Where Do You, Where Do You Go, My Portfolio?

Volatility has come down a little, however, the week’s movements have yielded few gains. Our weekly play by play analysis of the markets is very much like the third period of last night’s Toronto-Boston hockey game with a lot of back and forth, a few goals but the result not changing. What’s becoming more and more likely is a market environment that will register few gains until the next rate cut, be it June, July, September or December. As has been the theme?since the great financial crisis, the most dominant factor for markets is central bank policy, with earnings having little to no impact for the time being.

We are a few weeks into earnings season and 77% of companies have exceeded forecasts, yet few companies are posting new highs. There only two types of companies that registered significant moves: top performers that are having some small detail in their results being picked apart and sending the shares tumbling or underperformers that are surpassing lowered expectations and share prices popping. This is playing out like a trending market; something investors haven’t experienced since 2015 when the S&P 500 registered a gain of just 1.38% (2018 returns were at -4.38% but that was hardly a trending environment as strong gains were eroded in the fourth quarter due to the escalating trade tensions between the United States and China). Adding further credibility to this outcome, BMO’s own Brian Belski iterated this week that he expects that S&P 500 will the end the year at its current levels (5100). We are treating this outcome as our base case scenario and we have already prepared our portfolios for this outcome.

Sticking with the possibility of this neutral scenario, we wanted to highlight how we have evolved our portfolio strategy in order to boost returns in this environment. The first step we undertook, was to increase the yield across the portfolio. The most common way to accomplish this is to buy more dividend paying companies. While we are not opposed to owning dividend payers, we urge caution for investors who choose to go this route. Firstly, high dividend payers are concentrated in a few industries: finance, energy, telecoms and REITS. As dividends paid by Canadian companies are given preferential tax treatment, let’s examine the year to date returns of these sectors: energy is up a strong 14.3%, financials up 2.5%, real estate is down 6.3% and telecoms down 10%.

An investor who prioritized higher yielding sectors has likely built a underperforming portfolio which also behaved in a more volatile manner than the broader index. Furthermore, sectors like finance and energy are cyclical; their performance is sensitive to the economic cycle and should economic conditions deteriorate, these sectors are unlikely to perform well. While we have investments in all these sectors, we are attentive to our concentration and the trade offs that come with investing in these spaces. What exactly do we do differently in order to increase our yields? We prefer to buy income notes instead of overconcentrating in high dividend payers; here we are accepting the volatility of a targeted sector but we are trading the dividend + growth return for a predetermined fixed return. Receiving monthly distributions and yields between 9-11% is more appealing to us than buying all of the big five Canadian banks in order to collect their 4% yield, for example.

Another investment strategy that we have embraced, in order to boost our yield, is the covered call strategy. Covered call writing involves owning shares and selling call options (contracts) to speculators who pay a premium for the opportunity to buy our shares from us before an expiry date and at a fixed price. When markets move up quickly, this strategy risks underperforming as we are likely to lose some upside participation. In a trending market environment, however, there are few gains to register and the risk of not participating in rapid upswings on share prices diminishes. Furthermore, the sectors that we prioritize for covered call writing are defensive (when compared to cyclical industries, these are sectors whose results are less sensitive to the economic cycle and are therefore expected to perform better in a recessionary environment), so we are not necessarily giving up tremendous upside in our pursuit of higher yields. For our clients who hold non-registered assets, covered call strategies are even more tax efficient than dividend strategies.

Our last point of differentiation from the broader index is our embracing of private market investments. Public markets’ values fluctuate because shares are being exchanged constantly and are adjusting to thousands of pieces of information at every moment of the day. Private companies’ shares are not exchanging hands every second of the day, therefore their valuations experience a lag relative to their public counterparts. Generally, valuations are updated quarterly or semi-annually and are more sensitive to the cashflow that they generate, or, valuations are updated when private equity firms choose to sell out of a position (which does not occur daily). It is important to be selective when considering private market exposure; there are four times more private companies to invest in than there are public ones. Investors also have to account for different risks, such as liquidity constraints as we can sell our publicly traded shares and receive our money within two days while some private market mandates can lock up funds for up to ten years. Private markets are not some cheat code; the companies that they own are also sensitive to the economic cycle and to monetary policy, however, by broadening the pool of potential investments, firms that specialize in this domain can produce outstanding results in a less than outstanding environment.

I find it ironic that as I write this article positing the potential of a trending market until the end of the year, US payrolls numbers have come in below target and the pre market jumps up close to 2%. Remember that a cooling economy would encourage central bankers to lower interest rates, therefore, bad news is good for the time being (just like it was between 2011-2013). We shall see if these gains hold throughout the day or if they’ll be given up next week. Many of you may have heard the expression “sell in May and go away”; since we do not have that option, we’ll be going nowhere. Instead, we’ll continue to seek opportunities that help our clients achieve the portfolio performance that they need in order sustain the life they choose to live. Good markets, bad markets or boring ones, we must be prepared for any outcome and we will strive to find ways to boost performance regardless of the environment. As always, we encourage our clients and interested investors to ask more about the strategies that we choose as we can provide many more details in our one-on-one conversations than we can via our newsletter.

Healthy distraction

18 months ago, Leon and I embarked on this journey together and so far, we are both thrilled with the result. Through these newsletters, many of Leon’s clients are getting to know me. Gradually, through lunches and meetings, my clients are getting to know Leon. The latter approach is a little slower so this week, I wanted to profile my partner.

Leon and I worked together as financial planners in the downtown Montreal area. He started his career at BMO in 2005 and was the planner at the main office on St-Jacques for six years, up until his move to Nesbitt Burns. In our team, Leon spends a little more time on the financial planning aspect, although his contribution to portfolio cannot be understated. I may bring many of the ideas to the table, but we debate them together and our decisions must be accepted by the both of us. Leon is also a phenomenal partner for our private banking, branch and commercial partners; he often acts as the liaison between our clients’ needs and the contact at BMO. Without him, it is difficult to provide holistic wealth management.

Outside of work, Leon is a dedicated husband and a loving father. He is such a loving father, that when we were stuck in Zurich last year, he was heartbroken at not being able to see his children for another day (one of the few times that the glass was not half full for him). I say this not because he’s my partner but because he is genuinely a good man and someone that I am proud to associate myself with. To all of Leon’s clients, family and friends reading this, we are all lucky to have someone like him our lives. In a world where it is in fashion to place one’s needs above everything else, Leon is the furthest thing from that. He’s the person that cannot show up somewhere empty handed; when he comes to my home so we may work together, he always brings me a coffee.

I hope that as we continue to work together, my clients can get to know Leon a little better; if you do not need a financial plan, Leon is the better golfer between us two. Just let me know when you wish to play a game and I will invite Leon.

Have a wonderful weekend!

The opinions, estimates and projections contained herein are those of the author as of the date hereof and are subject to change without notice and may not reflect those of BMO Nesbitt Burns Inc. ("BMO NBI"). Every effort has been made to ensure that the contents have been compiled or derived from sources believed to be reliable and contain information and opinions that are accurate and complete. Information may be available to BMO NBI or its affiliates that is not reflected herein. However, neither the author nor BMO NBI makes any representation or warranty, express or implied, in respect thereof, takes any responsibility for any errors or omissions which may be contained herein or accepts any liability whatsoever for any loss arising from any use of or reliance on this report or its contents. This report is not to be construed as an offer to sell or a solicitation for or an offer to buy any securities. BMO NBI, its affiliates and/or their respective officers, directors or employees may from time to time acquire, hold or sell securities mentioned herein as principal or agent. BMO NBI -will buy from or sell to customers securities of issuers mentioned herein on a principal basis. BMO NBI, its affiliates, officers, directors or employees may have a long or short position in the securities discussed herein, related securities or in options, futures or other derivative instruments based thereon. BMO NBI or its affiliates may act as financial advisor and/or underwriter for the issuers mentioned herein and may receive remuneration for same. A significant lending relationship may exist between Bank of Montreal, or its affiliates, and certain of the issuers mentioned herein. BMO NBI is a wholly owned subsidiary of Bank of Montreal. Any U.S. person wishing to effect transactions in any security discussed herein should do so through BMO Nesbitt Burns Corp. Member-Canadian Investor Protection Fund.

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