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Investing for the Long-Term

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Long term investingOne of the things that often frustrates investment clients is the language used by investment professionals when markets go down. While the terminology is meant to soften the blow or put the current situation into context, the client is often left annoyed and confused. To help bridge the gap in understanding, I want to explain one of the main terms that you are likely to hear over the next few weeks, “investing for the long-term” or having a “long-term focus,” and why this is the perspective that clients should take during times like these.

Bull and Bear Markets

During bull markets (when stock markets are moving higher), the economy is typically growing, people are seeing their employment prospects and income increase, their assets (home and investments) are rising, so investors and corporate managers feel optimistic about the future.

The stock market is supposed to be priced on a forward looking basis. This means that the price of a stock is supposed to reflect future earnings and cash flow that the company will generate. In fact, one of the main valuation methods used is the Dividend Discount Model – a stock’s price is calculated based on future dividends investors expect to receive. During bull markets these forecasts are rosier, so higher stock prices are justified by assumptions of high growth in corporate earnings. In addition, because everyone is optimistic and does not want to miss out on the perceived easy gains, they are willing to pay higher and higher multiples to buy today.

During bear markets, as we are currently experiencing, everyone thinks of a worst case scenario. They assume that the expected economic downturn will remain for a very long period and often cannot foresee the inevitable recovery that takes place months later. As a result, they assume earnings will drop dramatically and stay low forever and therefore heavily discount the price they would be willing to pay for the same stock that only months ago they thought was a great purchase at a much higher price. In this environment, the emotion of fear and worst case scenarios are exacerbated by the negative news reports, leading many people to just want to exit the stock market no matter the price. Consequently, nearly all stocks and other risk assets (REITs, preferred shares, corporate bonds) drop in price regardless of the stability of their business model, their financial strength or if they had a reasonable valuation prior to the panic.

While I believe we are likely to have at least a technical recession in Canada (2 quarters of negative economic growth) and I think the number of cases of coronavirus and its associated stresses on the health care system and the economy, is likely to get worse in the short-term, this is the period where a long-term perspective is necessary.

What Is a Long-term Perspective?

Your investment portfolio is designed to grow not only until you reach retirement, but also to generate income (or dividends) and capital gains that will support your lifestyle in retirement. Given current lifespans, this could be 20-40 years and even possibly the lifespan of your beneficiaries, so your portfolio has a very long timeline. During periods of market declines bargains start to appear that can lay the foundations for ensuring that your long-term goals are met. I will provide a few examples below.

Canadian Banks

One of Canadians favourite pastimes is to complain about the record profits of the banks and their high service charges. Over the past few weeks, investors have only seemed to care about the risk to these banks’ loan portfolios due to the increase in credit provisions for bad loans or reduced capital market activity that occurs during recessions. Bank of Montreal (TSX: BMO) recently dropped over 40%. As a result, on Thursday, March 12th, it was offering a dividend yield of over 7% and was trading at an earnings multiple of only 7 (historical average is closer to 12 times earnings). While it is quite likely earnings will decline in the near-term, considering that the Canadian banks have an oligopoly on the Canadian financial markets and highly diversified asset bases (wealth management, lending, international operations), it is highly likely that in just a few years, if not sooner, Canadians will once again be complaining about their record profits, which will be reflected in higher share prices. On Thursday close, most of the Canadian banks were offering similar bargain prices, e.g. Bank of Nova Scotia was trading at 7.7 time earnings with a 6.7% yield. TD was trading at 8 times earnings with a 5.9% yield and CIBC was trading at 6.7 times earnings and offering an 8.4% yield. Buying in this environment provides a high current yield and likely capital gains in the future.

Pipelines

There is no question that Alberta and Saskatchewan are feeling real pain once again due to the massive price drops in oil prices from the expected economic slowdown and the game of chicken being played by Saudi Arabia and Russia, but only a few months ago the media was complaining about there not being enough pipeline capacity to handle all of the Canadian oil and gas production. In addition, hundreds of thousands of barrels of current production is being handled by higher price and less safe railway network – if there are near-term cuts, this is where it will likely come from. As a result of the current fear, Enbridge Inc. (TSX: ENB) had dropped over 35% and at end of day Thursday was offering a yield of over 9%. Enbridge has numerous projects expected to come on-line in the next few years and has provided guidance that it intends to raise its dividend each year into the near future. Other pipelines, such as Interpipeline (TSX: IPL), Pembina (TSX: PPL), TransCanada (TSX: TRP) have had similar and in some cases larger price declines with some of these companies offering current dividend yields of over 10%.

REITs

One of the more stable asset classes for income oriented investors in the past few years has been Real Estate Investment Trusts (REITs), which are actively managed portfolios of real estate holdings. Over the past few weeks, REITs have not been immune to the drop in the stock market, even though the real estate market is holding up well. As a result, many REITs have dropped 30% or more, offering compelling opportunities. For example, Northwest Healthcare (TSX: NWH.UN), which is a global REIT focused on health care related real estate (hospitals, doctor’s offices, etc.), recently saw a price decline of over 25% despite recording record profits just last week. The net asset value of the REIT’s portfolio is estimated at $13.17 per unit (35% higher than current trading price), its occupancy rate is 97.3% and the average tenant’s lease term is 14 years.1 The current yield is 8.3%, which is fully covered by the REITs cash flow. Many other REITs have seen price drops of 30% or more in the past week despite excellent fundamentals, strong management teams and a portfolio of real estate assets that would make institutional investors like pension plans salivate.

Preferred Shares

This is an asset class that is a hybrid security, meaning that it has some attributes similar to stocks and some similar to bonds. Preferred shares trade on stock exchanges, like stocks, but preferred share investors receive priority vs. equity holders in terms of dividend payments and capital protection. Unfortunately, they are also typically less liquid than many stocks and as a result do not have a lot of institutional ownership, but that also means they can and presently do trade at compelling prices. Enbridge Preferred Share Series D (TSX: ENB.PR.D) recently experienced a 35% price drop. This preferred share is a fixed rate reset, meaning that it pays the same dividend rate for 5 years and then that dividend rate is reset based on the yield of the 5 year Government of Canada bond plus a spread. As of Thursday, March 12, it was offering a dividend yield of over 11%. There is the risk that the dividend rate will be reset lower at its next anniversary date, but to put this in perspective, that date is 3 years into the future. Prior to the reset date in March 2023, an investor buying at Thursday’s closing price of $10.50 would receive $3.48 in dividends prior to the reset date and the new reset rate based on current yields would be 7.26%, still pretty high. Based on the recent price drops in the market, investors can currently buy rate reset preferred shares offering yields similar to the Enbridge example above and perpetual preferred shares, which consistently pay the same yield forever at yields of over 6%.

The Long-Term Perspective

While equity markets are likely to be volatile over the next few weeks to months and could even potentially go lower than Thursday’s lows, investors can find bargain investments similar to the ones listed above to help secure their financial future and long-term goals. For example, a one million dollar portfolio invested into some of the securities listed above would result in an annual income stream of over $70,000 plus the potential for significant price appreciation when markets return to normal. Considering that most financial plans are based on an average return of 4%-6%, this is the environment, despite the massive fear, when investors need to remain calm, not be forced sellers, and remain focused on that long-term income stream they want to support their future lifestyle.

During this period, the greatest skills your financial advisor can have are to remain calm, use a rational mind to assess the situation and clearly communicate with clients to relieve their anxiety and fear. The greatest asset a client has is time – the time to withstand this period of weakness to build a strong portfolio offering a high level of income and potential for growth.

[1] https://web.tmxmoney.com/article.php?newsid=6210584082240133&qm_symbol=NWH.UN.

 

Lorne Zeiler
Written By:
Lorne Zeiler, CFA®, iMBA
Senior VP, Portfolio Manager and Wealth Advisor
lorne@tridelta.ca
416-733-3292 x225

TriDelta Investment Counsel Q3 Review – US Government Battles – What Now?

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As we write this, the US government is locked in a battle around whether to increase its debt limit. Some government workers are taking a forced vacation, and if agreement is not reached by the October 17th deadline, the US could default on its debt in the week or two after that date.

Our general approach has been to be a little cautious heading into Q4, with higher cash weightings (approximately 10%) and even a purchase of an inverse ETF (we bought an ETF that will go up in value if the US S&P500 goes down in value).

We anticipate that the fear factor will build over the month as CNN and Fox News focus on an ‘impending’ US default that we believe to be highly unlikely.

We also anticipate that the height of this fear will likely create short-term market pullbacks that will be a great time for us to buy some cheap stocks.

Traditionally, November, December and January have been some of the best months of the year for the market, and we see a decent rally coming off of the almost inevitable decision for the US to raise their debt ceiling, and stave off a default… at least until the next debt ceiling deadline sometime in 2014.

Review of Q3

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As we review the third quarter of 2013, the numbers showed stable to solid stock performance and flat to negative bond and preferred share performance.

TriDelta clients had net gains in the range of 1% to 2.5% over the quarter (annualized at 4% to 10%).  Clients with a greater growth focus (higher stock weighting) were closer to 2.5% and those with more conservative goals (higher bond weighting) were closer to 1%.

In the North American stock markets, we saw Canadian stocks outperform the US by over 3% in the quarter.  This was the first quarter in quite a while where Canada outperformed.  There is certainly some belief that metals, mining and energy stocks are undervalued at the moment, and have an opportunity to outperform other parts of the market – although the timing of this remains to be seen.

Weakness continued on the Utilities and Telcos front vs. other sectors.

Our best performing holdings in the quarter were:

  • Home Capital up 30%
  • Priceline up 19%
  • Suncor up 19%
  • Two strong purchases this quarter were Goodyear Tires and Transcontinental – both up 17% so far.

Our worst performing holdings in the quarter were:

  • Potash down 17% (we decided to sell the stock after the market closed but before the announcement that the Russian potash cartel was dissolving – unfortunately by the time the market opened the stock had already fallen)
  • Trilogy Energy down 17%

Dividend Changes

Given our focus on dividend growth, we report on all dividend changes in the quarter.  Once again there were no declines in dividends in any of our holdings, while a few companies did have a dividend increase.

 

Company Name % Dividend Increase
Home Capital +7.7%
Royal Bank +6.4%
McDonalds +5.2%
TD Bank +4.9%
Norfolk Southern +4.0%
Bank of Nova Scotia +3.3%
Verizon +2.9%

 

Goodyear Tires initiated a $0.05 dividend that pays on Oct 30, 2013 after not paying a dividend for many years.  This puts its yield at a little under 1%.

On the bond front, we continued to outperform the bond and preferred share indices, but net returns were very flat over the quarter, with weak returns in July and August, and some recovery in September.

With preferred shares, we saw a tale of 3 stories in the quarter.  Somewhat surprisingly, rate reset preferred shares index lost 1.5% in the quarter, floating rate preferreds lost 1.8%, while fixed rate preferreds were actually up 0.2%.    We have taken a little heat for being overweight fixed rate preferreds, but given the view of short term rates holding for at least another 1 to 2 years, floating rate preferreds make little sense at the moment.  We also believe that 10 year interest rates will be trading in a range for a while, which will likely put fixed rate preferreds at a slight advantage.

It should also be noted that 10 year Government of Canada interest rates actually declined a full 25 basis points (0.25%) in late September.  We feel that this is a real sign that long term interest rates are unlikely to rise in the near time and there will likely be several opportunities for gains in bonds as rates wax and wane.

What we see in Q4

  • We remain cautious in the very near term as the US government politicians play ping pong
  • We will look to add stocks on pull backs
  • For now, we will keep the short S&P ETF
  • Valuations are fair overall, but are a little stretched on some of the less cyclical names (utilities, telcos, etc.) leaving greater opportunity in the cyclicals (financials, metals, consumer discretionary) as long as the economy doesn’t stall out.

Our worst case scenario for the US government is actually quite positive for bonds.  While we believe it is very unlikely that there will be a lengthy government shutdown and extremely unlikely to see a default, given the fragility of the current economic rebound, it would not be a stretch to even consider the possibility of a quick dip back into the recessionary zone.  The last government shutdown occurred in 1995/96 during an episode of better economic circumstances, and had essentially negligible economic impact, but long-bonds rallied.

In the short term we believe that US economic fears will lead to delays in US bond buying tapering and push off any risks of interest rate increases.

Summary

The markets move on fear and greed.

Fortunately, in the world of 2013, we can count on the media to intensify both of those emotions when the time is right – although the media does ‘fear’ much better.  We believe that by keeping our emotions in check, there will be opportunities to take advantage of this media enhanced fear.

We believe that October may be one of the best examples of this.

 

TriDelta Investment Management Committee

Cameron Winser

VP, Equities

Edward Jong

VP, Fixed Income

Ted Rechtshaffen

President and CEO

Anton Tucker

Executive VP

Lorne Zeiler

VP, Wealth Advisor

 
 

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