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Wired for value

Taking the speculation out of investing. 

In this era of real estate bubbles and sky-high tech stocks, it’s easy to get caught up in the excitement of speculating on the next big thing. The more stable approach of investing in companies with proven track records doesn’t seem to offer the same thrill.

Some clients may be curious about the roller-coaster stock ride, but when it comes to long-term financial growth, travelling a stable path of predicable returns tends to be the more popular choice.

That’s why Manulife’s value equity team takes a unique approach to identifying market opportunities. Helping clients to understand the difference between speculating and investing, while also taking the mystery out of how Manulife’s portfolio investment team works, is a key part of the education process for your clients.

Speculating vs. investing

So, what is the difference between speculating and investing? We turn to Manulife’s Chief Investment Strategist, Philip Petursson.

“You’re speculating when you buy a stock because someone else told you about it, or other people made money at it and you only see stock prices rising,” he explains. “You’re investing when you do the work to identify the investment opportunity, the return expectation, the underlying value of that business overall and so on. It requires more discipline and more research to understand what you are buying, why you are buying it, and what you hope to achieve.”

A sound investment is one that can generate a return based on a strong, viable business that has the ability to grow and generate profits. The stock value goes up because the value of the business has gone up.

Another way to make a clear distinction is by looking at the stability of returns. Macan Nia is a Senior Investment Strategist with Manulife Investments. “When you look at the major speculative bubbles over time, they all had three underlying factors,” says Nia. “And just as quickly when the hysteria ends, the prices come back down. Unlike markets that can fall but will eventually recover, once the bubbles crash they don’t come back.”

The three key indicators that something may be part of a speculative bubble are:

  1. The price is fuelled by speculation as opposed to the fundamentals of that asset class.
  2. The bubble is exaggerated by expectations of future price appreciation.
  3. The speculation and resulting activity is driven by higher trading volumes.

“Here’s how I separate between speculation and investing. When investing, you expect a consistent mid- to high-single-digit rate of return. With speculation, it’s an 80 per cent rate of return in one year. You could get that with some form of investing, but to do that consistently is very difficult,” says Nia.

Sometimes the line between speculation and investment is harder to draw. Kevin Headland, also a Senior Investment Strategist with Manulife Investments, points to cryptocurrencies as a good example. “It’s not to say that one or two of them isn’t a great investment and the future of trade, but right now there are 1,7001 different versions of cryptocurrencies,” says Headland. “Which one is going to be the one? It’s speculation: there’s no real tangible information or fundamentals that will help you identify which will be the best.”

Volatility and process

Not all stocks are created equal, and a lot of thought goes into picking the perfect combination for a portfolio with the goal of minimizing risk. Portfolio managers follow an investment methodology that sticks to the fundamentals.

“We truly believe in our process, and I think that’s important no matter who the portfolio manager is or what process they have,” explains Manulife Senior Portfolio Manager Alan Wicks. “If things become volatile and you aren’t following your process, then you might as well not have one. Rather than reacting to what might be trending, sticking to the fundamentals can help you identify the value in solid opportunities.”

That said, who doesn’t love a sale? “As value managers, we want to buy securities when there is more upside than downside,” explains Wicks. “If a stock goes down more than what the fundamentals warrant, that can be a good thing. But we want to be able to adjust the weight so we can get the returns without excess volatility.”

Risk and uncertainty

As you would expect, a lot of careful consideration goes into the creation of an investment portfolio. Wicks offers some insight into how risk and uncertainty are measured in the decision-making process.

“We spend all of our time and effort thinking about potential outcomes and the drivers of those outcomes,” he says. “For example, what are the risks, and how do we create portfolios to make sure that we appropriately address the risks without having to forecast a potential uncertainty.”

Risks are known and can be measured in probabilities. Uncertainty is unknown and can’t be measured. Consider an analogy: When we get in a car and drive, the outcome is the destination. The route we choose to take, the vehicle that we drive and all the other variables of the journey contribute to its uncertainty. If you compare an old car in disrepair to a new armoured vehicle, the risk is the car and its condition.

To reduce risk, diversification is essential. “Within our overall portfolios, we have a business risk maximum. So, one thing happening worldwide is not going to significantly impact the portfolio,” says Wicks.

Value of analysis

Analysis and evaluation lie at the heart of every portfolio asset selection to ensure anticipated performance with clearly defined risk. Duncan Anderson is a Senior Portfolio Manager with Manulife Investments.

“We believe our edge is in analysis and evaluation of business,” says Anderson. “We focus our time and effort understanding companies that have a lower uncertainty, or a higher probability of reaching our investment goals.”

One type of risk is company specific. “If we can construct a portfolio that is very profitable without having to borrow other people’s money to get a good return for shareholders, then we prefer to do that,” says Anderson. “It’s not to say that when you invest in companies with a lot of leverage you’re going to lose money; it’s to say the increased uncertainty on that investment can’t be diversified away, so we try to avoid it.”

Analyzing risk also includes geopolitical considerations. Some countries have a history of political instability, devaluations or expropriations of assets, and other risk factors. “We actually have a country risk premium for every country that we may go to,” says Wicks. “Buying a grocery store in Canada is not the same a buying a grocery store in Afghanistan. There is going to be a much bigger country risk premium for that.”

The Manulife difference

The weighting of stocks in Manulife portfolios often differs from the TSX and S&P benchmarks. Some people might misconstrue that as a highly differentiated portfolio with higher risk. Manulife’s portfolio management team views this difference as creating something unique and grounded in logic.

Image: Diversified sources of alpha.

“Constructing something different from a benchmark that we feel is fraught with uncertainty is not risky,” says Anderson. “There is no point in being different if you are not creating something better. We’re taking a private business approach and we’re utilizing the public markets or liquidity to create a conglomerate (portfolio). If the stock markets were to shut down tomorrow, we know that our conglomerate would compound at a higher rate of return than any given benchmark.”

Knowledge is comfort

Clients approaching retirement age are keenly interested in how their investment portfolios are performing. Communicating the approach taken to ensure a stable rate of return can be a key ingredient in building trust within the advisor-investor relationship. While the adrenaline thrill of skyrocketing stock prices might make for great drama, the more thoughtful approach of predictable, steady returns with minimal risk is likely a bit closer to reality for most investors. 

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