Time to change strategy?

February 28, 2012, 2:09 pm Andrew Page Yahoo!7

These days it is not uncommon for investors to lament the difficulties of a volatile market. Some even proclaim a new paradigm; long term investing is dead, or so we are told, and investors need either adjust to the new reality or instead flee to the relative sanctuary of safe haven assets.

It makes a modicum of sense I suppose if your experience of investing is limited only to the pre-GFC bull market, where the rising tide phenomena made experts of us all. Empathy can perhaps also be extended to those whose approach is predicated on expectations for immediate and regular capital gains (gamblers, in other words).

However for true investors, the volatility of the market should not be cause for great concern. Present market conditions are neither unusual nor special, and they certainly do not suggest any change to sensible and time honoured investment principles.

I am not suggesting that the current economic uncertainties are immaterial, but am trying to urge restraint and rationality. As such it is worth going back to basics, for when it comes to investing, and many things besides, it’s sensible to never stray too far from that which is patently straightforward and practical.

When price matters

The current market price of your shares is of paramount importance, but mercifully only at those times when you are buying or selling. At all times in between, though it be infinitely easier said than done, prices are best ignored.

For those that are prepared to commit their capital for at least several years, this provides a great deal of comfort, and indeed a great advantage. For while we have no control over the near term direction of the share price, we have every say in when we choose to act. As such, an investor with the luxury of time and the blessing of patience is at a real advantage.

On any given day, the market price for a particular share is nothing but a reflection of the combined sentiments of many individuals. Individuals that for the most part are emotional, irrational and easily influenced by the madness of crowds. Don’t ever convince yourself that the quoted share price on any particular day is the outcome of objective, considered and rational analysis of the underlying business and its long term return potential.

Rather than lament this fact, rejoice in it. It provides you with the ability to buy wonderful cash generating assets at a discount.

Invest in quality

The above remarks may only be considered sensible if the earnings (and hence dividends) of the underlying business are reliable and likely to rise over time. If this is the case, you can have every confidence that the price will eventually recover: you will find few examples where this relationship has been violated for any meaningful period. Great comfort is also found in the ongoing income stream afforded from your dividend payments. Indeed, these very payments are what define the business as an investment.

For this very reason you should take care not to be lured into companies where you cannot be virtually certain that earnings will be materially higher in the future. While most businesses will be able to present a plausible argument in the affirmative, you should take care to avoid those without a demonstrated capacity to endure difficult economic periods, and that do not exhibit reliable and sustainable earnings growth. Importantly, at all times ensure they are managed by honest, ethical and shareholder focused people.

When confidence and capital become scarce, businesses that trade on optimism and promise alone garner little support.

What’s the alternative?

There are always alternatives, and for those not well disposed to cope with the gyrations and hysteria of the market the relatively lower returns of cash are more than compensated by the peace of mind it offers. At present it is likely that you could generate about 5% per year with virtually no risk in a term deposit. Over 5 years, that’s a 25% return and this is the benchmark that you should measure all other potential investments. Unless you are confident that you can significantly exceed this, there is little reason to invest in a listed business.

However when you consider the fact that there are dozens of quality, defensive businesses that are offering yields well in excess of 5%, especially if you include franking credits, it should at least offer some food for thought. Not only that, as dividends have the potential to rise each year, the income component alone from these companies are likely to well outstrip the returns from a cash equivalent investment. While there is of course also the potential for a capital gain, you could still justify the investment even if you were to assume that the price of the shares will be more or less unchanged in 5 years’ time.

Investing in shares is all about anticipating rising share prices, isn’t it?

Unfortunately many investors focus only on capital gains, and as a consequence have in essence become speculators on market sentiment. Of course, rising share prices are essential to success, but this misguided focus has put the proverbial cart before the horse.

As the saying goes, if you look after the pennies, the pounds will look after themselves. In regard to shares, it could equally be said that if you look after the dividends, the capital gains will look after themselves. Businesses that reliably and regularly increase their dividends inevitably experience share price appreciation over time. In some cases it may take several years for the price to follow the dividends higher, but as your capital is generating an income stream along the way, the wait should be easily tolerated. It’s not as if your capital is idle; indeed it is anything but!

Summary

Each year there are seemingly sound reasons as to why you should avoid the share market, and at present the reasons seem even more compelling than usual. But the fact remains that long term investors, with an eye for quality, a focus on income and a temperament suited to volatility have absolutely no reason to change tact. This isn’t to suggest you continue to hold onto poor businesses, and a bad company is expensive at any price, but quality businesses will always win out in the end, and provide you with a reliable, rising and tax effective income in the meantime.

Several years down the track, the world will be facing a new set of challenges, the market will be as volatile as ever, and the future will remain unknown. Yet between then and now, there will be those businesses that while perhaps not as sexy and exciting as the latest start-up, will continue to be earning good returns, and distributing these back to the owners of the business.

Andrew Page is an Investment Analyst at teaminvest, a private membership organisation for self-directed investors. For further information, please email andrewp@teaminvest.com.au

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