Build a margin of safety into your investing, says TD chief strategist

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Retail investors are growing more confident in the resilience of the bull market, but they'll need to be careful where they place their bets, says the chief portfolio strategist at TD Waterhouse Group.

With much of the pickup in corporate earnings already priced into U.S. stocks, Robert Gorman believes it's time to be looking for margins of safety.

His best bet is on the rotation away from riskier small caps toward safer large caps, a trend he foresaw going into the year and one which he believes has legs.

"You're generally seeing a rotation from the lower quality to the higher. And it's been really pronounced," Mr. Gorman said. "So there's no need to drill down into lower-quality issues."

That's an important message for retail investors at this time. A recent TD investor survey showed that half of respondents expect their investments to increase in value over the next year, up from 41 per cent one year ago. And one in five intends to invest more if stocks continue to rise.

"I would view that as trend-following behaviour – typical of what you see among retail investors, whose moves tend to reflect what has happened, rather than looking ahead," Mr. Gorman said.

It's not an ideal investing approach. But that recency bias could serve investors reasonably well as long as stocks tread ever higher and investors go for quality names.

The large-cap S&P 500 has gained 4.5 per cent so far this year, compared to a loss of 2.8 per cent for the small-cap Russell 2000 index and a 5.1-per-cent decline in the Russell Microcap index.

Large-cap dominance is a new phenomenon in U.S. stocks, with small caps having posted the biggest gains in all but two years since 1999.

The small-cap era has resulted in a substantial valuation gap, whereby large caps now look comparatively cheap.

"Increasingly, it's become a market of stocks rather than a stock market," he said.

The inevitable transition to less-accommodating monetary policy is likely to reinforce the market's growing preference for large-cap stocks, since higher rates limit the credit available for smaller companies.

"At this stage, you really want to ensure you have a margin of safety built into what you're buying and holding."

Over all, Mr. Gorman believes there's every reason to expect that 2014 will mark the sixth straight yearly advance of the S&P 500 index. While he sees earnings growth moderating, S&P 500 earnings are tracking about 6 per cent higher this year than last, which means retail investors should, for the time being, be rewarded for their growing faith in stocks.

S&P 500 companies are now trading at an average trailing price-to-earnings multiple of about 17.4, so there is probably limited upside as a result of further valuation gains.

But with the U.S. economy having rebounded nicely from a weather-stricken winter, U.S. stocks can still benefit from the continuing rise in profitability of Corporate America.

"At the end of the day, this market's going to move along roughly in line with earnings growth," Mr. Gorman said.

Mr. Gorman also anticipated this year's stronger relative performance of Canadian stocks over U.S. stocks. But with Canadian energy names now closer to fair value, he expects the two indexes to converge over the rest of the year. "Within the TSX, we have felt that the second half would see a rotation from the golds and energy into the dividend growth stocks such as the financials, communications and selected real estate companies."