Double Blind

Since interest rates are so low right now (1-year GICs yield 2.5%, 3-year GICs yield 3.5%, and 5-year GICs yield 4.0%), banks have resorted to more slick marketing for GIC products in an attempt to make them look attractive to the general public. You frequently see the majors (CIBC, Bank of Montreal, etc.) advertise in the newspapers a product called the “escalating GIC” where the rate goes up every year you hold the thing.

The Bank of Montreal has the following for a non-redeemable 5-year GIC (non-redeemable meaning you’ve got to have your money locked in for the duration of the product):

Year 1 – 3.25%
Year 2 – 3.50%
Year 3 – 3.75%
Year 4 – 4.25%
Year 5 – 5.00%

CIBC has the following (same terms – 5 years and non-redeemable):

Year 1 – 2.00%
Year 2 – 2.50%
Year 3 – 3.00%
Year 4 – 4.65%
Year 5 – 8.00%

So here’s a question – which product gives you a better return?

The answer is actually “it depends”. If you don’t reinvest the interest payments, you will end up with $119.75 with BMO and $120.15 with CIBC. Reinvestment will result in slightly higher amounts. Assuming you can compound the return at their average compounded annual yield, the BMO one will yield 3.95%, while the CIBC one will yield 4.01%. One would instinctively think that the CIBC one is a better deal, but it depends on how you can reinvest the interest payments from year 1, 2 and 3.

Either option, however, is silly. Locking your money for 5 years is a disastrous decision unless if you are handsomely compensated for the liquidity risk – which you are not since you can purchase a straight 5-year GIC without the locked in terms. To get an idea of how long 5 years is, just ask yourself what you were doing in February 2004.

The slick part of the marketing is that CIBC wanted to give the impression you were being given a good deal with the 8% in the final year, when in reality, they were just giving you a “market rate”.

Since rates are so low, the only way to get a “real return” is to take risk. Preferred shares in the Bank of Montreal, for example, yield 6.7% on a glance.

I have written about this before (in January of 2008, a fairly successful post of the financial future), but when looking at the Drudge Report, it reports that the markets are tanking, and always uses a picture of the Dow Jones index as an illustration.

The Dow Jones is a horrible benchmark for US stocks, mainly due to two reasons:

1. It contains only 30 companies (list is here), and these companies aren’t a reflective snapshot of the US economy in general (although it does cover a good deal of it – almost every name in the index is recognizable, except for United Technologies).

2. The index itself is weighted on the price of the stocks within it, not the market capitalization.

Point number two will require further explanation.

Media commentators frequently use the price of a company’s stock as a proxy for its value. While the price per share is a good measuring tool comparing it to how the price of the same company was in the past, it is a very bad tool to measure different companies.

The reason is because different companies have different amounts of shares outstanding. Generally speaking, in order to purchase an entire company, you need to buy all of its stock. Assuming you can buy all the shares of a company, at the current price it is trading at, you have a value called the market capitalization. This never happens in practice, as when the market ‘gets wind’ of you trying to buy up all of the stock, the price will be higher than what it would be before you started.

However, market capitalization is a far more accurate measure of what the market considers to be the value of a company. To use an example, Microsoft has 8.89 billion shares outstanding, and is trading at $18/share. So to buy the entire corporation, assuming everybody is willing to sell at $18/share, you need to come up with $160 billion dollars. Adobe Systems (the company that makes software like Photoshop, Acrobat, etc.) has its shares trading at $18/share, but it has 524 million shares outstanding, meaning you can buy the entire company for about $9.4 billion if everybody was willing to sell at $18/share.

Despite the two companies having an equal share price, Microsoft is obviously larger. The share price also does not give any hints as to the relative financial positions of the two underlying companies – it only is a reflect of the market’s sentiments at that particular time of the company’s ability to pay future returns (either in the form of a dividend or capital gain) to its shareholders.

It generally means nothing to look at the share price alone – Warren Buffett’s company, Berkshire Hathaway, trades at $77,000 dollars per share, but this is because he only has 1.55 million shares outstanding.

So going back to the Dow Jones index, it is weighted by the price of its components (adjusted for stock splits that occur). Right now for every dollar that one of the 30 stocks in the Dow goes down, the Dow loses 7.96 points. The current market capitalization of the entire Dow Jones index is $2.938 trillion dollars.

So right now, if the Bank of America, Citigroup and General Motors goes bankrupt (and thus having its common shares go to zero), the Dow Jones will lose 59.8 points (0.8% of its existing value). The loss of market capitalization would be $30.7 billion (about 1.0%).

To use another example, if Microsoft, Pfizer and General Electric went bankrupt, the Dow Jones would lose 324 points, or about 4.4% of its value. The loss of market capitalization would be $350.6 billion, 11.9% of its value.

Other indexes (such as the S&P 500, the TSX 60, etc.) are generally weighted by market capitalization instead of share price. The S&P 500′s market capitalization is about $6,708 billion as of the end of February 20th.

Today is the third Friday of the month, and every third Friday of the month means that options expire, which tend to create a little more volatility than normal. Today was a very volatile day, especially in the markets for financial stocks.

I noticed that General Electric debt is trading at about 70 cents on the dollar, which is a really good sign that it is not really a “AAA” company (by definition, an AAA rating implies that the probability of default is nearly zero). Its 23-year debt currently yields 8.75%, which would be a spread of about 5.20% over the prevailing risk-free rate. If General Electric goes down the tubes (presumably because of solvency issues in its GE Capital unit), then that would be even more of a major story than the failure of the automakers (GM and Ford).

Right now there are too many securities (mainly debt) on my watchlist that will given an investor a “probable” 15% return on investment, at least in the corporate world. You should be demanding at least this right now, which is a huge premium above the risk-free rate. The risk-free rate right now for short term money is 2.5% (ING Direct), and 4.00% over 5 years (the best rate you can get on a GIC).

I have no idea whether the markets are going to go lower, whether they’ll stabilize, or whether they’ll head higher from here, but all I can do is deploy capital in the most efficient manner possible – the highest return and the lowest risk.

I just noticed this article about the cops busting down a house and discovering 80 cats living there, with 3 dogs.

How come it’s always the houses with insane numbers of cats that always get the media attention, and you almost never hear about houses with 100 dogs being condemned, unless if it’s an abusive puppy mill trying to sell dogs for commercial gain?

CN Rail looks like it has no problem getting credit:

MONTREAL, Feb. 18 /CNW Telbec/ – CN (TSX: CNR – News; NYSE:CNI – News) today announced a public debt offering of US$550 million 5.55 per cent Notes due 2019. CN expects to close the financing on Feb. 25, 2009.

5.55% is about 260 basis points above the risk-free government rate. Compared to what other companies have to pay for debt (e.g. 1000 basis points over the risk-free rate), CN has easy access to credit.

Warren Buffett also sees value in the railroad companies – he’s been buying shares of Burlington Northern (BNI) like no tomorrow – his ownership of the company is 23%. I’ve done some research on CN and CP Rail and while you are not going to see your investment triple overnight, they do provide a store of value that will perform significantly better than bonds or cash.

The reason why railroad companies are so valuable is not because of their operations (which do have value) but rather because they have ownership over rights of way over land that would otherwise be impossible to get if a company were to start up from scratch today. CP Rail and CN Rail are both (very) indirect proxies for Canadian real estate. The business of railroads will also not go away as it is the cheapest method of transporting goods over land – only barges can compete with rail, but only near navigable waters.

Allen Stanford (and his company) apparently managed $9 billion in assets, but was subsequently charged with the Securities and Exchange commission to be fraudulent. While this wasn’t at the $50 billion scale of Bernard Madoff, it still is a huge hit for those that invested with him.

It makes you wonder how many more of these frauds will be caught down the pipeline. When the markets are going up, everybody ends up looking like a genius, but when the markets are down, you can find out who were defrauding their customers and who were not.

This article gets it right.

There are a few variables that go into gasoline prices. One is crude oil.

The other is that there are different grades of crude oil. The most frequently quoted one is Texas intermediate crude. That said, it is not the most ideal of crude oils to be producing gasoline with. You also have to get this crude oil to the refineries – not a trivial process. Domestically, a lot of our crude comes from Alberta, which is more expensive.

There is also refinery constraints involved – refinery capacities have been flat for the past 20 years since it is very difficult with environmental restrictions to have any new ones built. So when there is demand for gasoline, refineries can charge more for the service.

Finally, government regulations in terms of the quality of gasoline will affect pricing – the higher quality gasoline that is to be used (especially ultra-low sulfur content gasoline), the more expensive it will be.

A great map is the following – showing the relative prices of gasoline between states in the USA. Although gasoline taxes between states vary, it should also be noted that California has the most restrictive gasoline legislation with respect to fuel quality and sulfur content. Not surprisingly, it has the most expensive gasoline in the USA. Not so conveniently for British Columbians, Washington State has the most expensive gasoline taxes in America.

In Canada, Alberta, Ontario and New Brunswick have the cheapest gasoline prices. Alberta has the lowest gas taxes in the country as well. People in the Greater Vancouver Regional District also have the privilege of paying the highest gasoline taxes in the country – 20.5 cents provincially, plus a 2.4 cent carbon tax (due to increase each July).

The Olympic Village fiasco in Vancouver (previously covered on a January 11, 2009 post) is going to get more expensive – part of the development involves a social housing unit which the city has already put in $32 million. Instead of costing another $33 million to complete, it will be another $77 million to finish off the 252 units.

This is like being told instead of costing $131,000/unit to finish off the project, it is $306,000.

Yet another cost overrun on a horribly managed project.

The amazing thing is the various sites on the internet are out there blaming each other (Vision Vancouver vs. NPA) when both are at fault for this fiasco – ideology trumped reality, and it is the taxpayers of Vancouver that will be paying the price for this one.

It’s amazing how “affordable housing” means getting taxpayers paying for housing that people can’t afford. Apparently when the government pays for it, the bill is easier to swallow.

Apparently 2008 was a popular time to have babies in Alberta.

Leonidas, Napoleon, Xerxes, Barack and Obama all appeared once each in 2008 as names for boys.

Parents looking for unique names named their kids Brazen-Lee, Coal, Delorian, Gonzo, Jazzy, Jury, Natorious, Rexall, Sequoia, Stetson and Zeppelin for boys, and Anarchy, Castle, Harloquinn, Jetaime, Queen, Science, Taffy, Tree, Tyranny, Valkyrie and Whiteangel-Victoria for girls.

OK, I can just imagine life with Gonzo. All I can think of is the muppet character.

I wonder if the parent(s) that named Anarchy and Tyranny was actually one parent that had twins.

And who is delusional enough to name their kids after a politician?

The CPP investment board lost 6.7% of its assets due to its investment decisions in the last quarter of 2008. Considering the mix of assets it had during this time (42% public equities, 15% private equities, 28% fixed income, 7% real estate), this is a miracle. The TSX was down 23.5% in the equivalent period.

The CPP board has delivered a 5.1% rate of annualized returns (after expenses) since April 1, 1999. Considering the TSX was up 2.7% on an annualized basis fro that date to the end of 2008, this is not a bad performance by the CPP investment fund.

If the CPP had a simpler investment strategy – for example, if they had chosen to invest in government of Canada 10-year bonds during the 10 year period, their average yield would be close to around 4.77%. While a 0.33% annualized performance increase over 10 years is a significant amount of money, one wonders if it is worth the management expense to diversify into public equities.

Still, one advantage of the existing strategy is the ability for the CPP fund to invest in global equities, and not constrain their capital to strictly domestic markets; if they kept to domestic markets it would result in excessive correlation to the Canadian economy, which would impair diversification efforts significantly.