Why the glass remains half full for investors

If you have a truly diversified portfolio that’s reinforced with regular and disciplined rebalancing, the glass remains half full for investors.

From one angle, that’s a hard sell when markets have dropped dramatically, fears abound of a deep, costly recession and the world has yet to get the coronavirus under any semblance of control.

But John Nicola, CEO and chairman of Nicola Wealth, believes his firm’s sound strategy can soften the blow for clients and put them in prime position to take advantage of any subsequent rally.

In a letter to clients this month, Nicola said that while the coronavirus may have been the trigger for the market meltdown and any recession that’s coming, it’s not the sole cause. As of December 2019, the S&P 500 was at its highest valuation level since March 2000 – using the Case Shiller model of measuring PE ratios using ten years’ earnings – and the second highest in history. In addition, the US has not had a recession in more than 11 years. He said: “At some point, both a major market correction and a recession were inevitable.”

During difficult times like this, Nicola focuses on cash flow from dividends, interest and rents, rather than price. In the week of the first drop, yields of the S&P 500 and TSX had risen by as much as the market has fallen (25% and 30% respectively). The cash flow being generated is the same as it was a month ago, Nicola explained, but since prices have fallen by 25-30%, it takes less capital to acquire the same cash flow as a month ago, meaning the yield on both indices has risen.

“While it is true that some companies may have to reduce their dividends during 2020, there are also many other companies with very strong balance sheets that will maintain their distributions,” he said.

“Some typically solid financial stocks have fallen by more than 35-40%. We can buy $1 of dividend income for 35-40% less with a number of Canadian banks and Lifecos than we could just a few weeks ago. All of these companies have very strong balance sheets and should be able to support their current dividends comfortably.”

He added: “As a group, these companies have fallen, on average, more than 25% and now payout dividends equal to a yield of just over 4.3%. As of March 11, that was about 7x the yield on 10-year government bonds in Canada and the U.S.”

For Nicola Wealth, a truly diversified portfolio model means owning real estate, private assets, public equities, and fixed income, not just 60/40 stocks and bonds. The firm’s chairman said that, in the last financial crisis, Nicola’s average client experienced a net drop in account value of 6.5% for 2008 and a positive return of 14.8% in 2009, resulting in virtually no change in the annual cash flow that the portfolio generated. By comparison, a 60% equity (Canadian/Global) and 40% bond (Canadian/Global) portfolio would have earned a return of -1.5%/year (assuming total fees of 1% annually).

Strategies and tactics
Nicola also warned that a long-term resolution to the coronavirus is many months off and that it will create significant fallout in the real economy globally. Tourism, transportation, supply chains, and capital investment are feeling the pinch and high volatility appears to be here to stay in the near term. He said there are four main areas of the company’s investment strategy particularly relevant right now.

1, Every investment strategy should have a financial plan bespoke for the individual or family who owns the assets. Now is the time to review that plan and reinforce the key objectives it is trying to achieve.

2, The focus on building cash flow is more critical than ever. This is a crisis that is also an opportunity to buy more income for considerably less money.

3, Record-low interest rates provide an opportunity to refinance existing debt and perhaps lock in some or all of it for longer terms - five-year personal residence rates are approaching 2% from some lenders.

4, The best way to take advantage of bear markets in any asset class is to rebalance on a regular and disciplined basis. Nicola’s average client had 32% of their portfolio in long-only equities, while typical advisor recommendations are for 60-80% exposure to stocks.

He explained: “Our objective is to systematically purchase equities and to do so even if markets continue to fall. The math worked in 2008/2009 and it will work in this environment."