Investment health check

As with domestic equities, international investing in the current market requires a different approach to that which worked during the bull market. Nervous investors who are still cashed up should consider prioritising a return to their investment strategy — and managing risk through diversification, value and stability rather than by sitting on the sidelines.

The challenge we face in the immediate future is to generate higher returns in a low return environment. World growth is likely to remain below trend for some years yet, and it is prudent in the short term to assume we will be in a low return environment — albeit one with high volatility.

But these factors should not be regarded purely as risk considerations. Low market returns and high volatility also provide investors with some unusual opportunities.

Things have changed since the general bull market that lifted most stocks. The possibility that a large, profitable company could go broke wasn’t really a consideration.

Investors now need to seek value in their stock selection rather than relying on market growth. Arguably, these rules apply for international shares even more than they do for domestic shares. Internationally there are considerations such as a wider choice of industry sectors, larger equity markets, and geographic and national economic factors.

Let us look at some of the factors involved, focusing on those that influence selection of a particular company, industry sector considerations and current national and geographic issues.

Geographic and national risk

Perhaps the main danger for investors at the moment is what will happen when governments and central banks stop pumping large fiscal and monetary stimuli into their economies. While these measures are working, and the benefits are now being experienced, they will eventually stop. Before this happens, the corporate sector must rediscover its risk appetite to avoid another downward spiral.

Whether this will happen is still uncertain. Many companies have had to make significant changes to the way they operate in order to survive. Prior to the downturn, the trend was for companies to take more out of the economy than they put back — they were ‘over-earning’ and had very high earnings bases. Many of the problems that led to the financial crisis can be put down to mismanagement brought about by overemphasis on the short term.

Another risk that investors must now consider is that of deflation, and a sustained fall in prices below zero per cent inflation. Deflationary forces are driven by contracting credit, global oversupply, record unemployment, and the contraction of the private sector, and are likely to affect some countries and economies more than others.

The main danger is that a deflationary spiral is created in which consumers delay purchases to take advantage of falling prices, manufacturing is reduced because of lower demand and investment stalls, leading to further falls in demand. The worldwide stimulus packages should help reduce the risk of this happening, but the threat shouldn’t be ignored.

While deflation is a short-term problem, inflation is a long-term risk to some of these economies, especially those with excessively lax monetary conditions.

Investors must carefully consider these aspects. Companies likely to be badly affected by either extreme should be avoided.

Stock selection

A healthy company in today’s investment climate is one that combines stable earnings with a historically low valuation and has a convincing long-term strategy.

Indeed, the difference between good and bad companies is not how far they have fallen, but how much they can recover.

There are companies that tick all these boxes and, if they can be found, they are excellent investments and will add short and long-term value to a portfolio, as well as diversification.

Trading techniques

When such opportunities in the current market are identified, the return can be enhanced with the use of options. For example, selling put options to gain exposure lowers the cost price and also generates income from the cash premium received. The sale of put options entails the receipt of this cash premium in return for the obligation to purchase the security at a specific price.

Such an approach allows investors to reduce downside risk while still accessing upside potential.

Case study

McDonald’s is a good example of what currently makes a company a good investment in its own right. And, as in the accompanying chart, it is also a good example of the benefits of purchasing via a put option-based strategy.

McDonald’s is benefiting from the current trend of ‘consumer trade-down’, allowing its share price to withstand the weak market conditions better than most. However, it also has fundamental strengths that give it a good medium- to long-term outlook. These strengths include increasing franchise revenues (ie, it is less capital intensive as a business) and a high return on equity, with solid cash flow generation and a sound balance sheet.

If the put option is not exercised, the return is limited to the option premium, in this case $1.90 per share, and the 23 per cent annualised return.

We believe McDonald’s can provide a double digit return that is not dependent on a rising share price, but can be achieved by the manner in which it is bought. This makes its current share price, which is at the lower end of its historic range, very attractive. The same cannot be said for all US blue chips.

Industry sectors

In addition to specific stock selection, some industry sectors offer better opportunities than others, particularly in the current circumstances.

There are not only more sectors in international investing compared to Australian investing, but they include companies with very diversified activities, and which are larger in their own right than counterpart industry sectors on the Australian Securities Exchange.

Most domestic investors would have read about, and experienced first hand, issues to do with petrol pricing. We feel positive about investing in the oil sector, and oil-related companies now comprise 30 per cent of our international fund’s portfolio.

In this we are still diversified with exposure across nine companies, taking into account refiners and drillers, as well as mature and high-growth producers.

We see the present global situation as being friendly to established companies. Current low oil prices and the credit crisis reduce incentives to explore, and there is reduced availability of finance for new projects.

As a result, there is an absence of large projects, offering a built-in market protection to established oil producers.

Overall, fund managers must find ways to achieve higher returns in a volatile but low-performing environment. The upside is that there are significant opportunities available to those that can find and take full advantage of them.

Chad Padowitz is chief investment officer at Wingate Asset Management, a joint venture with Australian Unity Investments.