Investing Strategies for a Global Capital Market
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George Lewis
Chairman & CEO
RBC Global Investment Management Inc.
Thursday, September 26, 2002
Good morning. Thank you very much Gay,
for your introduction and kind words, and thank you all
for coming this morning. This is not an easy time to be
making financial decisions, either for your business, or
for your own personal investments. The events of the past
year have brought on what many investors are viewing as
unprecedented market uncertainty.
The fact is, the uncertainty in today's
capital markets is anything but unprecedented. Imagine for
a moment, you were told that in a 30 year span the United
States would experience two of the worst bear markets in
history, witness a president forced out of office, lose
a war, and undergo a period of interest rates as high as
18 per cent? Where would you turn as an investor?
This not a hypothetical plot for the next 30 years, it is
the actual case of the last 30 years in the US, during which
the equity market returned 11% per annum (1972-2002). Without
mitigating the current turmoil brought on in today's markets
by international terrorism and our continuing response to
it, as well as the business and corporate governance failures
of Enron, WorldCom and others, we must remember that this
too shall pass.
We are all searching for that one "truth"
that will serve as a guidepost for our businesses and investment
portfolios. Unfortunately, our experience is likely to be
similar to the quest of the philosophy student for the perfect
political and economic system. Instead, he finds himself
confronted by the Bovinian Theory of Economics and Political
Philosophies explained in simple "Two Cow" terms:
Socialism : You have two cows. The government
takes one and gives it to your neighbour.
Communism: You have two cows. The government
takes them both and provides you with milk.
Fascism: You have two cows. The government
takes them both and sells you the milk.
Bureaucracy: You have two cows. The government
takes them both, shoots one, milks the other, pays you for
the milk, and then pours it down the drain.
Corporatism: You have two cows. You sell
one and force the other to produce the milk of four cows
and then act surprised when it drops dead.
Capitalism: You have two cows. You sell
one and buy a bull.
Clearly the preferred alternative.
I would like to share three things with
you today:
First, to provide RBC Investments' perspective on the capital
markets and long term investing in these challenging times.
Second, to review how RBC Global Investment
Management, (part of the RBC Investments wealth management
group) as a Canadian-based investor, is approaching the
management of equities in a global context.
Finally, as a manager of over $40 billion
of client assets under management, I will provide some of
the views of RBC Global Investment Management on the public
debate around corporate governance and financial reporting.
Let me begin by providing you with the
current capital market outlook of the RBC Investments Strategy
Committee. First, what is RBC Investments and second, what
is its Strategy Committee? RBC Investments is the division
of the RBC Financial Group focused on meeting the investment
needs of individual clients - through our financial planning
teams in RBC Banking branches, our self-directed and full-service
brokerage businesses, and our discretionary investment counselling,
private banking and trust services for high net worth individuals.
The mandate of the RBC Investments Strategy
Committee is to provide a quarterly strategic review of
the capital markets and recommended asset mix for use by
all RBC Investments businesses in serving their clients.
It is comprised of investment management professionals from
around the globe - North America, Europe and Asia. It is
supported by RBC Global Investment Management's in-house
research team that is focused exclusively on our needs as
investment managers to RBC Funds and other areas of RBC
Investments.
Beginning with our view of the global
economy, the economic recovery has, to this point, disappointed
as a burst bubble in equities, weak consumer balance sheets
and a lack of pent-up demand in the US has weighed heavily
on growth. However, unprecedented cuts in North American
interest rates and aggressive expansion of the money supply
are an effective offset. This is similar to the situation
in the early 1990s when the recovery was buffeted by headwinds
from plunging real estate prices, a reeling banking system
and over-stretched consumers. Then, as now, monetary conditions
were fixed, and left, at a very stimulative setting until
the economy found its own legs.
We look for growth of 2.5% in the US for
2002, rising to 3.0% the year following. In Europe, where
inflation, and not GDP growth remains the target for monetary
policy, we expect growth of only 1.1% in 2002 and 2.5% next
year. Japanese GDP should remain stagnant this year and
advance only 1.0% in 2003.
Around the world, inflationary pressures
remain benign, and outside of Japan, the threat of deflation
in our view is remote. With the exception of the Bank of
Japan, monetary authorities have provided the right amounts
of ease at the right time, and a healthy banking system
is putting all of that liquidity to work. The systemic failures
that come in advance of a protracted period of deflation
are simply not in evidence for most of the industrialized
world. We believe monetary policy is now positioned at an
appropriate level given the significant headwinds encountered
through this recovery. There remains, however the potential
for further modest rate cuts, particularly in Europe, if
the recovery does not gain traction. In any event, the next
round of monetary tightening now appears unlikely prior
to mid-2003.
With respect to bonds, the summer rally
in fixed income markets has moved yields to levels inconsistent
with the economy's current and forecast performance. Bond
prices have been bid well beyond their intrinsic value as
a result of their status as a safe-haven and the perception
that they are the only marketable investment alternative
to equities. The move has been exacerbated in our view,
particularly in US Treasuries, by leveraged hedge funds
purchasing long bonds and capturing the carry available
from a steep yield curve. With the Fed on hold, further
bullish yield curve flattening is possible, but it is an
increasingly risky proposition. Any signs that equities
are bottoming or that a Fed tightening is looming could
result in a dramatic sell-off, easily pushing 10-year Treasury
yields up 50-75 bps. in a very short time span.
With respect to equities, the three-year
bear market in stocks has reduced valuations in most countries
to attractive levels. Moreover, profits are stirring in
North America as the economic recovery and cost cutting
show through in firming margins and earnings. The road ahead
is not without obstacles. Low inflation and excess capacity
limit the potential for revenue growth and profit margins
even as the economy shifts into a higher gear. Increased
transparency in accounting, particularly with respect to
pension plan expenses, while raising the quality of earnings
and the level of trust in corporate America, will further
expose the difficult profit environment.
Nevertheless, in the wake of the tech
wreck, evidence of corporate malfeasance and excess and,
more recently, concern over aggressive accounting, expanding
risk premiums have pushed stocks to levels inconsistent
with interest rates, inflation and a reasonable view of
profitability through the cycle ahead. With increased transparency
will come trust and, eventually, the gradual lowering of
risk premiums, opening the way for a sustained recovery
in stock prices.
To sum up, this is an environment where
we would recommend a modest overweight for equities vs.
fixed-income securities. However, the larger message is
that we don't believe that all sectors of the equity markets
will perform equally well over the next twelve months, or
even the next decade. Rather than a broad market advance
across all sectors - financial services, consumer stocks,
technology, communications and media, natural resources,
health sciences, and infrastructure-related stocks - we
expect significant returns will depend on careful sector
and, in particular, stock selection.
With this backdrop, there is no substitute
for a financial plan that includes a balanced asset mix
and diversification within these asset classes. While asset
mix should depend on your investment objectives and risk
profile, the RBC Investments Strategy Committee currently
recommends an equity weighting of 60% for long term balanced
and growth oriented investors, along with a 30% weighting
in bonds and 10% in cash. A diversified portfolio, with
stock exposure at this modestly over-weight position will
give your portfolio greater staying power.
With respect to diversification within
the equity component of your portfolio, in a market with
reduced visibility of earnings and elevated risks, one of
the best strategies to manage those risks is by looking
at the sector make-up of your holdings.
Traditionally, investors have diversified
their portfolios along geographic lines, complementing their
Canadian holdings with some US equities and perhaps European,
Asian or Latin American holdings. While it is extremely
important to use your allowed foreign content of 30% within
your RRSP, at RBC Investments and RBC Global Investment
Management, we focus on a sector approach, and recommend
apportioning your portfolio into industry groups, thereby
achieving geographic diversification indirectly.
Why have we adopted this approach? Well,
in terms of conducting basic research and portfolio management
this approach reflects the increasingly "borderless"
markets when it comes to major businesses. Swings in various
industries occur globally rather than within the confines
of a specific region. As long as one has a defined investment
process, which we do at RBC Global Investment Management,
conducting global equity management by sector, rather than
geography, allows us to concentrate most of our research
and investment management resources in a few locations.
As such, while RBC Global Investment Management has personnel
in six international centres, the vast majority of our 200
investment research, portfolio management and other investment
management employees are concentrated in Canada.
The most important reason for adopting
the global sector approach is simply this; the benefits
of geographic diversification for investors have gone down
over the last five years, while the benefits of sector diversification
have gone up.
Numerous academic studies of the performance
of equity markets around the globe, certainly in developed
markets, have shown that the correlation among geographic
markets has risen - U.S., Canadian, European, Asian markets
have moved more in tandem in recent years. This means there
is less diversification benefit from having exposure to
each of these geographic markets.
On the other hand, these same studies
have shown that there is less correlation of stock market
performance across different industry sectors - financial
services companies perform differently from health sciences
companies, which perform differently from technology companies
within one market and across geographic markets. This means
that there are more diversification benefits from having
exposure to each sector in a global investment portfolio.
While academic studies support this, we
don't have to strain to recall a real-world example of this
in terms of the performance of equity markets for most of
the last three years. Investors who believed they enjoyed
diversification by holding Canadian equity funds, U.S. equity
funds, European equity funds and, yes, even Asian equity
funds had a rude awakening when all declined significantly.
The underlying reason in most cases was an exposure to technology
stocks of 30-40% in each fund at the beginning of the bear
market.
In terms of allocating investments among
various sectors under current market conditions, the RBC
Investments Strategy Committee has recommended a consistent
under weighting of Technology and Telecom for the last year,
which remains intact.
The sectors where we are recommending an overweight position
are Consumer Staples (vs. Discretionary), Health Care and
a modest overweight Financial Services. Several companies
within these sectors have demonstrated resilience in their
profit margins and have the ability to maintain pricing
power in a low inflationary environment. Further, these
sectors tend to perform well during periods of modest (versus
robust) economic growth, which is the environment we are
expecting.
Finally, with respect to Financial Services,
this sector has come under considerable pressure globally
as a result of credit, regulatory and other concerns. However,
we believe this has resulted in low valuation levels that
do not take into account the underlying earnings power and
stability of some of these companies' retail and asset management
franchises. As always, stock selection will be critical.
To sum up, the basic message of the RBC
Investments Strategy Committee to you as individual investors
-
#1 maintain an asset mix that fits with your investment
objectives and has a sufficiently large equity exposure
(60%) to enable you to meet your long term goals; and,
#2 ensure that the equity portion of your portfolio is diversified
across industry sectors on a global basis.
In reflecting on the messages I've shared
with you today concerning setting investment strategy in
this uncertain environment, I hope you'll agree on their
basic logic. But logic rests on basic assumptions and premises
about our world and our economy. Many of these assumptions
are now being tested.
At RBC Global Investment Management, we
consider many factors when analyzing companies for our potential
investment, including the quality of financial reporting
and corporate governance. When it comes to increasing the
rigour with which companies report their financial performance
and exercise good governance, we remain committed to two
basic principles: (1) trust in the natural forces of the
market; and, (2) an approach to regulation which seeks not
only vigorous enforcement, but also to reduce barriers to
the natural forces of the market which can act to improve
corporate governance.
As recently stated in The Economist, "If
the market comes to admire honesty, transparency and good
corporate governance, executives will rush to acquire those
characteristics. Even in morality, the market rules in the
end."
On the basis of these principles, we are
supportive of measures that many companies are taking to
strengthen their financial reporting and governance practices.
Many companies across North America have announced their
commitment to reform and transparency. The decision to expense
premiums related to employee stock options is an example.
On the heels of many of these announcements, we have witnessed
a rise in the value of the company's shares.
With respect to regulatory initiatives
in the US and Canada, we have been impressed with the degree
of ongoing thought and debate on both sides of the border.
Again, we are more encouraged by the regulatory initiatives
which seek to remove barriers to good corporate governance
rather than attempt to artificially guarantee it.
In an attempt to illustrate my point,
I sought the advice of my daughter, which is always a good
thing, and we came across this little anecdote on the internet:
"When NASA first started sending
up astronauts, they quickly discovered that ball-point pens
would not work in zero gravity. To combat this problem,
NASA scientists spent a decade and $12 billion developing
a pen that writes in zero gravity, upside down, underwater,
on almost any surface including glass and at temperatures
ranging from below freezing to over 300 degrees Celsius.
The Russians used a pencil."
Now, one has to acknowledge that, overall,
the US space program was much more successful than the Russian
space program, and that any serious global player in the
aerospace business needs access to the US space and defense
industry to be successful.
However, that does not mean each and every
aspect of the NASA space program or US regulations should
be emulated. There are plenty of pencils available to regulators
and public policy makers to reach the objective of enhanced
financial reporting and better governance.
Sharpening of these pencils, is required
however. Reinforcement and clarification of the roles of
fiduciaries and professionals would go a long way toward
achieving these objectives. Examples include measures to
enhance auditor independence from managements and ensure
that their clients are, in fact, the people addressed at
the beginning of auditors' reports: "To the shareholders
of XYZ Company…".
At the same time, a "clean"
audit opinion should be valued, and highly valued, for its
traditional conclusion - that the financial statements of
XYZ company present fairly its financial position at a single
point in time and its financial performance during a given
historical period - Not as a guarantor of the success of
the company's business model or its future financial performance.
There are other positive initiatives underway
in the regulatory arena consistent with the principle of
reinforcing fiduciary and professional duty rather than
prescriptive rule-making. But improving corporate governance
is not only (nor even primarily) the responsibility of issuers
and regulators.
The natural forces of the market do not
operate unless the owners step up to the plate - those who
exercise voting control of the companies that make up the
market.
RBC Global Investment Management has always
had clear voting policies in place with respect to governance
issues such as stock option plans, separation of board and
management roles, shareholder rights plans, etc. We have
exercised our proxy voting rights to maximize value for
our unitholders and clients.
Given the urgency of improving corporate governance, we have
come to the view there is strength to be had in numbers. We
have decided to join the Canadian Coalition for Good Governance,
a group of institutional investors that came together in June
of this year, led by the Ontario Teachers Pension Plan Fund
and Jarislowsky Fraser. This group has discretionary power
and a fiduciary duty to exercise proxy voting rights with
respect to more than $400 billion of assets under management.
Our goal, simply stated, is to improve corporate governance
in Canada. Our preferred method is to work with managements
and boards to achieve this goal with particular focus on the
following key issues:
- Board selection and independence
- Functioning of board committees, especially
the Audit committee
- Promotion of conservative accounting
- Compensation and its accounting
- Shareholding value issues in takeover
and other extraordinary situations
Not all members of the coalition will agree or need to agree
on each issue under consideration. However, our hope is that
this group becomes a strong, permanent voice on behalf of
shareholders with the Boards of Directors they have hired
to supervise the management of the companies they own.
Finally, from the perspective of individuals making investment
decisions, we should recognize that valuation bubbles which
burst, accounting scandals, and corporate governance irregularities
have been the hallmarks of bear markets for centuries. It
is somewhat comforting that we are in the third and final
phase of this "trifecta" and that companies, regulators
and shareholders are addressing these issues with vigour.
We remain of the view that capital markets in general, and
equity markets in particular, will maintain or regain their
status as primary wealth creation vehicles for patient individual
and institutional shareholders.
To borrow from both Adam Smith and Sir Winston Churchill,
the invisible hand of the market economy is the worst system
for the creation and distribution of wealth - except for the
all the rest.
That there is a need to state this view explicitly is a testament
to the depth and length of the current bear market in global
equities - one that we are cautiously optimistic - or optimistically
cautious - is drawing to a close.
Once again, thank you for your time this morning, I would
be pleased to take a few of your questions.
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