Blessed by the Potato

There are some readvancable mortgages that are sometimes billed as all-in-one accounts at a few different institutions. The way they work is to basically pull together your mortgage, line of credit, savings, and chequing accounts into one product. The stated benefit is that your emergency fund and cash float from your savings and chequing accounts will be used to pay down the mortgage, but are still available for your use as needed.

All else being equal, this would be a great idea, and indeed recently Nelson at Financial Uproar had a post covering them.

The problem though is that these products usually come with a higher interest rate than you could get on a plain vanilla mortgage, about 0.5-1% more. So does the benefit of having your whole float working on your mortgage balance outweigh the extra cost of the higher interest rate? Like many things, the answer is it depends… but mostly, no.

You can grab a spreadsheet and play along at home with the full calculations if you like, but for once I’m just going to back-of-the-envelope it. There will be some minor effects from the compounding, but not enough to really worry about.

So let’s say you’re a fairly typical recent homeowner: you bought a few years ago, and just recently crossed over into having enough equity to try out this scheme. You’ve got $10k in your emergency fund, and your chequing account balance varies through the month depending on the timing of your bills and payroll deposits, but is on average about $3k. So you could potentially put an additional $13k towards your mortgage with this plan. If you’ve got $400k left on your mortgage, then the amount of interest you’d pay in a year would be $12k at 3%. With the new plan, you’d only be paying interest on $387k, but at the higher rate of 3.5%, which would cost you $13.5k. So the higher interest rate makes it a fair bit more expensive to go with this plan (and any impact of compounding would be balanced by the interest the cash would be generating in a savings account).

If you have more in cash and less owing on your house, it may look better: with $20k in cash and only $100k owing on the mortgage, you’d be paying $3k in interest the traditional way, versus $2.8k for the all-in-one. Still, you need almost absurd amounts of cash compared to the mortgage balance for it to work out.

Plus, with just a little bit of effort on your part, you could in those situations do even better with separate accounts: you can get a regular mortgage at the lower rate, put all of that cash on the mortgage, and open a separate HELOC to get the flexibility to re-withdraw your emergency fund if and when needed. All the money goes on the mortgage at the lower rate — you can even put your chequing account float on the mortgage and use the HELOC for the revolving cash needs (which sounds scary, but is functionally exactly what is happening with the all-in-one products).

I keep coming back to look at poor unloved RIM, and I keep not buying it.

At one point I was openly wondering if it was a good buy, trading a hair above book value and some ridiculously low P/E. I even thought it was good enough for the misfit bloggers stock picking competition (good enough for fake money — now there’s a recommendation!). Then it fell lower than that even, and I still didn’t buy. It wasn’t due to any squeamishness about falling knives, but rather because the business outlook kept deteriorating just as fast if not faster than the share price. Not even a year ago I had figured that even if the BlackBerry brand was losing out to Apple and Android, it wouldn’t happen overnight, and there’d still be a year or two of positive earnings. Yet now they’re already reporting a loss.

A few months ago, I reasoned that they’d be worth the cash on the balance sheet plus some generous value for their trove of patents. After all, they had paid some billions of dollars for just a subset of the patents in the Nortel bankruptcy. Except, that line of reasoning kind of fell apart as I examined it: they were the highest bidder in the auction, so the patents would by definition be worth somewhat less than what they paid. Plus, those patents are a few years older and closer to expiry now. RIM’s own core patents might be valuable (they still do have some strengths)… but Apple and Google’s device manufacturers have had no problem moving product without access to those patents. How much could they really be worth?

So now I’m lowering my sights once again and demanding a larger margin-of-safety before buying. If the negative sentiment continues and the stock price continues to suffer then there may well come a time where I’m willing to buy. But now I think that point will be when the stock is trading at a discount to their cash: where I get the patents for free, the business for free, and a cushion to insulate against a few years of losses eating into that cash hoard. From a quick back-of-the-envelope calculation, I probably won’t be putting in any bids until I see it under $4.

This is a monthly update from the Blueberry Portfolio. The events I talked about below happened approx 8 months ago.

The market has been much stronger in the last month, and we’re now up just over 6% from the beginning, vs. the market up 2.5% (in the last report, the market was down 2.5%, so both us and the market are up about 5% in the month).

Though my goal is to be almost fully invested most of the time, at the moment we have about 15% cash in the portfolio: I just don’t have any great high-conviction ideas at the moment. I’m researching some options, but haven’t had much time to put towards that. One problem is fear: we own a bit of Indigo Books & Music, which is one of the few stocks that’s down a lot since we bought it, and though it looks even cheaper now, I’m afraid to put any more capital towards it in case I’m wrong about the book and knick-knack selling business in Canada. It has really clean financials, and due to the decline in the stock price the modest dividend is now on its own an attractive feature: it’s yielding about 7% at these prices. However, they lost money in the last quarter, and the big gamble is what happens over the next few months. Will Canadians buy books, music, upscale wrapping paper, and whatever else Heather Reismann wants to sell in Chapters stores over the holidays, or has Amazon finally caught up and killed Canadian bookstores, after feasting on the carcasses of the American chains?

That’s really the key question. Indigo at the moment is trading for just a bit more than the value of their current inventory and the shelving units in the stores: if the company is at all profitable for the next couple of years, then this is a stupidly low price for it and we could make a lot of money by buying now. Historically, most of their money is made over the holiday season. If they can come out in the black again this year, then the stock will probably go up on the news. But if their losses continue into the new year, then we may be looking at store closings and the end of an era for physical books.

At the moment I view Indigo as a potential high-risk, high-reward stock. Even just getting back to where we bought it a few months ago would be a huge percentage return. So while I do seek out and invest in high-risk, high-reward situations, I try to keep the size small so that if we see the high-risk side rear its head and lose money (as we already have to a large extent on Indigo) it doesn’t hurt us too much (indeed, the returns in the first paragraph include losing money on Indigo — not all of our ideas will be winners).

As to the cash, well that’s there in large part because we’ve had a few take-overs.

One of my big ideas at the beginning was Capital Power income fund: it was in the process of being taken over by Atlantic Power. Both were power utilities paying nice, stable dividends. I was happy to own either for the long term, but an interesting opportunity was in buying Capital Power just for the takeover: we bought at $18.60 per share, and Atlantic Power was promising to buy those shares from us at $19.40 in just a few months. It seemed like a very low-risk opportunity, and so it was immediately one of the biggest positions at over 10% of the portfolio. In the end, I made a small mistake in evaluating the deal: Atlantic Power was offering a combination of shares and cash, and I thought we would be able to choose just cash and get just cash, but Atlantic Power wanted the whole deal (across every shareholder) to average out to half cash and half shares. If I was being a proper arbitrageur, I would have shorted the Atlantic Power shares at the same time I bought the Capital Power ones (short about half of one ATP for each CPA). In the end, we ended up getting the equivalent of $18.98 per Capital Power share, plus one tax-effective dividend payment of $0.145. That’s a gain of 2.8% in two months, which is fantastic (some investments don’t make that in a whole year). Still, a bit less than I had figured we’d make in my mistaken initial all-cash estimate.

Anyway, one of our biggest positions has been turned from a stock back into cash, which explains why we once again have a fair bit of cash to invest in something else.

At the moment, I don’t know what to invest it in. I’ll be doing research from my end, but remember Peter Lynch’s advice: good stocks don’t come out of nowhere, many are the companies you interact with every day as a consumer. So if you see the beginnings of a new fad (like crocs or lululemons), or ongoing good value and customer support, something that you find your friends and family talking about and recommending to each other consistently, make a mental note of it and let me know.

And especially make note of how busy your local Indigo/Chapters is this holiday season, and how that compares to previous years.

There’s something of an art when it come to reading financial statements as an investor: a lot of things are open to interpretation in how you value them, and your own valuation may not necessarily agree with that of the accountants who prepared the statement.

A great example was brought up recently by SBrunner. She runs a very strange site, where she provides all kinds of data on a company, almost entirely free of commentary. Just spreadsheets and facts. Recently she highlighted one of my favourite companies (and largest holdings), Canexus. Though she doesn’t explicitly say that she disapproved of the change in Nexen’s ownership, she did prominently highlight the large drop in “book value” that happened at the time.

The thing is, the transaction had no effect on the true book value. It was all just an accounting shadow play.

Consider a case where I own 1/3 of some tangible thing, and my friend Netbug owns the other 2/3. I can choose to subdivide my ownership of the thing into 100 shares and then sell those shares on the stock market. Each share is ownership of 1/100 of 1/3 of the thing. If we put a value on this tangible thing, say $100,000, then each share is worth $333.33 in this example.

Now let’s suppose that Netbug wants to raise a bit of cash, but doesn’t want to sell his entire stake in our shared mysterious thing. He converts his ownership into shares that are identical to the ones I created: he creates 200 shares, so each is still worth 1/100 of 1/3 of the underlying thing (or if you prefer unsimplified fractions, 1/200 of 2/3). He could then sell those shares into the stock market (where they would not necessarily trade for the underlying value of $333.33/share).

This is a bit of a complicated transaction, and would greatly increase the float… but at the end of the day, the book value of each share didn’t change: the thing that we own is still the same, and each share still represents the same fractional ownership of this thing.

Well, that’s pretty much exactly what happened with the “buy out” in Canexus: Nexen converted it’s 2/3 ownership of the underlying business into shares, and dumped those shares on the market. Yet SBrunner reports a massive decrease in book value associated with the transaction. If one were to judge that and add some commentary, you might say that it represented massive dilution, or may have been a poor takeover, or something to that effect… if it indeed were a take-over and if book value had in fact changed.

So what happened? SBrunner, for the record, didn’t get it wrong: the book value according to the financial statements did drop by a massive amount. If you look to the balance sheet statements before and after the transaction, divide by the number of shares, you get the values she reports. She’s just faithfully tracking what the accountants are saying.

The problem was with the way book value was reported in the statements. For some reason, when the shares represented a minority ownership, the book value was calculated in a way that did not involve taking the net of the assets-liabilities and dividing by the ownership stake. In other words, the books of Canexus before Nexen spun off their stake did not simply represent 1/3 of the underlying operating business. There was this line item for the value of the ownership stake, and it got in there at the level it did by some accounting wizardry. From what I can tell, goodwill without calling it goodwill.

It was fine for the auditors, and probably made sense to the tax people, but as an investor, why would you have used that number as your figure for book value, instead of taking 1/3 of the value of the underlying business? If you had calculated book value yourself using that method (and the statements for the underlying operating company were reported in the same annual reports, just a few pages further in), then the transaction of releasing more shares from the previously non-trading part of the ownership didn’t affect your personal sense of how the company should be valued at all. If you relied on the way the statements were prepared, then suddenly there was this massive shift in value under your feet, simply because of how the accountants reported the worth of a minority stake versus the whole pie consolidated together.

So this is one real-world case where you may need to come up with your own interpretation of the financial statements, rather than relying on what the accountants have prepared according to GAAP/IFRS.

Be sure to look at the first two posts in this series introducing the retirement spreadsheet, and discussing the details of the inputs and how it works.

Here, I want to stress the importance of using this spreadsheet to look at a large number of potential scenarios. It’s good to have an idea of what you think would be the most likely outcome, and with a bit of conservatism, what would be the most likely base scenario (where things would be that good or better for you). But it’s also important to know how the factors will affect your ability to stay retired, in part so you know what to watch for as retirement unfolds. Keep updating the plan every year or so, and watch for any changes in the world that will require a course correction on your part.

When looking at this with my friend, I went through something like 25 different scenarios. I’ll outline a few for you below, but it’s important to do the exercise yourself: come up with your own range of reasonable values for all the various inputs, and understand how they’ll impact your retirement.

What might be an important factor can depend on circumstances. For instance, if a large part of your spending needs are met by a pension (plus CPP/OAS), then above-indexed personal inflation can have a massive impact on your ability to meet your expenses, while you may be ambivalent about market returns.

Let’s take the example in the default spreadsheet: someone who has $540k in assets, $45k in spending needs, and $43k in pre-tax pension income. They should be set up for a pretty secure retirement: only a small portion of the assets need to be used to pay for expenses — basically just the taxes and for the occasional big-ticket item every 5 years.

If their personal inflation rate matches the CPI rate that the pensions and government subsidy are indexed to, this person could expect to live to 92 on their assets even assuming conservative investment returns (-0.25% real return on fixed income, and 3.5% real return on stocks). Even after the money ran out, they’d only have to cut their spending by about $10k/year to live off the guaranteed pensions (it sounds like a lot, coming off $45k, but perhaps not so tough when you’re 92, and not the end of the world).

Even really poor investment returns don’t change that answer too much: lowering stock and fixed income returns by a full percent lowers the out-of-money age to 84; lowering stock returns right to 0% only brings it down to 80 — younger than many may expect to live, but zero nominal stock market returns for that long is, IMHO, needlessly pessimistic. So in that scenario you’re fairly insensitive to market returns.

Inflation, however, can be a killer. If your personal inflation rate is just 1% above that the pensions are linked to, your capital gets burned through at 80 instead of 92. At a personal inflation rate of 2% above the indexed rate someone in this situation may not want to consider taking retirement at the age 60 assumed in the scenario, since they’ll be facing shortfalls by age 75.

For someone without the pension, more personal assets might be needed to fund retirement. Let’s say that we had a similar base case: $45k/year spending needs, same CPP/OAS for the couple, but put off retirement until age 65, and an extra $100k of assets (all in the RRSP, for a total of $400k there). In this case, the person would make it to age 95 with their assets using the base assumptions (2.5% inflation for both inflation boxes, 6% nominal stock returns, 2.25% nominal fixed income). Personal inflation changes still have an effect: a 1% increase over CPI reduces the age of security to 87, and 2% to 82; but the effect is not as severe as when you were watching the buying power of your pension disappear under those inflation assumptions. And, if your investment returns increase by even half the increase in your personal inflation rate (e.g., by investing in companies based in the sectors that make the things you spend most on), then there’s hardly any pain at all.

If even more of your income is tied to the market, then so too will be your ability to retire.

I made a little document with a paragraph or two for each scenario, gave them names, and also discussed how likely they might be to occur — or perhaps more importantly, to work out that way or better. I focused mainly on the scenarios I thought were less likely: for instance, I think 2% real returns on stocks will likely be on the low side, but it’s more important to have a conservative plan for poor returns like that than it is to focus on more likely cases (say, 4+%/year) and be disappointed by reality. The next decade may very well bring extraordinary investment returns, following this previous decade of underwhelming ones. But hope and optimism are not a plan.

Since selling the house to fund retirement was not to be part of the plan for taking early retirement in my friends’ case, I didn’t explicitly build it into the tool. But if you’re close to retirement and using this tool, you could easily consider the case where you sell the house right away (either to downsize or rent): just adjust the annual spending budget accordingly, and increase the investments. Or, to consider the case where you sell it (or some other personal asset like a cottage) you can go to the calculations tab and change the line for the age where you sell it, and add in the extra assets. For instance, if the calculator says your retirement will be squeezed by age 78 under some scenarios, you may think that’s a perfectly fine outcome since the tool isn’t taking into account other assets that you have the option of selling at that point.

Also remember that financial planning isn’t a one-and-done exercise: it’s important to review your plan periodically to see how well you’re sticking to it, and how the world around you is unfolding relative to what you assumed. Then to make course corrections as necessary to keep moving towards your target.