Profit from volatility

PORTFOLIO POINT: Monitoring company fundamentals means investor can buy shares when they are below their real value, and sell when they overshoot.

It’s volatile out there. That won’t surprise too many investors, given the events of the past three years, although there is evidence that the increase in volatility might be something that investors have to think further about.

In a recent paper entitled Patience and Finance, the Bank of England’s executive director of financial stability, Andrew Haldane, discussed volatility in the sharemarket. His conclusion is that the price of shares vary more than the underlying fundamentals of the companies, such as their earnings or dividends.

This conclusion is interesting for investors. How should we react if we are investing in shares and the price of shares that we own vary more than the underlying fundamentals? Some suggested strategies might include:

• Keeping enough cash in reserve to take advantage of opportunities to buy shares when their price is lower than it should be.
• Rebalancing our portfolio when share prices are high, to ensure we are taking profits when the opportunity presents.
• Keeping an eye on the fundamentals of our investment assets, not just the value (price) of our portfolio.

Haldane directly compares the difference between share price movements and movements in the fundamentals of the underlying companies (eg, earnings or dividends) to see the extent to which these movements vary over different periods of time. The fundamentals of companies include their earnings and the cash dividends paid to investors.

As an example of fundamentals differing from share prices, it is worth thinking about what has happened to share prices in the past three years – falling roughly 55% from their late 2007 highs and then increasing in value by almost 50% since then – a far greater fall and recovery than what was seen in company earnings and dividends.

However, this is not the end of the story. Haldane then considers the increased number of “momentum” (short-term) traders, suggesting they force share prices to deviate more persistently that before from fundamentals. He presents evidence that suggests that:

• Over the past 100 years, US share prices have been three times more volatile that the underlying company fundamentals.
• Over the past 20 years, US share prices have been six to 10 times more volatile than underlying company fundamentals.

Haldane’s underlying argument has been made elsewhere: the authors of the Credit Suisse Global Investment Returns Yearbook also note the tendency of sharemarkets to overreact.

The next question is: if there is an increasing tendency for sharemarkets to be more volatile than fundamentals, what does this mean for sharemarket investors?

I suggest there are three key items investors should be thinking about:

• Ensuring they hold enough cash to take advantage of opportunities that present if sharemarkets fall further than company fundamentals.
• Be disciplined in rebalancing portfolios after strong periods of sharemarket returns, to take advantage of share prices increasing beyond company fundamentals.
• Be more sophisticated in the way we measure our portfolios, keeping an eye on measuring more than just the price of our share holdings.

It is the third of these suggestions that I want to explore further.

At the moment, by far the most reported number around any share portfolio is its value. However, if the hypothesis that sharemarket prices are more volatile than fundamentals is true, perhaps we should be looking at other ways of measuring portfolios, based more on fundamentals such as the earnings or dividends of companies owned.

For example, let's consider the two biggest companies in the market: BHP Billiton and Commonwealth Bank. Let's assume that a person has $50,000 (at current prices) invested in each of these companies.

The consensus forecast for CommBank earnings for 2010-11 is $4.27 a share and the forecast dividend about $3.10 a share. For BHP, earnings for 2010-11 are forecast to be $3.50 a share, with a forecast dividend of about $1 a share. These consensus forecasts for company earnings and dividends are usually not difficult to find: most online and full-service broking firms now offer them as part of their research service.

Assuming that this $100,000 represented our whole investment portfolio, we could see that owning BHP and CommBank entitled us to forecast earnings of $8545 and dividends of $4227 (plus franking credits valued at just over $1800). This gives us three measures of our portfolio:

• The value of the shares.
• The value of the company earnings.
• The value of the company dividends.

Investors who use ETFs, index funds or broadly diversified LICs such as AFIC or Argo can calculate the earnings and dividends based on the market average. Currently most reports suggest the market is on a price/earnings (P/E) multiple of about 14 (although this figure varies somewhat from source to source), which implies an earnings yield of 7.15%. The earnings yield is calculated as 1 ÷ P/E. This suggests that for a $50,000 investment in an Australian share ETF or index fund, the company earnings would be about $3580. Assuming a market average dividend yield of 4.2%, this leads to a dividend of $2100, plus franking credits.

I am sure that many investors track the earnings and dividends of the companies that they own. My suggestion is that if you accept we are in an environment where share prices are becoming increasingly more volatile than underlying company fundamentals, then these measures become more important. Indeed, there is no reason why investment managers (fund managers, LIC managers, superannuation funds) could not provide this data on portfolios for investors, as well as reporting the value of a portfolio the underlying earnings and income could be easily reported to investors.

-Forecast earnings and dividends per share, top 20 companies
Company	2011 forecast earnings	2012 forecast earnings	2011 forecast dividends	2012 forecast dividends
BHP Billiton	$3.52	$3.87	$0.97	$1.09
Commonwealth (CBA)	$4.31	$4.62	$3.17	$3.40
Westpac (WBC)	$1.96	$2.07	$1.34	$1.43
ANZ	$1.89	$2.10	$1.15	$1.35
National Bank (NAB)	$2.05	$2.40	$1.49	$1.62
Wesfarmers (WES)	$1.97	$2.31	$1.53	$1.77
Woolworths (WOW)	$1.82	$1.98	$1.26	$1.37
Rio Tinto (RIO)	$6.85	$7.56	$1.02	$130
Telstra (TLS)	$0.27	$0.27	$0.28	$0.28
Westfield (WDC)	$0.90	$0.92	$0.64	$0.66
Woodside (WPL)	$2.17	$2.55	$1.28	$1.19
Newcrest (NCM)	$1.57	$1.56	$0.23	$0.27
QBE	$1.60	$1.76	$1.30	$1.32
CSL	$1.90	$2.17	$0.85	$0.95
Origin (ORG)	$0.82	$0.91	$0.51	$0.53
Macquarie (MQG)	$3.05	$3.95	$1.86	$2.25
Fosters (FGL)	$0.40	$0.41	$0.28	$0.30
Suncorp (SUN)	$0.77	$0.90	$0.46	$0.54
AMP	$0.39	$0.43	$0.30	$0.34
Santos (STO)	$0.46	$0.51	$0.44	$0.46
Companies that have a December balance date (eg Rio Tinto, Westfield, Westpac, ANZ, Woodside, Santos) have forecasts for calendar 2010 and 2011.
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NB: These are simply forecasts, from which actual earnings and dividends are likely to vary – perhaps significantly.

Conclusion

The theme of increased volatility in investment markets is not a new one. If you agree with the premise that it is a reality, the next challenge as an investor is to think about how you will react to this increased volatility. Keeping an eye on the fundamentals of the investments you own might give you a more rational outlook on the value of the companies that you own, while keeping some cash aside might allow you to benefit when the price of shares fall beyond what is reasonable.

Scott Francis is an independent financial adviser, based in Brisbane.