How to participate in the IPO boom without taking the risk

by James Parkyn

One of the remarkable features of the bull market over the past year has been frenzied activity in initial public offerings (IPOs). Around the world, investors have shown an extraordinary interest in new stock issues and been willing to pay high prices for a piece of the action.

An IPO occurs when a private company raises capital by issuing shares to institutional and retail investors. IPOs have been setting records for both the number of companies going public and the amount of money being raised. The boom has gathered steam as investors have become increasingly enamoured of tech stocks and upbeat about the prospects for post-pandemic economic growth.

Globally, IPOs raised a record US$140.3 billion this year to May 10 through a total of 670 offerings, another record.

Most of those issues were in the U.S., which has by far the largest stock market in the world with over 55% of global equity value. The U.S. IPO market is coming off an unprecedented year in 2020 when 494 issues raised US$174 billion, a 150% increase over 2019. In the first quarter of this year, IPOs were even hotter with 365 issues, raising US$129 billion.

In Canada, the results were more mixed. The 77 IPOs in 2020 were fewer than in 2019, but the $5.6 billion raised was an increase of 116% over 2019. In the first quarter of this year, there were 32 IPOs worth $3.2 billion.

Investors have been willing to pay extraordinary prices for IPOs, especially tech issues. Between 2002 and 2019, the median tech IPO price-to-sales ratio never went above 12 in a calendar year, according to IPO expert Jay Ritter. In 2020 the ratio was 23, by far the highest since the dot-com era. To the end of April this year, it was 20.

The excitement surrounding new stock market entrants is quite a contrast from the tone just a few years ago. Back then, media attention was focused on the low number of IPOs and the shrinking size of the stock market.

A 2017 Wall Street Journal article titled Where Have All the Public Companies Gone? noted that the number of listings on U.S. exchanges had dropped to just 3,617, half the number there were in 1996. IPOs had fallen to 128 from 845 in 1996.

Plentiful money from private equity and venture capital investors meant companies could fund their growth without going public and taking on all the accompanying regulations, public scrutiny, and investor activism and lawsuits. Merger and acquisition activity also contributed to the disappearance of existing public companies.

As the Journal article noted, what was good for the private equity and venture capital investors was bad for retail investors who depend on public equity markets. The shrinking number of public companies meant passive investors who purchase whole markets through index funds were getting less diversification for their money.

From this point of view, the current IPO boom is positive news. However, there is also danger for small investors in the IPO frenzy as we discussed in a recent episode of our Capital Topics podcast.

Attracted by all the hoopla, many small investors are being drawn into buying individual IPO issues. Besides the well-known perils of buying individual stocks, IPOs tend to underperform the stock market following their first day on the market, according to research by Ritter, a professor at the Warrington College of Business at the University of Florida, who is known as Mr. IPO.

In an interview on Rational Reminder podcast hosted by our PWL colleagues Benjamin Felix and Cameron Passmore, Ritter said IPOs underperform the market on average over one-year and three-year periods, following the close of their first day of trading. (He noted it’s the smallest companies that tend to underperform the market. Larger companies, on average, neither underperform nor outperform.)

What’s more, brokerage firms often ensure large investors get IPO shares at the offering price. Small investors are left to purchase stock at higher prices on the secondary market (although online platforms are making it easier for individual investors to buy IPO shares). Additionally, brokers are sometimes paid bonuses to sell the IPO shares of lower quality companies to clients.

There’s been a lot of excitement and lots of headlines about IPOs over the last year. The good news for passive investors is IPOs are quickly included in indexes and thus you get to own them without taking the risks involved in buying individual stocks.

Investment returns are expected to be lower in the future—get used to it

by James Parkyn

Readers who are familiar with PWL Capital’s philosophy will know we don’t make predictions about where the markets are headed in the coming months or years.

We believe no one can predict the markets, despite all the time and money spent by active fund managers, analysts and media commentators trying to do just that.

Look no further than 2020 for the proof of the futility of forecasting market movements. No one predicted the COVID crash or the remarkable rally that followed.

Nevertheless, financial planning requires investors to consider not only personal factors such as their time horizon and tolerance for risk, but also to make assumptions about future rates of return.

What mix of stocks and bonds might provide you with the level of growth you need to achieve your retirement income goals? How bumpy might the ride be? To answer these questions, financial planners use expected rates of return and risk levels for different asset classes.

At PWL, Research Director Raymond Kerzérho provides us with his best estimate of stock and bond returns over the next 30 to 40 years. His projections are based on current asset prices and their return history. The methodology Raymond uses is explained in this paper.

In his latest report, his analysis produced an expected real return (not including inflation) of 4.7% for global equities, or a nominal return of 6.0%, if you factor in 1.3% inflation going forward. Of course, these are averages; there will be lots of ups and downs along the way.

Following a segment on expected returns in a recent episode of our Capital Topics podcast, a listener wrote in to ask why equity returns are expected to be so low in coming years.

The first observation is that they are not that low by historical standards. Over the last 121 years, global equities provided an annualized real return of 5.2%, according to Credit Suisse’s Global Investment Returns Yearbook. Over the last 20 years, global equity markets generated a similar real return of 5.0% per year.

However, strong returns over the last decade might be colouring investor perceptions of how much they should be earning from stock market. Recall that in 2011, the stock market was starting to recover from the financial crisis and stock prices, especially in the U.S., were much lower than they are today. Since then, global equities have generated an annualized return of almost 11%.

Today, it’s a different story. The Shiller-CAPE price-to-earnings ratio has risen to 35 from 21 in 2011 for the U.S. market. The price appreciation has been less dramatic in Europe, but stocks are still much higher than a decade ago.

This is a key reason why equity returns are expected to be lower in the future. Combining lower equity and bonds returns, we conclude a portfolio composed of 60% equities and 40% bonds has an expected return of just 4.34% annually. This is almost two percentage point lower than 6.15% that markets actually returned over the past 20 years.

What does it mean for investors? First, it’s a strong signal to temper your own expectations. In a low-return environment, investors are often tempted to take undue risk in an effort to beat the market.

Egged on by the financial media, they fall prey to recency bias, chasing the latest hot investment idea and ending up getting burned. Last year, they might have decided to load up on high-flying growth stocks. But markets can turn around quickly and without warning. So far this year, value stocks are outperforming growth by a wide margin.

The second conclusion investors should draw from lower future returns is that it’s critical to capture every bit of return that is available. That’s why at PWL we put so much importance on portfolio diversification, tax efficiency and rebalancing.

Building wealth over the long term requires you to make decisions based on the best available evidence and then patiently stick with your plan through good times and bad. A realistic view of future returns is an important part of the equation.

The hidden dangers of dividend investing

by James Parkyn

While its hard to prove, dividend investing seems to be more popular in Canada than in the U.S. and other countries. Certainly, there’s no shortage of media coverage, websites and mutual funds devoted to dividend-based investing strategies.

The popularity of dividend-focused approaches may reflect, at least in part, the special tax treatment Canadian dividends receive, or a home bias toward shares in Canada’s banks, telecoms, utilities and other blue-chip dividend payers.

Whatever the reason, the fascination of many Canadian investors with dividends betrays a misunderstanding of how equity returns work and exposes portfolios to higher risk.

Returns from equities are composed of capital gains (price increases) and dividends. As explained in this excellent article by our PWL colleague Dan Bortolotti, dividends and price appreciation are two sides of the same coin.

If a company pays a $1 per share in cash dividends from earnings, its shares become less valuable by that $1, in theory. As Dan explains: “This price drop will not be penny for penny, and it may even be washed out by the normal fluctuations in the daily markets. But there is always a trade-off. After all, when a company pays out, say, $10 million in dividends, it must be worth $10 million less.”

Therefore, it should make no difference to you whether your returns come from dividends or from capital appreciation (ignoring taxes and transaction costs).

However, the direct relationship between share price and dividends is clearly a difficult concept for many shareholders to grasp and that can lead to some risky investment bets. First among the risks is a serious loss of diversification to which dividend investors are prone.

A dividend focus excludes a large and growing number of companies that don’t pay dividends, despite earning high profits. One prominent example is Warren Buffett’s Berkshire Hathaway, which has never paid a dividend under his leadership. In fact, nearly half of all U.S. publicly listed companies paid no dividends between 1963 and 2019, according to this article.

The problem is compounded by the sector concentration of higher-yielding dividend paying stocks. This is particularly pronounced in Canada where dividend funds are dominated by a relatively small number financial, telecom, pipeline and energy stocks.

Then, there’s the danger that dividend payouts will be cut or eliminated during recessions. This was the case during both the 2008-09 financial crisis and the pandemic when one in five companies cut their payouts and one in eight eliminated them altogether.

Finally, investors often buy dividend stocks for the income, but this is less tax efficient than selling shares to generate cash.

The first months of 2021 have been kind to dividend investors as the market rotated from growth to value stocks, a group that includes many dividend-payers. The iShares Canadian Select Dividend ETF, the largest such fund in Canada, returned 12.99% in the first quarter, easily outpacing the broad-based iShares Core S&P/TSX Capped Composite Index ETF’s return of 8.11 %.

It was a very different story last year. Dividend boosters often claim these stocks hold up better in downturns, but that certainly wasn’t the case during the pandemic crash and recovery. ETFs focused on Canadian dividend stocks were “blown away” in 2020 by broad-based ETFs that track the S&P/TSX Composite Index. The iShares dividend ETF returned -0.51 versus +5.61 for the S&P/TSX Composite Index ETF.

The evidence is clear that the best way to build wealth over the long run is by diversifying as widely as possible within and across asset classes and geographies. Dividend investing not only fails the diversification test but also exposes your portfolio to the risk of not delivering the income you were counting on.

Certainly, dividends are an important part of overall stock market returns. However, when it comes to dividends, too much of a good thing can be bad for your financial health.

Learning the lessons of the bond market sell-off

by James Parkyn

The stock market is definitely the star of the investing world—it gets most of the attention from the media, analysts and individual investors.

That’s been especially true over the last year, thanks to a roaring bull market that’s sent the S&P TSX Composite Index up over 65% and the S&P 500 by over 75% since the COVID market crash bottomed out on March 23, 2020.

The bond market, by contrast, usually doesn’t attract a lot of mainstream attention even though it’s far larger than the stock market and plays a crucial role in both the economy and in diversified investment portfolios.

However, the bond market has been making headlines of late. Since the beginning of the year, bond prices around the world have fallen sharply and yields have spiked higher. (Yield is the rate of return investors currently earn from interest paid by bonds. Bond prices and yields move inversely.)

After hitting a low of just .45% last summer, the yield on the Government of Canada 10-year bond has more than tripled to around 1.50% currently. It’s been a similar story in the U.S. and other major markets.

The drop in bond prices (and rise in yields) reflects growing optimism about stronger economic growth as vaccination campaigns gather steam and stimulus continues to be pumped into the economy by governments and central banks. Investors are betting faster growth will cause an uptick in inflation, prompting higher interest rates.

It’s a big change from the sentiment that drove bond prices higher last year. Back then, the economy was suffering through a historic recession, central banks were cutting interest rates, and if anything, the concern was about deflation, not inflation. Bond prices rose sharply, sending yields to rock bottom levels.

As a result of those rising prices, the Canadian total bond market generated a generous 8.69% return in 2020. It’s been a very different story so far in 2021. The drop in bond prices wiped out more than half those 2020 gains in just two months.

This points to the relative riskiness of long-term term bonds, which are far more sensitive to interest rate changes than short-term bonds.

With interest rates being so low, many investors have been willing to buy long-term bonds or ones with lower credit quality because they pay higher yields. That’s in keeping with a general willingness these days to buy risky assets of all kinds, from cryptocurrencies to high-flying tech stocks to special purpose acquisition companies.

However, as we’ve seen with the reversal in bonds, capital markets can turn rapidly. It’s something Warren Buffett warned about in reference to low-quality bonds in this year’s letter to Berkshire Hathaway shareholders.

It’s important to remember the role a bond allocation should play in your portfolio. It’s there to cushion against volatility in the stock market and provide liquidity. That’s why we stick to short-term, high-quality bond funds in the portfolios we manage. Their low volatility provides the stabilizing benefits we are looking for through market cycles.

As for the recent drop in bond prices, the good news is that this short-term pain will give way to long-term gain. Bond yields have risen and that means higher expected bond returns over the longer term.

Why worry about whether we’re in another speculative bubble?

by James Parkyn

It’s been almost a year since the World Health Organization declared a global pandemic in response to the spread of COVID-19. As we discussed in our recent portfolio performance review 2020, no one could have predicted the extraordinary events of the past year or the markets reaction to them.

The market crash in February and March 2020 was the worst since 1929 as the gravity of the pandemic crisis became clear. Then, the markets came roaring back with extraordinary speed and ended the year at all-time highs.

It was a year like none other in memory and provided a remarkable lesson on the importance of disciplined asset allocation and the danger of trying to outguess the markets by jumping in and out of investments in hopes of cutting your losses or maximizing your gains.

That’s called market timing and researchers have found it to be one of the worst wealth-destroying mistakes you can make. For example, the Dalbar research firm found that poor trading decisions caused the average U.S. equity fund investor to earn annual returns that were 4.7 percentage points below those from the S&P 500 index in the 20 years to the end of 2015.

People who try to time the market are often driven by a fear of losses or a desire to make big profits, but as we’ve seen in dramatic fashion this year, it’s impossible to forecast where the markets are headed.

The danger becomes clearer when we dig a little deeper into recent market trends. Growth stocks in general—and big tech stocks in particular—produced by far the best results in 2020. In the U.S., large and mid-cap growth stocks returned 36% versus just 1% for value stocks—the largest divergence ever recorded.

Skyrocketing prices have captured the imaginations of many investors who have bought into tech stocks and other hot investments like electric car maker Tesla and cryptocurrency Bitcoin. Meanwhile, others are dumping their stocks because they fear a speculative bubble has inflated of the kind seen during the dot.com era of the late 1990s.

Which side is right? A rational investor doesn’t have to engage with either. The antidote to the stress of worrying about current market conditions is a portfolio that is broadly diversified across asset classes and geographies and a patient, long-term perspective.

We make no judgment about whether U.S. growth stocks are in a bubble, but we do observe that value stocks and markets in other parts of the world are currently trading at far lower valuations. The beauty of diversification is that when one market is falling, others will be performing relatively better.

The real danger in investing is not missing out on a hot sector bet or suffering through a market correction. It’s making poor decisions in the heat of the moment that can lead to a permanent loss of capital.

Our discipline of sticking to diversified asset allocation may not produce the excitement of jumping on the latest zooming tech stock or cryptocurrency, but it has been proven to be the prudent way to build wealth over the long term.