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Feb 1, 2021

Kill Your Darlings— When To Get Rid Of Old Favourites

by Rita Silvan
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Rita Silvan“Kill your darlings” is a common piece of advice to writers to chop pet phrases or characters for the sake of the overall story. It’s also good advice for investors who sometimes lose the plot by clinging to old favourites. Darlings are those types of investments we remain attached to long after their usefulness is gone. Here are some common infatuations:

Dividend Darlings

Who doesn’t love to make money while they sleep? Investing in companies with generous dividend policies can feel like an easy win. We’ve all heard the expression, “get paid to wait”. Unfortunately, that blithe spirit doesn’t take into account the inherent risks in leaning too heavily into high-dividend payers. Unsustainably high payouts come with the possibility of a dividend cut or elimination, a deeply out-of-favour company which becomes a value trap resulting in a permanent loss of capital, or a corporate head fake where a formerly generous dividend-payer never raises its payout and becomes a cheapskate.

Famous Flameouts

Celebrities know, fame is fleeting. One day they love ya, the next you’re treading the boards in Poughkeepsie. Recall the Nifty Fifty, the 50 fastest-growing companies (with Price/Earnings to match) on the New York Stock Exchange in the 1960s and 70s. Investors fell in love with them and no price was too high since their market values were expected to go into infinity. These darlings included Polaroid, IBM, Xerox, and General Electric. During the bear market in 1973-74, they, alongside many others, took a steep dive, with some, like Polaroid, dropping over 90 per cent.1

The performance of our current crop of high-tech darlings, the FATMAN-Gs, (Facebook, Amazon, Tesla, Microsoft, Apple, Netflix, Alphabet, formerly Google) has been a consistently bright spot through the darkest of days of 2020. Despite legislative headwinds related to uncompetitive practices and tax dodges, these companies may still have a very long runway, albeit with a potentially slower rate of growth. Just to put their current valuations into perspective, if each of these companies in aggregate generated 15 per cent annually over the next fifteen years, their market cap would be over $70 trillion in 2035, or the combined Gross Domestic Product (GDP) of the United States and Europe.2 If your portfolio is getting a little tech top-heavy, consider taking some profits off the table. In 2021, the phrase “growth at any price” might be replaced by “renaissance of value”.3

Home Alone

Everyone has a soft spot for home. For investors, that leads to an over-exposure to domestic companies because we’re familiar with them; they feel safer than foreign ones. Despite the favourable tax treatment on eligible dividends, too much Canada exposes investors to the vagaries of a relatively small set of sectors (financials, energy, consumer goods) potentially missing out on growth opportunities elsewhere. In 2019, Canada represented merely 1.43 per cent of global GDP.4

Low Energy

One old favourite which is now a deeply unloved former darling is Canada’s energy sector which contributes approximately $110 billion to our annual GDP, or a little over six per cent.5

Since January 2008, when a barrel of oil cost US$140, the S&P/TSX Canadian Energy Index has lost 83 per cent. (Ouch.)6, 7

Despite the penury for Canadian oil producers and investors, there is more pain ahead which COVID-19 has only accelerated. For many investors, the energy sector is a key pillar in their portfolios. Could this be the time to toss this favourite overboard and move to greener pastures?

In December, Mark Carney, the former Governor of the Bank of Canada and, more recently, the Governor of the Bank of England, addressed the Economic Club of New York on the topic of climate change and investment opportunities as countries transition to net-zero economies.

“This market is a $50-150 billion market,” Carney said. “Excluding the United States, 126 countries have a plan and Biden has committed to a conversion to clean energy by 2035 and to net-zero by 2050…this is the biggest commercial opportunity representing $3.5 trillion a year globally. Currently, only some of this is in the market.”

Carney refers to this trend as “mainstreaming the transition to a net-zero economy” as the investor class, including such companies as Blackrock, JP Morgan, as well as many European sovereign funds, aggressively push companies to move to net-zero—or even negative zero, as Microsoft has committed to doing to make amends for its legacy of carbon use.

“They anticipate where things are going and catalyze change. To get mainstream change, we have to see where the world is going,” Carney said.

One example of the mainstreaming trend is companies who kept their climate pledges during COVID. The forced lockdowns decreased demand and created an absolute reduction in emissions. Once the pandemic is behind us, Carney says, a realistic goal would be seven per cent reductions compounded annually for developed economies within five years.

“We may be able to isolate ourselves from the pandemic, but we cannot isolate from climate change.”

Companies have become more aware of both climate risk and also of transition risk. Waiting too long to transition to green energy, which is where the world is headed, means the possibility of stranded assets. And, as governments implement fiscal policies to address growing inequality, they are also targeting climate change, which is the ultimate intergenerational inequality as future generations will bear the economic and health burdens of a warming planet.

Investors will increasingly have to make some difficult decisions. Do they “kill their darlings” in the oil and gas sector, forfeiting the rich dividends and potentially incurring a permanent loss of capital? How can investors determine which companies have actionable climate change plans that the market will reward, and which are merely hand waving? Is avoiding all oil and gas companies the forward-thinking approach?

According to Carney, we “need to back the big energy and industrial companies which do have plans and get them to move versus shunning them.”

Some of the companies likely to benefit from a lower cost of capital and reward investors with higher returns include Fortis and Emera which are positioned toward electricity and gas.8 Enbridge has one of the biggest renewable energy portfolios in Canada. Suncor, Cenovus and Canadian Natural Resources have all announced intentions to reach net-zero by 2050.9

This is a good time to review your investment portfolio’s narrative. What changes should you make to give your investment narrative a happy ending?

Rita Silvan, CIM is a finance journalist specializing in women and investing. She is the former editor-in-chief of ELLE Canada and Golden Girl Finance. Rita produces content for leading financial institutions and wealth advisors and has appeared on BNN Bloomberg, CBC Newsworld, and other media outlets. She can be reached at