In 1999, the Canadian stock market benchmark, the S&P/TSX Total Return Index, was up 32% and the cumulative five-year return was 118%. As of mid-November 2018, the comparable one-year and five-year return figures were -2% and 30%, respectively. Why then are we comparing the recent period to the late 1990s? It’s what was going on beneath the surface, among individual stocks, that makes the current environment feel similar. There were a high number of exasperating stocks back then, just like there are today.
Although the hypothetical, all-equity Odlum Brown Model Portfolio’s returns were decent in the latter part of the 1990s, and considerably better than they have been recently, it was a frustrating time. Clients were understandably restless because we owned many underperforming stocks. The Model returned 11% in 1998, considerably better than the 2% loss in the Canadian equity benchmark index. Yet at year end, 17 of the 38 stocks – 45% of the Model Portfolio – were below our cost base. It’s natural to feel uneasy about poorly performing stocks. The feeling is even worse when other stocks in the market are doing well. That was certainly the case in 1998, with the U.S. equity benchmark up 38% and U.S. Information Technology stocks up more than 90%.
Sentiment regarding the Canadian market was so depressed that we issued a Special Report in March 1999 titled “Don’t Give Up on Canadian Stocks.” Although the Model appreciated by a satisfying 19% in 1999, clients were understandably unsettled because that average was achieved with many laggards and a couple of big disappointments. Moreover, clients were upset that we didn’t own Nortel Networks, the driving force behind the Canadian market’s 32% gain that year.
Patience paid off in 2000 and 2001. Many of our out-of-fashion and depressed investments came roaring back to life; the Model appreciated by 70% over the two-year period, as the Canadian and U.S. equity benchmarks declined 7% and 13%, respectively.
We reflect on the past to make five important points:
- Portfolios will always include a few disappointing investments, in good times and in bad.
- Disappointing investments will always feel worse in tough markets.
- It’s the batting average that matters – whether returns from successful investments outweigh those that disappoint – not how each individual stock performs.
- Diversification is important. It’s impossible to know which stocks/sectors will perform best in the short term. It would have been wonderful to have been concentrated in technology stocks in the late 1990s, yet disastrous to have held the same positions into the next decade when they crashed.
- A disciplined and patient approach yields satisfying results in the long term.
As of mid-November 2018, 14 of the 44 stocks in the Model Portfolio are below our cost base – roughly one third. For the year-to-date, the split between appreciating stocks (24) and depreciating stocks (20) is roughly even. Indeed, in many respects it feels like it did in the late 1990s.
But it also feels different. It was a two-tiered market back then. Technology and U.S. blue chip stocks were very popular and expensive, while almost everything else was neglected and cheap. Today, that’s not the case. There isn’t a mania in any sector, with the possible exception of Canadian marijuana stocks. Without mania-fueled sentiment, the overall market isn’t expensive. Odds are good that the major North American equity benchmarks will continue to trend higher and not experience a lengthy bear market like American stocks did following the 1990s boom and Canadian stocks did following the resource mania in the 2000s. In the late 1990s, there were many expensive and cheap stocks/sectors; today the valuation spread between the popular and unpopular is much narrower. While that reality suggests a well-diversified portfolio will produce reasonable returns, it also means that there is less opportunity to bet big on out-of-fashion securities and beat the benchmarks over the long term. We are positioned to do well, but not to significantly outperform the benchmarks like we did in the early 2000s.
The valuation of the overall market is a little higher than its historic average. Slower growth would suggest lower-than-normal valuations might be reasonable, but the lower-than-normal interest rates in today’s world suggest that valuations should be higher than normal. Knowing the exact answer to the valuation question isn’t important, or knowable. What is important is that we don’t have manias.
Some investors think technology stocks are too popular; they believe that the current conditions are similar to those in the technology bubble at the turn of the century. That’s like comparing apples to watermelons, in our opinion. Valuations are not as outrageous as they were back then. Take Alphabet Inc. (Google’s parent company) for example. It trades at a small premium to the average stock, yet is expected to grow three times as fast as the average company. That seems like a pretty good trade off. Growth would have to slow significantly at Alphabet to cause it to appreciate less than the average business over the long term. We don’t think that will happen. The premiums investors pay now for higher-quality, growth stocks are pretty modest compared to history. In our opinion, it’s still a good time to own great companies. If and when growth slows, or we have a recession, the companies that can deliver growth might become even more popular and expensive.
At the other end of the spectrum are the so-called value stocks – companies that are cyclical or lower quality or that are not executing their business plan well at the moment. They are very much out-of-favour and priced as if an economic recession is around the corner. The way they are priced, it’s not hard to imagine them doing very well over the long term. These stocks might struggle if we have an economic downturn, but they might not either. After all, value stocks did very well as we went through the technology bust and recession in the early 2000s.
Another group of stocks struggling this year are the more stable, dividend-paying businesses: Utilities, Telecommunications and Consumer Staples. These are generally considered safer and more dependable holdings, but they have sold off as interest rates have increased. While that is to be expected, we think investors have overreacted. Dividend yields are still very attractive relative to bond yields and the spread between the two is still very high compared to history. Interest rates would have to go up a lot more for these stocks to underperform over the long term, and we don’t think that will happen.
We are well diversified across the various sectors, as we don’t have strong reasons to favour one over another. We also have a good balance of stocks that are performing well, and those that have pent-up potential because they have lagged. Overall, we feel we own a collection of great businesses that will serve us well over the long term.
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* The Odlum Brown Model Portfolio is an all-equity portfolio that was established by the Odlum Brown Equity Research Department on December 15, 1994, with a hypothetical investment of $250,000. It showcases how we believe individual security recommendations may be used within the context of a client portfolio. The Model also provides a basis with which to measure the quality of our advice and the effectiveness of our disciplined investment strategy. Trades are made using the closing price on the day a change is announced. Performance figures do not include any allowance for fees. Past performance is not indicative of future performance.
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