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Finance: Constructing Constructive Returns

March 1, 2003
by Michael Birbari


These have been puzzling times for investors and economists alike. Opinions continue to diverge on where stock prices are going and whether current prices even represent fair value. As investors patiently await the return of reasonable growth in the markets, we must take care to ensure that the essential elements of successful investing remain intact. These elements are time, diversification and asset allocation.

While stocks can be said to have less risk today than three years ago (due to the almost 50% decline), their recovery potential may still be somewhat subdued. This is because the market is going through a transition where it is shedding the excesses and scandals of the past 10 years and reverting to the “basic investing” principles of fairly valuing companies with growing profits. In this environment of change, the allocation of your assets into other attractive asset classes will be necessary to augment returns. While the prospects for the market as a whole may be lukewarm, there will be individual stocks with above average appreciation potential. To capture these rising stars, one will need the most sophisticated of money managers. It will be important to focus on money managers who have produced top quartile performance and preferably outperformed their relevant benchmarks over the past five years. For example, American Equity funds should be compared to the S&P 500, and global funds to the Morgan Stanley Composite Index (MSCI), to truly determine if the money manager is adding value. In this stringent period for the stock markets, we must also favour mutual fund companies that have been outperforming their “value or growth” peers.

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For the foreseeable future, some of the world’s most respected analysts believe attractive returns will come from proper selection of individual stocks, as opposed to an upswing in the market as a whole. Therefore, our choice of money managers for our investment portfolios is more crucial than ever. Only money managers with proven stock picking skills will do, and firms such as Brandes Capital Management, Harris Investment Partners (AGF), Legg Mason Value Trust (CI Funds), Trimark/AIM and Ivy offer us some of the best.

Investor behavior must adjust to cope in this new and unsettled environment. Investors should have reasonable expectations for rate of return and be alert to identify relevant shifts in the investment universe where other asset classes offer better risk/reward opportunities. One of the areas we identified almost two years ago, was the Income Trust sector. Midway through 2001, we began to reposition portions of our clients’ assets into REITS and Energy Trust units so we could reap the 8%-9% cash yield consistently. This has paid off handsomely. With the prospect for the stock markets improving slowly and unpredictably, we must try to be flexible and take a creative approach. It is this “thinking outside the box” that will net us real returns that should compete well with stocks.

One such area would be investment grade corporate bonds in North America and government bonds of European countries. In a declining interest rate environment, bonds do very well as recently experienced with Canadian Government bonds and U.S. Treasuries. With rates in North America now at 40 year lows, the best returns from this sector have passed as yields have fallen in Canada to 5.0% for a 10 year government of Canada bond. In fact, we would now be reducing our exposure to these bonds if they have maturities of 10 years or more. However, in stark contrast are European bonds and BBB rated corporate bonds where yields to maturity of 8%-10% are available. When the economy in North America improves in 2003, the discounts on many of the corporate bonds will diminish as their credit rating (by Moody’s or Dominion Bond Rating service) improves with the overall economy and as the bonds approach their maturity dates. Whether a triple B rated bond, such as Telus (at 95 to yield 8.5%) which matures in December 2006, or a mutual fund with a portfolio of such bonds, the returns over the next 12 to 24 months could be attractive. As for European government bonds, if only we could set the clock back and take another run at the bonds market! Europe is only now beginning to lower interest rates as the Euro has appreciated to parity with the U.S. dollar. Moreover, with Germany coping with a deep recession, the prospects for a greater reduction in interest rates by the European Monetary Union is a distinct possibility. This would produce worthwhile gains for German bonds. Bill Gross, the manager of the $65-billion Total Return Fund, and one of the world’s most respected authorities on the bond markets, is cautious on domestic government bonds, and bullish on higher yielding European Government debt and bonds from Germany in particular.

Inside this month’s newsletter, we have featured both the Trimark Global Yield fund and the CI Value Trust, which is managed by Bill Miller, a seasoned veteran in the U.S. Bill has the distinction of doing what very few money managers have done, and that’s outperforming the S&P over the past 10 years. A recent issue of Smart Money magazine featured opinions for 2003 from some of the sharpest minds in the money world. Making the best list were people like George Soros, William Bernstein (economist), Robert Shiller (economist–Yale), Bill Gross (bond specialist), Warren Buffett and Bill Miller (Legg Mason & CI Value Trust). Miller sees the same opportunities for 2003 as Gross. He states: “I see a period of slow nominal growth ahead, but we will still get 12 months of good returns on equities because we are starting at such lower levels. Corporate bonds are pretty attractive. Higher yield bonds are very attractive.”

By strategically balancing your portfolio with the suitable levels of high yield corporate bonds, European government bonds, Income Trusts and well managed equity funds, your portfolio will have constructive returns over the next several years.

Michael Birbari is Director and Senior Investment advisor at Dundee Securities Corporation, providing service to the dental community.


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