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 Inc. (MAAM). I hope you enjoy this information, and it allows you to better understand what we see going on in the market place.
“Those who have knowledge don’t predict. Those who predict don’t have knowledge.” – Lao Tzu
Market Commentary: The Only Game in Town
With the turn of the calendar, we have entered into a new year, yet many of the prevailing winds which existed at the twilight of 2014 have persisted through the beginnings of 2015. Growth outside of the United States continues to be muted, resulting in volatile exchange rates and pressurized earnings for large companies which operate globally. As a result of depressed international growth, commodity prices continue to plummet globally, placing further pressure on emerging markets which rely heavily on commodity exports. The Eurozone is still an enigma, as deflation continues to threaten economic activity in the space and the Euro plunges towards parity with the U.S. dollar. The Canadian market has been materially stung by falling oil prices, causing our dollar to drop dramatically over the last six months, and giving rise to skepticism concerning near-term growth prospects for our nation, which remains heavily reliant on oil exports. The ‘wild card’ in this environment is the North American consumer, which stands to benefit from drastically lower retail gas prices and low interest rates. As consumer spending represents the lion’s share of economic activity in both the United States and Canada, a relief of pressure on consumers in regards to expenditure and debt servicing could serve to protect the western world from any dramatic downside.
As stated previously, the popular view at the moment is that the United States is currently the strongest economic environment in the world. While international markets continue to navigate through a menagerie of issues, the U.S. has seen steady improvement to key economic indicators, and the country’s key stock markets have been able to produce strong gains over the past few years. That being said, the current investing environment – even within the U.S. – remains what we have consistently referred to as a ‘stock picker’s environment’, and we continue to closely monitor key statistics which will signal whether or not the recent growth in U.S. stock markets can continue. For example, the expected 2014 S&P profit margin is 10%, which is an all-time high; while this has been a boon to stock prices, the salient question in such a situation is whether or not this trend can continue. Many believe that the answer to this question is no, since the two major contributors to elevated profit margins have been a steep decline in both corporate taxes (since 1980 down -24%) and interest rates (down -80%), with interest rates reaching rock bottom levels at this point. Another significant trend to consider is the prevalence of stock buy-backs in the U.S., as 75% of S&P 500 companies bought back their own stock during the third quarter of 2014. By returning capital to investors and lowering their share count, this has allowed companies to elevate earnings per share figures without necessarily raising notional net income. The final consideration lies in the real effects of the international exposure of large U.S. multi-national companies; an estimated ~40% of S&P 500 profits are tied to international markets, and these profits are likely to become under pressure in the near term and make large international companies less desirable.
In such an environment which was outlined previously, it is clear to us that we must favour growth stocks over value stocks. Barton Biggs, who founded Morgan Stanley Investment Management, stated that “Companies which can grow earnings and dividends in an Ice Age should be prized” and we could not agree more. Throughout our screening process, we seek to identify companies which are currently growing both earnings and sales in a sustainable manner, notwithstanding stock buybacks and other anomalies, and remain insulated from exposure to weaker international markets. It is our belief that, in the current environment, these companies will provide the strongest protection to investor’s portfolios, and will be continually coveted moving forward in a slow growth environment. The chart on this page displays the earnings growth of the S&P 500, by sector for the fourth quarter, and accurately portrays some of the sectors which we currently favour. Telecom, Health Care and Technology continue to be some of our favourite sectors. Additionally, we continue to find strong growth and opportunity within small cap companies, which are typically able to strongly outperform their large cap counterparts in slow growth environments.
Behavioural Investing: “The Perils of ADHD Investing”
For the Behavioural portion of this monthly, we dipped back into James Montier’s “Little Book of Investing” and found another extremely beneficial note, this time on ‘The Perils of ADHD (attention-deficit/hyperactivity disorder) Investing”. This concept is the fundamental principle which separates traders from investors, and is integral reading for those who believe themselves to belong to the latter group. We have always thought of ourselves, at our core, to be long-term investors, and therefore much of the wisdom to be learned from studying this phenomenon resonated with us.
ADHD Investing is used to describe those investors who are constantly trading in and out of various investments, and operate their decisions based solely on share price and valuation levels. This type of action is becoming increasingly common, which is evidenced through observing the chart below. This chart displays the average holding period for a stock listed on the NYSE, and it is clearly observable that this figure has fallen dramatically over the years. The current average holding period for stocks is somewhere around six months, whereas in the 1950’s and 1960’s, the average was closer to 7 or 8 years.
The main peril of such behaviour is a myopic view of investing which focuses on the near term, rather than the long-term. This is an important notion, as Mr. Montier notes in his book, because over a single year, the vast majority of investment gains result due to changes in valuation, or price fluctuations; in contrast, over five years, 80% of total return is related to the price you paid for the stock in relation to the growth of the underlying cash flows of the company. Because of the near-term visibility of stock-price appreciation, investors tend to favour trading in and out of stocks. Although this can look positive over the course of a short period of time, in the long-term, it is a dangerous game.
From the management side, investment managers are also affected, as they attempt to add perceived value through performing actions. Managers believe that they will have lower perceived value if they are not moving positions actively. This human instinct was illustrated through an interesting study of soccer goalkeepers. The study found that, despite the fact that penalty kick locations were fairly normally distributed across the left, middle, and center of the net, the goal keeper actually dove left or right 94% of the time. When questioned, the goal keepers stated that they wanted to at least be viewed as making an attempt, even though they would be better off staying in the middle over the long term.
The key to avoiding ADHD investing is patience, analysis, and confidence. As Warren Buffet says “Holding cash is uncomfortable, but not as uncomfortable as doing something stupid.” Valuation metrics and price fluctuations are useful for determining entry points or managing portfolio weightings, but the initial decision must be firmly rooted in extensive analysis and confidence in the business model over the long-term. At MacNicol, we utilize these tactics in order to maintain our reputation as long-term investors, and seek to minimize unnecessary trading activity.
We would like to expand upon our earlier comments about some newer members to our team. Erin O’Connor grew up in the Toronto area and attended University in Thunder Bay where she focused her studies on Sociology and Education. Since then, she has gained a strong background in relationship management, marketing and administration which she brings to the MacNicol & Associates team. Erin is also an active volunteer and is currently a Board member with Resources for Exceptional Children and Youth- Durham Region and is also a member of the Organizational Team with Frontier College; two causes Erin feels strongly about. In her spare time, Erin enjoys baking and doing yoga.
Recently, David Smith joined MAAM. David has over 15 years of experience in the financial services industry. He has held positions as Regional Sales Director with several large mutual fund companies and more recently with a real estate operating company that specialized in U.S. multi-family real estate. David has a broad understanding of the investment industry, as he has worked directly with individual investors, investment advisors and portfolio managers. He has always been committed to helping his clients find the right solutions for their needs, and he brings that same dedication to MAAM. David is the Father of three sons, the oldest of whom just turned 16 this month. His family just recently moved to a new home in Burlington.
David A. MacNicol, B.Eng.Sci., CIM, FCSI
MacNicol & Associates Asset Management Inc.