(Illustration: Jori Bolton)
On the face of it 2013 ought to have been a lousy year for investors. There was the U.S. government shutdown, the Federal Reserve’s threats of tapering, the Chinese slowdown and the slump in commodity demand. Yet the S&P 500 finished 2013 up nearly 30%, and the MSCI Europe Index climbed 18%. Not even a depressed materials sector could keep the S&P/TSX composite down. It returned 8%, its best performance since 2010.
It’s now clear that confidence has returned to the stock markets. But going forward, that poses some big challenges. For much of the past five years, investors haven’t had much trouble finding undervalued stocks. Today, says Aubrey Hearn, vice-president and senior portfolio manager with Sentry Investments, “you have to be much more selective.”
For those topping up their RRSP, that means looking beyond the broad market for more elusive buys that aren’t already overpriced. Here’s where to look for those winning bets, by geography, sector, size and style.
Best bets by geography
United States
Many believe the U.S. market’s four-year run can’t possibly continue. The S&P 500 is up nearly 150% since it bottomed in March 2009. But it’s worth remembering how deep and broad the U.S. market is, representing more than a third of global capitalization. Gaelen Morphet, Empire Life’s chief investment officer, says there are still areas that have yet to benefit from the upswing.
She also notes that the U.S. hasn’t fully recovered from the recession. The employment rate is now at 7%, a five-year low, but well off the 4.5% levels before the crash. Housing is improving, but it’s also off its pre-recession highs. That suggests there’s more upside to come. “A stronger economy makes everyone more confident,” Morphet says. “Companies will hire and spend money, and the ball will keep moving forward.”
Emerging Markets
One area that didn’t do well last year was developing countries. The MSCI emerging market index was down 6%, in part because tapering fears caused people to move out of risky assets and into more stable ones. As the global economy continues to improve, though, this region should do well once again, says Sadiq Adatia, Sun Life Global Investments’ chief investment officer.
U.S. growth ultimately will help developing markets, because many of the companies operating in these countries are American multinationals, says Adatia. The better it gets at home, the more they’ll spend and invest. Emerging-market growth is also starting to come from domestic sectors rather than from export industries. “They’re becoming less reliant on foreign factors,” he says. Right now, the region is trading at around 10 times earnings, but its historical average is closer to 14 times. “You’re getting a very good discount,” he says.
Best bets by sector
U.S. Financials
We take the financial sector for granted in Canada, but it was one of the hardest-hit areas in the U.S., and it still hasn’t fully recovered. Many banks are trading at 10 or 11 times 2014 earnings, which is cheaper than the overall market’s 15 times. They’re also less expensive than comparable Canadian banks.
Hearn thinks a lot of these companies will improve along with the economy. They benefit from the housing rebound with more mortgage loans, and they stand to make a boatload when interest rates rise. They also have much better balance sheets than they used to. The banks that pass their regulatory stress tests in 2014—and all the big banks will, he says—will likely boost their dividends. “There’s definitely some room for multiple expansion growth,” he says.
Canadian technology
With our materials sector in the doldrums, investors are looking for other sources of capital gains. Morphet thinks our domestic technology market is one such place. “There will be some companies that show up in people’s portfolios that haven’t been there in the past,” she says.
While the sector is hardly cheap—the S&P/TSX capped information technology index is trading at 33 times forward earnings—it’s on a growth tear after several years of underperformance. Many of Canada’s software companies are also cash cows, collecting recurring revenues from clients.
The sector is expanding too, says Morphet. Halogen Software’s initial public offering last May led a cohort of new listings. A September PricewaterouseCoopers report predicts we’ll see a lot more domestic tech IPOs in the future. “We haven’t seen this since the early part of the century,” says Morphet. “It’s going to be interesting.”
Best bets by size
Large-caps
Investment experts have been talking up the benefits of owning large-capitalization stocks for a while, but the message doesn’t seem to have sunk in. Nelli Oster, an investment strategist with BlackRock, points out that multiples on small-cap stocks have expanded a lot faster than on large-cap ones. The S&P 100 is trading at 15.4 times earnings, while the S&P small cap 600 is trading at 25.6 times, she says. That’s even though the return on assets for large caps is 3.2% versus 2.4% for small caps.
Small caps tend to do well in a recovering economy, so it’s not surprising that they’ve outperformed their larger-cap counterparts lately. But because of the run-up, Oster thinks bigger companies will shine in 2014. Large caps make more sense in a retirement portfolio anyway because they’re usually more profitable and less volatile than smaller companies.
Best bets by style
U.S. Growth
A market like this one can work for both growth and value investors; which style you use depends on where you want to invest, says Adatia. The U.S market, he says, is better for growth investors right now because an improving economy will give cyclical stocks a bigger boost than value plays.
Andy MacLean, a portfolio manager with Raymond James, is also finding better opportunities in growth stocks. He’s of the view that the market’s gains have been driven by multiple expansions and not earnings growth, thanks to all of the excess liquidity the Fed has unleashed. In that situation, higher-beta names—the more volatile stocks, in other words—outperform, he says.
International value
With the rest of the world still in a precarious situation, it’s a good idea to stick to value stocks outside of the U.S., says Adatia. Value plays tend to be less risky than growth to start with; if something does go awry, prices won’t fall as far. But only buy operations with sustainable balance sheets.
Morphet, who looks for value regardless of geography, says that investors will need to pay closer attention to the news this year than they may have in the past. Because multiples have expanded, you have to act as soon as a value opportunity presents itself. Value stocks tend to be solid companies that have been beaten down for a reason—maybe the company was hit with bad news or its entire sector is undergoing a change. If people are jumping out of a stock, find out why. If it looks the company can recover, get in. “You need to look for these opportunities,” she says.
What to sell and avoid
After such a strong year, Hearn suggests selling or trimming some of the more expensive names in your portfolio. For this value investor, when the stock’s price rises to around 17 times earnings, he’ll consider cashing in. “We try and find an 11-times earner and get it to 17 times,” he says.
Selling is a stock-specific task, says Morphet, adding that she doesn’t usually dump entire sectors. Like Hearn, she likes selling when stocks have outperformed. “You have to constantly redeploy the profits in stocks that are under pressure,” she says.
One theme she’s cautious on is gold. With the U.S. dollar likely heading higher and no sign of inflation on the horizon, she thinks the yellow metal will sink further in 2014. Hearn is underweight in materials generally, which he thinks will continue to suffer from poor demand and depressed prices.
BlackRock’s Oster will be avoiding Mexico and South America this year. Both are expensive relative to other regions, and she thinks they’ll be more adversely affected by the Federal Reserve’s tapering than other developing nations. “They’re just much less attractively valued today,” she says.
While you may have to dig a little deeper for opportunities this year, most experts still think the equity markets are the best place to put your money. “Valuations are not excessive, earnings continue to rise and dividends are still climbing,” says Morphet. “This all makes for good investing.”
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