Chapter x:

Your Money Goes to Work

(The excerpts you will read here use Canadian examples, but the issues and ideas revolving around working and middle class ownership of big business apply to all developed countries.)

Your comments, please! This is a draft version of Chapter 1, provided here for the purpose of getting reader feedback. This feedback will be incorporated into the final version.

It's 11 p.m. Do you know where your dollars are working tonight?

And, yes they are working. If you're a member of the Canada Pension Plan your contribution for this month is working in thousands of companies around the globe. If you belong to a private pension plan or contribute to a mutual fund, your dollars will be at work in even more places.

In this chapter, we explore the ways in which your money works between the day you make your contribution, and the day when it comes back in the form of a pension payment. Of course, we can't really trace any particular contribution, but let's assume we can for the sake of illustration. And, perhaps you buy and sell mutual funds; no matter, the principles still hold.

Before you opened this book, you likely knew that the money you contributed didn't end up under the couch cushions in the offices of a fund. You knew a fund manager would invest it for you. But, did you know how, and why?

Let's start with the why. That's mostly because you want your money to grow while it's away. What's more, when you retire, you want to at least recapture your purchasing power. Think of the situation this way: When you make your contribution, it takes, let's say, $2 to buy a carton of milk. By the time you retire, that same carton of milk might cost $3 or $5, thanks to inflation (deflation, when prices go down is also a possibility, but we have a long history with inflation and none in recent memory with deflation).

What's more, you may collect a pension for as long or longer than you work, and by the time the family gathers at your bedside and begins speculating (to themselves, of course) about the contents of your will, who knows what the price of a carton of milk may be. After all, if you retire at age 55, and live until you're 95, you may well collect a pension for more years than you'll work (a comforting thought for many of us). So, you need your money to grow, and you need it to grow more quickly than it would just sitting around in a savings account or a low-interest vehicle like a GIC. Bank ads on television may be warm and fuzzy, but the interest they pay won't cover your heating bills after you retire.

Actually, pension fund managers do a lot of that worrying for you. They look at the size of the contributions you're making, the number of years you're expected to live after you get your farewell handshakes, the expected rate of inflation, and how much they have to pay you in retirement. Since there's not much they can do about any of those issues, they look at what they can control: the allocation of investments made with your contributions.

Asset allocation refers to the mix of equities, fixed income, and cash in an investment portfolio. In other words, what percentage goes into stocks, what percentage goes into bonds and their equivalents, and what percentage sits in the bank waiting for good buying opportunities. By increasing the percentage of equities (stocks) they can increase the amount that's earned for you; by increasing the percentage of fixed income products such as bonds, they increase the safety of your portfolio.

So the fund manager's challenge, and the challenge for we individuals who manage our own retirement savings, is to find the right mix of equities, fixed income, and cash. Individuals, for example, often are told that the percentage of fixed income products should be the same as our age. If you follow that rule of thumb, you'd have 40% of your portfolio in fixed income when you're 40 years old, with let's say 55% equities and 5% cash. When you get to age 60, the allocation shifts to 60% fixed income, 35% equities, and 5% cash.

Fund managers will have their own guidelines for these allocations, but that's how they plan to help you pay the bills when you're old and gray.

Now, let's look at how they handle the equities side of investing. And, wouldn't you know it, we run right into more allocation issues. This time, they revolve around criteria such as the size of the companies in which they invest, industries or sectors, countries or regions, and more. Again, we see risk and reward tradeoffs. Buy a smaller company for stronger growth, buy a bigger company for stability and safety. Buy shares in Canada for safety and security, buy shares in countries like Brazil and China for better growth. Buy shares in the technology sector for growth, buy shares in the financial sector (insurance companies and banks) for predictable results.

When it comes to the younger and smaller companies, fund managers expect – and hope -- capital gains will bring in the bucks. In other words, they hope to buy a stock for $1 today and sell it tomorrow for $2. Sometimes that occurs, sometimes it doesn't (as the saying goes, "Shit happens"). When you watch the news and see the closing markets ("The Dow Jones closed down 17 points today,..."), you're also watching the fortunes of the money in your pension fund. Of course, if you have a defined-benefit pension fund, your employer carries the worry.

From bigger and more established companies, fund managers also hope to bring in some capital gains, but may depend more on dividends. Most of these companies have matured, or operate in mature markets. So, rather than plow their profits into new initiatives, they distribute much of that money to shareholders. They hold onto some of the profit, reinvesting it back into the business; a bank, for example, might buy a new generation of ATMs that swallows your bank card in new and unusual ways. The rest of the profits go to shareholders in the form of dividends. After totalling up the profits for distribution, they divide the total by the number of shares, and announce the dividend as so many cents per share. Dividends tend to the predictable, and few things warm the heart of a fund manager like a predictable flow of money back to the fund, money that can help pay current pensions or be reinvested.

Now, the bad news for Canadians who hate banks, insurance companies, and oil companies. In the Canadian universe of big companies that consistently earn profits and pay out predictable dividends, there's nothing like these companies. If a fund manager, could hear you swear when you see the unexpected charges on your bank statement or as you pay for your gasoline, and pulled all his investments out of those companies, you'd have a smaller pension.

Interestingly, we may not be very diversified, but we're apparently in better shape that the British. As a BP well in the Gulf of Mexico hemorrhaged tens of thousands of barrels of oil a day, the Daily Telegraph newspaper reported (on June 20, 2010), "The firm's dividend payments... account for £1 in every £6 paid out in dividends to British pension pots." That's a tremendous dependence on just one company.

Turning back to our country, financial institutions and oil companies are to the Canadian economy what coconuts are to the islands of the South Pacific. If you want to invest in Canada – and fund managers do – you have to invest in these sectors, whether you love 'em or hate 'em. Fund managers, not mention many individual investors want to invest in Canada for two important reasons. First, the companies sit right under our noses, and we understand the implications of changes in Canadian society and the Canadian economy. Second, and just as importantly, we don't need to worry about currency fluctuations. Imagine the frustration of collecting a capital gain or dividend from a foreign country, and then losing it because the Canadian dollar has gone up or down.

Oh, and one more thing for those who hate oil companies. You're an owner, or at least you were an owner of BP (like millions of British pensioners). On March 31, 2010, just a few weeks before the explosion, fire, and spill, the Canada Pension Plan Investment Board held $311-million worth of shares in BP PLC.

Let's move on, now, to explore how companies use the money you put into your pension plan or mutual fund. Companies may get that money by borrowing it (bonds), or by selling new shares.

When you and I go to the bank, make supplications, and get some money it's called a loan. When a company borrows money from a bank, it's called a bond. Needless to say, many differences set our loans apart from their bonds (in my case at least, I'm an awfully long way from being too big to fail).

Rather than make monthly payments that cover the interest and part of the principle, bonds cover interest only until they mature. Each month or quarter, the company pays what's called a coupon. This equals the stated bond interest; if you made a loan to a company (and you do, as a member of a pension plan or mutual fund) then the relative size of the payment is referred to as the yield.

Yield depends on the amount of risk, or at least the perceived risk, that the company will not repay the loan. Vast amounts of human energy go into determining the risk assessment of individual companies. Many people at ratings agencies, pension plans, and mutual funds spend their workdays doing the equivalent of counting the number of angels dancing on the head of a pin. What's worse: Some of these economists appear on TV and explain why the rate should be six and an eighth percent, rather than six and a quarter percent.

For pension plan managers, such talk matters. After all, another quarter point of interest on my savings account probably won't do much more than buy breakfast at McDonalds. But, when plan managers calculate yields on millions or billions of dollars, and perhaps compounding the interest for decades, the amounts are staggeringly big. So bond managers and analysts search the globe for the best trade-offs they can find between risk and reward. And the profit is yours, as bond returns help you get back more than you paid into your pension plan or mutual funds. To paraphrase the Beatitudes, Blessed are the bond managers....

Now perhaps you don't want to lend your money. Perhaps you'd rather buy something with your savings, something that would allow you to share in the profits of the enterprise, and to later sell your stake in it for more (you hope) than you put in. That makes you an equities investor, or if you work at a pension plan, an equities manager.

As an equities manager, you'd do much the same work as a bond manager. But, there's an important difference. If a company does an Enron, you have different places in the pickings pecking order. Bondholders get first crack at what remains of the company after its immediate creditors are paid; shareholders mostly get grief. In other words, equity investors usually don't get anything when a company goes under.

To make up for that, investors expect to get a higher yield than bondholders. Equities managers and analysts also scour the globe, looking for the deals that give them the best trade-offs between risk and reward. Again, you're the beneficiary, unless of course the equity manager at the pension plan missed a critical decimal point while calculating the risk-return trade-off.

As suggested, when you invest in equities, you can get your money back in two ways: Dividends and capital gains, or both. Well-established companies in a mature market pay dividends to their owners (that's you, again). On the other hand, companies focused on growth do not pay dividends; instead investors expect to come out ahead by selling their stock for more than they paid. The difference between what you paid and what you sold for is called a capital gain. It's made possible by growth that increases revenue and profits, since stock prices generally reflect expectations about future earnings.

Which leads us to the question: How do companies decide whether to pay out their profits in dividends, or to reinvest it in more growth for the company? In most cases, it depends on something called the 'hurdle-rate'. A few times a year, company managers go to the big boss, or even the board of directors, with their ideas for new products or services. If they get the money, they can expand their department, make more for the company, and maybe get a bonus that puts a BMW in the driveway. Of course, if they get the money and don't deliver, they may end up cleaning BMWs at a carwash.

As part of their pitch for getting funds for new projects, managers have to quantify the return they expect, and had better deliver (or else). In most companies, that return will have to beat the hurdle-rate. So, for example, if a company's hurdle-rate sits at 8%, then proposed projects will have to return at least that much to be even considered.

Companies set the hurdle-rate on the premise that if they can't deliver at least a certain percentage (again, say 8%), then investors might as well reinvest the money themselves. After all, why should a company hold onto its profits when its owners (the investors) could make more for the same amount of risk elsewhere. Companies that don't heed this rule find it hard to get and keep investors, which in turn may lead to termination slips for the guys in the corner offices. And the guys in the corner offices will sweat the details to keep their big desks and leather chairs.

It's at this point, we come to more bad news – well sort of bad news. Any time a really big company reports really big earnings, such as an oil company or bank making a billion dollar profit, you hear groans of indignation from taxi drivers, union leaders, television anchors, and quite frankly, most of the population. Unrestrained voices, of which there are many, use phrases like "a license to print money".

Since no knowledge is required to make such statements, and in fact often leads to more colourful (and more newsworthy) claims, you're may not get the context within which to read about billion-dollar profits. For example, a billion-dollar profit may sound very large in absolute terms, but perhaps less impressive when expressed as a percentage return on all the invested capital put into a company. Or, when considered in terms of results over the past five, ten, or fifteen years, some of which were undoubtedly lean years, when profits were small or non-existent.

All of which means the people running your pension plan or mutual fund would laugh in your face if you asked them why they weren't availing themselves of these licenses to print money. Like the rest of us, plan and fund managers have to work for the dollars they bring in. That means studying company after company, comparing their histories, trying to divine their futures, and hoping they haven't screwed up in any of their analyses.

To make their decisions, plan and fund managers use fundamental analysis, technical analysis, and intuition. Fundamental analysis means intensively studying a company's facts and figures: revenues, expenses, profits, capital expenditures, taxes, and more all figure into an assessment of a company's worth. And just as importantly, what a company can expect to earn in the coming quarters and years.

Technical analysis refers to wiggly lines on stock charts, lines that graph stock prices over days, months, quarters, and years. By studying these charts, technical analysts try to understand the sentiment of all the buyers and sellers who make up a market. When prices and lines trend down (in a wiggly way, of course), the trend is called bearish. When they trends upward, the trend is called bullish. And hence the expression, bulls and bears.

Many investors use both types of analysis. Fundamental analysis to choose companies in which to invest, and technical analysis to tell them when to buy and when to sell. Of course, such analyses only go so far; ultimately, every investor has to make hard choices and hope for the best. That's where the intuition comes in. History helps but cannot predict the future, so even though their skulls may be overflowing with data from all of this analysis, plan and fund managers are in much same spot as you are when you're trying to choose between the Corolla with low mileage and the Civic with leather seats.

So that's how your money goes to work, helping management of the companies generate new revenues and new profits. It also illustrates some of the disciplines that keep managers focused on making your money productive, so that you ultimately get back more than you put in – most of the time.

And, as we've noted those dollars come back in two main forms: as dividends and as capital gains. Dividends represent a monthly or quarterly sharing of the profits, generated mainly by well-established companies in mature industries or sectors. Your dollars also come back in the form of capital gains, when plan or fund managers sell stocks for more than they cost.

At any given time, money flows in both directions. When a plan, for example, has more money than it needs to pay current pensions and expenses, then it will put that money to work by investing it in fixed income or equities. When it receives dividends or capital gains, it will reinvest them, unless some of those returns are needed immediately.

Most importantly, it's your money. By putting it to work – productive work – when you're not using it, you make yourself an owner of big business, and an integral part of the Ownership Revolution.

Next...

Go to Apocalypse Addicted, the Table of Contents or watch for another chapter soon.

Please send me your comments and questions. Send an email to wordengines@gmail.com . Thanks!

Bob Abbott

People, Profits, & Pensions: The Ownership Revolution, Copyright Robert F. Abbott 2010