September 20, 2018

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Opinion

The high cost of investing

Markets are surging, begging the question: Are you buying too high and risking a loss?

Frank Gunn / The Canadian Press files</p><p>Today’s bull market has everyone wanting a piece of the action, but it’s bound go to the bear eventually. </p>

Frank Gunn / The Canadian Press files

Today’s bull market has everyone wanting a piece of the action, but it’s bound go to the bear eventually.

Hey there, time traveller!
This article was published 10/11/2017 (314 days ago), so information in it may no longer be current.

Buy low and sell high. It’s the goal of every investor. Yet, all too often, many do the opposite. We get greedy when markets are soaring, buying stocks at often overvalued prices. And we tend to not want to buy when stocks are on sale — when markets are falling.

The state of stock markets today — in Canada, the U.S. and just about everywhere else — point to everyone wanting a piece of the action. The TSX Composite is hitting record highs, and so, too, have the NASDAQ, Dow Jones Industrial Average and S&P 500.

So are we headed toward a bear market? Of course we are.

The challenge is figuring out when. It could be tomorrow (very unlikely), or next year (still unlikely)… or a decade from now (also unlikely). But it is likely to happen in the next five years — the trouble being no one knows exactly when.

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Hey there, time traveller!
This article was published 10/11/2017 (314 days ago), so information in it may no longer be current.

Buy low and sell high. It’s the goal of every investor. Yet, all too often, many do the opposite. We get greedy when markets are soaring, buying stocks at often overvalued prices. And we tend to not want to buy when stocks are on sale — when markets are falling.

The state of stock markets today — in Canada, the U.S. and just about everywhere else — point to everyone wanting a piece of the action. The TSX Composite is hitting record highs, and so, too, have the NASDAQ, Dow Jones Industrial Average and S&P 500.

So are we headed toward a bear market? Of course we are.

The challenge is figuring out when. It could be tomorrow (very unlikely), or next year (still unlikely)… or a decade from now (also unlikely). But it is likely to happen in the next five years — the trouble being no one knows exactly when.

While a downturn could be a few years off, that doesn’t mean investors shouldn’t become more prudent with their capital, say two Winnipeg portfolio managers.

Hardev Bains and Evan Mancer are prominent investment professionals — both have appeared on BNN — with similar approaches to buying stocks. As value investors, they specialize in finding undervalued companies with upside. Their very goal is the aforementioned mantra of buying low and selling high. Yet they have different takes on how to approach investing in the current market.

For Bains, the stock market is full of "Tiffany" (overvalued) prices with few "Walmart" bargains.

"I’m just not finding a lot of good stuff that’s priced reasonably," says the president of Lionridge Capital, who recently sent out a newsletter on the subject.

"At the same time, anything that I’m finding that’s inexpensive looks pretty crappy."

Mancer — president and chief investment officer at Cardinal Capital Management — agrees the markets are pricey, but not as overvalued as they might seem.

"A lot of people would be surprised about how the TSX has done over the past 10 years," he says, adding many may feel like we’ve experienced high returns because of recent performance.

"The TSX Composite has returned just over four per cent per year, and that’s including dividends."

Actual capital appreciation — stock price growth — has been below two per cent a year.

In the U.S, where markets have seemingly been breaking records monthly, the S&P 500 in U.S. has a total return annualized average of about eight per cent.

That’s still below the historical average of about 9.8 per cent, dating back about 90 years.

"And international markets are more like Canada," he adds.

Still, certain parts of the market are overvalued, particularly in tech. Specifically these are the FANG stocks: Facebook, Amazon, Netflix and Google (now called Alphabet).

"Even though these are great companies, we would stay away from them based on their valuation."

OK, great, but you might ask: "What do you mean by ‘valuation’ anyway?"

Valuation refers to the worth of the company — its tangible assets, revenues, cash flow, debt, etc — relative to its share price. At its heart, the art of investing (in most cases) involves using a number metrics — or measurements — to determine whether a security’s price is worth the intrinsic value of the business.

The most common metric is the price-to-earnings ratio (or P/E for short).

This metric represents how much investors are willing to pay to own a company for every dollar it earns.

The higher the P/E is, the more overvalued a company might be according to its share price. For example, Amazon’s P/E is 280 (also referred to as 280 times earnings).

That’s really high, considering the P/E for the S&P 500 is about 25 which, by historical standards, is fairly high itself. (The average is about 16.)

In contrast, Apple — no tech-sector slouch itself — has a P/E of about 19. Whether the tech titan is undervalued is debatable — and that’s where value money managers earn their keep.

They use a variety of metrics, such as free cash flow to equity, price/earnings to growth, debt to equity and price-to-book ratios to figure out if a stock is a buy, sell or hold.

But their work involves more than metrics. They also often get into the nitty-gritty of a company’s business.

"This has nothing to do with the market price," Bains says. It involves a business’s fundamentals, such as its management, the nature of its cash flow and debt and its competitiveness relative to its peers.

"It’s more like ‘what would a private buyer pay for such a company if it was being sold in the private market, as opposed to being traded publicly?’"

While this analysis really boils down to an "educated guess," portfolio managers use this process to decide whether to buy a new stock, add more to an existing holding, or scale back a position and even sell that holding entirely.

Right now, the formula Bains uses has been telling him to trim overvalued positions while standing pat on buying to the point where the portfolio he manages for clients consists of about 40 per cent cash.

"That’s not a market call; I’m not trying to time the market," he says.

"It’s just simply the result of the fact we went from a time where we were effectively fully invested, and even though the companies we invested in continued to be great, their price has become very expensive."

As a result, he scaled back positions in some companies and sold others entirely. Now money sits on the sidelines waiting for the opportunity to buy stocks he has been following when their share price shows upside.

Other value managers take a different approach, including Mancer. In part, his investment mandate does not allow for large cash positions. But Mancer also believes value can still be found.

"We bought Magna not that long ago, because investors are concerned the auto sector is reaching the peak of its cycle and about NAFTA," he says. "We think those risks have been overplayed and Magna trades at eight times earnings, so it’s a cheap stock versus the market, which is closer to 18 times earnings."

More broadly, Mancer argues the end of the bull market is still a ways away.

The typical predictors like high oil prices, high inflation and significant increases in interest rates are absent so far.

"Even if the market is a little more expensive than it was a few years ago, the returns haven’t been as high as people think compared with over the last 20 years," he says. "If you’ve got a five-year time horizon, stocks should do better than bonds and will do better than cash."

Then again, the ability to bargain-hunt will likely become increasingly useful as markets march forward.

For Bains, it’s like the difference between eating broccoli and jellybeans.

The former may not be all that appetizing, but it is really good for you, while the latter is a sweet treat with little nutritional value.

"We’re looking for broccoli stocks," he says. "The problem is that sometimes even broccoli stocks turn into jellybeans because they become too expensive."

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