Author: Mike Holman

The Personal Financier wrote a very interesting post on the idea that long term equity investments are not risk free which is not a popular opinion for most investors.

A lot of the investment books that I’ve read often quote a long term equity return figure of 10% for equities. The idea is that while volatility will ensure that the short term returns will be all over the map, if you wait long enough then things will even out and you will get your 10%. If this was perfectly true then you should leverage every bit of money you can get your hands on and buy some equities (assuming that you are reasonably young).

Past returns of equities and stocks

The idea that you can get 10% annual return on equities is based on studies where they measured the equity performance of American stocks for a good part of the last century (about 80 years). As Bernstein pointed out in his Four Pillars of Investing book, this particular time period was a pretty good one for US securities. Another thing he points out is that if you include other countries in the world which went through various wars and natural disasters during that same time period, the world returns would be much lower. There is nothing wrong with looking at the past but you have to keep it in perspective and don’t write the 10% return in stone.

Fees

Another key point that a lot of investors seem to be unaware of is that the 10% return figure is a gross returns. In other words they did not include any kind of trading fees like you would incur on stock or ETF trades or the management fees that are charged on mutual funds, which is how most investors buy equities. In the U.S. it appears that most equity mutual funds charge about 1.5% per year which would mean a net return of only 8.5% – not 10%. Here in Canada, I’m proud to say that we have the highest mutual fund fees in the entire world and they average about 2.5% for retail funds which would bring out expected return down to 7.5%. Over the long haul, these lower returns will make a huge difference in the amount of money you have in retirement. Taxes are another issue but the assumption (which I think is valid) is that with proper financial planning, you shouldn’t be paying excessive taxes on your retirement funds withdrawals.

How long is the long term?

Another misconception is the length of the “long term”. I’ve seen posts where people mention that equities are good for investment as long as you will be invested at least five years or ten years. It’s hard to imagine how someone can look at a return figure from an 80 year study and assume it applies for a ten year period. I don’t have an answer to this question but what I do know from my limited statistics knowledge is that the odds of meeting your expected return increase over time. This means that if you are investing for a 20 year time period and you are expecting a return of 7% then the odds of meeting or exceeding that return are higher than for a 10 year time period. By the same token – investing for a 40 year time period will increase your odds compared to the 10 or 20 year time periods.

Most Canadians are probably familiar with the company BCE (Bell Canada Enterprises) since it is the biggest telephone provider in the country. Last June, the Ontario Teacher’s fund made the winning bid of $42.75 per share for BCE for a total of $35 billion dollars. Since that time the collapse of the credit market has made the deal less profitable for the banks providing the loans which include Citigroup, Deutsche Bank AG and Royal Bank of Scotland. There have been many rumours regarding the deal and if it would go through or not. This is one of the reasons why the stock has been trading between $32 and $38 in recent months which seems pretty cheap considering the shares should be worth $42.75 when the deal is finalized June 30.

Yesterday it was announced that a lawsuit by BCE bond holders was successful in a Quebec court which could mean that the deal doesn’t get done. The lawsuit was intended to block the takeover which the bond holders feel is unfair to them. The case will now go to the Supreme Court of Canada which will delay the takeover at a minimum.

Last fall when the stock was trading at about $38, Mr. Cheap and I had a conversation about BCE and if it was “free” money to buy it at a discount to the takeover purchase price. We both thought it was, but at the same time there was the risk that the deal wouldn’t go through for whatever reason. If that happened we figured the stock would go back to it’s pre-takeover price of around $30 which would be a big loss from a $38 purchase price. Given the limited upside at the time, neither of us went for the “sure thing” and it looks like we made the right choice.
Only time will tell but considering that the banks lending the money want out of the deal and the fact that telcos in general have lost value over the past year (the deal might be valued too high), there are a lot of good reasons why this deal might not happen. Telus which is another large Canadian telco has lost a quarter of its value over the last several months.

What is stopping the BCE takeover deal?

Basically, the investors who own the BCE corporate bonds are upset because the buyout will mean the new BCE will have a lot more leverage (debt) than the old BCE which will reduce the quality of the bonds thereby lowering the bond values. The bond holders want more say in the deal or to get compensation. BCE is arguing that the bond holders should have known there was a risk of a takeover and subsequent down grading of the bonds.

What do the banks think about BCE?

The banks that are providing the financing for the deal are Citigroup, Deutsche Bank AG and Royal Bank of Scotland. Since the deal was created, the credit markets have taken a beating and the banks will likely lose money on the loans. While they are still obligated to go through with the deal, they have a lot of incentive to withdraw if given the ability to do so.

BCE takeover history

pre-2007 – BCE stock price languishes for many years.

February 2007 – two groups make bids for BCE. One bid involved the Teachers, the other the CPP (Canada Pension Plan). Both were turned down.

April 2007 – BCE puts itself up for auction.

June 2007 – Teacher’s group puts in the winning bid of $42.75 per share.

Jan 2008 – BCE bond holders go to court to kill the deal since the bond values have dropped a lot.

Mar 2008 – bond holders lose court case but will appeal.

May 21 – bond holders win key court case to block deal.