Reality Check
Gravity is a harsh Mistress.
--The Tick
We thought some concentrated thoughts might be instructive concerning the eventual return of reality. Risk asset prices cannot continue to climb forever. There will be a moment -- a catalyst perhaps -- that starts the selling pressure and prices will decline. This is the natural order of things: excess enthusiasm at the highs leads to demoralizing pessimism at the lows, and then the cycle repeats. Deny its existence at your own peril. Unfortunately, most people obsess over the questions of when will this occur, and to what degree, as if the answers to them are knowable. We feel a better approach is to review history, by investigating historical price movements, to get a better sense of how investments may react in the future. It isn’t perfect, but, as philosopher George Santayana once commented “those who cannot remember the past are condemned to repeat it”.
We like to use the Financial Crisis of 2008-2009 as a historical reference because there are so many examples to pull from it. A popular belief is that some companies are “too big to fail”. This myth was debunked back in 2008 as both Lehmann Brother and Bear Stearns collapsed. Most Canadians trumpeted the strength and safety of our big six banks, but their prices experienced epic drawdowns over that same period. A case in point is the Royal Bank of Canada. At the end of 2007, the Royal Bank had a market capitalization of $64.76B and was the largest company on the S&P/TSX Composite[1]. This fact did not shield Royal Bank shareholders from losing more than half their share price into the 2009 lows.
And while the bank certainly didn’t fail, it did test the resolve of any investor willing to accept at 57%+ drawdown. For anyone who exited this position, please don’t look at the next illustration as it may depress you. Here are the 10-year returns for both price appreciation and total return since the previous high back on March 24th, 2007. This looks incrementally better if we use the low, but that’s simply not fair.
As you can see, even if we purchased the Royal Bank at its share price high, our return was between 4-9% (per year) for the proceeding decade. Not a bad investment return given the prevailing environment of financial Armageddon.
This analysis becomes more meaningful when we consider Manulife Financial, the next largest company on the S&P/TSX Composite at $60.90B. There was a very similar price decline in Manulife, as should be expected, given both are in the financial services sector. Manulife’s drawdown eclipsed 75% at the lowest point with a share price of $9.20. So, it dug a deeper hole.
Unfortunately for its shareholders, its future return pathway took a different route than RBC. Over the same historical timeframe, its price performance experienced a negative price and total return. As you can see, an investor would have experienced a total loss between 16.50%-41% on their share purchase back in 2007. Clearly, this was not a profitable endeavour.
Now, that we have outlined a couple of real-world instances of share performance in a Bear market, let’s draw out a few observations:
- Quality Matters. The financial strength of these two financial services companies in 2007 was not on equal footing. Nor was the relative quality of their assets. While it may not be apparent in current times, “quality” is rewarded eventually as investors seek companies with better reward-to-risk metrics at compelling valuations.
- Embrace Volatility. The returns presented would look dramatically better if we would have had the courage to buy at or near the lows. Even without hindsight, we should ask ourselves why we are so fearful of buying stocks on sale. This is precisely why we tranche in and out of securities.
- No Guarantees. This is perhaps the hardest concept for investors to understand. There are no guarantees in investing. There are only probabilities of outcomes based on thorough research and analysis. We cannot tell you which stocks will be the best performers next year, but we can express an informed opinion on the fundamental qualities driving a good investment decision. In our estimation, investing becomes easier when we acknowledge that we must become comfortable with the unknown.
Information in this article is from sources believed to be reliable, however, we cannot represent that it is accurate or complete. It is provided as a general source of information and should not be considered personal investment advice or solicitation to buy or sell securities. The views are those of the author, Patrick A. Choquette, and not necessarily those of Raymond James Ltd. Investors considering any investment should consult with their Investment Advisor to ensure that it is suitable for the investor’s circumstances and risk tolerance before making any investment decision. Raymond James Ltd. is a Member - Canadian Investor Protection Fund.
[1] Source YCharts.
