The Men behind Contra Our Investment philosophy Our Annual Returns Contra in the Media Questions Frequently Asked Look Who's Talking Subscribe to Contra Renew to Contra Services for Subscribers how to get in touch with Contra Hear Benj Speak questions about Contra? give us your feedback about Contra site support
CONTRA logo
left navigation image map

Copyright © 2017
Gal^Stad
Investments Inc.

spacer July 2002
Commentary

With the stock market taking on the same putrid odour as Toronto during the garbage strike (or, given the Blue Jays' performance, Skydome during baseball season), many readers have been asking about non-stock investments. We're not sticklers for precise asset allocation, but this is as good a time as any to review some "competitors": bonds, income trusts, foreign stocks and real estate.

When scrutinizing the role of bonds within an overall investment strategy it is important to recognize that there are two very different ways to profit from them.

First, an investment in bonds can be made, essentially, as a bet on interest rates. Bond prices generally move in the opposite direction to interest rates, so buying when rates are on the way down sets up an opportunity to take a nice capital gain.

Such was the case a couple of years ago when the U.S. Federal Reserve began loosening the purse strings and rates began their steady slide and money was the cheapest it has been since we were Contra kids.

The other reason to buy bonds is strictly for income. In this case the future course of rates is much less important. For strip bonds, if they are held to maturity, the investor knows precisely what the return will be for the entire period that the bond is held.

For long-term investors, the key is the yield that the bond will generate, rather than what it will fetch on the market in the intervening years.

So, is this the time to buy bonds? If you are looking to make a capital gain, the timing is poor. It is highly unlikely that rates will go much lower in the next few years; a more plausible scenario has rates meandering around current levels until the economy finally recovers, when a gradual upward crawl begins.

If, however, you are buying for long-term gain, the situation is different -- not ideal, perhaps, but not all that bad either.

When we look at bond rates, what is immediately striking is that, although short-term rates have changed dramatically since September 2000, longer term rates have changed much less -- and rates on 30-year long bonds have barely budged at all!

It's also interesting to note that the dreaded "inverted" yield curve again accurately predicted an economy on the skids, though few heeded this danger signal at the time.

We normally prefer bonds with a term of about five years, but under current conditions the "sweet spot" has moved to longer ranges. For example, a Province of Ontario strip coming due in 2011 currently yields 5.65 percent to maturity. Other provincials are comparable. Nothing to write home about, but a reasonable return considering its near-perfect safety compared with the vagaries of stocks and other assets.

Investment trusts and REITs are important vehicles for earning income, but they are currently very popular and can't be considered contrarian plays.

Especially dangerous are the many IPOs of new units that are being foisted on a public that is anxious to find something that makes money when stocks fly south. Where competent management is involved, these units may represent a decent asset, but as always, the single greatest component of risk is the price paid.

Pay too much, and even with good luck it is extraordinarily difficult to maintain good yields. And bad luck invites utter disaster, because as we have seen so often, once the payout is terminated, these things fall through the floor.

The key, then, is not only to find a good operation capable of throwing off the required cash without running itself into the ground, but to buy well after the deal makers have moved their dog-and-pony shows to greener pastures.

For example, one of our favourites, Algonquin Power Income Fund, took over KMS Power Income Fund earlier this year. For the purposes of the transaction, Algonquin was valued at $10.10 a share. With all the regularity of a spinning turbine, the stock dropped a couple of months later when the spotlight was turned off. We backed up the truck and loaded up at $9.26.

An asset we are always gung-ho about owning is a home. But these days, a note of caution is required: real estate prices are showing an amazing ability to defy gravity, shrugging off the usual brakes such as rising unemployment and deflation in stocks. It's an impressive performance, but we have our doubts whether it can last.

History shows that when housing prices start to fall after a long period of growth, they tend to come down hard. That's because many homeowners are mortgaged to the hilt, so when the value of the collateral decreases, the home can quickly be worth less than the loan. If the bank comes calling, the house gets thrown on the market at a time when demand is at an ebb.

We're not predicting anything as dramatic as the meltdown of 1991-92, a situation that was exacerbated by rampant speculation -- which is not what drives the current boom. But it is worth remembering that Japan's wacky real estate market lasted a couple of years after the crash of the Nikkei. It took a long time for reality to bite, but when it finally did the wound was a deep and painful one that has not healed to this day.

Speaking of Japan, we are racking our brains trying to figure out the best time, and the best way, to invest there. We're fairly convinced that the worst is over for the Japanese economy, but less certain that a healthy recovery is ready to start in earnest.

There is also the problem that companies there are harder to follow, and the ones that are available as ADRs on the NYSE tend to be the largest, and best known firms -- hardly fertile ground for our methodology.

Mutual funds (and we grit our teeth as we say this!) appear to be a viable alternative. One way to mitigate some of the inherent problems with funds is to choose a closed-end fund. A couple of candidates we find attractive are Japan Smaller Capitalization Fund (JOF on NYSE) and Japan Equity Fund (JEQ on NYSE).

A combination of the two should offer good exposure to the improvement in Japanese corporations, both large and small. We are bullish on the Japanese yen, so an investment in this country may carry a currency bonus that gooses returns.

If all of the above suggests we are less than enthralled with the alternatives to stocks, then you understand us well. There really are times when nothing is a desk-pounding wonderful prospect. Regardless of how the asset allocation game is played, it will be very hard to generate the kind of returns to which we have become accustomed over the past decade.

An optimal time to pile money into the stock market will come along again, but it took many years for the bubble to form, inflate and finally pop. The idea that a clean slate, on which the story of the next bull market can be written, will become reality within a matter of months, is simply wishful thinking.

Until then, judicious investments in the various asset categories makes a lot of sense, as does holding a generous reserve of cash. Despite the many reverses of the past two years, the investment industry's obsession with the mantra of "putting your money to work" is unabated.

To see how silly this is, sit back for a moment and think of a scenario in which you would actually be better off parking your dough in an ING Direct account earning about three percent. You might envision a flat economy, with lacklustre corporate profits, a central bank unable or unwilling to further lower interest rates, a lousy housing market, high vacancy rates for commercial real estate, governments constrained by falling tax receipts, and very low inflation -- perhaps even deflation.

Look at the experience of the Japanese over the past decade and you can see exactly how easily the new North American paradigm could take on a familiar ring. Of course, our banks could never have a liquidity crisis. Ha, ha.

All of which need not be taken as doom and gloom, or the apocalyptic chatter in some corners about a repeat of the 1930s. At the worst of times, Japan's unemployment rate was about the same as Canada's at its best. Such an economy, which is neither growing nor contracting substantially, may be thought of as going through a period of stability or "steady state." Yet such is our addiction to robust growth that such a prediction is relegated to tales of horror and misery.

It is impossible to know how long such a period might last. By keeping a chunk of your assets liquid, not only is the maxim of capital preservation rigorously followed, but you will be both mentally and financially ready to capitalize on the next great opportunity to accumulate wealth when the investing climate turns sunnier.

In our minds the best way to play in today's financial world remains that old, boring strategy of paying down debt. Others might argue that with interest rates this low, it is time to stack up on the liability side of the ledger and shoot for high returns. Not in our minds. Just about anyone who can pay off credit card debt would be wise to do so. Have a chance to pay down the mortgage more quickly? Got margin on some stocks? Yuck! Pay it down. That gives a fast, handsome return.

Remember, investment returns are earned in before-tax dollars, knocking down their net substantially. So earning a six percent return on an investment, given a typical marginal tax rate, is not nearly as good as paying down a six percent mortgage. And debt reduction doesn't just pay off financially -- one should notice an improvement in sleep patterns as creditors are less likely to come pounding on the door.

spacer Archives \& Investment Info
bottom