Upturn promises to earn returns

A year of sharemarket volatility has left many stocks undervalued but with big dividends on offer, nows the time to buy, says David Potts.

A year of sharemarket volatility has left many stocks undervalued but with big dividends on offer, nows the time to buy, says David Potts.

Theyre all coming out of the woodwork with grim forecasts for the global economy. World Bank, International Monetary Fund, Joe the barber  but the only prediction worth anything last year was that markets would be volatile, not that it was much practical help, save for feeling good about doing nothing.

Mind you, plenty of experts were tipping the sharemarket would rise, so being put off by predictions of more volatility probably did you a favour.

The market dropped 11 per cent, capping off its worst four years on a rolling average  which is to say comparing each month with its equivalent for the past four years  since the Depression.

So stick to cash, perhaps buy some government bonds since theyre on a roll, stay away from shares because enough is enough and, for a bit of a thrill, maybe buy some gold, which has been a star, and youll be right?

Afraid not. The best you could hope for, especially when you take tax into account, would be to tread water.

OK, so thats better than losing money and I know staying in cash worked a treat last year but funnily enough thats one of the best arguments against doing it again.

Think of it this way. The better something does, and so the dearer it becomes, the closer it comes to the fine line of being overvalued.

Bonds are a great example. The prices of three-year maturities, for example, have been pushed so high youd only get a yield of 3.3 per cent if you bought some tomorrow. Barring a global depression, they cant fall much further and are more likely to rise at some point.

Its the opposite for the sharemarket. Values are depressed and while there are bound to be more bad hair days there must be a bigger risk of missing the upturn  which can happen before you know it  than suffering even more drops.

In fact, things seem to be on the mend. The turning point was around October, just after commodity prices, especially gold, slumped. Typical.

Instead of a wink or a nod to get back in, markets prefer to trick you by veering off the other way just to frighten you.

This is not helped by the contradiction between forward-looking share prices and backward-counting economic statistics.

Anyway, share and commodity markets have picked up since October, some by double digits no less, almost certainly because they think  though could always be wrong, of course  that all the bad news about the global economy is already known.

Even Deloitte Access Economicss Chris Richardson, who refers to the European debt crisis as a potential Eurogeddon, says if the world muddles through this crisis, then Australia will grow faster than many think it will.

The big fear is that as the capital-starved European banks pull in their horns therell be a credit squeeze in Asia as trade finance dries up, which would hurt us badly.

While you cant dismiss it, the worlds central banks are determined to see that doesnt happen. Even the European Central Bank, which has taken a hands-off approach, has relented by offering cheap finance to the banks, which seems to be doing the trick.

The other sign of the tide turning is the rebound in the dollar.

When theres no confidence in the global outlook it drops.

The game plan

So, whats the right strategy for 2012?

Not sitting in cash, unless you know youll need the money in a few months or youre saving for something for starters.

Otherwise youll only be watching your returns fall or, at best, stagnate.

Worse, youll be kicking yourself for missing better opportunities.

Nobody knows when the sharemarket will take off again and its bound to be before an improvement in the economy is obvious, but theres no denying there are good stocks out there paying amazing dividends.

If youre getting a double-digit income from a stock and dont need to sell it in a hurry, it shouldnt matter if the price drops for a while.

Besides, the payouts on some blue-chip stocks are so high, with their 30 per cent tax credit from franking, that even if they cut their dividends by 20 per cent youd still be getting a great yield.

As the accompanying table compiled by Dayton Way Financial shows, these yields start as high as 17 per cent with David Jones.

True, retailers are doing it tough.

But were David Jones to cut its dividend 20 per cent, the yield would still be over 10 per cent. As it would be with a 40 per cent cut.

Compare that with a 5 per cent return on a decent length term deposit  or as little as 2.7 per cent after tax.

Bond rates under 4 per cent are also unattractive. Even though these fixed-interest alternatives provide capital safety, income investors should consider switching into shares for the higher yield, Dayton Way Financial adviser, Tony Lewis, says.

When shares pick up you can cash in the capital gain and put more into bonds and term deposits which, by then, should be paying more.

After all, brokers say the market is under-valued and so there are good buying opportunities  but then they would.

Still, unless Australia is going into a recession theres no doubt the market is unusually cheap.

You can see that most clearly with the listed investment companies, known as LICs, which do nothing but invest in other shares, making them a bit like a managed fund.

Although many of them have been around longer than some of the companies they invest in, theyre trading for less than their share portfolios are worth. The only reason their prices have drifted down so much is because nobody can be bothered.

Milton Corporation, established in 1938, has a share portfolio worth just over $16 a share yet the stock is trading just over $15.

For others the discount blows out to as much as 30 per cent  for 88? Contango Microcap gives you shares worth $1.22.

But you need to be patient because LICs can trade at a discount to their value for a long time for no good reason.

Also undervalued are real estate investment trusts (REITs, once called LPTs) with good yields as a result of trading below the value of their properties.

The difference is their dividends arent franked and rather than the indifference meted out to LICs, the market is persecuting them for having borrowed too much.

But after slashing their debt and selling unprofitable properties, REITs are coming back into favour among fund managers.

Trim the weeds

Already have shares? Then you may need to rebalance. Since some stocks would have risen or fallen by more than the overall market, consider selling the good performers and buying more of the laggards or other stocks going cheap that might have caught your eye.

Then youre taking some profits and setting up other opportunities.

Whatever the market does it will be haphazard and erratic, so when buying it is safer to dollar-cost average, where you spend a fixed amount at regular intervals. The more the price rises the fewer shares you pick up.

That way you wont get caught paying too much at the wrong moment.

Investing internationally is a favourite theme of fund managers who, naturally, have global funds they can offer.

Frankly, the average global share fund has left a lot to be desired over the past decade. But the stars could finally be aligning for them.

Thanks to the debt crisis, European shares, gasp, are going cheap for starters.

And Asian emerging markets have been powering on, even shrugging off the dampener of the stronger dollar on returns.

Indeed some say the dollar is way overvalued, in which case were getting offshore assets cheaply and, at some point when it drops, the returns in the local currency will look huge.

The Australian dollar is now trading around 50 per cent above its fundamental value as characterised by purchasing-power parity measures of value, the director of capital markets at Russell Investment Group, Graham Harman, says. This may well prove to be as good a time for Australian asset owners to deploy some incremental spending power overseas, as it is for Australian tourists.

But whatever you do this year, know thyself when it comes to risk, which boils down to whether youll be able to sleep, and set a time horizon that youre going to stick to.

Oh, and keep your fingers crossed.

Diversification key to stability

DONT fret too much about your super going backwards last year because things are already looking up. Early days yet, its true, but the market has a habit of turning around just when everybody is at their most pessimistic.

And can you remember a January that was as gloomy and I dont mean just the weather?

The trick with super is to stay diversified and stick the course.

Your super fund has a list of investment choices and youre probably in the balanced one that has anywhere between 50 per cent and 70 per cent of your money in sharemarkets.

That should suit most people, most times. Under thirtysomethings should be in a dynamic fund that has more in growth assets such as shares.

Around retirement age you need to switch to a more conservative investment option with, at most, 50 per cent in shares.

Unfortunately, baby boomers hit hard by the 2008 crash who fled the sharemarket face falling interest rates. Having learnt to live with less, theres not much more they can do about it except, perhaps, to diversify whats left.

Keep aside enough cash to cover the next two years of drawdowns but dont think of it as an investment.

Sure it was a good performer last year but the chances are it will let you down this year.

A diversified fixed-income fund, where the manager can flit between bonds, floating-rate notes, preference shares and the like, depending on how yields are moving, would be better than just holding cash. Diversification is the only known way of coping with choppy markets.

The key to lowering the volatility of your investment portfolio is to diversify across and within all asset classes, George Boubouras, head of investment strategy and consulting at UBS Wealth Management, says.

Exposure to cash, domestic and international equities, REITs [real estate investment trusts], government and corporate bonds, and alternative [assets] from a portfolio perspective help lower volatility. Valuations for equities and corporate bonds look compelling in 2012 as the fundamentals support our core view of a recovery.

DIY super funds can use either managed or exchange-traded funds to become more diversified. Exchange-traded funds are low-cost managed funds that trade on the ASX. Theyre the easiest way to invest internationally, though they come with an exchange-rate risk.

The experts dont expect a year of big gains, which is all the more reason to be happy with a reasonable income.

In this market, a much larger part of investors total return is likely to come from income, whether it is dividend income or coupon payments from corporate bonds, Matt Sherwood, head of investment-market research at Perpetual, says.

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