Great Expectations?

The following is an excerpt by Richard N. Croft from our Q3 Market Review & Managers’ Commentary

In response to a cryptic question about his expectations, the Le Chiffre character in Casino Royale stated; “I believe in a reasonable rate of return.” Whether in a James Bond movie or today’s financial markets, the challenge is to determine what return is reasonable in order to avoid disappointment …or worse.

Professional money managers recognize that performance expectations rarely jive with reality. That’s a concern because unrealistic expectations usually cause investors to stretch their risk appetite in search of higher returns.

When we look at investor surveys there is a prevailing view that double digit returns are possible over the long term—likely because that is what we have seen since the equity markets bottomed in March 2009. Unfortunately, the performance metrics associated with that short glimpse of history are not supported by return data since the “dot com” bust at the turn of this century.

With all due respect to the industry-wide caveat that historical returns are not necessarily indicative of future performance, we cannot ignore long term trends if doing so results in unrealistic expectations. And the previous 16+ years of data comes nowhere close to current expectations about future growth!

Consider iShares S&P/TSX 60 Index Fund (symbol XIU) which is an excellent proxy for Canadian equity markets. On a price basis, XIU returned approximately 0.85% per annum from its high in early September 2000.

If you add back dividends the numbers look better, approximating 3.15% compounded annually over the same period.

In our view, it is better to develop reasonable metrics on which to forecast future growth and then adapt a portfolio to operate effectively within the constraints of the model. That’s why our Investment Review Committee has been so engaged in discussions around performance metrics for the global equity markets. If we can paraphrase Bob Dylan, the numbers, “they are a changing!”

 So… what’s a reasonable rate of return?

Reasonable expectations begin with an assessment of the economy in terms of its potential and pitfalls. Since the Canadian economy is influenced by exports to the U.S. as our largest trading partner, the potential and pitfalls are one in the same.

From our perspective, despite “Trumped” up criticisms (pun intended), the U.S. economy looks like a decent house on a bad street. Unfortunately, the homeowners are powerful, angry, divided and frustrated – a combination that could have dire repercussions for the neighbors. We believe over time that cooler heads will prevail because of the United States’ resilient middle class and predisposition to innovate.

In that light we see the Canadian economy as certainly not bed ridden and, despite the collapse in oil prices, with some room for optimism. That said, the Canadian economy functions between a rock (central bank largesse) and a hard place (a tepid global recovery). The implication being tepid growth for Canadian GDP, which will likely finish 2016 between 1.0% and 1.5% rather than the 2.0% to 3.0% range that approximates historical norms. Let’s say, few headwinds but walking slowly up a slight incline.

On the other side of the coin we have low interest rates and no evidence that rates will rise significantly or any time soon. We expect a quarter point hike in the US Federal Funds rate at the December meeting with perhaps another quarter point in 2017 and again in 2018.

Low rates are positive for borrowers, but not so much for income seeking investors. Low rates also lead to asset bubbles such as we see with real estate in Vancouver and Toronto, and as some would say, with overvalued equity markets. There lies the rub!

So, the objective is to build an investment thesis that optimizes returns in a low-rate, non-inflationary environment with toned-down growth expectations and equity and other asset prices at or near all-time highs. No small task!

A good place to start is to re-think the role dividends play in a portfolios’ total return. If you believe, as we do, that mid-single digit returns are the new long term norm, then mature blue chip dividend paying stocks should anchor every portfolio. If we add option writing to this mix, the combination of dividends and premium income should deliver returns in line with the new norms but with less overall risk.

Consider as a case in point BCE Inc., which is trading around $60.50. BCE is a blue chip Canadian company paying an annual dividend of $2.72 per share, which equates to a 4.52% yield. Further, BCE has increased its dividend every year since the financial crisis. As a standalone investment, BCE meets much of our criteria.

Now add options to the equation. If we sell covered calls on BCE, which is what we do in our CPC Option Writing Pool, we can enhance our return while reducing our risk.

For example, at the time of writing the BCE May 62 options were trading around $1.35 per share. By selling the BCE May 62 (covered) calls we have taken on an obligation to sell the BCE shares we hold at $62 between now and next May.

We receive $1.35 per share as compensation for assuming that obligation.

If the option is exercised at the May expiration, we would sell our BCE shares to the call buyer for $62 and retain the $1.35 per share premium we received when we sold the call option. That generates a net seven-month return of 4.71% not including the dividends.

Add in two quarterly dividends over the next seven months and the total ‘holding period’ return jumps to 6.96%.

Even if the stock remains unchanged between now and May the net return including dividends and the option premium is 4.48%. Moreover, the premium received from the sale of the option reduces the cost base on the stock to $59.15. That being the downside breakeven for the position.

From our perspective this type of strategy offers a reasonable trade-off between risk and return. When implemented as part of a diversified portfolio we believe it has a high probability of delivering returns in the mid-to-high single digits without requiring a large upside move in asset prices from current levels.

Perhaps the financial markets seem to afford less than great expectations for now, but our view is that there is always a way to do a bit better than just a reasonable rate of return!