5 steps to combat volatility

First up, what’s going on?

The market has been volatile of late and it might be that equities are the tail being wagged by the global currency dog. The question is, does this provide a buying opportunity for stocks that have been sold off?

Since the start of September (at the time of writing) the Australian dollar has declined 6.4 per cent from about US$0.94 to US$0.88, while the ASX All Ordinaries Index has fallen by 8.8 per cent.

The stock market’s volatility comes in anticipation of rising interest rates in the United States and the unwinding of the carry trade, where investors had borrowed a currency where interest rates are low, such as the US dollar, and bought a higher yielding currency, such as the Australian dollar. Under the Radar’s portfolio manager The Idle Speculator sums up the situation: “It’s a very crowded door and there’s only one way back (selling Australian dollars). The effect of the anticipated volatility is to increase volatility as investors exit their positions. Volatility feeds on itself.”

There are also definite signs to be nervous about on the domestic front, such as inflated residential property prices and a stagnant domestic economy, summed up by an unemployment rate that continues to hover above 6 per cent.

Even after the falls, equities around the world are vulnerable to a wider rout because they are liquid, being an easy way to raise money without incurring big costs. In the financial crisis, among the financial instruments, they were one of the only ways left to access cash, hence they got negatively impacted. The ASX All Ordinaries was sold down 55 per cent between mid-2007 and mid-2008 from 6873 points to 3090. This certainly puts its recent rout of just under 9 per cent in the past month or so in perspective. The AOI now sits at about 5173, some 73 per cent above its level in mid-2008.

With this in mind we have five steps you should follow with your portfolio.

Step 1. Don’t Panic

As the Idle Speculator says, Keep Calm. In conditions like this where volatility is high and investors are hitting the sell button, one factor to consider is not only what to buy, but also what you should hold on to. The stocks that will ride out the volatility the best are those whose business models can stand up to any environment.

Just look at Sirtex Medical (SRX), which is producing a fast selling medical device that is used to treat cancer. Its SIR-Spheres product which injects radiation into tumours could well move from being a third line treatment for cancer, to one which is the first port of call for oncologists.

We are tipping companies which we think have business models which can be as resilient as Sirtex’s. Obviously we hope that they can also quadruple in value like Sirtex’s stock has since we first tipped it in mid-2012.

Step 2: Look for value at the smaller end

The Idle Speculator has been a bear for the past six months, having been an active seller. At current levels he believes that it is time to step in and look to buy companies at the smaller end because this market has seen weakness since April.

Moreover, we believe that there continues to be very good opportunities at the smaller end of the stock market because despite the macro-economic risks which have led to the recent sell-off, we don’t think that the conditions exist that will lead to an Armageddon type situation aka the financial crisis. Certainly, corporate debt has been wound back, and asset prices will continue to climb so long as interest rates remain low.

Under the Radar’s universe of almost 2000 companies is so big that there are buying opportunities in the form of companies that have already fallen on rough times and have experienced big share price declines. Because much of the bad news is priced in, any positive news can deliver big returns. A good example has been the regional media company APN News (APN). When we tipped it in mid-2012, it seemed friendless, trading on a PE of about 5 times which suggested it was going broke. Fast forward to today and its stock has more than tripled.

Step 3: Don’t jump in and go on a buying spree

There could be more weakness in the share market. Asset prices are still fragile, so we would not rule out the possibility that there might be a price crash in the large caps around the world. The problem is still that many blue chip prices could fall by 10 per cent or 15 per cent or more, and still not appear cheap. The assets would simply not be as expensive. It’s also true that there is an absence of any alternatives to buy. It is difficult to identify a trigger that would trigger a 10 per cent plus fall in big caps from here. It is also still true that there are few alternatives to buy instead, so it is difficult to identify a trigger for such an event.

Step 4: Maintain discipline

If you do decide to buy, use the small steps principle and average in. Achieve your desired weighting over a number of weeks, or even months.

Step 5: Carry On Investing

Don’t be afraid of volatility. It is actually an investor’s friend because it allows you to profit from other investors’ distress. As an investor you want to act, not react, which is why we always encourage subscribers to maintain a healthy cash balance in the good times, allowing the flexibility to take advantage of times like this.