Oral Health Group
Feature

Finance: Cash (flow) is King – Getting the right Asset Allocation

April 1, 2001
by John Nicola


Interest and Bonds

Interest rates have fallen along way since 1991. While we will still see even lower rates the bottom is probably near. It is this decline in rates that has allowed bonds to perform so well.

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Since the secular peak of interest rates in 1980, the SMU Bond Index has shown a stellar return of 12 % annually. After inflation is factored in, it is still a respectable 8% per year, which is slightly better than the TSE 300 total return of 11.5%(7.5% net of inflation)

The important point to note is that, over the last century, government bonds averaged about 3% return over inflation. The last 20 years has been an anomaly that is unlikely to reoccur in our lifetime.

We had a taste of that in 1999 when the average bond fund in Canada lost about 4% because of a small interest rate rise. In 2000 returns improved significantly as rates dropped towards the end of the year and so far bonds have been a good place to be in 2001. However small increases in interest rates in the future will make bonds volatile. With current yields well under 6% it is unrealistic to expect this asset class to make much more than this over the foreseeable future.

Why is this important? If we assume that the average “balanced” investor has 40% of their assets in bonds, GIC’s or T- Bills and they are expecting to make a long-term total return of 10% annually, then the equity portion of their portfolio will need to average almost 14% annually to achieve that overall result. How likely is that?

Equities

Valuations of shares are still very high overall (although good opportunities exist for value investors). Technology is key to our future, but that doesn’t justify the valuations we still see today (even though the NASDAQ is 45% below its 2000 peak).?

Every technology goes through an incredible growth, followed by a massive shakeout that consolidates or destroys many companies. In their time, railroads and automobiles had just as much impact on the economy and the overall growth in wealth as the Internet is likely to have today.

At their peak, there were 5,000 railroad companies and 2,000 automobile companies in the U.S. alone. Today, 99% of those companies no longer exist, yet their industries are still here. This means that the art of stock picking will be alive and well over the next decade.

Does all of this make me a “Chicken Little” advisor who runs around telling anyone who will listen that our financial sky is falling?

Not at all. But let’s consider alternative investment approaches that generate cash flows ranging from good to great-and, in many cases, with a high degree of tax efficiency. I admit I am biased — to me good investments generate good cash flow, good earnings or both.

The following is a list of my favourites. They are in no particular order and work best when combined to meet a client’s risk tolerance and long-term investment objectives. Personally, I have money in each of these:

Mortgage Funds and Pools

Arguably lending is the oldest form of investment and often suffers from a bad image. A well designed package of mortgages or an interest in a mortgage pool can be a very effective method to improve interest yields.

Mortgage Funds: These are usually mutual funds which invest in safe mortgages, which are often NHA-insured. Annual returns over the last five years ranged between 5% and 7%. Cash distributions currently run about 6% annually. Most of the distributions from these funds are taxable as interest income and, for that reason, are ideally suited as either RRSP or Individual Pension Plan (IPP) investments, where they remain tax-deferred.

Mortgage Investment Corp.: Mortgage Investment Corporations (MICs) are mortgage pools. Their managers look for higher-return and higher-risk mortgages than those typically found in mortgage funds. The key to risk management is how well the MIC Board evaluates each loan application, and the security they get for the investors. We have developed a private MIC for our clients. Its initial pool was a combination of first and second mortgages, and it’s averaged a net return of 11.2% annually since inception. This MIC has recently increased its pools to offer a fund which deals only in first mortgages, and has a target return of between 8% and 9% annually. They will soon offer a debt/equity pool which will be higher risk, but with commensurately higher returns.

Mortgage syndication: People with more to invest (the typical minimum is $100,000) can participate directly in mortgage lending through syndication. The mortgage lender approves the loan and then divides it directly among a small group of private investors. Returns vary with the risk of the loan, but will likely be 3% to 7% higher than one could expect from a pool of such mortgages In today’s interest environment that would range between 14% and 18%. Of course, the risk is also increased by the fact that you are investing in one mortgage versus a pool of mortgages. This can also be designed for RRSP eligibility and, as such, the interest will remain tax-deferred. This strategy is only for sophisticated clients who understand (and can accept) risk and who also know real estate markets.

Income Trusts

Several years ago, investment pools were created to hold various kinds of assets, such as oil-and-gas wells, real estate, coal mines, shopping centers etc.. In each case, the purpose of the pool or trust was to allow an individual investor to acquire a direct interest in an asset class and receive the net cashflow the asset provided.

The initial response was good, but investors treated these high cash flow trusts as though they were term deposits: no risk and income paid every month. These trusts are as volatile as any stock you might buy, but because they distribute the bulk of their cash flow (in most cases), they generate a far higher yield than one would normally expect from dividends.

If we look at the three main categories we can see how these flows work.

Real Estate Trusts: There are many options here and these funds own everything-hotels, long-term-care facilities, shopping centers, commercial buildings and more. Here’s what makes them attractive:

– Many are selling below their break-up values;

– The-cash-on-cash returns are often in excess of 9% per year;

– The income receives some tax-favoured treatment since the trusts flow-through tax deductions such as depreciation.

– They can be bought or sold more easily than direct ownership in real estate, without the need for high commissions and property purchase taxes.

Oil and Gas Trusts: These can be quite volatile but they can also create some rather spectacular cash flows with attractive tax treatment. For example, an investor who bought Pengrowth in January 1999 received a 20% cash return that year plus capital appreciation. Of course if one invested in January 1998, it would have taken until June 2000 to break even on the stock price, although income received was still attractive. This year, though, these trusts have performed admirably primarily because of how much oil and gas increased in price. As we went to press, a pool of good trusts was still showing a cash-on-cash return of about 15% annually, with favourable tax treatment. One caveat:-investors have to keep in mind that many of these trusts expect to expire in about 15 years, and therefore you are receiving part of your capital back in these distributions. For me, the best way to participate in these trusts is through a balanced pool, such as the one managed by Guardian Capital, which also adds other asset trusts to reduce risk and volatility.

Long-term Trusts: These invest in either commodities such as oil, but only operations with a long life-expectancy, such as Athabasca Oil which is expected to last for at least 80 years, or in facilities, such as Westshore Terminals, the BC port operation that ships coal overseas. Long-term trusts have a lower cashflow than oil-and-gas trusts, but should be able to pay this out for a longer time.

Covered Writing

When I speak to some investors about options, such as puts and calls, they usually assume that this
is both exotic and high risk. It certainly can be. But options can also significantly reduce the risk and volatility of a stock portfolio while providing an attractive income stream that is taxed at favourable rates.

A covered-writing strategy involves selling options (calls) on a portfolio of stocks that you own. The purchaser of the option is paying you cash now for the ability to buy stock you already own at a fixed price later. They are gambling that the stock will rise enough before the option expires to make them a profit. You, on the other hand, are willing to give up some potential future capital gain, which may not ever happen, for some cash today.

This can be an effective strategy in markets that are volatile or declining. By selling options on shares you already own you are reducing the risk of owning those shares and at the same time increasing the cashflow you get today.

There are several ways to participate in this marketplace. One is to retain a private money manager such as Croft Management. Minimum investment is usually $200,000. Another choice is to buy one of several mutual funds that practice this strategy. Currently they are targeting a payout of 8-9% of the capital annually. Since options are taxed as capital gains only 50% of this income is taxable.

Insured Annuities No Risk but higher returns.

Insured annuities are ideal for the client who wants a replacement for term deposits or bonds but does not want any more risk. How do they work?

Consider the story of Mary Stinson.

Mary is a 73-year-old widow. She has $500,000 in various term deposits that are coming due this year. She has been averaging an 8% return until now, which works out to $40,000 per year of interest that is fully taxable.

Mary knows that if she were to renew those term deposits, she would receive about 5% on her funds which would drop her interest income to $25,000 per year, or about $15,000 less than she is getting now. Because she is paying tax at the highest marginal rate of 48%. she will have about $7300 less of spendable income each year starting in 2001.

If Mary acquired an insured annuity she would take the following steps and get this result.

– She would invest the $500,000 in a guaranteed life annuity which would pay an annual income of $50,000 per year for as long as Mary Lived. Twenty thousand dollars of this income would be taxable to Mary each year, and the rest would be treated as a tax-free return of capital.

– Mary would instruct the annuity company to pay $15,000 per year of this annuity to a second life insurance company as a premium, which would insure Mary for $500,000. This guarantees that Mary’s capital will always be preserved.

Mary’s net position:

Annuity Income $48,000

Life Insurance Premium$15,000

Spendable Income (6.6% cash flow yield) $33,000 Taxable Income $17,000

Tax Payable @48%$8,160

Spendable Income (after tax)$24,840

Now compare this to what Mary would have earned on term deposits:

Interest Income $25,000

Tax @48% $12,000

Net Income $13,000

The Net Interest Income method results in $11,480 per year less than the Insured Annuity method. Mary would have to earn more than 10% annually on her term deposits to equal the return on the insured annuity .

In addition to the income for Mary, she will also enjoy these benefits:

– She can name a beneficiary for the insured annuity and therefore eliminate $7,000 ofprobate fees on this $500,000 investment

– If Mary had an investment company with unrealized gain, then the insured annuity could reduce the taxes payable by her estate on those assets by as much as $170,000- that’s a 34% reduction.

Insured Annuities are a safe, effective way of generating tax-efficient income along with some attractive estate benefits.

Each of these vehicles provides excellent cash flow and some very tax efficiently. You may ask where the growth is in this portfolio. My answer is twofold.

Firstly, if I can get an average cash on cash return of more than 8% annually and consistently plus some inflation protection and tax benefits then I am happy with that result.

Secondly, in my case I reinvest the income that these assets generate in riskier vehicles such as technology funds, on a dollar cost averaging basis. That works well also and it keeps my overall capital safe and productive while it generates cash flow — which to me is the real key to effective wealth building.

John Nicola is president of the Nicola Financial Group. NFG is a member of the Barrington Wealth Partners.