By Dan Richards, Visiting Professor at Rotman School of Management
Introduction
Since 2008, I have posted templates to serve as a starting point for advisors looking to send clients an overview of the year that just ended and the outlook for the period ahead.
Advisors have told me they’ve received a great response to these letters and the templates rank among my most popular articles – that’s especially the case given today’s uncertainty.
This letter has three components:
- An update on performance
- Perspectives on today’s macro challenges from Warren Buffett’s most recent letters to investors
- Your recommendations for the period ahead
The first quarter in review: Why Warren Buffett is bullish on stocks
As we enter the second quarter of 2013, I’m writing to summarize markets developments since the start of the year and to share my thoughts on positioning portfolios for the period ahead. First though, a quick recap of the first quarter of 2013.
At the end of March, U.S. stock markets crossed the all-time high reached in October of 2007. This was due to an exceptionally strong performance to start the year following the agreement by U.S. Congress in early January to avoid the “fiscal cliff” that would have required dramatic reductions in spending and risked throwing the U.S. back into recession.
Three things worth noting about first quarter performance:
- Driven by a strong start in January, global markets were up by almost 9% in the first quarter, led by gains in the United States of over 10%. One word of caution: Last year global markets were up by 12% in the first three months before giving back almost all of those gains in the second quarter, in large measure due to concerns about Europe.
- On the topic of Europe, in spite of recent headlines about the bank crisis in Cyprus and continuing issues in Greece, the European market was up by 7% (in local currency) in the first three months of 2013. While Cyprus and Greece got the headlines, the large bulk of Europe’s economic performance will continue to be driven by the larger countries.
- Canada continued to underperform the United States and global markets. Since the beginning of 2010, the Canadian market is up by about 15%; in that same time the United States is up by roughly 50%.
Here’s how first quarter performance looked:
| Monthly Returns - Local Currency | Canada | U.S. | Europe | Emerging Markets | World Markets |
| January 2013 | 2.2% | 5.3% | 5.1% | 1.0% | 4.9% |
| February 2013 | 1.5% | 1.3% | 0.9% | 0.0% | 1.2% |
| March 2013 | -0.6% | 3.8% | 0.9% | -0.8% | 2.3% |
| Q1 2013 | 3.1% | 10.7% | 7.1% | -0.2% | 8.6% |
Returns to month end, all in local currency, including dividends
Warren Buffett’s view: Stocks still offer value
Warren Buffett is generally considered the greatest investor of all time. From 1966 when he began running Berkshire Hathaway to the end of 2012, the overall U.S. stock market (including dividends) has returned an average of 9.4% annually. That means that $1000 invested in the US market in 1966 was worth just over $74,000 at the end of 2012. During that same time, the book value of Berkshire Hathaway increased by almost 20% per year, twice the U.S. market return. The result: That same $1000 invested in Berkshire Hathaway’s book value would have grown to over $5 million.
That’s why Warren Buffett’s views are worth heeding. And that’s also why his annual letter to investors is awaited each year with such anticipation. Three key messages in this year’s letter:
1. Invest in “wonderful” businesses
Buffett is known for saying that he’d rather buy “a wonderful business at a fair price than a fair business at a wonderful price.” He’s written in depth about the competitive insulation that makes for a great business. (In another well-known turn of phrase, he’s said that he wants to buy businesses “so wonderful that an idiot could run them, because some day an idiot will.”
In this year’s letter, Buffett touched on Berkshire Hathaway’s investment in American Express (of which he owns just under 14%) as well as Coca-Cola, IBM and Wells Fargo, his other three big holdings in which he owns between 6% and 9%. In all four cases, he increased his stake in 2012; he quotes the Mae West line that “too much of a good thing is wonderful.”
2. Look past today’s uncertainty
Buffett addressed the uncertainty that preoccupies many members of the media and which has dampened the willingness of American business to invest. He points out that uncertainty has been a constant in the United States since 1776; the only variable is whether people ignore the uncertainty (which typically happens in boom times) or fixate on it.
Buffett continues to express confidence in the resiliency of American business, just as he did in his famous New York Times article in the fall of 2008 titled “Buy American I Am” that appeared close to stock market bottoms during the uncertainty in the aftermath of the global financial crisis.
3. Stay in the game
In this year’s letter, Buffett addressed the temptation to, in his words “try to dance in and out (of the stock market) based upon the turn of tarot cards, the prediction of so-called experts or the ebb and flow of business activity.”
He went on to say that since the long-term outcome of investing in stocks is so overwhelmingly favourable “the risks of being out of the game are huge compared to the risks of being in it.”
In an interview that followed the release of his letter, Buffett reiterated his view that given that at some point interest rates will inevitably rise, stocks of quality businesses continue to offer good value relative to bonds, even in the face of the run-up in equity prices since last summer. He also repeated his skepticism about owning bonds saying that today “the dumbest investment is a government bond.”
What this means for your portfolio
In my email at the end of last year, I outlined some guiding principles in my approach to building client portfolios, three of which I repeat here. I’d be pleased to discuss these guidelines at our next meeting.
1. Time to rebalance: Adhering to your plan
In light of stock valuations and the risk in bonds, early last year we recommended that clients increase equity weights to the upper end of their range. Given strong stock performance since the mid-point of last year, that has worked out well and we continue to advise that clients hold their maximum equity weight.
But strong performance by stocks means that today some clients are above the top of their equity allocation. In those cases, we have been recommending reducing equity weighting to bring portfolios back within their guidelines. Regardless of what happens to markets in the short term, barring a significant change in your circumstances, you should stick to your investment parameters.
2. Diversifying portfolios
When building equity portfolios, I’ve always advocated strong diversification outside Canada. This helped my clients through most of the 1990s, then hurt them in the decade after 2000, then helped them again in the past three years.
Going forward, I have no idea whether the Canadian market will do better or worse than global markets, but I do know that we represent fewer than 5% of investing opportunities around the world. In addition, because of our resource focus Canada’s market will tend to be more volatile over time than those of the U.S. and yes, even Europe. For those reasons, I continue to recommend geographic diversification of stock portfolios.
3. Focus on dividends and cash flow
The final principle relates to the role of cash flow from investments. Amid the uncertainty surrounding economic growth and equity returns, I continue to place priority on the cash yield from investments. While the headlines talked about US markets hitting new highs in March, investors who reinvested their dividends saw their account values exceed the 2007 peak significantly earlier.
Dividends on stocks in selective sectors continue to make these stocks attractive. When it comes to equities, we do have to be increasingly discerning, however; in some traditional high-dividend sectors stocks that pay steady income are expensive by historical standards and show signs of stretched valuations.
