Growth Portfolio and American Growth Portfolio Commentary
People buy investments for all sorts of reasons. As strange as it sounds, I’ve found that making money is not always at the top of the list. Everyone will tell you they invest because they want to make money, but often the real reason can be something different. Some people buy investments because their friends and neighbours are buying them. Some buy for a rush of excitement. Some buy to fulfill the wishes of someone else. Some buy because it gives them a feeling of control over their destiny. Some people buy out of altruism -- they feel a certain company is changing the world for the better. But if you buy a stock for any reason other than its value, it’s not investing.
The reason I bring this up is because I’ve noticed some interesting data recently about people doing strange things with their money. Particularly, I mean that people are buying index funds at a rate never before seen in history.
First a quick review: index investing (also called passive investing or benchmark investing) is when an investor’s portfolio is directly tied to that of the whole market. Indexers believe that earning a better return than the market is impossible, if not too hard to bother with, so they favour earning the market’s average return over time. The premise is that if you can hang on through the highs, and the lows, then you get the long term average return. Indexers buy exchange traded funds (ETFs) or mutual funds that directly track the largest stock indices. Looking inside these ETFs and mutual funds, you’ll see that the largest company holdings are held in proportion to their size in the market (geek speak: market capitalization). So indexers hold lots of the largest stocks in a market, and little to none of the other stocks in a market. Because of this, indexers tend to participate in a momentum effect, holding increasingly large positions of companies that everyone who came before them already bought.
In contrast, active managers apply investment strategies or techniques in an attempt to perform better than the general market. Some try to earn a higher return, some try to minimize risk, and some try for both.
Active managers and indexers have been in an eternal struggle since the first Investment Trusts were started in the 1920s. The chart below compares the performance of actively managed funds in the US to a passive investment in the broad US index over the last 50 years. When the blue lines are high, actively managed funds are doing better than the index. When low, the index is doing better than most active investment managers. Over the last five years, index portfolios have been winning out over most active managers.
This chart illustrates two important points. First, we recognize the cyclical nature of active/passive style over short time frames. We tend to move in broad multi-year cycles of one style leading the other. Second, and more importantly, this chart illustrates that only 10% of active managers did better than the index in 2016. That compares to other historic lows in 1999, the late 1980s, and the mid 1970s (red arrows). Each of those arrows marked the start of long periods of outperformance for active strategies. Although I cannot find a comparable chart for the Canadian market, it would be reasonable to believe it looks similar. And yes, the Growth Portfolio finds itself in the minority of managers outperforming the index over the last five years (12.3% average return per year vs 4.3% per year from the TSX Index).
Based on the chart above, if we believe that active strategies might outperform the general market going forward, the next question to ask would be what type of active strategy could work best? Broadly speaking, active strategies can be divided into two groups. One group would buy “value” stocks (those with low price-to-earnings/book value/revenue multiples), while the other group would buy “growth” stocks (those with high price-to-earnings/book value/revenue multiples). Typically, value stocks have a reputation for being cheap, unloved, and discounted, while growth stocks are the most popular, broadly followed companies.
The chart below compares the relative return of global value stocks and global growth stocks since 1984. When the blue line is moving higher, value stocks are performing better, and when the blue line is moving lower, growth stocks are performing better.
This chart illustrates two important points. First, the relationship between growth and value is cyclical, in context of value performing better than growth over the long term. Second, we see that growth stocks have performed dramatically better than value stocks from 2009 to present. It also appears, starting in the final months of 2016, that the tide is turning in favour of value, away from growth. While it’s too early to tell how long this lasts, it would be reasonable to expect, based on reversion to the mean, that value stocks stand a good chance of outperforming over the years ahead. That would bring value back in line with its historic better-than-average performance.
So if we expect active to outperform passive, and we also expect value to outperform growth, then it stands to reason that value investing is likely to outperform the general market over the years ahead. It also stands to reason that expensive growth stocks today comprise most of the passive index. In simple terms, this means that the cheaper value stocks being ignored by investors are likely much safer investments than the most popular stocks loved by investors. While it sounds rather common sense to say that cheap stocks are safer than expensive stocks, this idea is directly at odds with the prevailing trend towards indexing, whose buyers increasingly own greater amounts of expensive stock.
With that in mind, I return to my first point. If you’re not investing on the basis of value, you’re not really investing at all. As a matter of conjecture, I believe indexers tend to focus mostly on the upside of risk by putting too much faith in a safety-in-numbers approach. While herding worked as a survival mechanism thousands of years ago, it is not a useful skill in a market-based economy. As for value investors, they tend to focus mostly on the downside of risk by trying to reduce what they might stand to lose. I’ve found that if you spend time managing what you stand to lose, the upside tends to take care of itself.
It is reasonable to believe things might continue on the current path for a while. It is also reasonable to believe a renewed preference for value is already underway. The ability to accurately time when the psychology shifts from growth to value is unknowable (not just by me, but anyone). Regardless of when this happens, we can be assured it will happen. The balance of history is on the side of high quality companies purchased at cheap prices – in other words, value.
Income Portfolio Commentary
We noted in last month’s review that we were becoming sceptical of the US Dollar’s ability to continue trending higher. Our systematic investment process supports this outlook, and so this month we will take additional steps to reduce our exposure to US companies. We will sell our US dividend ETF at a good profit. We will reduce risk by investing the proceeds in a Canadian dividend-growers ETF that will boost overall portfolio income, as dividend rates are higher in Canada than in the US at this time. We will keep a small holding of US dividend payers for now. Our currency exposure is now fully hedged (our holdings will not be affected by shifts in the foreign exchange rate). On the whole, after a year spent abroad, we are now slowly returning to a preference for Canadian dividends, offering higher yields and more cheaply valued than foreign counterparts. There is no place like home.
We will continue to manage the Income Portfolio to preserve capital, grow conservatively and reduce risk.
- Interview with Ray Dalio, leader of hedge fund Bridgewater: https://www.youtube.com/watch?v=D3IUmpV-egY
- Lower quality stocks are up and away: http://blog.gavekalcapital.com/?p=12540
- Want to improve your forecasts? Think in non-linear terms: https://25iq.com/2017/01/13/why-is-it-so-hard-to-forecast-the-future/amp/
- Mohnish Pabrai (the fellow who bought lunch with Warren Buffett) talks about value investing: http://acquirersmultiple.com/2017/01/mohnish-pabrai-value-is-its-own-catalyst-the-market-is-a-weighing-machine/
- House prices, in context: https://pbs.twimg.com/media/C1vFGoFW8AA4xgp.jpg
As always, please let me know if you’d like to chat about financial planning, long term investing, and other investment opportunities.
Ben W. Kizemchuk
Portfolio Manager & Investment Advisor
Altus Securities Inc.
55 Yonge Street, Suite 1100