If you can’t wait for 2011 to end, you’re not alone. For money-conscious Canadians, this has been another difficult year. We’ve been told that we need to save more, that housing prices are unsustainable, that bailouts in Europe will help solve the globe’s economic problems, only to see Greece and Italy descend further into despair. The stock market has been jumpy too, and low bond yields make it almost impossible to grow a nest egg safely. But a new year is on the horizon, and there may finally be a reason for savers to be optimistic: equities have been so beaten down over the year that there’s nowhere for stock prices to go but up.
Most stock markets are dirt cheap. There are only a handful of times over the past 20 years that the Standard & Poor’s 500 and the S&P/TSX composite index have had price-to-earnings ratios this low. At the end of October, the S&P/TSX was trading at a P/E of 15—its average since 1994 is 19.25—while the S&P 500 had a P/E of 13, versus an average of 19.85. Price-to-book ratios are below average, too. With numbers like that, investors are finding more bargains than a snowbird in a Florida flea market.
“It’s time to open up the war chest,” says Michael Lehmann, a portfolio manager with New York’s Third Avenue Management. Lehmann bought stocks throughout 2011, but when the market fell in the autumn his spending went into overdrive. Investors can still play it safe by buying well-known, large-capitalization stocks, he notes, but it may be time to move money out of bonds, which continue to experience record inflows, and into stocks. Some professional investors (see The world according to Larry Fink) are recommending that people devote nearly 100% of their portfolios to equities.
Just because something can be bought at a discount doesn’t mean you should buy it, of course. Stocks were cheaper three years ago. It’s the combination of cheap stocks and clean balance sheets that’s making long-term investors salivate. Since the recession, many companies have been hoarding cash. They’ve also cut operating expenses, and margins are finally starting to grow. In other words, businesses are generally healthier than they’ve been in years.
These facts lead Jim Barrow, an executive director and portfolio manager at Dallas-based Barrow, Hanley, Mewhinney and Strauss, to doubt the likelihood of a double-dip recession. He also points out that the economic crisis was caused, in part, by a crash in the U.S. housing and automotive sectors. Autos and housing are still on the bottom, so they can’t go any lower, he says. “With any longer-term improvements in those sectors—and you will get improvements—the economy will do well.” Barrow is fully invested in the market. He knows the European debt crisis could send his stocks lower, but with many stocks trading at a 30% to 50% discount to what value managers deem their intrinsic value, he sees no point in waiting on the sidelines any longer.
Lehmann and Barrow’s views often get drowned out by the bears, such as Gluskin Sheff chief economist David Rosenberg, who think we’re headed for another recession. Rosenberg argues that productivity is declining, people are saving more, American job losses are going to increase and U.S. commercial real estate could be the next bubble to burst. In October, he wrote that we are “confronting the next leg of the most intense deleveraging cycle in modern history.”
Like many in the markets, though, Sam Wiseman, chief investment officer at Toronto’s Wise Capital Management, is tiring of the bears’ unwavering growl. “If you listen to these guys, it’ll seem like we got mauled 100% every year,” he says. Wise, who manages money for large pension funds and wealthy individuals, says that the longer someone stays in the market, the better the return. His research has shown that any five-year return in the Canadian market and any 11-year return in the U.S. since 1970 is positive, assuming you invested on the first day of the year. Crashes don’t matter, he says, as long as you stayed in and rode it out. “That’s the type of time frame you need to be in the market,” he says.
There’s another reason why markets will make people money in 2012, says Srikanth Iyer, head of global systematic investments for Toronto’s Guardian Capital Group: dividend payouts are set to climb. During the recession, many companies cut payouts or halted increases, he says. Now, with corporate balance sheets flush with cash, dividends will have to start rising again.
Iyer explains that dividends are due for a comeback. In 2010, stock price appreciation represented 85% of the gains made in the market. Dividends accounted for only 12%. That’s about the same as the ratio was in the 1990s, but in the decades prior, dividend appreciation accounted for between 24% and 71% of total returns. The reason for the decline, says Iyer, is that in the ’90s CEOs were rewarded with stock options. In order to get paid, the earnings had to rise. Companies put less emphasis on dividends and more on growth. Now, he says, CEOs are being rewarded with restricted stock that can only be sold after a certain number of years. Therefore they are more motivated to generate dividends in the meantime. That, combined with the demand for income from investors and the fact that companies have so much cash saved up, makes Iyer believe that over the next few years dividends will once again make up a significant part of the market’s total return. “What are they going to do with all that money?” he asks. “They need to grow the company or pay it out.”
To withstand the shocks that could still come, though, investors have to do their due diligence and choose the right companies. Lehmann first looks at debt. The company has to be able to roll with a short-term setback. He likes to see the ratio of debt to total capitalization (debt divided by shareholders’ equity plus debt) under 50%. He then looks for an above-average return on equity and a high percentage of the management’s own net worth invested in the company. When calculating the price-to-book ratio, Lehmann removes goodwill—a price put on intangible assets, like a strong brand name—in order to get a company’s tangible book value. As with P/E, the lower the ratio, the cheaper the stock. He also looks for companies that trade for under 10 times normalized earnings, under five to six times EBITA, and free cash flow yields should be in the 7% to 10% range.
Tim McElvaine, a value investor and president of Vancouver-based McElvaine Investment Management, wants his assets to at least double over four or five years, so he looks for stocks that he thinks will do just that. He pays particular attention to discounted cash flow—an estimate of future cash flow that factors in risk and length of time invested. “You’re making assumptions about the future,” he says.
The bottom line is that you want to buy a discounted company that’s running a solid operation, has strong earnings and lots of potential. Fortunately, in today’s precarious investing environment, there are a lot of sectors with companies that match those criteria.
One of the sectors poised to make investors money in 2012 and beyond is energy. Irwin Michael, founder and president of Toronto’s ABC Funds, says that energy companies are “very cheap” and not reflecting the still high price of oil. People aren’t just nervous that markets will fall; they’re worried energy prices could drop, too, and that’s depressed share prices. Add to that increasing demand from China, and the long-term outlook for oil stocks looks good. Lehmann and Wiseman also think natural gas—which is at US$3.69 per thousand cubic feet—should climb to at least $5 in the short-term and $9 longer term. Again, demand from China for cleaner fuel sources will push prices up.
Barrow and Iyer think investors should bet on tobacco stocks. While these companies are unsurprisingly out of favour with many investors—a lot simply won’t buy these companies on moral grounds—they think the sector’s high yields, low correlation with market cycles and steady earnings will make investors give them another look, and then stock prices will appreciate. If Philip Morris is any indication—its share price has increased 43% over five years and about 20% year-to-date—their prediction will be right. Wiseman’s also looking to agriculture for big returns next year. “The world is eating better and needing better yields on food,” he says. There are lots of stocks with good long-term potential, such as Agrium and PotashCorp.
Looking back from five years hence, 2012 could well be the year of the stock. “There are terrific long-term growth stories,” says Lehmann. “Get through the shorter-term period that’s focusing on Europe, and the next five years looks great for equities.”
Cheung Kong (Holdings) Ltd. (HKG: 0001)
This Hong Kong–based conglomerate is one of Michael Lehmann’s favourites. The Third Avenue portfolio manager likes Hong Kong commercial real estate, but Cheung Kong also owns retail buildings, it’s the world’s largest port operator and it owns infrastructure. It’s also dirt cheap with an 8.1 price-to-earnings ratio.
Glacier Media INC. (TSX: GVC)
Portfolio manager Tim McElvaine can’t get enough of Vancouver-based Glacier Media. The community newspaper and trade magazine publisher is small— it’s got a $160-million market cap—but it has all the criteria for a good stock. Directors own about 33% of the company, the head office is modest, it has good free cash flow and it recently acquired some bigger titles from Postmedia Network. It trades around 10 times earnings.
Savanna Energy Services Corp. (TSX: SVY)
Calgary-based drilling company Savanna is high on Irwin Michael’s list of must-buys. The portfolio manager likes its management team and diversification; it drills and rents oilfield equipment in Canada, the U.S. and Australia. It’s trading at a cheap 0.9 times book value and has a low debt to common equity of 16.4%.
AVX Corp. (NYSE: AVX)
AVX, based in Myrtle Beach, S.C., makes electrical components for cellphones, hearing aids and other devices. It’s a cyclical company, says Lehmann, and it tends to get too undervalued on the downswing and overvalued when business is good. The company has a dominant market share in its industry and is trading at eight to 10 times earnings—a 50% discount to what it should trade at, he says.
KeyCorp (NYSE: KEY)
Cleveland-based KeyCorp is a regional bank with about $50 billion in assets. It’s a stock Lehmann wished he could have bought years ago, but valuations were too high. No longer. The company is trading at 35% discount to its tangible book value. It is also well capitalized, though it did get caught extending too much credit in the mid-2000s. Its stock has rebounded, and Lehmann expects it to climb further as the economy improves.