A Millennial's Retirement Planning Journey (Q2 '18)

by: Investing for Millennials


Beginning to save for retirement at a young age is highly beneficial and significant long-term wealth can be generated with low monthly investment.

Younger investors should shift allocations heavily to equities and avoid long-term bonds, and focus investments in companies with sustainable competitive advantages.

A long-time horizon is a significant advantage over institutional asset managers; investors should take advantage of this by investing in companies with demonstrated ability to compound earnings.

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Having recently hit two major milestones in my life (home purchase and marriage), I've begun to turn my focus towards saving for retirement. In the below article, I outline a needs-based approach to retirement planning (specific to my own situation) and lay out my current retirement portfolio. I plan to publish quarterly portfolio updates, comparing my performance vs. a benchmark portfolio.

In writing this series, I am hoping to:

-Present my personal situation as a case study for other young people attempting to save for retirement

-Present my views on long-term financial planning

-Shamelessly crowd-source new investment ideas

-Solicit feedback on my portfolio construction and holdings

Personal Situation

I am married, and both my wife and I are in our late 20s. We own a home in a major Canadian city; our investments outside this portfolio are intended to finance renovations & home furnishings (which is shaping up to be quite a project). I work in M&A for a financial institution and contribute to a DC pension. Our risk tolerance is relatively high.

Retirement Goals

The ultimate goal of this portfolio is to generate a sufficient stream of dividends to fund the entirety of my family's expenses after my retirement. This is a conservative approach, given that: (a) portfolio principal could be 'drawn-down' as required and (b) it does not consider receipt of Canada Pension Plan payments.

I plan to invest for total return until retirement and then rebalance my portfolio into one that generates a yield of ~3%. This portfolio is held in non-taxable accounts; and therefore, rebalancing will not have a material impact on portfolio value. On retirement, I will transfer my DC pension plan balance into my retirement accounts, and treat them as one portfolio.

We plan to target minimum monthly retirement savings of $1,500 in Y1 of the plan, increasing at 2% per year (in line with projected salary increases). I contribute to an employee share ownership plan ("ESOP") ($500/month) and can sell my shares once per 13 months. I plan to include the $500/month in my $1,500/month target and will opportunistically sell my ESOP holdings and include them in this portfolio. This savings target will not include my DC pension plan contributions.

Calculation of Monthly Savings Target

To sensitize for both investment returns and monthly savings, I have presented a variety of cases. The calculation begins with target dividend income in today's dollars, which is then grossed up for inflation until my target retirement date. The inflation-adjusted income requirement is then divided by target portfolio yield to calculate the required value of my retirement portfolio. Since I will be combining my DC pension plan and this portfolio on retirement, I have backed out the DC plan's projected future value from my portfolio requirement.

Working backwards, I can calculate the monthly savings required to generate the portfolio sizes in each of the above cases over a range of annual returns. Assuming an 8% net return, saving ~$1,500 per month (and increasing amount saved at 2% per year) will generate a portfolio worth $4.6 million at my retirement.

Investment Strategy

I plan to construct my portfolio using the following guiding principles:

  1. Portfolio allocation of 85-100% equity/0-15% cash & short-term investments. I have excluded bonds from my allocation due to (a) my extremely long-term horizon, (b) historically low projected bond returns given current interest rate environment, (c) my exposure to inflation & bonds' inability to provide an inflation hedge, and (d) my current macroeconomic outlook. I will revisit this allocation as my personal situation and my macroeconomic outlook changes.
  2. Invest in equities that are trading below my estimate of their intrinsic value, regardless of any other screening criteria.
  3. Invest the majority of the portfolio in well-run companies that I believe will compound cash flows over my investment horizon. Do not sell these shares unless there is a clear deterioration in fundamentals or they become extremely overvalued.
  4. Focus on companies with sustainable competitive advantages and assets/networks that are essential for other companies to operate ("wide moat"/"bottleneck" businesses).
  5. Seek companies with exposure to growing economies (i.e. China, India, Southeast Asia), but limit exposure to any one emerging country to 15% of portfolio value.
  6. Seek companies benefitting from secular trends and prioritize investment over companies facing secular headwinds.
  7. No O&G exploration or mining companies, and minimal holdings with direct revenue exposure to commodity prices.

Performance Evaluation

My alternative to an actively managed portfolio as outlined in this article is a passive, ETF-based portfolio. I intend to track my performance against such a 'shadow portfolio', where I assume investments in two ETFs (50% S&P 500 CAD hedged and 50% S&P/TSX) at the same time as contributions into the portfolio.

Should I fail to generate alpha of at least 0% (i.e. I do not outperform my benchmark over a 5-year horizon), I will re-evaluate my investment strategy and consider the passive strategy outlined above.

I am not concerned with short-term performance against my benchmark and am willing to tolerate significant fluctuations in portfolio value.

I plan to use IRR to calculate my portfolio and benchmark returns.

Canadian Tax Considerations

As a Canadian investor, I have a tax-exempt account (TFSA) and a tax deferred account (RRSP) at my disposal. I plan to hold all US equities that pay a material dividend in my RRSP (dividends received in TFSA are subject to US withholding taxes; dividends received in RRSP are tax free).

Beyond this, I will distribute my RRSP and TFSA contributions in the most tax efficient manner for my personal situation. In my opinion (I am not a tax professional and this is not tax advice), RRSP contributions that reduce marginal taxable income above $93,000 are significantly more valuable to the average person than those made on income below $93,000. It may be valuable for young investors projecting rising incomes to consider deferring RRSP contributions until income levels rise.

Initial Portfolio Holdings

My retirement portfolio's initial holdings include:

American Tower (AMT): American Tower owns a worldwide portfolio of telecommunications infrastructure, which it leases to large mobile carriers. I view wireless communications as an essential service, and AMT and the other tower REITs as owning the 'bottleneck' for this service. The business carries a (justified) premium valuation but is trading roughly in line with historical FFO multiples. It has favourable unit economics, EBITDA margins, and low maintenance capex requirements. AMT has more exposure to worldwide markets and lower customer concentrations than peers, which I view as a positive. The business has multiple avenues for growth, including (i) increasing demands for data and telecommunications coverage (ii) the rollout of 5G technology, and (iii) M&A and continued international expansion.

Key risks include (i) industry consolidation reduces pricing power and harms unit economics, (ii) cell tower technology becomes obsolete, and (iii) a major customer experiences financial distress.

CVS (CVS): CVS operates a US network of pharmacies and owns one of the largest pharmacy benefits managers in the US, Caremark. There is a significant amount of market fear that Amazon (AMZN) will enter the pharma market (Amazon's recent acquisition of PillPack has not helped matters); this could be majorly disruptive to CVS' business. I believe these concerns are somewhat overblown but will be carefully monitoring the impact of Amazon's business moves on CVS' pharmacy revenues. CVS recently agreed to acquire Aetna (AET) (a large health insurance provider) at a very steep multiple, which drove a further decline in share price. While I feel that CVS overpaid for Aetna, the transaction has the potential to transform CVS' business and drive significant revenue synergies. CVS' core business is a free-cash flow generation machine and should have no trouble servicing the significant debt incurred for the Aetna transaction. Shares are priced for disaster and appear to trade at a significant discount to intrinsic value. As America's population continues to age, its healthcare needs will continue to increase, providing a significant demographic tailwind for CVS and the broader industry.

Key risks include (i) changes to governmental regulations (ACA, additional regulatory burden for PBMs, changes to Medicare/Medicaid), (ii) competition from net market entrants (i.e. Amazon), (iii) operational/cultural/integrational risk from mega-merger with Aetna, (iv) Aetna transaction is not approved by regulators (significant break fee, synergies not realized, competitive position vs. United Healthcare (UNH) weakened) and (v) elevated leverage driven by debt issuance to fund Aetna transaction.

The above are partially mitigated by recent events, which include CVS' previous strong experience with transformative M&A (acquisition of Caremark was ultimately highly successful), recent regulatory success for other vertical mega-mergers (AT&T/TWX), and the core business's ability to generate FCF (accelerating ability to de-lever).

Facebook (FB): Facebook owns a virtual monopoly on social media outside China, with key apps Facebook, Messenger, Instagram, and WhatsApp. The sheer mass of their user base (how do you leave the ecosystem if all of your friends/family remain a part of it) and lack of alternatives for consumers make their business extremely sticky. Facebook's massive user base gives it access to an unprecedented amount of data, which it is able to mine for the benefit of its advertising partners. This targeted approach generates significantly stronger ROIs than traditional advertising, allowing Facebook to charge premium prices and making advertising partners incredibly loyal to Facebook. I believe the business still has a massive runway for growth, given that (i) premium ad offering provides pricing power, (ii) monetization of Instagram and WeChat is currently minimal, (iii) potential for new value-added verticals (i.e. payments through WhatsApp), and (iv) growth in internet usage/middle class expansion in emerging economies (higher ad spend). Facebook earns a highly attractive ROIC, is extremely asset light, and has massive margins. Shares are expensive on a P/E basis but appear reasonably priced on a PEG basis.

Key risks include: (i) increased regulation re: data/privacy, (ii) EU antitrust/tax fines and regulations, (iii) user base migrates to new service (i.e. MySpace users adopting Facebook), and (iv) addressable market growth is not sufficient to fuel growth expectations priced into stock.

Fairfax India (OTCPK:FFXDF): Fairfax India is a holding company established by Fairfax Financial (OTCPK:FRFHF) (Prem Watsa's Canadian P&C conglomerate) to invest in India. India's economy is poised for massive growth for the foreseeable future and significant foreign investment-friendly economic reforms have been recently been enacted. I am not an expert in the Indian market and have chosen to outsource my exposure to a management team with an exceptional track record. Fairfax India uses a value investing approach and primarily holds investments in financial services, infrastructure, and industrials. It appears to be fully valued but offers a material diversification benefit and exposure to a high-growth, investor-friendly economy. Fairfax Financial charges 20% carry on returns above 5%.

Key risks include: (i) emerging market risk (political/FX/regulatory), (ii) Indian market valuations are elevated, and (iii) Fairfax Financial holds majority voting rights.

GOOGLE (GOOG): Google is a dominant provider of mobile and desktop internet search outside of China. Its core search business continues to grow rapidly and has many of the same network advantages as Facebook (i.e. large and loyal user base essentially requires advertisers to spend with them). Google's core business offers excellent ROIC and margins, though its mobile business (largest go-forward growth area) appears to have weaker economics than its mature desktop business (higher traffic acquisition costs for mobile compress margins). Google has also made significant investment in "other bets", which are long-shot ideas with high revenue potential if successful (i.e. Waymo self-driving cars, Google Fiber network). At current levels, Google shares appear to reflect a fulsome valuation for the core business, but do not appear to ascribe value to its "other bets". This effectively provides several free "lottery tickets" on investments that will be exceptionally valuable if commercially successful.

Key risks include: (i) highest short-term growth driver (mobile search) has weaker margins than consolidated core business, weakening unit economics, (ii) regulatory risks (GDPR, EU antitrust/tax risks), (iii) new technology/changing user prices cause users to switch search providers, and (iv) poor capital allocation by management (massive cash position used to fund poor acquisitions).

Philip Morris (PM): Philip Morris manufacturers premium tobacco products for worldwide (ex. US) sale. The organization is betting heavily on a premium smokeless tobacco product (IQOS), which they believe will drive go-forward growth. The tobacco market is facing declining fundamentals (fewer people are taking up smoking vs. people quitting smoking/dying), resulting in reduced volumes. Despite this, PM sells a highly addictive product, with high brand loyalty - resulting in significant pricing power. A weak Q1 report drove a material decline in stock prices and provided an opportunity to buy shares at a reasonable price. It should be noted that PM offers a forward yield of ~5.7% - the company only needs to grow its dividend at inflation to meet my return goals (assuming multiples hold steady).

Key risks include: (i) declining volumes/cigarette demand in key markets, (ii) elevated leverage profile, (iii) reliance on largely unproven IQOS product to drive future growth, (iv) regulatory risks, (v) FX risk, and (vi) tariff/excise tax risks.

AT&T (T): AT&T is the largest provider of telecommunications services in the US and has smaller operations in Latin America. Its recent acquisition of TimeWarner provided access to both a massive content library/ongoing content creation platform and a significant number of advertising impressions. AT&T's primary deal thesis was that it could use its existing consumer data to more effectively monetize these impressions vs. TimeWarner and that the acquisition would realize cost synergies. The transaction improves AT&T's competitive dynamics vs. Netflix and other streaming platforms, as they now have the content to compete head-to-head. AT&T's valuation is at multi-year lows (driven primarily by the key risks outlined below), and I have locked in a yield of ~6% that I expect to grow roughly in-line with inflation. This implies a very low hurdle for AT&T to meet my return target of 8% annually.

Key risks include: (i) highly price competitive US telco environment, (ii) operational/cultural/integration risk from mega-merger with TimeWarner, including the potential that revenue synergies are not realized, (iii) extremely high leverage profile magnifies risk, (iv) cord-cutting is becoming prevalent, (v) CEO has shown desire to 'empire-build' - potential for future capital misallocation and (vi) high sustaining capex costs.

Tencent (OTCPK:TCEHY): Tencent enjoys dominant market positions in Chinese social media (owner of WeChat - the unquestioned social media leader) and mobile gaming. It also provides mobile payments (via WeChat), media services, and has an ecommerce partnership with JD (JD). Tencent is in the nascent stages of monetizing the WeChat platform and has significant runway for growth. Like Facebook, WeChat enjoys a significant 'network effect' given the size of its user base and its exceptional user engagement (arguably greater - WeChat is far more integrated into daily Chinese life than Facebook is in North America). Unlike Facebook, WeChat has a very small share of China's current online advertising market and shows users significantly less ads than Facebook. I believe Tencent will increase advertising activities, which will significantly increase ARPU & profitability over the next 10 years. Tencent is also in the early stages of leveraging their WeChat user traffic as an ecommerce platform (in partnership with JD). Tencent's existing business generates extremely high ROICs and FCF margins; dynamics that appear likely to continue well into the future.

Key risks include: (i) risk of Chinese government expropriation of assets/undue influence on operations, (ii) poor capital allocation (large venture capital investments), (iii) user base migration to new services, (iv) valuation implies extremely high sustained growth rates (little room for error) and (v) corporate governance/corruption risks (elevated given governance standards in emerging markets vs. North American markets).

Brookfield Asset Management (BAM): Brookfield Asset Management manages real assets (real estate, infrastructure, private equity and renewable energy) on behalf of its publicly listed subsidiaries (in which it maintains significant LP interests) and third party investors. The current interest rate environment and demographic trends (longer life expectancies) have pushed (and should continue to push) institutional investors to increase allocations to real assets. BAM has directly benefited from this trend, having experienced significant AUM growth. BAM has several advantages over other real asset managers, which allow it to command premium prices and should drive continued AUM growth, including (i) exceptional long-term track record and reputation as a premium manager, (ii) third-party business not yet mature (i.e. more capital being raised then capital being returned) and (iii) alignment with third party investors (BAM invests alongside third parties at significantly higher levels vs. industry norms). BAM also offers shareholders well aligned interest with Management (Management owns a significant portion of the Company's equity) and exposure to real assets (though its ownership in subsidiaries) managed by a top-tier management team.

Key risks include: (i) interest rates (rising rates have several negatives, namely increased cost of capital and decreased demand for real assets as bonds become more attractive), (ii) aggressive accounting practices (valuation of assets is often aggressive), and (iii) potential for investor appetites for real assets to demand should bond/equity market valuations correct.

Brookfield Infrastructure Partners (BIP): Brookfield Infrastructure Partners is a listed subsidiary of BAM. Benefitting from best-in-class management, BIP owns a portfolio of infrastructure assets that include regulated utilities, transportation assets (rail, ports and toll roads), natural gas distribution/storage and communication infrastructure. All of BIP's assets are necessary for its ultimate customers to sustain their day-to-day lives/operations, offering a quality "bottleneck" and very stable cash flows. Combined with BAM's proven expertise, BIP has been able to opportunistically acquire these assets at significant discounts to intrinsic value and has proven to be highly adept at recycling capital from mature investments into new opportunities. The business targets long-term total returns of 12-15%, and historically has grown FFO at a 20% CAGR. Valuation appears roughly in-line with long term averages. BIP pays IDRs of 25% of distributions above $0.22/quarter.

Key risks include: (i) rising interest rates (increased cost of capital = decreased asset values), (ii) global demand for infrastructure is increasing, resulting in increased competition for assets, (iii) significant exposure to risky Brazilian economy and (iv) regulatory exposure (majority of assets are rate-regulated).

Enercare (OTCPK:CSUWF): Enercare sells and rents water heaters, furnaces, air conditioners and other HVAC products to consumers in Canada and the US. Enercare is focused on generating new rentals as opposed to sales, which has weighed on short-term results but is building a portfolio of highly attractive recurring revenues. This creates a very sticky relationship with the customer (who voluntarily replaces their air conditioner?) and provides significant pricing power. In addition to organic growth, the Company is planning to make tuck-in acquisitions of small companies, which have historically been highly accretive. Valuation appears reasonable given risk profile and growth opportunities.

Key risks include: (i) interest rates, (ii) high leverage profile, and (iii) demographic shift from single family housing to multi-unit residential.

Enbridge (ENB): Enbridge's provides oil transportation, natural gas transmission and natural gas distribution across North America. Recent concerns re: debt load and ability to gain approval for major capital projects (Line 3) have caused its valuation to drop to bargain basement levels. Long term investors should also be concerned with Enbridge's exposure to the oil industry, as there is the potential that society will shift away from oil (rendering Enbridge's oil transport assets worthless). I do not view such a shift as imminent, though it does bear monitoring. Despite these drawbacks, I believe Enbridge is mispriced at current levels. It generates strong, stable cash flows, and pays a very high dividend (yield over 6.5%). It has a significant number of secured growth projects and will be able to grow its dividend even without its flagship project (Line 3 replacement) being approved. I plan to hold Enbridge and collect its dividend while waiting for market sentiment to turn in its favour.

Pattern Energy Group (PEGI): Pattern Energy Group owns and operates wind power generation facilities in North America and Japan. Its shares have sold off dramatically for a variety of reasons, including (i) lower than projected wind volumes driving lower revenues, (ii) natural disaster in Puerto Rico caused disruption to operations, (iii) shift in market preference for YieldCos and (iv) rising interest rates. I believe this sell-off was overdone, and that PEGI shares represent a value opportunity for patient investors. PEGI has a very high payout ratio and extremely high leverage (when considering both recourse and non-recourse debt); both of which significantly increase risk. That said, PEGI's track record of acquiring assets at fair prices, access to institutional capital (partnership with PSP Investments) and long-term power purchase agreements imply to me that the dividend is manageable. I do not expect PEGI to raise its dividend in the near term, as it looks to reduce its payout ratio by ~20%. PEGI benefits from societal preference for green energy (reputational benefits, regulatory requirements); I believe that demand for green energy will continue to grow over my investment horizon.

Key risks to PEGI include (i) access to capital dries up (which would be a significant growth inhibitor), (ii) natural disaster risks, (iii) high leverage, (iv) rising interest rates and (v) wind conditions remain poor over long-term due to changes in weather patterns.

Smart REIT: Smart REIT (TSX: SRU.UN) owns and leases large shopping plazas in Canada, the majority of which are Walmart anchored. Their core assets are primarily located in urban/near urban markets, and virtually all sites contain a food store and a pharmacy (driving regular foot traffic and increasing the value to other merchants, especially vs. traditional shopping malls). Smart's portfolio includes a great deal of land available for development, either through holdings of vacant land or through land available for intensification at its shopping centres. Smart has wisely used these land holdings to diversify beyond its core business and has used the land to enter into JVs to build outlet malls, senior living facilities, self-storage units, office buildings and residential developments. The market currently appears to be pricing Smart's core retail business at a slight discount to intrinsic value, but attributing no value to its future development portfolio.

Key risks include: (i) rising cap rates, (ii) channel shift in retail (online vs. brick & mortar), (iii) development risk and (iv) concentration risk re: Walmart.

Next Steps

I plan to publish quarterly updates, where I discuss my portfolio's performance, any key developments re: my portfolio holdings, investment decisions re: new portfolio contributions, and any other transactions.

Disclaimer: This article does not constitute investment/tax/other advice, and is merely a collection of my thoughts/a summary of my personal situation.

Any opinion expressed in this article is mine alone.

Disclosure: I am/we are long ALL STOCKS MENTIONED.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.