Consider
small caps, overseas stocks, and hard assets
While last
week’s article reviewed and evaluated past recommendations, this week I’ll
provide some suggestions on portfolio positioning for the year that lies ahead.
I’m not suggesting it’s a good idea to make major shifts in portfolio exposure
– that’s flat out market timing. Rather, I’m suggesting making subtle shifts in
some components of some portfolios, to improve diversification and hopefully
boost returns.
I’ve just
published a report for our firm’s financial advisors and discount clients about
the opportunities remaining in small cap stocks, particularly those in Canada.
Some would attribute this recommendation to “performance-chasing”. While it’s true
that small cap stocks have outperformed their larger counterparts over the past
year, smaller companies remain fundamentally more attractive. In Canada, not
only do smaller companies offer greater growth at a lower price, but they also
carry less debt than larger companies. In fact, capital markets forced them
into shape – call it tough love.
During the
latter part of the 1990s, when the market’s infatuation with large caps really
blossomed, it became tougher for smaller companies to get access to capital.
Venture capital investors catered to the specialty class of small private
companies, while the public markets were in the throws of a love affair with
large cap stocks that were tapping into high growth segments. However, the
small and mid cap segments of the public markets became neglected. Whether it
was a bond issuance or a public offering of shares, smaller companies were seen
as risky compared to their larger counterparts (unless they were hot tech
firms). Tight access to outside expansion capital forced many smaller companies
to get lean and mean to facilitate more organic growth.
After
completing a study on small caps and speaking with many managers, the top four
of the eight Canadian small cap funds I recommend include Mawer New Canada,
Standard Life Growth Equity, Beutel Goodman Small Cap, and Trimark Canadian
Small Companies. Those interested in other small cap funds should look for
funds with reasonable fees, low turnover (look in the prospectus), and between
$20 and $400 million in net assets.
Throughout
the 1990s, the United States lead both the economic boom and the stock market
race – compared to nearly every other developed nation. As a result of the
economic slowdown, the huge write-offs taken by U.S. firms, slowing earnings,
and the strong recent returns, U.S. stock prices are at very high levels, when
measured in traditional ways. Looking back over the past 75 years, the median
price-to-earnings ratio (P/E) for the S&P 500 lies between 14 and 15. Lately,
the ratio has been between 45 and 50. In other words, investors buying the
S&P 500 stocks (i.e. through an index fund) are effectively paying $50
today for each dollar of last year’s profits.
That figure
of 50 times profits is a bit clouded by the fact that many large tech firms
have been taking big hits to their earnings due to bad acquisitions, resulting
in an overly dramatic fall in profits this year. (Be aware that taking a big
hit all at once sets the stage for potentially misleading big earnings growth
in many firms’ next financial reports.) However, the index remains on the
expensive side of history, and remain more expensive than many foreign
developed regions, such as Europe, on that same basis.
This was
the message delivered by John Arnold, global money manager for AGF Funds, in a
recent meeting in Toronto. He says long-term profit growth in both the U.S. and
Europe has been nearly identical but that the U.S. market has far outperformed
it over the same period. The result, according to Arnold: The best relative value opportunity in over
twenty years, as European stocks trade at much cheaper levels.
Some of my
favourites among overseas stock funds include Mawer World Investment, AGF
International Stock, Templeton International Stock, and Spectrum European
Growth. The first three are broad based large cap overseas stock funds, while
the Spectrum fund is a small cap European fund.
Hard
assets, like natural resources, precious metals, and real estate, are an important
long-term portfolio component. They provide some inflation protection, have
risk-reduction characteristics, and offer some protection against inflation.
Many managers maintain that gold continues to be undervalued and natural
resource should generally pick up when the economy starts revving its engine.
While I
wouldn’t hold a larger than usual amount in such funds, some longer-term
exposure remains a prudent idea. Some of the better hard asset funds include
Dynamic Global Real Estate, Standard Life Natural Resources, Mackenzie
Universal Canadian Resources, Royal Precious Metals, and Mackenzie Universal
Precious Metals.
As
mentioned previously in this space, I expect interest rates to at least start
heading north sometime over the next twelve months. Particularly if you buy
into the fact that even a moderate recovery will get underway, interest rates
are bound to rise. When rates rise, conventional bonds suffer price declines.
While I
wouldn’t advocate changing the amount of fixed income exposure, perhaps it’s
time to review the composition of this component. In a rising rate environment,
cash tends to do well. In a mutual fund context, I’m talking about money market
funds, which invest in treasury bills (i.e. government bonds with maturity of
90 days or less) and short-term corporate debt with similarly short terms.
Another way
to insulate your portfolio from rising rates and inflation is to have some
exposure to real return bonds (RRBs). RRBs are issued by the government of
Canada but offer a maturity value and interest payment that move along with
inflation. There is one fund investing exclusively in RRBs but with a MER of
1.7 per cent annually, I wouldn’t recommend it.
This week’s
advice isn’t to be interpreted as recommending big tactical shifts in
individual strategy. Only an in-depth review of individual goals and
constraints (perhaps with the help of a qualified advisor) can properly assess
the necessity (or lack thereof) of such a shift. Rather, this week’s advice is
meant to give readers food for thought regarding potential subtle shifts in the
context of current strategies, based on my expectations for the year ahead. For
some it will fit; for others it won’t.
Dan Hallett, B.Comm., CFP, CFA is Senior
Investment Analyst with Sterling Mutuals Inc. He can be reached at dhallett@sterlingmutuals.com Sterling Mutuals Inc. is registered as a
mutual fund dealer in Ontario, British Columbia, and Manitoba.