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15 Mar 2012

Stock Selection Key To Future Investment Returns

Many studies have proved that over the long term, listed share markets generally outperform other asset classes. An investment strategy constructed solely around this principle, however, is a dangerous gamble. In fact, investors working from the assumption that broader equity markets will always outperform in the long term run the risk of significant loss of capital.

This is according to Andrew Coultas, an Equity Analyst for Foord Asset Management who says that the past three decades have been characterised by unprecedented world economic growth - this growth has supported a positive earnings trajectory for many companies. In addition, equity markets have been collectively buoyed by falling inflation, falling interest rates and higher P/E multiples (a measure of how much investors are prepared to pay for a future stream of earnings). “They say that a rising tide lifts all ships. Similarly, most listed shares benefitted from these effects.”

“However, the past does not easily extrapolate into the future, which is intrinsically uncertain,” warns Coultas.  “Looking forward, there is a low probability of the previous decades’ earnings trend repeating itself across the broader equity market. Lower world economic growth, financial turmoil in Europe and rising commodity costs are some of the headwinds faced by companies.”

That is not to say that equities as an asset class are a poor investment.  Rather, it is apparent that not all shares will deliver similar returns. “In the future paradigm, there will be clear winners and losers. The market will ultimately reward companies that deliver on their strategies and objectives and penalise those that fail to do so. Stock picking – successfully picking the winners while avoiding the losers – will be the strategy that delivers the best returns.”

Stock picking will be the strategy that delivers the best returns.

Government bond yields are currently at historic lows. After the US housing bubble burst in 2008, the US mortgage agency debt market is quite rightfully no longer considered safe. The European crisis has stripped all of the periphery’s sovereign debt of their previous status as a safe haven. As a result, there is a shortage of traditionally “safe” assets as an alternative to government bonds of AAA rated governments.  “The result,” says Coultas, “has been a flight to safety into the bond markets of the world’s largest economies. Compounded with massive injections of liquidity by central banks, the consequence has been that yields on US treasuries have fallen to all-time lows.”

“Normally, low bond yields imply a benign inflationary outlook. In the current environment, however, they point to an imbalance between supply and demand. As a result, the risk of inflation cannot be ignored despite what the bond yields seem to be indicating. In the near term, inflationary pressures are being driven by input cost pressures, with specific reference to those linked to commodities. Investing into the bond and cash markets thus also comes with a significant risk of loss of real capital.”

So what is the best investment strategy when the broader equity, bond and cash markets all carry material risk of loss in real terms?  In Foord’s view, the strategy to negotiating the current environment lies in building portfolios that have an equity bias to protect against rising inflation, but most importantly, the equity component of the portfolio has to be carefully selected. “In this environment, stock selection is critical to achieving inflation beating returns. A strategy of simply buying the market as a whole is unlikely to achieve this goal.”

“Shares that are attractively priced and that exhibit a growing dividend stream are very important in our equity selection criteria,” advises Coultas. “We look for quality companies with pricing power that will provide a hedge against inflation. Investing in quality companies at reasonable valuations with a margin of safety reduces the downside risk.  A growing dividend provides a stream of income for reinvestment.”

“Many multinational companies have very strong balance sheets and stable, sustainable cash flows to support their dividend yields. With pricing power, earnings growth potential and dividend yields superior to the 10 year US Treasury note, certain equities remain an attractive proposition. The key is picking the right ones,” concludes Coultas.

Ends

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