Published in Brian Gaynor’s NZ Herald Articles on 23 Jun 2012
It is a difficult time for investors as they face record low interest rates, volatile sharemarkets and a plethora of negative news, particularly from Europe.
What is the best investment strategy in this environment? Is it bank deposits, fixed-interest securities, the sharemarket, residential property or other asset classes?
The past 40 years can be divided into three distinct periods:
* Between 1972 and 1982 the world economy suffered under rising oil prices, anaemic economic growth and flat or negative sharemarkets. The Dow Jones industrial average went from over 1000 at the end of 1972 to 770 in mid-1982.
* The 1982 to 2007 period was marked by a huge increase in global debt, strong world-wide growth and buoyant sharemarkets interspersed by short, sharp downturns. The Down Jones index went from 770 in mid-1982 to 14,280 at the end of 2007.
* The post-2007 period has been similar to the 1972 to 1982 years, but this time it is the excessive debt, rather than rising oil prices, that is spooking investors and the global economy.
The Dow Jones is at 12,570 and present conditions are expected to continue for several years.
The present situation is not as bad as it seems for equity investors because we are now in a stock pickers market and investors can generate high returns as long as they choose the best performing companies.
A research paper by Robert Hagstrom, a portfolio manager at Legg Mason Capital Management in Baltimore, supports this.
Hagstrom looked at the US sharemarket between October 1975 and August 1982 when the Dow Jones industrial average started and finished at 784. He found that over this period Warren Buffett’s Berkshire Hathaway achieved total investment returns of 676 per cent and Bill Ruane’s famous Sequoia Fund achieved 415 per cent.
Legg Mason looked at the performance of the 500 largest US listed companies between 1975 and 1982 and found that, on average, 16 of the 500 stocks doubled in any one year.
The research also revealed that, on average, the sharemarket returns of an amazing 38 per cent of stocks appreciated by 100 per cent or more over any five-year period between 1975 and 1982.
Thus, 190 of the 500 companies achieved investment returns above 100 per cent over these five years.
Hagstrom concluded that investors who focused on the Dow Jones index between 1975 and 1982 would have concluded that the market had moved sideways “when in fact the variation was dramatic and led to plenty of opportunities to earn high excess returns”.
It is important to note that Hagstrom believes high returns can be achieved through superior stock selection in sideways markets, rather than through trading.
He had this to say about trading: “The idea of buying a stock that is quickly going up and then selling it before it rolls over is intellectually appealing but incredibly difficult to employ successfully. Only a very small percentage of people are able to do it profitably.”
John Littlewood’s book The Stock Market looks at the UK market between mid-1970 and mid-1979. The FTSE all-share index started this period at 115 and finished at 116 yet Littlewood says investors had plenty of opportunities to achieve excellent returns during these nine years.
The New Zealand sharemarket had a similar situation in the 1970s. The NZX50 capital index went from 405 in mid-1973 to 357 at the beginning of 1980 yet there were fantastic individual stock performances over this period.
These included Alex Harvey Industries, Arthur Yates, Brierley Investments, Bruce Judge’s Bunting & Co, Cable Price Downer, Carter Holt, Ceramco, Challenge Corporation, Dalgety, Donaghys, Feltex, Fletcher Holdings, Freightways, Goodman Group, Healing Industries, L.D. Nathan, Marac, Montana Wines, NZ Farmers’ Fertilizer, Progressive Enterprises, Rothmans, TNL, Wattie, Wilson Neill, Winstone and the radio companies.
This list is deliberately long to show there can be some fantastic sharemarket opportunities even when indices, which reflect market averages, go sideways or fall.
Investors with diversified share portfolios can perform better in a sideways market than a long-term bull market, as occurred between 1982 and 2007. This is because sharp corrections in long-term bull markets usually occur when individuals are highly leveraged and overinvested.
Investors are often happier in sideways markets because they are less volatile than the long-term bull ones.
For example, New Zealand sharemarket investors were happier at the beginning of 1980, even though the benchmark index had fallen from 405 to 357 over the preceding seven years, than they were at the end of 2007 when the same index exceeded 3200.
This is because the 1980 to 2007 period was far too volatile for most investors, even though the index increased nine-fold.
It is no coincidence that investors rushed into residential property during one of the great equity bull markets because it gave some relief from the extreme market volatility.
Thus the message for individuals in the present environment is that they should have a well-diversified investment portfolio containing cash, fixed-interest securities, shares and low-geared property.
With this in mind, Australasian markets offer good opportunities because of tax advantages, high interest rates compared with the rest of the world and listed companies with high dividend yields.
There are interesting prospects in the secondary bond market, particularly for securities not rated by one of the main rating agencies.
But investors should obtain qualified advice – or use professional investment managers – before they enter this market because these bonds are complex in terms of maturities, interest-rate variations and security.
Although capital preservation should be most investors’ main objective, they should also have some risk assets, mainly shares, to increase the value of their portfolio in real terms.
A recent survey by London’s Financial Times showed that the average balanced British portfolio had 56 per cent in shares.
The risk asset allocation can be lower for New Zealand investors because of the country’s relatively higher cash and bond yields.
But there is a strong case for equities because some companies will do very well in the low-growth economic environment – Trade Me and Ryman Healthcare being recent examples of this.
Investors should also obtain professional advice, or use an investment manager, because there is likely to be a big difference between the best- and worst-performing shares in the years ahead.
There is also a strong argument to switch from passive to active funds. Passive funds were popular in the 1982 to 2007 bull market, but individual stock selection will become much more important, and passive funds do not offer this option.
Finally, residential property has become increasingly risky because of the sharp increase in prices between 1982 and 2007, the collapse of many Northern Hemisphere housing markets and tighter credit conditions.
New Zealand investors, on average, should reduce their exposure to this asset class.
The best option is to establish a diversified investment strategy based on the premise that the next few years will be more similar to the 1972 to 1982 period than 1982 to 2007.
Once that strategy has been established it is important to avoid the distraction of daily news from Europe and other troubled areas.
Investment markets will survive the economic uncertainties as they survived the oil crisis 40 years ago.