The Two-Minute Portfolio got taken to school last year by the S&P/TSX composite index and even the average Canadian equity mutual fund.
The sad results will be familiar to investors who put a big emphasis on quality blue-chip stocks. Focusing on quality, defined in large part by size, payment of dividends and low volatility, has for years been the key to investing success in the Canadian stock market. But things changed in 2016, a year during which speculative sectors such as energy and mining led the market and more conservative stocks lagged.
It's in that latter group of underperformers in which we find the 2MP, an ongoing experiment to see if you can make a competitive return over the long term simply by investing equal amounts of money in the two largest dividend stocks in each of the subindexes of the Toronto Stock Exchange.
Thirty years of back-testing results tell us the 2MP is a long-term index beater, even when you factor in the cost of brokerage commissions to rebalance the portfolio every year. But last year was a setback that demands attention because it has a lot to say about the experience of being an investor who focuses on quality. The 2MP delivered a total return (dividends plus share-price changes) of 7.6 per cent, while the S&P/TSX composite index soared 21.1 per cent.
Two factors worked against the 2MP and other investing products and strategies that focus on big blue chips. One is that resource-based sectors led the market. The other is that smaller, more speculative companies (many of them in the resource sector) were in favour last year.
Conservative, quality-focused investing typically means avoiding smaller stocks and underweighting the volatile energy and materials sectors. The 2MP does this by targeting large companies and assigning all sectors a weighting of 10 per cent. Energy and materials together make up 20 per cent of the 2MP, compared with 33 per cent for the index. Both sectors were up by 50 per cent in the 12 months to Jan. 10, a surge that benefited the index much more than the 2MP.
The 2MP just wasn't made for these times. If you have a portfolio of big blue chips, you may find yourself in the same predicament. What to do about it? The 2MP's long-term results suggest a do-nothing approach.
The people at Morningstar CPMS crunch the numbers for the 2MP and have established a record back to 1986. Since then, the portfolio has produced an annualized return of 10.3 per cent and the S&P/TSX composite has made 8.3 per cent. Over the past three-, five- and 10-year periods, the 2MP outperformed the index by two to four percentage points.
These numbers suggest holding a diversified portfolio of big blue-chip dividend stocks is a sound strategy over the long term, even if there are years when your holdings massively lag the market. This 2MP has been through this before. Back in 2009, the rebound year after the financial crisis, the portfolio made 13.7 per cent while the index made 35.1 per cent.
So how does egregious underperformance such as this turn into better long-term numbers than the index? One way is by doing better in down markets. When the index lost 33 per cent in 2008, 8.7 per in 2011 and 8.3 per cent in 2015, the 2MP produced losses of 19.8 per cent and 2.9 per cent and a gain of 0.3 per cent, respectively.
Let's be clear about the 2MP's quality tilt. It applies for the most part, but there was one exception in the health-care sector last year. The selection of companies here is slim to begin with, and even more challenging if you're looking for dividend payers. This scarcity forced the 2MP in 2016 into Concordia Healthcare, which plunged a staggering 91.8 per cent on a total return basis.
Such is life when you use a screening process that demands you pick stocks in all sectors. At least Concordia was limited to just 5 per cent of the total portfolio. On the plus side, the 2MP included Suncor Energy, Magna International, Royal Bank of Canada and Toronto-Dominion Bank, each up more than 25 per cent on a total return basis.
For 2017, there are just three substitutions to be made in the 2MP. Concordia is replaced by Extendicare Inc. in health care, Restaurant Brands International (which owns Tim Hortons) replaces Thomson Reuters in consumer discretionary and Barrick Gold replaces Agrium in materials. Minimal portfolio turnover is one of the benefits of running the 2MP. However, you also have to sell a portion of your winning stocks and buy more of the losers to get back to an even 5 per cent weighting for all.
If we estimate 20 trades a year to run the portfolio and we cost out those trades at the $10 commission most brokers charge, then we get total annual costs of $200. On a $50,000 portfolio, that amounts to a fee load of 0.4 per cent. A portfolio of index-tracking exchange-traded funds could easily cost less.
Another portfolio maintenance issue for 2017 is the recent addition of a real estate subindex to the S&P/TSX composite index. Real estate used to be included under financials – now, it's the 11th subindex. Accordingly, there is a pair of real estate stocks to add to the 2MP this year – RioCan REIT and Brookfield Property Partners.
Monitor the progress of the S&P/TSX composite index if you want to gauge the prospects for the 2MP in 2017. If resources and smaller stocks keep surging, the 2MP will continue to lag. Back in the mid-2000s, the portfolio had a four-year stretch of underperforming the index. Even so, it's the stronger long-term performer by a solid margin.
Rob Carrick