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Archive for September, 2010

Why the BTSX won’t go to the Dogs

In my last post I noted that there are fundamental differences between the TSX 60 and the DOW 30 which I believe make comparisons of the Dogs of the DOW and the Beating the TSX portfolio difficult. Specifically, I do not believe the performance of the Dogs of the DOW is a proxy for the Beating the TSX index. The reason lies within the components of the indexes: the DOW contains many companies that have a wide moat around their business compared to the TSX 60 where companies with wide economic moats are concentrated in particular sectors. Selecting for the highest dividends results in a BTSX portfolio that is concentrated in wide moat stocks, making it a fundamentally different group of companies than the original TSX 60 whereas this concentrating effect is absent for the Dogs of the DOW.

To illustrate this effect, let’s first take a look at the sector composition of the TSX 60 (data from Morningstar):

Of note, the Industrial Materials sector makes up 25%  of the TSX 60. With the exception of a few companies like SNC Lavalin and Bombardier, the companies in this sector are miners. The profitability of these companies is closely tied to the commodities that they supply and in general they are not stable, free cash flow generators. Additionally, the qualities that create an economic moat such as brand loyalty, networking effect or switching cost are generally not applicable to commodity producers.  Furthermore they tend to be low dividend payers and are rarely selected for by the BTSX approach.

However, the TSX 60 also contains 10 companies from the financial services sector of which 6 are banks. Unlike  miners, Canadian banks have wide economic moats due to the oligopolistic nature of the industry in Canada.  Similarly, the pipeline companies TransCanada and Enbridge have wide economic moats. Once a pipeline has been built, competition is very difficult because the existing pipeline becomes the most economical means of transporting oil and gas and the regulatory approval to build a competing pipeline for the same route is hard to obtain. Both TransCanada and Enbridge operate the kind of expansive network of pipelines that will provide the long term stable cash flows associated with wide moat companies.

Now let’s consider the companies that constitute the Beating the TSX. Here is a chart of the companies in the BTSX from 2006-2009:

2006 2007 2008 2009
BCE Great-West Lifeco Shaw Comm. Manulife  Financial
Great-West Lifeco Enbridge Power Corp. BCE
TransCanada BCE BCE Power Corp.
Enbridge TransCanada TELUS Sun Life Financial
Bank of Nova Scotia Bank of Nova Scotia Bank of Nova Soctia TransCanada
Royal Bank Royal Bank TransCanada Bank of Nova Scotia
National Bank National Bank Bank of Montreal Bank of Montreal
Bank of Montreal Bank of Montreal Royal Bank National Bank
Teck Resources TD Bank National Bank TD Bank
CIBC CIBC TD Bank CIBC
CIBC
Number of Bank or Pipeline Companies in BTSX
2006 2007 2008 2009
7 of 10 (70%) 8 of 10 (80%) 7 of 11 (64%) 6 of 10 (60%)

Notably, banking and pipeline companies consistently make up a large proportion of the companies on the BTSX, despite making up only 13% (6 banks and 2 pipeline companies) of the TSX 60.

Now let’s consider the DOW 30. Here is a breakdown of the stocks by sector:

There are a couple of things to note: the industrial materials sector makes up the largest sector in both indexes, but in the TSX 60 most of the companies are miners and 8 of the 15 are gold miners. The industrial materials sector on the DOW is comprised of diversified manufacturers; household names such as GE, Boeing, Caterpillar and 3M. Energy is a much smaller component of the DOW making up only 6.67%  (2 companies: Exxon and Chevron) as opposed to the TSX 60 where energy makes up 21.67% (13 companies). On the other hand, healthcare makes up 10% of the DOW (3 companies: Johnson and Johnson, Pfizer and Merck) while it makes up less than 2% on the TSX 60 (1 company: Biovail). Furthermore, if we look at the consumer goods and consumer services sector, the companies on the DOW are well known global brands (Procter & Gamble, Coke-Cola, Pepsi) which are very different businesses than the consumer sector on the TSX which is mostly made up of retailers that service the Canadian market (Loblaws, George Weston, Canadian Tire, Tim Horton’s). In short, the DOW Jones industrial average is comprised of a number of companies from a range of sectors that have built distinctive competitive advantages and wide economic moats. Companies on the TSX in general have far fewer of these advantages.

In The Five Rules for Successful Stock Investing Pat Dorsey lists the companies that Morningstar considers to have a wide moat and 14 of these are members of the DOW. So, according to Dorsey 47% (14 of 30) of companies on the DOW have wide moats. However, turning our attention to the 2010 Dogs of the DOW we find only 3 wide moat companies from that list: Home Depot, Merck and Pfizer. Repeating the exercise for the 2009 Dogs yields only 2 wide moat companies: Merck and Pfizer. This suggests that investing in the DOW in general would result in a higher percentage of wide moat companies than the Dogs of the DOW since sorting on dividend yield does not correlate with selecting wide moats in the case of the DOW.   This could explain why the Dogs of the Dow has underperformed relative to the DOW over the last 15 years.

In direct contrast, if we accept the argument that the wide moat companies on the TSX are the pipelines and the banks, then the BTSX does in fact single out the wide moat companies and essentially concentrates them into one index.  In my opinion this is a key differentiator and the underlying reason why the BTSX should continue to outperform the TSX 60 over the long term unlike the Dogs.

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