September 22, 2017
Stock Market Performance in 2017 to date
As of Friday, September 22, the S&P 500 is up about 13.1% including dividends and the Dow Jones Industrial Average is up about 14.8% including dividends. In Canada, the Toronto Stock Index is only up 1.1%. But that’s about 2.8% including dividends.
So, once again in 2017 investing in the major North America stock indexes has been rewarding for investors. The major stock market indexes do not provide positive returns every year, but they do most years.
At InvestorsFriend, we had three stocks rated Strong Buy at the start of 2017. These three have risen an average of 15.7%. In addition we had 18 stocks rated Buy and those are up an average of 6.7%, which would be about 8.7% with dividends included.
Those who have not been participating in these rewards, directly or indirectly, as an owner of stocks, might want to consider how they can participate in the future.
Why Do The Broad Stock Indexes Provide Positive Returns Most Years?
A stock index like the S&P 500 or the Toronto stock index represents an ownership share in the largest publicly traded companies in the United Sates or Canada. Almost every year the great majority, though not all, of these companies have positive earnings. These companies produce goods and services that are valued in the market and they do so on a profitable basis. A portion of these profits, averaging roughly 30 to 50%, is paid out as dividends to owners. This provides a cash return of about 2% per year to stock index investors. The remainder of the annual earnings (50 to 70%) is retained by the companies and reinvested for growth.
Due to the fact that roughly 50 to 70% of its annual earnings are retained by a typical company in the S&P 500 or Toronto stock index, most of these companies grow over time. Their assets and scope of operations and sales and earnings typically increase most years. In some cases this is accomplished partly by buying other companies. If these companies retain and reinvest 50 to 70% of their earnings for growth and if they can earn returns of about 10% on those investments then, assuming that earnings on the prior level of investments is unchanged, this should cause their earnings to grow by 5 to 7% annually. And earnings per share would grow by the same amount. If the price to earnings (P/E) ratio is unchanged then an earnings per share increase of 5 to 7% would cause stock prices to rise 5 to 7% per year.
So, the annual retention of earnings along with dividends can provide an average return of perhaps 7 to 9% per year. This is what drives stock index returns to be positive most years.
So, Why Are Stock Prices and Stock Returns So Volatile?
Even though the earnings of a major stock index like the S&P 500 grow relatively steadily, there are other factors that cause stock prices to be volatile such that instead of anything close to a steady 7 to 9% annual return from stocks we get volatile returns including some years with significant losses.
Even if annual earnings increase by an average of 5 to 7%, there can still be significant volatility around that and even on a broad index of stocks, earnings do decline some years.
In addition, other factors cause the P/E ratio of individual stocks and even broad stock market indexes to be volatile. This can easily cause stock prices to decline even as earnings are rising.
Investors push the P/E level up when their outlook for corporate earnings increases and they push the P/E level down when their outlook for corporate earnings growth declines, such as during a recession.
Investors also quite logically push the P/E level on stocks down when interest rates rise and up when interest rates decline.
The average P/E level can decline rapidly and this can cause a negative return on stocks even when earnings have increased.
Changes in the P/E level linked to changes in the outlook for growth (or retraction) and linked to changes in the outlook for interest rates are the biggest reasons for volatility in the return from the S&P 500. Volatility in actual achieved earnings growth on the S&P 500 usually contributes a smaller amount to stock price volatility. In the case of the Toronto Stock index, annual earnings are much more volatile due its concentrated nature and are responsible for a more significant portion of the volatility of that index.
How to Invest in the Canadian Stock Market
Imagine that a Canadian investor wishes to invest in Canadian stocks. How might they proceed?
This depends on the knowledge level of the investor and how they are going to invest.
Many such investors have very little knowledge of the markets and also are often not prepared to open self-directed accounts. In that case, they are going to need advice. The easiest path in that case is to seek advice at their bank branch or from an investment adviser.
The comments below are relevant to investors that have accounts enabling them to invest in individual stocks and Exchanges Traded Funds. Those without such accounts may be interested in our article on how to get started investing in individual stocks and ETFs.
Let’s assume that the investor has no particular special ability to forecast corporate earnings, interest rates or the general future of the economy. In that case, a very logical approach is to assume that current stock market prices are efficiently pricing in forecasts for future stock earnings and for interest rates. In this case the logical approach is to buy a low-cost index fund representing the stock market index.
Warren Buffett suggests that investors can participate in owning their share of “corporate America” by simply buying a low-cost S&P 500 index fund. Buffett has always expressed confidence that “corporate America” in aggregate will continue to be profitable and to increase earnings over the decades. Buying a low cost index fund that holds a broad section of “corporate America” will allow investors to participate in those gains over time. The same logic applies to investing in Canada or other countries.
What if an Investor Wants to Invest in Individual Stocks?
For a variety of reasons, many investors prefer to invest in individual companies in addition to or instead of broad index funds.
In selecting individual companies to invest in, it would seem logical to look for profitable publicly traded companies trading at attractive or at least fair prices.
In keeping with Buffett’s idea of investing in corporate America (or corporate Canada) investors can simply look around them.
Which publicly traded companies in your area and/or where you are spending money, appear to be profitable?
It is generally well known that the banks are highly profitable. What about the grocery stores in your area? Do they appear prosperous? What about Walmart, Home Depot, McDonalds, Tim Hortons, and Starbucks? Other profitable looking retailers that come to mind include Dollarama, lululemon, Canadian Tire, 7-Eleven, the big drug store chains, and certainly Costco and Ikea. Not all of these are publicly traded especially on a stand-alone basis but some of them are. You may own Apple phones and computers and you are likely spending material dollars each month on internet/ telephone and cable. Most investors are spending money on electricity and natural gas utilities. Are those publicly traded and do you suspect that they are reasonably profitable? There are some prosperous looking businesses that are usually not publicly traded including auto dealers and hotel chains. But some of these are publicly traded.
On the other hand most investors will be aware of some publicly traded companies that have been struggling. It is well known that newspaper subscriptions have been falling for years. Most of us could see for years that Sears stores were not prospering. (They were often the store that you simply walked through to get to the rest of the shopping mall.) Airlines have a notorious reputation for not being profitable most of the time due to brutal price competition.
The point is that it is probably not difficult for investors to look around them and identify many publicly traded companies that appear to be prosperous and likely profitable. The more you look around, the more you will see that there are many dozens of businesses all around you that appear to be prosperous. These can provide a good starting point in thinking about where to invest.
But What About the Stock Price?
It’s true that even the greatest of businesses will be a poor investment if the price you pay is too high. But most of the time the great businesses tend to grow enough to ultimately justify the price you pay if you are patient enough. The bigger mistake often comes from buying a really poor business at what appears to be a bargain price.
Those investors with little or no ability to judge if the stock price is reasonable might do well to invest fairly evenly in a dozen or more businesses that appear to be strong and prosperous. Those able (perhaps with some assistance) to evaluate the stock prices could be somewhat more discriminating and try to concentrate in those strong and prosperous businesses that appear to be selling at the more attractive prices. To a large degree, providing such assistance is the goal of InvestorsFriend’s paid subscription service.
There is little doubt that the publicly traded businesses that are all around us will, on average, be good investments if held for the long term. It therefore seems wise to be in a position to participate in this over the years.
Shawn Allen, InvestorsFriend Inc.