Dominant-Theme Investing

The stormy October 2014 sell-off in the global equity markets had the financial media dispensing the usual advice on how prudent investors should protect themselves during periods of crisis-driven volatility.

I am sure you’ve heard this all before.

A typical item in a Toronto business daily published on Friday October 17, 2014, says, “Why this market correction is no cause for panic.” Readers are advised to “invest in shares of high quality companies either directly or in mutual funds or ETFs [and] these companies are leaders in their industries by sales, market share and profitability.” The readers are also told that, “The best companies pay dividends which means they give something back in good times and bad.”

Well, during the October correction, many of those “best companies” had big declines from their pre-October 2014 price peaks: Bank of Nova Scotia -14%, BCE Inc. -7%, Canadian Natural Resources Limited -29%, Canadian National Railway Company -16%, Enbridge Inc. -17% and TransCanada Corporation -23%.

By early November, the storm clouds had parted and in New York the Dow Jones Industrial Average posted a fresh new all-time high in response to the U.S. midterm election results. Unfortunately that new high in the Dow was not accompanied by a handful of high quality dividend-paying components such as Coca-Cola Co. (KO), McDonald’s Corp (MCD) and the late great International Business Machines Corp (IBM).

Back in Canada, a number of mutual fund manufacturers jumped onto the storm-clouds-parting bandwagon, with one posting a half-page ad in a business daily, “Don’t fix a ship in a hurricane.” They advised that, “But while the volatility has increased, now is not the time to panic.”

Of course all of this “no time for panic” noise in the financial press may be justified when you consider the non-stop run-up in the major global stock indices since the lows of March 2009.

A prudent investor could adopt several strategies to somewhat avoid panic-related bullish and bearish stampedes in and out of the equity market. One could either re-balance the portfolio, raise the cash component of the portfolio or simply do nothing and adopt a long term buy-and-hold strategy.

Many technical analysts seek out long-term trends, and one long term strategy I embrace would be to seek out and invest in the current dominant theme.

A dominant theme is usually associated with a longterm secular trend in a particular asset class that tends to ignore the smaller boom-and-bust business cycle. A secular trend is usually associated with innovation and the emergence of the "next big thing," be it the age of steam, the railroads, the automobile, transatlantic air travel, the microprocessor or the internet.

Some recent obvious dominant themes would be the first twenty-year technology boom of 1980 – 2000 along with the fifteen-year Financial Services boom of 1992 – 2007 and the recent Global Commodities boom of 2002– 2007. All of these have been quite investable—thanks to our developed capital markets—through a direct stock purchase or by using a related exchange traded fund (ETF).

An early un-investable dominant theme would be the English Industrial Revolution beginning with the waterpowered Cotton Mill (England 1775-1800) and then the steam powered Cotton Mill (England 1815-1855). This morphed into the U.S.’s Golden Age with later generations of modern factories and trade unions (1855–1898).

The next dominant theme was the railroads of pre-Civil War United States (1811- 1860), an era dominated by canals, steam locomotives and westward expansion. The “echo” railroad boom was the post-Civil War (1865–1900) which led to infrastructure, steel mills and the great American tycoons (Rockefeller, Morgan and Carnegie).

The next dominant theme was the automobile led by the Ford Model T (1908–1927), the internal combustion engine and mass production. The second or “echo” auto boom effectively ended the Great Depression and introduced the Post WWII Era (1946–1974) of highways, urban sprawl, hotels, motels, theme parks and fast food.

The post-World War II boom of 1949 through 1966 was our first modern investable dominant theme, otherwise known as the Nifty Fifty—a basket of NYSEtraded 50 popular large-cap stocks that were widely regarded as solid buy-and-hold growth stocks.

The Nifty Fifty asset bubble popped in reaction to the 1973 Arab Oil Embargo which effectively ended the post WWII auto boom. Some survivors today are The Walt Disney Company (travel, theme parks), McDonald's Corporation (fast food) and Halliburton Company (fuelthirsty automobiles).

The second dominant modern theme was the first new economy technology boom of the 1980s and 1990s that followed the 1973 Arab Oil Embargo. We had the introduction of the PC and the internet thanks to the humble beginnings of Cisco Systems Inc., Intel Corporation and Microsoft Corporation. Dumb automobiles became smart thanks to fuel injection and computers.

In the late 1990s, investors began to stampede into the internet and dot-com space, creating exponential price spikes in the shares of Cisco Systems Inc., JDS Uniphase Corporation, Corning Inc., Nortel Networks Inc. and Sycamore Networks.

In early 2000, the bubble burst and many of the dot-com players ran out of capital and were acquired or liquidated. The first twenty-year technology boom was over.

During the 2000 technology/dot-com peak, a second energy-led commodity boom was getting underway—a dominant theme introduced by the emergence of a Chinaled global boom that ended abruptly with the global financial crisis bust of 2007–2008.

The subsequent recovery from early 2009 has exposed several new dominant themes which are quite diverse when you look at the stocks posting post October alltime highs.

Some recent all-time-high examples:

• The Home Depot, Inc., (HD) Weyerhaeuser Co, (WY) and West Fraser Timber Co. Ltd— all U.S. housing- and lumber-related
• The SPDR Health Care Sector ETF (XLV)—health-care related.
• Lockheed Martin Corporation (LMT) and PowerShares Aerospace & Defence ETF, (PPA)—both aerospace related
• The SPDR Technology Sector ETF (XLK) and the iShares S&P/TSX Caped Info Technology Index (XIT)— both information-technology related

In summary, here are some probable dominant themes to persist for at least the next ten years.

Lumber:

Lumber is one of the only major commodities to post a ten-year low during the financial crisis of 2007-2008 and is now operating counter-cyclical to the broader commodity space. Exposure is good to this emerging dominant theme with U.S.-listed stocks like Rayonier Inc. (RYN) and Weyerhaeuser Co,  (WY). In Canada, the go-to names are Acadian Timber Corp. (ADN) and West Fraser Timber Co. Ltd (WFT).

To enjoy the sector and avoid stock picking, use the NYSE-listed iShares S&P Global Timber & Forestry ETF (WOOD) which holds companies that correspond generally to the performance of the S&P Global Timber & Forestry Index.

Keep in mind that in addition to a U.S. housing recovery, lumber demand from China and Japan is a long-term growth story.

Health Care – Pharmaceutical and Biotechnology:

The life sciences companies span a range of industries such as Pharmaceuticals, Healthcare Services and Supplies, Healthcare Facilities and Equipment and Biotechnology.

The biotechnology story is not new: the late eighteenth century and the early nineteenth century saw the advent of vaccinations, and crop rotation involving leguminous crops. The end of the nineteenth century was a milestone of biology as microorganisms were discovered; early pioneers were Mendel, Koch, Pasteur and Lister.

In 1977, a public company (Genentech Inc.) reported the production of the first human protein manufactured in a bacteria: a human growth hormone-releasing inhibitory factor. For the first time, a synthetic, recombinant gene was used to clone a protein. Many consider this to be the advent of the modern age of biotechnology.

In Canada there are only three constituents in the S&P/TSX Capped Health Care Index, namely Catamaran Corporation (CCT), Extendicare Inc. (EXE) and Valeant Pharmaceuticals International, Inc. (VRX). The index is dominated by Valeant which is by far the biggest TSX-listed health-care-related company

For Canadian dollar accounts, the best way to avoid stock picking is to use the BMO Equal Weight US Health Care Hedged to CAD Index ETF (ZUH:TSX) which is a basket of United States health care companies that fall within the Health Care supersector of the industry.

U.S. dollar accounts would use the SPDR Health Care Sector ETF (XLV) which holds companies from the following industries: pharmaceuticals; health care providers and services; health care equipment and supplies; biotechnology; life sciences tools and services; and health care technology.

Aerospace & Transportation:

This sector involves trains, planes and ships—basically anything related to moving goods or people. A travel/consumer spending boom has the major airlines upgrading their fleets. The war on terrorism means endless spending—a boom for the defence industry. Congested highways have driven municipalities spending to upgrade their transit networks. The railroads are hard pressed to meet the growing demand to move coal, crude and grains.

For U.S. dollar accounts, the major beneficiaries are, Honeywell (NYSE–HON), General Electric (NYSE–GE), and defence contractors such as Lockheed Martin Corporation (LMT). To avoid stock picking, one could use the PowerShares Aerospace & Defence ETF, (PPA).

For Canadian dollar accounts, the selections are scarce in Canada with a small group of names – some are thin traders such as AirBoss of America Corp. (BOS), Bombardier Inc. (BBD.B), CAE Inc. (CAE), Heroux-Devtek Inc. (HRX) and Magellan Aerospace Corp (MAL).

Technology:

The first technology boom of 1980 – 2000 was confined to the English-speaking countries—and was basically a North American event. The current “echo” technology boom is now a global phenomenon that should persist for at least a generation. We have the rollout of on-line banking and retailing, streaming video, smart phones, social media and cloud storage.

In Canada, the investable product is the TSX-listed Shares S&P/TSX Caped Info Technology Index (XIT), which currently holds a basket of seventeen technology related companies. For U.S. dollar accounts, the investable product is the NYSE-listed SPDR Technology Sector ETF (XLK)

As an example of a new dominant theme component, West Fraser Timber is displayed in a very long term chart spanning about fifteen years, with monthly high, low and close bars. Note the very long term no-growth base which now acts as support for a new period of long term growth—driven by the new global demand for lumber.

Bill Carrigan, CIM is an independent stock-market analyst. He can be reached at: info@gettingtechnical.com