Upside of volatility

Forget trying to pick the bottom of the market. While the recent rally in share prices has given investors hope that last year's horrors are behind us, no one knows whether 2012 will bring another downturn, continued recovery, or just muddle through.

Shares are not at absolute bargain basement levels but analysts say dividend yields are still high enough to entice more defensive investors, while more bullish buyers should be selectively buying undervalued stocks to position themselves for recovery.

It takes nerve but the best time to buy is when you least feel like it, according to the portfolio manager for Australian equities at Fidelity Worldwide Investment, Kate Howitt. As the chief executive of Lincoln Indicators, Elio D'Amato, points out, this means "going against every gut instinct that tells you to be wary" but while you can't control what is happening in Europe, he says you can control the price you're paying for shares and your potential to make money over the longer term.

D'Amato says this is a good market for both defensive and more bullish investors. Defensive, because the market is still offering fully franked yields well in excess of what you can get from term deposits growth because just as all stocks go up in a boom, share prices of quality companies were trashed in the downturn despite many making more money now than in 2007.

The head of investment strategy and consulting at UBS, George Boubouras, believes shares are good buying for a three-year time frame but warns there will still be volatility and individual stock disappointments, especially in the current reporting season. He believes this year's opportunities lie in many of the "detractors" from 2011 - stocks such as BHP, Rio Tinto and Woodside.

He says income-oriented investors can generate a yield, before franking credits, of about 7.5 per cent.

The chief market strategist at CMC Markets, Michael McCarthy, says one of the beauties of these conditions is that some of the best businesses in the country are selling at similar prices to small companies, so investors don't have to take on extra risk.

"There is a huge argument for large-cap quality businesses," he says. "BHP, for example, is still down 24 per cent from last year's peak but it is still making record sales and profits. It's biggest problem is what to do with all the cash it's generating."

Howitt says stocks such as Rio, which was sold off during the global financial crisis because of its balance sheet problems, will be profitable even if the Chinese economy slows or there is a fall in commodity prices.

The senior portfolio manager for van Eyk, Otto Rieth, says while the "expensive defensives" were trading off a forward price-to-earnings ratio of 13.97 in late January, cyclicals were trading on 11.92 - a disparity unlikely to be maintained. But investors will need to be selective.

Howitt warns defensive investors should ensure dividends are sustainable and Reith says investors need to look for companies with strong balance sheets to avoid "value traps".

Roger Montgomery, the founder of Montgomery Investment Management, says: "[On our analysis] only 25 companies are trading at a discount to their intrinsic value.

"The only defensive investment is a great quality company that's cheap."

Note: The writer has shares in BHP, NAB, Woodside, CBA, Telstra, Tabcorp, Transurban and Woolworths.

Top share picks

DEFENSIVE

Lincoln Indicators: CBA, ANZ, Telstra, Hansen Technologies, MyState, Fleetwood Corp.

UBS: CBA, Westpac, NAB, Duet, Metcash, Spark Infrastructure, Tabcorp, Telstra, Tatts Group, Westfield Retail Trust.

Fidelity: Sydney Airport, Telstra.

CMC Markets: ANZ, Wesfarmers.

RECOVERY

Lincoln Indicators: Forge Group, Decmil, Industrea. Telcos such as iiNet, TPG.

UBS: AMP, BHP, CBA, NAB, Origin, Rio Tinto, Transurban, Telstra, Woolworths, Woodside, WorleyParsons.

Fidelity: Wesfarmers, Rio Tinto, Iluka Resources.

CMC Markets: Woodside, ERA, gold stocks.

Montgomery: Seymour White, Medusa Mining, Breville Group, Codan, Maca, Global Construction Services.