tarik.ca analytics : a canadian financial blog

Since Dec 18th, 2007, the Tarik.ca Fundamentals Canadian Equity Fund has returned 26.89 %

The Performance of Market Indices since inception:

S&P/TSX Composite Index : 12.80 %
S&P/TSX SmallCap Index : 7.57 %
S&P/TSX Income Trust Index : 20.83%
Dow Jones Industrial (USD) : -1.28%
Nasdaq (USD) : -1.41 %
FTSE All World ex-US (USD) : 1.83 %

The Tarik.ca Canadian Fundamental Fund has preformed remarkably well since inception on December 18th 2007. These are some of the significant highlights

ARC Energy Trust has increased distributions by 20%, making it the only Natural Gas weighted trust to increase distribution since late 2006.
Canadian Oil Sands Trust has increased distributions twice since December, up a total 50%, due to it’s unhedged exposure to crude oil.
Royal Utilities a Saskatchewan coal producer was bough out at a 25% premium, by Sherritt.
Potash Corp of Saskatchewan has experienced strong performance due to strong potash prices.
Macquarie Power & Infrastucture and Great Lakes Hydro are experiencing strong water flow in their Hydro facilities and strong cash flow.
Capvest the closed end fund, has preformed very well as the discount to NAV has shrunk while the underlining NAV has performed well as income trusts have outperformed the TSX Index.
Fording Coal Trust has performed extremely well as metallurgical coal prices have doubled in the last year as global steel production grow at above trend and as mine disruptions have been experienced in China and Australia.

Tarik.ca Canadian Equity Fund : Performance Graph (As of May 8, 2008)
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Tarik.ca Canadian Equity Fund : Investment Weightings (As of May 8, 2008)
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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.

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.

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.

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.