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ETFs and Funds Income Investing Investing

Review: BMO Equal Weight Banks Index ETF (ZEB)

With Q3 earnings for the Canadian banks behind us, you might be considering investing in the banks using BMO Equal Weight Banks Index ETF (ZEB). This ETF exclusively holds an equal weight of each of the big 6 Canadian banks. While the convenience of this one-ticket solution is enticing, I believe using this ETF is a bad financial decision for long-term buy-and-hold investors.

I wouldn’t blame you for wanting to invest in the Canadian banks. I believe the banks have provisioned adequately for significant loan losses and are well prepared for the current economic disaster. Furthermore, Royal Bank, TD, CIBC, Scotia and Bank of Montreal respectively pay a 4.2%, 4.8%, 5.6%, 6.3% and 5.1% dividend yield (as at August 28, 2020). Many investors view these companies as interesting long-term holdings.

While ZEB can simplify the investment into Canadian banks into a single transaction, investing in a highly concentrated ETF like ZEB can be a bad idea. Anyone interested in buying-and-holding the Canadian banks for a long time might be better off simply buying the individual stocks.

Forget BMO Equal Weight Banks Index ETF (ZEB)…Buy the Stocks Instead

For example, let’s say you have $20,000 you want to invest. With an MER of 0.61%, ZEB ETF will cost you $122 per year to own plus any trading commissions. That cost (excluding the trading commission) is repeated each year in perpetuity and will rise as your holdings appreciate in value.

In contrast, you can buy 5 of the banks for a total one-time trading commission of between $0 and $50 (depending on your online broker). Let’s be generous and say you could pay $100 in commissions for the round trip. If you plan to hold your investment for a decade ZEB would cost you at least $1220 while owning the individual stocks would cost a maximum of $100.

While it’s true that ZEB rebalances between its holdings, one could easily replicate this at minimal cost annually using the dividend income spit off from these stocks.

Overall, the value proposition for ZEB is fairly weak for long-term investors. Of course, the story is different for people using ZEB for short term trading or hedging purposes. But I would guess that a significant number of people who hold ZEB don’t realize this.

If you’re a buy-and-hold investor I just saved you $1120. Don’t spend it all in one place.

Categories
Investing

Why is The Market At All Time Highs?

Many people right now are wondering why the stock market is at all time highs while the economy is in recession. I too wondered if this were an anomaly created by excessive Fed printing. So I looked to see if something similar has happened before.

As it turns out, during the 1981-1982 recession, the stock market (blue line in chart below) hit an all-time high after recovering from significant losses.

During the 1981-1982 recession, the return to stock market all time highs occurred close to the end of the recession as unemployment (maroon line) peaked.

Of course, the end of the 1981-1982 recession was only known later in hindsight, so people likely asked the same questions they are today. What they could not see was that the market approached all-time highs because the recession was close to ending. While the transition to growth was slow and painful – as I expect it to be today – with unemployment taking years to return to normal, the markets rallied once economic growth resumed.

The return to growth (second chart below) in 1982 is easily identified by unemployment (maroon line) beginning to fall and Industrial Production (blue line) starting to rise (second chart below). This occurs right near the end of the recession, as indicated by the grey shading.

Industrial Production is a great indication of economic recovery. As you can see (if you have good eyesight) in the chart below is that at the end of every recession (grey shading) Industrial Production immediately grew. The second chart below zooms into the current recession. It is clear that Industrial Production has started to grow once again while unemployment has started to trend down. This indicates the current recession likely ended in April or May and growth has resumed, explaining the stock market’s return to all time highs. (Note the entire period is shaded until the recession’s end is officially retroactively declared months later.) Again, this growth doesn’t feel like growth because we’re rebuilding from an uncomfortable bottom, but the market only cares that things are growing.

The 2020 recession was sharp, deep and short. Markets reacted accordingly and crashed faster and deeper than ever before. The recovery will be long and painful, but we are back on the growth path. Markets sniffed this out months ago explaining the rally. Markets hit all-time highs in 1982 – when unemployment was near its peak. The same thing is happening today.

Categories
Income Investing

Why Invest in Dividend Stocks

There are great reasons to invest in dividend stocks. And most are not taught in business school.

Anyone who went to school for finance learned that – all things equal – a company’s dividend policy should theoretically have no impact on your investment decision-making.

Since transaction costs are minimal and taxes a wash, you should be indifferent as to whether you are paid a dividend or manufacture a dividend (by selling shares). In theory, a dividend simply takes something that is already yours (cash on the corporate balance sheet) and places it in your personal bank account.

Reality is quite different – there are great reasons to invest in dividend stocks.

Note: not all dividend stocks are equal. Personally, when looking at dividend stocks I prefer to invest in companies with sizable moats, growing revenues and easy dividend coverage. You shouldn’t chase yields for the sake of it. Some companies have high dividend yields because they are in dying industries and/or the market is anticipating a dividend cut.

At the corporate level, there are a number of arguments as to why some companies should pay dividends. Perhaps the biggest is that dividends enforce discipline on company management by restricting cash flow. This forces managers to limit projects to those with a higher IRR (Internal Rate of Return).

Note: Fast-growing companies with massive opportunities (e.g. Shopify) inherently have a lot of high IRR projects to invest in. For this reason, it makes more sense for these companies not to return capital to shareholders.

In contrast, cash-rich companies that don’t give cash back to shareholders are more likely to waste money on low IRR projects or acquisitions that only serve to bolster executive pay. Instead, these companies should be giving cash back to shareholders who can then re-allocate to companies with higher return projects.

Dividend policy can also signal insiders’ confidence in the future. The current economic crisis is a perfect example. While some companies have recently cut their dividend (e.g. Wells Fargo) to free up cash in a collapsing environment, others have actually raised dividends. A company that raises its dividend during an economic depression signals to the market the resilience of its cash flows. In today’s environment, I’m much more comfortable giving my hard-earned cash to companies that are still raising dividends.

At a more personal level, I like dividends because they help me stay disciplined. A stock with a 5% dividend yield at the time of purchase provides me a 5% return regardless of the stock price. Knowing this, I’m less likely to make emotional buy and sell decisions. It’s purely psychological, but a known cash return that accumulates in my account beats an unknown potential return that sits in a company’s account (or is tied up in other corporate assets).

While I can manufacture those cash dividend returns by selling shares as they increase in value, this requires more intervention on my part. Do I systematically sell each quarter? Or only sell when share prices rise to crystallize some of my gains? Do I sell a fixed percentage or dollar amount? Do I stop selling when prices fall?

While these questions can be answered and a systematic process created, the emotional gyrations of the market could make me change the process at the worst time. In contrast, if a stock declines but I know I’ll continue to receive my 5% dividend I’ll be more inclined to hold on.

If you’re like me, activity is detrimental to your investing returns. The more I sit tight, the better I do. So any investing strategy that helps me avoid unnecessary activity is helpful.