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.

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.

Studying past fund performance won’t get you where you want to go

by James Parkyn

It’s been quite a rollercoaster ride for investors this year. A deep plunge in the stock market last spring was followed by a powerful rally that has sent the S&P 500 to new highs and the S&P/TSX Composite close to its high.

Let’s imagine a retirement saver, named Robert, who has been sitting on the sidelines through all this turbulence and has finally decided to take the plunge and invest a chunk of his money in the stock market.

Robert watches business news channels on TV and has heard various mutual fund managers predict where the markets and individual stocks will be heading in the coming months. With all the conflicting advice and predictions he’s heard, it’s no surprise he has a hard time deciding which managers to trust with his money.

It’s at this point that Robert and his investment advisor decide to look at the past performance of various mutual funds as a guide to finding the best ones to buy.

Of course, they know about the fine print at the bottom of mutual fund marketing materials that warns “past performance is not an indicator of future results,” but how else is Robert supposed to choose?

Sadly for him and countless other investors in actively managed funds, the fine print isn’t just perfunctory boiler plate. Past fund performance actually offers little insight into future returns.

Research by Dimensional Fund Advisors shows that just 21% of top quartile equity funds in the U.S. maintained a top-quartile ranking in the following five years (in data from 2009-2019). For fixed income, the number is 29%.

Even if you were one of the lucky ones who had invested in one of those top-performing funds, you would have had no way of knowing it when you made your investment. The odds were definitely against that outcome.

Indeed, a huge percentage of fund managers don’t generate returns over their benchmark index. In the case of actively managed U.S. equity funds, 89% underperformed the S&P Composite 1500 index over ten years to the end of 2019, according to the S&P Dow Jones SPIVA report.

Even a mutual fund manager who is able to beat the market for 10 years or longer might just be the beneficiary of random luck.

The most famous example of a manager whose luck ran out spectacularly is Bill Miller. Managing Legg Mason’s flagship fund, Miller beat the S&P 500 index for an astonishing 15 consecutive years from 1991 through 2005. Then, as the financial crisis and recession began to unfold, Miller made disastrous bets on financial stocks that led to his fund losing two-thirds of its value by the end of 2008.

Miller himself attributed his winning streak to “maybe 95% luck.” And a former investment strategist at Legg Mason estimated the probability of beating the market in the 15 years ending 2005 was 1 in 2.3 million.

The reality is that relying on past performance to choose investments is like driving your car looking in the rear view mirror. It doesn’t work (unless you’re driving in reverse). The evidence clearly shows that actively managed funds cannot consistently beat the market and studying their past performance will only gives you the illusion they can.

For Robert, the answer is to stop worrying about finding the best active managers and, instead, use passively managed index funds to build a broadly diversified, low-cost portfolio. That’s the way to keep your eyes on the road ahead and be prepared for any turns, bumps or detours that may come along the way.

How to make sure diversification doesn’t turn into “di-worse-ification”

by James Parkyn

At its core, investing should be a relatively simple process. However, when emotions, misguided theories and bad advice enter the picture, things can get very complicated.

The right way to invest is to decide on an asset allocation strategy that fits your goals and risk tolerance while ensuring your portfolio is broadly diversified across asset classes and geographies. Then, you implement the strategy by selecting low cost securities and staying invested through the ups and downs in the markets to reap all the returns they are offering.

Of course, it takes expertise to optimally follow this recipe, including choosing the best securities to do the job; rebalancing periodically back to your target asset allocation; and making sure your portfolio is tax efficient.

Nevertheless, the guiding principle should be simplicity. But many investors opt for just the opposite—they choose to make their portfolios more complex.

That’s not surprising. They are bombarded every day with news about the economy, international affairs and market ups and downs. They hear pitches from advisors about the latest specialized investment opportunity, and they end up buying.

Their portfolios become packed with a wide variety of investments—evidence of the different fads and theories they’ve fallen prey to over time. They may even believe they have diversified their portfolio by adding narrowly focused funds or individual stocks. In fact, the result is not diversification but di-worse-ification—they’ve made their portfolio worse by not optimizing their diversification.

If they were to take off the fund wrapper and look at the underlying securities they own, they would find they had increased their risk by weighting it toward a particular sector, region or asset class,  and incurred high management fees to do so. All will be well when the market is going up, but when the wind turns their returns can end up on the rocks.

For example, there’s a huge number of mutual funds and ETFs focused on the tech sector. They’re popular these days with people hoping to cash in on this year’s tech sector rally. In my previous blog, I discussed the dangers of becoming transfixed by the U.S. stock market, as its led higher by tech stocks, to the detriment of other asset classes, such as emerging markets.

Another example is the current search for yield in light of historically low interest rates. This is leading some to take on more risk by concentrating their portfolio in dividend stocks or other higher yielding securities.

There are many other possible sector or tactical bets you can make, but they all share the same defect—you are trying to outsmart the market by forecasting winners and losers. We know from long experience that this doesn’t work over the long run and that all these bets are not helping to diversify your portfolio.

On the other hand, robust, global diversification does work. By combining securities whose performance is not well correlated, you lower your risk without reducing your expected returns.

It’s not easy to stay disciplined when the economy is going through a sustained period of turbulence and the markets are volatile. But it’s good to know that sticking to simplicity in your investments is your best choice when everything else has become so complicated.