Foresight - Summer 2020

Every portfolio we manage has its own story. Portfolios may be in accumulation phase as a client family saves for retirement, or in drawdown phase for retired clients using their portfolios to fund retirement lifestyle, or when there are expenditure draws for  expenses, such as purchasing a vehicle, renovating a kitchen or travelling. In some cases, a retired client’s portfolio is not required to fund living expenses, such that the portfolio effectively is being managed for the next generation. All of this is to say that each rebalancing strategy we execute is very portfolio-specific.

We began rebalancing portfolios on March 13th, as we felt that the global equity market sell-off was close to exhausting itself. Between mid-March and mid-April, we reviewed every family portfolio and were by-in-large selling fixed income (bonds) and buying equities (stocks). Corporate earnings forecasts for the coming quarters seemed largely irrelevant, given that no one really could predict how long the Covid-19 shutdown will last, nor the extent of the impact upon those earnings. In this economic environment, corporate balance sheets are the focus: can a company survive through this current economic slowdown and continue paying its dividends? We focused our equity purchases on high quality dividend-paying companies with good balance sheets, that would be able to survive through the global economic shutdown caused by the Covid-19 pandemic.

In mid-March we did not know if the market correction in equities was a one-and-done episode, or if we would be doing further rebalancing at yet lower prices, as we worked through the effects of government-led economic shutdowns. While we didn’t know if we would be happy in two or three months that we were buying stocks at current low prices, we were very confident that we would be very happy that we were buying at these prices in two to three years.

At writing in June, global equity markets have rebounded significantly from mid-March lows. The Canadian TSX index and the U.S. S&P 500 index are both up over 40% since then. Meanwhile, interest rates and bond yields in Canada and the United States have moved to new lows as Central Bankers provide massive amounts of liquidity to debt markets to ensure the viability of the global economies during the Covid-19 shutdown.

As we were feverishly rebalancing portfolios post March 12^th to take advantage of buying stocks “on sale”, we did not envision global stock markets rebounding over 40% from their lows in two short months. As a result, we have just spent the first half of June rebalancing portfolios again, and in almost all cases were selling equities and buying fixed income, as equities were now overweight due to their rebounding performance. The return to a more normalized global economy will be determined by several factors, including a) how quickly  Covid-19 vaccines are developed, b) how successful countries will be in restarting their economies post-lockdowns, c) whether the global economic recovery turns out to be V or U shaped and d) what will be the long term effects of the trillions of dollars in aid packages issued by governments to their citizens and corporations. Global equity markets may well correct again…as investors worry about these issues, which will provide us another opportunity to rebalance portfolios and buy stocks “on sale”.

UNDERSTANDING RATE OF RETURN

“What kind of return are you making”? That’s a common question asked of an investment manager. ...and the answer is important. But the question is mis-directed. It is the Market that makes the return!  The investment manager contributes to it, but does not make it. At the next level down, the portfolio strategy and portfolio construct contribute a lot….and after that comes individual security selection and response to market moves.

Components of return

Cash return is the dividend and interest income divided by the capital.

Appreciation return is the rise (or fall) in value of the holdings divided by the capital. The rise/fall has two components: unrealized, being the gain/loss on paper from one period to the next and, realized, being the gain/loss that becomes recognized because the holding has been sold.

Total return is the sum of the cash and appreciation returns.

Total rate of return can be tracked longitudinally, both in simple and compound returns, by:

· individual security

· investment account

· total portfolio

Return on Compound Capital

Lets start with the industry status quo in rate-of-return reporting, which we call Return on Compound Capital. The return is the arithmetic result of a numerator divided by a denominator.

The numerator is the investment income in the period (typically a year) and is the sum of the cash income (dividends and interest) plus the change in value of the holdings between the start and end of the period plus any gain/loss on holdings disposed during the period.

The denominator is the value of the portfolio at the start of the period. If there are cash withdrawals or contributions during the period, the dominator is a time-weighted average amount. The key point not to miss here is that the denominator notionally “recapitalizes” your investment each year to the value that the portfolio attained at the end of the prior year. Imagine simplistically that you invested $1,000 one day, and each of the next five years you earned 10%, at which point it has compounded to $1,610. In year 6, it will again earn 10%, now on $1,610 (the Compound Capital) which is $161.While the market-place of investment management reports Compound Capital rate-of-return, there is value in looking at things with multiple perspectives…..

Return on Contributed Capital

A different, uncommon perspective on rate of return is what we call Return on Contributed Capital, which differs from the industry-standard in the denominator of the return calculation. Here, the denominator is purely based upon the money the investor puts in...in the example $1,000. Therefore , this rate of return in year 6 is $161/1000= 16.1%...more than the 10% conventionally calculated as Return on Compound Capital. We have run this analysis on a real client portfolio over 25 years. The annual, conventional Return on Compound Capital was 7.03%, while the Return on Contributed Capital was 12.56%.   

So..which one is right…? The answer is...BOTH... because they each serve different purposes. The Compound Capital statistic needs to remain as the industry-standard for comparability. But the Contributed Capital return is an excellent financial planning tool and personal motivator. Compounding doesn’t happen unless the investor contributes in the first place! So, the disciplined act of saving over the 25 years rewarded this investor’s Contributed Capital with 12.56% per annum! 

This can be appreciated graphically below: the top two bars are appreciation and cash incomes, in that order, and the bottom bar is Contributed Capital. You can see the relative contributions of each of each over 25 years, and see that the investor’s Contributed Capital is less than a third.

 As above, an investment can contribute either or both of cash income and appreciation. It is interesting to study the relative proportions of these two components to the “total” return. Over the 25 year 12.56% annual return in the portfolio above, the relative contributions of cash income (dividends and interest) and appreciation were approximately equal: the compound, annual cash return on Contributed Capital was 6.08%. In a different portfolio, we have been tracking the same statistics for thirteen years and found the same relative proportions based upon Compound Capital.

Simple versus Compound returns

Simple returns are the history of portfolio returns year-by-year. Compound returns are the cumulative, running average return per year across multiple time periods, eg three year, five year, ten year and since inception. The graph below tracks these returns for the same portfolio.

The more erratic line is the simple returns, which are responding to market conditions year-by-year. The more stable line tracks the running compound returns. The longer the investing period, the more insightful the compound return is. Ideally, every investor would have this running statistic tracked over their entire investing life. Note the relative stability of the compound returns since 2002, despite the gyrations in the simple returns.  

 Returns by Account Type

Tracking simple and compound returns by investment account (ie RRSP/RRIF, TFSA, Trading accounts) should not be dwelled upon; each account pulls it weight according to relative size and to its role in tax-smart investing. For instance, we tend to load TFSAs with foreign equity and load RRSP/RRIFs with fixed income… the former will have way more volatility and the latter will have way lower returns. Think….”The sum of the parts equal the whole”. The individual security returns may be of interest to monitor how particular stock-holdings have fared over time, and vis-à-vis other holdings. However, a specific security may appear to bear a large impact if, for instance, it sits in a particular small account, but its impact upon the total portfolio is much less significant. There is a saying in the industry: “The portfolio’s the thing, more than the individual things in it”. Thus, total portfolio compound return is the most important return statistic for the investor.

From Macro (the portfolio) to Micro (a stock)

The components of rate of return on the portfolio as a whole are the same as those for an individual holding, eg a stock. Your return on 100 shares of a stock is the dividend income plus/minus the change in market price, divided by the opening market price at the beginning of the period. The alternative perspective of return on Compound versus Contributed Capital also can be applied to an individual stock. One of the companies we were adding after the Bear Market correction in March was the Bank of Nova Scotia (BNS). The bank has an excellent balance sheet and a history of unbroken annual dividends dating back to the 1830s. The dividend yield was close to 7% at the prices we were purchasing the stock…. and taxable Trading accounts enjoy extra return from the Canadian dividend tax credit. Not only is the current dividend yield extremely attractive, the bank has a very long history of consistently growing its dividends over time. For instance, the client with the graphs above purchased BNS back in the mid-1990s at $7.90 per share. The BNS annual dividend today is $3.60 per share, which is an impressive annual Return on Contributed Capital of 45.5% on the original purchase price…. and that’s not counting price appreciation. An excellent example of how long term growth in corporate earnings, resulting in growth in dividends, powers the overall portfolio’s Return on Contributed Capital.     

Foreign currency impact on return

As a global equity investor, implicitly your invested Canadian dollars are deployed in a multitude of currencies. Thus, currency movements contribute to the portfolio return. Most notably, of course, we Canadians focus on the loonie in its relationship with the US dollar. Logistically, it is impractical to accurately parse the exchange impact on portfolio return. We are only able to do so if a US Dollar account is used for global investing opportunities. We have tracked this data quarterly for thirteen years. Over that period, foreign exchange gain (meaning a fall in the Canadian dollar) has contributed approx. one quarter of unrealized gains. The interplay of economics and the stock market is interesting. As a contributor to volatility management, foreign exchange and market movements have gone in opposite directions in 70% of those quarters. Both of them were negative in only 8% of those quarters. As we have written in the past, many of our global investments are purchased in Canada with Canadian dollars, and are hedged to take currency fluctuation out of the rate of return.

Finally, as we always say: beware of “lies, damned-lies and statistics”! These analyses are only based upon the 13 and 25 years that we have been tracking this data. Prudent investing always needs a long term perspective.