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Mar 2, 2015

Three Easy Steps to Increase the Consistency of Your Investment Returns

by Peter McMurtry

Peter McMurtryAre you sick of trying to pick the right stock that will outperform the Toronto equity market? Are you bored just buying an index and feel you could do better?

By making three relatively simple investment decisions, you will significantly increase your chances of being successful.

Take the three largest sub-groups of the Toronto market: namely, Financials, Energy and Materials. As of the end of 2014, these three sectors represented 68% of the index. The only decision you will need to make is to determine which of these three groups will do better than the market and which ones will do worse. You will notice that these options do not involve any individual stock decisions, so your chances of being right are much higher.

The year-over-year comparisons as of the end of December registered a TSX Composite Capped total return of 10.4% with the Energy, Materials and Financials reporting a -16.5%,-1.7% and a + 11.8% change respectively. If you had only been in Financials and nothing else, your performance would have been greater than the overall market return without assuming all that volatility from the energy and mining sectors. On the other hand, if you had chosen the energy sector only (as many investors did) you would be panicking at this time.

The combination of improving your odds of both beating the overall market in addition to ensuring your returns are more predictable and consistent are entirely feasible using this strategy.

Let’s say you choose to be in financial stocks. Which ones would you select? Once again the answer is relatively easy. You can simply pick the iShares financial exchangetraded fund with the symbol XFN in Toronto. On the other hand XMA is the Materials ETF symbol while XEG is the Energy one. These ETFs try to emulate their respective TSX sector sub-indices.

How are you to choose between these three groups? Both the Materials and Energy sectors are cyclical in nature, meaning that they are more sensitive to world economic growth than the rest of the market. China and Japan are major consumers of commodities and as their economies expand and contract, the effect on commodity prices is dramatic. In addition a strengthening US dollar relative to world currencies is negative for gold, base metal and oil prices as these commodities are normally sold in US dollars throughout the world. When the US dollar rises, these commodity prices become more expensive in their own domestic currencies causing the demand to drop with prices falling.

The general rule of thumb is that as world economic growth expands with a corresponding increase in inflationary expectations, commodity prices will follow suit. Energy prices differ in that they are also affected by political unrest in the Middle East in addition to the major influence on production and ultimately prices exhibited by Saudi Arabia.

While Financial stocks’ profits most definitely benefit from a stronger economy, they are much less sensitive than the Materials or Energy sectors are. Bank stocks are more affected by consumer spending and by the spread they receive on their loans. Currently, bank profits are expected to expand with longer term interest rates anticipated to rise faster than shorter ones. Secondly, financial stocks have a history of growing dividends and earnings over long periods of time without a lot of volatility. Bank stocks are typically the first sectors of the equity market to rebound after a serious prolonged recession. In my opinion, financial stocks should always be included in stock portfolios due to their much lower risk parameters.

Despite choosing one or two of these three sectors that you think will outperform the other, it is still essential to diversify your holdings by having exposure to all three. This will avoid you chasing investment performance by establishing an initial weight in the non-favoured sector before it eventually goes up.

For example, the outlook for the Gold component of the Materials sector has not been favourable for quite some time, yet they have rallied nicely off their recent lows. The energy and materials sectors represent 22% and almost 11% respectively of the Canadian equity market as of year-end. Try to limit your overall exposure to 10-12% of your holding for these two sectors, taking into consideration that the first six months of 2015 will remain a difficult environment for commodity stocks.

Just because this strategy seems too simple in no way diminishes its effectiveness. Taking the complexity out of a decision makes it much easier to solve whether it is a mathematical equation or a financial decision. By making fewer investment decisions, the probability of being correct increases proportionately.

This is not an index strategy. This is solely a method to make your investment decisions a whole lot easier. For example using an index strategy does not work well in a falling market. Matching negative absolute returns will not please anyone. However, my strategy is entirely different. Choosing to have a minimal exposure in the materials and energy sectors would have most definitely improved your returns over the last year.

Every equity market has a different set of dynamics. For example the top three most heavily weighted sectors in the US market have only a 51% weight, considerably less than in Canada. In consequence, I would not recommend making an investment call only on the top-weighted US subgroups of Financials, Healthcare and Information Technology.

Starting right now, try to limit your Canadian stock investment decisions to an assessment of the earnings and market outlook for the Financial, Materials and Energy sectors. You will be surprised how easy it really is.

Peter McMurtry, B.Com, CFA, Financial Writer, peter.mcmurtry@yahoo.ca