It may seem hard to believe. The wall of bad news facing investors – the European debt crisis, terrible investor sentiment and highly volatile share prices – has created one of the best buying opportunities that is likely to occur in your lifetime.
Just think that the S&P/ASX 200 fell by 8% over a 15-day period in November – before investors rushed back into the market over the past week. And some of Australia’s best stocks paying double-digit, grossed-up dividends were dumped by unnerved investors.
Ross Bird, head equity strategist for researcher Morningstar, says buying opportunities of this magnitude are relatively rare. And he is convinced that tough global economic conditions and investor sentiment have led to “one of those moments” when quality shares are very cheap.
Bird believes this is an excellent time for long-term investors to either build a top-class portfolio from scratch or to revamp a tired portfolio with an injection of quality stocks.
“You have to try not to get caught up in the day-to-day negative headlines; there is very good value in these stocks.”
And Charlie Aitken, managing director of broker Bell Potter Wholesale, writes in his November 28 newsletter: “In my 20 years in markets, through crisis and boom, I have never sensed a greater investor-sentiment capitulation than over the past few weeks.”
“But conversely,” Aitken adds, “I can never remember cheaper valuations and sustainable dividend yields in Australian equities – particularly in the top 20.”
Prasad Patkar, portfolio manager with Platypus Asset Management, says there is “very good value in the markets on almost all the metrics”. However, he stresses that the catalyst for a change in investor sentiment is missing at this point.
And Patkar highlights the lack of economic leadership in the US and Europe. “In the meantime, the economic recovery stalls and everyone remains focused on one crisis after another.”
Although Patkar agrees that now is a good time to build a portfolio, he emphasises that investors should be extremely patient and expect to hold stocks for the long-term.
On November 30 – at SmartCompany’s request – Ross Bird created a widely diversified portfolio of discounted quality stocks that he believes are well placed to ride out the prevailing turmoil and to deliver solid long-term returns.
Bird has stayed away from discretionary/cyclical businesses, sticking to resilient companies providing essential, everyday services. These businesses have a large exposure to the Australian market – a key factor given the relative strength of our economy.
And the companies are paying good-to-excellent franked dividends and are trading at a “reasonable” discount to what Morningstar regards fair value. Their price-earnings ratios are modest.
Significantly, the resource stocks included in the portfolio will benefit from what Morningstar expects to be continuing robust growth in China.
Bird’s 11-stock portfolio diversified, covering 10 industry sectors, comprises banking, Westpac and National Australia; insurance, QBE; consumer staples/resources, Wesfarmers; health care, Ramsay Health Care; utility/energy, Origin Energy; energy, Woodside Petroleum; diversified resources, BHP; telecommunications, Telstra; information technology, Computershare; and real estate, Lend Lease.
Morningstar forecasts that this portfolio will produce:
Patkar is drawn to quality resource companies with low operating costs as well as production growth. He believes that such stocks will be re-rated by the market or by acquisition. And he names Regis Resources, PanAust and Atlas Iron as examples.
“With the strong Australian dollar,” Patkar adds, “it may not be a bad time to buy some quality stocks with offshore earnings, [bio tech] CSL and Computershare.”
Among the banks, Patkar’s preferences are those with strong mortgage businesses, pointing to the Commonwealth Bank and Westpac. Mortgage income is less volatile, providing more protection for dividends.
In this difficult investment environment, true blue-chip stocks are likely to benefit most from rises in the market, sustain their dividend yields and suffer less in market downturns.
Sticking to quality is undoubtedly the core message for investors. “Quality stocks are going to be the ones investors want,” Bird emphasises.
Investors should feel more able to withstand rollercoaster movements on the markets – and plummeting share prices from time to time – if they are confident that strong dividends will continue to flow.
In short, they can take their minds off meaningless day-to-day gyrations in the market to concentrate on the longer-term.
Bird expects that stocks paying sustainable high franked dividends would not tend to fall as much during market downturns because the strong yields provide “a built-in return” that isn’t reliant on growth.
In terms of what are believed to be sustainable dividends, Bird’s portfolio includes some beauties.
The champions in terms of forecast grossed-up dividends are Telstra and National Australia Bank, each with a remarkable forecast of 12.57%, at the time of the portfolio’s creation. Westpac is another standout with 11.71%.
Patkar comments: “Income has become more important in a market that could go sideways for another few years. It is really hard to look beyond sustainable, fully franked dividends.”
He regards high-yielding bank stocks as appealing despite an outlook for fairly flat earnings growth over the next few years. “In the absence of a housing crash, bank dividends are sustainable.”
Don’t hold on to second-rate stocks in the wishful hope that their prices may recover one day. Chances are their prices will keep falling.
“The market is going to be very selective about which stocks it supports and which it doesn’t,” says Bird. “It has to be quality all of the way.”
Bird is convinced that given the outlook for subdued returns and continuing global economic uncertainly, most investors will not want to touch stocks of doubtful quality
In other words, replace dud stocks with blue chips.
Any investor creating a new portfolio or putting life into an ailing portfolio should recognise that world’s economic woes may deepen, driving share prices lower.
So don’t invest any more money into this market unless you are willing to take a long-term perspective and are able to cope with intense volatility.
Bird says that if the Europeans were to adequately address their debt problems with a plausible plan, the “market will rally – and rally hard”.
And if the market should suddenly awake, investors who had fled to all-cash portfolios would be left flat-footed. But as Bird says, “whether this will happen and its timing is very difficult to accurately predict”.
Patkar agrees that it is not difficult to foresee an abrupt improvement in investor sentiment if Europe adequately confronts its woes. “A positive event such as that would allow investors to focus on fundamentals, which indicate that equities are undervalued.”
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