In This Issue

THE NEXT TWO MONTHS

By Gordon Pape

We have entered what is historically the worst period of the year for stock markets. The month of September statistically shows the largest average annual loss. October, surprisingly, is marginally profitable on average but when things go wrong it can get ugly.

Dave Paterson, who is the editor and publisher of our companion Mutual Funds Update newsletter, has drawn on figures from Yahoo Finance to compile a table summarizing the performance of the S&P 500 from January 1950 to July 2012. It’s an eye-opener.

It shows that over those 62-1/2 years, the S&P lost an average of 0.57% in September. Only three other months were losers: February at -0.12%, August at -0.04%, and June at -0.02%. Moreover, the best September return was only 8.76%.

Interestingly, October showed the best one-month return over that time at 16.3%. It also showed the worst one-month loss by far, 21.76%. The obvious conclusion is that October is often highly volatile and anything can happen.

The best time to be in the markets is November-December and again in April.

Performance of the S&P 500 from January 1950 to July 2012

 
Average Monthly Return
Worst Monthly Return
Best Monthly Return
Range of Returns
January
1.10%
-8.57%
13.18%
21.74%
February
-0.12%
-10.99%
7.15%
18.14%
March
1.18%
-10.18%
9.67%
19.85%
April
1.49%
-9.05%
9.39%
18.44%
May
0.14%
-8.60%
9.20%
17.80%
June
-0.02%
-8.60%
8.23%
16.83%
July
0.96%
-7.90%
8.84%
16.74%
August
-0.04%
-14.58%
11.60%
26.18%
September
-0.57%
-11.93%
8.76%
20.69%
October
0.78%
-21.76%
16.30%
38.07%
November
1.52%
-11.39%
10.24%
21.62%
December
1.71%
-6.03%
11.16%
17.19%

Source: Yahoo Finance

So what do all these numbers tell us in terms of an investing strategy for the next couple of months? Obviously we have to be careful when it comes to averages – don’t forget the old story about the man who drowned in a river that averaged only one foot in depth when he stepped into a hole.

Nonetheless, this is a time when experience tells us to exercise caution. September and October have histories of producing violent market upheavals. The Crash of 1929 took place in October. So did Black Monday, the Oct. 19, 1987 plunge that took down markets around the world. A decade later, the Asian crisis triggered what was then the biggest one-day drop in the history of the Dow on Oct. 27, 1997.

The terrorist attacks of Sept. 11, 2001 sent markets reeling just as they were starting to recover from the high-tech plunge. Then in September 2008, Lehman Brothers collapsed setting off a chain reaction that almost brought down the global financial system.

Instead of “sell in May and go away” a more appropriate adage might be “sell before Labour Day, buy after All Saints Day”.

Of course, we could be pleasantly surprised. So far, September is off to a good start with the S&P/TSX Composite Index up 3.4% for the first four trading days while the S&P 500 added 2.6%. But it’s still early.

There are so many cross-currents right now that it is hard to predict what is going to happen in the short term. In its policy statement last week, the Bank of Canada cited widespread slowing of economic activity, the recession and financial crisis in Europe, and the sluggish U.S. recovery as reasons for holding its 1% target rate, even though Governor Mark Carney would dearly like to raise it.

Added to that was the election of a minority Parti Quebecois government in Quebec. The markets appeared to shrug it off but some businesses may be reluctant to make new investments in the province. The reason is not so much the threat of separatism (which is almost non-existent right now) but rather the uncertainty created by the PQ’s promise to raise taxes on the “rich” and certain types of corporations, such as mines. Those aren’t the kind of policies that attract new money.

On the positive side, U.S. auto sales were strong again in August, housing prices in that country are finally starting to edge higher, business investment in Canada as a whole remains “solid” (the Bank of Canada’s description), and second-quarter financial results from S&P companies came in stronger than expected, as Tom Slee points out in his column.

In such a shifting sands scenario, markets are likely to overreact to news, good or bad. An announcement from the U.S. Federal Reserve Board that it will implement a third round of quantitative easing (QE3) would likely send stocks soaring, even though the underlying implication would be that the U.S. economy is weakening. Conversely, if third-quarter financial results, which will start coming out in early October, are unusually weak it could spark a major sell-off.

The best advice I can offer in these circumstances is to avoid being swept up in day-to-day frenzies and have some cash available for buying opportunities. If we see a pronounced pull-back in the next two months, be ready to take positions at the start of November (or after the U.S. election if you want to be ultra-cautious). There are some good values in the market right now but they may look even better in eight weeks.

 

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U. S. STOCKS A BETTER BET RIGHT NOW

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Contributing editor Tom Slee is back this week and kicks off the fall season by looking south of the border at the U.S. market. Tom managed millions of dollars in pension money during his career and is also an expert on taxes. Here is his report.

Tom Slee writes:

On balance, the dog days of summer were kind. Despite some strong headwinds, North American stock markets tended to inch higher during the last few months and September is off to a strong start. There was no significant groundswell. The recovery continues to splutter and the Europeans are still struggling to resolve their problems. Nevertheless, our stocks are showing signs of strength as investors steadily shift more money into equities. Badly underperforming large-cap mutual funds have been forced to make commitments. Many of the hedge funds are now actively buying stocks and positioning themselves as we head into post-election 2013.

My feeling is that stocks have support at these levels. True, the economy is a mixed bag but keep in mind that there are continuous cross-currents in the market. It’s not driven just by the GDP and other national statistics. Thousands of players each have their own agendas. Traders respond to short-term buying opportunities. As an institutional money manager I was engaged in large, gradual buying or selling programs that were not affected by breaking news, although our orders were sometimes placed on hold.

My point is that we may enjoy relatively good markets for the balance of this year even though the fundamentals remain unchanged. For example, the institutions, especially hedge funds, cannot afford to remain defensive. With even junior junk bonds yielding a paltry 7% they have to step into the stock market and take more risk.

Here is the situation at the moment. As Gordon has pointed out in past issues, there are a couple of big question marks hanging over the TSX. Our powerhouse resource sector has run out of steam and the banks and insurers have been treading water. The Canadian market is unexciting. It’s just a phase, of course, but one we have to factor into our decisions. That does not mean there aren’t some excellent investment opportunities in our market. However, you have to seek them out on a stock-by-stock basis. There is no rising tide.

On the other hand, I think that American markets look a lot more promising. The tone is better and, as always, the choice is larger. Perhaps most important, the crucial second-quarter U. S. corporate earnings beat expectations. Analysts had warned everybody to brace themselves for a 1% decline in the S&P 500 results year-over-year. They actually came in 2% higher. Top-line numbers were a little subdued; only 34% of the companies generated better than expected revenues because international sales, especially in Europe, were disappointing. Earnings, though, were encouraging with 68% of the companies beating the forecasts, mostly as a result of tighter cost controls. Moreover, according to Barron’s, most corporate balance sheets were sound at the end of the quarter.

Those are not rousing results but they do show that corporate America is in relatively good shape during this fourth year of the downturn. It’s worth noting too that profit margins have been improving. Companies are increasingly efficient.

Incidentally, I think that those second-quarter numbers are another indication that the American unemployment rate is going to remain stubbornly high for the foreseeable future, which is a tragedy for many people. Historically, an improving job picture, powering consumer spending, has driven economic recoveries and a strong stock market. There are few signs of that happening this time.

Corporations are turning to technology in order to increase production, not picking up workers as orders improve. Robots no longer replace people one at a time. In the automobile industry, one new and improved model can do the work of four people in assembly and packaging. That is not going to change. In fact, the restructuring problem is going to become worse. As a result, the recovery and stock markets are likely to gain traction even though the unemployment figures remain a concern. We should not wait for this indicator to improve.

U.S stocks, meanwhile, are cheap. At the moment, the S&P 500 is trading at 13 times forecasted 2013 earnings compared to a long-term average of 16 times. The market has several other things going for it as well. European investors continue to switch funds into North America on a more permanent basis and this money is no longer being jammed into Treasury bills. European institutions, like our own, are under pressure to perform and are turning to American equities.

As Canadian investors, I think that we should also keep in mind that according to a lot of economists our loonie is now substantially overvalued because of inflated commodity prices and a flood of foreign money into our bond markets. The Organization for Economic Cooperation and Development (OECD) believes that the Canadian dollar is really worth about 80 cents U.S. If this is even half right the loonie is going to adjust downward at some point. Ergo, we now have an unusual opportunity to earn a foreign exchange profit as well as capital appreciation from U.S. stock purchases.

Turning to the stocks themselves, I think that we should be guided to some extent by a suggestion from Don Coxe, Chairman of Coxe Advisors LLC. He says: “Do not invest in companies which produce what China produces or will soon be producing. Invest in companies which produce what China needs to buy”. Of course, that narrows the field considerably but still leaves some attractive stocks. Here are my choices and suggestions.

Caterpillar Inc.

Founded as the Holt Manufacturing Company in 1904, Caterpillar (NYSE: CAT) was restructured and renamed in 1925, became a tractor manufacturer, and then expanded. Today it’s the world’s largest maker of construction and mining equipment as well as a leading manufacturer of natural gas engines and industrial gas turbines. With more than 132,000 employees, CAT operates in nearly every country throughout the world.

Revenues totaled $60.1 billion in 2011 (all dollar amounts are in U.S. currency) and operating profit came in at $9.7 billion. Cash flow of $7.5 billion was up sharply from $5 billion the year before.

The stock is currently trading at $88.10, substantially above its 52-week low of $68, but I think that given the company’s earnings growth there is still a lot of upside potential. CAT is part of our IWB Growth Portfolio.

Caterpillar conducts its business through three major divisions: Construction Industries (33% of revenues and 21% of profit), Resource Industries (26%; 34%) and Power Systems (33%; 31%). Financial Products, primarily financing for CAT dealers, makes up the balance. That mix, however, may change significantly. In July 2011, the company acquired Bucyrus International, a major U.S. surface and underground mining equipment company for $8.8 billion. The deal gives CAT an opportunity to rapidly expand its coal and metals mining business, especially in the emerging countries. The purchase also allows the company to offer a full line of excavation equipment.

Most encouraging is CAT’s earnings performance. Second-quarter profit came in at $2.54 a share, easily beating the forecasted $2.27 and up 67% from $1.52 in 2011. Net income has increased 49% year-over-year on average across the last five quarters. It’s a remarkable performance given the worldwide economic difficulties.

Looking ahead, Caterpillar could earn close to $10 a share this year, compared to $7.40 in 2011 and climb to $11.75 or more in 2013. Analysts are expecting 17.5% long-term earnings growth. A global economic slump or another credit crisis could put a crimp in these numbers but CAT has so far been able to weather the storms.

Action now: Caterpillar is a Buy at $88.10 with an initial target of $115. I will revisit the stock if it dips to below $75.

United Rentals

Another U.S. stock that I like and am watching closely is United Rentals (NYSE: URI), the world’s largest equipment rental company with over 500 locations throughout the U.S. and Canada. The company’s general rentals segment services the construction and industrial markets while its trench safety and power division focuses on municipalities and utilities. Annual revenues exceed $3 billion and earnings have been increasing rapidly.

Equipment rental is an unexciting but growing industry that has been largely overlooked by investors. Yet the business makes a lot of sense. In these difficult times a great many medium-sized companies and local governments are opting to rent equipment rather than make substantial capital investments and then have machinery sitting idle. Because of its size, URI, with a rental fleet of 230,000 units, is able to service a full range of customers, from Fortune 500 corporations to individual homeowners. At the same time, the company is mopping up competitors in a highly fragmented industry.

Earnings of about $3.50 a share are expected in 2012 with a significant jump to the $5 range next year. My only reservation is that U.S. commercial and residential construction remains fragile. A sudden economic downturn could hurt this stock. Nevertheless I shall continue to monitor the situation. The stock is now priced at $37.83. Wall Street is looking for $50.

Action now: Watch. I think that this is a great stock but we have had a series of false dawns in the U.S. construction industry and some really disappointing statistics or forecasts could drive URI lower. The shares have a 52-week low of $14.48. I intend to monitor the company closely and will add it to the Buy List if we see a good third quarter (earnings of $1.25 or better) and the recovery continues.

Estee Lauder Inc.

One company that I have no hesitation in recommending is Estee Lauder Inc. (NYSE: EL) currently trading at $61. The big story here is that new CEO Fabrizio Freda is successfully firing up the organization. This leading manufacturer and marketer of makeup, fragrance, and hair care products is on a roll and earned $2.27 a share for the year ending June 30, up 23% from 2011.

Trumpeted as “Estee Lauder’s Makeover Man”, Mr. Freda was brought in three years ago to shake up the company after three generations of family rule. It was a bold move, and so far it’s paying off in spades.

New York-based Estee Lauder reports its results on a regional basis and at present the Americas account for 43% of sales and 22% of profits. Europe, the Middle East, and Africa account for 37% and 55% while the Asia/Pacific contributes 20% and 23%.

Incorporated in 1946, the company has successfully introduced and marketed a stream of new products including Clinique and Aramis. Tommy Hilfiger’s fragrances are produced in conjunction with Estee Lauder.

In 2008, though, the company stumbled badly when the financial crash undermined consumer spending. People were no longer inclined to buy $900 skin care creams. At the same time, department store chain mergers drastically reduced Lauder’s outlets. Profits plunged and chairman William Lauder went outside the tightly-knit family to hire Mr. Freda, a marketing executive with experience at Proctor & Gamble and Gucci. Soon after, a cadre of senior managers left the company and new policies were introduced. The numbers started to improve.

Going forward, Mr. Freda intends to focus on the Asia/Pacific business. China in particular offers a great deal of potential as its population adopts North American styles and habits. At the moment, Chinese women spend $19 per capital on beauty products compared to $229 in the U.S.

What I really like about the new program, however, is that it’s not just a gung-ho marketing campaign. Controls are being tightened and the overall operating margin has increased to a record 14.2%. Free cash flow reached an all time high of $1.1 billion in the year just ended. Management is forecasting $10.5 billion in revenues in 2013 compared to $9.7 billion this year. We could see earnings of $2.75 a share or more in 2013.

Action now: Estee Lauder is a Buy at $61 with a target of $72. I have set a $52 revisit level.

 

 

TOM SLEE’S UPDATES

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Kinder Morgan Inc. (NYSE: KMI)

Originally recommended on Sept. 6/11 (#21132) at $25.19. Closed Friday at $35.84. (All figures in U.S. dollars.)

Kinder Morgan Inc. continues to power ahead and reported second-quarter cash available for dividends of $307 million, up 83% from $168 million the year before. Total first half net cash flow of $610 million grew 40% from the comparable period in 2011 and as a result KMI increased its distributions to $1.40 per annum. They are expected to grow at an average annual rate of around 12.5% through 2015.

The company, general partner of Kinder Morgan Energy Partners and El Paso Pipeline Partners, essentially owns and manages a diversified portfolio of energy transportation and storage assets, a sub-industry that is expected to perform well over the next 12 months. The U.S. Energy Information Administration (EIA) projects a 0.3% increase in liquid fuel consumption and a 1.6% increase in natural gas consumption next year. This follows liquid fuel declines in 2011 and 2012.

As far as KMI is concerned, I expect to see growth in all of its business segments with pipeline numbers particularly strong. Earnings of $1.45 a share are expected in 2012 and $1.55 next year. We could see a dividend of $1.66 a share in 2013. The stock at $35.84 is up 42% since our recommendation in May but still offers excellent value. KMI is part of our IWB Growth Portfolio.

Action now: Kinder Morgan Inc. is a Buy at $35.84 with a revised target of $42 although investors who bought at the time of our recommendation might consider taking at least some of their profits off the table. I will revisit the stock if it dips to $28.

ShawCor Ltd. (TSX: SCL.A, OTC: SAWLF)

Originally recommended on July 9/12 (#21224) at C$36.28, US$36.51. Closed Friday at C$41.85, US$43.09.

Ms. Virginia Shaw, chairperson and 67% owner of ShawCor, has announced that the company is for sale. No reason was given, although it’s probably a move to maximize shareholder value. ShawCor is in excellent shape and there is a lot of mergers and acquisitions activity in the energy services industry. Credit Suisse has been retained to handle the process.

The announcement was unexpected but as we pointed out when recommending ShawCor as a Buy at $36.28 in July, the stock has been undervalued. We set a target of $42, which is about where it is trading now, so we have a gain in two months of more than 15%. Of course, a control block commands a higher price and if you tumble the numbers on that basis SCL.A is worth at least $45. If the expected bidding war gets underway, the shares are going to trade well above that. I have seen close to $60 mentioned.

This is a tailor-made deal for the hungry hedge funds and large oil field services companies such as Halliburton and Schlumberger are bound to be interested. A word of warning, however: ShawCor has carved out a leadership position in the crucial pipe coating business. Its customers and the competition bureaus may raise objections if a giant corporation attempts to swallow the company.

Action now: ShawCor becomes a Hold at $41.85. The stock is likely to move much higher but anything above $47 or so would be pricey. Alternatively, if for any reason Ms. Shaw decides not to sell, the shares will plummet and I would regard that as a buying opportunity. This is a first-class company that is just moving to a new level of production and earnings. I will be sorry to see it go.

– end Tom Slee

 

PPN CRACKDOWN

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It has taken far too long but finally our securities regulators are cracking down on the way in which principal-protected notes (PPNs) are sold.

The Canadian Securities Administrators (CSA), which represents our patchwork quilt of regulatory bodies, has issued a notice that it expects all registered dealers to apply the know-your-client and suitability rules before recommending the purchase of PPNs to anyone. Even more to the point, the CSA says it wants the banks and other deposit-taking institutions to use the same standards. Banks have been the biggest issuers of PPNs, led by BMO and CIBC, but until now the sales of these securities have largely been unregulated. That’s going to change.

All I can say is that it’s about time. The financial industry has been raking in billions of dollars from PPNs, peddling them to people who, in many cases, have little understanding of how they work.

The main sales pitch is safety. PPNs guarantee you’ll get your capital back at maturity, no matter what happens. Whether you receive anything more depends on the performance of the security the PPN tracks. That could be a single stock index, one or more mutual funds, a portfolio of blue-chip stocks, a basket of selected stocks from a single sector (e.g. mining, agriculture, energy), or almost anything else.

With memories of the 2008-09 market crash still raw, many people are attracted by the idea of investing in a security that offers exposure to the stock market without putting their capital at risk. That provides a comfort blanket to nervous investors.

What these people often fail to understand is the high price they pay for PPNs in fees and commissions or the fact that many PPNs have a cap on how much they will pay out if things go well. Moreover, they don’t think about the fact that a zero return after tying up money for as long as five years is the same thing as a loss. The purchasing power of the capital has been eroded by inflation over that time and any interest or dividends that would have been earned by investing in conventional securities have been lost forever.

In a document published on its Investor Tools page, the CSA lumps PPNs into the Alternative Investments category, along with options, futures and forward contracts, foreign currency trading (forex), and hedge funds.

“Each of these different types of investments has medium to very high risk. They also have various costs associated with them, which could include: commissions, sales fees, management fees, operating fees or early redemption fees, among others,” the CSA warns. “They are meant for very sophisticated investors or investors who can afford to take higher risks and pay for specialized advice… Although you may be offered an investment in this class, it is important that you be comfortable with all risks and costs involved, and never invest in anything you don’t fully understand.”

The track record of most PPNs is not encouraging. Globefund includes them in its Miscellaneous – Other Funds category which has 1,128 entries. I did a search to see how many funds in this group beat the 6.21% average annual compound rate of return of a Canadian neutral balanced fund over the three years to July 31. Only 49 funds passed the test and most of those were not PPNs.

The most successful PPNs I found were the six series of Principal Protected Blue-Chip Notes issued by Sentry in 2004 and 2005, most of which showed three-year returns that were roughly double the balanced fund average. However, because of the effect of the 2008-09 crash, their returns since inception were much less impressive, ranging from 4.1% to 5%. That’s high by PPN standards – most issues don’t come close. But it’s not likely to excite many people, especially after they look closely at the costs and risks involved.

The bottom line is that investors should not allow themselves to become so fixated on the guaranteed principal pitch that they lose sight of the costs and risks involved. PPNs are a pure sales gimmick, albeit a successful one. Avoid them. – G.P.

 

GORDON PAPE’S UPDATES

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Walmart (NYSE: WMT)

Originally recommended on June 25/12 (#21222) at $67.30. Closed Friday at $73.82. (All figures in U.S. dollars.)

For a dull, blue-chip stock, Walmart has done very well for us in the two and a half months since it was recommended. As of the close on Friday, we had a capital gain of $6.52 per share plus we received a dividend of $0.398 on Aug. 8 for a total return so far of 10.3%.

On Aug. 16, the world’s leading retailer posted impressive second-quarter numbers (to July 31). Earnings per share came in at $1.18, the top of the company’s guidance range. That was up 8.3% from the same period a year ago. As well, the company raised its guidance for the full fiscal year to between $4.83 and $4.93 per share. The previous target range was $4.72 to $4.92.

U.S. comparable store sales were up 2.2% while Walmart International comparable store sales advanced by an impressive 6.4%. Overall, consolidated net sales were ahead by 4.5% over last year, to $113.5 billion.

The company reported free cash flow of $6.1 billion for the first six months of the current fiscal year. Return on investment (ROI) for the trailing 12 months was 18.1%.

“I’m really pleased with the continued momentum in our Walmart U.S. stores, evidenced, in part, by three consecutive quarters of positive comparable traffic and four straight quarters of positive comparable sales,” said CEO Mike Duke. “The team is very focused on delivering broad assortment and price leadership. Walmart’s low prices drive greater customer loyalty.”

Obviously, the shares are no longer the great value they were last June and the yield on the stock has dropped to 2.15% as a result of the price increase. (The annual dividend is $1.59 a share.) Therefore, I am changing the rating to Hold. We’ll look for a new entry point if the stock pulls back.

Action now: Hold. Short-term traders may want to take part-profits.

Steadyhand Income Fund (SIF120)

Originally recommended on Jan. 23/12 (#21203) at $10.56. Closed Thursday at $10.84.

Mackenzie Sentinel Income Fund – Series B (MFC732)

Originally recommended on Sept. 4/07 (#2731) at $9.60. Closed Thursday at $7.91.

The Steadyhand fund is ideal for nervous investors. It offers some exposure to the stock market (20.1% of the portfolio as of June 30) but most of the assets are in bonds (71.7%) with a small percentage (8.2%) in REITs. The bond segment of the portfolio favours corporate issues (63.8%) with 24.9% in provincial bonds and 11.3% in Canadas. Just over 8% of the portfolio is invested in the Connor Clark and Lunn High Yield Bond Fund – CC&L is the portfolio manager.

The fund posted a 3.61% gain in the six months to July 31, well ahead of the average of 0.69% for the Canadian Fixed Income Balanced category. Since my recommendation in January, we have a capital gain of $0.28 plus distributions of $0.20 per unit ($0.10 per quarter) for a total return of 4.55%.

This is not the kind of fund that will make you rich in a hurry but it will allow you to sleep comfortably at night knowing that your money is safe and is earning a respectable return by today’s standards. It’s also inexpensive to own – there are no sales commissions and the management expense ratio (MER) is just 1.04%.

One reader wrote to say his broker did not offer this fund and asked if I could suggest another one with a similar asset mix. Unfortunately, the Steadyhand funds are not available east of Ontario and in the Territories. Even in provinces where they are sold, some brokers won’t handle them because they don’t offer trailer fees.

You can always buy direct from the company – the minimum investment is $10,000 per fund. To set up an account, go to www.steadyhand.com.

If you don’t have that much to invest or prefer to work through a broker, one alternative is the Mackenzie Sentinel Income Fund (Series B), which is also on our Recommended List. It has a slightly higher stock component – 33.9% as of July 31. But the rest of the portfolio is in fixed-income securities and cash, giving it a low-risk profile. The main negatives are a much higher MER (1.95%), the fact it is a load fund, and a gradual erosion of the net asset value over time because of the monthly distribution of $0.033 per unit. We have not experienced that kind of erosion with the Steadyhand fund to this point.

Steadyhand Income also wins out on performance by a wide margin. It’s three-year average annual compound rate of return to July 31 was 10.06% compared to 5.63% for the Mackenzie fund. So while Sentinel Income looks similar to Steadyhand Income in terms of portfolio composition, it’s a weak second choice.

Action now: Steadyhand Income Fund is a Buy. Mackenzie Sentinel Income Fund remains a Hold, however if it is possible you may wish to switch to the Steadyhand entry. – G.P.

 

YOUR QUESTIONS

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Could Manulife fold?

Q – After receiving the previous newsletter, I took a $20,000 buy-in on the 10 stock Growth Portfolio suggested by Tom Slee. I have another 31 years to 65 so they will probably eventually grow. But on to the question.

I’m 34 and was diagnosed with MS (multiple sclerosis) at the age of 30 which left me unable to work due to a significant attack that I never fully recovered from. Long-term disability (LTD) was a hard adjustment but at the age of 30 I realized that my income would be static for the next 35 years. I decided that I had to pay off my student loans and mortgage to minimize interest cost. The student loan was paid in early 2009 and the mortgage will be paid off by late 2013 (instead of 2031). Once my debt is paid, I will bank the same amount, which is quite large, and plan for a retirement. I have my retirement plan set now because life didn’t give me much choice, but my biggest concern, other than my health, is the health of Manulife, my LTD insurer.

I know it’s a recommended Buy in the IWB. I also know that Manulife has suffered from low interest rates for some time now. They have had to receive an emergency loan from TD, I believe. They have had several very poor recent quarters with significant losses. They have also diluted their share price at least once by offering more stock to be sold on the market to raise capital. This is obviously a concern for investors but for someone like me, who relies on this income to live, it is a huge worry. Do you think that it is remotely possible that Manulife could fold? – Steve W.

A – I asked Tom Slee, who follows Manulife closely and once worked in the insurance industry, to answer Steve’s question. Here is his reply.

Yes, it is remotely possible that Manulife could go under. Three Canadian life insurance companies have declared bankruptcy, the last being Confederation Life in 1994. However, in the very unlikely event that Manulife runs into trouble Steve should be reassured that the company is a member of ASSURIS, a government and industry funded organization that protects policyholders in the event of default. It’s a sort of insurers’ insurer.

Steve should take a look at the website. The coverage limits are listed and Long Term Care and Long Term Disability Policyholders are protected up to $2,000 a month or 85% of currently provided income. However, these are subject to change so perhaps Steve could obtain a more detailed description of what is involved from ASSURIS if he is worried.
 
That having been said I am extremely confident that Manulife is not only going to survive but will prosper in the years ahead. The present problems were the result of massive, aggressive, and unhedged stock market positions prior to the 2008 crash to support the variable annuity business. That damage is being repaired but there is still a lot to be done. – T.S.

 

That’s all for this issue. We’ll be back on Sept. 17.

Best regards,

Gordon Pape
gordon.pape@buildingwealth.ca
Circulation matters: customer.service@buildingwealth.ca

All material in the Internet Wealth Builder is copyright Gordon Pape Enterprises Ltd. and may not be reproduced in whole or in part in any form without written consent. None of the content in this newsletter is intended to be, nor should be interpreted as, an invitation to buy or sell securities. All recommendations are based on information that is believed to be reliable. However, results are not guaranteed and the publishers, contributors, and distributors of the Internet Wealth Builder assume no liability whatsoever for any material losses that may occur. Readers are advised to consult a professional financial advisor before making any investment decisions. The staff of and contributors to the Internet Wealth Builder may hold positions in securities mentioned in this newsletter, either personally or through managed accounts. No compensation for recommending particular securities, services, or financial advisors is solicited or accepted.

In This Issue

THE NEXT TWO MONTHS

By Gordon Pape

We have entered what is historically the worst period of the year for stock markets. The month of September statistically shows the largest average annual loss. October, surprisingly, is marginally profitable on average but when things go wrong it can get ugly.

Dave Paterson, who is the editor and publisher of our companion Mutual Funds Update newsletter, has drawn on figures from Yahoo Finance to compile a table summarizing the performance of the S&P 500 from January 1950 to July 2012. It’s an eye-opener.

It shows that over those 62-1/2 years, the S&P lost an average of 0.57% in September. Only three other months were losers: February at -0.12%, August at -0.04%, and June at -0.02%. Moreover, the best September return was only 8.76%.

Interestingly, October showed the best one-month return over that time at 16.3%. It also showed the worst one-month loss by far, 21.76%. The obvious conclusion is that October is often highly volatile and anything can happen.

The best time to be in the markets is November-December and again in April.

Performance of the S&P 500 from January 1950 to July 2012

 
Average Monthly Return
Worst Monthly Return
Best Monthly Return
Range of Returns
January
1.10%
-8.57%
13.18%
21.74%
February
-0.12%
-10.99%
7.15%
18.14%
March
1.18%
-10.18%
9.67%
19.85%
April
1.49%
-9.05%
9.39%
18.44%
May
0.14%
-8.60%
9.20%
17.80%
June
-0.02%
-8.60%
8.23%
16.83%
July
0.96%
-7.90%
8.84%
16.74%
August
-0.04%
-14.58%
11.60%
26.18%
September
-0.57%
-11.93%
8.76%
20.69%
October
0.78%
-21.76%
16.30%
38.07%
November
1.52%
-11.39%
10.24%
21.62%
December
1.71%
-6.03%
11.16%
17.19%

Source: Yahoo Finance

So what do all these numbers tell us in terms of an investing strategy for the next couple of months? Obviously we have to be careful when it comes to averages – don’t forget the old story about the man who drowned in a river that averaged only one foot in depth when he stepped into a hole.

Nonetheless, this is a time when experience tells us to exercise caution. September and October have histories of producing violent market upheavals. The Crash of 1929 took place in October. So did Black Monday, the Oct. 19, 1987 plunge that took down markets around the world. A decade later, the Asian crisis triggered what was then the biggest one-day drop in the history of the Dow on Oct. 27, 1997.

The terrorist attacks of Sept. 11, 2001 sent markets reeling just as they were starting to recover from the high-tech plunge. Then in September 2008, Lehman Brothers collapsed setting off a chain reaction that almost brought down the global financial system.

Instead of “sell in May and go away” a more appropriate adage might be “sell before Labour Day, buy after All Saints Day”.

Of course, we could be pleasantly surprised. So far, September is off to a good start with the S&P/TSX Composite Index up 3.4% for the first four trading days while the S&P 500 added 2.6%. But it’s still early.

There are so many cross-currents right now that it is hard to predict what is going to happen in the short term. In its policy statement last week, the Bank of Canada cited widespread slowing of economic activity, the recession and financial crisis in Europe, and the sluggish U.S. recovery as reasons for holding its 1% target rate, even though Governor Mark Carney would dearly like to raise it.

Added to that was the election of a minority Parti Quebecois government in Quebec. The markets appeared to shrug it off but some businesses may be reluctant to make new investments in the province. The reason is not so much the threat of separatism (which is almost non-existent right now) but rather the uncertainty created by the PQ’s promise to raise taxes on the “rich” and certain types of corporations, such as mines. Those aren’t the kind of policies that attract new money.

On the positive side, U.S. auto sales were strong again in August, housing prices in that country are finally starting to edge higher, business investment in Canada as a whole remains “solid” (the Bank of Canada’s description), and second-quarter financial results from S&P companies came in stronger than expected, as Tom Slee points out in his column.

In such a shifting sands scenario, markets are likely to overreact to news, good or bad. An announcement from the U.S. Federal Reserve Board that it will implement a third round of quantitative easing (QE3) would likely send stocks soaring, even though the underlying implication would be that the U.S. economy is weakening. Conversely, if third-quarter financial results, which will start coming out in early October, are unusually weak it could spark a major sell-off.

The best advice I can offer in these circumstances is to avoid being swept up in day-to-day frenzies and have some cash available for buying opportunities. If we see a pronounced pull-back in the next two months, be ready to take positions at the start of November (or after the U.S. election if you want to be ultra-cautious). There are some good values in the market right now but they may look even better in eight weeks.

 

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U. S. STOCKS A BETTER BET RIGHT NOW

Contributing editor Tom Slee is back this week and kicks off the fall season by looking south of the border at the U.S. market. Tom managed millions of dollars in pension money during his career and is also an expert on taxes. Here is his report.

Tom Slee writes:

On balance, the dog days of summer were kind. Despite some strong headwinds, North American stock markets tended to inch higher during the last few months and September is off to a strong start. There was no significant groundswell. The recovery continues to splutter and the Europeans are still struggling to resolve their problems. Nevertheless, our stocks are showing signs of strength as investors steadily shift more money into equities. Badly underperforming large-cap mutual funds have been forced to make commitments. Many of the hedge funds are now actively buying stocks and positioning themselves as we head into post-election 2013.

My feeling is that stocks have support at these levels. True, the economy is a mixed bag but keep in mind that there are continuous cross-currents in the market. It’s not driven just by the GDP and other national statistics. Thousands of players each have their own agendas. Traders respond to short-term buying opportunities. As an institutional money manager I was engaged in large, gradual buying or selling programs that were not affected by breaking news, although our orders were sometimes placed on hold.

My point is that we may enjoy relatively good markets for the balance of this year even though the fundamentals remain unchanged. For example, the institutions, especially hedge funds, cannot afford to remain defensive. With even junior junk bonds yielding a paltry 7% they have to step into the stock market and take more risk.

Here is the situation at the moment. As Gordon has pointed out in past issues, there are a couple of big question marks hanging over the TSX. Our powerhouse resource sector has run out of steam and the banks and insurers have been treading water. The Canadian market is unexciting. It’s just a phase, of course, but one we have to factor into our decisions. That does not mean there aren’t some excellent investment opportunities in our market. However, you have to seek them out on a stock-by-stock basis. There is no rising tide.

On the other hand, I think that American markets look a lot more promising. The tone is better and, as always, the choice is larger. Perhaps most important, the crucial second-quarter U. S. corporate earnings beat expectations. Analysts had warned everybody to brace themselves for a 1% decline in the S&P 500 results year-over-year. They actually came in 2% higher. Top-line numbers were a little subdued; only 34% of the companies generated better than expected revenues because international sales, especially in Europe, were disappointing. Earnings, though, were encouraging with 68% of the companies beating the forecasts, mostly as a result of tighter cost controls. Moreover, according to Barron’s, most corporate balance sheets were sound at the end of the quarter.

Those are not rousing results but they do show that corporate America is in relatively good shape during this fourth year of the downturn. It’s worth noting too that profit margins have been improving. Companies are increasingly efficient.

Incidentally, I think that those second-quarter numbers are another indication that the American unemployment rate is going to remain stubbornly high for the foreseeable future, which is a tragedy for many people. Historically, an improving job picture, powering consumer spending, has driven economic recoveries and a strong stock market. There are few signs of that happening this time.

Corporations are turning to technology in order to increase production, not picking up workers as orders improve. Robots no longer replace people one at a time. In the automobile industry, one new and improved model can do the work of four people in assembly and packaging. That is not going to change. In fact, the restructuring problem is going to become worse. As a result, the recovery and stock markets are likely to gain traction even though the unemployment figures remain a concern. We should not wait for this indicator to improve.

U.S stocks, meanwhile, are cheap. At the moment, the S&P 500 is trading at 13 times forecasted 2013 earnings compared to a long-term average of 16 times. The market has several other things going for it as well. European investors continue to switch funds into North America on a more permanent basis and this money is no longer being jammed into Treasury bills. European institutions, like our own, are under pressure to perform and are turning to American equities.

As Canadian investors, I think that we should also keep in mind that according to a lot of economists our loonie is now substantially overvalued because of inflated commodity prices and a flood of foreign money into our bond markets. The Organization for Economic Cooperation and Development (OECD) believes that the Canadian dollar is really worth about 80 cents U.S. If this is even half right the loonie is going to adjust downward at some point. Ergo, we now have an unusual opportunity to earn a foreign exchange profit as well as capital appreciation from U.S. stock purchases.

Turning to the stocks themselves, I think that we should be guided to some extent by a suggestion from Don Coxe, Chairman of Coxe Advisors LLC. He says: “Do not invest in companies which produce what China produces or will soon be producing. Invest in companies which produce what China needs to buy”. Of course, that narrows the field considerably but still leaves some attractive stocks. Here are my choices and suggestions.

Caterpillar Inc.

Founded as the Holt Manufacturing Company in 1904, Caterpillar (NYSE: CAT) was restructured and renamed in 1925, became a tractor manufacturer, and then expanded. Today it’s the world’s largest maker of construction and mining equipment as well as a leading manufacturer of natural gas engines and industrial gas turbines. With more than 132,000 employees, CAT operates in nearly every country throughout the world.

Revenues totaled $60.1 billion in 2011 (all dollar amounts are in U.S. currency) and operating profit came in at $9.7 billion. Cash flow of $7.5 billion was up sharply from $5 billion the year before.

The stock is currently trading at $88.10, substantially above its 52-week low of $68, but I think that given the company’s earnings growth there is still a lot of upside potential. CAT is part of our IWB Growth Portfolio.

Caterpillar conducts its business through three major divisions: Construction Industries (33% of revenues and 21% of profit), Resource Industries (26%; 34%) and Power Systems (33%; 31%). Financial Products, primarily financing for CAT dealers, makes up the balance. That mix, however, may change significantly. In July 2011, the company acquired Bucyrus International, a major U.S. surface and underground mining equipment company for $8.8 billion. The deal gives CAT an opportunity to rapidly expand its coal and metals mining business, especially in the emerging countries. The purchase also allows the company to offer a full line of excavation equipment.

Most encouraging is CAT’s earnings performance. Second-quarter profit came in at $2.54 a share, easily beating the forecasted $2.27 and up 67% from $1.52 in 2011. Net income has increased 49% year-over-year on average across the last five quarters. It’s a remarkable performance given the worldwide economic difficulties.

Looking ahead, Caterpillar could earn close to $10 a share this year, compared to $7.40 in 2011 and climb to $11.75 or more in 2013. Analysts are expecting 17.5% long-term earnings growth. A global economic slump or another credit crisis could put a crimp in these numbers but CAT has so far been able to weather the storms.

Action now: Caterpillar is a Buy at $88.10 with an initial target of $115. I will revisit the stock if it dips to below $75.

United Rentals

Another U.S. stock that I like and am watching closely is United Rentals (NYSE: URI), the world’s largest equipment rental company with over 500 locations throughout the U.S. and Canada. The company’s general rentals segment services the construction and industrial markets while its trench safety and power division focuses on municipalities and utilities. Annual revenues exceed $3 billion and earnings have been increasing rapidly.

Equipment rental is an unexciting but growing industry that has been largely overlooked by investors. Yet the business makes a lot of sense. In these difficult times a great many medium-sized companies and local governments are opting to rent equipment rather than make substantial capital investments and then have machinery sitting idle. Because of its size, URI, with a rental fleet of 230,000 units, is able to service a full range of customers, from Fortune 500 corporations to individual homeowners. At the same time, the company is mopping up competitors in a highly fragmented industry.

Earnings of about $3.50 a share are expected in 2012 with a significant jump to the $5 range next year. My only reservation is that U.S. commercial and residential construction remains fragile. A sudden economic downturn could hurt this stock. Nevertheless I shall continue to monitor the situation. The stock is now priced at $37.83. Wall Street is looking for $50.

Action now: Watch. I think that this is a great stock but we have had a series of false dawns in the U.S. construction industry and some really disappointing statistics or forecasts could drive URI lower. The shares have a 52-week low of $14.48. I intend to monitor the company closely and will add it to the Buy List if we see a good third quarter (earnings of $1.25 or better) and the recovery continues.

Estee Lauder Inc.

One company that I have no hesitation in recommending is Estee Lauder Inc. (NYSE: EL) currently trading at $61. The big story here is that new CEO Fabrizio Freda is successfully firing up the organization. This leading manufacturer and marketer of makeup, fragrance, and hair care products is on a roll and earned $2.27 a share for the year ending June 30, up 23% from 2011.

Trumpeted as “Estee Lauder’s Makeover Man”, Mr. Freda was brought in three years ago to shake up the company after three generations of family rule. It was a bold move, and so far it’s paying off in spades.

New York-based Estee Lauder reports its results on a regional basis and at present the Americas account for 43% of sales and 22% of profits. Europe, the Middle East, and Africa account for 37% and 55% while the Asia/Pacific contributes 20% and 23%.

Incorporated in 1946, the company has successfully introduced and marketed a stream of new products including Clinique and Aramis. Tommy Hilfiger’s fragrances are produced in conjunction with Estee Lauder.

In 2008, though, the company stumbled badly when the financial crash undermined consumer spending. People were no longer inclined to buy $900 skin care creams. At the same time, department store chain mergers drastically reduced Lauder’s outlets. Profits plunged and chairman William Lauder went outside the tightly-knit family to hire Mr. Freda, a marketing executive with experience at Proctor & Gamble and Gucci. Soon after, a cadre of senior managers left the company and new policies were introduced. The numbers started to improve.

Going forward, Mr. Freda intends to focus on the Asia/Pacific business. China in particular offers a great deal of potential as its population adopts North American styles and habits. At the moment, Chinese women spend $19 per capital on beauty products compared to $229 in the U.S.

What I really like about the new program, however, is that it’s not just a gung-ho marketing campaign. Controls are being tightened and the overall operating margin has increased to a record 14.2%. Free cash flow reached an all time high of $1.1 billion in the year just ended. Management is forecasting $10.5 billion in revenues in 2013 compared to $9.7 billion this year. We could see earnings of $2.75 a share or more in 2013.

Action now: Estee Lauder is a Buy at $61 with a target of $72. I have set a $52 revisit level.

 

 

TOM SLEE’S UPDATES

Kinder Morgan Inc. (NYSE: KMI)

Originally recommended on Sept. 6/11 (#21132) at $25.19. Closed Friday at $35.84. (All figures in U.S. dollars.)

Kinder Morgan Inc. continues to power ahead and reported second-quarter cash available for dividends of $307 million, up 83% from $168 million the year before. Total first half net cash flow of $610 million grew 40% from the comparable period in 2011 and as a result KMI increased its distributions to $1.40 per annum. They are expected to grow at an average annual rate of around 12.5% through 2015.

The company, general partner of Kinder Morgan Energy Partners and El Paso Pipeline Partners, essentially owns and manages a diversified portfolio of energy transportation and storage assets, a sub-industry that is expected to perform well over the next 12 months. The U.S. Energy Information Administration (EIA) projects a 0.3% increase in liquid fuel consumption and a 1.6% increase in natural gas consumption next year. This follows liquid fuel declines in 2011 and 2012.

As far as KMI is concerned, I expect to see growth in all of its business segments with pipeline numbers particularly strong. Earnings of $1.45 a share are expected in 2012 and $1.55 next year. We could see a dividend of $1.66 a share in 2013. The stock at $35.84 is up 42% since our recommendation in May but still offers excellent value. KMI is part of our IWB Growth Portfolio.

Action now: Kinder Morgan Inc. is a Buy at $35.84 with a revised target of $42 although investors who bought at the time of our recommendation might consider taking at least some of their profits off the table. I will revisit the stock if it dips to $28.

ShawCor Ltd. (TSX: SCL.A, OTC: SAWLF)

Originally recommended on July 9/12 (#21224) at C$36.28, US$36.51. Closed Friday at C$41.85, US$43.09.

Ms. Virginia Shaw, chairperson and 67% owner of ShawCor, has announced that the company is for sale. No reason was given, although it’s probably a move to maximize shareholder value. ShawCor is in excellent shape and there is a lot of mergers and acquisitions activity in the energy services industry. Credit Suisse has been retained to handle the process.

The announcement was unexpected but as we pointed out when recommending ShawCor as a Buy at $36.28 in July, the stock has been undervalued. We set a target of $42, which is about where it is trading now, so we have a gain in two months of more than 15%. Of course, a control block commands a higher price and if you tumble the numbers on that basis SCL.A is worth at least $45. If the expected bidding war gets underway, the shares are going to trade well above that. I have seen close to $60 mentioned.

This is a tailor-made deal for the hungry hedge funds and large oil field services companies such as Halliburton and Schlumberger are bound to be interested. A word of warning, however: ShawCor has carved out a leadership position in the crucial pipe coating business. Its customers and the competition bureaus may raise objections if a giant corporation attempts to swallow the company.

Action now: ShawCor becomes a Hold at $41.85. The stock is likely to move much higher but anything above $47 or so would be pricey. Alternatively, if for any reason Ms. Shaw decides not to sell, the shares will plummet and I would regard that as a buying opportunity. This is a first-class company that is just moving to a new level of production and earnings. I will be sorry to see it go.

– end Tom Slee

 

PPN CRACKDOWN

It has taken far too long but finally our securities regulators are cracking down on the way in which principal-protected notes (PPNs) are sold.

The Canadian Securities Administrators (CSA), which represents our patchwork quilt of regulatory bodies, has issued a notice that it expects all registered dealers to apply the know-your-client and suitability rules before recommending the purchase of PPNs to anyone. Even more to the point, the CSA says it wants the banks and other deposit-taking institutions to use the same standards. Banks have been the biggest issuers of PPNs, led by BMO and CIBC, but until now the sales of these securities have largely been unregulated. That’s going to change.

All I can say is that it’s about time. The financial industry has been raking in billions of dollars from PPNs, peddling them to people who, in many cases, have little understanding of how they work.

The main sales pitch is safety. PPNs guarantee you’ll get your capital back at maturity, no matter what happens. Whether you receive anything more depends on the performance of the security the PPN tracks. That could be a single stock index, one or more mutual funds, a portfolio of blue-chip stocks, a basket of selected stocks from a single sector (e.g. mining, agriculture, energy), or almost anything else.

With memories of the 2008-09 market crash still raw, many people are attracted by the idea of investing in a security that offers exposure to the stock market without putting their capital at risk. That provides a comfort blanket to nervous investors.

What these people often fail to understand is the high price they pay for PPNs in fees and commissions or the fact that many PPNs have a cap on how much they will pay out if things go well. Moreover, they don’t think about the fact that a zero return after tying up money for as long as five years is the same thing as a loss. The purchasing power of the capital has been eroded by inflation over that time and any interest or dividends that would have been earned by investing in conventional securities have been lost forever.

In a document published on its Investor Tools page, the CSA lumps PPNs into the Alternative Investments category, along with options, futures and forward contracts, foreign currency trading (forex), and hedge funds.

“Each of these different types of investments has medium to very high risk. They also have various costs associated with them, which could include: commissions, sales fees, management fees, operating fees or early redemption fees, among others,” the CSA warns. “They are meant for very sophisticated investors or investors who can afford to take higher risks and pay for specialized advice… Although you may be offered an investment in this class, it is important that you be comfortable with all risks and costs involved, and never invest in anything you don’t fully understand.”

The track record of most PPNs is not encouraging. Globefund includes them in its Miscellaneous – Other Funds category which has 1,128 entries. I did a search to see how many funds in this group beat the 6.21% average annual compound rate of return of a Canadian neutral balanced fund over the three years to July 31. Only 49 funds passed the test and most of those were not PPNs.

The most successful PPNs I found were the six series of Principal Protected Blue-Chip Notes issued by Sentry in 2004 and 2005, most of which showed three-year returns that were roughly double the balanced fund average. However, because of the effect of the 2008-09 crash, their returns since inception were much less impressive, ranging from 4.1% to 5%. That’s high by PPN standards – most issues don’t come close. But it’s not likely to excite many people, especially after they look closely at the costs and risks involved.

The bottom line is that investors should not allow themselves to become so fixated on the guaranteed principal pitch that they lose sight of the costs and risks involved. PPNs are a pure sales gimmick, albeit a successful one. Avoid them. – G.P.

 

GORDON PAPE’S UPDATES

Walmart (NYSE: WMT)

Originally recommended on June 25/12 (#21222) at $67.30. Closed Friday at $73.82. (All figures in U.S. dollars.)

For a dull, blue-chip stock, Walmart has done very well for us in the two and a half months since it was recommended. As of the close on Friday, we had a capital gain of $6.52 per share plus we received a dividend of $0.398 on Aug. 8 for a total return so far of 10.3%.

On Aug. 16, the world’s leading retailer posted impressive second-quarter numbers (to July 31). Earnings per share came in at $1.18, the top of the company’s guidance range. That was up 8.3% from the same period a year ago. As well, the company raised its guidance for the full fiscal year to between $4.83 and $4.93 per share. The previous target range was $4.72 to $4.92.

U.S. comparable store sales were up 2.2% while Walmart International comparable store sales advanced by an impressive 6.4%. Overall, consolidated net sales were ahead by 4.5% over last year, to $113.5 billion.

The company reported free cash flow of $6.1 billion for the first six months of the current fiscal year. Return on investment (ROI) for the trailing 12 months was 18.1%.

“I’m really pleased with the continued momentum in our Walmart U.S. stores, evidenced, in part, by three consecutive quarters of positive comparable traffic and four straight quarters of positive comparable sales,” said CEO Mike Duke. “The team is very focused on delivering broad assortment and price leadership. Walmart’s low prices drive greater customer loyalty.”

Obviously, the shares are no longer the great value they were last June and the yield on the stock has dropped to 2.15% as a result of the price increase. (The annual dividend is $1.59 a share.) Therefore, I am changing the rating to Hold. We’ll look for a new entry point if the stock pulls back.

Action now: Hold. Short-term traders may want to take part-profits.

Steadyhand Income Fund (SIF120)

Originally recommended on Jan. 23/12 (#21203) at $10.56. Closed Thursday at $10.84.

Mackenzie Sentinel Income Fund – Series B (MFC732)

Originally recommended on Sept. 4/07 (#2731) at $9.60. Closed Thursday at $7.91.

The Steadyhand fund is ideal for nervous investors. It offers some exposure to the stock market (20.1% of the portfolio as of June 30) but most of the assets are in bonds (71.7%) with a small percentage (8.2%) in REITs. The bond segment of the portfolio favours corporate issues (63.8%) with 24.9% in provincial bonds and 11.3% in Canadas. Just over 8% of the portfolio is invested in the Connor Clark and Lunn High Yield Bond Fund – CC&L is the portfolio manager.

The fund posted a 3.61% gain in the six months to July 31, well ahead of the average of 0.69% for the Canadian Fixed Income Balanced category. Since my recommendation in January, we have a capital gain of $0.28 plus distributions of $0.20 per unit ($0.10 per quarter) for a total return of 4.55%.

This is not the kind of fund that will make you rich in a hurry but it will allow you to sleep comfortably at night knowing that your money is safe and is earning a respectable return by today’s standards. It’s also inexpensive to own – there are no sales commissions and the management expense ratio (MER) is just 1.04%.

One reader wrote to say his broker did not offer this fund and asked if I could suggest another one with a similar asset mix. Unfortunately, the Steadyhand funds are not available east of Ontario and in the Territories. Even in provinces where they are sold, some brokers won’t handle them because they don’t offer trailer fees.

You can always buy direct from the company – the minimum investment is $10,000 per fund. To set up an account, go to www.steadyhand.com.

If you don’t have that much to invest or prefer to work through a broker, one alternative is the Mackenzie Sentinel Income Fund (Series B), which is also on our Recommended List. It has a slightly higher stock component – 33.9% as of July 31. But the rest of the portfolio is in fixed-income securities and cash, giving it a low-risk profile. The main negatives are a much higher MER (1.95%), the fact it is a load fund, and a gradual erosion of the net asset value over time because of the monthly distribution of $0.033 per unit. We have not experienced that kind of erosion with the Steadyhand fund to this point.

Steadyhand Income also wins out on performance by a wide margin. It’s three-year average annual compound rate of return to July 31 was 10.06% compared to 5.63% for the Mackenzie fund. So while Sentinel Income looks similar to Steadyhand Income in terms of portfolio composition, it’s a weak second choice.

Action now: Steadyhand Income Fund is a Buy. Mackenzie Sentinel Income Fund remains a Hold, however if it is possible you may wish to switch to the Steadyhand entry. – G.P.

 

YOUR QUESTIONS

Could Manulife fold?

Q – After receiving the previous newsletter, I took a $20,000 buy-in on the 10 stock Growth Portfolio suggested by Tom Slee. I have another 31 years to 65 so they will probably eventually grow. But on to the question.

I’m 34 and was diagnosed with MS (multiple sclerosis) at the age of 30 which left me unable to work due to a significant attack that I never fully recovered from. Long-term disability (LTD) was a hard adjustment but at the age of 30 I realized that my income would be static for the next 35 years. I decided that I had to pay off my student loans and mortgage to minimize interest cost. The student loan was paid in early 2009 and the mortgage will be paid off by late 2013 (instead of 2031). Once my debt is paid, I will bank the same amount, which is quite large, and plan for a retirement. I have my retirement plan set now because life didn’t give me much choice, but my biggest concern, other than my health, is the health of Manulife, my LTD insurer.

I know it’s a recommended Buy in the IWB. I also know that Manulife has suffered from low interest rates for some time now. They have had to receive an emergency loan from TD, I believe. They have had several very poor recent quarters with significant losses. They have also diluted their share price at least once by offering more stock to be sold on the market to raise capital. This is obviously a concern for investors but for someone like me, who relies on this income to live, it is a huge worry. Do you think that it is remotely possible that Manulife could fold? – Steve W.

A – I asked Tom Slee, who follows Manulife closely and once worked in the insurance industry, to answer Steve’s question. Here is his reply.

Yes, it is remotely possible that Manulife could go under. Three Canadian life insurance companies have declared bankruptcy, the last being Confederation Life in 1994. However, in the very unlikely event that Manulife runs into trouble Steve should be reassured that the company is a member of ASSURIS, a government and industry funded organization that protects policyholders in the event of default. It’s a sort of insurers’ insurer.

Steve should take a look at the website. The coverage limits are listed and Long Term Care and Long Term Disability Policyholders are protected up to $2,000 a month or 85% of currently provided income. However, these are subject to change so perhaps Steve could obtain a more detailed description of what is involved from ASSURIS if he is worried.
 
That having been said I am extremely confident that Manulife is not only going to survive but will prosper in the years ahead. The present problems were the result of massive, aggressive, and unhedged stock market positions prior to the 2008 crash to support the variable annuity business. That damage is being repaired but there is still a lot to be done. – T.S.

 

That’s all for this issue. We’ll be back on Sept. 17.

Best regards,

Gordon Pape
gordon.pape@buildingwealth.ca
Circulation matters: customer.service@buildingwealth.ca

All material in the Internet Wealth Builder is copyright Gordon Pape Enterprises Ltd. and may not be reproduced in whole or in part in any form without written consent. None of the content in this newsletter is intended to be, nor should be interpreted as, an invitation to buy or sell securities. All recommendations are based on information that is believed to be reliable. However, results are not guaranteed and the publishers, contributors, and distributors of the Internet Wealth Builder assume no liability whatsoever for any material losses that may occur. Readers are advised to consult a professional financial advisor before making any investment decisions. The staff of and contributors to the Internet Wealth Builder may hold positions in securities mentioned in this newsletter, either personally or through managed accounts. No compensation for recommending particular securities, services, or financial advisors is solicited or accepted.