Don’t look back – look ahead
Are you a backward investor? That’s not meant as a slur.
Backward investing is defined as making the decision to purchase stocks and/or equity funds based on recent or current performance. For many investors, this means buying them at or about the time they peak. These kinds of investments are kind of like long-distance runners just before they cross the finish line. They look fine up to the wire and then, suddenly, they collapse in a heap, exhausted of all potential.
If you’re a backward investor, you’re not alone. The tech-stock crash that accompanied the start of the new millennium claimed a lot of victims. I attended a gerontology conference at Simon Fraser University in Vancouver just after the crash and met seniors on the verge of tears telling tales of how, just before the collapse, they made the decision to buy Nortel when it was trading in the $120 range. Many had their savings wiped out. And in case you’ve forgotten, the stock eventually bottomed out at 69 cents, although it managed to “rally” and is now trading in the $3 range.
Unfortunately, backward investing seems to be built into our genes. Behaviorists even have a term for the tendency to act on the recent past while placing too little emphasis on long-term evidence. They call it recency. When you see something doing well, whether it be a hockey team or a stock offering, you assume that’s the way things are going to continue. Take, for example, today’s energy market.
How many times have you driven by a gas station and thought that it would be smart to invest in the energy sector? Prices at the pump are going up, so profits must also be going up for suppliers, so why not buy their stock? Good idea? Maybe not.
I called Murray Leith, Odlum Brown’s Vancouver-based VP and director of the firm’s investment research branch, to comment on the wisdom of investing in today’s energy front-runners, and he was anything but enthusiastic. The energy sector is certainly where the lion’s share of investor spending is going these days – energy stocks comprise somewhere between 25 and 30 per cent of the TSX – but it’s a little late to attend that party.
“Energy stocks have done extremely well,” he says, “but the time to invest in a commodity is when it is doing poorly, when prices are depressed and nobody wants it.”
“Three years ago, the energy stocks we liked were trading at three times their cash flow, and that cash flow was based on oil at $25 US a barrel. Now, they’re trading at six to seven times cash flow predicated on $70 oil, so not only are the valuation multiples twice what they were, but the underlying commodity assumptions are more than twice what they were. The risk is if the commodity price goes down, valuation multiples will come down as well.” Translation: all those who bought late could get pounded.
Remember tech stocks?
Think it can’t happen? Just ask those folks who bought Nortel or Ballard, a company that designs, develops and manufactures zero-emission fuel cells. While its product may or may not be a winner, Ballard’s failure to deliver on its promises quickly enough to suit investors combined with the company’s astounding ability to burn through cash has reduced the stock’s value from a high of nearly $200 to about $6 today, albeit with a three-to-one stock split along the way.
Stay ahead to get ahead
Here’s the thing: if you want to stay ahead of the curve, you can’t count on the stocks you read about on the front page of the newspaper. Those ones have already been “figured out” by the vast majority of investors and probably have little growth potential remaining.
Consider what happened with natural gas-weighted income trusts last spring. Income trusts are often sold on the grounds that they are indestructible cash cows for investors but last May, a little story on page D7 of the Globe and Mail started out with this juicy lead: “Falling natural gas prices are prompting the once high-flying royalty income trust sector to cut distributions and protect cash flow.”
Leith says his advice to buy energy stocks was being dolled out back in the Stone Age, but there were few takers. “During the tech mania, I was telling people to buy them,” says Leith, “but they didn’t want to hear about it. They wanted to buy Nortel.”
Adding insult to missed opportunity is that the year 2000 was actually a good time to be a buyer of certain investment products, just not tech stocks. The good deals were to be had on stocks that were out of favour – value stocks, as they are referred to in the vernacular – including income trusts, particularly in the real estate and natural resource sectors, banks, pipeline. In short, just about anything that wasn’t a tech stock.
Here’s the thing: if you want to buy into a stock or sector that everybody likes and that analysts are recommending, then everybody who’s going to buy it probably already has, so you have to ask yourself who’s left to sell it to at the higher price you imagine – hope – it will get to? Evidently, the answer is that it’s probably somebody with a worse case of recency than you!
Conversely, if you buy a stock everybody hates, then everybody else has already sold it, and there probably won’t be a lot of selling coming down the pipeline that’s going to drive the price down. Odds are that sometime in the future, provided of course that the company is legit and has a useful product or service to sell, that the fundamentals will change and there will be renewed interest.
Buy it and keep it
And if you’re the kind of investor who’s constantly buying and selling on your account in an effort to stay ahead of the pack – another symptom of recency – a study by Gavin Quill, director of research at Boston’s Financial Research Corporation, might give some pause. Using data gathered over a three-year period and extrapolating it out over 25 years, Quill found that a $10,000 investment would grow to $123,000 if an investor stuck with a fund portfolio throughout the 25-year-period. That same investment in the hands of a churner would only grow to $70,000.
It’s interesting to note that Quill blames this frequent trading phenomenon on the deluge of financial information flooding investors, who jump this way and that every time the wind shifts. Think about it: if your broker churned your account, you’d probably file a complaint. If it’s bad for him or her, it’s also bad for you.
Of course, that’s all very easy to say, you say. Look forward instead of back, etc., but where exactly does one actually look?
Favour the unpopular
Glenn Stewardson, a CFP and FMA with Assante Capital Management in Halifax, says investors looking for good buys need look no further than the Canada-U.S. bor-der. For the past three years, the Canadian stock market has been humming along showing great gains, so, faithful recency advocates that we are, many Canadian investors are piling their money into Canada.
“What they should be doing is selling some Canada and buying into the U.S.,” he says. “Everybody counters that the U.S. has been doing nothing for five years and asks why they should invest there. Well, everything goes in cycles. Eventually, the U.S. market will hum, and everybody will jump then.”
By then, of course, it will be too late. However, it’s well to point out that if the U.S. dollar goes through another round of devaluation as it did earlier this year, some of the gains U.S. stocks produce will be tempered for foreign investors.
“Look around,” Stewardson adds. “What are money managers doing now? They’re de-investing in Canada and investing in the U.S. and overseas.”
What’s more, U.S. stocks are actually a pretty good value these days. Five years ago, Canadians investors were buying big American companies, paying 50 times earnings in some cases, and with 65-cent dollars no less. Nowadays, these same companies are trading at only 15 times earnings, and the dollar is looking like Superman stepping out of the phone booth.
What about investing in the retirement market? With all those baby boomers heading into retirement and old age – thee and me, as it were – does it make sense to invest in things like retirement homes? Yes, no and maybe. The problem is that this industry has a built-in volatility factor because it’s one in which governments can and do get involved by introducing beds at other than market prices.
That said, one sector of the economy is likely to profit in spades from the retirement boom – the financial planning sector!
Ultimately, investors are better advised to steer clear of major trends and examine companies they like on an individual basis. Figure out who is the best at what they do in their respective industries, who has good fundamentals and buy them when these companies are unpopular. If you’re not prepared to do the homework, find a good managed money or mutual fund portfolio with a healthy mix of bonds and equities, including Canadian, U.S. and international equities, and leave the analysis to someone else.
Ultimately, investors need to realize that what happened yesterday is no guide to what will happen in the future. Of course, realizing it and acting upon it are two different things. It takes courage sometimes to purchase investments that are out of favour, especially when your investment-club pals think you’ve lost your mind. However, if you spend your time and money buying yesterday’s dreams, you’re more likely to wind up flipping the old investment adage on its head and buying high in order to sell low.
Older but not necessarily wiser
Age may bring wisdom but not necessarily when it comes to picking winners in the stock market. A University of Notre Dame study found that investors’ stock picks tended to trail the market by ever-larger amounts as they grew older. The reason cited was cognitive decline associated with aging. On the plus side, older investors are less likely to make all-or-nothing bets
“The worst thing you can do is follow past performance, and almost everybody does it.”
Glenn Stewardson, Assante Capital Management