By Guest Blogger Sinan Terzioglu
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After dropping over 35% in 3 weeks the S&P 500 has rebounded over 54% and sits slightly below February’s all-time high. However fear still persists as many believe there’s another storm coming around the corner. So they sit in cash.
It’s incredibly unproductive to your long-term investment results when you think only of the things that can go wrong. It keeps you looking backwards instead of forward. You miss the big picture and what actually drives the equity markets up over the long term. While the economy is still very challenged, it is improving. Vaccines and better treatments are coming and we will adapt as we always have. Corporate profits are recovering and expected to grow again in 2021. Interest rates will remain low for a prolonged period making equities even more attractive.
Recently I spoke to someone who said they cashed out of the market two months ago. His excuse:
“None of this makes any sense. There is a second wave coming and the markets are overvalued. It feels like the technology bubble again with Apple, Amazon, Microsoft, Facebook and Alphabet now making up over 22% of the S&P 500. I clearly remember how the tech bubble ended and I don’t want to go through that again”
During that bubble 20 years ago the valuations of tech companies were absurd. Many were not even profitable. Today the FAANG stocks are comparatively well-priced. Given their incredible and long runways of growth it can be easily argued that they’re undervalued. Four out of the five just grew revenues by a double digit pace in the last quarter – remarkable given their size and since all were impacted by the virus. Sure, they benefitted from millions staying at home but their growth during the pandemic was incredible.
Free cash flow for Amazon, Apple, Microsoft, Facebook and Alphabet is expected to swell by 20% in 2021. The cash flow they collectively generate now accounts for 20% of the entire free cash flow thrown off by the 500 companies in the S&P index. Astonishing would be an understatement. The FCF yield of the group is ~3.5% vs. a yield of ~0.60% for the 10-year US Treasury. These are by far the most incredible and most profitable corporations ever. They earn very high returns on their invested capital and are able to borrow money for essentially nothing. The can very easiyly continue to move the market higher over time.
There will certainly be lots of volatility, but sitting in cash and waiting for another blow-out like we had in March is a risky strategy. Don’t be your own worst enemy. Investing in a high quality ETFs that hold the world’s most profitable corporations is one of your best chances of growing your money over the long term and staying ahead of inflation.
Gold – at your peril
Since the price of gold recently rose above US$2,000 an ounce I’ve been getting questions such as:
“Should I buy some gold for my portfolio? Isn’t gold a good store of value and a good hedge against all the uncertainty right now?”
Gold is not a productive asset. There’s no internal rate of return as it produces nothing and therefore is impossible to value. It costs money to store and insure it. A buyer is betting someone will pay more for it at some point in the future, so it’s a speculative asset rather that an investment based on expected cash flows. If you are a trader go ahead and buy, but if you’re investing towards a pension-like income stream in the future, I’d recommend steering clear.
Over the very long term the real (inflation adjusted) return of gold has been substantially less than equities. When gold hit its previous all-time high in 2011 an ETF of senior golf producers (GDX) was trading above US$60 and fell below $20 over the following 5 years. GDX is now trading in the low $40’s. So if you bought a basket of senior gold equities in 2011 based on the same investment thesis as today then you’d be down ~35% vs the S&P 500 which is up well over 150% during the same period.
Technically gold looks strong but always keep in mind how easy it is to blow money in resources. If you lose 25% on an investment it requires a 33% return to get back to even. So if you insist on making gold part of your holdings, ensure it makes up only a very small portion and only if you only have a large portfolio. Buy a diversified ETF of gold producers and place it in a non-registered account so if losses come you can at least apply future gains against them.
REITs – don’t believe all you hear
As malls have been empty and offices closed over the last few months there’s been a lot of pessimism about REITs, particularly retail and office REITs. Over the last few months I have gotten many questions such as:
“Is it not very risky to buy REITs right now? It looks like the work from home trend is here to stay so office properties are going to sit empty and likely never recover.”
There will certainly be some changes in the way we work and shop but we believe the concerns are overblown and more than priced into the sector. In fact, the risk is much lower now as many retail and office REITs are trading for substantially less than their net asset values, and even their replacement cost. Real estate is a tangible asset so there will always be value in the building and the land. Properties can be converted to mixed use. For example, when I lived in New York one of my first apartments was in a building that used to be a Goldman Sachs office tower.
Many of the largest office property managers have been seeing an uptick in demand as businesses plan to return and prepare for more space between employees. One of the largest property managers in the world, Brookfield Property Partners, announced last week that their office portfolio is 92% leased on a long-term basis with a remaining average lease term of almost 9 years. The CEO wrote:
“While there has been some discussion over the last several months as it relates to the ‘future of the office’, it is our belief that a corporate office represents much more than a place for employees to sit every day; companies utilize their offices as incubators of culture and as an important tool to recruit and train younger talent. Collaboration and innovation cannot take place remotely or over conference calls and some companies are already observing a decline in these areas amongst their employees. As time goes on, we think the loss of innovation and collaboration will become even more apparent and companies will shift emphasis back to having employees in the office. However, until a vaccine is discovered and widely available, it is likely that companies will need to have portions of their employees working remotely as they simply don’t have enough space currently to accommodate them all. In the long run however, we do not think remote working represents a threat to the office as we know it. In fact, concerns around social distancing and density ratios are very likely to drive additional office demand in the future and may prove to reverse the trend of increased densification we have witnessed over the past 20 years.”
Risk can be kept in check so long as you position size your exposure accordingly and hold a well-diversified REIT with exposure to residential, retail, industrial, office, healthcare and diversified properties. The dividends yields are attractive and paid monthly. You get the benefit of being a landlord and having experienced management teams allocate and recycle capital for you all the while you don’t have to lift a finger or fix a toilet. It sure beats buying a single overvalued condo and being cash flow negative.
Sinan Terzioglu, CFA, CIM, is a financial advisor with Turner Investments, Private Client Group, Raymond James Ltd. He served as vice-president of RBC Capital markets in New York City and VP with Credit Suisse in Toronto.