark Long-maturity RRB yields from the 1990s. 
  • Excel's function PMT = (RRB rate, Years remaining, Portfolio value, ,1) straight from Waring and Siegel's paper. The 1 means take the withdrawal at the start of the year. PMT = the maximum withdrawal amount for the current year.
  • Example PMT (4.5%, 35, $1,000,000, , 1) = $54,804 in 1992, year 1, of the chart below.
(click on image to enlarge)

  • Maximum ARVA withdrawal beat the historical 4% rule or $40,000 real constant dollars by a big margin - the lowest withdrawal under ARVA was the $54,800 in 1992, the average was $68,000 and the highest was an impressive $83,873 in 2000. Wow, that's wonderful, time to jump on board?
  • Huge variation in the annual ARVA withdrawal - 1992 min to 2000 max was a 53% range and there was more than a $10,000 drop from one year to the next twice over the whole period, from 2002 to 2003 and 2008 to 2009. This might present quite a severe psychological challenge to the retiree - you get used to nicely rising income during the 1990s, perhaps upsizing your spending "needs" then bang suddenly the markets drop for a year or two or three and you need to scale back in a major way. Looking at the chart after the fact tells us that all would have turned out fine but during we could not have been so confident. Hard basic spending needs have to be well below the maximum to be sure the strategy won't catch us out.
What matters most - Retirement duration, then portfolio value, then RRB yield
To see how the parameters inter-act, we plugged various plausible numbers into the formula. Right now, the yield on a benchmark long term RRB (which currently is the 2041 maturity bond) per the above-linked Bank of Canada webpage is around 0.6%.

The table below shows the sensitivity of the withdrawal amount to changes.
(click to enlarge)
The length of retirement has by far the biggest impact on maximum ARVA withdrawal. Longevity is the most significant risk. Next is the portfolio size, as year to year changes translate directly into proportional changes - up 10% or down 10% means the same increase or reduction in withdrawal, other things being equal. Reducing portfolio volatility greatly helps anyone wanting to use the ARVA method.

Finally, and surprisingly, the change in RRB yield has a relatively minor effect! Note how under today's conditions, the base case million dollar portfolio for a 30 year retirement, which is near life expectancy for a 65-year old, gives a far less generous withdrawal amount than in 1992 - only $36,500 per year i.e. less than the 4% rule and a bit more than the our lower 3.5% market valuation adjusted figure.

We took the same formula to create the chart below showing how various combinations of RRB yield and retirement duration inter-act with the $1 million dollar portfolio.
(click to enlarge)

The necessity to make funds last a long time has a huge impact on sustainable withdrawal rates. The difference between 40 and 20 years is much greater than even a several-fold increase in yields, as the contrast between the top and bottom lines vs the left and right edges of the graph show.

Bottom Line: Cautious spending, or the willingness to make fairly substantial spending adjustments year to year are required for the investor looking to use the ARVA method to ensure that his/her portfolio will not expire before he/she does! Building a diversified portfolio that minimizes volatility will directly and proportionally minimize the withdrawal variations.

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.