Newsletter September 29, 2013

InvestorsFriend Inc. Newsletter September 29, 2013

Stock Market Returns (Recent and Future)

Investors in U.S. stocks have, on average, done very well in 2013 and very well since 2009. But if 2008 is included then they have not done well. Investors in Canadian stocks did well, on average, in 2009 and 2010 but not since then.

Here are some figures.

2008 2009 2010 2011 2012 2013 through September 29
Toronto Stock Index -35% 31% 14% -11% 4% 3%
S&P 500 -38% 19% 13% 0% 13% 19%

The recent past pattern of investment returns is of little value in predicting future returns. In fact, I don’t think it is possible to predict the short-term direction of markets.

What we can do however is make reasonable judgments as to whether current stock market prices are reasonably priced in regards to the potential to make reasonable returns in the long run.

My most recent analysis of the Toronto Stock Index concluded that a reasonable value for the Toronto stock index (if a 7% return was targeted) was in the range of 12,630. Since the Toronto index is currently at 12,844, my assessment is that the Toronto index is reasonably priced and should provide a long-run return in the range of 7%. The range around the estimated 7% average over 10-years is large and it could feasibly instead average 4% to 10% per year. We should expect the return to be negative in some years.

My most recent analysis of the S&P 500 Index concluded that a reasonable value for the S&P 500 index (if a 7% return was targeted) was in the range of 1410. Since the index is currently at 1692, my assessment is that the S&P 500 index is somewhat over priced and should provide a long-run return in the range of 5%. The range around the estimated 5% average over 10-years is large and it could feasibly instead average  2% to 8% per year. We should expect the return to be negative in some years.

World Economic Events and Investing

World economic events including various wars, terrorist threats, recessions, bankruptcies of counties, slower growth of emerging counties, climate change, trade treaties and trade wars and many others can certainly¬† have major impacts on investment values. However, these events are unpredictable. Many events such as the demise of the euro or the insolvency of countries are constantly predicted to happen but usually don’t happen or have not yet happened. When these events do happen, it is usually too late to react. Stocks can open lower with no opportunity to sell before the decline.

The best approach to world economic events is usually to ignore them. Warren Buffett has always said that the fear of such events does not impact his investment decisions. To be sure, if stock prices decline after such an event he often takes advantage of that. But he does not sell stocks or refrain from buying them out of fear of such events.

Recently investors feared the impacts of the civil war in Syria. But it appears that the situation has cooled down somewhat and it appears that it would have been unwise to sell stocks due to fears related to the situation in Syria.

Today, the fear of the moment is about the possible shut-down of the U.S. government as the house and senate appear set to fail to pass a budget bill. It does seem likely that stocks would decline somewhat on that news. Then again perhaps the situation will be averted at the last minute. I am prepared to buy if stocks fall due to this but I am not prepared to sell on speculation that stocks could fall.

Next up will be the debt ceiling debate which again appears set to go down to the last minute in mid October. The market took this seriously when it happened back in August 2011 but then the crisis was averted and the market recovered. Perhaps this time the market will decide to ignore the political theatrics. We shall see. Again, my strategy is to keep some cash on hand to take advantage of possible bargains but I do not intend to sell stocks due to this fear.

Defined Benefit Pension Plans – Relief May Finally be in Sight

Ever since stock markets crashed in the early 2000’s, defined benefit pension plans have been hammered by bad news including another stock market crash in 2008 and, most damaging of all, brutally low interest rates that have caused pension liabilities to soar. Most defined benefit pension plans are in a deficit position despite large increases in contributions. Many defined benefit pension plans have been closed to new members or shut down altogether. Even government plans are reducing benefits to deal with the problem.

However in 2013 many defined benefit pension plans are starting to turn the corner. Market returns have improved and most importantly, interest rates have started to rise. Pension deficits are starting to shrink. This topic is explained further in my updated defined benefit pension article.

Attractive Value Ratios Are Neither Necessary Nor Sufficient

Whenever a potential stock investment is mentioned the first question that is often asked is “does it pay a dividend”?

The assumption appears to be that only dividend paying stocks are good investments. If so, someone forgot to tell stocks like Berkshire Hathaway which has been a spectacular investment despite the fact that its last dividend consisted of a lowly and lonely ten cents paid in 1967. Another example is Stantec Inc. which has risen over 2000% from $2.50 in September 1999 to $53.66 today. It traditionally did not pay a dividend and only started to pay a dividend in 2012.

Many investors insist on a high dividend yield. Others insist on a low price to earnings (P/B) ratio. Others insist on things like a low debt level, strong cash flow, strong revenue growth, strong earnings growth or a high return on equity.

These are all good qualities to look for in an investment. And they may tend to work on average. But there simply is no valuation ratio of this sort that is either strictly necessary or sufficient, on its own, to qualify a company as a good investment.

For one thing these ratios are calculated at a point in time. At many companies profits can be notoriously volatile. A profit figure that is affected by a large and unusual gain or loss can completely distort ratios such as the P/E ration, the earnings growth, return on equity and return on capital.

The payment of a dividend is no guarantee of a good investment. There have been many cases where companies continued to pay dividends even as earnings evaporated. Obviously, that can only occur for a limited period of time.

In some cases investors are far better off if the company does not pay a dividend. If a company has the opportunity to grow and can invest in highly profitable projects and expansion opportunities then investors may be better off if the money is used for that investment rather than paid out as dividends.

In theory, every good investment in a stock should be made at a share price that is not greater than the estimated true (or intrinsic) value per share. In theory then, a price to intrinsic value ratio must never be grater than 1.0. In practice it is impossible to ever precisely know the intrinsic value. However, for some companies reasonable and conservative estimates can be made.

In conclusion, investors should be cautious when adopting strict rules about dividends or other value ratios. There simply is no one ratio that is both necessary and sufficient to assure that a given stock is a good investment. Nor can any one ratio conclusively rule out a company as a good investment.


Shawn Allen, President
InvestorsFriend Inc.

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