Portfolio positioning for '02
Consider small caps, overseas stocks, and
While last week's article reviewed and evaluated
past recommendations, this week I'll provide some
suggestions on portfolio positioning for the year
that lies ahead. I'm not suggesting it's a good
idea to make major shifts in portfolio exposure -
that's flat out market timing. Rather,
I'm suggesting making subtle shifts in some
components of some portfolios, to improve
diversification and hopefully boost returns.
Small cap stocks
I've just published a report for our firm's
financial advisors and discount clients about the
opportunities remaining in small cap stocks,
particularly those in Canada. Some would
attribute this recommendation to
"performance-chasing". While it's true
that small cap stocks have outperformed their
larger counterparts over the past year, smaller
companies remain fundamentally more attractive.
In Canada, not only do smaller companies offer
greater growth at a lower price, but they also
carry less debt than larger companies. In fact,
capital markets forced them into shape - call it
During the latter part of the 1990s, when the
market's infatuation with large caps really
blossomed, it became tougher for smaller
companies to get access to capital. Venture
capital investors catered to the specialty class
of small private companies, while the public
markets were in the throws of a love affair with
large cap stocks that were tapping into high
growth segments. However, the small and mid cap
segments of the public markets became neglected.
Whether it was a bond issuance or a public
offering of shares, smaller companies were seen
as risky compared to their larger counterparts
(unless they were hot tech firms). Tight access
to outside expansion capital forced many smaller
companies to get lean and mean to facilitate more
After completing a study on small caps and
speaking with many managers, the top four of the
eight Canadian small cap funds I recommend
include Mawer New Canada, Standard Life Growth
Equity, Beutel Goodman Small Cap, and Trimark
Canadian Small Companies. Those interested in
other small cap funds should look for funds with
reasonable fees, low turnover (look in the
prospectus), and between $20 and $400 million in
Throughout the 1990s, the United States lead both
the economic boom and the stock market race -
compared to nearly every other developed nation.
As a result of the economic slowdown, the huge
write-offs taken by U.S. firms, slowing earnings,
and the strong recent returns, U.S. stock prices
are at very high levels, when measured in
traditional ways. Looking back over the past 75
years, the median price-to-earnings ratio (P/E)
for the S&P 500 lies between 14 and 15.
Lately, the ratio has been between 45 and 50. In
other words, investors buying the S&P 500
stocks (i.e. through an index fund) are
effectively paying $50 today for each dollar of
last year's profits.
That figure of 50 times profits is a bit clouded
by the fact that many large tech firms have been
taking big hits to their earnings due to bad
acquisitions, resulting in an overly dramatic
fall in profits this year. (Be aware that taking
a big hit all at once sets the stage for
potentially misleading big earnings growth in
many firms' next financial reports.) However, the
index remains on the expensive side of history,
and remain more expensive than many foreign
developed regions, such as Europe, on that same
This was the message delivered by John Arnold,
global money manager for AGF Funds, in a recent
meeting in Toronto. He says long-term profit
growth in both the U.S. and Europe has been
nearly identical but that the U.S. market has far
outperformed it over the same period. The result,
according to Arnold: The best relative value
opportunity in over twenty years, as European
stocks trade at much cheaper levels.
Some of my favourites among overseas stock funds
include Mawer World Investment, AGF International
Stock, Templeton International Stock, and
Spectrum European Growth. The first three are
broad based large cap overseas stock funds, while
the Spectrum fund is a small cap European fund.
Hard assets, like natural resources, precious
metals, and real estate, are an important
long-term portfolio component. They provide some
inflation protection, have risk-reduction
characteristics, and offer some protection
against inflation. Many managers maintain that
gold continues to be undervalued and natural
resource should generally pick up when the
economy starts revving its engine.
While I wouldn't hold a larger than usual amount
in such funds, some longer-term exposure remains
a prudent idea. Some of the better hard asset
funds include Dynamic Global Real Estate,
Standard Life Natural Resources, Mackenzie
Universal Canadian Resources, Royal Precious
Metals, and Mackenzie Universal Precious Metals.
Cash and RRBs
As mentioned previously in this space, I expect
interest rates to at least start heading north
sometime over the next twelve months.
Particularly if you buy into the fact that even a
moderate recovery will get underway, interest
rates are bound to rise. When rates rise,
conventional bonds suffer price declines.
While I wouldn't advocate changing the amount of
fixed income exposure, perhaps it's time to
review the composition of this component. In a
rising rate environment, cash tends to do well.
In a mutual fund context, I'm talking about money
market funds, which invest in treasury bills
(i.e. government bonds with maturity of 90 days
or less) and short-term corporate debt with
similarly short terms.
Another way to insulate your portfolio from
rising rates and inflation is to have some
exposure to real return bonds (RRBs). RRBs are
issued by the government of Canada but offer a
maturity value and interest payment that move
along with inflation. There is one fund investing
exclusively in RRBs but with a MER of 1.7 per
cent annually, I wouldn't recommend it.
This week's advice isn't to be interpreted as
recommending big tactical shifts in individual
strategy. Only an in-depth review of individual
goals and constraints (perhaps with the help of a
qualified advisor) can properly assess the
necessity (or lack thereof) of such a shift.
Rather, this week's advice is meant to give
readers food for thought regarding potential
subtle shifts in the context of current
strategies, based on my expectations for the year
ahead. For some it will fit; for others it won't.
Dan Hallett, CFA, CFP is the President of Dan Hallett and Associates Inc., an independent investment research firm based in Windsor, Ontario. Dan can be reached at email@example.com.