Index funds leading to greater volatility

Passive funds are becoming so popular that they’re starting to influence the price of securities rather than merely reflect them, says Joe Sirdevan, CEO of Toronto-based Galibier Capital Management.

Sirdevan said that since index funds grow as a proportion of investment dollars at work, their buying power is beginning to have an outsized influence on markets.

“They’ve gone from being price takers to being price makers,” he said.

This trend, which has been gathering steam for over 30 years, could lead to volatility that attentive investors could take advantage of, he pointed out. The factors that drive prices up could suddenly reverse themselves, and drive prices back down.

“If people are doing crazy things, or computers are doing crazy things, then you ultimately have the opportunity to take advantage of ‘Mr. Market,’” he said. “We might be looking at incredibly big declines in the market. And that is a great place to be, as long as you’ve got cash to buy.”

He pointed out that index funds seek only to reproduce the weight of the companies in a particular index.

“If Shopify [Inc.] is 7% of the Canadian index, then for every $100 that flows into an index-linked product in Canada, $7 of that goes to buy Shopify. And the fund doesn’t care if Shopify is at $1,200 or $1,800. It just buys it, up to the 7% weight,” he said. “That’s an interesting phenomenon, when a passive product is making valuation decisions.”

(Shopify stock has ranged from $1,275 to $1,857 since the beginning of 2021.)

Another market-moving trend Sirdevan has noticed is the gamification of investing, where investors — usually novices — treat the stock market as a proxy for gambling. Enabled by new computer applications that make trading cheap and easy, these retail investors could face devastating losses.

“The market has been up, up, up. So, everyone is feeling very good about themselves. But if this reverses, people are going to be facing real losses, and that’s really going to be something,” he said.

“We have to make sure that people are not getting margined way beyond their ability to extract themselves without getting really killed. That is something to worry about.”

Sirdevan said his firm uses five main criteria to identify companies worthy of further analysis. Those companies must demonstrate:

• an enduring competitive advantage;

• a management team with strong environmental, social and governance principles and a record of maximizing the company’s competitive advantage;

• healthy earnings (defined as free cash flow from operations, less the necessary capital expenditures to support growth drivers);

• appropriate financial leverage (no balance sheet risk whatsoever); and

• above average long-term growth prospects.

Companies that meet that bar are then examined more closely to determine future earnings potential. The resultant calculation is discounted 12% to 15% to determine a reasonable present-day valuation.

Among the Canadian equities he has found to be materially undervalued is Premium Brands Holdings Corporation, based in Richmond, B.C. This producer of processed meat, seafood and ready-to-eat sandwiches is a big supplier to Starbucks. According to Galibier’s analysis, the stock — which was trading at around $118 — would be a good deal even at $124 a share.

Another company he likes is Parkland Corporation of Calgary. The Galibier estimate of intrinsic value for this operator of North American convenience stores is $46.75 per share, but the stock was trading at $39.

The firm’s valuation for Rogers Communications Inc., trading at around $61, comes in at $71 a share.

“We’re an absolute-return investor,” he said. “So, we’re trying to identify companies trading below their intrinsic value, and then we buy them and wait for that valuation gap to close.”

Sirdevan said he prefers to restrict his Canadian equities portfolio to about 25 names, but controls risk by ensuring all of them have good fundamentals and healthy prospects.

“If you are benchmarked against a wildly diversified many-named index, then to hedge out that risk, you’re going to have to own a lot of stocks to keep similar levels of diversification and similar levels of exposure to all the different sectors in the marketplace. That’s not the game we play,” he said. “Our five criteria define our business selection, and price paid is defined by our calculation of intrinsic value. That’s how we control risk — not through diversification.”

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This article is part of the Soundbites program, sponsored by Canada Life. The article was written without sponsor input.