Canada: Don’t Market Time, Have Market Discipline

Over the nine year period from March 31, 2002 to March 31, 2011, Canada was a much better place to invest than the U.S.  In that period, the TSX index rose by a cumulative 79.8%, compared to only 15.6% for the S&P 500, the index of the 500 largest public companies in the U.S. Moreover, during that period the Canadian dollar rose from $.64 US to about par, a gain of 56%. For a Canadian invested in US stocks, the combination of the anemic return in the market and the devastating devaluation of the American dollar against the Canadian dollar resulted in a loss of 26.4% over the period.

Things have been different in the past year.  From March 31, 2011 to March 31, 2012, the S&P 500 outperformed the TSX in 9 of 12 months. The S&P 500 rose 6.2% while the TSX fell 12.2%. To add insult to injury, the Canadian dollar actually fell by 2% against the US dollar, making the overall differential about 20% for the year.  Why is this year so different from the nine years that preceded it?  The reasons lie in the differences between the US and Canadian economies, and in the way that the stock market indices are composed.

The most obvious difference has to do with the importance of three different parts of the economies. In the US, information technology makes up 20.5% of the value of the S&P 500. Apple, now the most valuable company in the world (worth $568.7 billion at the time of writing) accounts for 4.5% of the index. Microsoft, Google and Cisco make up another 4.5%. In Canada, the information technology sector makes up only 1.3% of the index, and about 1/3rd of that consists of Research in Motion. Over the last year, those four big US tech stocks gained 32.8% on average. This has been the biggest driver for the S&P, and accounts for the entire gain during the period.  Owning all of the other 496 stocks would have produced a return of about zero.

In Canada, the biggest sector is Financial at 31%, compared to about 15% in the US. Of the nine largest Canadian stocks, four are banks. In the last twelve months the bank stocks have gone mostly sideways, although they have continued to pay and increase their dividends. The other two large sectors in Canada are Energy at 26% of the Index and Materials at 20%. The four largest Canadian companies in these sectors are Suncor, Potash, Barrick Gold and Canadian Natural Resources.  All four are down in the past twelve months, by an average of 22.5%. In the US, Materials account for only 3% of the S&P 500, and Energy has a weighting of 11%, less than half the weight of the energy sector in Canada.

So, to put it in a nutshell, over the past year the most dominant sector in the U.S., technology, has done very well and has driven the markets up, while the two of the three largest sectors in Canada, Energy and Materials have done poorly and have driven the markets down. Does this mean we should sell all of our energy and mining companies and go head long into high tech? Of course not.

In the first place, chasing last year’s best performers is an almost sure road to ruin.  Experience has shown that investors always get too optimistic on the way up and bid stocks to unsustainable levels. Those who are late to the party end up paying too much, and underperform the market  This phenomenon is commonly seen in mutual funds, where the best performers of one year become mediocre also-rans in subsequent periods. One need only think back to Nortel at $128 and Research in Motion at $150 to understand how over-enthusiasm can lead to disaster.

Secondly, diversification is the best way to combine performance and protection from volatility. No one knew, a year ago, that four technology stocks would be the best performers on the US markets, and no one knew that the largest commodity producers in Canada would go from stock market gods to dogs. Having 25% of one’s portfolio in one sector, no matter how attractive, is in our view a mistake.  It invites disaster. The Canadian stock market is notoriously concentrated in the three sectors noted above, and is thus prone to violent movements, both up and down. Our investors need not be so exposed, and they are not.  As of this month end, our overall portfolio weighting in Energy is only 6.3% compared to 11% for the Index, in Materials 8.6% compared to 20% for the Index, and 13% in Financials, compared to 31% for the Index. As a result, our portfolios are more stable, and outperformed the market by a large margin over the past twelve months.

Finally, one year is not a very long period for investors. How we do over five years and ten years, or even fifteen, is much more important than the results over any twelve month period. Of course we would like to do better than the markets every month and every year, but this aspiration must be tempered by realism. Individual stocks and whole markets are not as predictable as we would like, nor as rational.  As value investors, we know that over time stocks trade at their real value, but at any given time, the market may give a price that is much too high or much too low. Market discipline works better than market timing, and chasing value works better than chasing past performance.