A thought for investors who are unnerved by the Canadian stock market’s terrible 2018: Play strong defence in your portfolio and let the offence take care of itself.
This strategy is brought to you by the Two-Minute Portfolio, which once again outperformed the S&P/TSX Composite Index in a bad year for Canadian stocks. The index lost 8.9 per cent on a total return basis (dividends plus share-price changes), while the 2MP fell 1.7 per cent.
The 2MP is a continuing experiment in bringing quick and simple portfolio-building with individual Canadian stocks as opposed to funds. Just buy the two largest dividend-paying stocks as measured by market capitalization (shares outstanding multiplied by share price) in each of the 11 subindexes of the Canadian market. Rebalance annually at the start of the year to discard any stocks that no longer qualify and add newcomers.
The 2MP is a dud in bull markets and stud in bad times. When the S&P/TSX Composite soared 21.1 per cent in 2016, the 2MP made 7.5 per cent. The year 2009 also humbled the 2MP – it gained 13.7 per cent, compared with 35.1 per cent for the index.
In bad years for Canadian stocks, the 2MP redeems itself. Including 2018, there have been four down years for the index in the past 15. In each case, the 2MP outperformed.
Combine the dud and stud years and you get a 15-year annualized total return of 7.8 per cent and a 10-year return of 9.9 per cent for the 2MP. The TSX made an annualized total return of 6.6 per cent over the past 20 years and 7.9 per cent over the past 10. (Data for the 2MP is maintained by Morningstar CPMS.)
Another perspective on the comparative risk levels in the 2MP versus the index can be seen in their respective maximum drawdowns, which is the worst peak-to-trough loss over any time frame. The biggest plunge for the 2MP was 31.5 per cent, which compares with 43.4 per cent for the index.
One more measure to consider is beta, which allows you to compare the volatility of indexes, stocks and portfolios (a lower beta means less volatility). The S&P/TSX Composite has a beta of 1.0, compared with a current reading of 0.76 for the 2MP and 0.91 for the average Canadian equity fund.
The 2MP is emphatically not a low-risk strategy for investing in stocks. It’s just a way of building a portfolio of Canadian stocks that has in the past provided a smoother ride than the definitive index of Canadian stocks.
Returns for the 2MP do not include the cost of stock trades, which typically run from $5 to $10 at online brokerage firms. If you estimate 20 trades a year to manage the portfolio, commissions would add up to as much as $200 a year. That’s enough to take as much as 0.8 of a percentage point off the returns of a $25,000 2MP portfolio, 0.4 of a point off a $50,000 portfolio and 0.2 of a point off a $100,000 portfolio.
In all of these examples, the after-fee returns from the 2MP over the past 10 and 15 years still came in ahead of the index, which you can buy into through exchange-traded funds. There are costs to owning ETFs as well, but they’re cheap. The latest Globe and Mail ETF Buyer’s Guide includes several Canadian equity ETFs with management expense ratios in the 0.06-per-cent range. You may also have to pay brokerage commissions to buy ETFs.
Even if they lag the 2MP over the long term, Canadian index ETFs have some definite advantages for investors. Mainly, you just toss money in and everything takes care of itself. Buying a share of an ETF tracking the S&P/TSX Composite gives you instant exposure to roughly 250 stocks, including both the blue-chip stalwarts of the 2MP and smaller stocks with greater growth potential.
The 2MP, while conceptually simple, involves a fair bit more work to maintain. Usually, you have to sell at least a few stocks at the beginning of each new year and replace them with others that have assumed the position of first- or second-largest (by market cap) dividend payer in each S&P/TSX subindex. The easiest way to get the list of stocks for the year ahead is to check my annual 2MP update, shown in the accompanying table.
Another bit of 2MP maintenance is to sell a bit of your holdings in stocks that have surged and buy a little more of the laggards. This process is called rebalancing and the aim is to start each year with more or less equal holdings in each of the 22 stocks in the portfolio.
Canadian index ETFs offer a strong alternative to the 2MP, but mutual funds are more problematic. CPMS analyzed returns for the 2MP, the S&P/TSX Composite and the average Canadian equity mutual fund from Dec. 1, 1985, through Nov. 30, 2018. Canadian equity funds averaged 7.1 per cent, the index averaged just under 8 per cent and the 2MP averaged 10.1 per cent.
Don’t automatically discount mutual funds as your go-to way to put Canadian stocks in your portfolio because there are some good ones out there and mutual funds are the ultimate in convenient investing. But the numbers suggest that weakling funds are sadly plentiful – find out if you own one by using the fund data available on Globeinvestor.com.
This year is an easy one for current 2MP investors because all the same stocks are carried over. Included in this group are 2018 stars such as Rogers Communications Inc., up 19 per cent on a total return basis, and Loblaw Cos. Ltd., up 12.6 per cent. Brookfield Property Partners LP led on the losing side in 2018 with a loss of 12.2 per cent, while Suncor Energy Inc. fell 10.6 per cent.
Focusing as it does on big blue chips, the 2MP delivered a reasonably strong dividend yield of 3.1 per cent in 2018, according to CPMS. The highest-yielding stocks in the portfolio last year were Brookfield Property at 7.8 per cent and Enbridge Inc. at 6.9 per cent, while the lowest-yielding stocks were Constellation Software Inc. and Alimentation Couche-Tard Inc., both around 0.6 per cent.
A final note on diversification: A properly balanced portfolio combines U.S. and international stocks with Canadian holdings. The 2MP strategy was tested on the U.S. market several years back – it flunked.