Now that we have final figures for 1999 we can take time to reflect on "performance" or "relative performance". For a long period the Canadian benchmark used for measuring a manager's performance was the TSE 300 Index. This worked relatively well and was generally accepted as fair. However, during 1999 a funny thing happened. For various reasons, huge amounts of cash continued to flow into a relatively small number of stocks. This caused distortions within the index to the extent that while the index gained a total return of 31.7%, if we removed Bell and Nortel, the remaining 298 stocks increased only 8.8%. For the recently introduced S&P/TSE 60 Large Cap Index, the 1999 capital gain was 24.9% but excluding Bell and Nortel, the return was a mere 0.22%. When we compare the TSE 300 index performance for 1999 against the ABC Fundamental-Value Fund (+16.25%) and the ABC Fully-Managed Fund (+10.38%), we did quite well, considering we owned no Bell, Nortel, Celestica, JDS, etc.
The fact is that both the TSE and U.S. Nasdaq indices are being driven by a very select group of high-technology/telecommunications stocks. Momentum and growth investing are currently the rage whereas value investing is not. Fundamentally undervalued stocks, because they are so overlooked, offer excellent opportunities for mergers, reorganizations and takeovers. Two present ABC Funds' examples are SMED International and FPI Ltd. There is, however, another issue to consider with many questions to be answered: are the TSE 300 and S&P/TSE 60 fair benchmarks today with their respective weights of Bell and Nortel at 26 1/2 - 27%? Should two interrelated stocks be such a significant percentage of a 60 or 300 sample index? Does their huge proportion truly represent the Canadian economy and the stock market? Furthermore, should investors put all their eggs in an index basket so drastically skewed to two securities? We do not think so. We believe, moreover, that this action would be imprudent.
As portfolio managers we are restricted by RRSP, pension and mutual fund legislation from putting more than 10% of a portfolio in any one security. Given that Bell and Nortel are over 26% of the index, it is understandable why so many could not match the 1999 index returns. Furthermore, the 1999 TSE index returns are sending out the wrong message to Canadian investors. Many believe that under-performing managers have lost their "touch". We do not believe so. Rather the present situation is as if one is trying to take a patient's temperature with a faulty thermometer.
While some investors may simply wish to buy a trendy "index investment", rather than buy individual securities or a mutual fund, we believe that this is shortsighted. Firstly, the fad for index investments, which has been self-reinforcing, will eventually burn out just as all fads do. Secondly, if it was so simple to buy indexes, why do any research on individual stocks? A five year old child could simply put together a multi-million dollar investment portfolio by merely buying an index.
But we are not despairing of the present situation. As opportunistic fundamental value stock pickers, we are, in fact, quite optimistic due to the frenzied index buying. Now ponder this thought: if investors are collectively pouring millions of dollars into passive index investments, they are obviously shunning many excellent, under-valued, individual common stock opportunities. We intend to hunt for these stocks. We believe in value and value investing. We fully intend to stick to our style.
Irwin A. Michael, CFA
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