Query from a Reader: Time to Buy?

I received the following communication recently:

new BMO & BNS preferred shares
These are apparently bought issues, but if you recommend them I would  consider a purchase. I have taken an interest and a position in  various preferred since reading your articles in the Canadian Money  Saver. Until then, I was nothing more than a passive observer. I am  76 years old, wife is 71 this year and our pensions are inadequate to replace my income before retiring more than 10 years ago. Now a  considerable portion of my investments are in bank, insurance and  utility companies common and more recently preferred shares.  Unfortunately I also have about 10% in BCE bonds in RRIF. Would you consider the new issues at 5.25% a good investment in a non- registered account? Except for CU all other preferred shares that I  have are below par with approx 4.5% coupon. I have more than 10% cash  to invest. Would it be prudent to wait?

Well, I’ll take a stab at it, but I have the horrible sinking feeling that I am not only going to frustrate my inquirer, but I’ll probably offend him as well.

The basic problem with the query is the implicit assumption that market-timing is possible – if you recommend them I would  consider a purchase … Would it be prudent to wait?.

I can’t time the markets. Neither can anybody else. There is no shortage of bozos who will claim that they can time the markets on behalf of their clients – and even believe it themselves – but when you look at their justification for such belief, you will invariably find that they have been looking at the past with rose-coloured glasses and making excuses for the times that they got it wrong. The way to unmask these people is to ask them for a “CFA Institute compliant composite performance report from inception to present”. Information about what this means is readily available. Essentially, the standards insist that every single dollar under management be assigned to a particular composite and that clients be informed of the existence of each composite. You won’t find many stockbrokers or advisors who have such a thing – and most of those guys will get fairly huffy when asked.

Market-timing is not possible, but this does not mean investors should just buy a generic batch of index funds and forget about it. There are two mechanisms whereby professional money management can add value:

  • Tayloring of asset allocation to suit the client’s specific needs
  • Outperformance within each asset class

And yes, this discourse is relevant to the original question! My correspondent is asking for advice on market timing, but he should really be asking himself two questions:

  • How much of my portfolio should be allocated to preferred shares?
  • Once I’ve made that decision, which preferred shares should I buy?

Let’s try to answer the first part of that question. The couple is retired; in their seventies; they have at least some investments; they need income. There is a fair bit of detail missing from the query:

  • How big is the investment portfolio?
  • How much income do they need (as opposed to “want”, which is another matter entirely)?
  • What are their plans for the capital – are they planning to run it down to zero, or do they have bequests in mind that are important to them?
  • And finally, the distasteful question: what’s their health like? Is it prudent to plan for 25 years, or can we get away with ten?

It is impossible, for me or anybody else, to provide investment advice without knowledge of these issues … well, I shouldn’t say “impossible”, because it’s done all the time. A better word is “reckless”.

So lets make a few generic points:

  • A 10% position in BCE bonds? The remaining term to maturity of these bonds is not given in the eMail, but the client is now learning the purpose of diversification the hard way. Bell Canada and BCE have been “A” credits for the past ten years. My correspondent is most assuredly not the only person to find himself in this predicament, but a client who is
    • Retail, and therefore subject to the tender mercies of the retail bonds desk at his brokers, and therefore highly illiquid
    • With insufficient portfolio size to diversify properly
    • Unable or unwilling to devote a lot of time to watching the market

    …should stick to names rated “AA” or better.

  • The “bank, insurance and utility companies common” is a good, high quality, high yielding equity allocation, but there is no indication of the percentage allocation. Using the famous “100 minus your age” formula indicates an allocation of 20-25%, but there are other variables. Basically, this allocation should be as high as possible, subject to:
    • generating sufficient income from the portfolio that there will not be forced sales to raise cash
    • a maximum desired portfolio volatility based on needs – the chance that a major liquidation will be required
    • a maximum desired portfolio volatility based on wants – how much sleep will you lose if these stocks go down 30%?
  • The allocation to preferred shares should be no more than half the allocation to fixed income generally. Preferred shares do, indeed, provide a significantly greater after-tax income than bonds, but they also have special risks of their own. Most of the ones worth buying are perpetuals, with a potentially volatile price; and the universe of investors is smaller than with bonds, which brings with it liquidity risk.
  • Given that
    • The bond portfolio is – probably – of relatively low quality (due to its exposure to BCE), and
    • the allocation to preferred shares will probably be of insufficient size to allow for efficient diversification, and
    • the inquirer is not a professional investor

    I recommend that investments in preferred shares be restricted to those names rated Pfd-1(low) or better.

Which, at long last, brings us back to the subject of the inquiry: the BMO & BNS new issues. My correspondent notes that they are “bought issues”, but this indicates nothing more than that the underwriters have guaranteed to the issuers that the issue will be sold … in other words, they have agreed to buy the entire issue for resale, rather than acting on an agency ‘best efforts’ basis.

They are both highly rated, meeting the quality needs I outlined above. And when they were first announced, they were far superior to most issues on the market … but then the market fell. At present, I estimate the fair value of both of these issues to be a little above $24.80, which means there is other stuff out there that might yield a little bit more with comparable risk.

My correspondent is in the unfortunate position of being protected from rapacious Ontario-based portfolio managers by the brave heroes of his provincial securities commission – and I have not yet been able to extract sufficient expressions of interest in his province to make it worth my while to register with his commission. So, unfortunately, I cannot offer him a subscription to PrefLetter, which was developed to be useful to investors finding themselves in precisely his position – that is, having money allocated to preferred shares, but not sure which ones.

I suggest, however, that he may wish to keep an eye on this blog, watch the commentaries for mention of good yields, check out the characteristics of the issues of interest on PrefInfo … and to get some professional advice on asset allocation, based on his own particular circumstances.

Update, 2007-10-5: I forgot the ad for the fund! While PrefLetter is designed for do-it-yourself investors who want a place to start, there are funds available: I reviewed three funds last year and another last spring … but I trust I won’t be criticized too severely for recommending my own fund for those investors who seek to outperform the indices and  are either “accredited” or have $150,000 to invest. Unlike PrefLetter, Malachite Aggressive Preferred Fund is available to all such investors in Canada.

Update, 2007-10-19: I should also link to two of my other posts on this general topic: One Bull Checks in and Reflections on a Bull

2 Responses to “Query from a Reader: Time to Buy?”

  1. […] HSBC Securities? So it’s a stockbroker they’re blaming? What was his Money-Market track record? I wonder how much due diligence they did before hiring him. […]

  2. […] The RY.PR.F issue, for instance, is now quoted at 20.73, down a lot from its issue price of $25.00, but it’s still paying the same dividend now as when it started: $1.1125 annually. It would have been a lot nicer to have bought that dividend stream for $20.73, of course, rather than having paid $25.00 … but I can’t time the markets and I don’t think anybody else can either (as I have discussed elsewhere). What I do think MAPF can do – and what MAPF has historically been able to do – is to trade between issues, selling them when they’re ten cents expensive in order to buy something else that’s ten cents cheap, and passing those gains through to unitholders. […]

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