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Invesing in IPOs, MBS and Emerging Markets

October 28th, 2007 ·

I wanted to comment on posts on investing in Initial Public Offerings, Mortgage-Backed Securities and Emerging markets that were recently featured in some of the blogs that I follow.

Canadian Money Blogs Reviewer wrote a post on how you can profit from IPOs by buying them without paying a commission and selling them in a few weeks when the volume picks up. Unfortunately, it is not so easy. Most IPOs are stinkers like Vonage Holdings (VG) and profitable offerings like Google (GOOG) are the exception rather than the rule. There is evidence that investors can make money on the first day of an IPO but small investors cannot get in on the popular IPOs and if you can get in on an IPO, you probably don’t want it! Verdict: Avoid.

Preet featured two posts on Mortgage-Backed Securities (MBS) and pointed out that they offer higher yield than GICs. However, the main problem with MBS is that distributions are in the form of interest and principal repayments. Since most mortgages come with pre-payment privileges, when interest rates are falling, homeowners are likely to repay principal faster and slower in a rising interest rate environment. Investors, on the other hand, end up with the losing side of the bargain in both a falling and rising rate environment. David Swensen (in Unconventional Success) thinks that the downsides of MBS does not make up for the slightly higher interest rate and classifies it under “non-core” asset classes. Verdict: Avoid.

Confused Capitalist thinks that an overweighted position in emerging makets is prudent because “soaring GDP growth rates of 8-12% annually in some of these countries, expecting their stock valuations to follow isn’t much too much of a mental stretch”. Actually, there is a correlation between GDP growth and equity returns but in the other direction. Jeremy Siegel notes in The Future for Investors that “[GDP] Growth is not enough to sustain a profitable investment strategy”. The market weight of emerging markets is 9% in the world capital markets and there is no reason to allocate more than that for emerging markets in the international equities portion of your portfolio. Verdict: Market weight for emerging markets is plenty.

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20 responses so far ↓

  • 1 Joe // Oct 29, 2007 at 10:11 am

    I read market weight is closer to 20% for emerging markets.. e.g. stated here:
    http://seekingalpha.com/article/38252-a-world-market-cap-approach-to-allocation

    Which suggests that the 10% number you mention may be out of date.

  • 2 Canadian Capitalist // Oct 29, 2007 at 10:44 am

    Joe:

    I am sure if the author has the weightings correct. Here’s what I have (sourced from Dan Solin, author of The Smartest Investment Book You’ll Ever Read) for end of 2006:

    USA - 46%
    EAFE - 41.5%
    Canada - 3%
    Emerging Markets - 9.5%

    Other sources I checked out (for e.g. weighting of emerging markets in VEU, which is world ex-USA, is 20%) agree with Dan Solin’s number.

  • 3 Hungry Table // Oct 29, 2007 at 12:29 pm

    I never said anything about trying to get in on “popular” IPOs. Recent IPOs such as Lullulemon and Tim Horton’s were obviously oversubscribed even before the date with all the press coverage. My point was that it’s not often that the average investor can participate in a Canadian and/or US IPO.

    Four months ago, TD Waterhouse offered it’s clients the opportunity to place “an expression of interest” for Rugged Communications (RCM.TO). I ordered a couple hundred, was alloted the requested amount and promptly sold them two months later. ROI (+15%).

  • 4 HT // Oct 29, 2007 at 12:32 pm

    Btw, I made the original IPO comment on:

    http://www.canadianmoneyblogs.com/2007/10/your-broker-and-ipos-he-offers-easy.html

  • 5 Canadian Money Blogs Reviewer // Oct 29, 2007 at 12:36 pm

    CC: as usual you’ve done a good job warning investors about the risks inherent to such dealings. I agree with HT though that there are cases where it’s really a good way to make money. Common sense obviously needs to be applied and serious investors only should buy into IPOs.

  • 6 Canadian Capitalist // Oct 29, 2007 at 1:26 pm

    HT: I don’t dispute that some IPOs can make you money. But how do you tell the one you can profit from the ones that will turn to be stinkers? And, as a group are the IPOs you can get in on, better than the market, esp. since small investors cannot get in on the popular ones?

  • 7 Canadian Capitalist // Oct 29, 2007 at 1:30 pm

    HT: Great website, BTW. Some of the comments on the restaurants I am familiar with are spot on.

  • 8 WhereDoesAllMyMoneyGo.com // Oct 29, 2007 at 6:04 pm

    Hi CC - good point - I will amend my post to include that info. I believe you can find MBS’s that do not offer pre-payment clauses - although rare and with lower yields than ones WITH the clause.

  • 9 WhereDoesAllMyMoneyGo.com // Oct 29, 2007 at 6:15 pm

    Another note: I don’t know if I would “avoid” MBS’s altogether without qualifying that you can take advantage of falling interest rates by selling the MBS in the open market at a higher price… Whereas you can’t do that with a GIC.

    The position of avoiding MBS’s certainly warrants merit when comparing to a cashable GIC of similar yield. But a locked in GIC has liquidity constraints - so you might be willing to trade the higher yield for liquidity and slightly more risk.

    Canada Savings Bonds are liquid but may not pay as high a yield as an MBS. So you might not want a corporate, but want a slightly higher yield than a CSB and get a chance at capital appreciation too.

    Thoughts?

  • 10 Hungry Table // Oct 29, 2007 at 9:27 pm

    CC: Research, research, research. :)

    And like one great investor said to his flock, if you don’t understand the business don’t bother! (Or something like that…)

  • 11 Canadian Capitalist // Oct 29, 2007 at 9:54 pm

    HT: And you’re sure that it’s your “research” that is uncovering stocks that are going to go up over the next 60 days? I hate to break this to you, but stock movements over the short term are almost random.

  • 12 Canadian Capitalist // Oct 30, 2007 at 1:11 pm

    Preet: Why take any risk at all (other than interest rate risk) with the fixed income portion of the portfolio? If an investor wants to take risk, they can take it in the equity portion. Personally, I restrict my fixed income portion to short bonds and RRBs.

  • 13 WhereDoesAllMyMoneyGo.com // Oct 30, 2007 at 4:42 pm

    Well, don’t forget not everyone has the same risk/reward tolerance that you might have. Some people may not want to invest in equities AT ALL due to business risk associated with ownership or for whatever reason. Have you ever talked investing with someone who lived through the depression? Some will have your head for mentioning stock! :)

    Maybe all they can stomach are debt instruments - and that being the case, are they not entitled to select the degree of risk/reward that’s appropriate for them? Even though it might be restricted to the left most quarter of the spectrum?

    Donal Trump might tell you that he personally only invests in real estate - does that mean everyone should?

    Isn’t the decision to stick to short bonds and RRB’s narrowing down the fixed-income universe and hence potentially taking more risk than an indexation strategy WRT the fixed income portion?

    No, I think your point is well taken for certain types of investors - but are there other types of investors out there? I think so.

  • 14 Canadian Capitalist // Oct 30, 2007 at 5:27 pm

    The point I am making is about most investors out there. How many investors out there have 0% allocation to equities? I’ll wager the numbers are pretty low.

    You can justifiably take the position that investing only in short bonds and RRBs is pretty narrow. That’s not under discussion here. It’s whether it is justified for most investors to take a position in MBS. My point is that the negative characteristics of MBS outweighs the positive benefits of a slightly higher yield. Of course, that doesn’t mean nobody should touch these things.

    However, I am curious why you think avoiding long bonds is taking more risk? If anything, I would have thought it is lowering risk, since long bonds are more sensitive to interest rate changes.

  • 15 Canadian Capitalist // Oct 30, 2007 at 5:44 pm

    Oh, and it’s not fair to compare a diversified portfolio that has a narrow fixed income focus to a real estate only investor. Diversification doesn’t mean owning everything under the sun - just those asset classes that make the most sense for a portfolio.

  • 16 WhereDoesAllMyMoneyGo.com // Oct 30, 2007 at 6:26 pm

    You would be surprised how many accounts are nothing but GIC’s and CSB’s! :) I am still shocked at how petrified some people are with respect to their investments.

    And you could take them to meet Warren Buffett and he could impart oodles and oodles of wisdom on them and it will never change their minds.

    Granted, you will find more of the “totally-risk-averse” people in the older categories of the population. While financial education is severely lacking, the message about asset allocation is making the rounds at least in the information generation.

    While most people who are actively interested in investing (say, enough to read and participate in blogs) are comfortable with risk/return and asset allocation theories - there are as many, if not more, who view their finances as a big black hole. No word of a lie.

    There are some investors who will actually come out and say “I have no idea about anything to do with investments, and I never will and I never want to - here is my portfolio and savings, just handle it for me - that’s what I pay you to do.” And then there are others who are totally self-sufficient and could teach financial advisors a thing or two. But the non-self-sufficient investors vastly outnumber the DIY’ers.

    And then you have people who have sadly been burned by an advisor or have been ripped off through some other financial scheme or what have you. Depending on the severity of the situation, they may never trust anyone or anything ever again with respect to their money.

    To sum it up, given that the debt markets are roughly 21 times the size of equity markets, the data and what I have seen from dealing with all sorts of investors would support that there stands to be a great deal of people not exposed to equities. (It blows me away too!) :)

    In any case, to address the short term bonds. First off, I’m a shorter bond kind a guy myself - I’m just stirring up some healthy dialogue! - and short term bonds do carry less risk in almost all cases. My point is that you are taking a bet with your fixed income (not a big one, mind you - a good one) by choosing to narrow in on a certain way of picking your short term investments. Anytime you make a call, are you not potentially making a “bet” (not in the gambling sense strictly speaking, but you know what I mean).

    Of course hindsight is 20/20 but in the early 80’s, you might think twice about just staying short when long term bonds were paying double digit interest rates.

    So perhaps the risk is opportunity cost or the risk of not diversifying? What if interest rates gradually decrease (at a snail’s pace) for an extended period of time? The longer bonds may have been a better buy.

    If we pretend that interest rates were to creep lower and lower until they were at (this is a stretch) 0.5% and short term bonds were issued at 0.5% for argument’s sake then if/when interest rates inflected (is that a word?) a 0.25% increase has a bigger effect on 0.5% that on a 5% bond. Bonds become more sensitive to interest rate changes when yields are low. If you had a portfolio of short-, medium- and long- term bonds then you lessen that particular kind of pain, as some of the longer bonds, while increasing when interest rates were going down and decreasing when interest rates come back up, would still pay your coupon payments as long as you hold the bond. You could just sit on it and collect your payments (relatively) worry free.

    I suppose that was a really convoluted way of saying that if bonds are paying what might be the long term going rate, people may be happy holding longer bonds and not worrying about interest rate movements and just collecting their interest payments.

    Or, if they don’t want to make bets and are in it for the long term perhaps they would just index both equities and fixed income.

    CC - I’m enjoying this thread!

  • 17 WhereDoesAllMyMoneyGo.com // Oct 30, 2007 at 7:22 pm

    Re: Donald Trump - agreed. Peter Lynch (I think) coined the phrase deWORSEification to describe just that. :)

  • 18 Paul the BondGuy // Oct 31, 2007 at 8:42 am

    I’m not sure I understand. Maybe it’s the Canadian accent. I have read the post 3 times.

  • 19 Canadian Capitalist // Oct 31, 2007 at 9:19 am

    Preet: Fair enough. I don’t work in financial services, so I’ll accept your contention that a lot of investors have no exposure to equities.

    Paul: I’m not a bond expert, so it’s always possible that I am totally out to lunch. Which part don’t you understand? Thanks.

  • 20 kevin // Nov 17, 2007 at 5:58 pm

    I know the misery of IPO’s. Years ago I got ATT wireless on its first day and made the mistake of holding it too long.

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