Market outlook 2015

It’s going to be a tough year for value, growth and dividend investors alike. Luckily there are still opportunities for those who know where to look

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From the January 2015 issue of the magazine.

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(Photograph by Raina + Wilson)

(Photograph by Raina + Wilson)

If you’ve bought any stocks this year, you’ve probably noticed that it’s a bit of an odd time to be an investor. For most of 2014, Canada’s market did well—between January and September our main market index, the S&P/TSX Composite, was up by nearly 15%. But it’s been another story since then. Thanks to plummeting oil prices our energy-heavy market has fallen by 11.3% since September and at press time in December it was up a measly 1.7% year-to-date. The U.S. has done much better—the S&P 500 is up 10% on the year—but oil uncertainty is starting to drag their market down too. Stranger still is the fact that this correction isn’t making stocks in other sectors much cheaper. Yes, there are bargains in the energy sector if you can stomach the risk, but the sell-off hasn’t impacted other industries nearly as much as it has oil and gas.

With our market trading at 21 times earnings—that’s on the higher end of its historical average—value investors are having trouble finding bargains outside of oil and gas. Growth investors are now paying more than they typically like to for a high-growth business. Canadian small-cap seekers are bracing for a few bad months ahead, while income investors are having to look farther afield to find companies that pay well and aren’t overpriced.

Of course, anything can happen—oil could fall further, or it could recover—but consensus is that 2015 will be more of the same. “We’re in a sideways market and we will be in one for a while,” says Kim Shannon, president and chief investment officer at Sionna Investment Managers. In other words, if you were expecting to make a 10% return next year you’ll probably be disappointed. “It’s a low-return environment,” she says.

Waiting for value

It’s been a challenging year for deep value investors like McElvaine Investment Management president Tim McElvaine. For most of his career, this long-time fund manager has been buying companies that you probably wouldn’t want to touch. He’s not unlike the junkyard scavenger who’s hoping to find a forgotten gem among scraps of metal. When he finds his potential prize, he buys it, hopes it will improve and then sells it when it’s back in favour again. Although not everyone goes to the extremes that McElvaine does—he craves seriously down-in-the-dumps operations—that’s the essence of value investing. Buy a once-attractive company that people don’t want to own and then sell it when it returns to its former glory. There’s one problem with McElvaine’s strategy of seeking out unpopular corners of the market: “These days there are a lot fewer areas that people want to avoid,” he says. It’s a problem that all value investors face today: When the market gets expensive, those bargains get harder to find.

In an environment like this, you may want to follow McElvaine’s lead and keep more of your assets in cash. He has about a quarter of his assets in liquid form today, up from his mid-teens average, so he can buy when the market falls. As difficult as things have become, there are still some areas in Canada and beyond that have been “dislocated,” says McElvaine. For instance, Russia and Brazil are incredibly inexpensive, and will likely continue to be cheap in 2015. Russian sanctions over Ukraine have put pressure on the economy, while elections in Brazil and lower commodity prices have hurt that country.

In Canada, there are opportunities in the underperforming resource sector, but he’s not as excited about oil’s big fall as some others are. “It’s like being on a treadmill,” he says about oil companies. “It’s a never-ending journey.” Cash flow, he says, is dependent on a depleting resource pool so companies have to continually find more. That constant search for commodities is tough to follow.

Sionna’s Kim Shannon, a more traditional value investor, would agree that while opportunities have been harder to come by, she’s not waiting around in cash for a brilliant opportunity to arise. She would rather be fully invested in a diversified basket of stocks than keep a piggy bank full of loonies. “Cash gets you nothing,” she says. “With inflation where it’s at, cash is actually losing you wealth.”

What she is doing, though, is rebalancing her portfolios by selling her more expensive names and using that cash to buy similar, but cheaper, operations. For instance, she’s taken profits from Loblaw, which is trading at about 25 times earnings, and bought Metro, which is trading at about 17 times earnings. “Metro is inexpensive, but it still has a juicy return on equity,” she says. “Loblaw has done a lot of good things, but investors have gotten excited. So we’re doing more of this kind of thing.”

If you want to be a successful value investor, then you’ll need to keep an eye on the market and pay close attention to your portfolio’s overall price-to-earnings ratio. Shannon wants her large-cap Canadian fund to be trading below the benchmark’s multiple, which it is—it’s trading at 15.9 times earnings, compared to about 21 for the overall market. She knows gains will be modest next year, but she still hopes to outperform the market by about 2% after fees.

Grasping for growth

There’s a misconception among investors that the higher the stock market goes, the better it is for growth buyers. If you’re a growth-focused stock picker, though, you know that’s not true. Sure, you’ll buy companies with numbers that would make value investors squeamish, but there’s such a thing as multiples being too high. “The whole market is harder for everybody,” says Mark Schmehl, a portfolio manager with Fidelity Investments. “Even in growth-land the valuations are high and fundamentals are at the point where things are not really getting better anymore.” Concerns around a market correction and a slower growth economy have caused some growthier names to pull back recently, but generally, many of these companies are still expensive.

Still, growth investors are generally less concerned about the current price or valuation of a company. Instead, you’re buying future potential. In many cases, a growth company has little to no earnings when it goes public, but if you think it has some competitive or technological advantage that will help it outperform its peers then you buy—those earnings will come. However, growth investors won’t settle for single-digit earnings, they want to see massive increases in revenues, earnings and profits.

There is a downside to growth investing: Since expectations for growth are high, if a company misses a target, investors tend to panic and its stock price will fall hard. Some growth investors, like Schmehl, can stomach the volatility, so they’ll pay little attention to valuations. Others, though, like to buy growth companies at a reasonable price, called GARP investing. They want those high double-digit returns, but they don’t want to pay too much to get it.

If you’re more on the GARP side, high valuations are likely tripping you up today. Even if good growth is ahead, your stomach may not be able handle the ups and downs that come with owning a company that has such rich valuations. Schmehl, though, is happy to pay a high price for something as long as he thinks it can continue to expand its earnings. The main issue for him today is that there aren’t as many new innovations to back. “A lot of ideas are getting long in the tooth,” says Schmehl. “We know what technologies are leading the wave. There’s nothing fresh.”

As a growth investor, the companies you should be looking at are the ones that are “winning,” he says. Businesses such as Facebook, LinkedIn, Google or even apparel company TJX, all businesses that are leaders in their market, will be the ones that outperform in 2015. “I want the best players on the team,” he says. However, he admits that it is getting harder for companies to win. Wages are starting to rise, competition is increasing and there are a number of global headwinds that could slow down growth. “Things are starting to move against these companies,” he says.

Right now, the best opportunities for growth investors are below the 49th parallel. Not only are there more companies to choose from in the U.S., but it’s the only developed economy that’s still seeing good growth. He’s particularly bullish on pharmaceutical companies, which have a lot of innovative drugs, including new cancer therapies, in the pipeline. Many are trading at expensive valuations because of their future earnings potential. They’re not earning much now, but they will when new drugs hit the market, likely in 2019.

Technology, which is typically where growth investors reside, still looks interesting, but it’s becoming a crowded field. There are a lot of “me too” operations—companies that are essentially copying what’s already out there—listing on U.S. exchanges, he says, and there’s not a lot of industry-changing products on the horizon. It’s here where sticking to those market-leading operations is important.

While it may be getting harder to find growth opportunities, Schmehl’s not changing his approach. He wants to own companies that are “getting better.” What that means is different for every business, but investors should be able to identify five areas of improvement. Microsoft is a good example. The company had been considered a value play for a while, but it’s now a growth buy. It’s trading at 18 times forward earnings, up from 11 times a year ago. The stock is up 40% and he thinks there’s real momentum there. (Momentum investing is when you buy a stock with a consistently rising price, thinking that it will keep going up.) There’s a new CEO, there’s a new board, it has a much stronger strategy for growth than it’s had in years, it’s making inroads in cloud computing and better allocating its capital.

It’s companies like Microsoft—businesses that have a lot of good things going for them—that investors need to own in this market. People will have to look harder for those types of companies, though. “I’m less active than usual,” he says. “My turnover is lower than it usually is and when I do sell the biggest question I have is what am I going to buy instead?”

Searching for yield

You probably hold at least a few dividend-paying stocks in your portfolio and there’s no doubt you love the income boost that these yielders provide. As much fun as it is to collect those quarterly payouts, though, there’s something you probably haven’t paid much attention to when it comes to these stocks: valuations. Dividend equities have become the in-vogue investment over the last few years as a result of historically low bond rates. The only way people have been able to generate a decent yield is to buy income stocks in sectors that traditionally have had high and stable payouts, such as REITs, utilities and telecom. Unfortunately, that’s made these industries much more expensive than other parts of the market.

That’s a problem for the person who holds a few income equities and the folks who treat dividend investing as an actual stock picking style. Dividend investing is often considered a specialized form of value investing. If you want to build a portfolio of dividend stocks, you typically want inexpensive companies that pay more than the S&P/TSX Composite Index’s yield. As stock prices rise, dividend yields fall—even though the actual price per share doesn’t move—so expensive stocks tend to have smaller yields. While owning dividend stocks has worked wonders for many investors—since 1980, dividend payers have outperformed non-dividend payers by about 19%—sky-high valuations mean that a stock’s price could fall fast if something doesn’t go its way.

What income investors have to worry about next year is rising bond prices. When fixed-income rates rise, stock prices in more stable paying sectors, such as REITs and utilities, tend to fall. That’s because fixed income, which is still considered safer than stocks, starts becoming more attractive. We’ve seen it happen before. Between June 1, 2013 and December 31, 2013, the U.S. 10-year treasury yield climbed by 42%. Over that same time period, the S&P/TSX utilities index fell by about 7%, while the S&P/TSX Composite Index rose by just over 8%. The numbers prove that when bond rates rise, these high-priced sectors often fall in a hurry.

This is important to keep in mind in 2015, because while no one knows when rates will climb, more people think we’re getting closer to a hike than ever before (see “Are interest rates set to rise?” on page 38). If the overnight rate rises, which would also push long-term yields higher, then these expensive sectors will tumble. “The dividend might stay constant, but if the share price declines because the market is moving in another direction, you’ll still lose money on capital,” says Stelmach.

In 2015 you may want to avoid those overvalued sectors and put money in industries that aren’t typically associated with income instead. There are still good opportunities in banks, says Stelmach. While it is a favourite among income buyers, it’s still a relatively inexpensive sector thanks to worries around higher housing prices and slower loan growth.

Struggling small-caps

If you’re a Canadian small-cap investor, then you’ll need to brace yourself: 2015 is going to be a trying year. Nearly half of the domestic small-cap market is made up of energy and resource companies, two sectors that have been hit hard. Between January and December 1, the S&P/TSX Small-Cap Index has fallen by about 9.5%, though it has dropped by nearly 21% since September. Those losses could continue into the New Year, says Scott Carscallen, a vice-president and portfolio manager with Mackenzie Investments.

Small-cap investors tend to lean a little more towards the growth side of things, though there are value stocks in this space too. Most stocks, though, are small operations with a lot of growth potential. You typically want to own companies that can go from small, to mid-cap to large, says Carscallen, and doing that requires a lot of growth. It is a risky part of the market, though. It’s a lot less liquid than the large-cap space, especially in Canada, so it can be harder to sell a smaller company. Many of these stocks are also unproven businesses and they operate in volatile sectors, such as mining. But because earnings and revenues are expanding off a small base, returns are often quite juicy. Since 2000, the Russell 2000, an index of small-cap U.S. stocks, has returned about 160%. The S&P 500 is up about 90% over that time period.

If you want to play in this space today, you’ll have to be choosey—a benchmark-following ETF won’t cut it in this environment as it’s unlikely we’ll see a turnaround in energy or resources anytime soon, says Carscallen. Gold, he points out, has been a “horrific” performer all year and with America’s quantitative easing program now over, the U.S. dollar taking off and no signs of inflation, the commodity, and the companies that produce it, will continue to suffer.

While it’s harder to know where energy prices will go—the price of oil has fallen by about 40% since July, but could rebound at any time—there are a number of headwinds that could keep prices lower. In November, the Organization of the Petroleum Exporting Countries (OPEC) said that it wasn’t going to force its members to cut production; an increasing amount of supply is also coming from America, while slowing resource demand from China and other emerging markets suggest that demand for energy will be lower. None of this bodes well for oil prices.

If oil continues to fall, some energy companies—especially the small-caps—could cut back on their capital expenditures or even fold. Weaker energy and resource sectors could also impact related companies, such as construction operations or drilling businesses. “These weaker sectors are a big weight against small-caps,” he says.

Carscallen suggests looking at sectors that aren’t as correlated with energy or base metals, such as consumer discretionary or financials. He likes Linamar Corporation, a mid-cap auto parts company—“anything to do with consumer spending is not a bad place to be right now,” he says—and Gluskin Sheff and Associates, a $860 million market-cap investment firm that should benefit from still improving equity markets.

It’s also important to avoid penny stocks or freshly listed high-risk companies and there are many of those on small-cap exchanges. “You want the small-cap to eventually grow into a large-cap,” he says. “You want to try and find the next Microsoft.”

3 comments on “Market outlook 2015

  1. Very interesting article !
    Lots of food for thought to think about and another year of volatility

    Reply

  2. “What income investors have to worry about next year is rising bond prices”
    Did you not mean “lower bond prices” due to “higher” interest rates?

    Reply

  3. excellent overview

    Reply

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