It's time to plan. Or perhaps more aptly stated, it's time to invoke our longstanding existing plans. 2017 fades into the history books as another strong year for investors, marking the 9 th consecutive year of gains for the U.S. equity markets and the 7 th year of gains since the 2008 financial crisis for the Canadian market.
The S&P 500 index earned a total return of 21.8% in 2017 and the S&P TSX Composite index posted a 9.1% total return. Accordingly, risk appetites are running hot. For instance, speculative and junior marijuana and blockchain stocks dominate the leaderboard on Canadian markets almost daily with frantic media hype and trading volumes suggestive of a typical holding period that spans just a few weeks...hardly the stuff of disciplined investment. Bitcoin, that most enigmatic of things...is it a currency? an asset? a commodity? the mother of all Ponzi schemes? closed the year above $14,000...15x the level where it began the year.
The implied volatility of U.S. stocks (VIX...the barometer sometimes referred to as the "fear" gauge) has been plumbing all-time lows below 10, and the S&P 500 index has posted an almost unprecedented string of 14 successive months of positive returns. Here in Canada, job creation has been nothing short of sensational, with a whopping 422,500 jobs created year to date, such that the unemployment rate at 5.7% is at the lowest level in recorded statistics, going all the way back to 1976 (Chart 1).
So, does all of this good news portend a bad ending? Of course not, and there's no immutable law that says another good year can't follow a long string of successful years. But it does call for caution, particularly since stock market valuations are at or above long term averages in both Canada and the United States (Chart 2) - which is not in its own right either a necessary or a sufficient condition for a decline in stock prices, but in combination with other risk elements it could be problematic.
As we all know, trying to time markets is invariably a failed strategy. Goodreid's tried and true approach over a thirty-year period has been simply to try to be better during good times and less bad during poor times. We have succeeded in this challenge as evidenced by our North American Balanced Composite performance record vs. our peer groupbenchmark, the Globe Canadian Equity Balanced Index, which measures performance of the typical balanced fund in Canada. Goodreid has outperformed in 12 of the 13 years since we started tracking this composite, including this most recent year.
A cautious or more defensive stance must ensure that we don't choke off opportunity. It should be viewed as a dial with varying degrees of risk exposure as opposed to a switch, which has only two options, risk on or risk off. The tools at our disposal include the management of asset mix, our degree of exposure to select industries and sectors, and security selection. Past experience shows that most investors find their portfolios over-weight their targeted equity exposure when stock market corrections inevitably occur. This happens for a couple of reasons: first, arithmetically, equity weightings naturally rise during strong markets and secondly, psychology leads investors to reward what has rewarded them and to eschew that which has disappointed them.
Rebalancing to target asset weights as outlined in your investment policy statement is something that we do on an ongoing basis and we will continue to do in 2018. This is a natural and recurring feature of our practice; as each of you have specific goals, constraints and risk tolerances and your specific target asset mix was purposely built to achieve those goals while respecting your risk limits and constraints. We know that many clients openly question the validity of bonds in their investment portfolios at times like these, with interest rates near historic lows and rising. We too are certainly mindful of the impact of low but rising interest rates on a bond portfolio, but history teaches us that bonds often "zig" when stocks "zag"...a truism that is easy to forget nine years into one of the strongest U.S. equity bull markets in history.
We also know that sectors react differently to the various stages of an economic cycle, as certain elements of the economy are more interest rate sensitive than others, while other sectors are more inflation, growth and capacity utilization sensitive. Thus it pays to be mindful of clues (and they are indeed only just clues, as opposed to empirical facts as economics remains an imprecise social science) that the economy may be moving from recession to early expansion to middle expansion to late expansion and finally back into recession. Economic cycles have been getting longer since about 1980, coinciding with the rapid rise of the service sector, and with the advent of business practices like just-in- time inventory management, and for various other reasons as well, but by no means has the business cycle been eradicated. Thus taking profits in fully valued defensive sectors for reinvestment into cyclical sectors as an expansion takes hold makes sense, just as taking profits in fully valued cyclicals for reinvestment in defensive sectors also makes sense as an expansion gets long in the tooth (Chart 3).
Finally, company specific attributes help to shape performance during positive and negative times in the market. The time will come, perhaps in 2018, or maybe in later years, to position equity portfolios more defensively, reducing beta (or specific company volatility) and cyclicality. Characteristics like revenue visibility and stability, low operating leverage, formidable balance sheet and financial strength and consistency of growth take on added importance in a slowing economy. In a nutshell, the emphasis shifts towards companies where we have a high level of confidence in the company achieving financial forecasts and executing on its business plan and away from more rapid and dynamic, but also more erratic growth situations. We will be closely watching a number of indicators including the slope of the yield curve, employment growth, retail sales and purchasing manager indices as well as market breadth and other sentiment measures to guide us in making this pivot.
Furthermore, we will be diligently and proactively trimming winning stocks within Canadian and U.S. equity portfolios, so as to preclude the risk of any one single stock growing to an undue weight in clients' overall portfolios. Again, this is an ongoing feature of our practice and an essential element of prudent risk management.
To be clear, this defensive game plan is not market timing, which we consider to be a fool's errand. Rather this is strategic asset allocation and investment strategy in practice with a view to firstly, protecting capital and secondly, growing it responsibly amidst a potentially more challenging investment terrain. 2017 was another solid year for Goodreid clients, both in absolute terms and relative to our formal benchmarks. We enter 2018 with a continued resolve to be diligent stewards of your wealth and we wish you all the best in the coming year.
Investment lore tells us that “there’s gold in them there hills”, when it comes to initial public offerings (IPOs) of stocks. Surely everyone has heard stories of those fortunate enough to “get in on the ground floor” of McDonalds, Microsoft, Tim Hortons, Apple, Dollarama, Amazon, etc. and the countless number of times those stocks have multiplied since then. Faced with tales of eye-popping returns like these, it’s tempting to conclude that initial public offerings are a great investment opportunity. Reality however is different, and accordingly, our practice is to cast a wary and cautious eye towards all IPOs. Why?
The best way to answer this question is to jump directly to the conclusion: the typical IPO stock, not only doesn’t multiply 10-fold like some of the market darlings above, but in fact doesn’t even keep pace with the S&P 500 Index. Over the last decade, the Bloomberg IPO Index, which tracks the performance of U.S. IPOs in their first year, has generated a total return of just 59% whereas the S&P 500 has returned 105%. In Canada, among the 92 initial public offerings on the TSX over the last ten years, just 47 made gains in their first year. The typical IPO underperformed the S&P TSX Composite Index with remarkable consistency, lagging the index in eight of the last ten years, such that the typical IPO buyer incurred a loss of 3.5% per year, whereas the TSX earned 9% in a typical year. The monetary incentives in place for sellers and their agents to inflate IPO prices, the risk of the seller being better informed about a company’s prospects than the buyer, the need for management to demonstrate credibility in setting performance targets and the risk of adverse selection, sometimes known as “the winner’s curse” all contribute to this dramatic and consistent underperformance of initial public offerings in their rookie year.
When evaluating an IPO the notion of “caveat emptor”, or buyer beware is paramount. While an initial public offering may superficially look just like any other trade one might execute on an exchange, it is a decidedly different beast. Unlike other trades where existing public shareholders sell their shares in exchange for money from a new buyer, an IPO is either a treasury or a secondary offering. In a treasury offering, typically the company is raising money to fund growth plans and the new investor buys shares directly from the company. With a secondary offering, the company does not raise any money, but lists its shares on an exchange and the new investor buys shares from an existing shareholder - quite often the founders of the company, or occasionally from earlier stage investors like private equity or venture capital firms. In both cases, the company’s executive team and board of directors will have hired one or more investment banks to manage the IPO. The investment bankers, for a fee ranging between 3-6% of the value of the deal, advise the company about how to price, structure and market the offering and help create demand for the shares. Understanding the incentives at work here is important: in both a treasury offering and a secondary offering, the selling shareholder’s gain is the buying shareholder’s loss….it is a zero sum game. Treasury shares sold at higher prices raise more money and relinquish less voting control than shares sold lower. Secondary issues sold higher enrich the founders more so and give up less voting control than shares sold lower. Selling shareholders will always prefer a higher valuation and a higher IPO price for this very reason. Investment banks also compete aggressively amongst themselves to win an IPO mandate, since the fees can be very lucrative for a large IPO. Often, the winning investment bank is the one whose pitch to the company’s board makes the most aggressive valuation case for the shares to be issued. Systematic over-pricing of IPOs is the norm in light of these direct and large incentives.
A further peril to an IPO investor is the risk of information asymmetry: the risk of dealing with a counterparty who is better informed about the value of the asset than the buyer. Anyone who has ever bought a used car will understand this…the seller knows intimately how the car was driven and maintained, how often the oil was changed, etc. The casual car buyer kicks the tires and maybe hires a mechanic to give the car a cursory inspection, but nevertheless won’t even approach the deep understanding of the car’s value and condition that the seller has. This is precisely the situation facing an IPO investor. The founding shareholders will have toiled inside their company daily over decades perhaps, accumulating an incredible body of knowledge that an outsider, even a professional investor could never fully replicate. They know their competitive position in the industry, they know customer demand drivers, they understand macro-economic sensitivities in the business, regulatory risks, emerging disruptive competitive forces, supply chain dynamics and a plethora of other value relevant information. Taking the other side of this trade (especially in the case of a secondary offering), and buying the stock at the very time they have chosen to sell is a bold move indeed. The question IPO investors ought to ask themselves is: “if the expert insiders think NOW is such an opportune time to sell, what is it that I know that they don’t that makes me so confident NOW is an opportune time to buy?”
Once issued, a new IPO undergoes a seasoning period in the public markets. This is a multi-quarter time frame where price discovery occurs under less contrived conditions compared with the IPO process. During this time, brokerage analysts initiate research on the stock and publish target prices, which usually validate the IPO price and suggest further opportunity for gains in the stock. Investors should be wary about the objectivity in these reports though, as many of them will be published by the same investment banks who managed the IPO, who will accordingly be extremely reticent to cast their big fee paying corporate client in a negative light with a downbeat initial research report. Establishing management credibility in setting and achieving various operating and financial goals is another important part of the seasoning period. All too often during the IPO process overzealous management teams set very lofty goals for the company, which they are then unable to achieve. In one notable IPO early this year the management team laid out plans to open more than 550 new retail locations over the next three years, with 150-160 new sites in 2017 alone. However, the company had managed to open just 275 stores cumulatively since its inception in 2005. It had taken fully ten years to open their first 178 stores. Not surprisingly, reality set in, and the company was later forced to talk down these hyperbolic hopes and dreams and sure enough, this has been one of the worst IPOs of the year, with the stock down 49%. Nothing irritates a new shareholder more than a company overpromising and under-delivering. Neophyte executives at public companies often don’t foresee the severity of investors’ reaction should they disappoint on key performance metrics. A final argument for allowing a reasonable seasoning period for a new issue is the expiry of management and selling shareholder lock-up agreements. Selling shareholders and key executives typically covenant not to sell any further shares for a certain period of time - usually 3, 6 or 12 months after an IPO. In principle this shows good faith, as new investors don’t want to see a mass exodus of money (and with it, confidence) immediately after they’ve just bought the stock. In practice though, the whole market knows exactly when the lock-ups expire and this can create an overhang on the stock, as investors fear that insiders may dump the shares in droves upon the expiry of the lockup.
The final caution in buying an IPO is the most insidious one: adverse selection, whereby a retail investor will get as many shares of a lousy company as they request on its IPO, but very few or none at all in a good IPO. This isn’t supposed to happen, but it does. Investment bankers managing the IPO are supposed to treat all investors fairly. In practice however, the little old lady in Lethbridge with the $120,000 discount brokerage account buying 100 shares is totally overmatched by powerful pension funds, mutual funds and hedge funds who may not be shy about throwing their weight around and advocating for more than their fair share of “hot IPOs”, knowing that they pay the investment banks millions of dollars in commissions every year, thus crowding out smaller investors on oversubscribed new issues. Related to this notion of adverse selection is the trend of large institutions increasing their allocations to venture capital and private equity, significantly deepening these pools of capital and allowing them to cherry-pick the best opportunities pre-IPO. At the same time, the costs and regulatory burdens associated with a public listing have risen exponentially in recent years, making private financing rounds increasingly appealing for many successful and growing companies that in earlier times might have been good IPO opportunities.
While this missive might sound sombre, or even jaded, we believe that success in investing hinges just as much on avoiding loss as it does on picking winning investments. We won’t poison the well so far as to say that all IPOs should be shunned, but certainly they do deserve a healthy dose of skepticism because the deck of cards is heavily and systematically stacked against new buyers…despite the selective memories of those who spin tales of tantalizingly big wins on new issues. The silver lining in all of this is the fact that systematic mispricing of IPO’s often sets new issues up for a big swoon in their debut year, affording patient investors the opportunity to make their own “initial investment” at a more favourable price and time - as we have done with companies like Shopify, Facebook, Alphabet and Visa, among others from time to time.
Today marks the thirtieth anniversary of an investment approach developed to aid investors who were searching for a path to long-term wealth creation.
Back in 1986, the term “portfolio approach” was often met with blank stares while the listener waited for a breathless tale of a “can’t miss” stock idea. Goodreid was amongst the first retail investment managers who preached diversification and portfolio structure, and even openly talked of how they’d approach inevitable stock loss situations, in an unemotional and measured way.
From its early days, Goodreid also focussed on long-term results, knowing that any conclusions of short-term success or failure were likely more emotionally impactful than fundamentally meaningful, and ran the risk of throwing the investor off a successful path.
On August 4th, the Globe and Mail reported that just 17% of large-capitalization equity fund managers in Canada outperformed their benchmark in the second quarter, which proved to be the worst quarter for active managers in at least 17 years. Similarly, the second quarter was the worst one for U.S. stock pickers in at least thirteen years, according to Merrill Lynch data which showed that a mere 18% of U.S. active managers outperformed their benchmarks during the quarter. Not surprisingly, the hue and cry for passive investments has never been louder, with a new ETF launched seemingly every other day, and with robo-advisers, albeit most of them still in in their infancy, attracting increasing investor attention. The active management world, for the most part, are taking these body blows in grudging silence, knowing full well that most active managers empirically do not keep pace with a passive index over time. We’d like to address some of the reasons why most do not, and why we believe we are different.
Market corrections are uncomfortable. Investors’ emotional responses are rooted in the worry that a catastrophe will occur. Our companies go bankrupt. Stock prices go down and STAY DOWN…or become worthless.
The plain truth is that there is no basis for this happening. Stocks are not priced in a vacuum. Simply stated, the more money companies generate and the faster they grow, the more they are worth.