Saturday, February 9, 2019

Investing using fundamentals - Conclusions

When you summarize our fundamental analysis in a table like shown below, the story of these financial companies becomes clear. Brookfield Infrastructure is one of Canada’s most promising and yet conservative investments. It doesn’t have the overvaluation of many Hi-Tech companies. If it can maintain its compounding growth rate of 8.78% and its IRR of 17.71% it would be a stellar portion of any portfolio. Its share price would nearly quintuple of the coming 25 years, what is not to like? The beauty is that it has a dividend that would recoup the share purchase in around 11 years!  

The Canadian Banks are also part of such a core portfolio. It is a well known investor trick to buy the worst performing bank of the year and it will likely outperform the other banks over the foreseeable future.  Insurance companies like Manulife and Power Corp are not as attractive. That stands out like a sore thumb. Power Corp has been very hard hit last December and as such it is trading nearly 25% below last year’s typical pricing around $30 and far below its intrinsic value. Including a 5.76% annual yield, a Power Corp price recovery could result in a one year return of 13.4% or better.  Not shabby in the current economic environment.

You may like Manulife’s dividend yield but we are near the end of the current business cycle. Maybe we will be without a market crash for another year after such a dramatic December. But why take on this risk and hope for a major turn-around?  Too risky for me. I would not buy this stock today or if it was in my portfolio, I would sell it and hold on to the cash until the economic clouds are cleared.

Figure 1 summary of our fundamental analysis.  Click on image for a more detailed view.
Isn’t that something? You could easily transform the above summary into a portfolio!  Based on simple portfolio allocation rules, often advocated here, you should not have more than 5% of your paper securities portfolio in one single stock. An exception to this rule maybe stock options or shares you earned through employment in your employer’s company. But even there you have to be very confident to do so.
A maximum portfolio exposure of 5% is for risk management. If you combine it with a stop-loss of 25% then the maximum impact of loss on your portfolio is 5% x 25% or 1.25%. If you have a $100,000 with 5% or $5000 invested in say Brookfield Infrastructure, then if things go wrong you’d sell at a maximum loss of 25% of $5000 or $1250; the impact on your total portfolio is minimal. Especially when the other holdings in your portfolio aren’t affected. 

If like in a stock market downturn, your entire portfolio crashes this game may not work. I strongly advice against selling off your entire portfolio in the panic of a crash. It is better to rebalance your holdings based on asset allocation or sell off extremely high-priced assets during the climb to a market peak – especially during an euphoric market. And sit through the downturn as discussed in many previous posts.

In the above portfolio, I would allocate 5% of total value to , BIP, TD, BMO and RY each. POW would be no more than 3% as it is nearly as safe as a GIC (except in a market crash) and there is the possibility that it will revert to its former glory.

That we have gone through the process of fundamentally evaluating or stock holdings does not mean that our projections come true. The world always changes, sometimes right in front of our eyes. You, the investor, must judge what these changes mean for your portfolio or for specific companies that you own. Investor pain never goes away. The closest thing to protection is the ‘All Weather’ portfolio allocation designed by Ray Dalio which is back tested for the last forty years and shows astounding performance. 


Figure 2 Converting the fundamental summary into a portfolio.  Click on image for a more detailed view.
Obviously, figure 2 does not represent a complete paper security portfolio – a portfolio of stocks, bonds, mortgage Investments, and whatever is easily liquified into cash. You can also supplement this portfolios with ETFs. A good nugget on BNN I recently learned, was that individual stocks can literally go to zero but not the entire market which evolves over time adjusting for obsolescence and other forms of business failures.

Nobody really knows the future. You can only outline the most likely scenarios and prepare for them. And then there are the back swans! Canada’s markets are currently cheap, especially the resource industry. But is it reverting to its previous high valuations?  What is the impact of the incompetence of Trudeau and his indifference if not outright animosity towards the West?  What about erratic Trump and the trade war with China and his behavior towards his ‘allies’? Will the U.S. economically outperform the world, or will Canada outperform the U.S. in the next commodity boom?  Nobody really knows and investors should acknowledge that by not betting on just one egg in the basket. You must diversify – no matter how right you believe you are.

Having said that, especially when investing in individual stocks, fundamental analysis makes buying stocks like investing in real estate. You become the owner of good business rather than an erratic trader that lives of nearly random stock market movements. Over the long term, our economy grows and stock portfolios grow with them. This is especially so when we can take advantage of the emotional and sometimes hysterical movements of the markets. When I mentioned in this post the use of 'stop-losses', I have to warn you not to use this tool blindly. Financial companies and other sectors with predictable earnings may be ideal for the use of stop-losses. But in the commodity space this is much more questionable. 

As always, in investing there are no hard rules. The same goal – making money – can be achieved in many different ways. A lot depends on your own mentality, your goals and the risks you are willing to take.  Good hunting!

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