investment tips

Do you need an emergency fund? Reflexions on what to do in a high inflation, low interest environment

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Tyler and Claire require $85,000 to renovate their house but started saving late and now want some advice.  So the Globe and Mail enlisted the services of TD Waterhouse investment advisor, Eric Davis.  The first thing, he says, is to establish an emergency fund:

Before they begin their renovations, though, Tyler and Claire should build up an emergency fund of anywhere from $15,000 to $30,000, which could be held in a tax-free savings account, he adds.

The standard wisdom today coming from financial advisors is that everybody needs to have an emergency fund.  Usually this consists of up to as much two-years worth of living expenses to tide one over in case of illness, unexpected expenses such as car or home repairs, or loss of a job.  All is good.  Save for rainy day?  Seems like pretty sound advice, right?

But in my mind, it isn’t sound advice in all circumstances.  Why?  Because the spread between the savings interest rates and mortgage rates is usually about 3-5 %.  So you can get 1% interest in your savings account; but you pay 4% on your mortgage.  Why not make an extraordinary payment on the mortgage, and save 3% in the meantime?  The problem is one of liquidity.  The money one uses to pay down a house is illiquid and you can’t access it in an emergency.  So that is why I recommend instead to get a line of credit, preferably a home equity line of credit (HELOC) because they have the lowest interest rate.  As you pay down the house, the bank will increase the HELOC.  Now use the HELOC only for emergencies and any excess cash can pay down the mortgage, saving you 3% interest in the meantime.  Interest earned is taxable, except of course in the TFSA (Canadian Tax Free Savings Account).  The government gets its cut.  Interest saved is not taxable.  So the home owner makes a double win.

I think it is necessary to be extremely wary of the advice from financial advisors because they don’t work for you.  Do you ever wonder why your advisor will make a trip to your house and spend a couple hours working out a financial plan?  Who pays them?  Our broker from Scotia McLeod did that; and Scotia McLeod earned full standard commissions from us: that means 2% or an $80 minimum per transaction.  One time he wanted me to put a stop loss on RSI.un (Rogers Sugar) saying that I’d made some nice gains, I should try to lock them in.  Well I didn’t want to do it because Rogers was paying a tidy dividend every month.  He insisted and finally talked me into it.  When all was said and done, the stop loss evacuated the stock at a $30 dollar after-commission loss to me, my broker got is his fat fee for selling it, and I lost a source of income.  I wanted the long term position for the dividend, but the financial industry made money churning my position.  Today, RSI has continued to pay (now monthly) and it is trading at 25% higher than my stop loss.  I would have won if I held it for the last six years which was my intention.  But the industry doesn’t make any money when you hold, only when you churn.  This incident is one of the reasons that I become a DIY investor.

Eric Davis would probably offer the couple a TFSA account at an anaemic rate of interest at TD Bank. Such a savings account will help the bank, for banks crave savings accounts, needing of capital these days.  But the inflation rate is greater than the interest rate by at least 2 basis points, and so now Tyler and Claire will lose 2% buying power on every dollar in their TFSA; if hyperinflation hits, and in my mind that is certain, then they could lose double digits or higher–food prices are going up like crazy, I know, I do most of the shopping in my family.  But TD Bank wins.  They will use Tyler’s and Claire’s capital earn  money by lending it to someone else at at 4-5%.  They don’t have to worry about inflation because it is not their principal.  The principal belongs to Tyler and Claire!

I think that its better to pay down the mortgage and make your bank hold your available credit in reserve.  Make them hold the money for you rather than the other way around.  If you need it, you’ll pay a little more than the mortgage rate (my HELOC is at 3% compared to my variable rate mortage at 2.1%), but in the meantime, it has reduced your debt, saving you money.

Reflexions on how to invest in an inflationary environment using leverage

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The clear winners during the Weimar inflation were debtors.  This according to historian Adam Fergusson, author of When Money Dies (pdf link).  Indeed, it pays to owe money during inflation and even 2% inflation is theft–stealing from anyone who has lent money.

I have said in previous posts that the only reason that home owners win is because they enjoy a cheap debt product, a mortgage, and that as time passes, inflation reduces the value of the mortgage, while it appears in nominal dollar terms that their house has increased in value.  But if measured in something more stable, like gold, real estate hasn’t really improved in value over the course of the last 100 years.  It is just the dollar that has fizzled out.

Thus, I conclude that leverage that is under control and manageable, is the best weapon against inflation.  What is leverage that is under control?  (1) Keep debt to equity near or below 1:1; (2) Use debt to  purchase of a cash-flow producing investment, such as a dividend paying stock or rental housing, which in covers the interest payments and creates income;  (3) Avoid consumer debt.

In any case, here is the video in which Adam Fergusson explains how debtors win:  they pay off mortgages with “postage stamps” (i.e., eventually, the cost of postage stamps is similar to the total mortgage debt).

Hat tip:  Zero Hedge

Gold versus paper currencies in the aftermath of war

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To understand the value of gold as a currency with intrinsic value versus paper currencies which have only derivative value, it is perhaps helpful to consider what happens when a war comes to a conclusion.  The victors, if they ask for tribute or war reparations, will only accept gold.  Consider that throughout history, when conquerors overtook cities, they would strip them of gold and silver and other precious real goods, such as when Alaric sacked Rome in 410.  They didn’t say, “Oh please, would you print some images of the Emperor and give them to us.”  Instead, the barbarians forcefully took away the intrinsic wealth of the city.

In our more recent past, we see that the United States has been able to force its paper currency on the losers of wars.  At the end of the Civil War, the Confederate dollar became worthless paper.  The loser cannot make the winner accept its paper.  Then, at the end of World War II, the US was able to begin to impose its currency on the rest of the world, until it became the world’s reserve currency.  Originally the US dollar was a derivative for gold; but  afterwards, Nixon took it off the gold standard, and it became a purely fiat currency.  But had the United States not won World War II, we’d be speaking German and Japanese and Yen and Marks would have become the world’s reserve currencies.

At the end of World War I, the Treaty of Versailles imposed war reparations upon Germany, mind you not in the paper currency of the Weimar Republic, the Deutsche Mark, which became so much wallpaper in a few years, as it began to fill the wheel barrows of the country.  No, the treaty required that the Germans pay back their debt in gold.  Funny, isn’t it?  How is it that the loser of a war can impose upon the winner the acceptance of a metal which has been in a 6000 year bubble?

Should Canadians boycott the USA?

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I wrote the following comment at Beating the Index, after Mich asked us what we thought of an oil company operating in Texas:

Hi Mich:
I gave up my US citizenship on February 28 2011, and I am very angry with the United States and its attempt to persecute Canadian residents, about 1 million of us, with extra-territorial taxation and persecution through laws that are intended to attack money launderers, drug dealers, and terrorists. Many innocent Canadians with dual citizenship with the US have become fearful of not even being able to cross the border to visit their families now, and Canada’s finance minister, Jim Flahrety, has told the IRS to back off of innocent Canadians who are not tax cheats.

When you expatriate from a country because you think that the people running it are persecuting you, treating you in an unfair manner, do you think that’s gonna be the first place you would want to invest? I’ve decided to stop even travelling to the US, except for family emergencies where the risk reward ratio makes sense. I did invest in Texas a few years ago, but thanks again to the US Federal government, I was basically fleeced for 70K. No thanks. Never again.

I think EGL could turn out to be a good investment, but with the OWS movement and an administration that wants to tax the rich, is not nationalization of the resource sector not far off? Paint me as paranoid, but the US federal government has caused me great suffering by threatening me, someone who’s lived in Canada now 25 years, I feel like requesting my fellow Canadians to keep their money at home and to boycott the USA until they [the Yanks] can figure out that it is not right to attack innocent Canadians.

Thanks for letting me rant a little. I just think people should know about this.

What does the sale of Brigham Exploration tells us about the value of Petrobakken?

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Today we learn that Statoil has offered 4.4 billion for Brigham Exploration, a company with holdings in the US Bakken. Using a number of interesting methods of comparing the Brigham Exploration with Petrobakken, Devon Shire concludes that Petrobakken could be worth as much as 300% of its current market price (at close on Oct 17, $8). This kind of comparison is very interesting, because, as I reminded readers in a previous post about Petrobakken, the true value of an junior or intermediate oil company isn’t so much its market capital, but by how much an industry insider such as Sinopec or Statoil is willing to pay. Devon Shire writes:

I don’t know exactly what Petrobakken is worth. But common sense tells me that an acquirer would be willing to pay a lot more than the current share price.

Petrobakken is just like Brigham. They are both companies that have years and years of drilling locations ahead of them and both companies sit on vast amounts of oil. That is why the multiples of flowing barrel of production and EBITA being paid for Brigham are so high.

You can’t value these companies using the same approach as you do for a conventional oil and gas producer. Much of the value is in the huge land positions that these companies have in unconventional resource plays. And much of that doesn’t show up in proved reserves because most of the undeveloped acreage isn’t booked as proved reserves.

It isn’t just Petrobakken that is massively undervalued right now. The entire sector in Canada is. Pick an unconventional producer and I almost guarantee it is trading at 50% or less than what an acquirer would pay.

All it takes is some common sense to see it. And some patience to wait for Mr. Market to figure it out.

See also:  What does the sale of Daylight Energy tell us about the value of Petrobakken?