Most investors remained calm during recent sell-offs in global equity markets, with a September 2015 CIBC poll finding 77% chose to stay in the market.
Waiting to get a better read on opportunities can be a smart move, says Colum McKinley, portfolio manager and vice-president of Canadian Equities at CIBC Asset Management in Toronto. After all, over the last 50 years, the average rate of return for buying, holding and reinvesting the dividends of the S&P/TSX Composite Index was 9.7%. (See “Long-term returns for buy-and-hold domestic investors”.)
But when markets dipped and peaked over that period, there were opportunities to adjust portfolios. For example, prior to the tech crisis in 2001, investors were “overly optimistic and market returns were as high as 15.6%,” says McKinley. “At that point, advisors could have reduced exposures to improve overall returns and take advantage of price volatility. I’m also an advocate for tactically adding to equity exposure when fear is at its highest.”
We spoke to experts for tips on how to strategically boost your clients’ portfolios. McKinley is an equities manager; Tom O’Gorman, a senior vice-president and director of fixed income for Franklin Bissett Investment Management in Calgary, manages bonds. Advisor Jolene Laing is an associate portfolio manager at Scotia McLeod in White Rock, B.C. Each expert favours active strategies.
Q: When does buying and holding make sense, and when does it not?
O’Gorman: Many experts think buying and holding never makes sense in the midst of volatility. But, when an investor leaves the market, the question becomes whether he can get back in when markets gap higher. Consider what just happened in North American credit markets: in October, there was a big rally and November was quiet. Then in December, the market was more illiquid than normal because it was the end of the year.
Also, a distressed-debt mutual fund in the U.S. announced it was closing its doors to redemptions and people started selling. Then, oil cratered in January, and liquidity, rather than the underlying values of bonds, was driving price in credit markets. More people were selling than buying and, overall, things got really cheap due to negative sentiment. But, going into March, markets gapped higher.
For example, a Cenovus investment-grade bond that had two investment-grade ratings, but that Moody’s had downgraded to junk, gapped higher by 10 points in only one or two days. A retail investor likely wouldn’t have been able to catch that sudden shift if he’d gotten out of that bond, or a fund that held that bond.
Still, active management is all about looking for opportunities strategically. I’m always in the market because cash pays nothing, but I can shift positions tactically and I look at metrics such as the VIX. And, there are similar volatilty measures for the income market, such as the MOVE index. [Editor’s note: The MOVE index measures bond market volatility by looking at options contracts on one-month Treasury issues.] We try to avoid an excessive turnover rate but, that said, you can have a lot more positions and higher turnover in fixed-income portfolios than in equities portfolios.
For example, our equity partners might have 40 or 50 positions in their portfolios, while we may have 200. One reason for this is liquidity; you can’t buy just one Royal Bank bond when you want to add exposure to the bank. There may be 40 different issues and, to build your position, you may have to buy three or four of them. Also, we don’t concentrate our portfolios as much as equity managers because we like to diversify across the yield curve.
Laing: In particularly volatile times, I have the odd conversation with a client who’s really worried and thinks we should sell everything. I run a discretionary portfolio, but I’ll calm such clients by going through their portfolios on a position-by-position basis. This alleviates a lot of stress. So, buying and holding makes sense in a lot of market environments, especially if you’ve built a good, balanced portfolio.
But I don’t believe in a simple long-term buy-and-hold strategy because there are ways to mitigate risk in the short term. This includes sitting on a bit of cash or choosing to get out of one sector completely to more heavily weight another. To decide on when to do this, I look at the upper and lower limits of where a stock has traded over the last 12 months.
If I’m looking at a stock that’s trading at or near its 12-month high, that’s a potential exit point. Alternatively, I could use covered calls, where you own the underlying security but where you’re getting paid a small premium to write a call option on it. As a result, you’re still capturing some of the upside, but are limiting that for a small premium. I also use strategies like putting stop-loss orders on positions if I expect the market to turn south.
Q: Where have you found fixed-income opportunities in the current low-interest-rate environment?
O’Gorman: Credit is really cheap right now. The 10-year Canadian government bond has traded as low as 1% and, as of the end of March, the year-to-date average was 1.22%.
So, when you compare that with solid investment-grade bonds that have coupons of more than 4%, it’s obvious that investment-grade corporate bonds are where you’re supposed to be; their spread provides a ton of cushion against changes in interest rates and volatility in general. Plus, when I looked at the ratio of corporate spread as a percentage of yield in February, it was more than 70%, and we were finding a lot of bonds where the ratio was as high as 85%—those were five-year bonds.
Currently, we’re overweight energy and REITs, and have a modest allocation to high yield. In particular, we like Canadian investment-grade energy, including Canadian Natural Resources, because these bonds got way overdone in terms of spreads widening. We also like pipelines and U.S. investment-grade bonds such as non-energy, high-quality hospital companies that have done well.
Q: Regarding equities, where are you finding opportunities that can outperform while not contributing outsized risk?
Laing: I converted a lot of my domestic equities into U.S. equities when the loonie was worth US$0.95. This was in late 2013 through mid-2014, so I’m excited about unwinding those trades. I’m maintaining a lot of U.S. and global equity positions, but am doing so by buying back positions in managed products. I don’t use ETFs, but have been using some currency-neutral mutual funds.
I’m also actively trading my positions in stocks I love, such as BCE, which I bought back in December 2009 at around $28 a share. It was around $59 in March and, based on its 52-week data, I find it tends to top out at that level and then drop back to around $50. I usually will take profit by cutting back 25% or 30% of the position at $58. Then when it drops back down, I’ll buy it back between $52 and $54. In a given year where BCE might go up 10% and have a 4% dividend yield, for a total return of 14%, my clients might actually have made 22% or 23% off of BCE. That’s because we actively trade small portions.
McKinley: In all my portfolios, I hold CN Rail; it’s a premier Canadian company. But, there will still be opportunities to add value by using volatility to our advantage and recycling capital. Looking at CN Rail over the last year, there have been about three times where it sold off and subsequently recovered, and each time we added to our position when it was low.
At the end of January, for example, it dropped to around $70 and then, as of mid-March, it was back to $80. But the earnings power of this holding doesn’t change, even though the stock price falls and then rallies. Our view is that CN Rail will continue to be the centre of freight activity in North America, which will drive its earnings power. Even if the economy continues to slow, we’ll look through that.
We’ve also added to our REITs exposure. In February, many REITs offered above-average dividend yields while trading at valuations well below their historical averages. People became fearful about cyclical risk based on what’s happening to the Canadian economy. So, we examined the true financial exposures of these companies, such as their leverage and underlying assets. We found we like REITs because they’re backed by hard assets. There could be some short-term cyclicality and volatility, but they’ll remain intact over the long term.
For example, we’re a large shareholder in Dream Office, which cut its dividend on February 18, when it announced it was reducing its monthly distribution to $1.50 per unit (from $2.24) on an annualized basis to reflect a more conservative payout ratio. The company does have some exposure to Western Canada, but had been trading as if all its exposure was to that region. The stock moved from $15 to nearly $21 after its decision to cut its dividend—a 40% improvement in valuation.
Q: What investments should clients be cautious on now?
O’Gorman: We’re cautious on anything consumer-related in Canada because of high indebtedness and the over-stored state of the retail space.
Laing: The benchmark for my portfolio mix is 40% fixed income and 60% equity, but fixed-income returns are so low right now. Over the last year, I’ve been slightly underweight in fixed income, with my allocation at about 32%; I have 5% or 10% in cash and the rest has been in equity. Even though I’m running a conservative discretionary portfolio that targets returns of 6% net of fees, I can’t get 6% with 40% of my portfolio making nothing.
Also, I don’t have a lot of direct investment in oil right now. I’m avoiding the sector because I don’t think there’s any real near-term catalyst to turn oil prices around. Plus, most energy companies (i.e., the actual producers) don’t have dividend yields that are high enough to fit my mandate. Generally, I work with a dividend mandate of a 3.5% minimum, but most companies I own have dividend yields of more than 4%.
Further, I took a big loss this past year in Crescent Point Energy, since a lot of my clients owned this dividend-paying security. It was the only oil play I had in my book and I got stung because I added to my position when it was $42 in 2014. It dropped to around $15 in December 2015, but I fortunately sold when it was around $20 in October. I bailed when the company started cutting its dividend since it no longer met my mandate.
McKinley: Financial risk is one of the key things that people should avoid right now, especially in cyclical stocks, such as energy. We’re paying more attention than normal to the amount of financial leverage these companies have. We’ve aggressively moved our portfolios into the highest-quality energy companies, including Suncor and CNQ. And, even with these companies, we analyzed the amounts of financial leverage they have and the maturities of their financial debts to determine whether there was risk of the companies running out of liquidity. Still, there will be opportunities in the energy space, given we’re seeing the early stages of higher energy prices for 2017.
Originally published in Advisor's Edge Report
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