How new investors can buy into an expensive market

New investors are in a tough spot: they need to build portfolios while stock indexes are setting records. But there are ways to find value in the market and build a correction-proof portfolio, too.

The Dow Jones has jumped more than 142% since March 2009. In the same period, the S&P/TSX Composite Index has leapt 85%. It’s been a boon to investors who lost in the financial crisis, but people getting in now must overcome the feeling that stocks may have no more room to rise.

Tell your clients to breathe easy, says Ryan Lewenza, private client strategist for Canada at Raymond James. “Just because the market is up big, it doesn’t mean the top is imminent.”

His analysis says the market is five years into a long-term bull cycle that could go on for another decade. So far, companies’ rising price-to-earning ratios have driven the market. In 2009, he points out, companies in the S&P 500 had an average price-to-earnings ratio of 10. Now it’s 17.5, and economic growth is picking up.

Investment options

For clients who still don’t want to invest in equities, there are few alternatives, he says. Bonds yields are low, and other investments may be either unrealistic for most clients, or correlated to traditional asset classes.

North American commercial REITs, for instance, can lose value when interest rates go up, says Michael Sprung, president and CIO of Sprung Investment Management. When interest rates increase, investors expect a higher return (meaning capitalization rate) on their properties. Higher cap rates push property values down. Interest rates are expected to rise in the next year, so these investments would lose value.

Barry Schwartz, CIO and portfolio manager at Baskin Financial, says mortgage funds are less volatile than equities because their returns are based on regular rent payments. But the drawback for an investor who’s skittish about being locked in during a correction is that private funds come with fixed ownership periods. They’re also only available to accredited investors. Publicly traded funds don’t have such restrictions, but, like all other equities, they’re exposed to market volatility, so people looking for a safer place to invest aren’t any further ahead.

Wealthy investors could turn to private equity, but that’s not practical for those with less capital, says Lewenza. Instead, he recommends clients get private equity exposure by buying the companies brokering deals, like Onyx Corporation or Brookfield Asset Management.

Most investors don’t have the capital to go outside of the stock market. And, right now, they must be selective to find equities with potential.

“This really is a stock picker’s market,” says Sprung. “We’ve been finding it much more difficult to find things we want to buy.”

But he and other experts say there are still sectors and stocks worthy of a new investor’s portfolio. For instance, as the bull market enters its economically driven phase, investors should turn to high-quality companies, says Lewenza. During the first part of the recovery, low-quality stocks can outperform, he says, because they often have the most ground to recover after a recession. “Later into the business cycle, you’ve really got to focus on high-quality stocks.”

The advisors say Canadian banks continue to be a sound investment. They’re “trading at a price-to-earnings ratio of about 13 times,” says Lewenza. “That’s a 20% discount to the overall market, considering the TSX is trading around 16.5 times.”

If the North American economy were to enter into recession, or if inflation were to spike, Lewenza says, banks wouldn’t be such an attractive investment. In either scenario, consumers would be using fewer financial services since they’d make fewer purchases and would delay buying homes.

Dividend growth is a particularly good indicator of long-term returns, as his analysis of the S&P 500 has shown. “On average, the top 20% of the highest dividend growth stocks returned 57% over a five-year period. The bottom 20%—the companies that either don’t pay dividends or are cutting dividends—declined around 36%.” The banks often pay dividends, notes Lewenza. “If the stock market were to decline, TD Bank and Royal Bank are still going to be paying a dividend of 3.8% or 4.8%, and they’re going to be growing their dividends,” he says.

Schwartz agrees dividend-paying stocks are a good bet. But, he cautions that, in some cases, money could have been better used by management. “We’ll also look for companies that use that capital in other places, such as mergers and acquisitions, paying down debts, or buying back stock.”

Returns for life insurance companies have lagged behind banks, and those companies could soon see a boost, say Lewenza and Sprung. The fortunes of those companies are tied to interest rates and bond yields. When rates rise, so should returns. The yield on the 10-year U.S. Treasury Bill bond has already gone up by more than 20 basis points this fall, notes Lewenza.

Long-term growth

For clients with long time horizons, Sprung is also looking at the materials sector. He cautions it can be volatile, but prices are lower than usual because of lower demand in China, North America and Europe.

In the long term, once worldwide growth picks up, demand for materials should also pick up, as construction and manufacturing increase. Economists say this could be months or years away. In fact, TD Economics is calling for many materials prices, including those of metals, coal and some grains, to drop further in 2015. But Sprung says HudBay Minerals, for example, should do well when commodity prices strengthen. It’s already secured financing for upcoming projects. Two mines in Manitoba have recently gone into production, while its Peruvian copper mine is expected to go into full production in 2016.

Another option is large-cap energy companies such as Suncor, Husky Energy and Canadian Natural Resources, which Lewenza says are undervalued. They’re trading at price-to-cash-flow ratios of 6 to 6.9, while the sector as a whole is trading at 8.3.

These companies have spent much of their cash flow in recent years on infrastructure for new projects. “Now you’re going to see the benefit of that,” he says. Cash flows should be much stronger in the coming years, driving stock prices up.

Sprung is concerned low commodity prices will eventually cause oil prices to drop, so he’s not optimistic. Lewenza’s endorsement of the sector is also limited: “We’re not talking small-cap energy names with a couple of wells. We’re talking about large, integrated, exploration companies.”

Buying a start-up in the hopes of a merger payoff is also a bad bet, says Sprung. “It might not happen, and the timing of an acquisition is an unknown variable,” he says. If a company isn’t an attractive enough investment without the prospect of a buy out, investors should stay away.

Despite the market’s projected security, some clients may unreasonably think their investments could evaporate in an imminent market drop. There are ways of reassuring them and protecting their portfolios if markets do decline, say the experts.

Emphasize to long-term investors that they’ll be okay, even if there’s a brief slump, as long as they hold on. “Even if your client invested today and there was a 15% pull back in the next year or two, over the next 10 years you’re still going to do well in stocks, given [the] long-term bull market,” Lewenza says.

Investing in dividend-paying stocks will also help cushion portfolios in a downturn, provided companies can keep paying out in difficult times, notes Sprung. “You’re going to have some correction in the capital portion of your portfolio, but you’re still going to be paid those dividends going forward. You can afford to wait through the period until the markets correct again.”

Sprung says he’s holding more cash than usual, just in case. “We wouldn’t be surprised to see a correction, but we don’t know when,” he explains. Should there be a decline, he adds, extra cash will be useful to buy companies they’ve been monitoring, but that are currently overpriced.

Cautious investors could also invest their principal in batches, Lewenza says, by buying into the market a chunk at a time.

Now is also a good time to choose low volatility stocks. Lewenza says a stock with beta volatility rating of one or less is best. One example is Bell Canada Enterprises, which has a rating of 0.29.

While volatility has been low in the North American market since 2012, he anticipates it will pick up after the U.S. Federal Reserve ends its bond-buying program. That’s expected to happen as early as this month.

While low-volatility stocks aren’t immune to price swings, “if the stock market goes down, they’ll go down much less.

“We don’t say, ‘Go out and buy the whole market,’ ” he adds. “We say, ‘Buy these specific areas of the market at current conditions.’ ”