Tuesday, 20 September 2011

Eat Or Get Eaten - Where do you stand in the investment food chain? (Priority of Claims)

Lets assess your portfolio.  What percentage is invested in stocks? What percentage is invested in funds? If your answer to those 2 questions equals higher than 50% then you are nearing the bottom of today's investment food chain. 

Banks have a specific style of lending. When you ask them to invest your money, they put it into the markets. When they invest their money, they insist on security and rigid fixed terms. That security puts them near the top of the food chain as they seldom lose money.

How does the Priority of Claims process affect me?  

Priority of Claims is how Canadian law determines who gets paid first. Imagine a stream that is flowing past a number of villages. As the villagers draw from the stream, the amount of water diminishes. Investing too much in stocks and funds puts you at the end of the stream. If something goes wrong, maybe there will be enough water - or maybe it will be dry.

In Canada, the priority of claims looks like this (note - banks would fall into the "bondholder" class being a secured creditor):

Now lets get into the real world - we will use Nortel as an example. First, taxes were due and paid - CRA always takes priority. Second, the employees (actually, mostly executives) received more than $140MM in bonuses above their regular paycheques. Next, the bondholders (who were secured against assets) walked away with all their capital plus about 10.25%1 interest. Now right here is where the stream ran dry - their stock holders were left with less than a penny2 for every dollar that had been invested. The bottom of the food chain gets fed last - if at all.  

Debt to Equity: How much water is reserved upstream?

(Accounting nerds, you can skip this section) 

Debt to Equity (DTE) (Similar to Loan to Value or LTV) is a financial ratio that indicates the value of assets compared to liabilities (or debts). It indicates how much water should come down the stream if a business was to become insolvent (bankrupt).

There are many ways to translate this ratio. If there are more assets than debts the DTE is a fraction of 1. For example, if you home was worth $500,000 and your outstanding mortgage was $250,000, your DTE would be 0.5. Alternately, if the housing market dropped significantly and your home was only worth $100,000 (outstanding mortgage still at $250,000) your DTE would be 2.5.

What does DTE do to protect you, the investor?

If you are a bondholder or secured creditor, you have security against the assets. It is important that the total debt is less than the value of the assets and it is very beneficial to have a good sized buffer in place too.

Lets look at the Canadian bank mortgage model to gain a better understanding of DTE and this buffer. Your bank will generally lend you up to 80% of the equity in your home. Below 80%, or a DTE of .8, they have sufficient security. In case of default they can foreclose, sell the home and have a buffer of 20% or more for safety. This will cover their fees, interest owed to them, payments that may be in default, legal costs and Realtor fees when selling the home. When everything is settled, the chances that the bank will cover all their costs and have some money left over.

Back to your investment - you want to be secured like the banks do. Understanding DTE is a key part of safe investing. There are many types of assets ranging from real-estate to contract cash flow - investigating the quality of the asset becomes key. 

Exempt Market vs. Traditional Markets

So how do the markets differ from each other? 
  1. Traditional Markets - Bonds generally trade good security for lower returns and vice versa then issue shares and stock for remaining opportunity for excess return with no security. Often shareholders/stockholders are lower priority than the principals of the firm.
  2. Exempt Market - Good, reputable firms can issue bonds and/or shares to investors so that they have both security against the assets through the bonds and potential for growth through the shares. In all cases, we ensure that the debt to equity is well in the favour of the investor. (Note: Not all exempt market investment firms operate in this manner or ensure that proper security exists. Ensure your advisor or exempt market dealer are qualified to properly inspect the security and structure so that you remain protected.)

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