When your stocks are down, remember that every dog has its day.
Equity markets have had a strong start to the year. The positive shifts in investor sentiment and stock prices since the end of 2018 are remarkable. Fears of an economic recession have morphed into optimism that the global economic expansion will continue.
We are at a loss to find material factors that explain the dramatic change in attitudes. From our perspective, we are neither overly excited, nor fearful about the outlook. With most stocks reasonably priced, and some deeply discounted, we believe prospective returns are attractive.
The seven dogs of Odlum Brown
At our 2019 annual address, we highlighted seven stocks in the Odlum Brown Model Portfolio that performed especially poorly last year. Surprisingly, the audience reacted with chuckles. Perhaps that was because of the guilty-looking dog we projected on the screen. We suspect some of the quiet laughter reflected relief that we were acknowledging our mistakes.
Investing is a humbling affair at times and it’s always wise to recognize errors, but that was not the purpose of the discussion. Rather, it was to suggest that selling the dogs when they are loathed and depressed would likely exacerbate the situation.
It’s natural to have doubts when investments disappoint. However, doubt can damage your portfolio if it promotes selling at an inopportune time. Most investors perceive greater risk when stocks go down, but the opposite is often true. The risk of losing money goes down as prices fall, while prospective returns go up. Think of it like a teeter-totter, price and risk on one end and return on the other.
Coty Inc. (NYSE—COTY), ING Groep NV ADR (NYSE—ING) and Colfax Corp. (NYSE—CFX) were among the worst-performing companies in our Model, and among the seven companies we highlighted. Canadian energy investments had been a huge disappointment as well, with companies like Peyto Exploration & Development Corp. (TSX—PEY) and Cenovus Energy Inc. (TSX—CVE; NYSE—CVE) well off their highs. Likewise, US housing-related stocks, such as home-builder TRI Pointe Group Inc. (NYSE—TPH) and timber owner Weyerhaeuser Co. (NYSE—WY), which rounded out the list, weighed on our results.
These dogs, indeed, had their day
Nevertheless, we’d owned frustrating stocks before, and our patience had yielded satisfying rewards. Not all of the disappointing companies would recover and do well, but if history was a guide, the odds were very good that many would be top performers down the road.
That has certainly been the case this year. The seven stocks highlighted at the annual address produced an average return of 31 per cent for the year through to mid-April, led by Coty, our worst performer in 2018, with nearly a 70 per cent return.
Comparatively, last year’s 10 best-performing stocks yielded an average return of 13 per cent; that’s less than the 16 per cent and 15 per cent returns for the S&P/TSX Composite Index and the S&P 500 (in Canadian-dollar terms).
While this recent experience highlights the potential benefits of a contrarian investment approach, it would be a mistake to get carried away betting on the laggards. We believe our dogs have done particularly well this year because the general disdain for such stocks was extreme late last year.
Riding the winners works too
In fact, it was the first time in many years that we felt investors were irrational and justifiably negative toward a group of stocks. In December, we identified leveraged businesses, Canadian energy stocks and US housing-related stocks, as severely beaten up and discounting an overly pessimistic outlook.
Investor sentiment has improved considerably since then, and the valuation spread between loved and unloved stocks is not as extreme; as such, the odds the dogs will outperform are no longer as good.
Moreover, contrarian investing has generally not worked well in recent years; it has been more profitable to ride the winners. While that might seem intuitive, it is not always the case. In the Model’s first 10 years, we regularly took profits from our winners and reinvested them into the laggards. This strategy worked very well and produced a compound annual return of roughly 20 per cent between 1994 and 2005.
Sometimes it helps to be a contrarian
We would love to outperform all the time, but realistically, that will never be the case. We often challenge the crowd mentality and purposefully position our portfolio differently than the general market in order to achieve above-average, long-term results. Being different is a part of our philosophy and has yielded the expected rewards over time. Yet, a number of times along the way, periods of poor absolute and relative performance have rattled our nerves and tested our resolve. Most great money managers have shared similar experiences.
Warren Buffett is arguably one of the world’s best investors. Shares of his company, Berkshire Hathaway Inc. have underperformed the S&P 500 in 16 of the 53 years since he’s been at the helm. That’s 30 per cent of the time, and is similar to our experience. Our year-over-year return has been less than the Canadian benchmark in seven of the last 24 years, roughly 29 per cent of the time.
Riding a winning streak
Perspective is important when considering relative performance. Prior to 2018, we bettered the performance of our benchmark for seven consecutive years. That represented the longest winning streak in our Model’s 24-year history.
Over the last 10 years, the Model has risen 302 per cent and more than quadrupled in value. The S&P/TSX Total Return Index is up only 161 per cent over the same period. Nonetheless, a good long-term record doesn’t change the fact that it feels lousy when we are not keeping up. It’s hard on everyone when the investment winds aren’t blowing our way.
As director of investment research, I ask our analysts a lot more questions. Our advisors wonder if our research team has lost its mojo. The conversations clients have with their advisors are not as fun, and more time is spent talking about the equities that are not doing well rather than those that are. It’s natural to have doubts, and to feel nervous and uncomfortable when results fall short of the benchmark. It’s human nature to want more of what is going up and less of what is going down. Humans are instinctively wired to act on those emotions and make changes—to sell what is not working and buy what is popular and performing well.
Unfortunately, doing so often sets the stage for poor performance and further disappointment down the road.
Adhere to discipline
When we reflect on previous periods of poor relative performance, there are some common themes. It’s often late in the economic cycle and there’s usually a fairly clear delineation between what investors love and what they hate; between very expensive and very cheap stocks. We typically underperform when we hold on to our out-of-favour stocks.
In 2000, we didn’t keep pace with our benchmark because we were overweight in Canadian stocks, at a time when investors loved US stocks in general and technology stocks in particular. Before and after the 2008 financial crisis, we didn’t keep up because we favoured high-quality US growth stocks, when Canadian resource stocks were popular and expensive. Our patience, along with the resolve to adhere to our discipline and stay focused on the long term is what set the stage for the solid recoveries we experienced following those periods of poor relative performance, and we are confident this strategy will yield rewards again.
Nonetheless, we caution that it’s harder today to make a difference by being different. Investors are not manic like they were in other cycles, and consequently fewer equities are materially under priced.
The high-quality growth businesses we own are popular and yet reasonably priced. While we don’t expect ‘reasonably priced’ businesses to meaningfully beat the market over the long term, it seldom makes sense to sell great businesses unless they are excessively priced. We have selectively taken some profit and added to our out-of-fashion holdings, as we strongly believe that group will outshine the market over the next few years. Still, we think it would be a mistake to overemphasize today’s unloved equities, since most are lower-quality businesses.
Focus on quality and be patient
We believe focusing on quality businesses and being patient with disappointing holdings during tough times (unlike the often emotionally-driven crowd) makes us different, and will make a difference again.
We live in a more challenging, slower-growth world, in which the competitive advantages of the best businesses are fortified. Technology, increased regulation and globalization are key reasons for this trend and are unlikely to change. Our investment style has evolved to reflect our view that the best businesses are most likely to thrive in this economic environment. It’s not the good old days, when a rising tide lifted all boats.
Still, we reflect on the strong performance of our dogs this year as a reminder that contrarian investing is not entirely dead. It’s a strategy that works when investor sentiment is excessively negative. It’s worth remembering the expression ‘Every dog has its day’ the next time you feel anxious about a bad market and the dogs in your portfolio.
Murray Leith is executive vice-president and director of investment research at Odlum Brown in Vancouver.
This is an edited version of an article that was originally published for subscribers in the May 24, 2019, issue of Investor’s Digest of Canada. You can profit from the award-winning advice subscribers receive regularly in Investor’s Digest of Canada.
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