How the Bank of Canada's Rate Hike Affects Canadians

Photo courtesy Chris Wattie of Reuters

On July 12, The Bank of Canada (BOC) raised lending rates for the first time in 7 years; the overnight rate rose 25 basis points to 0.75 per cent. It was a highly anticipated move as futures predicted a greater than 90% chance the hike was coming. Tightening monetary policy has immediate and medium-term effects that touch many aspects of regular life, and we're here to discuss just a few of the impacts it may have on yours.

Foreign Exchange

All things being equal, higher interest rates in Canada would raise the value of the Loonie. This is due to the increased demand from foreign investors purchasing Canadian investments, such as government bonds (debt). Since Canada is a net exporting country, this would reduce the overall demand for Canadian products or make it more expensive for our trading partners to buy our resources. A reduction in demand therefore would reduce economic output. However, it is beneficial for residents that flock to the US for vacations. Needless to say, a higher Canadian dollar increases purchasing power for Canadians travelling aboard, but reduces tourism into Canada. Many argue that a low currency is a more effective economic stimulant than government policy.

Better Bank Profitability

If you are an employed in Canada, then you have a direct interest in the profitability of the financial industry. Other than the fact that banks are one of the largest employers in Canada and we rely on their sustainability as a nation, all working Canadians contribute to some form of pension plan, whether it be privately-held at work or through CPP. Most pension plans invest their funds into mutual funds and in Canada, all mutual funds focused on growth, income, blue chip, or index-matching, possess all five big banks in their portfolio. The reduction in profitability for banks hinders share price and dividend growth.

When interest rates rise, it gives banks larger margins on their lending rates. Banks make money by borrowing short and lending long. Borrowing short means they borrow money from their customers and investors through chequeing accounts and GIC's. The interest rate on these are under 1%. Banks then lend long buy purchasing long term bonds in the market or offering mortgages which are typically 5 years. Rates on 5-year bonds and mortgages have an interest rate about 2.5%. This is the yield curve and is the spread that banks attempt to profit off. This dance exists as long as there is demand for short term investment vehicles and use of chequeing accounts.

Inflation

Most people view inflation as the rise in prices of goods, however, it is not the true definition. Inflation is the reduced value of money and as more money is printed, each unit is fractionally reduced increasing the amount of money needed to buy the same good. Rising interest rates slow down the efficiency of an economy and therefore reduces the demand for money and speed at which money decays. For the average person, this means a decelerating pace of inflation. This may be viewed as positive or negative, depending on your needs. If you have investments, you would seek inflation. This increases the value of the investment. Many however seek slow inflation to combat stagnant wages and increase their personal buying power.

Mortgages

We didn't start off with mortgages as our first topic because it was important to understand how mortgage rates are priced. Some people believe that interest rates on mortgages are aligned with lending rates, however, historically speaking, this is actually untrue. Mortgages move in line with longer-term government bonds. This is often why variable rates move prior to central bank decisions, as was the case last week, when RBC raised variable rates 20 basis points. The longer-term bonds were already moving in anticipation of the Bank of Canada's decision. With that said, although there is no direct impact, mortgage rates should theoretically rise if the Bank of Canada implements one more rate hike in 2017, which is highly expected because longer-term bonds will drop in value.

If inflation declines, then this also leads to a reduction in the long-term bond yields of 10 and 30 year notes. Typically, these long-term debentures are in tandem with inflation expectations. If inflation rates do start to decelerate, then it is highly possible for the value of these bonds to rise and their yields to drop. This could potentially reduce variable mortgage rates without intervention from the central bank.

Consumer Spending

If you're a small business owner, then you should expect to see a reduction in consumer spending. However, the Bank of Canada revised their GDP growth from 2.6% to 2.8% which is an encouraging sign. Historically, the idea of raising rates increases the cost of debt. The average Canadian has over $20,000 of debt, excluding mortgages. Now that rates have risen or may start to rise, more people may start to funnel their cash from expenditures to debt. The direction from money out of the economy into savings and vice versa is the true nature and intent of interest rate decisions and monetary policy.

Amazon Effect and Urban Sprawl Killing Retail

Amazon (AMZN) has always been known as a market disruptor. Its unique model two decades ago was unseen by the world and as the Internet expanded across the globe, the ability to shop from one's home went from a luxury to a norm. In 2016, nearly 20% of all retail was done online. The evolution of retail has rapidly changed within a generation and brick and mortar retail outlets are being tormented.

Malls are more vacant and retailers are closing up shop. Stock prices of retailer are down and margins are thinning. There are more self-made millionaires opening up businesses in their homes and using their garages as a warehouse than millionaires making money through traditional retail. 2017 is proving to be the threshold for many companies that find ways to either survive or fade away in history like ESPIRIT.

In the US, Bebe Stores (BEBE) announced in the spring of 2017 that they would be shutting down all worldwide stores and focus solely on providing retail businesses online. It was the first international brand to make the switch. Other American companies are on the brink of bankruptcy or being bought out by private firms who will no doubt alter business models to maintain profitability. American Eagle Outfitters (AEO) recently sparked rumours it would be bought out. Nike shares have come under pressure as sales show lacklustre growth. Foot Locker (FL), Nordstrom (JWN), Michael Kors (KORS), and Target (TGT), just to name a few, have seen shares tumble this calendar year.

In Canada, long-time standing retailers like Sears, Ben Moss, and HMV went through major overhauls. Target's attempt to expand in Canada failed to penetrate market share from Wal-Mart.

But, most of the pain is only coming from American and Canadian stores. LVMH, better known as Louis Vuitton, has seen its shares rise almost double in the last 52 weeks, a stark contrast to its peer. And European retailer are showing little negative effects to online shopping. So, what's the reason?

Canada and the US, with exception to a few pockets of high-density urban areas such as Manhattan, have one major luxury that most nations do not offer: land, a lot of land. During the rise of retail, it was obvious that companies built large shopping centres which offered hundreds upon hundreds of products. The American (and Canadian) market is over-served and ready to correct. Forbes reports that organic growth in retail averages 3% annually, but during retail's expansion in North America, land for retail surged significantly more than 3%. In fact, the USA has more retail space per 1,000 people than any other country.

The US has more than twice as much retail space per capita than Norway, which is second on the list. Yet most people in Europe and Asia do not feel under-served by their choices. Businesses needed to built upwards instead of outwards. Urban sprawl is not as significant a problem in Asia and Europe as it is in North America.

Imagine a 7-Eleven situated underneath a 20-storey condo unit. If each floor contains 25 residents, the 7-Eleven has access to 500 residents living above it alone. However, if this 7-Eleven is located in a suburb or a low-density city such as Edmonton (my home town), 500 residents would take up over 4 square kilometres. That is 40 times more than the average 125 square metres per city block. For many people, a 30-minute walk to the convenience store might not be convenient enough.

Amazon offers something that malls do not and that is the ability to shop for multiple types of brands and products from our couch while also offering discounts on all the total cart and free shipping. Shopping online is so convenient. It has caused such large problems in Canada that inbound items from China sit at the border for months as security needs to screen items. Backlogged by huge shift in consumer spending, Canada Post and Canada Border Services are falling behind.

A correction or collapse in retail is highly needed in North America to find equilibrium. If Norway can maintain a strong retail sector with current space, that means that the US could expect to see a reduction of 60% of stores closing. However, if the happy medium in a post-Amazon ruled world is closer to Germany's size, that would mean 90% of retail space would need to close up in North America.

The love for urban sprawl coupled with online shopping means that most malls may start to look like warehouses for FedEx and UPS. Amazon has done something magical for the world at the cost of brick and mortar retailers, but the gains have been seen by delivery and courier companies. Over the next decade, it is apparent that major consolidation will come about. Amazon's recent purchase of Whole Foods (WFM) indicates that perhaps Jeff Bezos sees the same potential in food as he did with tools, books, and teddy bears.

Why Jordan Eberle Should Remain

A strong sample size of Edmonton Oilers armchair general managers want Jordan Eberle gone. A poor regular season performance coupled with zero goals in 13 playoffs games cannot justify his $6 million salary. He's the whipping boy of the current season. It was formerly Justin Schultz, Shawn Horcoff, and Devan Dubnyk. It is an annual tradition in Edmonton, and probably most major hockey markets, to find the weakest link and trade him. But, he's useless, according to Oilers fans, so what team would want him? In this man's opinion, if the Oilers decide to offer him up at the expansion draft or trade Eberle, there would be a strong list of teams that would be willing to acquire the 6-million dollar man but the list of teams willing to offer fair value for Eberle would be short, extremely short.

In finance, herd mentality offers up big opportunities. When the market is selling, long-term investors can find discounts on strong assets, and this is similar in sports. From the Oilers perspective, Jordan's stock value is low, at least in this city's eye, but what is our junk is going to be another city's treasure. And other GMs know this and will give the team as little as possible because they know everything outlined below.

Jordan Eberle completed his 7th season in the NHL with 51 points in a full campaign. Compared to his professional career, this is definitely below his average. He has 3 seasons with more than 51 points and 3 seasons with fewer than 51 points, but in the worse seasons, Eberle played just 69 games twice and the other season was the NHL lockout. So, on a points-per-game basis, this was his worst.

Jordan Eberle finished 94th in the NHL in points, 88th by forwards, 21st by right wings, and 3rd on the team. There were a total of 888 skaters that recorded one game played in the year. 94th puts him in the top 11% of the league in points-production. And players that finished with 53-49 points include Corey Perry, Taylor Hall, Anze Kopitar, Henrik Sedin, Joe Thornton, and Jason Spezza. Are you surprised to see a list of elite players (subjective) that surround Eberle's name in the standings? Or were you expecting to see the likes of Alex Chiasson, Mike Fisher, and Max Domi? No offense to these players either.

That list of elite players also have one thing in common. They are all paid at least 6 million USD. If Jordan Eberle's poor results do not justify his salary, then that is your opinion. Businesses and NHL GMs need more than just an opinion before making any decision and the facts do not support how poorly a season fans claim.

Here is the fact: if we look at it on a point-production basis, Jordan Eberle would be a first line right-winger on at least ten teams and a guaranteed second liner on all. Although there are players that make less money and produced more, there is a longer list of players that make more money and produced less.

If Oiler fans feel the need to blame the Oilers failures on Jordan Eberle or criticize his season, go ahead, you have every right. But replacing Jordan Eberle holds very little merit when we consider the data from around the league. In fact, compared to Thornton, Kopitar, and Spezza, Eberle's salary is a steal. If you want him gone and replaced with another right winger, try to find one on the market that has an opportunity to come to Edmonton for cheaper and produce more points. Because right now, the only noise I'm hearing are complaints that do not come with any solutions.

Weed Stocks: A Further Analysis

Photo credit: Drew Angerer — Getty Images

The euphoria that took the Canadian stock market by storm at the end of 2016 has subsided as marijuana stocks have traded essentially flat year-to-date. Investors paid heavy premiums (based on traditional valuation methods) to access the budding industry with the hopes of being part of the next big thing. Muted trading has given the market a breather and provides us a moment to analyze the shares. Are stock prices trading at a premium or a discount? Will investors make money or should they bail at break-even? Will this industry become as large as the rest? Here are some facts which we will use to provide you with both a bullish and bearish case.

In 2016, the state of Colorado reported total revenue of marijuana sales at $1.3 billion US. This equates to a total base of about $225 US per resident. The government projects sales will rise another 25% in 2017 which will generate $250 million in tax revenue for the state. This revenue projection would equate to about $280 US per resident.

National surveys done in the US showed a reduction in teen usage in the state of Colorado compared to the national average and a slight reduction in teen usage year-over-year within the state. Most international surveys also cannot prove or come to the conclusion that the legalization of marijuana increases total usage and some surveys draw the conclusion that total net consumption is reduced.

Canada projects total users (above the age of 15) to exceed 5 million if/when marijuana becomes legal in the country. However, total market consumption is undetermined.

When industries are newly forming and do not earn a profit, one metric used to measure a public company is by the price-to-sales ratio (PSR). This divides the stock price by its revenue per share or alternatively, divides the market capitalization of the company by its total revenue. The industry with the highest PSR is Internet software (6.66) and the lowest is auto parts (0.67). Click here for the full list.

Metrics

If we draw parallels from Colorado and apply it to Canada, and we expect that consumer trends remain similar, the expected size of Canada's weed industry should be $10 billion CDN assuming the average resident consumes $280 of weed per year (note we removed foreign exchange from the calculation as marijuana would most likely be unaffected by foreign exchange or futures markets).

The three most prominent stocks in Canada by market cap are Canopy Growth (WEED), Aphria (APH), and Aurora Cannabis (ACB) with a combined market capitalization of $3.15 billion CDN. Their 2016 revenues were $30.27 million, $15.07 million, and $4.51 million; a combined $49.85 million. This results in a PSR of 63.19.

Bullish Case

The legal weed industry is still in its infancy and the market has discounted its potential value. A $10 billion market could push stock prices higher. With a comparable PSR to tobacco of 5.66 (or 6 for simplified math), this would value the total industry at almost $60 billion in market capitalization, which is about 20 times more than the current value of the three companies mentioned above. Triple-digit growth proves that there is significant growth and it may not peak or plateau for years down the road.

Legalization could also increase tourism and it is estimated that an additional 900,000 Canadians would consider trying it after legalization according to a recent survey. The total market capitalization predictions also exclude the potential for expansion into the US which has a market ten times larger. There is a strong movement for legalizing in the remaining states to boost government tax revenue.

Bearish Case

Bears do not doubt that these businesses will grow, however, their shares may not. Current PSR show that the market is pricing the stocks almost ten times more than the highest industry. Its current PSR of 63 requires growth over 1,000% (or 11-fold) before its PSR matches the tobacco industry. A projected 20-times increase in revenue would only double the stock (at most) and this assumes Canopy, Aphria, and Aurora control more than 99% of the market share. The second assumption is that market capitalization does not grow due to increased float, which means the company issues shares and reduces the amount of ownership per unit.

The most recent quarter showed Canopy posting revenue up 180%, but the shares declined 8% on the news. Premiums are now catching up with fundamentals and the $10 billion projection could be an overstatement due to concentrated data from Colorado. In economics, the law of big numbers indicates that a company growing rapidly cannot maintain that level of growth forever because there are fewer new customers available. If this law applies to weed companies as well, it can be inferred that the following quarter will show less than 180% growth which results in an "asymptote-like" chart; a plateau or peak is an inevitable part of any business.

The $1.3 billion generated in Colorado includes tourism revenue. This is an important fact to dissect because it would provide evidence where revenue can plateau. If legalization hits all 50 states, would revenue specific to marijuana be reduced for Colorado on a resident-based average? The current projections assume $280 spent per individual, but in Canada, only 5 million (or about 15%) of Canada's population would be a regular consumer. This means that in a room of 7 people, the one individual would generate revenue of $2,000 directly to the producer.

When Should You Dump Your Mutual Funds?

The 2016 RRSP deadline is fast approaching; that means large lump sum contributions for many. The majority of that money is allocated into debt (bonds) or a mutual fund. Most employee savings plans and pension plans directly buy mutual funds, but mutual funds are not necessarily the best choice for the average consumer due to their fees. As one's wealth rises, it may be ideal to move away from them, but when should you dump your mutual funds?

Firstly, what is a mutual fund? Essentially, they are professionally managed portfolios. They provide access to the bond and equity markets with minimal capital. In most cases, mutual funds do not charge for transactions. Instead, their earnings are made through a management expense ratio (MER) which is used to pay employee salaries, accountants, lawyers, and other operating expenses. These fees tend to be between 2-3% of the fund's net asset value. Although this amount seems small, these fees add up over time, and we are here to expose how much money is actually lost by retirement.

Let's assume you are contributing equal payments of $10,000 annually for 40 years into a mutual fund with an MER of 2.5%. We will also assume there is zero net growth in the fund to simplify the calculations. This means the fund's value rises equal to the MER and thus shows no growth.

In the first year, the MER paid would be $250 and in the 40th year, the MER paid would be $10,000. If you've forgotten the formula for this kind of arithmetic, it is (first year's MER plus final year's MER)/2 multiplied by number of years. We can see that the total MER paid by you is $205,000. While your retirement account is worth $400,000. The total MER paid is over 33.8% of your total wealth.

Of course, that's not all. Depending on the source, it is measured that in any given year, just one-quarter of all mutual funds will beat their benchmark. Over the long-term, less than 0.1% of funds outpace the index. In 2014, a report by Jeff Sommers, writer for the New York Times, concluded that just 2 funds out of over 2,800 beat the S&P 500 for five consecutive years (2009 to 2013). Both were small-cap funds, and thus, had a higher probability of beating the index. Unfortunately, both funds, in 2014, failed to maintain their run.

There is strong evidence to support that active funds cannot outperform an index, and this information is vital for investors looking to manage their own capital more efficiently. The alternative to mutual funds would be index funds, such as the iShares TSX 60, SPDR S&P 500, or SPDR Diamonds Index. MER's for these ETF trio are roughly 0.10%. Assuming zero net growth, the total MER paid over the same period is $8,200. If the index also grew by 2.5%, you would have an additional $196,800 at retirement, almost 50% more, by reducing your overall fees. These gains exclude potential capital appreciation and dividends, which historically yields 8% on average.

So getting back to the original question, when should you dump your mutual fund? Most self-directed registered accounts at a brokerage will charge up to $125 a year if the total equity is below a certain threshold. And trades on ETFs will run about $10. This translates into an annual cost of $135. Based on all that has been discussed, if your total portfolio exceeds $5,400, then it may be profitable to move your mutual fund into an index fund.

Many investors stick to mutual funds because they lack investment knowledge. Their lack of confidence or education persuades them towards products that are managed professionally, but as we see, spending just an hour a year educating yourself will pay significant dividends down the road. Even by simply making this transition, you will be 50% richer.

Minh Luu is a former Canadian investment representative with a major in finance. All advice and information in this article is opinion-based and is not a recommendation on buying or selling. Always speak to your investment advisor.

Put Options Versus Stock Ownership

Traditional buy and hold strategies have long been proven effective over the long term, especially when investors select quality companies. However, buy and hold is actually the least efficient investing method when it comes to generating returns. Although we have a bias for options, it is important that investors educate themselves on alternatives to just buy and hold because beating the market while driving on the same highway as everyone else is nearly impossible.

Hedge fund managers and professional traders often employ the use options over owning stock. Stock ownership requires significant capital and produces lower returns versus selling options. The advantage of using options is the ability to profit even when the stock falls; stock ownership has no room for error.

Take for example Google shares, now known as Alphabet. Priced at $827, these shares are most likely out of reach for the average investor looking to fulfill a board lot. This would require almost $83,000 just to avoid interest. However, selling a put option just out of the money (820 strike) would require only $17,200 cash. The difference in capital requirements is staggering and can actually limit the demand for companies. The ability for younger or financially strapped investors to buy and hold is often burdening and not possible.

If we take the 2018 LEAPs, you can sell the $820 puts and earn $67 a share. This is immediately paid to you. Regardless of what the shares are valued in a year from now, you keep the $67. This represents a return of almost 39% for the year. To match the same return in percent for a stock owner, the shares would need to climb to $1,150. To match the return in dollar value, shares would need to climb to $894. Now, selling a put does have its own risks as well. If the shares fall, you would be obligated to buy the stock at $820 or close the option. However, if the shares are worth more than $753, you would still be left with a profit. This advantage only lies with an option trader.

If the stock owner had purchased the shares in 2017 and held them for one year only to see the shares fall to $770, the stock owner would see a paper loss of $57 a share or $5700 per board lot. We however, have seen a profit of $17 a share or $1700. The cost to close the option on expiration date would be $50 but we received $67. This is an example of more efficient investing. Since Alphabet shares do not currently pay a dividend, there is no added benefit on owning the shares with the exception that the stock could be worth more than $1,150 in a year (let's see how it plays out), but this is worthwhile trade-off for option traders. It is very rare for a stock to return 40% a year every year and in the long term, the reality is that the option trader will be better off than an investor with a buy and hold strategy.