December 2009
“A New Year is born”
Thanksgiving is behind us, and Christmas and the New Year now beckon. This is a time where capital markets have traditionally practiced goodwill towards investors – indeed, since 1955, on only nine occasions has the Canadian stock market declined over the November-December period. The “Santa Claus” rally appears set to leave gifts under the tree once again. As we curl by the fireplace and watch snowflakes drifting by the window, thoughts naturally turn to considering the forces that will drive investment returns in the coming year, and beyond.
Recent news has tended to confirm some of the themes we regard as central to the outlook for the coming year. Economic data has been consistent with the “modest growth” scenario. US consumer confidence stalled at its June levels. Europe grew at a 1.6% annual rate in the third quarter, while bank lending actually declined from year-ago levels. Third quarter profits generally exceeded expectations, resulting in further upward revisions to forecasts for 2010. Merger and acquisition (M&A) activity continued to ramp-up as companies exploit the attractive environment for corporate debt financings; in recent weeks Cisco bid $3.4 billion for Tandberg, Black & Decker agreed to be acquired by Stanley Works for $4.5 billion, Kraft formalized its $16 billion bid for Cadbury, and Warren Buffett’s Berkshire Hathaway offered to acquire Burlington Northern in a $34 billion deal.
“Growth versus Value”
One question that investors often wrestle with is whether “growth” or “value” oriented investment strategies will outperform over the coming year. “Value” managers tend to focus on balance sheets and asset values, and emphasize such valuation criteria as price-to-earnings multiples, price-tobook value ratios, and dividend yield when trying to identify compelling investment opportunities. “Growth” managers tend to favour companies with superior earnings growth characteristics, and will thus tend to construct portfolios that are more economy-sensitive; they will emphasize price-to earnings relative to growth (“PEG”) ratios, relative earnings growth and return on equity in their evaluation of investment opportunities. The chart on the right shows the annual median performance of Canadian equity “growth” managers versus Canadian equity “value” managers, as defined by Morningstar.
One observation is that “growth” tends to outperform when economic growth is accelerating (2003-2007), but “value” seems to lead when economic growth is slowing or negative. Our forecast of steadily improving global economic growth for 2010 suggests that “growth” may have the upper hand in the coming year. However, it is interesting that over the long term, there is little difference in the performance of “growth” versus “value” managers in Canada. This is probably a result of the narrow breadth of the Canadian equity market; because the number of strong companies having sufficient liquidity to satisfy investor demand is limited, many leading companies (e.g., Research in Motion) are held by both “growth” and “value” investors.
“Quality” – an intriguing opportunity
The market recovery has seen lower-grade companies outperform the top quality companies by an unprecedented margin, as highlighted in the table below. This reflects the re-valuation of poor quality business from “bankruptcy risks” to “going concerns” as credit market conditions have improved.
While we would characterize equity markets as being fairly valued today, “quality” appears to be cheap. In addition, a subdued economic recovery is likely to see leadership return to quality companies. Businesses that are more profitable, and have a stronger balance sheet, are likely to gain market share from their weaker, low quality peers. This presents an attractive investment proposition for investors on a risk-adjusted basis, made even more so because quality companies tend to have a consistent record of boosting dividends. US healthcare stocks (see chart below) present a particularly extreme example of the opportunity in quality issues as their valuation has also been doubly penalized by the uncertainties pertaining to healthcare reform.
What about the long term?
The beginning of a new year also presents an opportunity for investors to ponder the long-term investment returns that they should contemplate. The “credit bubble” period which saw the S&P/TSX composite index post double-digit returns for five successive years (2003-2007) probably encouraged investors to boost their return assumptions; similarly, the market’s plunge in 2008 might now encourage investors to be overly conservative. It is helpful to consider that since 1956 the Canadian equity market has provided investors with a total return of 9.26% per annum. It should provide investors with some comfort to know that over this time period there has never been a 10 calendar year period where returns were negative, with the lowest return being 3.43% per annum for the period ended December 1974; if we expand the time horizon to 25 years, then the lowest return improves to 7.85% per annum for the period to December 2008. Since equity markets are presently fairly valued, incorporating a return of 9% per annum appears reasonable; for investors fortunate enough to have a 25-year time horizon, a 7.5% return assumption might even be considered conservative. Since 10 year Canada bonds offer a yield of 3.5%, and highgrade corporate bonds a yield premium of 1.4%, a reasonable estimate of the ten year return from bonds would be 4.2%.
Combining the 9% equity return and 4.2% bond return projections with a 60% equity / 40% fixed income mix (the crossover point between the “neutral balanced” and the “equity balanced” fund categories) yields a forecast diversified portfolio return of 7.1% per annum for the coming 10 years. While I can only guarantee that markets will not perform as forecast, this approach offers a solid framework for long-term financial planning.