Are markets more Darwinian or Newtonian? Plus, a new ETF seeks to juice returns from the Big 6 banks, and utility stock picks

Another great column by American venture capitalist Morgan Housel ponders whether markets are more like Newtonian physics, where formulas predict outcomes, or the Darwinian product of an evolving biological system. His answer is important for any investor waiting for stock valuations, yields, or any other market condition to “revert to the mean.”

Mr. Housel’s answer to his own question is that “Darwin is usually the boss, but anything that does answer to Newton is exceptionally important.”

The author details the history of corporate dividend and bond yields as an example of a trend thought to be Newtonian but turned out to be straight Darwin. For most of the 20th century, individual equity dividend yields were higher than the yield on the company’s corporate debt. Equity yield was riskier, so it was thought that investors had to be compensated for this with higher payouts.

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Dividend yields eventually fell below bond yields as companies retained profits to reinvest in future growth. “Some people thought [this] was a sign of madness that must revert,” Mr. Housel writes. “But it didn’t. Today we think it’s normal because bonds have no upside.” What was thought to be an iron law of finance changed as markets evolved in a similar way to Charles Darwin’s descriptions of nature.

“Compounding reports to Newton,” according to Mr. Housel. The math behind compound interest never changes and it will remain among the most fundamental, lucrative and important concepts in investing.

The column reminds investors that reversion to the mean remains a powerful force in markets, and metrics that are far away from their long-term averages are likely to return. There is one important case, however – price to book value ratios – where I don’t believe this is true.

The average price-to-book value ratio for the S&P 500 since 1973 (as far as my data goes back) is 3.9 times and the current level is 12.6. The economy of the 1970s and 1980s was much more capital intensive than today’s technology-heavy world – huge investment in assets was necessary for expansion in manufacturing industries – and this kept price to book value ratios low.

Today, the costs of expanding production – producing another copy of a software program, for instance – are virtually zero. As a result, price to book ratios are much higher. Much more revenue and profits can be generated with a small and stable asset base.

The average price-to-book value will likely never revert to the average of four times (and if it does it won’t be for long) because the economy and the stock market has evolved, and is much more profitable and deserving of higher valuation multiples. This is another example of a case where Darwin rules, and Newton – to the extent that any investor is waiting for a price to book ratio of four times to reoccur before buying stocks – is left behind.

Mr. Housel’s lesson for investors is to be very careful using formulas and metrics that worked in the past, and to be conscious of the ongoing evolution of the economy and markets which may very well feature more expensive stock valuations than before.

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— Scott Barlow, Globe and Mail market strategist

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Stocks to ponder

Sangoma Technologies Corp. (STC-X) Analysts believe this provider of cloud-based communications has considerable upside. The average one-year target price suggests the share price may rally 43 per cent over the next 12 months. The company recently completed an equity financing, shoring up its balance sheet and providing the company with the financial flexibility to fund an opportunistic acquisition. The stock has a unanimous buy recommendation from four analysts. Jennifer Dowty has this full profile of the stock. (for subscribers)

Goodfood Market Corp. (FOOD-T) Late last week, this skyrocketing growth stock announced the launch of “Goodfood WOW,” a new unlimited same-day grocery delivery service in the Greater Montreal Area. The company said the new service is scheduled to expand to other major Canadian cities over the next year. Analysts expect shareholders to continue to reap the rewards from the company’s aggressive growth strategy and the trend towards online grocery shopping amid the pandemic. Brenda Bouw reports (for subscribers)

The Rundown

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Canadian stock picking pros still no match for the humble index investor in the volatile and uneven markets of 2020

The remarkable volatility in the stock market over the past year should have been a stock-picker’s dream. In reality, though, most professional money managers failed to match the performance of Canada’s benchmark index. That’s right: The vast majority of Canadian equity mutual funds has again underperformed dull, passive investing, according to the latest SPIVA Canada Report Card from S&P Dow Jones Indices, underscoring the virtues of investing in low-fee funds that simply track major indexes. David Berman reports (for subscribers)

A cautionary story for ETF investors scoping out hot sectors

There’s a plentiful selection of sector and subsector ETFs available today, many of them in a technology sector that led the markets back from the March crash. Don’t buy these or any other sector ETFs without remembering the lessons of these two failed BMO products, says Rob Carrick. (for subscribers)

If the worst is over for Canadian bank stocks, here’s a strategy

The threat of soaring loan defaults continues to weigh on Canada’s biggest banks, but some observers believe the threat is subsiding thanks to an improving economy and adequate financial reserves to handle what’s coming. Is there considerable upside ahead for the sector? Robert Wessel thinks so. The managing partner at Toronto-based Hamilton ETFs, and a former stock analyst who has been following Canadian banks for 25 years, is backing up this optimistic view with a new exchange-traded fund that aims to goose investor returns using modest leverage. David Berman reports (for subscribers)

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How the market learned to stop worrying and love the blue wave

Investment banks and asset managers, who have for decades argued markets would balk at tax and spend policies and prefer congressional gridlock to curb any excesses, are now positively embracing the likelihood of a clean sweep for a Democratic Party expected to spend big and also raise wealth and corporate taxes. With less than a month to go, Wall Street stocks are racing to record highs again and long-elevated implied volatilities of the S&P500 benchmark – the VIX ‘fear gauge’ and its November and December futures contracts – are draining to 6-week lows. Mike Dolan from Reuters reports. (for everyone)

Also see: ‘Blue wave’ U.S. election expectations trigger green stocks frenzy

Why portfolio manager Christine Poole likes utilities and her three picks in the sector

Portfolio manager Christine Poole is cautious about the bounce back in stock markets since the March slump. Like many investors, she believes the coming U.S. presidential election and the second wave of the COVID-19 pandemic could bring more market volatility in the months ahead. There are sectors she finds attractive though, particularly utilities as an income alternative for investors in the current low-interest-rate environment. She reveals her top picks. (for subscribers)

Investment strategy based on reducing risk faces its own challenge

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A fund trading strategy that tracks hundreds of billions of dollars in assets and often gets blamed for exacerbating market selloffs is facing a challenge from the policy response to the pandemic. Most closely associated with investment funds such as Bridgewater Associates and AQR, the strategy, called risk parity, typically spreads risk over stocks, bonds and other financial assets, as against traditional 60-40 stock and bond portfolios where equities carry more risk. It uses leverage to magnify returns from lower-risk assets such as bonds. But the U.S. Federal Reserve’s policy of keeping interest rates near zero in response to the coronavirus crisis has raised questions about the strategy. Megan Davies and Maiya Keidan of Reuters report. (for everyone)

Others (for subscribers)

Wednesday’s analyst upgrades and downgrades

Tuesday’s analyst upgrades and downgrades

Wednesday’s Insider Report: Director invests $1.4-million in this high-yielding stock

Tuesday’s Insider Report: Company leaders make million dollar purchases in these two stocks

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Others (for everyone)

Sustainable funds offer downside protection, investors say

Canadian gold miners share wealth from high prices with dividend increases

BlackRock’s Larry Fink says markets have more upside than downside

Globe Advisor

Market zeitgeist turns toward cyclical stocks

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Ask Globe Investor

Question: I want to buy an exchange-traded fund that invests in utilities. I am trying to decide between XUT and ZUT. What are your thoughts?

Answer: Utilities and power producers are a good choice for investors seeking income and modest capital growth. These companies supply products that are always in demand – namely electricity and natural gas. They pay solid dividends that in many cases grow every year. And they are on the conservative end of the investing spectrum because their returns are regulated or governed by long-term sales contracts. The advantage of owning an ETF over individual utilities and power stocks is that you get broad exposure to the sector, which increases diversification and reduces risk.

The iShares S&P/TSX Capped Utilities Index ETF (XUT) and the BMO Equal Weight Utilities Index ETF (ZUT) are similar in several respects. Both hold a basket of utilities and power producers, including familiar names such as Fortis Inc. (FTS), Emera Inc. (EMA), Algonquin Power & Utilities Corp. (AQN) and Brookfield Renewable Partners LP (BEP.UN).

XUT and ZUT also have similar dividend yields and costs. XUT yields about 4 per cent, slightly higher than ZUT’s payout of 3.6 per cent. XUT’s management expense ratio is 0.62 per cent, virtually identical to ZUT’s MER of 0.61 per cent. Both ETFs pay dividends monthly.

The big difference is how the ETFs weight their constituents. Because XUT is weighted by market capitalization, its largest utility – Fortis – accounts for nearly 21 per cent of the ETF’s total assets. XUT’s next four constituents – Brookfield Infrastructure Partners LP (BIP.UN), Emera, Algonquin and Brookfield Renewable – collectively make up another 43 per cent. So just five of XUT’s stocks – out of 16 in total – account for 64 per cent of the fund.

Such heavy concentration is not ideal, because smaller renewable power companies – many of which have been on a tear this year as investors snap up green energy stocks – are significantly underweighted in XUT. Boralex Inc. (BLX) and Innergex Renewable Energy Inc. (INE), for instance, together account for just 5.2 per cent of XUT’s assets.

ZUT doesn’t have this problem because it gives each of its 14 constituents a roughly equal weighting. As a result, ZUT’s exposure to pure-play renewable electricity producers, at 30 per cent, is more than twice as high as XUT’s, at 14.3 per cent. ZUT’s higher weighting in the sizzling renewables sector is likely a major reason its total return of 22.3 per cent for the year ended Sept. 30 was more than twice as high as XUT’s total return of 10.7 per cent over the same period.

Will ZUT’s outperformance continue? That remains to be seen, but green energy is benefiting from a very strong tailwind as governments and corporations aim to reduce their carbon footprints. ZUT not only provides more exposure to the fast-growing renewables sector, but also provides better diversification overall thanks to its equal-weighting methodology. For these reasons, if I had to choose between the two, I would pick ZUT.

–John Heinzl

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Compiled by Globe Investor Staff