The true cost of leaving stocks

Gross recently wrote that “the cult of equities may be dying,” done in by a world suffering from slower economic growth. U.S. stock market returns that had averaged 6.6% annually during the past 100 years are unlikely to be repeated, says Gross, and investors can expect no more than “mere survival” from bond investments. What’s more, notes Gross: “The cult of inflation may have only just begun.”

PIMCO manages US$1.8 trillion in assets, and Gross manages the world’s largest bond mutual fund.

In a recent message to clients, the bearish Rosenberg cites sharp outflows from equity mutual funds and the attraction of securities offering income for baby boomers as reasons to declare: “The equity cult is clearly over.”

Nonetheless, many seasoned investment managers in Canada, particularly those with a “value” focus, say clients could hurt their returns and sabotage retirement income by having too little exposure to stocks, particularly in an inflationary environment in which growth is necessary just to maintain purchasing power. These money managers spot budding opportunities as beleaguered investors depress the price of good companies as they withdraw from the fray.

“I’m loving this,” says Kim Shannon, president of Toronto-based Sionna Investment Managers Inc., referring to the pronouncements of equities’ demise. “You can’t start a new bull market until people have thrown in the towel and walked away in disgust. Capitulation creates a natural cleansing. And the more negative headlines and comments, the closer we are to the bottom.”

Shannon points to the infamous article published in BusinessWeek magazine in August 1979, entitled “The Death of Equities,” that had warned that inflation would decimate stocks. A year later, one of the greatest bull markets in history began, with the S&P 500 index soaring by 2,635% between 1980 and 1999.

“Equities markets have been underperforming,” concedes David Taylor, president of Toronto-based Taylor Asset Management Inc. and subadvisor on two funds sponsored by Toronto-based IA Clarington Investments Inc. “But without these fears of economic underperformance, you would not get this opportunity to buy at good prices. So much fear and pessimism has created a plethora of high-quality companies trading at attractive valuations.”

Taylor, who manages IA Clarington Focused Canadian Equity and IA Clarington Focused Balanced funds, has been featured recently in an ad campaign while saying, “The biggest risk is giving up on equities.”

Lack of equities exposure at this juncture, he says, means being left on the sidelines in a market in which superior companies are trading at attractive valuations that could set the stage for juicy future gains.

Taylor acknowledges the issues that are making clients nervous, including slower economic growth around the globe (and particularly in China) and the debt troubles of European and other governments. But even in times of slow growth, he says, there are stocks that outperform.

Taylor questions investor preference for bonds and guaranteed investment certificates, as well as stable, dividend-paying stocks such as pipelines and utilities whose prices have been bid up substantially in recent years. He sees no advantage in buying shares in a utility company such as Enbridge Inc. that is trading at a price/earnings (P/E) multiple of around 25 but has the growth potential of about 3% a year, when he can buy shares of a fast-growing company such as U.S. railway CSX Corp. that are trading at nine times earnings and seeing annual profit growth of more than 20%.

With a 2.2% dividend, CSX has a lower yield than Enbridge and some other popular, dividend-paying stocks. But, Taylor says, a growing company has the potential to increase dividends more quickly than a stable utility. A company like CSX also could benefit from an increase in its P/E multiple, he adds, while the valuation of Enbridge and other utilities are in danger of moving downward to the mean.

Other U.S.-based growth companies – such as Honeywell Inc., Caterpillar Inc., Deere & Co. and McDonald’s Corp. – are also inexpensive and pay dividends as well, Taylor says.

He also sees some gems among beaten-down resources stocks, and says this currently unpopular sector should also be included in a high-quality, balanced portfolio. “It’s the first time in my career that I’ve seen growth companies trading cheaper than non-growth companies,” says Taylor, whose 24-year career includes stints in managing portfolios for Dynamic Funds and Altamira Investment Services Inc. “Pipelines and utilities are now seen as proxies for bonds in a low interest rate environment, and investors are pouring money into them.”

Money managers who seek undervalued stocks tend not to rely on overall economic growth to generate returns; rather, they rely on the eventual recognition by the market of a stock’s true potential.

“Buying cheap securities and waiting for them to go to fair value is an easier way to make money than trying to predict the economy,” says Shannon, adding that economic activity is responsible for only about a third of the movement in stock prices. “There are always stocks that can do well even in a bad market.”

Clients who’ve been fleeing to the perceived safety of fixed-income may now be nearing a danger point, some money managers say. Interest rates are currently at rock-bottom levels, and monetary stimulus by various governments around the globe has sown the seeds of inflation. Bonds and fixed-income securities are vulnerable to the eventual increase in interest rates, which would hurt the value of outstanding bonds.

Clients flocking to fixed-income seem oblivious to the risk of capital losses, as well as to the risk of the erosion in spending power if inflation returns, preferring the perceived safety of fixed-income to the more immediate and uncomfortable volatility of stocks.

Although clients’ fears of lower economic growth, rising unemployment and high government debt are well founded, says Tye Bousada, president of EdgePoint investment Group Inc. in Toronto, fixed-income securities are not the solution for capital preservation in an inflationary environment.

Assuming an annual inflation rate of 3%, Bousada says, a client needing $40,000 in income in today’s market would need more than $84,000 to maintain the same purchasing power in 25 years. Clients earning 1% on cash would be 22% poorer in just 10 years, he adds. And they’re not doing much better by investing in a 10-year bond paying about 1.5% a year.

And future inflation could be even higher than historical rates, particularly if health care and food costs rise. At 6% inflation, the same client would need $172,000 in 25 years to maintain $40,000 worth of purchasing power. Says Bousada: “Many people view volatility as the real risk, while we think the most serious risk is running out of money before you die.”

The best way to ensure a retirement income that keeps up with inflation, Bousada says, is to own shares in companies that have the ability to pass on higher costs and grow in a tough environment: “The key is to differentiate between the stock market overall and companies that can grow bigger and more profitable in the future. The vast majority of companies in the stock market need economic growth to do well, and we are not cheering for the entire market. The headwinds are real, and it wouldn’t surprise us if the overall stock market is flat for the next three to five years. The best thing to own is a small collection of good businesses.”

“Good businesses” also often spend their excess cash on raising dividends or on buying back their own stock, Bousada says. And successful companies often attract takeover offers, resulting in gains for shareholders. IE

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