With this commentary, we plan to communicate with you every month about our thoughts on the markets, some snap-shots of metrics, a section on behavioural investing and finally an update on some of the people at MacNicol & Associates Asset Management (MAAM). I hope you enjoy this information, and it allows you to better understand what we see going on in the market place.
“Investing is the activity of forecasting the yield over the life of the asset; speculation is forecasting the psychology of the market” – John Maynard Keynes
Market Commentary: A Year in Review
December is often a month of celebration, family, friends, and also, of reflection. As such, we would like to take the opportunity to reflect on the year of 2015; we will attempt to provide a snapshot of the global economic environment, the North American stock markets, and vocalize our opinion on how these key developments will evolve as we continue on into 2016.
In any given year, there will always be certain issues which are consistently discussed, debated and considered in regard to their eventual effect on stock prices. As of late, the most oft-discussed topics have been the fall in oil prices, the Federal Reserve raising interest rates, and, most recently, a possible recession in China. It was the latter of these topics which led to the most volatile period of 2015, during August and September, where the S&P 500 fell by over 10% for the first time since 2011. The precipitous drop was a result of a crashing Chinese stock market, as investors begun to fear that there could be undisclosed issues in the world’s second largest economy. We issued a note at that time in order to voice our opinion that this was completely sentiment-driven and should not largely effect the ongoing business of most North American companies, unless they were commodity-focused or had a direct presence in China. The S&P 500 did eventually recover by the end of October, however, the TSX – which has a much higher commodity, and specifically oil exposure – has not been as fortunate. Despite the brevity of this correction, there were two very interesting trends which emerged from this period, and have continued to persist throughout the end of the year. One is a lack of market ‘breadth’, and the other is a noticeable ‘risk off’ shift in investor sentiment. Both will be discussed further below.
As referenced previously, the S&P 500 was able to reclaim its lost value over the month following the initial market decline in late August; this, however, does not mean that investors in particular have regained their account values. The reason for this has been an increasingly divergent stock market, with a larger separation between the ‘winners’ and the ‘losers’, which serves to misrepresent the actual performance of the overall stock market. For example, the S&P 500’s performance this year has been propped up by the performance of 5 of its largest companies (Apple, Microsoft, Amazon, Facebook, Google), while the remainder of the index constituents have largely performed poorly. The divergence between these five market leaders and the average performance of the rest of the companies which comprise the index has been the largest divergence since the 1990s, with a difference in performance of almost 20%. The result of such a scenario is that, if you did not hold these companies, you likely underperformed the market. The issue with this prospect is that most of these companies are high growth tech companies with lofty valuations, which are difficult to stomach for value investors. Most trade at elevated levels of book value or earnings, which means that they have very little tangible value to protect the downside in a correction. An additional result of this scenario is what we view to be a higher probability of volatility moving forward for index investors, and a lower level of support for the overall market. In healthy bull markets, investors would ideally like as many stocks as possible to participate in the upside activity. As such, if one or two companies experience headwinds, it will not drastically affect the stock market as a whole. With a select group of names propping up the stock market, there are much fewer things that must go wrong for a correction or a steep decline to occur. There will always be strong individual companies to invest in, regardless of the environment, but we believe this scenario has significantly increased the risk to investing in indices in the near term.
From an economic standpoint, the recent dichotomy between the U.S. economy and the rest of the world has seemed to do nothing but strengthen. Recently, American economic data has improved – most notable was last week’s 211,000 non-farm payroll figures, coupled with an upward adjustment to November’s figures – while most other major countries remain mired in anemic growth and possible recession. The Eurozone has recently pledged to extend their own version of Quantitative Easing in an effort to foster economic activity in the region; the actions of China’s government seem to indicate that their economy is also slowing; Japan remains in trouble and has not slowed down their own economic easing; India is also beginning to ease; the emerging markets, who are feeling the pain of the ending of the commodity super-cycle and a slowing Chinese economy, are also in trouble economically, and our own economy in Canada remains damaged by a collapse in oil prices. Meanwhile, the US has been putting out strong economic and employment data, which is leading most to believe that the Fed will definitely begin to raise interest rates in December. Although ostensibly negative for the stock market, the initial move will be very minimal notionally, and also serves as a vote of confidence from the Fed on the health of the economy. There are still some who believe that the US economy is doing worse than data suggests, but we do not believe this to be true. One common argument is that, although unemployment is at 5%, most of the jobs being added are part time positions, which are being taken by those who cannot find full-time work or need some additional income due to other increasing costs in their lives. As it turns out, the Fed has a chart for this, which can be seen below; this chart shows the number of Americans who are working part time but wish to work full time, or are only working part time out of economic necessity. As can be seen, the current level is below where it has been recently, and much below where it was in the 1990’s. It should be noted that, despite our belief that the US economy will continue to be the strongest in the world, we do not expect significant economic growth. We still believe the global economy to be in a slow economic growth environment.
Given our belief that the American economy will continue to stand out amongst the rest of the world, we foresee a few repercussions. Firstly, as we said above, the December interest rate hike is now, in our view, very likely to happen. As such, we believe that it is prudent to shift away from highly interest-rate sensitive sectors such as utilities and pipelines for the near term. Despite the small hike, these sectors are likely to sell off on consumer sentiment. Another likely scenario will be the continued strength of the USD. Two major factors in currency strength are relative economic strength and relative interest rates, and we believe that both of these forces will work to further increase the demand for US dollars. This strong demand will likely cause our CAD to depreciate relative to the Greenback, even if our economic data and interest rates do not decline. In terms of sectors and stocks, a strong USD would likely further damage commodity and oil stocks, as well as large multi-national companies who are vulnerable to currency translations.
As a whole, we believe the stock market to be fully valued. Current market valuation multiples are above average in a historical sense, and therefore have little justification to expand further. In conjunction, as noted above, we also believe that economic activity and growth will continue to be unimpressive. In order for the stock market to gain ground, there needs to be an expansion of multiples, an expansion of growth, or a mixture of the two. Therefore, with extended multiples and slow growth, we believe it is likely that we will have a sideways market in 2016, which will not benefit index investors.
Upon the backdrop of fully valued blue chip stocks and weak economic growth, we continue to believe that small cap growth names are a lucrative avenue to achieve outperformance. Small companies have the ability and scope to focus on niche markets or areas which are able to grow faster than the overall economy, which therefore allow them to relatively outperform larger stocks which are heavily dependent on overall economic activity. In conjunction with a strong base of value-oriented stocks, as well as our MacNicol Alternative Trust, small capitalization stocks complete our ‘Barbell Portfolio’ structure which is illustrated below.
This structure aims to build a portfolio with a strong ability to protect capital, but which also exhibits qualities which will allow you to outperform and achieve capital growth. However, no investment is without risks, and with small caps, the most unfortunate reality is the fact that investor sentiment and broker activity have a large impact on the near term stock price of the company, regardless of operational success. This is a scenario which was put on full display this year, brought on by a noticeable shift in investor sentiment following the August correction. Small cap names are typically seen as ‘riskier’, so when investors are willing to take more risks, small caps benefit, and vice versa when they are not. The threat of a Chinese slowdown and the August correction caused – what we believe to be a short-term- shift to a ‘risk off’ mentality, resulting in capital to flow away from small cap stocks. When investors are concerned about the overall market, they will raise cash, and they are much more likely to sell their small cap allocation rather than their investments in GE or Google. Unfortunately, this can sometimes result in the proverbial babies being thrown out with the bath water, and solid companies experiencing stock price weakness due to the poor performance of others. One notable example of this behaviour can be seen on the Canadian TSX Venture exchange – down 25% year-to-date – where strong companies have suffered due to the prevalence of small cap resource, mining and oil companies on the exchange. However, moving forward to 2016, given what we stated in regard to our opinion on the relatively limited upside of most blue chip stocks, we believe that the risk appetite will return to the market and that small cap stocks will benefit. All of our investments in small caps are with strong companies, whose performance has remained solid despite sector weakness. Performance is always king, and we firmly believe that the prices of the small cap stocks will return to favour once it is readily apparent that their businesses are churning on at a faster pace than the surrounding economy.
We at MacNicol & Associates Asset Management firmly believe ourselves to belong to the previously touched upon camp of investors who tend to heavily favour ‘value-oriented’ stocks, which we believe to be due to several sound logical reasons. The first reason was already discussed; stocks which trade at attractive valuations will typically have a much stronger price floor and thus have a much more protected downside. As we have said in the past, capital preservation is our number one priority, and a value-oriented tilt is always critical in order to achieve this goal. Value investing also allows us to focus more on the investment side of the business, and less on the prediction side of the business. Value stocks are typically labeled as such because they are currently valued cheaper either relative to their own history or to their closest peers; there is often a logical justifiable story as to why they should increase in price. High growth stocks, from an investment standpoint, do not allow such considerations, as they are often operating in uncharted territory in regards to their valuation, and have very few directly comparable competitors. One of our key layers of analysis which we utilize in order to assess this aspect of any given stock is provided by our partners at Strategic Analysis, whose service allows us to quickly and efficiently view the valuation of a company in regard to its own history. We also favour value stocks because, historically, it has been a winning strategy. For example, the chart below, taken from a Barron’s article, illustrates how the ‘cheapest’ stocks in the index have outperformed the rest of the index by an annualized rate of 4.6% per year from 1926 to 2007. Keep in mind that sometimes stocks are cheap for a reason, so this data likely also includes many poor companies which would not be considered suitable investments upon layering on additional levels of analysis. If we were able to choose only the true value stocks, the performance would likely be even better.
Behavioural Investing: Risk On, Risk Off
Although not a traditional pillar topic of Behavioural Investing, we thought that, given the previous discussion on small capitalization stocks and investor sentiment, it would be of interest to discuss how fear and greed trigger market sell offs and create opportunities for savvy investors.
‘Risk Off’ behaviour is typically categorized by a flight to safety or a fear of unpredictability. Typical causes of such scenarios are headline news stories or significantly negative data points or geo political activities. Examples of such scenarios are the 2010 ‘Flash Crash’ caused by Greek fears, or the correction earlier this year due to the Chinese stock market collapse. Fear, in these scenarios, often causes investors to sell their stocks simply because they are not sure what has happened or what will happen next. This results in lower asking prices and lower bid prices, which cascades upon itself until a crash has fully manifested. In statistical terms, Wai Lee, CIO and Director of Research at Neuberger Berman, defines extreme ‘Risk Off’ scenarios as ‘periods when stock correlations go to one’. That is, when everything within a specific group of stocks moves down directly in tandem.
‘Risk On’ behaviour is the opposite scenario, where greed and purchasing behaviour are the dominating forces of the market. Typically, these scenarios are driven by strong economic times, low interest rates (cheap capital), or when popular stock sectors are performing poorly or present limited upside.
These two scenarios are constantly in flux, and the presence of one or the other does not necessarily mean the presence of a bull or bear market. They are traditionally unpredictable and more often than not a backwards-looking descriptive measure for the performance of certain sectors. Do to their constant flux and lack of predictability, they are not reliably able to be capitalized upon in order to achieve long-term outperformance. Their existence is a result of the collective sentience of market participants, and long term investors should remain focused on company fundamentals, not market psyche. This does not mean that we should completely ignore market sell-offs, but the ability to discern a temporary shift in sentiment from a justifiable correction or bear market is an integral skill to have for a successful manager. Over analyzing all risks, or attempting to predict risk scenarios which are unpredictable, will only result in what we previously outlined as ‘choice paralysis.’
An Opportunity of a Lifetime:
Toys “R” Us Canada’s Chief Play Officer, Alex Thorne, is stepping down. Last week, Thorne performed the last toy test of his three-year career, though he will officially retire in December, according to CBC. His next calling? High school. The 13-year-old CPO said that he has to focus on his studies, but that working for Toys “R” Us Canada was “the coolest job in Canada.” The teenager received sample toys from the companies to play with and review. His other responsibilities included going to charitable events and riding on the Toys “R” Us float in Santa Claus Parades. Now, the toy company is sorting through applications for a new CPO to replace Thorne. He has already reviewed a number of videos submitted by applicants and will be present for interviews with the top-10 finalists.
“My job is to test toys. Toys R Us sends me toys; it’s my job to play with them and know what’s really awesome about them, and then I go and I do interviews and I talk about what’s awesome about the toys. I’m kind of sad that I’m leaving this job, I mean I can’t keep this job forever, I can’t hog the awesomeness of this job.”
– 13-year-old Alex Thorne, retiring from his position as Toys “R” Us’ Chief Play Officer
*Taken from Canaccord Genuity’s Morning Note
Although we like to think of ourselves as one big happy family at MacNicol & Associates, the holidays are a time where we are reminded of the importance of our actual families. Here are some notes on what our staff will be up to this holiday season.
Naima Egal will be spending her holidays with her sons in Atlanta, as well as her aunt from Montreal. Although she does not celebrate Christmas, she looks forward to the opportunity to enjoy her family’s company. She plans on taking her sons skating for the first time and show her aunt around the city.
Erin O’Connor will be spending her holidays moving apartments, as well as with her fiancé and close family.
Scott Baker will be hosting his own family dinner in Oakville with his family and daughters.
Ross Healy will be hosting his own extended family dinner, with total attendance of approximately 15. David Smith will be spending time with his girlfriend Anabela’s family on Christmas Eve and will be spending Christmas with his sons and three (!) sisters, one of whom is coming in from California.
James Winckler will be heading home to Vancouver for Christmas with his parents, as well as his brother and sister. Christmas dinners are typically a small affair, limited to only 5 people, but he looks forward to seeing his family for the first time since the summer.
Diane and Dave MacNicol will be hosting Christmas dinner this year for the MacNicol family. There will be 23 attending, 13 of which are Grandchildren. Should be a ton of fun! Afterwards, they look forward to the World Junior hockey tournament which is an annual event always worth attending.
Here’s hoping that everyone has a Merry Christmas, Happy Hanukkah and Happy New Year!
David A. MacNicol, B.Eng.Sci., CIM, FCSI
MacNicol & Associates Asset Management Inc.