The 15-minute RRSP makeover

What to buy, hold and sell.

Illustration by ilovedustFor more than 50 years, Canadians have been pouring money into their registered retirement savings plans. For most of that time, what they put into those plans didn’t matter all that much. Stock markets steadily climbed for decades. In the 1990s, most equity categories rose and the value of investors’ nest eggs soared. Today, it’s a different story. Many RRSP portfolios were decimated during the recession, and countless baby boomers, who will soon be forced to withdraw from their accounts, are wondering if their investments will ever recover.

If we’ve learned anything during the past few years, it’s that people need to take a more active approach to their portfolios. We can no longer just scoop up whatever looks good and admire our capital gains. We need to concern ourselves with how our RRSPs are structured.

See MoneySense‘s RRSP Guide 2013

At a minimum, investors should rebalance their portfolios once a year in response to both their evolving needs and the changing marketplace. That means selling winners that have had their day, and duds that will never have theirs, and reinvesting the proceeds. The goal is to get your overall asset allocation—the proportion invested in equities versus fixed income—back where it started. If the stock market does well one year, your assets could become too exposed to stocks. If it does poorly, you may end up owning less equity than you want. By selectively selling and buying, you can get back to your desired asset balance. According to Ken Solow, author of Buy and Hold is Dead (Again), that simple act can add 50 to 80 basis points of extra return (each basis point equals one one-hundredth of a percentage point). If now’s the time to rebalance your portfolio, it’s time to review what some top market minds think you should continue to hold, what you should sell and what you should buy (more of) going forward.

What to Hold

One thing that hasn’t changed is the basic approach to RRSP investing. An RRSP is a long-term savings vehicle that you don’t want to touch until you’re sporting wrinkles and grey hair. “This is your pension plan and should have the characteristics of one,” says Paul Gardner, partner and portfolio manager at Toronto-based Avenue Investment Management. “You want to own life-long assets.”

Generally, long-term assets mean large-cap equities that pay a dividend. While it’s always been important to hold these types of stocks, it’s especially prudent in today’s return-challenged environment. Because they’re so big, and often multinational, large-caps—companies with a market capitalization of $10 billion and up—have a lower risk profile than smaller companies. Their dividends help portfolios grow even in up-and-down markets. Anyone who doesn’t make steady, yielding companies the bedrock of an RRSP portfolio, says Gardner, is foolish. “You have to own these because you’re getting paid something while you wait for returns,” he says. “If returns were 6%, you wouldn’t need dividends. But they’re not.”

For A. J. Sull, president and chief investment officer of Vancouver’s Pacifica Partners Capital Management, it’s not just about market cap. He’s looking for businesses that are dominating their industries, have done well over time and have strong balance sheets. Ultimately, he wants to own the business with the best profits. “They don’t have to be the largest, but they should be the most profitable,” he says. When it comes to dividends, he looks at dividend growth rate, rather then yield percentage. A company with a 3% payout that’s growing 25% a year is better than one paying 6% with no growth, he explains. While some investment pros recommend holding dividend stocks outside your RRSP (where they enjoy the dividend tax credit and don’t use up RRSP room), Sull says they belong in retirement accounts too. The extra income will help you grow your savings in sideways markets and allow you to buy more stock.

Canadians who focus on their home markets don’t have a lot of choice when it comes to the type of large-caps they can buy. The Toronto Stock Exchange is mostly concentrated in two sectors, banks and energy. So, by default it’s those two sectors that the vast majority of RRSPs hold. Fortunately, these are good industries for Canadians to build a portfolio around. Many banks yield 4% to 5% and, as we saw during the recession, they’re durable businesses. Oil companies, says Colum McKinley, vice-president of Canadian equities at CIBC, have two things going for them right now: they’re cheap (close to autumn 2008 levels, and oil is about $40 a barrel more expensive than it was back then.

Every basic RRSP portfolio should probably have some exposure to these two sectors, along with the telecom sector, which can pay a 5% yield. Also, in the equity portion of a portfolio, experts say an overall 50% allocation to Canada’s domestic market is enough, splitting the other half equally between American and overseas stocks. The same RRSP rules apply to these parts of the world too; in general, you should look for large-cap, dividend-paying stocks.

Rob Evans, president and portfolio manager with Evans Investment Counsel, says that these days, Canadians should favour brand-name businesses such as Coca-Cola, Pepsi, Microsoft and ExxonMobil. Not only are they high-quality global companies, but they’re also cheaper than they’ve been in years. “These companies are trading at reasonable multiples compared to 10 years ago,” he says. “They have great balance sheets, and risk-return-wise, they’re attractive.”

Every RRSP portfolio also needs to have a fixed income portion, even in today’s low interest-rate environment. How much depends on each person’s personality and net worth. Generally, the younger you are, the less exposure you’ll want to bonds. With most government bonds yielding almost nothing—a five-year Government of Canada bond pays a measly 1.28%—most experts suggest mixing in some high-quality corporates, which can yield between 2% and 4% higher than government notes. In general, you should stick to corporate bonds rated BBB or above, to ensure you’re not taking on too much risk.

Steven Belchetz, president and chief investment officer with Toronto’s T. E. Wealth, suggests buying bonds through an exchange-traded fund or mutual fund. It can be costly to buy individual bonds yourself, and funds are more liquid. He recommends buying a mid-term bond portfolio, which holds fixed income that matures in five to 10 years. The longer maturity adds some extra yield and, since an RRSP is meant for longer-term assets, you shouldn’t worry about rising interest rates lowering bond prices.

What to Sell

Selling duds and overachieving companies is an integral part of building solid retirement savings. The main reason most people sell is to rebalance a portfolio. If the market has a good year, your assets will be more heavily weighted to stocks. If your 60/40 stocks-to-bonds allocation is suddenly 70/30, you’ll want to sell some shares and buy bonds to get your asset allocation back in line.
In fact, you may want to sell stocks more than once per year to take advantage of high valuations. If you really want to boost returns, consider taking profits on companies or funds that have gone gangbusters. The old adage “buy low, sell high” goes for RRSP investing too. CIBC’s McKinley buys stock when a company’s valuation ratios, such as price-to-earnings and price-to-book value, are low. That generally means the stock is out of favour. He sells when those metrics reach fair value.

“When people love a stock or sector, they can trade well above what is a rational valuation of that company,” he says. “We want to capture that enthusiasm by selling into strength.” One of the ways he determines whether a stock is expensive or not is by looking at the company’s historical valuations. If a business trades below the historical norms it could be a sign to buy. When it bounces back to its average valuations he considers selling. Canadian banks, he explains, are trading at about 10 times earnings. When they reach their long-term norm of 12 times, he may begin to realize some gains.

However, selling high isn’t just about making money. Dumping a pricey stock is also a good way to reduce risk. If a company’s valuation gets too high, it can become more volatile; even the smallest piece of bad news can destroy share price. Gardner points to Netflix Inc. as an example. In the summer of 2011, the movie-rental service’s shares were trading at a sky-high 70 times earnings. In the fall, when the company announced that it was going to split its DVD rental and streaming services into two companies, the share price suddenly dropped by about 60%. While investors weren’t happy with Netflix’s change in direction (which it has since abandoned), its high price-to-earnings ratio made the drop that much more dramatic. “If you own something that has a low P/E, there’s some extra protection there,” Gardner explains.

Of course, you’ll also want to sell your underperformers. This is trickier, says McKinley, because you have to decide whether the stock simply hasn’t realized its potential yet or is, in fact, a terminal dud. The first thing to look at, says Sull, is if something’s changed. “Look at the original reason you bought the company,” he says. “If those reasons no longer hold, then it should be sold.”

In some cases, the market can change so quickly that it’s hard to know you’re hanging on to a loser. Many investors, including Evans, were bullish on Research In Motion even as its price was falling. Evans bought some stock at $60—down from $148—and figured he bought a good company cheap. “But then the stock price dropped more, there was bad news, the Playbook wasn’t selling. All of a sudden competitors were eating RIM’s lunch. We reassessed it and realized we were wrong about this business,” he says. Evans sold it at $40. “It hurts taking losses,” he says.

As a value investor, McKinley loves to see stock prices fall. But he also takes a hard look at why they’re falling. “We want to avoid businesses that have deteriorating fundamentals or financial positions,” he says. “Those are situations when we see a competitive position that’s deteriorating or earnings position declining.” Another reason to sell is if the company’s insiders, like the CEO, are dumping stock. “That’s never a good sign,” says Sull. “It shows a lack of confidence and conviction.” Gardner wants to see management own a large piece of the company. If they don’t, he may not buy it to begin with. If the executives’ stake diminishes, he’ll get out.

At minimum, investors should realize gains on the outperformers and take losses on the poor players once a year, when it’s time to rebalance. More active investors should assess their portfolio far more frequently and especially when news comes out that could affect stock prices. “If the news changes, you want to be on top of it and make a decision whether it’s worth keeping,” Sull explains.

What to Buy

Once you own the bedrock investments and know when to sell a bad idea, you can begin adding some additional investments to help boost returns. While sizzling small-caps don’t belong in an RRSP, that doesn’t mean you should avoid growth stocks altogether. The idea, says Gardner, is to buy something cheap enough that, if it doesn’t work out, you can sell without taking a big loss. You still want to look for long-term investments, but you’ll need to pay closer attention to these purchases to make sure they’re moving the way you want them to. “Non-core sectors are usually something that’s washed out or cheap,” says the Avenue Investment manager. “If you’re wrong, you can get out.”

McKinley says people should look at places or sectors that are out of favour. The CIBC portfolio manager only deals with Canadian equities, but he’s taking advantage of global economic fears by buying domestic businesses with exposure to overseas markets. For example, Vancouver-based Finning International, the largest Caterpillar dealer in the world, sells equipment in Canada, South America and the United Kingdom. McKinley bought in at 10 times earnings two summers ago, as investors began turning away from anything European-related. It’s now trading around 17 times. “The company faced challenges, and may still have a couple of earnings-depressed quarters, but it was a good buy at an inexpensive valuation,” he says.

There are many European-based multinational companies that have potential too, says Evans. In general, eurozone companies are trading 20% lower than they were during the recession. Each country’s market is trading at about 10 times earnings or less. The American S&P 500, by contrast, is trading at about 14 times earnings. Many European companies also pay healthy dividends. “If it’s a global business, and you can get it at the right price, then it’s a good buy,” Evans says.

Gardner suggests adding some U.S. financials into the mix. The big ones are incredibly cheap, trading at around 10 times earnings. Plus they have long-term potential if you believe the global economy will recover. Of course, Canadians don’t need to own any more banks—you’ll own a bunch as a result of investing domestically—but that’s the point. In this part of the portfolio, you’ll own things you don’t need, but which will likely pay off one day. Sull points out that it’s rare to have a sector this big and this vital to the global economy trading so cheaply.

Investors, especially those nearing retirement, may also want to hold some gold in this basket. Most experts suggest putting no more than 5% of RRSP assets into the yellow metal. Don’t buy gold because you think the price will climb by another $1,000; buy it as a portfolio hedge. Gold typically climbs if the market drops, but the opposite is also true: it will fall if stocks do well. So consider owning a small percentage in order to mitigate losses should stock markets go awry. The easiest way to hold gold in an RRSP is through ETFs that hold bullion.

A more affordable way to get precious metals exposure is with stock in mining companies. While the price of physical gold went up last year, increasing their profits, stock prices went down. Moreover, gold stocks are easier for investors to evaluate, since they produce annual reports, profits and, in some cases, dividends. Gold simply rises or falls based on demand. As with any RRSP investment, stick to large-cap names with long-term potential. Kinross and Barrick Gold, says Sull, fit the bill.

Whether you own mutual funds, ETFs or individual stocks in your RRSP, consider this three-part approach. And whatever you do, don’t panic if the markets fall again. “Don’t use any new trading strategies,” says Gardner. The point of rebalancing is to make your portfolio fit the long-term plan again, not the other way around.

See to MoneySense‘s RRSP Guide 2013

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