Stocks for sale, cheap

An ugly market can offer beautiful opportunities.

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by

From the November 2008 issue of the magazine.

  91

Steep market declines are rare investment opportunities. When major markets are down by 25% or so — which is where they stand as I write this — you have an opportunity to buy stocks at bargain prices.

Given current valuations, I believe that you are likely to make money in the long run on almost any equity fund that you buy now. And if you can find yourself a downtrodden fund that has temporarily underperformed its peers, you might be able to do even better. In saying this, I am not predicting that the bear market will end tomorrow. The financial crisis rocking the world is by far the worst that we have seen since the Great Depression. How long it will last, or how much further pain will be involved, is anybody’s guess.

But I do think that many stocks are selling for tempting prices. No matter which metric you examine — price-to-earnings, price-to-book, price-to-sales — you can find dozens of solid companies selling for prices that would have been considered unbelievably low a year ago. These stocks may stay cheap for a while, but in the long run, they should provide you with a good return.

I know it takes courage to keep your money at risk in these volatile markets. It’s tempting to get your cash out now, and plan to jump back into the market in a year or two, when things will presumably be less chaotic. I wouldn’t recommend this manoeuvre, though. Market timing is likely to hurt you in the long term, because you won’t know when to get back in. You are almost guaranteed to miss the beginnings of the next upswing.

A smarter strategy is to minimize your risk of loss by investing in battered mutual funds that are likely to lose less than the market if the crisis continues and gain more than the market when the turmoil finally ends. The idea in picking these funds is to ride the ups and downs of what academics call “reversion to the mean.” This is the tendency of any volatile process to go through periods of unusual highs or lows, but eventually come back to its long-run average.

In the world of mutual funds, reversion to the mean implies that good fund managers often have periods of poor performance followed by periods of superior performance. So at times like this you should identify funds that have underperformed in the past year or two for reasons that you think are temporary. As long as the manager remains at the helm, and stays faithful to his or her style and portfolio focus, you should be able to expect much better times ahead.

The trick, of course, is to understand the factors behind the recent weakness and make sure that these factors are temporary, not permanent. Permanent weaknesses would include an unreasonably high management fee, or a flawed investment approach that has consistently delivered poor returns both in good and bad times.

Trying to select funds ready to rebound is not a straightforward exercise. I’ve scoured my database and come up with only six funds that I think fit the bill.

Mackenzie Cundill Value Fund is headed by Peter Cundill, a manager with an excellent long-term record. The fund has lagged the market recently, in large part because of its low exposure to oil and other commodities. That said, this is a fund that sticks to a philosophy of buying bargain stocks on the cheap and that operates with an investment horizon of three to five years. I think it is well suited to patient investors. Drawbacks? I do not like the fund’s large size (more than $6 billion in assets), because it’s difficult to be nimble when you have to put large amounts of cash to work.

Brandes Global Equity has lost 25% of its value in the past year, mostly because of its high concentration on financial stocks, which have been hammered by the recent crisis. But the fund’s bold approach has delivered good results in the past and I have no reason to doubt its ability to repeat its past successes when the tide turns in its favor. Just remember: this is a fund that will experience big ups and big downs. Invest only if you have a healthy appetite for risk.

PH&N Dividend Income has trailed its peers in recent months because of its hefty holdings of financial stocks and its relative lack of energy stocks. But I’m not too worried by its sluggishness. As a dividend income fund, this fund is supposed to stick to high dividend-paying stocks, such as banks. It has done exactly that. But its mandate has proven to be poisonous over the past year, as one bank after another has run into problems. Other dividend fundshave done better because they’ve taken liberties with their mandate and bought hot stocks, particularly in the energy sector, that do not pay high dividends.

I expect PH&N to do much better in the future as the current turmoil in the financial sector eases. Yes, the recent mess will take time to clean up, but all signs are that the U.S. government is finally taking serious action to fix things. At press time, the financial sector looks undervalued to me. I believe that Canadian banks, in particular, are sound.

Because I like bank stocks, I’ll point out Mackenzie Maxxum Dividend Fund, which contains a high weighting of those stocks. This fund would not be my first choice since its management expense ratio is almost double that of PH&N Dividend Income, but if you already have other Mackenzie funds, you can switch to this one without incurring redemption fees. The fund also has a “corporate class” version that protects you from capital gains taxes if you invest outside your RRSP.

PH&N Canadian Equity Fund has fallenbehind its peers in recent months, but this unpretentious fund is cheap and it’s good. It does not make big bets. Its long-term track record is impeccable. And guess what? You can grab it for a management expense ratio of only 1.12%.

RBC O’Shaughnessy International Equity Fund follows a by-the-numbers approach to stock selection. It had a disappointing 2007 because of its low weighting in energy and materials stocks. The rising Canadian dollar also hurt, because most of the fund’s holdings are denominated in other currencies. The fund’s management expense ratio is somewhat pricey, but not outrageous compared to others in this category. You are paying for an investment formula that has been proven to work in the long term. This fund, like the others I’ve listed, should be in for better days ahead.

Betting on a rebound

These funds have recently lagged the market, but have the right ingredients to do better than their peers over the next few years.

FUND NAME 3-YR AVG. ANNUAL RETURN STANDARD DEVIATION OVER PAST 3 YEARS MANAGEMENT EXPENSE RATIO
Brandes Global Equity Fund -3.49% 3.62% 2.57%
Mackenzie Cundhill Value Fund Series C 0.93% 2.58% 2.40%
Mackenzie Maxxum Dividend Fund Series A 2.74% 2.51% 2.35%
PH&N Canadian Equity Fund Series A 7.32% 3.34% 1.12%
PH&N Dividend Income Fund Series A 3.76% 2.80% 1.11%
RBC O’Shaughnessy International Equity Fund -0.11% 3.88% 2.17%
Source: Fundata Canada Inc., August 2008

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