While analysts are predicting gains for the markets in the second half, it's hard for investors to avoid being skeptical, especially as major benchmarks continue their seemingly unstoppable march upward.
It has the feeling of semi-euphoria that preceded some big declines. Investors who got burned in the 2000 dot-com bubble and the 2008 financial crisis probably haven't forgotten that.
Pessimism is an investing survival instinct. And investors tend to rely on recent experience as their guide to decision making. A hot stock attracts a lot of attention, even though taking a moment to think about it might lead to the conclusion that it has already had its best run. A beaten-down stock tends to be ignored, even though an astute investor might recognize a buying opportunity.
Warren Buffett has long urged investors to think about the long-term, a time horizon that is longer than normal people usually consider. Stock markets rise and fall, as do individual stocks, but ultimately over the long term, a careful investor will see gains – at least that's Mr. Buffett's vision.
In 2011, when Bank of America was dealing with big losses and large legal bills related to the subprime-mortgage crisis, Mr. Buffett plunked $5-billion (U.S.) on an optimistic bet that the lender could recover. Earlier this month, that bet paid off. His Berkshire Hathaway Inc. is sitting on a $12-billion-paper-profit once it converts warrants into 700 common shares of Bank of America.
He has stood by other banks, as well, when others have turned against them, notably Goldman Sachs Group Inc. (another crisis-era investment that paid off) and Wells Fargo & Co. More recently and closer to home, Mr. Buffett provided the troubled Home Capital Group Inc. with a line of credit to shore up business, and although the firm has already paid Berkshire back, there are favourable terms (interest and a stake in the firm) for Mr. Buffett that provide nice upside should the company turn things around.
Mr. Buffett isn't alone in encouraging optimism where others cast doubt. James O'Shaughnessy, who wrote What Works on Wall Street in 1998, says the tendency to use recent history to project what will happen in the near future is a mistake a lot of investors make. That's because the long-term will always involve some volatility along the way. Just since 2000, there have been two major market downturns along with a few other bumps along the way. But it's hard to argue that over the course of those 17 years, there haven't been significant gains over all. About 66 per cent for the S&P 500, for example.
Investors who stepped aside, or worse, sold, when the going got tough lost some pretty big opportunities. Patience and the willingness to ride out market declines would have rewarded them.
I have developed screening models based on the investment strategies of Mr. Buffett, Mr. O'Shaughnessy, Mr. Graham and others. Since 2010, I've been running a Canadian equity portfolio that holds the top-10 stocks that pass the stock-picking methodology outlined in the book Buffettology. This strategy, which seeks to emulate the approach once espoused by Mr. Buffett, has an annualized return of 14 per cent, compared with an annual return of 3.7 per cent for the TSX (price returns only). Here are three high-scoring stocks in the portfolio that have yet to put in solid returns but hold potential based on the models I run.
Shaw Communications Inc.
The Calgary-based company provides phone, TV and Internet to Canadian customers. The company just reported strong quarterly subscriber gains. Consistent and repeatable earnings along with a healthy dividend yield help the stock get high marks from both my Buffett model and the approach based on James O'Shaughnessy's quantitative research. The stock is a current holding in the Buffett Patient Investor portfolio.
Equitable Group Inc.The lending company has seen downside pressure and volatility in its shares as investors question the strength of Canada's housing market and economy. The stock was added to the portfolio in April of this year, so we are down 18 per cent so far, but the recent decline has made the score and expected return even higher using my Buffett model, which estimates future return of 15.1 per cent a year over the long term using the current fundamentals.
MTY Food Group Inc.The Montreal-based restaurant operator and franchiser gets a 70-plus score (out of 100) from three different models on Validea.ca. The Buffett model gives it an 87. The stock has been flat over the past year, but if shares can start to put up stronger relative returns some of the other factors important for short- to medium-term momentum look to be intact.