The Importance of Perspective
We’ve all been taken for a ride during this stock market downturn, and the truth is that nobody really knows when it’s going to end. It will end, eventually, but you may be more than a bit saddened when it’s all said and done.
In trying to come up with a title for this article, the word “perspective” kept popping into my head. One Google search on the word revealed this definition:
It means to have knowledge of potential occurrences - to know other experiences or have considered what could happen or other results. If you have perspective for something, you have knowledge that allows you to understand why certain things happen or why certain results exist; and it's not all blind opinions.
Having perspective, in these circumstances, means to have a good understanding of various investing methods, and not just your own. I’ve structured my 2020 Canadian equity portfolio to outperform the market during such downturns and so far, it’s playing out as planned but that doesn’t mean the tide won’t turn against me later on. Having perspective means to regularly seek out opposing opinions and strategies and consider integrating them with your own strategy rather than just listening to like-minded individuals. We can all learn from each other if we have the patience.
On Monday, I was unfortunately hospitalized and diagnosed with pneumonia and a fractured rib, brought on by months of sickness and misdiagnosis by several doctors. It’s forced me to slow myself down, and so I’ve been doing a lot of reading about investment strategies and have been far more active on social media than normal. I’ve been fortunate to come across some very smart and reasonable individuals willing to share their investment wisdom with me. They all have one thing in common too - they don’t invest like I do.
There Can Be Many “Right” Ways To Do Things
My approach is certainly analytical in nature - that’s just how I’m programmed. I believe that cash is king and the main two fundamental metrics are return on equity and free cash flow. I generally ignore valuation metrics such as PE and PB ratios. I distrust analyst ratings, and the way I minimize volatility is based on the concepts of mean-variance optimization as described in Modern Portfolio Theory. I calculate my own standard deviations and covariances of stocks based on time periods I believe are relevant rather than relying on websites where I can’t see the behind the scenes details. I don’t make stock picks, but instead make portfolio picks. I also believe you should think of investments in terms of the amount of risk taken on rather than the potential returns they could generate. Oh, and I don’t really quite understand dividend investors.
Or should I say, I never really understood dividend investors until now.
Until now, I just couldn’t quite figure out why someone, especially young people with jobs and an income to cover their normal living expenses, would be a dividend investor. First of all, companies pay out dividends with after-tax income and then you are given a dividend tax credit (for Canadian-owned companies only), which pretty much every time works out to be less after-tax income than the favourable capital gains tax rates here in Canada. The stock exchange automatically reduces the share price by the amount of the dividend on the ex-dividend date so it’s technically a wash. And to top it all off, this cash is now unavailable for company management to utilize to grow the business, pay off debt, and all the other things you’d expect a well-managed company to do for you. And if you don’t trust the company to reinvest it wisely, why even bother investing in them at all?
The Look At Bonds
I do stand by these points, but I’ve overlooked one very good reason for dividend investing which is consistent with my primary objective of constructing a low-volatile portfolio for higher returns. Dividends should theoretically actually lower a stock’s volatility. It dawned on me earlier to consider dividend-paying stocks like bonds. For those of you unfamiliar with these instruments, bonds have the following components:
A coupon rate
A maturity date
A yield to maturity
A price
Bond prices move inversely with interest rates. As interest rates go up, bond prices go down and vice versa. A bond’s yield to maturity is the expected yield if an investor were to hold the investment until its maturity date. And the coupon, expressed as a percentage of the bond’s par value (usually $1,000) is usually paid out semi-annually.
From these details, bond investors can calculate a very important metric known as duration. Duration can be thought of as the effective term of a bond and is a measure of sensitivity to interest rate changes. If a bond’s duration is, say, 10, this means that for every 1 percent increase in interest rates, you can expect about a 10% decrease in the bond price. Risk-adverse investors should therefore seek out bonds with short durations.
Applying This To Stocks
The major point I want to make is that if you have a high coupon rate, this means that you’re set to get a rather hefty payment every 6 months. This takes some investment risk off the table. Also, the longer you hold your bond, the more uncertainty/risk you have as well. Now take this same principle and apply it to dividend-paying stocks. The coupon rate is the dividend yield, and term to maturity is your expected holding period or time horizon. We can therefore conclude that the higher the dividend yield, the lower the “duration” of the stock is. Now I’m at least reading the same book, if not on the same page, as dividend-focused investors. These people aren’t necessarily just investing in dividend-paying stocks because they believe they are simply better non-dividend-paying stocks - they’re using it as a means to reduce portfolio risk! The same end goal that I have.
How To Judge A Dividend Stock
No method is immune from the various business and credit risks both stocks and bonds face. I think you’d be a fool to invest in a stock simply because of its high yield. But dividend-paying stocks offer investors the option to keep investing in the company (e.g. with a Dividend Reinvestment Plan, or DRIP) or take some risk off the table by accepting the cash dividend. Having options is undoubtedly a good thing.
I believe that dividend investors should be focused primarily on investing in established companies with histories of increasing their dividends. Think about it - if you’re planning on holding a stock for 10 years and you’re trying to come up with a long-term annual return rate, wouldn’t you trust the company with 30 years of history rather than one with only 5 years? Do yourself a favour and take into consideration the number of years a company has been in operation as well as their history of dividend increases. Don’t rely on dividend yields alone to guide you. With stocks universally down, you may be lured into snatching up some attractive-looking yields - just do your homework first.
Of course, you’re going to have to figure out a way to manage the risks of any investment you make. A company may be exposed to an unhealthy amount of credit risk, have a history of constantly diluting its shareholders through new share issuances (I’m looking at you, Crescent Point Energy), or may just have the deadly combination of an inexperienced CEO and a weak board of directors. At the very least, force yourself to do regular check-ins to monitor how your portfolio is performing. Institutional investors have investment mandates - you should have one too.
What To Do Now?
With this recent market turmoil, I encourage everyone now to take a look at their investment style and consider other opinions and strategies. If you can integrate some ideas with your own strategy, that’s great too. I’ll link below to a few websites that have helped me along the way, as well as the brains behind them. There’s a very nice mix of value, growth, dividend, and indexing strategies for you to consider, along with a good chance that you’ll come across something you’ve never considered before.
There’s also plenty others which you can find at Feedspot, under their list of Top 40 Canadian Investment Blogs. It’s a pretty simple way to get updates on some of your go-to blogs.
What’s next for me is that once this recessionary period is over, I’m going to calculate 10 years’ worth of returns and standard deviations from 2010 onwards, rather than using 2008-2019 data. I had included 2008-2009 returns to compensate for the fact that there hadn’t been a recession in quite some time, but I’m not blind that this is potentially outdated. It will be interesting to see the new statistics generated with this updated information, and I’m going to use it to shore up any gaps I can find in my model. In short, I hope this recession will lead to a more accurate equity model and thus, better returns in the future.
That’s my silver lining. What’s yours? Feel free to leave a comment below! Thanks for reading.