WEALTH Matters — sUMMER 2012

The Case for Equities

The collapse of the ‘tech bubble’ and the impact of 9/11 in 2001 caused a major market downturn, and the massive market collapse of the 2008 ’global financial crisis’ only a few years later sealed the fate of the first decade of this century to be one of the worst 10-year periods for returns on stocks. As a result, many investors are much less enthusiastic about equities (and some want nothing to do with them anymore).

Yet, stocks have outperformed bonds and GICs in almost every 10-year period on record, and the case for stocks as a key component of a diversified investment portfolio is as strong as it ever was. Here is an overview of the arguments favouring equity content in investment portfolios.

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The Case for Equities

Interest Rate Trends

Investment Market Commentary

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Growth Assets

So if GICs and bonds are not expected to deliver real growth in excess of inflation, what will do that job? Generally growth assets will be equities: real estate and stocks which trade in financial markets.

In the case of real estate, there is a limited supply close to urban centres. A growing population should increase values by more than the growth in wages and prices (inflation). In the case of rental real estate, there may be ongoing net rental income as well as the potential for market price increase (or decrease) over the time it is owned.

In the case of stocks, the owners of the business will want to maximize the return on their capital, and will make business decisions that they believe will lead to higher returns. Many corporate finance departments will not fund projects with a projected return less than 10 or 15%. Of course, not all projects will be able to achieve that and some will fail. The role of the investment analysts and portfolio manager is to assess the capabilities and track records of corporation managements to decide which are most likely to lead successful strategies, and to buy their stock.

Dividends

The returns of the past 10 years may have been much higher than many stock index charts would suggest. The reason is reinvested dividends.

Dividends are that share of the company’s profits that the management doesn’t think it needs for expansion, and which are paid out to shareholders. Most stock charts use a price index, which ignores the value of these dividends. Most indices are published also in a ‘Total Return’ version which includes the value of dividends and assumes they were reinvested (ie compounded) back into additional shares. The difference is startling, as shown by the comparison in the graphs below.

Portfolio Objectives

While the objectives will be different for different portfolios, what will usually be consistent is a desire to minimize the volatility and risk for a given target rate of return. The lower bound for volatility is the ‘risk free return’ - generally the return on short term bonds or treasury bills issued by a solvent government, or GICs from a deposit-insured financial institution.

It will be no surprise to most, that the returns offered by such instruments today are very low. Some may be surprised that these instruments have rarely returned more than inflation on an after-tax basis.

The chart below shows the past 60 years of  yields on 3-5 year government of Canada bonds, before and after tax at 40%, compared with the annual inflation rates (Source: Bank of Canada).

Corporate America is Very Profitable

US-based corporations pared back expenses after the 2008 recession and have become very profitable during the recovery. The graph below shows average profitability higher than it has been since the 1960s. Also notable is that business investment in the US has been on the rise the past few years, but is well below profit levels, meaning that excess profits are piling up instead of funding business investment by taking on more debt.

Conclusion

If you want your portfolio to grow in its purchasing value after tax on investment returns, you will need to hold some part of your portfolio in equities. Dividend yields on larger company stocks will likely pay you what a GIC would pay you in interest, plus you have the potential for capital gains. Stocks overall have lagged their expected returns for the past 10 years or so but strong market growth usually follows long periods of stagnation. Corporate profits and cash levels in the US are at historic highs offering some protection in case of economic slowdown or recession. If you have sufficient fixed income investments to meet your income requirements for a few years, you can probably afford to have some of your investments in equities for long term growth. Now may be a good time to re-evaluate your overall asset allocation, and make sure your equity holdings are properly diversified to capture market upside while minimizing overall volatility.

Please call us if you would like to discuss your own situation.

Even when interest rates were over 10% in 1982 and 1989, the after tax return was about the same as the inflation rate. Over the period shown in the graph, the bond yield after tax averaged 3.82% while the average inflation rate was 3.81%. The role of the interest payments was not to grow your capital, but to prevent it from being eroded by inflation as it would be if you put it in your mattress. Now, as ever, GICs and bonds are for income or preservation of capital. The only place you’re likely to see growth in excess of inflation, is investing in equity assets such as stocks or real estate.

But haven’t bonds done really well lately?

Bond returns have two components: the interest rate and the change in market value. Bond prices move the opposite direction to interest rates. From 1982 to present, interest rates have generally been declining. Those who held long term bonds in this period will have received not only their interest payments (based on rates at time of issue) but also may have had capital gains on their bonds as market rates declined. In a low interest rate environment, we would expect interest rates to increase slowly to a more average level over the next few years, limiting returns on short term bonds to only their interest yield, and risking losses on long term bonds.

In fact, dividend yields among large established companies are high by historical standards and exceed today’s low bond yields as shown in the graph from Advisor Analytics.

Cash Levels are Very High

Because profits have been higher than business investment, US companies hold a very high level of cash and short term investments on their books—some $2trillion according to consulting firm Treasury Strategies Inc. This is cash not being used to buy equipment or hire people to grow the company value: much of it was accumulated to protect companies’ solvency against the impact of future possible credit crises, and generally against possible declines in consumer spending given weak economic growth projections. These high cash balances could also help sustain regular dividends in case of a recession, or increase them in the absence of a recession.

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