Monthly Archive for March, 2008

What is Risk ? And the Case for Redefining Risk

Published on March 29, 2008 in Finance. 1 Comment

In the world of finance risk has become synonymous with volatility. But is volatility a good measure of risk? Quite simply it’s not.

Beta is currently the financial industry’s main way to measure volatility and hence their version of risk. A Beta greater than1 means the security is more volatile than the market average. A Beta smaller than 1 means the security is more volatile than the market. Because an asset class has a low beta does not mean its safer.

For example when examining the stocks of financial companies most have a beta smaller than 1. Does that mean they are less risky? The answer is simply no. Different companies have different risks.

Financial companies, typically considered a “conservative” investment, have a special type of risk, that of leverage risk. For example a quick look at BMO’s balance sheet tells us that they have 377 billions in assets and 360 billions in liabilities, leaving the company with 17 billion in equity. In contrast EnCana has 47 billion in asset and 26 billion in liabilities leaving them with 21 billion in equity. A 4.5% drop in asset leaves BMO with no equity while it is 45% for EnCana. All you need is 4.5% of assets (i.e. mortgages, loans and other investments) to go default and BMO will no longer exists. The dangers of being leveraged has recently been observed with the recent asset write downs at many large US financial institution due to the current credit crisis. This has resulted in many firms panicking and looking abroad for capital (i.e. from Dubai and Singapore) to shore up their balance sheets. Leverage is not only dangerous when asset values decline at banks, but leverage is also dangerous if liabilities (i.e. deposits) decrease which can result in a bank run, as recently observed at Bear Sterns. In the case of BMO a 9.5% drop in deposits (about $22.8 billion) will leave BMO insolvent.

As investors it is important that we understand the risks implicit in different types of investments instead of relying only on Statistical Analysis such Beta, Standard Deviations and Probabilities which are all based on previous performance. And because pass performance and volatility is not indicative of future performance and volatility we should take most statistical analysis with a grain of salt. Many risks have to be analyzed when investing, a few are outlined below:

1) Bonds are subject to inflation and interest rate risks.
2) Financial and commodity companies are subject to leverage risk.
3) Commodity companies are subject to commodity price risks.
4) Companies are exposed to management risk.
5) Foreign companies are subject to currency risks.

If investors continue under the current statistical paradigm of analyzing risks, while ignoring and failing to analyze real risks it can leave investors vulnerable to loses such as those in financial companies over the last year.

When the Efficient Market Hypothesis Breaks Down

Published on March 28, 2008 in Economics and Finance. 0 Comments

In free and open markets, the Efficient Market Hypothesis (EMH) is a function of the information available to profit seeking investors. However there is one scenario where the Efficient Market Hypothesis breaks down, that of collusion. While most most markets are inherently efficient there are a few notable exceptions to the rule.

The most common example of market collusion is government intervention in the foreign exchange markets. Currently many Asian currencies are pegged or manipulated by their respective governments. Governments may execute such interventions in order to stimulate exports or in other cases to make imports cheaper. The fact that Governments aren’t profit seeking institutions distorts the Efficient Market Hypothesis. In Hong Kong, Saudi Arabia and in Dubai for example, their currencies are perfectly pegged the US Dollar. However, due to US government pressures, China is following a strategy of slowly revaluing the Yuan at higher values against the US dollar.

This creates an interesting situation for profit seeking investors. Investors can invest their US dollars into Chinese Yuan and make virtually guaranteed profits, assuming the current exchange rate policy continues, which currently runs at 7% appreciation per year. So how can an investor exploit this flaw in the Efficient Market Hypothesis? For starters one can open a Yuan savings account in China. However, for most individuals this is not an option. For most investors the Market Vectors – Chinese Renminbi/USD ETN (NYSE:CNY) is the easiest route to take. Unlike the Rydex CurrencyShares ETF (Exchange Traded Fund) which physically own the currency in the form of an interest bearing bank deposit, the Market Vectors Chinese Reminbi ETN (Exchange Traded Note) is a note which does not pay interest. The note own futures contracts instead of the actual currency and are a liability of Morgan Stanley. Unfortunately, there isn’t a Yuan Currency ETF which currently exists. As long as Morgan Stanley does not go bankrupt the ETN is just as safe as an ETF without the interest payments.

Q&A @ Tarik.ca : Canadian Oil Sands Trust, Earnings & Dividends

Published on March 19, 2008 in Finance. 0 Comments

Question
COS 2007 earning is 1.55 per unit but the annual dividend is 3. Explain why the dividend is higher than the earnings? Will the high dividend sustainable given the low earning figure? Thanks

Answer
Hello, In the Income statement we have revenues and expenses and we are left with Net Income(or Loss). Net Income(or Loss) is then transferred to the Balance Sheet account as retained earnings(or deficit) under Shareholder’s Equity. Dividends are a temporary balance sheet account under shareholder’s equity. When dividends are paid out, it is paid out from retained earning. Hence, EPS is INDEPENDENT from dividends. EPS does not show earnings before dividends.

The real reason COS.UN pays more in dividends than it makes in EPS can be explained by its legal structure. Income Trusts have to pay all out all CASH FLOWS FROM OPERATIONS, in order to retain their Income Trust status.

In order to calculate Cash Flow from Operations we take the following formula (Cash Flow from Operations = Net Income + Depreciation and other Non-Cash Expenses). We add back Depreciation because it is a non-cash expense, which does not effect cash flows. Because Cash Flows from Operations are always higher than Net Income COS (as do all Income Trusts) will pay out more than EPS. That’s why most income trusts have accumulated deficits instead of accumulated retained earnings when we observe the balance sheet.

To analyze the sustainability of dividend payments we need to look at the Cash Flow Statement. COS.UN dividends are sustainable as dividends last year were smaller than cash flow. They paid $791 million in dividends last year while Cash Flows from Operations were $1377 millions, giving us a dividend payout ratio of 57%, which is one of the lowest and safest in the energy trust sector.

Note: Their EPS currently looks low at a $1.55 for the Trailing Twelve Months, however if you exclude the one time tax loss (declared in Q2 2007) for income trusts their adjusted EPS is closer to $2.80. And assuming oil prices stay north of $90 their forward EPS as of Q2 2008 should be around $3.40.

Hope that helps.

Tarik.ca Technical Trading System

Published on March 10, 2008 in Finance. 0 Comments

Using Fidelity Wealth-Lab I created the following trading system with the aim of creating absolute returns. The trading system currently trades in and out of HED (Which tracks 200% the inverse of the TSX/S&P Energy Index). Over the last year the system has returned over 60% while the ETF has returned -13% on a buy and hold strategy. The system switches between long and short according to short term technical indicators including, moving averages, RSI and others. The system also uses automatic trailing stop loses for risk management and the system also works well on the other Horizons BetaPro ETFs. The System is not yet to be complete. The system will eventually hold all 9 leveraged BetaPro ETFs on a equal weight basis, in order to lower non-systematic risk and to decrease the size of a max drawdowns.

Click the graphs below to enlarge:

 

Musing with Regression Analysis

Published on March 8, 2008 in Finance. 0 Comments

Curious to see the predictability of fundemental financial measures, I decided to do a series of regression analysis on 4 important financial measures. I took the top 30 holdings of the TSX/S&P 60 Index and performed a regression analysis comparing 1 year returns against Net Margins, Return on Equity, P/E and EPS Growth.

Below are the regression analysis comparing 1 year returns to : Net Margins, Return on Equity, P/E and EPS Growth.

Corr1

corr3
corr4

corr5

Taken individually, no financial measure can tell an investor any important information about the quality of an investment. Moreover, the most quoted financial measure, that of the P/E ratio actually has a positive correlation with returns and is the worst measure. However, when all the measures are combined together (see below) we get a strong positive correlation with an r value of 0.74. These discoveries reinforces the idea that individually no single financial measure is of any use; but when used in combination, financial fundemental measures are reasonably good at predicting potential returns.

Corr2

Internet Financial Resources

Published on March 7, 2008 in Finance. 1 Comment

Bloomberg News is the best website for general financial news. The article are well written and unique. The website also features an Economic Calendar, various indicies and other specialty news and financial items.
http://www.bloomberg.com/

A biweekly report put out by the Commodity Futures Trading Commission that shows the number of long and short positions held by traders in the U.S. commodities markets. Long positions are futures contracts that have been purchased; short positions are contracts that have been sold without the seller owning the underlying contract. The reports also show the open interest, or number of contracts that exist, in the market. Traders look at the report for signals about whether the market is likely to move higher or lower.
http://www.cftc.gov/marketreports/commitmentsoftraders/index.htm

Seeking Alpha is the leading provider of stock market opinion and analysis from blogs, money managers and investment newsletters, and a provider of its own high-value, complementary financial content.Seeking Alpha is different from other finance sites because it focuses on opinion and analysis rather than news, and is primarily written by investors who describe their personal approach to stock picking and portfolio management rather than by journalists.

http://seekingalpha.com/

SEC Info is the Securities and Exchange Commission (SEC) EDGAR® database and Canadian Securities Administrators (CSA) SEDAR® database service on the Web, with over One Billion links created within the SEC/CSA documents and exhibits. You can find prospectuses, who owns which companies, annual and quarterly reports and other company information.

http://www.secinfo.com/

ShortSqueeze.com provides short interest stock market data and services, users will be better informed of short selling in the market, track shorts in stocks.

http://www.shortsqueeze.com/

Only Earnings.com lets you get the latest corporate information, with access to: The most reliable Investment Event Calendar available anywhere displaying Earnings Releases, Conference Calls, Splits, Dividends, Economic Events and more. Live Webcasts and Online Replays of Earnings Calls, Annual Meetings, Investor Meetings and more. Annual and Quarterly Report. Transcripts and Event Briefs (non-biased summaries of corporate conference calls). Company Profiles. Management Presentations. Press Releases. Information Requests and E-mail Alerts. Corporate Governance – including Management Biographies, Insider Transactions, and more…
http://earnings.com/

View Open Market Operations performed Federal Reserve.
http://www.ny.frb.org/markets/omo/dmm/temp.cfm

View North American Coal prices form the Energy Information Agency. http://www.eia.doe.gov/cneaf/coal/page/coalnews/coalmar.html#weekly

View North Americans Natural Gas Inventories, updated weekly at 10:30 A.M. Thursdays. http://www.eia.doe.gov/oil_gas/natural_gas/ngs/ngs.html

A Precious Metals Website, containing news, prices, articles and commentary on Gold, Silver and other PGMs.
http://kitco.com/

The best Financial Statistic Blog on the internet, applying statistics to finance.
http://bespokeinvest.typepad.com/

The Toronto Stock Exchange website, containing information on companies, indicies and trading.
http://www.tsx.com/

Contains the prices for all most Futures Contracts.
http://quotes.ino.com/exchanges/

List the Premiums and Discounts on Canadian Closed End Funds.

http://globefunddb.theglobeandmail.com/gishome/plsql/

Canadian Small-Cap informational resources.
http://www.agoracom.com/

Watch Bloomberg TV live.
http://www.bloomberg.com/streams/video/LiveBTV200.asxx

Find Uranium Prices
http://www.uxc.com/review/uxc_Prices.aspx

A Canadian Prefered Shares Website
http://www.prefblog.com/

Basic Canadian Stock Screener provided by GlobeInvestor.
http://www.globeinvestor.com/v5/content/filters

American University in Bulgaria Lectures

Published on March 5, 2008 in Economics and Finance. 0 Comments

If you go to Google Video there are over 20 lectures posted by professor Krassimir Petrov in the the feild of Economics and Finance. So far i’ve watched 8 lectures and plan to finish listening to the rest of the over the next month. He teaches Economics from the Austrian perspective unlike most universities which teach from the Neo-Classical Keynesian perspective. Economists from the Austrian school have the best track record out of all economists.

Krassimir Petrov holds a Ph.D. degree from the Ohio State University in Economics (1999). During 2000-2004 he worked at Sterling Commerce, a subsidiary of SBC Communications. Since 2005 he has been a full-time Assistant Professor at The American University in Bulgaria teaching Macroeconomics, Money and Banking, International Finance, etc. Since 2007 Dr. Petrov currently writes a newsletter for Agora Financial. He is an Austrian economist and uses for his analysis the Austrian approach to investing.

Link:
http://video.google.ca/videosearch?q=Krassimir+Petrov&num=10&so=0&start=0

Note: His best lectures are the those on the business cycle and inflation, his investment lectures deal mostly with technical analysis and i would not recommend them.

The Efficient Market Hypothesis : And The Case for Small Caps

Published on March 4, 2008 in Finance. 0 Comments

In 2007, only 24.3% of active funds outperformed the S&P/TSX composite index last year. In contrast, 51.8% of Canadian small/mid cap equity funds outperformed the S&P/TSX SmallCap Index according to S&P. Furthermore, only 5% of large cap fund managers beat their respective index in the long term (10 years). In contrast, 35% of small cap fund managers beat their respective index in the long term (10 years) .

Furthermore as highlighted in “A Random Walk Down Wall Street”, by Burton Malikiel. Small Caps, since 1926 have returned an annual rate of 12.6% while large caps have returned 10.4%. Large caps have a standard deviation in return of 20.2% and with small caps having a standard deviation in return of 32.9%.

When doing the math an investor has much better potential when investing in small caps in the long run. And small cap mutual fund are more likely to outperform their index when compared to large cap funds.

Investors often perceive small caps as risker for many reason including: their higher volatility, low analyst coverage, low news coverage, fear of internal corruption, and fewer buy recommendations lead to investors to avoid the asset class.

However for investors who are willing to conduct their reasearch, there are more opportunities in the small cap sector. As Hesperian Capital noted, “It is an Axiom of the markets that it’s easier to show a 50% return on one dollar than a million dollar.” Because smaller companies simply have more growth potential.

The main reason small cap managers outperform their large cap counterparts is due to the Efficient Market Hypothesis. The Efficient Market Hypothesis (EMH) asserts that financial markets are “informationally efficient”, or that prices on traded assets, e.g., stocks, bonds, or property, already reflect all known information and therefore are unbiased in the sense that they reflect the collective beliefs of all investors about future prospects. However in the small cap arena, the Efficient Markets are not as prevalent as in the large cap arena due to lower investor and media coverage. Hence, making potential returns to investors who are willing to put the time and effort into the reasearch of small cap companies greater.

Mutual Funds such as Hisperian, Sprott and Resolute have prospered due to this philosophy. As Eric Sprott recent remarked, “But we don’t like buying the big guy. We like buying the little guy that no one else is buying.” And as Hesperian Capital noted “It is an Axiom of the markets that it’s easier to show a 50% return on one dollar than a million dollar.”

The Sprott Canadian Equity Fund did not make an annualized 29% rate or return over the last 10 years for no reason. Their ability to reasearch the less transparent, higher growth and unnoticed small caps are directly responsible for their success.

However small caps aren’t for everyone. Due to the lack of readily available reasearch, investing in the small caps requires much more reasearch and grounds up analysis, failing to do so will expose one to a a higher degree of risk.

Constructing a core-satellite portfolio with a market cap weighted ETF’s for your large cap exposure and a high quality Mutual Funds for your small cap exposure would be the best approach for the average retail investor when faced with the Efficient Market Hypothesis.