Irealise I run the risk of sounding like a broken record, but I’m growing more and more concerned that private investors are facing a very difficult five to 10-year investment horizon.
I’d love to cheer you all up by saying that the west will power out of a severe global recession and the recent equity surge will carry on relentlessly, pushing the FTSE back up to 6,000. It’s just that I don’t believe it. I’m preparing for really big spikes in volatility over the next few years as stock markets surge and then fall back sharply, all within a fairly long-term, narrow trading range.
Various strategies have been put forward for dealing with this volatile environment. Absolute return funds have been at the top of the list. However, with a few honourable exceptions, I think they are a marketing sham – with long-only fund managers being presented as born-again traders/speculators. Maybe they can make money going long and short sequentially on markets – but if I had to put any of my money on this kind of speculative approach, it would be with hedge fund managers who’ve spent years mastering the discipline of timing markets. Sadly, very few of their funds are available to private investors – and those that are either structure themselves as open-ended investment companies (Oeics) with a stack of charges or trade on the stock market at a massive discount to their net asset value.
I think a different strategy is worth considering: stock screening. Screening involves doing a computerised search of equity markets, looking for shares that are undervalued on key fundamentals. You can try it on the FT website at http://markets.ft.com/screener/customScreen.asp
In particular, I favour three simple strategies.
● Progressive dividend heroes. Search for FTSE 350 companies that can afford to pay decent dividend, well covered by earnings, which has been increasing for the last five to 10 years. If you go to my online Adventurous Diary next week, I’ll put up a big spreadsheet of my current watch list – but please note that this will only be a list of companies that warrant further research.
● Quality companies. Search for big blue chips with solid operating businesses in reliable sectors, churning out cash flow, and paying decent dividends.
● Good stuff that looks cheap to private equity buyers. Search for companies with quality franchises that are churning out cash, and look reasonably priced on fundamental valuations. At the moment, the big private equity houses are a little troubled but, sooner or later, they’ll look to buy listed companies again.
Of course, this stock screening approach requires a good understanding of valuation metrics, a personal computer and a stack load of effort. Saddo types, like yours truly, actually enjoy the thrill of screening the market in this way.
But it’s a lot easier to get someone else to do it for you. That usually means buying a fund run by an active fund manager. In my book, though, I’d rather pay less for the managerial genius and invest in an index that holds a basket of carefully-chosen stocks. Ideally, I would do so via a listed security that simply tracks an index built around a sensible screening system, based on the long-term research insights of analysts such as Andrew Lapthorne at SG or Graham Secker, in-house strategist at Morgan Stanley.
Thankfully, Morgan Stanley is now offering exactly that. It is launching a series of listed certificates and Oeic funds that track strategies built around simple research ideas. Two in particular stand out: Graham Secker’s Target Equity index family and the Value Driven Alpha approach.
Secker’s indices track companies that could be attractive to private equity buyers or trade buyers based on free cashflow, asset backing, earnings before interest and tax (Ebit) and dividend yield.
Valued Driven Alpha looks for companies that pass a test for both quality and value, utilising measures such as return on equity and Joseph Piotroski’s “F score” of a company’s strength.
Both approaches are transparent and easy to understand. I’d humbly suggest that using this kind of screening methodology might be the only way to build a core portfolio of UK stocks over the next decade. I’ll post more details about both strategies in my online Adventurous Diary next week.
adventurous@ft.com
