All posts by Pat McKeough

Is Now a Bad Time to buy Bonds? Yes, and Here’s Why

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We think Now is a bad time to Buy Bonds … Here’s Why

Recently a friend asked, “Pat, I see that several prominent Canadian investor advisors recently wrote articles that said it’s a bad time to buy bonds right now. Do you agree?”

He was surprised when I told him I haven’t bought any bonds for myself since the 1990s. I haven’t bought any for our Portfolio Management clients in the last couple of decades, except on client request.

In the 1990s, I used to buy “strip bonds” for myself and my clients, as RRSP investments. This was the Golden Age of bond investing. Back then, high-quality bonds yielded almost as much, pre-tax, as the historical returns on stocks. In addition, they were more stable than stocks and provided fixed income that simplified financial planning.

Bonds have tax disadvantages, of course. But you can neutralize those disadvantages by holding your bonds in RRSPs and other registered plans.

The big difference back then was that bond yields and interest rates were much higher than usual. That’s because we were still coming out of (or “cleaning up after,” you might say) the inflationary bulge of the 1970s and 1980s.

In the 1980s, government policies pushed up interest rates and took other measures to hobble inflation, and it worked. But interest rates stayed high for a long time after the government policies broke the back of inflation: kind of like finishing the antibiotic prescription after the infection goes away.

Long-time readers know my general view on the stocks-versus-bonds dilemma. When interest rates are as low as they have been in recent decades, high-quality stocks on the whole are vastly superior to bonds. However, you have to understand the differences between the two. For one thing, stocks are more volatile than bonds. But volatility and safety are two different things.

Volatility refers to sharp price fluctuations, often due to short-term uncertainty and the randomness of short-term market movements. Safety refers to the risk of permanent loss.

Bonds improve portfolio stability but cut investment returns

You might say that what you get from bonds is the opposite of what you get from the stock market.

Inflation near-automatically reduces the purchasing power of bonds. Inflation can also hurt the returns you make in the stock market, of course. However, companies you invest in can take steps to cut the costs of inflation. They can pass on cost increases to their customers. They can introduce new processes and equipment to improve productivity and cut their costs. Continue Reading…

The revival of the 60/40 rule: Good for brokers, but not for investors

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The revival of the 60/40 rule is a plus for brokers – but not for investors

Image by Pexels: RDNE Stock Project

Some experienced brokers (now more often referred to as investment advisors) are pleased at the recent rise in interest rates and inflation. After all, it could lead to a revival of the 60/40 rule, which was in common use for much of the second half of the 20th century, especially among experienced stockbrokers. Veteran brokers understood how to use it to spur clients to do more trading between stocks and bonds, and pay more brokerage commissions and fees.

The 60/40 rule is based on the proposition that a good-quality, balanced portfolio is made up of 60% good-quality stocks and 40% good-quality bonds. This idea leads to another: that investors can enhance their results by “rebalancing” their portfolios when they get away from that 60/40 goal, due to divergences between the bond and stock markets.

This is one of those clever ideas that at first glance, seems to make sense to many investors. It makes sense to brokers because it’s sure to make money for them. The payoff is rather less certain for the paying customers: the investors.

The problem is that stock and bond prices rise and fall under the influence of ever-changing sets of random factors: sometimes moving them in the same direction, other times moving them apart. These sets of random factors will vary in a random fashion as well. The stock/bond balance in a portfolio can hold steady for long periods, or swing abruptly from the “ideal” 60/40 split in a single day. This can happen even on a quiet day with few news developments to promote buying or selling.

The 60/40 rule gives the broker a rationale for proposing trades in a portfolio when changes in stock and bond prices have moved the portfolio away from the idealized 60/40 split.

This leads to another of the many conflicts of interest that exist in the investment business. However, unlike the hidden bond commissions I mentioned above, some brokers made a living out of the 60/40 rule. In my days as a broker, some old-timers in the office told me they could use the rule to add 2% to 4% of a client’s total portfolio to their gross annual commissions.

Any trade in your portfolio will cost you money in the form of fees and/or commissions, regardless of whether you make or lose money. But every trade you do in your portfolio will make money for the brokerage firm and/or salesperson, of course. That’s how they get paid.

Useless as a market indicator, great as a marketing device

We’ve often pointed out that market indicators sound a lot better than they perform. The 60/40 rule falls a step or two below an indicator. Rather than telling investors how they can make money in their investments, as market indicators supposedly do, this rule tells brokers and financial advisors how they can encourage their clients to do more buying and selling in the market, and thus increase broker incomes.

After all, the rule is based on a belief about the supposed advantage of a particular ratio of stocks to bonds in a portfolio. It’s not as if the rule comes with instructions on when to buy or sell, as you can derive from many market indicators. Instead, it gives brokers a rationale for advising their clients to buy bonds and sell stocks (or vice versa) more often. Continue Reading…

Why Debt-to-Market-Cap matters more than Debt-to-Equity

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Understanding the Importance of the Debt-to-Market-Cap Ratio in Stock Analysis

Image courtesy TSINetwork.ca

When evaluating stocks, it’s crucial to assess their resilience during economic downturns and their potential for future prosperity. While the commonly used debt/equity ratio offers insights into a company’s financial leverage, it fails to capture certain nuances. In this article, we explore the significance of the debt-to-market-cap ratio in stock analysis and why it surpasses the debt/equity ratio.

By understanding the intricacies of this approach, investors can make more informed decisions and increase their chances of identifying companies poised for long-term success.

I was recently asked why I use debt-to-market-cap in my analyses, which is different from the debt/equity ratio seen in most other reports. My answer is two-fold. In analyzing a stock, you need to form an idea of how much it would get hurt in a recession. To put it another way, how likely it is to survive a business slump and go on to prosper when good times return? To do that, you need to look at a number of factors. These include the interest rate on its debt, how sensitive it is to the economic cycle, its pluses and minuses in relation to competitors, its vulnerability to adverse legal and regulatory decisions, its credit history and current credit rating … and so on.

Analyzing Debt-to-Equity Ratio

Many successful investors start by looking at the debt/equity ratio. This ratio comes in several variations, but the basic idea is that you measure a company’s financial leverage by comparing its debt with its shareholders’ equity. You assume an attractive company can earn a higher return on its total capital than the interest rate it pays on the debt portion of its capital. If so, the excess goes to shareholders’ equity, raising the total return to shareholders.

But leverage works both ways. If the total return falls short of the interest costs, the difference comes out of shareholders’ equity. When a company loses money, it still has to pay the interest and one day settle the debt. Generally, it does so by dipping into shareholders’ equity. In extreme cases, losses wipe out shareholders’ equity, and the stock becomes worthless. Then bondholders and lenders take over the assets to try to get back their investment. A high ratio of debt to equity increases the risk that the company (that is, the shareholders’ equity in the company) won’t survive a business slump.

However, this ratio can mislead because it compares a hard number with a soft one. Debt is usually a hard number. Bonds and other loans generally come with fixed interest rates, fixed terms of repayment and so on. Equity numbers are softer or ‘‘fuzzier.’’ They mostly reflect asset values as they appear on the balance sheet (minus debt, of course). But the balance-sheet figures may be misleading. They may be too high, if the company’s assets have shrunk in value since the company acquired them (that is, lost more value than the company’s accounting shows). In that case, the company may need to correct its balance sheet figures by cutting them or “taking a writedown.”

Or the equity value may be too low if the company’s assets have gained value since the company acquired them. This can happen with real estate, patents and other assets (which we refer to as “hidden assets”).Much of a company’s real value may rest in its “goodwill” — its brands, or the reputation and relationship it has built with customers over the years. This value would only appear on the balance sheet if it was bought rather than built up by the company’s operations.

Analyzing Debt-to-Market-Cap

Efficient market theory also leads us to favour debt-to-market-cap over debt-to-equity. This theory says that it’s impossible to beat the market, because the market is efficient and eventually reflects all information, good or bad. This idea had a lot to do with the creation of index funds. Market cap — the value of all shares the company has outstanding — benefits from the “wisdom of crowds.” Continue Reading…

Investing in Emerging Markets: Capitalizing on the Changing Global Export Landscape

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When considering investing in emerging markets, explore opportunities in the rise of emerging economies, exports, and shifting trade patterns

BRICS countries/Deposit Photos

Global trade has undergone a remarkable transformation over the past four decades, with its share in the global economy increasing from 36% to 57% by 2022. This surge in international trade has created opportunities for investing in emerging markets, which have become pivotal players in the ever-changing global trade landscape. Notably, China experienced a remarkable ascent, transitioning from a mid-size player to the world’s largest exporter within a mere two decades. Alongside China, other emerging economies, like Mexico, exhibited impressive growth, propelling them to the top echelons of global exporters.

In fact, Mexico is now among the top 10 exporters and a number of smaller emerging economies are growing their exports rapidly.

China still Dominates Global Exports

Although it has slowed lately, China remains the largest exporting country in the world. It delivered goods worth $3.6 trillion to global customers in 2022, or 16% of all global exports. This was roughly the same value of exports from the second and third-ranked U.S. and Germany combined.

Fellow Asian countries received almost half of Chinese exports while European and North American customers both imported 20% of the total. The largest single-country customers for Chinese goods are the U.S. (16%), Japan (5%), Germany (3%), Netherlands (3%), South Korea (5%), Vietnam (4%), and India (3%).

Chinese exports grew rapidly in the years after its entry into the World Trade Organization in 2001. For the decade after 2001, exports increased by 20% per year and contributed almost 30% of the Chinese economy for that decade.

However, growth in Chinese exports has slowed down over the past decade to around 5% per year. Also, when expressed as a portion of GDP, the importance of exports began dropping — averaging 20% over the past decade, down from over 30% in the previous decade. Continue Reading…

Why Canadian Investors should Include U.S. Stocks in their Portfolios

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U.S. stocks can provide Canadian investors with all the foreign exposure they need

I’ve been advising Canadian investors to include U.S. stocks in their portfolios for more than 30 years. I continue to recommend them today. The U.S. stock market offers the widest variety and highest investment grade of companies to invest in of any country in the world. It also offers a wider selection of growth opportunities for those companies to pursue, in North America and around the world.

For our portfolio management clients, our general preference is to invest one quarter to one third of their holdings in U.S. stocks and the remainder in Canadian stocks.

Many major financial institutions recommend investing in North America. Some also recommend investing outside North America, especially in developing nations. They say that countries outside North America also offer great opportunities, and they may be right in some cases. They note that foreign investing offers an additional chance for diversification. This may be true, but we see it as irrelevant. Our view is that North America offers all the diversification that you really need.

Many promoters of emerging-market investing are also motivated at least in part by a conflict of interest.

By offering imported investments in their home market, they can earn higher profit margins than they get with domestic investments alone. That is, they make more money by promoting foreign investments. Investors may not make any more money, but they undoubtedly face more risk.

We have occasionally offered favourable advice about a handful of high-quality foreign stocks in the past few decades, while mentioning the added risk. But we’ve stressed our view that the U.S. and Canadian markets provide all the investment opportunities that you need to succeed as an investor.

Of course, the Canadian market offers opportunities that beat those available in the U.S.: in bank stocks, in the Resources & Commodities sector, and in specialists like CAE Inc. But Canada has nothing to compare with, say, Alphabet, Microsoft, McDonald’s and any number of other household names.

Neither too hot nor too cold

Some investors say they agree with our view on U.S. stocks in principle, but they disagree with our timing. They think the U.S. dollar is just too high at present levels: too hot, you might say. These folks seem to think that the natural foreign exchange rate between the U.S. and Canadian dollars should be around parity.

As of late 2023, the U.S. dollar has traded at around one-third higher than the Canadian dollar. Way above parity! In fact, the U.S.-Canada exchange rate has not been anywhere near parity in the past decade.

The U.S. dollar has mostly stayed between $1.20 Cdn. and $1.46 Cdn. since the start of 2015. It’s now around the middle of that 8-year range.

Since 1971, the U.S. dollar has stayed between $0.94 Cdn. and $1.60 Cdn. It’s now around the middle of that 52-year range.

Timing is worth a look. But if you make it the deciding factor in your investment decisions, it’s apt to cost you money, in the long run if not in the short.

“Has-been” U.S. dollar has a long life ahead

A lot of foreign governments share the view that the U.S. dollar is overvalued.

In March 2023, in a meeting in New Delhi, the representative from Russia revealed that his country is spearheading the development of a new currency. It is to be used for cross-border trade by the BRICS countries: Brazil, Russia, India, China, and South Africa. (Potential recruits include Iran, Syria and North Korea.)

I put this ambition on a par with the claims of cryptocurrency promoters. Some of them still predict that cryptocurrencies will take the place of the U.S. dollar. Continue Reading…