The Times They Are A Changing
April 11, 2016
Like pretty much everything else, the stock market has changed over time. The world of investing has become shorter term in nature as investors try to fuel the need for instant gratification. Much like fast food restaurants or microwave ovens, investors want their returns sooner and often those return expectations are unrealistic. This has resulted in more chasing of returns as investors switch between countries and asset classes in order to get short term satisfaction. Given the increased flow of information and investor access to view accounts in real time, this is not an unexpected result. However, it has caused advisors, portfolio managers and even companies to change the way they invest or run their business.
Ten years ago, investors were happy if they could pick an investment that doubled over six years (12.3% per year) and they did not worry as much about the path it took to get there. In other words, they made an investment with a six year time horizon and did not watch what happened to it on a daily basis. Today, with the added flow of information, investors will often abandon the initial investment thesis after a bad quarter or two. That is not necessarily wrong but it has caused a change in the investing landscape to which everyone has had to adapt. It has certainly caused managing money to become more difficult as advisors need to spend more and more time managing client emotions rather than stocks and fund managers are pressured to focus more on short term results rather than providing solid long term returns.
Below, we will take a look at why this change came about and how it has trickled down.
Media and Technology
Nowadays, you cannot go anywhere without hearing about what is happening in the stock market in general or about news on a specific stock. People used to talk about the weather but now it is about the market. Whether it is on television (even restaurants and airports seem to have a business channel as the default station these days) or on the radio or in an elevator or at lunch, there always seems to be someone with an opinion. One of the most interesting things might be how those opinions vary and how whoever is giving them speaks with such conviction. Is gold going to $2,500 or $500, is oil on its way to $80 or is it falling back to $20, is the market ready to take off or is this a false rally and will it falter again? We have all heard arguments on both sides of the above questions and have had to draw our own conclusions. Only time will tell which side is right, but the market will bounce around more as long as these extreme opposing beliefs exist.
While the media usually reports facts, how those facts are framed can change the magnitude and direction of the market reaction. For example, if a company reports a bad revenue number but a good earnings number, how it is portrayed in the media will make a difference. If the media focuses on the fact that the revenues were weaker than expected, the stock may go down significantly but if they focus on the strong earnings number and increased margins despite the lower revenue number, the stock may move significantly upward. With the widespread reach and frequency of media reports, their slant on how news should be perceived, matters.
While how instantaneously news is reported has evolved, it would not mean much unless people had the ability to react quickly to that news. With the increased use (and decreased fees) of discount brokerages as well as the ability to look at brokerage accounts in real time, the market has become more reactionary to both good and bad news. Short term reactions to news releases have led to increased market volatility. Investors tend to chase returns based on positive press releases and sell stocks quickly based on negative press releases forgetting about the longer term thesis.
Investors as a whole have fallen into a trap without realizing it. They have discovered that they can make more money on an individual stock quicker than they can in a fund forgetting the subsequent increase in risk. While it sounds obvious that one stock at a 100% weight will move more than a diversified portfolio of 40 stocks at 2.5% weights, it really has not registered with many investors. It is also human nature to remember your winners and forget about your losers so many investors do not know how they have done on an overall portfolio basis. The outcome of this added stock trading is that investors have come to think of mutual funds as stocks and are incorrectly applying many of the same trading strategies.
Investors seem to have forgotten that funds are professionally managed portfolios of stocks run by a team of well qualified portfolio managers and analysts. These professionals are continually altering the holdings based on news, valuations, prospects, reported numbers, etc. To treat them like a stock makes little to no sense. We have heard many comments in recent years that a fund is “at a high” or that it “has had a good run” so they will wait to buy it. They forget that the portfolio manager has likely changed the underlying holdings in the meantime so being at a new high has no relevance. To give a fairly basic example, suppose a fund manager believes that energy stocks have sold off too much and thus increase their portfolio energy weighting to 30%. Then, suppose energy stocks go on a 30% run to increase the portfolio exposure to 39%. That manager may now believe that they are no longer oversold and therefore sell half their energy positions so as to be underweight compared to the market. In this case, performance may very likely be at a new high but the current portfolio looks nothing like the portfolio that made that new high. Treating funds like stocks is a problem in today’s market.
Ten years ago, if stocks sold off too much, funds were willing buyers at those lower levels and thus helped the market remain relatively efficient. Today, with individuals treating funds like stocks, when there are market sell offs, investors redeem their funds too. Instead of mutual funds being there to buy these undervalued stocks, they too may be sellers to meet the redemption requests resulting in a double whammy. The stocks therefore get pushed down further leading to a new group of panicked sellers which may lead to it snowballing out of control in the short term. We believe that this behaviour is one of the reasons for the added market volatility.
Another problem we see is that investors seem to invest based on what they hear or what they know. They hear “diversification” and they buy five Canadian Equity mutual funds not realizing that they own the same underlying holdings in most cases so they have not diversified much. They hear “small cap” and they think risky not realizing that owning a small cap fund may actually reduce overall portfolio risk through diversification. They hear “hedge fund” and they also think added risk when again, owning one may actually reduce overall portfolio risk. Individual investors often expect all their holdings to work at once which, of course, means none of their holdings may be working at a point in time. Diversifying may mean that not all things are working at any given time, but will hopefully mean that something is always working resulting in decreased volatility. By investing in what they know, Canadian investors, in general, own too much Canadian equity at the expense of global or U.S. equity funds. While this is changing, it has been a very slow moving process.
The biggest problem facing individual investors in today’s market comes from the need for instant gratification. Most want 10% -15% annual returns with no downside potential. Unfortunately, that does not happen. Today’s investors tend to chase what did well yesterday and sell what did not do well often resulting in lower returns than had they done nothing.
In today’s new world, advisors have had to adjust as well. A good advisor will follow well thought out goals and targets over a long time horizon for their clients. That objective might be to generate income, deliver aggressive growth or provide a more guarded growth portfolio. If a decision was made to have guarded growth and the advisor delivers in an average or weak market then everything is fine. However, in a strong market, the end investor might talk to their neighbour or best friend and wonder why they did not get higher returns and change advisors, forgetting their investment objectives. If a client states that they want aggressive growth and the market is weak, they may significantly underperform and may change advisors. Today, advisors need to continually review their clients’ objectives and remind them of how their portfolio is structured but I am not sure it will help in this world of high expectations. The long term return of the TSX is less than 8% per year but investors seem to unrealistically expect significantly higher returns from a diversified portfolio of stocks and bonds. Advisors have to spend more time managing expectations nowadays because the average investor feels more informed but unfortunately, does not have all the facts. Balancing target returns, appropriate risk levels, and expectations based on the incomplete information that investors have is the biggest challenge facing advisors.
Many public companies get caught up in the quarterly earnings game and try to announce some positive news to go along with any short term problems in an attempt to try to protect their share price. Many focus on things that the market wants rather than what is best for the company resulting in the overemphasizing of things that are often no big deal. This should not be surprising given that executive compensation is often tied to short term performance metrics, their shareholder discussions are based on short term events and their portrayal in the media is based on recent happenings.
The last few years, the trend was to add a dividend and to continually increase it, even when it made no sense. A prime example of this was energy companies. We all know that the energy sector is cyclical so why pay a big dividend at the cycle peak when eventually having to cut it is inevitable? The initial few companies that added a dividend benefitted greatly so others followed. The resulting increase in share price after a dividend announcement allowed companies to issue equity to pay for those dividends and, in many cases, increase them. Despite making almost no business sense in most cases, more and more companies followed as they were falling behind compared to their peers and felt investor pressure to keep up. The next phase of the dividend story was to provide the option (the default option in many cases) to have them automatically reinvest in additional shares rather than cash. This allowed companies to pay higher and higher dividends without actually coming up with any money. As more and more investors began taking cash, many companies created an incentive or paid a premium to individuals to take their dividends in shares over cash. The obvious question is: Why pay a dividend (which has tax consequences) if you are just going to pay it in shares? What does the investor gain if everyone picks the share option? They own the same percentage of the company. A company can then raise their dividend again as all it really does is dilute the shareholders. We believe that over time, more investors began wanting the cash, particularly on cyclical companies so we are now seeing the fallout as there are dividend cuts almost every day. This dividend fad appears to be over.
The latest fad is to make big announcements about the number of shares that the company may buy back over the next year. In most cases, the requirement is to buy “up to” a certain number of shares. Being able to buy shares allows companies to provide liquidity and prop their share price up when irrational sellers enter the market. Share buyback announcements are today’s dividend increase announcements. The good news is that share buybacks are optional one-time events that are usually not done unless the company can afford it and they feel that their stock price is undervalued. In today’s environment, almost every bit of bad news is accompanied by some potential good news as executives are worried too much about short term performance. Most negative announcements these days are accompanied by an announcement of a big share buyback, an increased dividend, a big cost cutting initiative, or a review of strategic alternatives (which means that they may try to sell the company at a premium). It is transparent yet it still appears to work.
The old saying that “a little knowledge is a dangerous thing” definitely applies to investing. More and more individuals are taking control of their own finances and making emotional short term decisions at the holding level rather than making unemotional long term, portfolio decisions. Many of their conclusions are being made using incomplete or inaccurate information which has led to increased market volatility, particularly inter-day. For example, people are buying $100 positions of a stock through a discount brokerage, paying a $10 commission to buy and a $10 commission to sell, not realizing that the stock needs to go up 20% for them just to break even. Individuals are mistakenly thinking that they can run their personal portfolios on a part time basis better than trained investment professionals on a full time basis. All this adds up to a different market today than in years past. As a result, it has become a more difficult investing landscape but those who set an unemotional plan and stick to it should be rewarded in the long run.
There is nothing wrong with taking control of your financial future but do it in conjunction with an investment professional as you set realistic expectations for future growth and understand the purpose of each holding in your portfolio rather than chasing what worked yesterday. The world has changed but long term investing has not. Be patient and remain unemotional.
For More Information:
Keith LeslieChief Risk Officer & Portfolio Manager
Keith Leslie is the Chief Risk Officer (CRO) and a Portfolio Manager at Norrep Investments. Keith leads two of the firm’s alternative investment strategies, with a focus on Canadian equities. He has over 17 years of investment management experience and…
Keith Leslie CFA
Chief Risk Officer & Portfolio Manager
- ExpertiseQuantitative Investing
Keith Leslie is the Chief Risk Officer (CRO) and a Portfolio Manager at Norrep Investments. Keith leads two of the firm’s alternative investment strategies, with a focus on Canadian equities. He has over 17 years of investment management experience and is an award winning Portfolio Manager. Prior to joining Norrep in 2001, Keith worked as a Quantitative Analyst at a western Canadian investment firm.
Keith brings a different perspective to the firm’s investment process, using statistical techniques, valuations tools and modeling. He is the Portfolio Manager of Norrep Market Neutral Income Fund, Norrep Canadian Enhanced Equity Fund and Norrep Core Canadian.
Keith graduated from Western University with a Bachelor of Science in Statistics and Mathematics and is a CFA charterholder.
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