An update on investment strategies & opportunities will be discussed in this article. They are based on my outlook and expectations of the economy, investments, and the markets, which have been outlined in the previous two articles,
For function-centric and value investors, market trends do not form the basis for our investment decisions. Markets are largely unpredictable from day-to-day, month-to-month, and year-to-year. Market conditions are much more useful indicators, than trying to predict market direction or movement. Knowledge of the conditions and our expected outlook of them, can be useful for determining the likelihood of opportunities that may be created by those conditions.
It would also be beneficial for investors to include and plan out scenarios which consider the outlook for investments and the market. It is prudent to plan for a variety of different scenarios (declining ones in particular), in order to make the most informed decisions. However, investors should always refer back to their original detailed plan and corresponding planned actions.
General Investment Strategies
Increase cash position
If a broad based market decline occurs, there will be an abundance of opportunities at low valuations. Having lots of cash on hand will definitely be advantageous. The trade-off, is that by holding more cash, less of it is allocated towards the opportunities that exist now or present themselves in the short term (even though there are fewer opportunities now). My current cash position is the highest it has been since mid 2007, and my acquisition activity has also slowed to the lowest point since early 2007.
A balanced approach
A balanced approach is recommended. Invest in some really good opportunities in the short term (provided you find any), but hold back the majority of your capital for an abundance of easy opportunities that may come. The easy opportunities would give the largest return with least amount of work, and at better prices. In other words, allocation of capital is much more efficient in those circumstances than it is now.
Reduce specific positions
Scale back & reduce positions where the investment/asset is trading close to or above fair value, in order to increase capital resources for redeployment later on. Investments close to fair value, and those that are overvalued, are more likely to experience price declines (in general). Reducing overvalued positions allow you to capitalize and profit from general investor over-enthusiasm. For certain investments where an investor intends to hold them indefinitely (perhaps due to income or other reasons), the following questions & trade-offs should be considered:
• Would the remaining portion of the investment still provide the required amount of income according to your investment plan? If so, then reducing would not impact that functionality, but would maximize future opportunity through redeployment of capital. However, if it does, then it would not be recommended to change that position and continue to maintain the income level that the investment currently provides.
• Would the proceeds & profit gained from a reduction (capital gains) be much larger than the normal return attributed to the distribution (dividend) payments received? If not, it is likely not worthwhile to reduce that position just to gain a few more percentage points of return. However, if it is much larger, then it may be more efficient to capture that capital gain from the position reduction and redeploy the capital.
• The amount of reduction made to any current position, should not be so large that the remaining size of the holding no longer performs its original intended purpose in the investment plan.
Focus on areas that require attention
Review your detailed investment plan and create an itemized list of all functional areas that require attention. This will help you to prepare for opportunities and ensure you make the most of them. Some details to include:
• Prioritize each item in terms of importance and need.
• Consider the expected market outlook, and the likelihood that there will be the opportunity to adequately address each item.
• Compare the likelihood of those opportunities with each other. Consider how best to handle the mix of opportunities that might present themselves. For example, one item that may be of much higher importance than another area, may present relatively fewer opportunities. Or an item of lower priority may present an abundance of opportunities first.
• Don’t forget that high priority items cannot be neglected for too long.
Create a wish list
From the prioritized list, look for actual investments that may fulfill the intended purpose of each item. Create a “wish list” of candidate investments and perform the necessary research & due diligence now, even if the opportunity to acquire them at a discount doesn’t exist yet. This is a time saving activity, as you likely won’t have enough time to perform all the work needed to make the most of out a broad abundance of oppournities:
• Filter out any candidates that do not meet your investment criteria. Determine the amount of capital you plan to allocate towards the functional item in total, as well as towards each candidate.
• For each candidate – Set price ranges at which you would invest a small portion of capital, ranges for which you would consider investing significant capital, and ranges where you would not acquire the candidate at all.
• Keep your search broad at first, by looking at a wide range of assets & financial instruments. With functional investing, try not to constrain yourself to thinking about investments which you already know exist. Instead, think about the need you are trying to address and look for something that might fulfill that need. Remember that instruments such as ETFs were not widely available 15 years ago. When they first became available, it took many more years for investors to look into them. In many cases, ETFs could have been used over other more well known instruments, as more effective tools in specific circumstances.
Focus on higher quality & lower risk assets
Global risks are increasing. You do not want to be caught holding high risk assets when things turn bad. The negative impact of a global recession, economic problems, bursting of bonds bubbles, and a significant market decline, is likely to be greater for assets that are more risky. Minimize unnecessary risk. For equities, focus on companies with solid balance sheets, strong competitive advantages, and realistic growth outlooks. For bonds, focus on companies that have a strong business with solid finances, that are highly likely to be able to continue paying distributions in the event of a bond market decline (more difficult to raise financing at that time). Currently, government bonds are not looking very reliable as debt loads and social costs have literally broken their banks. Corporate bonds are likely over priced. Equities and bonds are discussed in further detail in the following sections below.
The current low rate environment still makes a very good case for equities as a major medium of investment, but investors must be very selective under the current conditions. In general, value opportunities still exist, but there are far fewer on a broad basis and more difficult to uncover.
Current market conditions are not providing too many high quality opportunities within North American equities. However, more value can be found in the U.S. financial sector, as investors have largely avoided it post-financial crisis. Changes to banking regulations & requirements have made it more difficult for banks to do business and operate as profitably as they have in the past. This has also created larger differentiation between the stronger & more competitive banks, and the weaker & less efficient ones. This will help investors to filter potential investment candidates. The large caps have been the most popular among investors for the U.S. financial sector, and there are a small number of good value plays left of higher quality. However, small and mid-cap regional financials in the U.S. present a much greater source of opportunity. As bank failures continue, the stronger banks have been taking over weaker ones, as well as the assets of failed banks through the FDIC. For banks and thrifts, look for ones that are able to maintain strong revenues, deposits, NIM, ROA, ROE, EPS, TCE (Tangible Common Equity), and low ratio of non-performing loans. Refer to the Bank Valuation Series for more metrics. Look for banks that are very profitable, but well capitalized, rather than highly leveraged. Also look to ones that are growing their market share and expanding their physical presence (i.e. increasing retail branches, new divisions or industries).
There are slightly more value opportunities in European listed equities. However, risk is actually present. Though, some ADRs and some within the UK might be worth considering. Investor should stick to quality global names. Average investors should avoid euro area financials, as they are difficult to assess (hard to estimate impact and asset linkage). The more enterprising investors should approach them with caution, be intimately familiar with them, and be realistic about the risks. Recalling the circumstances surrounding American real estate and financials in 2008 is beneficial. The fine details are extremely important and relevant.
Japan and Korea offer more value opportunities. Japan in particular, has been depressed for quite some time. Despite the recent uptrend in the Japanese market, their stocks are still undervalued and at multi-year lows on a broad basis. Even though Japan’s stimulus may not move through the economy as they expect, the policy measures do support the Japanese equity markets, and benefits from the strong U.S. dollar (and weaker Yen). The value within these companies may be finally unlocked in their share prices. Korea which is also highly developed, has seen huge economic growth in the past ten years and remains an economy that is expected to continue steady growth. If you are unfamiliar with these two countries, it is easier to start researching the ADRs listed in North America (with English financial reports) before using your global trading accounts (Japan & Korea listed investments have financial reports that may not be in English!).
Commodity related equities
Commodity related equities are cheaper than most other sectors, and by a larger margin. In particular, the metal miners have seen their prices decline severely within the past two years. That presents investors with some very good value opportunities. Look for miners with very good growth potential, but also with enough capital on hand to execute its growth strategies. Those with strong balance sheets and growth will likely do well in the long term. However, we should expect to see more consolidation in this sector than we have so far. Micro caps will likely be swallowed by juniors, or mid-tier mining companies looking to expand their presence. Large cap mining companies may look to replenish their pipelines with micro caps and juniors. As of late, the blue chip commodity giants have seen a lack of growth in the pipeline (some of which have experienced difficulties), but have spent large amounts of capital. Investors have been pressuring them to be more effective with their exploration programs and capital spending. The acquisition of junior miners with better growth potential and discoveries, become an attractive and immediate answer. Oil & gas sectors have some value, and will also likely see more consolidation activity especially related to mid-tier and junior level companies. Though, the bulk of value remains with the miners.
Inverse Equity Indices
Given my investment & market outlook, one might conclude that inverse equity index ETFs may be a great tool to capitalize & profit from the decline of markets. However, because indices essentially track trends, you want to capitalize on the large and longer-term trends, not small and very short-term ones. These tools may not yet be useful at this exact level and current condition. The key is not trying to time “getting in” at the very start of a trend (in this case, a large decline), and you don’t need to in order to make a good return. Attempt to capitalize when a long declining trend and investor uncertainty has been confirmed. Likewise, as the conditions stabilize and the market uncertainty begins to disappear, exiting early or even shortly after the long declining trend is actually over would be profitable (i.e. you don’t need exit at the very bottom of a decline). When you add up the numbers, the return will be significant nonetheless. Large trends are easy oppournities, but you must have the stomach for it. It is also true you will lose out on a few percentage points, by not purchasing at the absolute start and end of a trend. However, as I mentioned, you don’t need to.
Any guaranteed investments should be held as cash, or locked-in at very short terms and at special rates (ex: 100 days special rate). With rates at multi-year lows, they are not likely to go any lower. Rates are likely to stay low for at least the next 6 months, and are more likely to go up than down at this level. The few percentage points more for locking in longer, doesn’t give much more in terms of overall return. Avoid anything long term. Investors may be enticed to lock in for the long term with stepper or laddered rates. Some are offering 4% in the 5th year. However, with rates so low in the first few years, the annualized rate of return will still be very low over the 5 years. 5 years from now, investors would likely be able to get a higher rate of return at that time, for 1 year, than locking in at 5 years now. The benefits of market linked GICs may also be enticing. Investors may be drawn to the performance of the equity markets over the past 4 years, and the most recent performance. Most of these require a minimum lock-in period of 3 years. However, given my outlook, it is likely that the performance going forward will not be sustained within that 3 year period. Market linked or equity linked GICs / guaranteed investments are not recommended. Those are best utilized during, or immediately after, a large market decline.
I’m not a gold bug, but gold may not a bad investment, from the perspective that it can be used as a potential store of value. Despite the recent plunge in gold prices and outflows from gold ETFs, central banks and consumers have still been buying the precious metal. It is interesting that gold has actually fallen in market price during the past 6 months, considering that quantitative easing (money printing) by several nations has increased dramatically and that the Euro Zone debt problems continue to persist without any end in sight. I would recommend the conservative approach, and expect only moderate returns from gold. It might not go up at same rate it did before, but it is still seen as store of value in uncertain times by many investors and central banks (a view that will not change quickly, or easily). If corporate earnings disappoint, uncertainty will likely rise.
The use of leverage at these low rates can be useful, especially for real estate investments. Current rates are likely the lowest cost of capital you’ll be able to get. You can secure investment loans against term deposits at low rates. However, leverage should only be used by advanced investors, who can cover the interest and the entire loan itself. Caution is definitely needed. I do not recommend the use of leverage for average investors. It is an easy way to boost returns, but also an easy way to lose money, or put yourself in a terrible situation.
Equities / Stocks
With more & more analysts issuing buy recommendations, price upgrades, and even higher market targets, it may be easy for investors to get caught up in the euphoria & hype. The number one risk right now is overpaying for equities. Be careful not to over pay for any specific security no matter how good recent performance has been and how high growth expectations may be. Valuation matters more now, than ever!!
Equity Index ETFs
Equity or market index ETFs are not recommended at these levels. You may not be overpaying yet. However, the market is not cheap, and it is likely to only give a smaller return going forward than it has in recent years. Price declines are more likely at these levels.
In recent months, there has been huge inflows in to emerging market funds and stocks, as investors look for higher yields. However, BRIC and emerging markets, do have higher risks than North American equities, and investors need to take them into consideration. Their markets and financial systems have yet to experience the same type of turmoil that developed nations have. They have never had to implement new regulations on securities to handle crises situations. In fact, regulations may be looser and still loosening on securities. For example, the Chinese market has indicated it plans to loosen regulations and form new ABS (Asset Backed Securities) policies, which would allow more entities to sell them. China is often turned to as a source of high growth by investors, but it has many problems. It is difficult for average investors to be certain about a company’s true financial condition, or the intentions of management. China still remains a challenge even for enterprising investors. Brazil may be a better alternative than China and is a bit more mature.
Bonds and bond funds are conventionally seen as stable, conservative, and low risk. Yet, the current market prices of bonds, and underlying bonds of bond funds and ETFs, make bonds and related investments a high risk proposition. Bonds would be the worst use of capital resources, as they they are more likely to go down by significant amount than up. At the moment, yields are very low as investors have been paying price premiums for government and corporate bonds. A downward movement in price for a bond results in a yield increase. Given the high prices, it is best to wait for them to come down. When bond prices ultimately fall back to earth, the bursting of this huge bond bubble will be bad (investors will see large losses). But the effect will be worse than most expect, as investors haven’t been buying up just typical bonds, but also bonds of lower quality (including junk bonds) and has overpaid for them. Simply put, don’t buy bonds, bond funds, or bond ETFs.
Too many investors have been chasing income yields, whether it be from bonds or dividend paying stocks. Canadians in particular, have a love affair with dividend stocks, such as the big banks or large telecom companies. REITs, pipelines, utilities, income funds, and other income type securities are likely to be fairly or overvalued, on a broad basis. Don’t chase these yields. However, some individual securities may be of good value. These will be few, and harder to uncover. But enterprising investors willing to do the leg work to find good value may be rewarded.
The Bottom Line
If you haven’t gotten back into the markets during the past few years, current valuation levels suggest that conditions are NOT appropriate for deploying the majority of your capital. The level for doing so has passed and is far behind us.
Increase your cash position for more attractive opportunities that may present themselves at a generally lower market level. If you are going to invest a little on good opportunities that you may find, a balanced approach is recommended. Continue stick to high quality at low valuations and don’t over pay!
NOTE: Please consult a financial professional before employing any of these ideas.
Thanks & Happy Investing! — The Investment Blogger © 2013