I must say that I have a special affection for the energy sector. In fact, it was a decision to pile into oil stocks in the late 1990s that provided some of the most lucrative investing experiences of my lifetime. Sure, it was partly luck, but it was also the belief that oil at just over $10 a barrel didn’t make sense.Market Dad was also involved, as his passionate fling with energy trusts was about to transform itself into a serious, long-lasting relationship. No conversation about investments was complete wihout him mentioning Pengrowth, Enerplus, and all the early names in the patch. Having been a mutual fund investor and GIC refugee, I only had a few years of experience with equities and many of his arguments for energy trusts were very appealing. He also recognized my love of income product and speaking of energy trusts cast him in the role of dealer to my addict. Hey, it worked. Back in those days (I now wax poetic) I remember talking with others about income trusts and the common response was something like, “yeah, but what about Nortel?” Well, good luck with that.

Fast-forward a few years and oil is now around $50 and I find myself feeling uneasy. That’s why the current edition of The Market Guy is devoted to a couple of recent trades in the energy patch and an exploration of the madness behind my method.

Trading notes

I have sold 50% of my position in Real Resources (RER on the TSX) at $10.45. As I mentioned in MG #21, the shares were purchased in August at $7.40. That works out to a gain of roughly 42% in 2 months. Two factors at play here: 1) The upward trend in the price of oil; and 2) the company approaching production levels that have seen many others converting to the trust structure. I really don’t care what’s involved. You could tell me it’s all about Venus and Saturn being aligned in a certain way and my only response would be “great!” This remains a speculative play and so, once again, luck has a substantial amount to do with it. Thanks luck! In fact, I’d like to take this opportunity to congratulate luck and all the fine things it has done for me, lo these many years. We don’t have enough national holidays in Canada , so perhaps we should have one devoted to luck. I’d certainly get behind a Luck Day. Where I work, all of the psychologists would call it External Attribution Day. That’s good too. Besides, the underlying meaning would resonate with me about 800 times more than Victoria Day. I’ll bet there’s a significant portion of the population that couldn’t pick Queen Victoria out of a lineup (with a fair number believing that she’s actually available for the lineup).

In a related story, I have sold 1/3 of my position in ARC Energy Trust (AET.UN on the TSX) at $16.96. The full position was acquired in May of 2003 at a price of $12.09. I still love this royalty trust, with its conservative payout ratio, solid management, quality assets, neat balance sheet, and long reserve life. More importantly, I’ve enjoyed the $0.15 a unit each and every month. Don’t you just love distribution day? It’s such a beautiful, perfect, wonderful day. The sun is shining, the birds are singing, and the only thing I have to contend with is unbridled joy. I trust you are same.

The yield on my originally invested capital is almost 15%, but with the price appreciation, any new investors would capture just over 10%. And I know what you’re thinking. Why is this guy cutting back on his energy holdings as oil inventories are low, we’re heading into the winter season, and there are more bulls in the energy sector than in Pamplona. Sure, taking profits in this environment is hard because you’re doing the exact opposite of what most others are doing. But for me, it’s all about risk management at the portfolio level, sector level, and individual level. Let’s have a look at each factor involved:

a) Managing the risk to my portfolio

First off, I’m not eliminating my exposure to the energy sector. In fact, I can’t imagine a circumstance in which my portfolio would be completely devoid of energy names. That would feel wrong. Rather, I’m cutting back to avoid overexposure. With the gains, energy was about to disproportionately influence the performance of my portfolio. Warren Buffett says that you have to assume overweight positions from time to time or else you are destined to generate market returns, at best. True, but I’d prefer to be overweighted in a sector that has fewer gains on the table. As any stock rises (especially among my speculative plays), I have to ask myself if the expected return is high enough to justify the risk. I take an overall approach, meaning that I’m looking at how the gains have changed the sector allocations of the portfolio. The paring of RER and AET.UN represent an attempt to restore an appropriate level of diversification, thereby reducing my risk.

Overweight, underweight, welterweight. When you have over $40 billion (like Warren Buffett, shown here) it’s all gravy.

b) Managing the risk associated with energy price movements

Second, I remember the last time everyone was so excited about energy…and then the price of oil collapsed to around $10. I’m sure you’ve all been hearing “it’s different this time” coming from the mouths of analysts and commentators alike. Maybe it is different this time. But I’m not prepared to stick my neck (or my hard-earned cash) out on a bet. And let’s be clear about something: Nobody knows where the price of oil is going to be in a year. If I told you it’s going to be $65, we could all generate explanations for this possibility, each making perfect sense (e.g., cold weather, more pipelines blown up, and Chinese demand continues to skyrocket). Alternatively, I could suggest that it’s headed to $35 and we could all generate explanations for this possibility, each making perfect sense (e.g., warm weather, fewer pipelines blown up, and Chinese demand misses expectations). Well, if either possibility is reasonable, that indicates the presence of considerable risk. My recent trades represent an attempt to manage against these risks and reduce my exposure to a sector that can move with alarming speed.

How much for a barrel of oil? As others have remarked, prognosticators predict not because they know, but because they are asked

c) Managing the risks associated with being me

There is something you should know about me. It’s fairly significant, but I feel comfortable that I’m not breaking any social conventions regarding personal disclosure. Here it is: I almost always sell too early. There it is, off my chest. My investment history is littered with good investments that were subsequently compromised by premature liquidation. Yes, my name isMarket Guy.and I’m a premature liquidator. I’ve come to accept my problem, even have it fully integrated into my investing self-concept. If only there was a way to see if my sell decisions could be used to improve the world, if only in a small way. Surely I’ve become so predictable that a mathematical function could be developed to determine how much money is still to be made after I sell. If you could arrive at such a function, the Nobel Prize for Economics would surely be yours.

Having identified my problem, the next logical step is to determine if I am unique. Do others exhibit similar tendencies? You bet they do, Chester!

In order to make sense of what’s involved, we need to hit the books from my old intellectual stomping grounds, the world of behavioural finance. Here the focus isn’t on what economic decision-makers should do. Rather, the attention is paid to what investors actually do. There are often substantial differences between the two and behavioural finance is interested in charting these differences. Some of the most influential theories in the field belong to Daniel Kahneman and Amos Tversky. Their prospect theory (1979) notes we tend to be risk-averse when faced with a gain situation and risk-seeking when faced with a loss situation. The idea has been applied to a number of different areas, including business studies. For example, it can be used to explain why so many companies escalate their commitments to losing strategies (i.e., throwing good money after bad).

Hersh Shefrin and Meir Statman (1985) took prospect theory and applied it to the realm of investments. Their disposition theory noted that we tend to sell winning investments too soon and hold on to losing investments for too long. In terms of selling our winners early, this reveals a tendency to behave conservatively and protect our profits even if that means leaving possible future gains on the table.

Assuming all of this is true, then what is a small investor to do? Here’s what I’ve been playing around with: I much prefer to pare back a quality holding rather than blowing it out of the portfolio altogether. Think of it as a hedge against myself. If the stock continues to rise, then I get to participate (but to a lesser extent than before). I may decide to sell the remaining shares at a later date, depending on my overall portfolio makeup and a variety of other factors. If the stock goes down, then my paring has left my butt less exposed to the wind. By taking some profits I’m less concerned about the performance of the shares I didn’t sell. At this point, RER could completely collapse and I’d still be ahead of the game; same goes with AET.UN.

In response to my tendency to first pare back a holding rather than eliminate it altogether, loyal reader Pat in Ottawa suggested that such holdings must be sizeable in order for paring to make sense. Partly true. However, using a discount broker with competitive fees can allow you to pare even a modest-sized position without incurring unreasonable costs. Again, fees matter (seeMG#22 for the definition of the word, “rot”). If I were paying a full-service broker, the extra trades would render my “self-hedge” completely ineffectual.

Here are the punchlines: You can know about investor tendencies, even conduct research in the field, and still commit some of the fundamental decision errors that compromise performance. Gotta be me. The fact of the matter is, I much prefer to book a few profits on the way up so that I can minimize my risk and my potential regret. I have always been very risk-averse when dealing with gain situations. I mean, is there anything worse than having substantial gains and then watching them vanish before your eyes? Heck, you might as well be a Yankees fan. At least investors have a chance to get out with gains at a point of their choosing.

The Yankees would have sold after Game Three. Thankfully, the sports world plays by different rules…andThe Market Guy can’t stop giggling about it!

So I’m eager to lock in some profity-goodness and move the fresh, newly-minted capital elsewhere. There’s nothing sweeter than newborn capital. You fall in love the moment it comes into this world. You want to pick it up, hold it, and protect it with all you have. And let’s be honest: It smells beautiful. Come to think of it, maybe all that glitters…is oil!

The Market Guy is an Instructor with the Department of Psychology at Carleton University. He’s not a professional advisor. He’s just a guy who loves investing and talking about the markets. Next week he’ll be dying his hair for the local United Way campaign and his students will be picking the colour. It could be pink, red, orange, blue. It’s all about making some green over at mail@marketguy.ca

In this Back to School edition:

• Feature: Method Of Modern Love: How I Think About Mutual Funds
• Looking ahead: Changes to Marketguy.ca?
• Trading note: AFT Income Fund (AFT.UN)

In the previous edition of Market Guy, I gave in and decided to start writing about mutual funds (see MG #21). Even I was surprised at how long it took for me to finally break down. Perhaps I should have addressed the topic earlier, especially given that a majority of Canadians are involved in funds in one way or another. But here’s the thing: I’ve been so obsessed with the stock market (income trust area, in particular), that any interruption would have been like asking a heroin addict if they’d switch to Tylenol. Despite all the good intentions and wishful thinking, it just ain’t happening. Those of you addicted to income product understand, and no doubt there is a 12-step program in our future. Well, I’m not sure what those 12 steps would involve. Perhaps I could include my handy, dandy 5-step approach to selecting mutual funds. Hey, you have to start somewhere. Recovery is a slow-process.

When it comes to my financial portfolio, the emphasis is overwhelmingly on stocks and as of the other day, cash. The stocks that I own are investments that I am able to follow rather closely. More importantly, these are vehicles about which I have achieved a reasonable and comfortable level of understanding. However, it’s important to recognize that it’s virtually impossible to become an expert on all of your investments…if any of them. It’s been estimated that in order to be an expert in any domain of activity, 10000 hours of deliberate practice is required. I’ve come to recognize that as I become more fully-entrenched in my career, there is only so much time that I can devote to investments (let alone 10000 hours). In fact, if someone were to ask me “how’s the portfolio?,” I’d have to ask: “Do you mean my financial portfolio or teaching portfolio?” This year I’m supervising almost 60 fourth-year honours projects, teaching a couple of first-year classes, and chairing a recruitment committee that involves speaking about the virtues of Carleton to high school students and their parents. So you can understand my confusion. There are only so many things that one can think about without having a complete meltdown.

Enter mutual funds, which at a general level, I regard primarily as investment vehicles that help me participate in markets or sectors about which I lack the confidence, knowledge, or time to follow with any rigour. I use them to help me diversify and enhance the overall balance of the portfolio. However, I will only invest in a mutual fund if there is no equivalent or compelling exchange-traded fund (ETF) available. An ETF is an open-ended mutual fund that trades on a stock exchange. You trade them like stocks, and they have many advantages over traditional mutual funds (as we’ll see). Before I get ahead of myself, here are the 5 questions I consider when purchasing mutual funds:

The Fantastic Five

• Does this fund accomplish something unique for my portfolio?
• Does the fund have low fees?
• Has the fund outperformed its peers?
• Will this investment allow me to sleep at night?
• Is the fund relatively tax efficient?

Sounds simple enough. Well if it were so simple, the only 5 I’d be working with would be a 5-iron (in other words, I’d be taking a page from the book ofMarket Dad). Instead, I’m lucky if I can find the sticks in my basement. And if it were so simple, you’d be…well, I don’t know what you’d be doing. I mean we only just met and I’m not about to make assumptions. I’ve heard stories about you and those pictures on the Internet…well, let’s just move on.

Before we get started, you might be interested to know where I get my information on mutual funds. The overwhelming majority of my data is obtained from two Internet sites: Globefund and morningstar.ca. These sites give me everything I need to make, what I believe, are informed investment decisions. I also find it useful to browse through fund company websites looking for prospectus information. Now on to the five:

Does this fund accomplish something unique for my portfolio?

I know many investors who own several funds that are essentially the same. In other words, they’ll have 4 Canadian equity funds or 3 health care funds. Looking at the top holdings of each fund reveals many of the same holdings. To be honest, I don’t understand the need for duplication. Why own Pfizer or BCE 4 times? Isn’t once sufficient? (unless of course you enjoy popping Viagra while watching ExpressVu).

When choosing a specific fund, I want to make sure that it’s adding something new, rather than simply piling on to existing holdings. Ideally the fund will fill a gap and enhance the diversification of the portfolio. My first inclination is to search for an ETF. However, such products are not always available, especially in the relatively limited Canadian market. Therefore, if I want exposure to the Canadian small cap market and there is no corresponding ETF, then I will consider using a mutual fund.

Does the fund have low fees?

By now, we all know that fees matter. Fees eat into the performance of your investments and do so with alarming power. If only people were as upset with mutual fund fees as they are about taxes. I detest fees. I loathe fees. I’d rather get kicked in the groin with a steel-toed boot than pay fees. This is my religion.

My buddy Bouch in Embrun is building a house and he’s obsessed trying to make the place water and air tight. In fact, the place is going to be so completely sealed that if he farts the windows will blow out. In any event, it’s wise to be concerned about water. It’s especially adept at finding a way in and doing serious damage. Mutual fund fees are to investors as water is to the homeowner. It’s all about the rot. To completely overkill the point, allow me to present several definitions for the word, rot (courtesy of dictionary.com):

1. To undergo decomposition, especially organic decomposition; decay.
2. To become damaged, weakened, or useless because of decay.
3. To disappear or fall by decaying.
4. To languish; decline.
5. To decay morally; become degenerate.

Sounds about right. Fees creep into the fund via a number of directions. First, we need to focus on purchase and sell fees. I focus mainly on no-load funds, but will purchase front-load funds if the broker waives the fee. Many of the discount brokerages have arrangements with the fund companies that allow them to waive the load, so it’s all gravy. The list of qualifying funds can be quite impressive and I’ve never found myself wanting to purchase a fund and then having to pay for it. I use a discount broker because I am doing the research myself and refuse to pay a full-service broker who would be acting as nothing more than a processing agent.

I will never, under any circumstances purchase a rear-load or deferred sales charge (DSC) fund. These are funds that charge you a redemption fee that declines with each year that you hold the fund. Some funds require an investment of 7 years before the fee declines to zero. Seven years? Looking at my portfolio, I can’t find one thing that I can say with certainty that I’d want to hold for 7 years. That’s too long a commitment. So Jennifer Lopez is allowed to make the ultimate commitment of marriage 5 times in 3 years (or whatever) and I can’t redeem a fund once in 7 years? This is just wrong. I know too many investors who are stuck with inappropriate DSC investments and have several more years to go before they are permitted to make an affordable exit. Many fund companies allow you to switch out of a DSC fund without incurring a penalty, but only if you keep the money within a select family of funds. But so often there are slim pickings within the family and basically all you’re doing is replacing a crappy fund with a somewhat less crappy fund. This is not the way to build a portfolio. The only people who benefit from the DSC are the fund companies. I’ve heard the old argument that you need to establish a fee structure that declines over time so that inexperienced and jumpy investors are dissuaded from frequent trading (and annoying the crap out of their brokers). However, I refuse to subscribe to the idea that fund companies are there to protect us from ourselves. I’m about to have an an aneurysm.

In terms of specific funds, fees creep in mainly via the management expense ratio (MER). This includes all the expenses of running and advertising the fund. Don’t think fees matter? Even a quarter point difference in fees can result in thousands of dollars of lost money over the life of a portfolio. It’s quite remarkable. Play around with the iUnits MER Calculatorprovided by Barclays, the managers of all those Canadian ETF’s (iUnits). If you want something more, Industry Canada provides a Mutual Fund Fee Impact Calculator, and a very detailed version is also offered by the Investor Education Fund. Powerful stuff.

I will only purchase funds that offer an MER that is below average for its category. For example, according to PH&N, the average MER for a US equity fund is 2.43%. You’re telling me that in this day and age when Warren Buffett says we should expect mid to high single-digit returns from equities, I should be paying 2.43% to the managers? Paying 2.43% to make single digits? That’s insane. If the managers are outperforming the indices, then we’ll talk. But so many fail to even match the indices…and I can pick up a US exchange traded fund with an MER well south of 1%. Where do you think I’m going to send my money?

A below-average MER tells me the fund company has placed a high priority on me. It imposes a discipline on the managers in the same way that having to pay a regular dividend imposes discipline on a company. A lower MER shows me the managers are confident in their ability to generate wealth for me and for themselves. In other words, our interests are more fully-linked. It also suggests that maybe, just maybe, the firm is less interested in advertising expenses and wooing new clients and more interested in making money for existing holders. It shows me they are willing to let performance serve as its own advertising. But what about the old “you get what you pay for?” argument? Wrong. You think the fund managers pay top dollar when it comes to making their own investments? I thought not.

Has the fund outperformed its peers?

Obviously, this is key. I don’t need the fund to outperform each and every year. But I do want the fund to have a solid track record, leaving me with the impression that out-performance is a reasonable expectation. I focus primarily on quartile performance. A first-quartile performer has beaten at least 75% of its peers, a second-quartile has outperformed 50%, third has beaten 25%, and the dreaded fourth quartile jobs haven’t fooled anyone. A fourth-quartile return is about as useful as Ralph Wiggum at a Mensa meeting. Remember that Ralph eats paste and has an imaginary leprechaun friend who tells him to start fires.

As Miss Hoover once noted, “The children are right to laugh at you, Ralph.” Perhaps Ralph will grow up to manage a 4th-quartile mutual fund.

I examine quartile performance across a number of different time frames (each year in the history of the fund, one-year, three-year, five-year, etc.) and like to see a lot of 1’s and 2’s. I’m not perplexed if the fund drops a 3rd quartile on me one year, as long as they follow that up with some goodness. If the underperformace continues, then I’m apt start looking around. Much depends on the market context and how the fund answers my other 4 questions. But in general, life is too short and I’m not there to support managers who aren’t getting it done. Besides, there are so many options out there. So you appreciate loyalty? Get a dog. Am I being too crusty? In any event…

Will this investment allow me to sleep at night?

When I go to Harvey’s and order an original bacon cheeseburger, I always make sure they add plenty of hot peppers. I like spicy food. However, beyond the modest portion of the portfolio dedicated to speculating, I’m not very excited about spicy investments; especially when it comes to my funds. Generally speaking, I tend to adopt a buy and hold strategy when it comes to mutual fund investing. Therefore, I don’t want to be always worrying about what the fund is doing and what the managers are up to. I don’t want to follow the daily price movements of the fund. I don’t care about its charts. I don’t care about its moving averages. Fun stuff to talk about, but I’m unlikely to ever use this information.

So how to assess peace of mind? I look at numerous measures of volatility. I’ll glance at the fund’s best performing period and worst-performing period, get a feel for how it performs in both up and down markets, and have a look at its beta analysis. Beta is a fund’s volatility measured against a specific index (e.g., the S&P 60), which has a set beta of 1. Here’s how you interpret the information: If a fund has a beta higher than 1, it means it’s moving up and down more than the rest of the market. Therefore, it’s more volatile. A fund with a beta of 1.5 will move up 15 percent when the S&P 60 rises 10 percent. Some of the pundits recommend looking at high beta funds when the market is going up and low beta funds when the market is going down. Fair enough, but this requires a crystal ball and some trading. I don’t have the first and I’m not interested in doing the second. Of course the pundits also generate such gems as “buy low and sell high.” So deep.

What’s the punchline? I gravitate to funds with relatively low beta’s. I’m prepared to miss out on some of the fun of a bull run, but I don’t want to get slammed very hard when things get ugly.

Is the fund relatively tax-efficient?

People rarely talk about this. But here’s the thing: Taxes matter! If an equity fund is delivering solid returns but has a high turnover, then much of the returns may be snatched away by the government. By recognizing the tax implications before you invest, it’s relatively easy to decide whether a fund belongs in or outside your RRSP. If you don’t have room in your RRSP or you’re done contributing, then why consider a fund that is brutal from a tax perspective? It’s considerably more challenging if you start thinking about taxes after the fact. Morningstar.ca does a thorough job of rating the tax efficiency of mutual funds and I rely on their numbers, even if some of the information they present is rather cryptic.

Looking ahead: Changes to Marketguy.ca?

In a future edition of Market Guy, I’ll write about a number of funds that have made the cut and are in the portfolio. Using the five questions, we’ll see if these funds are still getting it done. Speaking of looking ahead, I’m considering making some adjustments to the site. Feature articles take a while to develop and my current workload makes it difficult to publish more than once a month. However, I have thoughts that I’d like to share between official editions. I’m considering maintaining a web-log (or blog, for those of you hooked up to the techie groove). The entries would be brief, but I’d be updating the site at least once a week. In fact, the blogs could be packaged into some sort of extra monthly edition placed in the archives. Just brainstorming here. As always, if you have any suggestions or feedback, don’t hesitate to send a note to mail@marketguy.ca

Trading note

I have eliminated my position in Advanced Fiber Technologies (AFT.UN on the TSX). Took a beating on this one after the fund unexpectedly slashed their distribution and the units took a dive. This fund is more spicy than many in the business trust universe, and I knew that going in. However, I was hoping for some growth in distributions…and received the exact opposite. The warning signs were in the quarterly report delievered in August. Declining margins, increased competition from OEM’s, and a drawing down of their cash reserves all meant trouble. I was so busy with moving into the new Market Shack and getting ready for the fall term that I failed to read the report. If I had, the units would have been sold right away. Basically, there is a fine for being dumb and I just paid it. Call it the Dumb Tax.

Although a cut in distributions seems to be the prudent move, many have been caught off-guard by the size of the cut. The company wants to play it conservative and I can appreciate that. However, that doesn’t mean I’m going to keep money in harms way. One commentator suggested that perhaps the “smart money” (whatever that is), would regard the drop as a buying opportunity. However, I’m looking at it from a different perspective. Who says AFT’s business situation is going to get any better? So, I’ve decided to move on and book the tax loss. The trusts have been so rewarding that a tax loss will do some good when filling out next year’s return (what you call “rationalizing”, I’ll call “seeing the glass as half-full”). In any event, I’ve reviewed all of my remaining trust holdings and feel good about stability of distributions. I’ll put together an update soon.

The Market Guy is an Instructor with the Department of Psychology at Carleton University. He’s not a professional advisor. He’s just a guy who loves investing and talking about the markets. The title of this edition borrows from the 80’s pop duo, Hall & Oates. Ah, Maneater, Private Eyes, Kiss On My List, and my personal favourite, Out of Touch. You’re never out of touch when you’re with mail@marketguy.ca

In this latest edition:

• Feature: There’s No Time Like Fund Time
• Trading note: Real Resources (RER on the TSX)

The other day, I was talking about the markets with Tim at Carleton. We were discussing the amount of time it takes to manage a portfolio and he asked about my time commitment. Rather quickly I replied “about a half-hour a day.” I’d never really thought about it, but that sounded right. Still, I was curious.

So, for the next few days I kept a record of how much time I was actually spending. And well, my assessment was a tad off. Here’s what I found: I spent about an hour checking stock quotes, browsing the latest research from brokerages, and doing some of my own crunching of numbers. This was hard core stuff and required a fair amount of brain work.

On the lighter side, another hour was spent watching ROB-TV and CNBC. I say “lighter side” because I regard business programming as 2 parts entertainment to 1 part information. Market Gal would say it’s just 3 parts annoying. Each day she spends an hour with Oprah, so I’m giving her assessment zero weight. Back to me: Add another 20 minutes with theGlobe and Mail’s Business section. If I don’t read this each and every morning, I get the shakes. Add about a half-hour related to Market Guy(answering emails, talking with other investors, a number of column activities). All of this tallies up to almost 3 hours. So my initial assessment was off by a factor of 6. What’s going on here? Is it a case of time flies when you’re having fun? You bet.

vs.

If ROB-TV is wrong, theMarket Guydoesn’t want to be right

However, this exercise in temporal accounting prompted a broader consideration of how I spend my time. OK, work is really busy these days. I teach very enjoyable, but high maintenance courses. I just finished reviewing a social psychology textbook for an American publisher, and I have a number of other projects on the go. On the home front, we just moved and that took up an incredible amount of time. Yup, we said goodbye to the original Market Shack. For now, we’re living with relatives until Market Shack 2 is ready in September (why move once when you can move twice, I always say). So how exactly am I spending my time? Let’s break it down:

I’m in bed for about 7 hours a night, so that leaves me with 17 hours to be productive. Toss out 2 hours for cooking, eating and personal hygiene. This may be an overestimation, but I recently picked up one of those scrunchy shower thingies, so the whole experiment with exfoliation has thrown my day into flux. Toss out the hour in the car because that hour is dedicated to 80’s music, and who can be productive while listening to 80’s music? Toss out the 2 hours when my brain is incapable of directed activity. Instead, I’m nothing more than a passive mound of humanoid goo. So that leaves me with about 12 hours to make this world a better place. And of that, I spend almost 3 hours on the markets. That’s 25% of my available brain time.

How much of your brain is focussed on the markets? Keep in mind, the Market Guy may not be well.

At first I was alarmed by the number, feeling like there was something wrong with me and that my family and friends would soon be staging an intervention. I mean the ones with the problem are so often the last to know. Are you reading this, members of the NHL Player’s Association? Anyway, the jury is still out. So either this column will be an important step in my gradual move towards wellness, or it will plunge me deeper into the existential abyss. So at least I have that going for me. At the moment, I’m content to lean on a number of defence mechanisms: denial and repression being two of my personal favourites.

However, I am prepared to admit that there is one market-related activity that does require a substantial time commitment. In fact, when I’m engaged in this particular activity, I’m hunkered down in my den, I’m leaning into my computer monitor, and I’m completely focused. There is no point in approaching me or attempting communication of any kind. You may be there, but I will not see you. You may speak, but I will not hear. If you prick me, I will bleed…but won’t notice. What could I be doing? Surely it must be something of considerable importance. It can only be one thing: I’m researching mutual funds.

When I’m looking at funds, I’m like Sonny Crockett on Miami Vice, when he went on a mission to avenge the killing of his wife; man, was he focused. Or the 1993 Blue Jays with White, Alomar, Molitor, Carter, and Olerud (WAMCO) topping the order. Sure, the Phillies scored 14 runs in game 4 of the World Series, but that was OK because you knew the Jays would score 15 (and they did). Simply, some individuals and groups will not be denied. For me, I will not be denied the purchase and subsequent holding of quality mutual funds.

This may come as a surprise, especially to longtime readers of the column. This owes much to the fact that it’s taken 21 issues before mutual funds even came up (save for a couple of sentences in the Market Guy #7: Money Gripes column). It’s not that I dislike mutual funds. It’s not that I’m avoiding mutual funds. It’s just that I don’t follow my funds on a day to day basis. In fact, apart from my obsessive and bordeline pathological research period, I don’t pay much attention to my funds at all. I have compartmentalized them quite differently than my stocks and other investments (more on this later).

So, I’m going to dedicate a few columns to mutual funds. I’ll take you through the process I use to research and purchase funds, and talk about specific fund choices that I’ve made. I have a multi-point system that helps me to process the reams of available information.

Mutual funds have been given a rough ride as of late. Much of the press and analyses have been focused on the negative side of the equation. With so many bad funds out there, I believe this skeptical treatment is long overdue. However, I’m not here to pile on. The fact of the matter is, I do believe funds can represent an important part of a portfolio.

To get the ball rolling, I’m interested in how you approach funds. What do you look for in a fund? What performance expectations do you have? Where do you obtain your information? Which funds have attracted your attention? Do you have any tips that might benefit other investors? Don’t feel compelled to answer all of these questions. Whatever you share is gold. I’ll include a selection of reader comments as we move along. No matter how you slice it, I think this is time well-spent. Remember thatmail@marketguy.ca never closes. Stay tuned.

Trading note

I picked up some shares in Real Resources at $7.40 (RER on the TSX). This is a junior energy company with operations in Alberta and Saskatchewan. Current production is 7000 barrels a day and at the time of my purchase, the shares were trading at a discount to many of its peers. For me, this is purely a speculative play based on the fact that it is nearing the production levels at which many juniors consider trust conversion. Failing that, the company is growing its production and there are a number of opportunities for further expansion. The company does not pay a dividend, but I don’t expect any income from my spec plays. As I’ve mentioned, I allocate a small percentage (about 5%) of the portfolio for goofing around. My other energy holdings remain Acclaim Energy Trust (AE.UN on the TSX) and ARC Energy Trust (AET.UN on the TSX).

The Market Guy is an Instructor with the Department of Psychology at Carleton University. He’s not a professional advisor. He’s just a guy who loves investing and talking about the markets. His temporary residence lacks cable, Internet, air conditioning, and even Globe and Mail delivery service (the delivery guy says he couldn’t get a key to the building). Although the Market Guy is urban camping for now, there’s still a world of amenities to be found over at mail@marketguy.ca

In this extra-special deluxe anniversary edition:

• Revisiting the first column (Transalta)
• Whose idea was it to keep an archive? (Apple)
• Don’t feel insecure about your endowment effect
• Even more from the Market Guy Mailbag
• Market Guy’s Closing Bell

Well, the column is celebrating its one-year anniversary and I’m feeling a tad retrospective. Of course, being retrospective is nothing new for me. Many of my drives to work are accompanied by a CD of 80’s classics and in a couple of weeks I’m going with my buddy Lamont to see Journey perform at Casino Rama. There’s something quite satisfying (and moderately amusing) about Steve Perry belting out Don’t Stop Believin’ or Who’s Crying Now? The point, if there is one, is that I’m going to use this edition to reflect on a year in the life of an investment web column.

My buddy Lamont (shown here) can hardly wait to sing along to lyrics such as “Anyway you want it, that’s the way you need it.”

OK, so this column won’t be taking us back to the 80’s. However, that shouldn’t prevent us from engaging in some meaningful reflection. So join me, won’t you, as we travel back in time to the spring of 2003. The world was a far different place. At that time, the Americans were having trouble in Iraq, Martha was having legal problems at home, and the Sens were reflecting on a season that fell short. My how things have changed. Anyway, the very first edition of Market Guy dealt with Canadian electricity generator, Transalta (TA on the TSX) and how I’d been trading my position. Specifically, I was outlining a number of reasons for taking out the holding. Well, Larry in Montreal has asked for some follow-up:

What about Transalta? It has a high yield and the stock has been beaten up. Are you buying in again?

I receive a considerable amount of mail, but rest assured, if your name is Larry, your chances of getting into the column are 10x better than anyone else. I have no explanation for this. In any event, I have fond feelings about this stock, owing to the fact that it’s always made me money. It indulged my addiction for dividends and income product at a time when I was just starting out. In fact, it was the second stock that I have ever owned. But let’s fast forward to the 2004 edition of TA. Here’s the good news:

• Its yield is nearly 6%, which is basically impossible to get from a common stock (Rothmans being an exception; see MG#14).
• The stock is roughly $3 off its 52-week high and I like buying when there’s a sale.
• It’s widely held, reducing the volatility that comes along with some of the relatively illiquid power trusts. 
• Management seems really focused on cleaning up the balance sheet and reducing the debt load.

Now let’s weigh the cons:

• The debt load, although declining, is still very heavy
• They may have to sell some assets to keep the credit rating agencies at bay. And selling assets could further erode the earnings picture.
• It’s going to be tough growing earnings with a significant number of maintenance projects occurring at several plants and a couple of other plants of questionable economics.
• Interest rates are rising and 6% may not look so good a year from now.
• There’s no dividend growth to speak of. In fact, the payout ratio on this thing is over 100%.

It seems to me that the only reason to own the stock is for the yield. If I’m interested in a power company that offers a high yield, I might as well pick up a power income trust. In fact, Transalta sponsors an income fund called the Transalta Power LP (TPW.UN on the TSX). It currently offers a 9% yield, with the distributions almost entirely tax-deferred. As I mentioned in MG#19, I’ve already unloaded my holdings in this fund, largely due to the rising interest rate environment. However, if forced to choose between TA and their income fund, I’d pick the fund.

Whose idea was it to keep an archive?
From the very beginning of this little experiment that is marketguy.ca, I decided to include an archive. That way, newcomers could be brought up to speed and longtime readers with masochistic leanings could have another look at the older editions. What’s interesting about an archive, is that it affords a sense of permanence to the words of the author. In the world of investing, that can mean treading on some perilous ground. Overall, I think the columns hold up well. But every family has at least one crazy uncle or problem child. For example, last July I wrote negatively about the stock of Apple (AAPL on the NYSE). It was trading at $19.85 with a trailing price-to-earnings (PE) ratio of 122, forward PE of 70. I panned the stock as expensive and questioned the growth prospects of the company. At the time, investors were excited about Apple’s new online music store and I questioned its profitability. Well, the music store continues to have only a modest effect on Apple’s bottom line. However, the stock is now trading over $32. Now I feel like Jamie on the final episode of WB Superstars USA. Simply, I’m torn between embarrassment and feeling the rest of the world is wrong. Heads, we’ll go with rest of the world is wrong, tails it’s embarrassment. Heads it is! Are you going to argue with the coin? I thought not.

Apple has been aggressively trying to diversify and the iPod music device has been the cornerstone of this process. Last year I thought Apple was a computer company that also happened to make gadgets. Soon they will be a gadget company that also happens to make computers. This tidbit drives the point home: iPod shipments now exceed PC shipments, with percentage of revenue coming from PC’s on a steady decline. In fact, I read one report estimating that PC’s will account for only 55% of Apple’s revenue by the end of 2005.

An informal survey of the Market Guy’sfirst-year students revealed that 10% of them own aniPod.

Overall, the stock still trades at over 50x trailing earnings and over 40x forward earnings. Projected growth rates were 10% a year ago, but now I’m seeing 15-20% in most of the research. Music lovers have embraced the new iPod Mini, although it furnishes lower margins than the standard version. Apple is very expensive, still doesn’t pay a dividend (for me, a stock without a dividend would be like Vegas without the Strip), and still faces a brutally competitive environment. Who knows what the next big thing will be? More importantly for investors, who knows which company will be leading the charge? I’m still content to sit this one out.

Don’t feel insecure about your endowment effect
Over the past year, I’ve also learned that people develop very emotional attachments to their investments. For example, Mitch in Toronto writes:

I don’t know why you’re so negative on Nortel. I’m a Nortel shareholder and I think this company is a Canadian leader. Sure, they’ve had problems, but they’ll figure it out. Just be patient and give it some time. The stock is ready to head up and not by just a little amount. I bought in at $10 not too long ago and the shares are worth far more than that.

Thanks for writing in, Mitch. This reminds me of what behavioural finance people refer to as the endowment effect. This refers to the tendency of people to attribute extra value to items in their possession. For example, I have an old Houston Astros jersey that is in rough shape and objectively worth about $1. However, it would take a lot more than that (say $50) for me to sell it. The item has been endowed with added value due to the fact that it’s mine. And how much would I be willing to pay for someone else’s Astros jersey? About $1.

Sometimes we see the effect manifested at garage sales, with buyers and sellers being insulted by the spread between bid and ask prices. Get into a conversation with the sellers and you discover they earnestly believe their items are worth far more than anyone is offering. It works in reverse: When they head over to a neighbour’s garage sale, they assume the role of buyer and correspondingly assign a much lower value to items on sale. What’s especially interesting about the effect, is that we don’t have to own the item for a long time and the item doesn’t have to be worth very much in order for the effect to occur. Nobel-prize winning economist Daniel Kahneman, along with Jack Knetsch and Richard Thaler (1991) were able to demonstrate the effect with students at Cornell; and they did so using nothing more than coffee mugs. So, if it works with coffee mugs, it sure as heck can work with our investments.

Even more from the Market Guy Mailbag
Sometimes when you’re up against it and the breaks are beating the boys, it’s best to hang your head on the good stuff. For me, the good stuff has been your letters. Let me illustrate with a fair, objective, and completely trustworthy assessment offered by a fine, upstanding, intelligent reader:

Caroline writes:

I happened on your site when doing a search for Manitoba Telecom on Google. Never did I think I would come upon your little treasure trove of columns on a subject near and dear to my heart - Canadian dividend paying stocks and income trusts. I appreciate your breezy, personal writing style on your approach to investing. Entertainment and informative analysis - what a killer combo. Again please add me to your mailing list for FREE, my most favourite of terms.

Know that I lap your praise up like a parched dog. Additional feedback was offerered by Richard in Kingston:

I really enjoy the investment material, but I’m not sure what to make of your constant harping on burgers, the 80’s, and your peculiar assortment of friends. I’ll let you know when I decide. Just curious: How old are you?

The assortment may be heading to Kingston, Richard. There are plenty of reasons for a trip to your town. The waterfront, the museums, and the feel of the place are all fantastic. But I’m more interested in the Arby’s on Division Street, which just happens to be the closest franchise on this side of the border. Perhaps I’ll see you there for a round of Beef n’ Cheddar’s! As for my age, a picture is worth a thousand words:

The Market Guy(shown here) at last year’s Halloween party.

Market Guy’s Closing Bell
As part of my website package, I can track the search engine keywords that result in a hit for marketguy.ca. “Riocan,” “Manitoba Telecom,” and “Income trusts” rank at the top of the list. Makes sense. But I especially enjoy looking to the bottom of the list, for the peculiar and not so obvious terms that web surfers have been using. Over the past year, I’ve been treated to the following bottom-dwellers:

• “Who has dollar margaritas in Las Vegas?”
• “Outdoor garbage receptacle”
• “Jimmy Buffett financials”
• “Kathy Lee Gifford smoking cigarettes”
• “Rusty wheelbarrow for sale”
• “Is it wrong for a guy to look at another guy’s penis?“

And the Google IPO may be worth $2.7 billion. All right, then.

The Market Guy is an Instructor with the Department of Psychology at Carleton University. He’s not a professional advisor. He’s just a guy who loves investing and talking about the markets. At this year’s convocation ceremonies, he served as one of the beadles. You’re always more important than the fifth beadle over at mail@marketguy.ca