Three Questions for Bill Richardson Part 6

Question 1:  Many Canadians are complaining about the performance of their portfolios.  They say they haven’t had good returns for a number of years now.  What is the main problem that they are experiencing?

I have examined a lot of portfolios presented to me when people approach me for a second opinion and there seems to be a standard structure that I believe is leading to poor performance.  There is no single problem but a combination of factors.  Let me go over these in detail.

Usually, when you work with an advisor, you will complete some sort of risk tolerance analysis and will be slotted into a portfolio that contains a percentage of fixed income or bonds and a percentage of equities or stocks.  The higher your tolerance for risk, the higher the percentage of equities.  Usually, they are somewhere in the 60% equities/40% bonds to 40% equities/60% bonds. 

This used to work well when interest rates were high or in the 5% to 10% range.  Rates have been declining for over 40 years and government of Canada bonds now sit below 0.5%.  So, there’s problem #1.  Rates are too low today to contribute to performance and you are now totally dependent on equities or as little as 40% of your portfolio to generate a return.  Compound that with fees that may be more than 2% on your overall portfolio (including bonds) and there’s a pretty big wall to climb for the balance of the portfolio to scale.

Many portfolios that I review have most of their equity exposure in Canadian stocks.  The explanation for this is favourable treatment of dividends from Canadian corporations and the desire to avoid currency risk. 

The problem here is that there are very few “great” companies in Canada and Canadian indices are highly concentrated in financial services (banks), energy and basic materials (mining companies).  Banks have performed well in the past but earnings growth has been declining.  Three-year earnings per share growth now stand at 8.87% for Royal Bank compared to Apple at 12.68% and Microsoft at 21%.  Energy stocks are dependent on commodity prices and stocks, like Imperial Oil, have performed poorly and are now showing a five-year compound annual return of -12.96% or total return of -53% over the past five years (source: Ycharts).  Energy stocks and mining stocks go up and down but mostly trend sideways over time, so they are not generally great investments for long-term investors. 

Question 2: So, if interest rates are at historic lows and you don’t want 100% equities in your portfolio how can you generate low risk return in a portfolio?

Many of the large institutions and pension plans, like Canada Pension Plan have shifted funds from public debt, like government and high-quality corporate bonds to private debt.  In many cases, this is a shift from one kind of risk to another.  That is, from duration risk (bonds drop when interest rates rise) to liquidity risk (you may be locked in or unable to get at your money for a period of time). 

Private debt can generate stable returns in the 5 – 6% range and is a good option for investors.  Risks should be analyzed very closely and don’t put all your eggs in one basket, but it is a great place to start.

Question 3: If Canadian stocks are not generating good returns, where do we look for performance?

Say what you want about their president, but the United States is still the world’s economic superpower.  Compared to Canada where it is difficult to find more than a dozen or so “great” companies, the US has many.  The two strongest sectors over the past ten years have been technology and healthcare.  We have a handful of good Canadian software companies, like Constellation Software but it ranks poorly against US tech companies and there are no proven healthcare companies in Canada. 

If you want to improve portfolio performance, shift from traditional fixed income to private debt and focus on US companies with consistent and predictable earnings growth, where that trend is expected to continue and companies that be purchased at reasonable prices, diversify and watch your performance improve.

As always, please let us know if you have any questions or concerns. Feel free to share with family and friends that you think would benefit.

Thanks,

Bill