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Thinking Correctly About Corrections

On April 24, 2015, a year before the UK voted on leaving the European Union, a year before Donald Trump won his first presidential primary race, and six months before Justin Trudeau was elected, the TSX closed at 15,408.  Less than 9 months later, on January 15, 2016, it closed at 12,073, a drop of 21.6%.  By definition, this was a market correction. Do you remember that? Me either. Most would think that a drop of more than 20% would stick in our memories as a traumatic event, but clearly most would be wrong. Clients call us on a regular basis worried about a market correction. We had one. We barely noticed it. We will have others. My expectation is that a year after the next correction we will again barely remember that it happened. I think that there are several reasons for this.

In the first place, we are focused on what has happened in the recent past, and on what is happening right now. Daniel Kahneman, the Nobel Prize winning economist calls this the recency bias. After a dreadful start, 2016 turned out to be a good year for stocks. When we think back on our returns, we don’t focus on the horrible results in the first six weeks of 2016. We think mostly about the terrific gains in the last quarter, simply because that memory is more available to us; it is more recent. More importantly, the memory of the recent success blocks the memory of the miserable period from April 2015 to January 2016. We have, in some way, overwritten or replaced the memory of the bad period by substituting the results of the subsequent good period.

A second reason we tend to forget the correction that ended a year ago is that we did not suffer any lasting harm from it. Only three Baskin Wealth clients sold out at the bottom (at their request). Many more took advantage of what, in hindsight, were some great bargains. We remember painful incidents; if we did not experience any, or much, pain we forget the event more easily. For almost all of our clients, the correction of 2015/16 was a non-event.

A final reason why we have mostly forgotten the more than 21% drop in the market is that we own great companies in our portfolios. Since April 2015, 80% of our portfolio companies have increased their dividends, by an average of 19%. Companies increase dividends when they are doing well. When they are doing well, we know that share prices will eventually rise. We know that the market will often assign values to our stocks that we consider to be too low, sometimes for a long time; we have learned to live with it. Our central belief is that value is recognized over time. We cannot say it too often, or stress it too much.

This month, on January 20, 2017, almost exactly a year after the end of the correction, the TSX closed at 15,547. During that 12 month period it gained 28.8% to get back to where it was when I started this story. Had you turned off your computer on April 24, 2015 and only turned it on again on January 20, 2017, you would honestly believe that the market had been very stable, producing a modest gain of 139 points or about 1% over a period of 20 months.

Do market corrections matter? Our conclusion is that they matter much, much less than most investors believe. If a portfolio consists of a well-diversified spread of high quality stocks, it will certainly fall in value during the correction, but it will almost certainly rise again to its previous value as the market recovers. Buy and hold investors will not be damaged by market corrections. Market timers, momentum investors and others who, in spite of overwhelming evidence to the contrary, believe they can sell at or near the top, and buy at or near the bottom, will almost always suffer.

Two final points. It is hard to underestimate the importance of dividends to the long-term investor. Most of our stock portfolios produce dividend income of between 2.5% and 3.5% of the value of the portfolio, per year. Moreover, those dividends tend to increase over time, and if history is our guide, should double every eight to ten years. Even during the worst recession in 80 years, in 2008-09, only one of our portfolio companies cut its dividend, and many continued their records of annual increases. We expect dividends to provide between one-third and one-half of total investment returns over time.

The last point has to do with taxes. Most investors in Canada are now faced with fairly punitive levels of income tax, topping out at close to 54% in a number of provinces.  Realized capital gains are now subject to a tax hit of close to 27%.  Selling winners and paying a large part of that gain to the government not only results in foregoing dividend income; it results in a permanent loss of the capital from which future dividends could be earned.

Will there be a next correction? Without a doubt. Do we know when it will happen? No. Neither does anyone else, in spite of what you read in the papers and hear on the news. Will we sell high quality stocks in anticipation of the next correction? No. We have been in business for 25 years and we have never seen the wisdom in that course of action. Not only would we not know when to sell out of the market; neither would we know when to buy back in. Our strategy avoids making two difficult decisions, either or both of which could be disastrously wrong, as well as ensuring that our portfolios continue to earn lucrative and growing dividends while avoiding the payment of confiscatory income taxes.

We know that during the next correction our clients will be unhappy while the market falls. The short term pain is unavoidable, but it is far, far better than the permanent loss of capital that so often results from abandoning a winning investment philosophy.

 

David Baskin