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

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.

The long and short of it: 2010 DIY summary

Our DIY investment portfolio has had a strong performance this year.  It is very difficult to determine actual performance because of contributions of new principle, but suffice it to say that our personal wealth experienced a 25% increase since January 1, 2010.  Considering that the TSX was up 14.4% this year, I shall now claim that I beat the index in 2010, and so far since becoming a DIY investor (Nov 2005) that has been the case: the TSX is up 15.8% over the last 5 years, while we are standing at 76% unrealized gain in our current positions (plus considerable dividends and realized gains over that same period). Our net worth has nearly doubled since June 2008 (before the meltdown) and our current rate of monthly increase is at 5.5 times what it was before I became a DIY investor in 2005.  I’ve discussed on these pages the strategies that I’ve employed (see category “investment tips”).  But to summarize below:

Long:  Gold, silver, oil & gas, sugar, loonie, Canada

Short: US dollar

Best moves:  Held Midway Energy (mel), up 48%; held New Gold (ngd), up 255%.  Added Crocotta Energy (CTA), up 53%. Used leverage in US margin account to buy Canadian high yield stocks (pwe, pgh, erf, pvx, avf.un) and traded favorably in and out of these positions.  Received approval to trade options and used them to great advantage–in particular, I greatly benefited from the sale of put options on Canadian oil and gas and gold mining companies (esp. the following–Canada exchange: cpg, dgc, gg, abx, pbn, pbg, day; US exchange: gg, abx, pwe, pgh, erf and ngd).  Increased non-margin credit facility by 230%: these consist of a loan from a relative (10%), two HELOCs (80%) and a unsecured line of credit (10%).  NB: Most of this credit facility is unused and left in reserve to cover put options–this allows me to safely sell more put options and not have to worry if there is a decline in excess margin credit in the portfolio.

Worst moves: Added more Perpetual Energy (pmt), new positions down 28% (overall position is down 35.6% not counting dividends); held Prospex (psx) which went to as high as $2.52, ended year at $1.31. Natural gas: bought Terra Energy (TT–up 0%), added more pmt, psx, Pace (pce).  Sold a covered call on Detour Gold and became more bullish afterward–this resulted in a $4.49 loss to buy back the call.  Failed to pay all taxes on income trust distributions in 2009 because an unintentional oversight by myself and by my accountant–I will seek a new accountant, and I’ve decided to include an income summary with all the paper work that I provide my accountant in the future: the CRA fined me 20% (over $1000–it was nearly $3700 total notice of reassessment) because of a similar oversight in my 2008 return.  The worst part of this whole episode is the fear of being on the radar of the taxman for the next few years.

Is this a recommendation to become a DIY investor?  I don’t know but it is an apologetic, since most financial writers in the official media say that retail investors do poorly and that they can’t beat the index.  After five years of experience and after not merely surviving but thriving in a period that included one of the worst bear markets in history (September, 2008-March, 2009), I have a growing confidence that I can consistently beat the index and make better money at this than at a day job.  While I won’t give a blanket recommendation to everyone to become an DIY investor, Adam Hamilton does recommend that everyone become a trader (see Monty Pelerin).

The successful DIY investor


Would you have bought this stock in January 2009? If yes, you too could become a DIY investor

Both Preet Banerjee at the Globe and Mail (see also his Lap of the blog) and Jonathan Chevreau at the National Post have written recent articles recommending that DIY investors use financial advisers.  I chose to step out completely on my own a few years ago, moving all our assets from full brokerage accounts to DIY discount brokerage accounts–the transfer fees were all paid by the receiving firm as a incentive to move our assets.  That was February, 2007.  Since that time, our retirement accounts are up a total of 154%.  I have also done well in our TFSA’s (up 40%) as well as our non-registered accounts.  Thus, I am not in the least tempted to follow their advice because I am confident that I can do well without a financial adviser.

I have learned through experience and here are some things that make DIY investor successful:

(1) Financial education:  I’ve learned through reading as much as I can from blogs and internet Newspapers including the Financial Post and Global and Mail financial page.  I’ve a limited number of books.  Benjamin Graham, The Intelligent Investor and Neill Ferguson, The Ascent of Money.  This is time consuming work, and those who don’t have the desire or the time to do it, should probably stick with index funds or a full-service financial adviser.  I’ve also occasional taken advantage of seminars or webinars to increase my knowledge–but these can be expensive so I am careful about them.

(2) Control of cash flow and leverage:  It is important to understand and control cash flow.  For example, it is probably a bad idea to buy a momentum stock using leverage.  You can never tell whether it is going to go up or down and the hold period may be much longer than expected.  By the time it goes up, the return may be greatly diminished by the interest paid.  However, it is much safer to use leverage to buy a dividend stock–as it can cover or exceed the interest rate during the entire period that it is held.

(3) Accurate tracking of results:  I keep track of such things as total net worth, total net sales of stocks, total value of stock portfolio and its net gain or loss, total debt to equity ratio, and the total amount invested in each sector (e.g., oil & gas, mining, food, banks, cash-GIC-bonds).  This makes it possible to know whether my strategies are effective or losing money and it helps me to manage risk.

(4) Specialization.  I can’t know everything about every sector.  So I invest most heavily in the oil and gas sector and am becoming more comfortable with how to evaluate the risk of buying into an energy company.  I do rely on published reports by professional analysts (at TD Waterhouse and Scotia Capital).

(5) Familiarity with different trading and investing strategies.  I use the following strategies:  Averaging down, selling of cash covered puts, and value investing–particularly the attempt to buy companies close to book value, a.k.a. shareholder’s equity.

(6) Control of emotions.  The best investors are probably not always geniuses; it is probably incorrect to say that the reason Warren Buffet succeeds is because he is smarter than everyone else.  Rather, it is his ability to control fear and greed.  He can bring himself to buy when everyone else is selling and to sit on cash while everyone else is buying.  A DIY investor must be cool and collected and must be able to buy into market when all the numbers are red and sell in a market where all the numbers are green.  My most successful move was averaging down on a company whose book value per share was $3.40 but its market price had dropped to a tenth of that: that was Trafalgar Energy (now MEL).   One day it fell so low that I called their office in Calgary and the investor relations guy said that they were still generating positive cash flow.  So I overcame my utter fear of loss and bought thousands of shares that day and the next.  It turns out that it may have been the trade of a lifetime.

Do DIY investors need financial advisers?

Jonathan Chevreau of the National Post says that smart DIY investors also need financial advisers, and by this he means paid financial experts.  The crux of article is this:

You may be an expert stock-picker who doesn’t need help with security selection but are you also an expert on bonds and interest rates? How about insurance products? Options and portfolio hedging strategies? I suggest that unless you’re in the investment business yourself, it’s a rare individual investor who can master all these different disciplines.

I commented as follows:

Hi Jonathan: Thank you for this article. I think that as I DIY investor, I could tell you my story and it would perhaps contribute to this discussion. I started as a DIY investor for a couple of basic reasons: (1) My adviser charged me 2% or $80 per stock transaction (now I pay $9.99); (2) I would ask for investment ideas, and sometimes he would not respond; (3) when I suggested my own ideas, he would often take on the role of trying to talk me out of them—this was good at first, but as I gained experience I began to outgrow these limitations; (4) he would suggest putting stop losses or to sell when I felt it better to hold. I started DIY investing in 2005 and took complete control of the portfolio in 2007, when I transferred everything to my discount brokerage. My adviser’s role seems to have been to prevent me from implementing my own vision and strategy and to enforce his own. Well, I’ve had considerable success since taking over, so I am not interested in finding an adviser: there is a plethora of financial information and advice available on the internet and in books: so my advisors are many: Peter Schiff, Jim Rogers, Marc Faber, Jonathan Chevreau, Rob Carrick, Patricia Lovett-Reid, Monty Pelerin, Ivestopedia, The Dailey Reckoning, The Daily Bell, and the Business Insider, to name a few. When I’ve talked to financial people about what I do, they say, “Oh that’s really risky!” So I am not at all convinced that I would be better off seeking advice. So I am not expert in all three areas of stocks, bonds (interest rates) and insurance products. I fear inflation and therefore I am not in the market for fixed income. I don’t need any more insurance yet. I think it less important to have a mastery of these three areas, and more important to have a working strategy that leads to success. But I will admit, however, using a lawyer for estate planning and tax issues—and we also have to have an accountant to calculate our tax and give us advice about how to avoid paying tax.

Calculating book value: Case study, Petrobakken (PBN)

The value investor should pay attention to book value (assets-debt). I aspire to be a value investor, but I depend on stock analysts to do part of the work for me. Here is my dilemma. The discount brokerages make some of the research available to their clients to encourage their clients to invest in stocks. This generates revenue for them, as they depend on commissions. This is one reason to hold in suspicion their recommendations, since they will often be more optimistic than they should. If I always obtained the 52-week target price that they suggest, I would be probably be fabulously wealthy. That being said, their information is nevertheless very useful to me.

But what happens when their numbers don’t appear to agree, either with each other or with the reports from the company in question. Consider the case of Petrobakken, which both TD Waterhouse and Scotia Capital give a high rating. A couple of days ago I blogged that I would buy some shares, and I did, though the stock has continued to drop. Not to worry, I calculated that this growing oil-weighted company was selling at less than shareholder’s equity/book value; typically, if a private investor wanted to come in and buy the company, they would have to offer the shareholders premium on the book value in order to convince the majority of shareholders to relinquish the company. That means that Petrobakken is selling at a discount. I calculated the book value based upon  their quarterly report (in billions) as 5.5 (assets)-0.698 (net debt) / .188 (total shares)=$25.54 per share.

Now it is interesting to me that on TD Waterhouse website under markets and research, PBN is listed as having a book value of only $17.18:

Analyst Jason Bouvier for Scotia Capital lists PBN’s “value” at 4.467 billion and its net debt at 0.902 billion. Analyst Roger Serin at TD Newcrest (TDSI Morning Action Notes, August 11, 2010) reports PBN net debt as 1.642 billion. He provides the following explanation:

Balance Sheet – At the end of Q2/10, the company had net debt of $1.48 billion, with $557 million drawn on its recently revised covenant based $1 billion credit facility (previously $900 million reserve based). At year-end 2010, we forecast net debt of 2.5x trailing cash flow and 14% available on its current facility, or 30% with working capital deficit. Net debt includes US$750 million convertible debentures due 2016. We also note PetroBakken pays annual dividends of ~$180 million, providing additional flexibility.

I see. The debentures are added to the debt which is only correct. Using this measure we arrive at the following book value (in billions): 5.507-1.448/.1886=$21.52 per share. This is higher than the book value indicated on TD Waterhouse’s Markets and research page, and it is the price at which I purchased shares earlier this week.

Of course Petrobakken at the end of their report explain how they calculated “net debt”:

Non-GAAP Measures. This press release contains financial terms that are not considered measures under Canadian generally accepted accounting principles (“GAAP”), such as funds flow from operations, net debt and operating netback. These measures are commonly utilized in the oil and gas industry and are considered informative for management and shareholders. Specifically, net debt is used to evaluate financial leverage and includes bank debt plus and accounts payable and accrued liabilities, less current assets. Operating netback is determined by dividing oil and gas revenue less royalties, transportation and production expenses by sales volumes. Management considers operating netback important as it is a measure of profitability per barrel of production. Net debt and operating netbacks may not be comparable to those reported by other companies nor should they be viewed as an alternative to net income or other measures of financial performance calculated in accordance with GAAP.

There is no mention here of debentures. And this could explain the difference. Thus, there seems to be different ways that debt is calculated, and the DIY investor must be aware of this and dig a little deeper to make sure that the data being reported is accurate.