It appears that the prevalence of Exchange Traded Funds (ETFs) may be increasing and extending both the positive and negative trends in the financial markets. When an index ETF is bought or sold, capital will flow in or out of the components of that index regardless of the fundamentals or valuation of the individual securities. In positive trending markets, this may create equity overvaluation, a “snowball” effect as more and more capital moves into the companies that have done well. In negative trending markets, the “snowball” effect will work in reverse as capital moves out; select stocks may become undervalued.
Investors may take advantage of potential extremes in ETF capital flows by selling overvalued securities and by buying undervalued quality companies. This strategy of “value” investing in momentum driven markets may offer substantial added return (alpha) to investors over the coming years.
What to Look For
Opportunities for investment have similar characteristics:
- Positive Reward/Risk: Buying “value” is a contrarian strategy that identifies stocks that have been weak and often substantially weak. There may be further potential downside if the market or sector remain under pressure and one should identify situations where potential further downside appears reasonable. Opportunities should have at least 3x the upside reward to potential downside risk.
- Corporate Importance: The focus should be on companies with long operating histories that are important to both the economy and the market. We are looking for opportunities that market participants care about; this usually means very large capitalized securities.
- Good Balance Sheet: Companies should have strong capital ratios including a low debt/equity ratio. There may be larger upside in higher leveraged companies but the focus on positive balance sheets should help to limit risk.
- Dividend Support: If the balance sheet is solid, the dividend should be sustainable which may also be helpful in limiting downside risk.
When to Buy
We look to make an initial purchase at prices that may be within 10% of a potential downside technical target. This initial purchase is recommended as the target on the downside might never be reached. The combination of the fundamental analysis above and technical charting establishes the right security at the right time. We believe in buying “value” with a focus on the highest quality companies. We do not need to see a turn in the market to establish an initial position. Potential investments will have been on a watch list for a substantial period of time.
Contrarian value investment strategies have always been available but the growing utilization of passive ETFs may have created another level of opportunity. To confirm, we are buying individual high-quality companies with this strategy and have already taken advantage of some attractive situations this year. Most of the focus in the coming weeks may be on large U.S. Blue Chip stocks which are in sectors that have corrected. The current strength in the Canadian dollar makes the opportunity even more attractive.
This publication is solely the work of Jon Batchelor for the private information of his clients. Although the author is a Manulife Securities Advisor, he is not a financial analyst at Manulife Securities Incorporated and Manulife Securities Insurance Inc. This is not an official publication of Manulife Securities. The views, opinions and recommendations are those of the author alone and they may not necessarily be those of Manulife Securities. This publication is not an offer to sell or a solicitation of an offer to buy any securities. This publication is not meant to provide legal, accounting or account advice. As each situation is different, you should seek advice based on your specific circumstances. Please call to arrange for an appointment. The information contained herein was obtained from sources believed to be reliable; however, no representation or warranty, express or implied, is made by the writer, Manulife Securities or any other person as to its accuracy, completeness or correctness.