However, bull markets do tend to frustrate all types of investors because, when so many investors are waiting for a pullback to buy in on, then one generally doesn’t occur.  Our overall view continues to be that stocks will advance over the next two years as the economic data improves, interest rates remain relatively low and earnings growth continues.  We would rather ride out any short-term pullbacks in the market rather than trying to time an exit and re-entry and potentially miss this longer-term upside.  Almost all our measures of overall stock valuations are showing stocks as under-valued.  The chart below shows the earnings yield on stocks (blue line) versus the yield on corporate bonds (red line) and government bonds (black line).  The 8.0% current earnings yield compares favourably to the 5.1% on another risk asset, corporate bonds, while both of those asset classes look exceptionally undervalued compared to the paltry 1.9% yield on government bonds.  Investors are clearly being compensated for taking the higher degree of risk associated with stocks by getting an earnings yield almost quadruple that of the ‘risk free’ asset class, government bonds.

Some risk is rewarded

The chart above is specific to the U.S. market but we also show in the next chart below how the price-earnings (P-E) multiples of small stocks are lower than average on a global basis despite the rally of the last few months.  Investors have been bracing for a slowdown in growth or even a decline in earnings by pricing stocks at such discounts to historical levels, particularly since multiples should be higher when interest rates are lower, as they are now.  As investors start to recognize that economic growth is resuming and earnings growth along with that, stocks should continue their upward move.  The chart also shows how this is true in almost all major markets; in particular, the European and Japanese small cap stocks are trading at the most significant discounts to their longer-term averages.

Stocks still at a Discount

The riskiest time to own stocks is when multiples are high and fear about the future is low.  We only need to wind the clock back about 12 years and look at some of the big names in the U.S. to see how falling earnings multiples can lead to poor stock performance despite earnings growth.  General Electric, Coca Cola, Walmart and almost all of the large technology companies were trading with earnings multiples of over 30 times in the late 1990’s as investors believed the long-term growth of those businesses would sustain high valuations in perpetuity.  Those stocks had lead the bull markets of the 1980’s and 1990’s and investors had become accustomed to paying premium valuations for the names and the growth, despite the fact that growth was slowing as the businesses became more mature.  But now we look around and see most of those same names trading with PE ratios in the 8-10 timies range despite meeting all the expectations for earnings growth in the interim period.   Microsoft earnings have more than tripled over the past 12 years but the stock has lost over 50% despite recent gains.  Similar story for GE, Walmart and Coke.  Investors buying high earnings multiple stocks today need to be wary of the same phenomenon.  Amazon is a classic case of this in our view and we see it very much as being the next Walmart or Coke.  Amazon earnings could triple over the next eight years at current growth rates, but if the earnings multiple contracts to average market levels over that same period then the stock price will be unchanged!  Social networking stocks will experience the same fate in our view; moreover their growth is less than guaranteed.  Investors are effectively paying today for the next 6 years of growth at Linked-In.  In an industry where the landscape can change so quickly, why should investors feel comfortable paying for all of that growth today.  Google has surpassed almost all of their expectations for growth and the stock has done exceptionally well since going public, gaining from the initial $80 issue price to over $600 today.  But the stock is also trading at just around 13 times current annualized earnings versus the multiple of over 80 times it traded at when it went public.  Google has the exception not the rule.   We currently own Google because its valuation is attractive and we still see growth ahead from new initiatives such as ‘Google Plus’ as well as the surprisingly strong growth of their Android operating system for smart phones.  But wouldn’t get involved in Amazon, since we believe that it is effectively just a very efficient retailer, not a technology company.   Trading at over 40 times current earnings, the growth rate just does not justify the valuation.  Same story now for any of the social networking stocks at these valuations; also for Facebook when it does come public.  The market appears to be ready to value the company at over 40 times current operating cash flow.

On the subject of technology stocks where the earnings multiple has imploded due to slower growth and pessmistic outlook, we recently met with the new CEO at Research in Motion, Thorsten Heins, as well as David Smith, who is  responsible for the development and recent upgrade to the Playbook.  The corporate mantra continues to be that the ‘future is mobile computing and that RIM is exceptionally well positioned with products, software and the network to compete in that growing space.’  We wouldn’t argue with that premise at all.  Technology is moving to a mobile framework with most applications and data being supplied from ‘cloud computing’ and housed on ‘server farms.’  The devices will continue to get smaller and yet more functional.  For RIM, the technology has never really been the issue as its greater security  behind the corporate firewalls, its more efficient use of bandwidth and the popularity of the BBM network had made it a favourite with its major customers, the global telecom companies, as well as with most major corporations and government agencies.  Their shortfalls have been in marketing and execution of plan.  The Playbook has been a classic example of this;  while the poorly timed marketing launch and incomplete first version made the initial offering a joke and lead to nearly a US$500 million writedown, the operating efficiency of the tablet, the multi-tasking in programs and the broad software offerings easily make it a competitive offering to the iPad, and this is coming from an avid iPad user!  We have not added to the stock position recently since we still think the next 2 quarters could be below expectations given that Blackberry7 sales are slowing and the Blackberry10, which will feature the same software as the Playbook, won’t be ready until the fall.  But serious larger investors are starting to take significant positions in the stock, the valuation is ridiculously low at under 5 times currrent earnings, and the potential for a “Wow” factor experience with the next round of product offerings still exists.  2011 was ‘annus horrilibus’ for RIM investors but we currently see the valuation range for the stock as being between $10 on the low side and $40 if they can deliver on the new devices; pretty good risk-reward with the stock currrently around $15.00.

We also remain overweight in techology in general with a focus on the wireless computing companies;  Qualcomm and Broadcom for the integrated chips, Google and Apple to cover the smart phone market, and Microsoft and Open Text for software.

We also are still overweight the Energy sector with a focus on oil stocks and the service companies.  With oil prices hovering above US$100 per barrel, capital expenditures should remain strong.  Key service names include Calfrac Well Service and Trinidad Drilling in Canada as well as Haliburton in the U.S.  We do remain under-weight the  natural gas stocks for now though as ample supplies from shale gas growth will put continued downward pressure on the price of gas as well as the stocks.  Other key sector positions include continued overweights in the copper, uranium, auto and energy infrastructure stocks and underweight positions in financial services, utilities, consumer staples and telecom.  The latter group would be classified as ‘interest sensitive defensive stocks’ and we don’t think that their stronger performance seen in 2011 will continue in a period where economic growth is recovering and interest rates are no longer falling.  In our Global Hedged Growth Fund we have sector ETF overweight positions in the sectors mentioned above and are also short U.S. government bonds.  Within our Balanced Funds, we remain underweight bonds and have stock allocations at about 120% of the benchmark weight for the specific accounts.

While markets may see an overdue short-term correction in the near future, we are not trying to time such a move and have instead rotated to the sectors where we see the best relative growth.   If there is a pullback in prices of great than 5%, then we would become active buyers again across our existing holdings. 

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