Dividends, defensive sectors to lead growth

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At this time last year, in the depths of the global financial meltdown, investment strategists were generally trumpeting optimism – things had fallen too far, too fast. They were right.

The pendulum hasn’t yet swung so far that strategists are calling for a flight to safety, but after a spectacular run-up in the equity markets, there is a sense investors need to be very selective.

According to Bob Gorman, a portfolio strategist and vice-president with TD Waterhouse, the run-up to date has been fuelled by anticipated earnings growth and by market conditions being better than the near-apocalyptic scenarios pondered in 2008 and 2009.

Where prices go from here really depends on the strength of the global economic recovery. It’s difficult to see equities in particular continuing their current trajectory, Gorman points out.

“The sharp rebound in equity markets has been largely based on beating low expectations for both the economy and corporate profits,” he says. “As expectations rise, that hurdle will be more difficult to beat.”

In a recent market outlook, TD Waterhouse said the S&P 500 was trading at about 15 times earnings – its long-term historical average. Based on this broad valuation metric, Gorman says equities are likely more attractive than fixed income.

Consumer staple and defensive sectors of the market, such as technology and healthcare, offer the most significant upside in earnings.

“We’re in the early stages of the rotation of the market leadership,” he says. “If you were to contrast very close to year-end, the materials sub-index is up 47%, energy was up 29.8%, but consumer staples weren’t up very much at all. We think there is going to be significant rotation in those sectors as things get under control in the economy.”

Smaller, more economically sensitive companies could also come to the fore, as could financial service stocks, which were beaten up in the downturn.

Noah Blackstein, vice-president at Dynamic Funds and manager of the Dynamic Power American Growth Fund and Dynamic Power Global Growth Class, is tremendously bullish on the prospects for technology companies.

He says the global technology business, partly fuelled by growth in emerging markets such as India and China, is in the midst of a secular bull market.

Blackstein points to a global push to centralize data centres and the fact that China will add 80 million subscribers to 3G networks in the coming years.

“Technology companies had been managing their balance sheets as if the recession went from 2002 to 2009. These companies are flush with cash. They have net cash per share and no debt. When the financial crisis hit, tech held in very well because they are very conservatively managed companies,” Blackstein says. “Technology over the last decade has not been the place of excess. There has been a lot of cash in the big cap companies that will be used to acquire some of the smaller growing technology companies. M&A will become front and centre in the technology sector over the next year.”

Brent Smith, the chief investment officer of Franklin Templeton Managed Solutions program, has been lowering his equity exposure to an almost traditional 62/38 equities to fixed income asset mix on the Quotential portfolio program his team oversees.

He says much of the growth in the stock market has resulted from a run-up in commodity and emerging market stocks. He’s uncertain how much more growth there is in those areas over the intermediate term.

“We’ve taken down our emerging market exposure a bit. In 2009, as a percentage of our global allocation, we had actually increased our exposure by about 400%. We’ve taken it down somewhat. I think that valuations in the emerging markets are not as compelling as they once were. Any central bank tightening is going to come for the developing world first, and that’s going to play on the valuations,” he says.

Smith says the majority of the world’s equity capitalization is still in the midst of a bear market.

”We think that 75% of the world market cap happens to be in a secular bear market. Western Europe, the U.S. and Japan [are still struggling],” he says.

Smith says results from the last year support active asset allocation in increasingly volatile market conditions.

“If you allocate to have a constant 30% exposure to the U.S. and it’s in a long-term bear market, you’re going to see periods where it’s up 20%, 30% and 40% and periods where it’s down 40% or 50%,” he says.

Martin Hubbes, chief investment officer of AGF Management, says the reality is that many of the core retail investors, boomers, are nearing retirement. For this reason alone, he expects a tendency toward more conservative asset classes. To mitigate risk, he says it’s more important than ever that Canadian investors are well diversified.

“It’s such a volatile market right now. Longer term, the boomers are aging; a more conservative asset allocation and a more conservative stock selection for a large portion of their portfolios are not a bad thing,” he says.

Hubbes is concerned too many Canadian investors are retreating from buying foreign content and instead are focusing on Canada, making an assumption they will get foreign growth exposure from the commodities portion of the Canadian stock sector. He says the tenets of diversification still apply to mitigate risk. Investors should maintain emerging market and foreign content exposure in their portfolios.

The risks of fixed income

Another growing concern is the low yields of fixed income products. Blackstein passionately argues investors who think they are being more conservative by being in fixed income are taking on a lot more risk than they realize. Rates are artificially low, in his opinion.

“Too many investors think the most risk-free asset with the least amount of volatility is at the shortest end of the curve. That’s where I think the biggest risks in the market are today,” he says. “There are massive amounts of debt piling up, massive printing of paper, yields that are being kept artificially low; when I look at sovereign debt around the world, whether it’s the U.K., the U.S. or even Canada, I just think that there is nothing but risk and no reward.”

Blackstein adds, “Lending any of these governments your money at 4% over the next 20 years, after inflation eats it up, is a for sure way to lose your money.”

Blackstein says the risk/return profile of well-researched equities is a far better opportunity for long-term investors, despite a growing chorus of commentators who believe that equity returns will be muted over the next few years.

“Twelve years ago, everybody expected 8% to 10% returns for equities after coming through 20% returns during the previous 10 years. Even 8% was conservative at that time, and 10% to 12% was the normal forecast,” he says. “The stock market has now completed the worst decade in history. We have negative returns on a 10-year basis, which we’ve really never seen before. If equities continued to underperform over the next five years, on a 10- or 15-year basis, it would be unprecedented in the history of the stock market.

“While most forecasters will take current trends and extrapolate, I think that if this economy does begin to recover and gain traction, given the amount of stimulus, one might expect higher returns than they have seen over the past 10 years.”

The importance of dividends

Dividends may play an increasingly important role in a portfolio’s total return, Gorman says.

“As the stock market recovery begins to mature, investors increasingly focus attention on the sectors and companies that demonstrate more consistent sales, earnings and dividend growth. We believe we are now in the early stages of this shift, another part of a rotation of market leadership,” says Gorman. “As part of this trend, investors will increasingly emphasize dividends as a larger element of total return. Today, dividends in a number of sectors are abnormally high relative to bond yields, even before considering the dividend tax credit, which makes each dollar in Canadian dividends like earning $1.30 in interest.”

Both Hubbes and Gorman stress, though, that high dividends are not what investors should be chasing. They say dividend growth is a much better indicator of the long-term earnings growth of a company.

“The best long-term strategy is to find companies that consistently grow their dividends,” Hubbes says. “The yield may not necessarily be that high compared to the price of the stock with these companies, but when you go back and look at yield versus the original book value, it can sometimes be very high. This is what matters to long-term investors. You’re going to be looking at a nice payout, and there is going to be some degree of protection against inflationary pressures.”