How to create wealth in a volatile market

With the sharemarket bouncing, but heading downhill, smart money will seek out stocks that have been dragged down by the stampede, despite their obvious quality. MICHAEL LAURENCE reports.

By Michael Laurence

With the sharemarket bouncing, but heading downhill, smart money will seek out stocks that have been dragged down by the stampede, despite their obvious quality.

The sharemarket is providing the best wealth-creation opportunities in many years – for astute long-term investors who are brave enough to buy savaged stocks at bargain prices.

But be prepared for rising volatility. Don’t be unnerved whenever the market dips sharply in coming months, and don’t pour all of your cash into the market at the same time.

The intense volatility at the level experienced over the past few months is likely to continue for at least six months, perhaps much longer – with prices racing downwards only to bounce upwards again to, almost inevitably, give false hope that the storm is over.

Whenever much of the market panics or many investors are forced to sell following margin calls, as they have been in January in particular, astute buying can become particularly appealing.

By the end of January, the S&P/ASX200 was trading on a forward price-earnings multiple – which measures past one-year corporate profits against estimated future earnings – of 12.6 times compared with an average over the past 10 years of 15.3 times.

This signals excellent buying opportunities for careful, highly selective investors to progressively buy into the market.

The key opportunities may include the big banks, food and electronic retailers, heavyweight, diversified resource companies, telcos and perhaps even the top-quality listed property trusts that are not handicapped with the heavy gearing that has caused this sector to be punished over the past three months.

I am not suggesting that investors try to time the market – attempting to pick the best times to buy and sell – which is one of the biggest errors that investors can make. Even the best professional investors cannot find the right time to buy, except occasionally by extreme luck.

A smart strategy is not to try to pinpoint the exact low in the market – and pouring in a massive amount at the one time – but to invest progressively into oversold quality stocks in accordance to your personal circumstances; including your ability to cope with risk.

Your tolerance to risk is unlikely to have altered just because of the recent rocky market.

Investors who buy at this time should, however, steel themselves for the possibility of a long market downturn. And as this column has said again and again: Never panic!

“The best time to invest is when everyone is unsure about whether to invest,” says veteran Sydney financial planner and actuary Graham Horrocks. “I wouldn’t suggest investing boots-and-all at this stage – invest over a period. It is a good time to create [or expand] a portfolio.”

A key point is that the rollercoaster ride of the market should not be seen as a reflection of the state of the Australian economy, which remains extremely strong. Although the US is bordering on the edge of a recession, our economy these days is more dependent on China than the US.

Further, the strong gains in Australian share prices since 2003 have generally been supported by gains in company profits and dividends.

Here are a few tips for creating wealth in this market:

Look for oversold quality stocks

When searching the market for oversold stock, be highly selective in your purchases. Don’t be caught by buying duds that may seem bargains simply because their prices have collapsed.

Speaking to SmartCompany on the evening of January 22, after the market really nose-dived, Shane Oliver, head of investment strategy and chief economist of AMP Capital Investors, named a selection of his best buys.

Oliver’s picks include:

Retailer Harvey Norman. “The stock has plunged. Investors have really thrown the baby out with the bathwater.”
Woolworths. Its sales should hold up regardless of the economic environment.
The banks. Australian banks “have been hammered” by the difficulties of the US lenders with sub-prime mortgages. “Most Australian banks [however] are in pretty good shape,” says Oliver, “with a growing market share [given the plight of non-bank lenders], and their dividends are very high.”
Telstra. Oliver says this was cheap even before the latest bout of intense volatility.
Listed property trusts. “These are worth looking at, cautiously,” Oliver says. “Definitely do not rush in. The high gearing of some trusts makes them vulnerable.” On the positive side, trusts are paying high dividend yields.
BHP Billiton. Oliver favours the big diversified resource companies that have fallen sharply in price. “Chinese growth should remain strong [benefiting the miners].” He says the large diversified resource companies represent less risk that the small ones that are vulnerable to any downturn. Investors should expect “tumbles” in the prices of the large resource companies from time to time.

Michael Heffernan, private client adviser and strategist for Austock Securities, believes that it “absolutely” makes sense for investors with long horizons to now boost their portfolios with quality stocks.

“If stocks are good, and down in price, you couldn’t get a better time to buy – there is no question,” Heffernan says.

“Look at the top 10 stocks [on capitalisation]. The big banks, St George and Woodside – these two being just outside the top 10. You couldn’t go wrong with any of them.” And he points to BHP Billiton as a buying opportunity, after its severe fall in price.

“Buy when prices are low and hold on, if the reasons that you bought the stocks in the first place haven’t changed,” says Heffernan. “If the stocks’ fundamentals are good, you don’t worry about what has happened in the markets.”

Invest progressively

Financial planner Graham Horrocks believes it can make sense for buyers to begin progressively buying carefully selected stocks in this market. “Perhaps buy every month or quarter,” he says. (This approach is also known as dollar-cost-averaging, because buying prices are averaged over the buying period – investors buy more stocks when prices are cheaper and fewer stocks when prices are higher.)

In suggesting that investors consider a progressive approach to investing, if appropriate for their circumstances, Horrocks warns that investors may be investing into a market that may fall for some time.

Oliver says he agrees with the strategy of buying progressively (or practising dollar-cost-averaging) into the market. He believes “it is highly likely that we have seen the market low” but, nevertheless, is not against progressive investing even if the market were to continue to fall.

“Over the last 50 years, there have been numerous examples of sharemarkets falling by 20% or more [as experienced from November to January].” But, Oliver says, this should be always seen in the context that shares have provided better long-term returns than any other asset class.

“For those wondering when the best time to buy shares is, the best approach is to average in over the next six months rather than hope to predict the precise bottom of the market.”

Oliver is emphatic that now is not the time to freeze existing arrangements to regularly make salary-sacrificed contributions into super funds with a large percentage of their portfolio in shares. “It is precisely the wrong time to stop.”

Look for strong dividends

Favour investing in quality companies paying strong dividends. Such dividends will provide a cushion for any further falls in share prices, Horrocks says.

Indeed, long-term investors can concentrate on their dividends rather than being distracted by the daily fluctuations in share prices.

A fully franked dividend of 5% is the equivalent of a return of more than 7% on a fully taxable investment. And the tax position is particularly favourable if the shares are held in a concessionally-taxed super fund that will receive tax refunds for excess franking credits.

When the market fell to its lowest depth for January, the grossed-up yield (which takes the value of the franking credits into account) of the banks was outstanding.