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How to weather the storm

A desire to lessen risk in uncertain times can adversely affect an investor's capacity to earn solid returns.

A desire to lessen risk in uncertain times can adversely affect an investor's capacity to earn solid returns.

When equity markets become volatile, fearful investors often turn to defensive sectors such as consumer staples including supermarkets, food producers and healthcare, expecting these to hold up well in any economic downturn.

Other investors lean towards shares in companies providing high-dividend yields, believing a solid dividend signals a financially strong corporation.

In the recent highly uncertain investing environment, such strategies continue to have many advocates.

But some experts warn that investors, in their desire to minimise risk, might in fact end up sacrificing attractive returns.


The chief executive officer of the market data firm Lincoln Indicators, Elio D'Amato, argues that the market has been sold off so heavily that investors risk missing some strong performance if they stick to defensive stocks.

"Many stocks are cheap right now," he says. "This is a great time to be getting excited about the market.

"I know a lot of people want to go to defensives because they are worried about all the volatility. But the current market offers an amazing opportunity for investors who do, I suppose, have to be of stronger stomach. It gives them the chance to pick up stocks that have fallen sharply for no other reason than sympathy with the problems in Europe."

D'Amato warns more generally against defensive stocks, citing the example of bionic ear pioneer Cochlear, which in September had its shares plunge 20 per cent in a day on news of a product recall.

"Cochlear is a great business," he says. "One would argue that it is a defensive stock. It has a market-leading product that is global. Yet just one problem occurs and the share price gets battered."

He also urges caution on buying stocks simply because they offer high-dividend yields. "A lot of people have incorrectly associated high dividends with company safety," he says.

"But we saw during the Global Financial Crisis, with the property trusts and the like, that irrational asset values caused significant strain and pressure, and some of those companies just stopped paying dividends altogether."

The chief market analyst at City Index, Peter Esho, advises investors in the current market environment to adopt a three-pronged strategy.


"Your portfolio should be diversified," he says. "You do not want all your eggs in one basket.

"And there will be big question marks over economic growth for the next five years. We expect to be in a low-growth environment. So you do not want to be buying stocks with high price-earnings multiples, as these have been priced for high growth. In fact, you want to be in businesses that have had their growth prospects discounted by the market - very heavily discounted."

Third, he advises investors to incorporate some type of insurance mechanism in their portfolios as protection against sharp market falls.

For more sophisticated investors this could even extend to buying derivatives, such as options. For others it means maintaining a strong cash position.

He also cautions against buying stocks simply because they are in traditional defensive sectors.

"A business might be very defensive, like Woolworths," he says. "But it might trade on a price that assumes growth. We find it hard to justify paying a price-earnings multiple of 15 for a company like Woolworths that expects just 4 per cent profit growth next year."

The head of research at Fat Prophets, Colin Whitehead, says: "We view the market as pretty historically under-valued." In his opinion, defensive stocks do not offer the same capacity to rebound when the market returns to a more reasonable valuation.

However, he expects markets to remain volatile for quite some time and believes that investors will probably need to be "more nimble" than they have been in the past. He says: "Certainly the investors who generate the best returns over the next two years are probably going to be more active, as opposed to the traditional buy-and-hold approach."

But the senior equities analyst at Morningstar Australasia, James Cooper, continues to believe traditional dividend investing is still a viable strategy.


"We have had 20 years of debt-fuelled growth," Cooper says. "Now there is all this deleveraging going on and that is going to depress growth for a number of years. People buying growth stocks might be unpleasantly surprised.

"So once the penny begins to drop, investors might start gravitating towards stocks where there is a fairly solid dividend yield that allows them to keep pace with inflation."

He adds: "There has been this myth that investing is about capital gain. But at the end of the day it should really be about the return that the company can generate in terms of dividends.

"We are starting to see a return to this more pure form of investing."

Among individual stocks, D'Amato recommends billing systems provider Hansen Technologies and Tasmanian financial products business MyState, both of which offer attractive dividends and growth prospects.

Esho likes Qantas Airways, which he believes has been heavily oversold and which, he says, is now worth considerably more than its mid-October market capitalisation of $3.5 billion.

He also recommends office real estate investment trusts such as Commonwealth Property Office Fund and Dexus Property Group, which offer good dividends and are trading at a discount to their valuations.

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