Too Good to Be True ?

January 31 2000

Too Good to Be True ?

January 31 2000

Rarely has the outlook for the Canadian economy appeared so favorable. But is now a good time for Canadians to invest in stocks and equity mutual funds, or are today's lofty share prices a sign of looming trouble? Maclean’s Senior Business Correspondent Ross Laver discussed that issue with three experts: Patricia Crofi, an economist and portfolio manager with Sceptre Investment Counsel Ltd.; Ian Ainsworth, a vice-president of Altamira Investment Services Inc. and manager of its equity, e-business, and science and technology finds; and Roger Martin, dean of the Joseph L. Rotman School of RIanagementat the University of Toronto, a consultant to some of the world’s top corporations and a director of two major Canadian companies, Thomson Corp. and Celestica Inc. Excerpts:

‘The big picture is extremely bright, but I’m always worried when there’s a consensus because it’s probably wrong’

Maclean's: The economy is growing, unemployment is falling, and the stock market is near record highs. Are things really as good as they seem?

Croft: The big picture is extremely bright, but I’m always worried when there’s a consensus because it’s probably wrong. Where I think it could be wrong is that the inflation threat may be bigger than people expect. Right now, there’s a lot of confidence that we won’t have to worry about inflation ever again, that growth will be strong around the world and that technology will rule forever. I do believe we’re in a powerful disinflationary era that has much further to go. But I also think we may be in for a cyclical uptick in inflation. That may catch the market off guard.

Maclean’s: What’s behind the current economic expansion?

Ainsworth: Technology is one contributor, but we’ve also got the whole globalization phenomenon, which means companies are now sourcing production in emerging markets and there are opportunities for companies to grow globally. We’ve got corporate restructuring as investors search out the best-managed companies around the world. Obviously there are ups and downs in that process, but it’s very positive that capital flows into these countries and continues to reward the better business models.

Maclean’s: Presumably one reason for the optimism is that investors believe productivity is increasing. Are they right?

Martin: There are economists who argue vociferously on both sides of the question. I tend to agree with the side that says productivity growth has been weaker in Canada than the United States. Overall, though, I think the argument that our economies are getting more productive is correct. I’m actually really optimistic about globalization. For almost a half century, we have been attempting to fix Third World countries using things like the World Bank and the International Monetary Fund— and it didn’t work at all. What’s working now is that global corporations are investing in these countries. If we can get the Third World consuming more, exporting more and importing more, it will be positive for everyone.

Maclean’s: The protesters who shut down the World Trade Organization talks in Seattle recently might not agree with you.

Martin: Well, I’m sure those protesters are all dedicated people who think big corporations are destroying the world and global trade is bad for everybody, but they’re dead wrong. From my vantage point as someone who has consulted for a number of big global companies, if anyone is going to clean up Third World corruption, it’s the big global companies that are governed by rules in their home countries.

Maclean’s: How exactly is new technology contributing to economic growth?

Ainsworth: Well, technology is very significant as a driver for disinflation. And it’s been accelerating in the past decade. We’ve got twice the productivity growth per capita in the United States in the past five years than in the previous 15 years. That’s coincident with the rise of the Internet, and I think there’s a connection. By the year 2003, Internet traffic business-to-business, according to Forrester Research, a U.S. think-tank, should reach about $3 trillion (U.S.) globally. That has a major impact on companies in terms of their ability to predict demand, manage inventories and make their operations more efficient. And that has a dramatic impact on reducing the volatility in the business cycle, a lot of which is caused by inventory swings.

Martin: By the way, it turns out that the sector of the U.S. economy that has the fastest productivity growth is electrical and electronic equipment. Its productivity has been increasing at 10 per cent annually over the past decade. It’s the fastest-growing sector of the economy— the productivity engine.

Maclean’s: How do we know this isn’t just a temporary phenomenon?

Croft: We don’t, but I think the stock market is sending us some messages. If you look at the valuations attached to Internet-related companies and compare that with the old-economy stocks, there’s a huge disparity. You might question that, but I think the stock market is saying that going forward, the old-economy companies are going to face tremendous competition.

Ainsworth: I agree. It’s not often that you can open up a retailing concept and have 130 million people at your doorstep, but on the Internet you can achieve that overnight. And the reality is that we’ve created more global brands in the past three years on the Internet than in the previous 15 years in the consumer-products industry. So I see dramatic growth opportunities, balanced against greater risks in the bricks-and-mortar world. I do think, though, that the productivity gains made possible by the Internet will expand into the bricks-and-mortar companies.

Maclean’s: So it’s not just technology firms that stand to gain from the Internet?

Ainsworth: Look at the partnerships that are emerging between companies like Ford and Oracle, the software company, or between General Motors and Commerce One, an e-commerce software company. Those companies are partnering to save money on procurement. Ford buys about $70 billion a year worth of auto parts and all of that is moving to the Internet. That could save Ford as much as $7 billion a year, which has a dramatic impact on profitability. So, many companies are going to benefit from this.

Maclean’s: If you’re right, the outlook for stocks is extremely good. Yet already the major stock indexes are two or three times higher than a few years ago. Can investors really expect the boom to continue?

Martin: One of the reasons the market has gone up so much in the past decade is that we’ve taken out the inflationary factor that causes investors to discount future growth. So we’re not going to get another bump in stock prices from inflation going down another point. But on balance I’m more optimistic than pessimistic. And if we get the Third World humming, that will turbocharge the global economy.

Maclean’s: The Toronto Stock Exchange 300 index now boasts a price-earnings multiple—the ratio between stock prices and earnings per share—of about 40. Traditionally, investors considered 20 to be on the high side. Isn’t that worrisome?

Ainsworth: Not necessarily, because it’s hard to use historical measures to forecast the future. Certainly, we’re in different times today than we were in the 1980s, when price-earnings multiples were in the teens. But today were not faced with the big economic cycle risk that we had before, we’re not faced with high interest rates, and we’re not faced with an outmoded capital base. When people look at the recent gains in the stock market, they’re comparing it with that terrible period when the economy, particularly the U.S. economy, was under incredible pressure. That’s a dramatic difference from today.

Maclean’s: But aren't some investors getting carried away with optimism?

Croft: If you look at the conventional models, they suggest the U.S. stock market is 40 or 50 per cent overvalued. But another way to look at them is to consider the equity risk premium—the spread between the expected rate of return from holding a stock rather than a bond. Historically, it’s been seven per cent, yet the markets are now saying it’s only one or two per cent. I think that’s absolutely justified because we do live in this era of low and well-contained inflation. The other factor that investors are aware of is that there is less risk in stocks because Alan Greenspan, the chairman of the U.S. Federal Reserve Board, has continually proved that he is central banker to the world. Investors know that if this market falls 25 per cent tomorrow, the Fed is going to pump in liquidity and save the day.

Martin: If you’re looking for the downside, that’s it. Why would someone be willing to accept such a low premium to hold stocks, which are inherently riskier than bonds? It has to do with peoples supreme confidence in capitalism and the power of financial assets. Yet we know a mere 20 years ago, there was flagging confidence. The minute the world says, ‘We’re not so sure about financial assets,’ money is going to shift over to physical assets—commodities. Right now, our economy is a machine that is running to extremely tight tolerances. Inflation is about as low as it can get, confidence is about as high as it can get. And anything that would shake either of those things is a risk.

Croft: There’s no doubt we’ve come very far, very fast. The total value of the stock market is now 150 per cent of the size of the U.S. economy, which is unprecedented. The current account deficit, which is what the United States owes the rest of the world, is four per cent of gross domestic product, the largest on record. The savings rate is at a record low and net private debt is at a record high. So you could argue this is a bubble, but I’m not of that camp. I believe this is a new era. I don’t think the business cycle has been entirely repealed, but it has been reformed.

Maclean’s: Are you suggesting that recessions are a thing of the past?

Croft: I think what well see are recessions by industry, by sector and by region. In Canada right now, we could argue that we’ve had a recession in British Columbia, but we’ve had boom times in Ontario and more recently Quebec. We’ve had a recession in the public sector, with downsizing and cuts in spending, but we’ve had boom times in the private sector. So I don’t think we’ll see economy-wide recessions, because what used to cause recessions was that there was too much money chasing too few goods, which meant inflation took hold and central bankers had to jack up rates. If we now live in a world of well contained inflation, we can forget that.

Maclean’s: At the beginning of the 1990s, there was a lot of concern in Canada about competitiveness. Is the picture any more positive now?

Martin: No, and in my view that’s the defining issue for Canada. In 1990, we were third in the world in gross domestic product per capita. The 1998 numbers have just come out from the Organization for Economic Co-operation and Development and we’re fifth. And the difference is this: if we had stayed in third place, every family of four would have $13,000 more per year than they do now—$600 or $700 a month after taxes. That means every Canadian family could go out and buy a minivan for nothing, or have a house that’s worth almost $100,000 a year more. Even more worrisome is that when the OECD says we’re fifth, that’s based on calculations of purchasing power with the Canadian dollar at 85-5 cents (U.S.). If it were 80 cents, we’d be 11th in the world. At 74 cents, we’re 18th, behind Finland. So while I’m optimistic about Canadians, I’m not optimistic about Canadian businesses.

Maclean’s: Ian, as a fund manager, you’re always looking for leading-edge companies. Are you finding many in Canada?

Ainsworth: Some. Nortel is a great company. So are Bombardier and Magna. But I agree with Roger. Part of the problem is that governments haven’t been proactive enough in creating the right environment for technology companies. The good news is that you’re starting to see capital pouring in, you’re seeing overnight millionaires created in Ottawa, and you’re starting to see big institutions put money into venture capital, targeting new, innovative business models. But we’re years and years behind the United States.

Martin: I agree. I’m feeling encouraged that we’re finally getting Silicon Valley style investors here in Canada. But the thing that worries me is the educational component. Canada has spent big on that historically, but there’s a trend now towards disinvestment in that sector. In the past three years, 48 of 50 U.S. states—all except Alaska and Hawaii— have increased their spending on higher education. In Canada, only four of 10 provinces have increased their spending on higher education—Manitoba, Alberta, Saskatchewan and British Columbia. So we’ve started to disinvest in higher education at exactly the time that the United States figured out that you can’t spend too much on higher education.

Maclean’s: Many investors are confused this RRSP season. On one side are experts who say that the stock market is overvalued. Yet the economy is growing rapidly. What’s the best strategy?

Croft: I think this will again be a year when the Canadian market could outperform its global counterparts, as it did last year. Part of it relates to global growth, which should benefit our resource sector. And even though interest rates will rise in the short run, I think by the end of the year rates will be lower than today, so that should help our banks. Having said that, it’s important for investors to think globally. We’re not a hotbed of technology, despite a few success stories, and I think you absolutely do have to have some exposure to technology. So don’t ignore technology. I don’t think it’s a bubble. I think this thing is in its infancy.

Maclean’s: Looking at some of the recent returns, a lot of investors are obviously tempted to put all their money in technology stocks. Is that the way to go?

Ainsworth: We believe technology should be a significant part of your portfolio, but look at other areas of the market as well. And I think the market will broaden out and we’ll see some of the cyclical areas of the Canadian economy participate this year. Already you’re seeing some pretty good returns from companies like Alcan and Dofasco. So having everything in technology may not be a prudent strategy. It’s a volatile sector and if we do get some kind of inflation shock, it’s good to be more diversified.

Martin: The only thing I would say to supplement that is, yes, have investments in the technology sector, but within that sector I would be betting that e-commerce is going to be a continuing trend. So I would be careful of companies that haven’t been responsive to the new economy. The fact that GM is working assiduously with Commerce One to restructure their parts procurement—I’d say, ‘OK, they understand, they get it.’ But other companies in the old economy who take the view that ‘this too shall pass,’ I would stay away from those. So my portfolio would be heavily weighted to technology stocks and companies that have recognized the pervasive impact of technology.

‘Right now, our economy is a machine that is running to extremely tight tolerances’