Great returns were easy in 2013. To make money in 2014 you need a different approach

Surprising buys in unpopular places

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Bay and Wellington streets in Toronto

2013 was a great year for the markets, but 2014 will require more thought and skill on the part of investors. (Sam Javanrouh)

Making money in the stock market last year was easy. Pretty much every major index boomed. The S&P 500 soared 32%, while the Dow Jones and the Nasdaq grew 28% and 41% respectively in 2013. Even that laggard among developed markets, Canada’s S&P/TSX composite, returned a respectable 10%.

Low interest rates are still pushing investors away from bonds and into equities in a hunt for returns, inflating stock prices as a result. But the remainder of 2014 (and beyond) will require more thought and skill on the part of investors. The five-year-long bull market is looking tired. Overvaluation is becoming a problem in some areas, and good deals are scarce. Sitting back and enjoying the prevailing market trends won’t cut it anymore. Investors will have to dig a little deeper to find the best returns.

The job will be made harder by the fact that the Canadian economy is sputtering. The Bank of Canada dropped its tightening bias back in October and has remained cautious ever since. In April, governor Stephen Poloz said he couldn’t “shut the door” on the possibility of rate cuts. Economists think that outcome is remote, but the fact Poloz even brought it up does not inspire confidence. Chief among the central bank’s concerns is Canada’s lousy export performance. Global trade is still weak, and a stronger U.S. economy has so far failed to juice demand for Canadian goods and services. Harsh winter weather skewed first-quarter numbers, but an even bigger problem, according to the central bank, is that Canadian factories are not as efficient as their competitors abroad. Even when U.S. demand picks up further, it will take time for Canadian firms to get back up to speed, since many companies slimmed down during the recession. As such, the bank doesn’t expect spare capacity in the economy to be fulfilled until at least 2016.

GDP growth will come in at only 2.3% this year, the Bank of Canada estimates. That’s a slightly downgraded forecast from a few months ago, and is in line with private-sector estimates. Capital Economics in Toronto, probably the most bearish prognosticator, expects 2% GDP growth. “We think the Bank of Canada will have to keep rates low for much longer than the market expects, as this will be necessary to support a flagging economy hindered by underperforming exports, declining housing activity, and heavily indebted households,” economist David Madani wrote in an April report.

Bank of Canada governor Stephen Poloz

Bank of Canada governor Stephen Poloz has scaled back growth projections. (Adrian Wyld/Canadian Press)

As seasoned investors all know, however, a tepid outlook can have a counterintuitive effect on equity markets. A weak economy means the Bank of Canada will maintain its easy money policy, which creates a favourable environment for stocks. Still, some market watchers are doubtful. “This bull market is starting to show its age,” says Vincent Lépine, vice-president of economic strategy at CIBC Asset Management. “The uptrend is going to remain in place, but it’s going to be increasingly challenged.” Although equities are still more attractive than bonds, he says, the returns will probably not be as impressive as last year.

Canadian stocks, for the most part, are fairly valued or slightly overvalued today. “There is an unhealthy thirst for yield in the market, and this has driven up certain segments of the market to super-premium valuations,” says John Berry, a senior vice-president and portfolio manager for Canadian equities at Foyston, Gordon & Payne. Investors have singled out dividend stocks as they chase returns, regardless of the quality of a company’s income statement. Dividends are paid out of a company’s earnings, so a poorly performing company is essentially returning invested capital back to shareholders at the expense of enterprise value. “Those companies are ripe for a correction when interest rates start to move,” Berry says. “There are a lot of retail investors who don’t understand that.” Energy exploration and production firms that were formerly income trusts fall into this category. Utilities stocks, favoured for their dividends, may also be played out, given they’ve experienced a double-digit gain since the start of the year.

Canadian banks are a different story. Each one pays a dividend, but they’re trading at or slightly below their historical valuations. Fears about consumer debt and a slowing housing market are keeping some investors away. Berry argues the concern is overblown and the banks look like a good buying opportunity. “The actual health of these businesses is a lot better than what you would expect if you just read newspaper headlines,” he says.

Valuations won’t be the only thing holding stocks back. A major factor driving equities the past few years has been something called multiple expansion. Companies boosted profit margins by cutting costs and laying off workers. But in many cases, there hasn’t been a comparable increase in top-line growth. Investors hoped to see improvement this year, but Robert Swanson, a principal and portfolio manager at Cambridge Global Asset Management, is not optimistic. Terrible weather over the winter damaged sales for a lot of companies and caused them to miss earnings expectations, which doesn’t bode well for the rest of the year. “I don’t think you can go back-to-back quarters like this and not begin to soften up your numbers for the full year,” he says. “It’s going to be tough to hit your target.”

That’s why investors will need to take a detailed look at individual stock picks. Andrew Marchese, chief investment officer at Fidelity Investments, is finding opportunities in the materials sector, which has fallen out of favour. Commodities and basic materials enjoyed a decade-long run until the global recession hit. Demand from emerging markets tanked just as more supply became available, depressing prices. Commodities stocks followed suit. “Eventually prices will get low enough that it scares off investment, and commodity prices come back,” Marchese says. That’s already started to happen in some areas, such as natural gas producers. Methanex, a Vancouver company that produces methanol, was one of Fidelity’s stronger Canadian stocks last year, returning approximately 80%.

At least investors won’t have to worry so much about shocks from Europe in the near term. A combination of monetary policy initiatives, easing of fiscal austerity and labour-market reforms in troubled countries is leading to a more stable situation in the eurozone. There are positive signs in the underlying economy, too. The manufacturing purchasing managers’ index, a measure of health in that industry, remains above 50, which indicates growth. “I do expect this recovery to continue this year,” says Kai Lam, a vice-president and portfolio manager at Gluskin Sheff + Associates, “but you have to remember that some of these markets are coming from a lower base.” There is still a risk that inflation runs too low and the European Central Bank is forced to implement quantitative easing. But with more liquidity in the system, equities would get a boost. A weaker euro would also benefit European exporters.

Outside of Europe, some emerging markets are looking better after underperforming in recent years. Lépine at CIBC forecasts a 10% return from emerging-market equities this year, compared to low single digits for Canadian stocks. There are still big economic risks in the developing world—in many nations they have intensified—but after three years of flat to falling valuations, equities from this region are irresistibly priced. Some countries, such as India, have also started to normalize by removing liquidity and hiking rates. “They now give you a risk premium after hiking rates to where you feel as a foreign investor that you’re getting a return that’s interesting,” Lépine says.

China requires constant monitoring. Financial headlines have been dominated by claims that the country is approaching a “Lehman moment”—an insolvency akin to that of investment bank Lehman Bros., which precipitated the 2008 financial crisis—as some Chinese companies feel the weight of excessive debt. The failure of Shanghai Chaori Solar Energy Science & Technology to make an interest payment in March, the first domestic corporate bond default in nearly 20 years, sparked a fresh wave of worry.

Such fears are probably overblown. Instead of signifying pending doom, the default was part of a necessary adjustment for the economy. The government is trying to instil discipline so that corporations and investors don’t take on excessive risk in the belief the state will bail them out should things go awry. “China is engaging in a fine balancing act between injecting enough support to prevent a full-on meltdown, but also allowing certain parts of the system to self-correct,” says Vijay Viswanathan, director of research and a portfolio manager with Mawer Investment Management. A managed deleveraging such as this can still cause turbulence, and investors might have to contend with periodic shocks.

Meanwhile, Lépine at CIBC is watching the U.S. Last year, the Federal Reserve began talking more seriously about removing stimulus from the economy. Bond yields and mortgage rates have risen since then, followed by a big slowdown in mortgage approvals, Lépine says. The housing market plays a huge role in the U.S. economy. If the housing rebound loses strength, hopes of a sustained recovery will fade too.

Focusing too much on what can go wrong in the markets means you miss out on opportunities, of course. Berry at Foyston, Gordon & Payne is already thinking ahead to when interest rates start to rise. Companies with big pension deficits today will be rewarded. A pension fund’s solvency rate is based on the yield of long-term government bonds, which are at historic lows. The lower the return, the more assets a fund needs to hold to ensure payouts to its members. Contribution obligations decrease when rates rise. Today, many investors are scared off by the balance sheets of companies with pension deficits, and their share prices are depressed. “If all of a sudden these deficits disappear, then these companies have stronger balance sheets,” Berry says. Investors will jump on board. These companies will also have more capital to reinvest and grow once they’re not required to allocate large chunks of money to their pension plans.

The day when rates rise may be well into the future, but earning sizable returns with equities will take more foresight and research than in the recent past. Those returns will be all the more satisfying, though, when you have to work for them.

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