Profit from volatility - Eureka Report article
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:
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:
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:
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:
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.
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.