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As I write this column at the end of December, the S&P/TSX Composite is down 44 per cent for 2008. Many hedge funds that were supposed to be able to resist downturns have tumbled. Had you put $10,000 into one energy hedge fund in 2002, you would have had $40,000 four years ago. Today, you would have $26 left. One fund that invests in Chinese stocks is down 58 per cent in the last 12 months, having fallen fairly steadily since inception in December, 2007. The carnage in common stocks is nearly complete, sparing only a few grocers like Loblaw Companies Ltd. and burger giant McDonalds Corp., both trading near their 52 week highs. The odds of being in the right place at the right time in this bear market have been slim. An investor is entitled to swear that he or she will never be at the mercy of the market again. It is time for a fresh start and, in fact, one that may help recoup losses.
Like an alcoholic swearing off booze, getting over common stocks takes some hard lessons and three commitments.
First, quit investing in booms. They are fleeting and punish latecomers mercilessly. Stock prices gyrate up into manias. Bubbles form in real estate, stocks, commodities, collectibles, and even some bonds.
Second, focus on sustainable returns. What a stock may do in a period of weeks, months or even a few years has relatively little influence on its returns over periods of decades. For the 20 years ended Nov. 30, 2008, the S&P/TSX Composite Index produced an average annual compound return of 5.3 per cent. The S&P 500 Composite in U.S. dollars produced an average annual compound return of 6.1 per cent.
Finally, the MSCI world Index produced an average annual return of 5.2 per cent. All short term returns above these numbers were transient and, in retrospect, due to fall to the long term average. In comparison, U.S. bonds returned an average annual real return of 2.9 per cent for the two centuries ended in Dec., 2001. That is the baseline to judge
what the turmoil of equities added to the less volatile returns of bonds.
Third, abandon faith in timing the unknown. The time it takes to realize returns is unknowable or, if you like, a matter of faith. It is an old saying that it is the goalposts that determine investment returns. It's true, for if you put one post down in a market bottom and the other at a top, the gains will be stunning. And if you put them down first at a top and then at a bottom, the losses will be shocking.
With those three promises kept, it's time to move into assets that have no timing issues and no question of boom or bust pricing. So what can you buy? Bonds with known maturity or call dates and preferred stocks with fixed redemption or call dates that lock in a return at the moment of purchase. Hold until those dates and your gains will be precisely as expected.
Corporate bonds are fertile ground for locking in high returns. The market is
intensely concerned with the problem of default. As a result, there are many investment grade issues that have high returns. For example, a 5.95% Brookfield Asset Management issue due June 13, 2035 has recently been priced at $50 to yield 12.38% per year to maturity. In U.S. bonds, gold and copper producer Freeport McMoRan Inc.'s 8.375% bond due April 1, 2017 has recently been priced at $65.50 (U.S.) to yield 16 per cent per year to maturity. These are extraordinary returns at least twice the long run returns of
stocks coming out of bonds that are far more secure than any shares. After all, bondholders must be paid or they can seize a business. Stockholders are paid out of any residual income and at the pleasure of each company's directors. In an insolvency, the bondholders usually get a vast amount of stock for their debt holdings while stockholders walk away with nothing.
Preferred shares are a middle ground between stocks and bonds. Less secure than a bond, a preferred share gets paid before any common share dividends. And in an insolvency, preferred holders get to pick over the carcass of a business before the common holders.
Financial services companies, under fire because of exposure to derivatives and defaulting loans, have had their preferred shares clobbered. For example, in the insurance industry, an Industrial Alliance 4.6% Class A Series B perpetual with a Pfd-2 (high) rating has recently been priced at $14. At first call on May 21, 2011, the shares will pay $26. Counting the redemption price plus $1.15 annual dividends, these shares offer a 34.2 per cent gain total gain, assuming that redemption takes place. If it does not, the holder still gets that $1.15 per year.
Credit-sensitive bonds and preferreds are a buyer's market these days. If held to maturity or call, they offer more security than common stocks and a way out of both boom-bust pricing and the goal post timing problem.
There are risks, of course. Companies are challenged in the present environment and a crumbling world economy could force some to shut their doors. But for companies with strong balance sheets and for investors prepared to do some research, the potential gains are big and the risks manageable. After all, if you were prepared to buy common stocks in a rising market with no assurance of a payoff, you should be willing to consider
bonds and preferreds with higher than common security and known payoffs.
Andrew Allentuck writes about investments for The Globe and Mail, and reviews books on finance for globefund.com and globeinvestor.com. He is also the author of several books.