Getting An Edge On The Sharemarket
From the minute you invest in shares the sharemarket will largely drive your returns
. If the sharemarket falls or rises, your investment portfolio will move in the same direction.
In the wake of the recession and global financial crisis, our sharemarket fell 41% from October 2007 to March 2009. Over 94% of NZ stocks went down over this period and things weren't any better overseas as 90% of global markets also fell. That's a very strong tide to swim against.
Since March the reverse has happened. Our sharemarket has rebounded by 30% and most other international markets have risen by a similar, or larger, amount.
Given the indisputably dominant role the "market" has on returns, some investors choose not to bother with stockpicking at all and simply seek to track the market by investing in broad, low-cost, index funds.
Their returns will simply follow the market, less the index fund fees and any tracking error. And there are an increasing number of good index funds with very low fees, of 0.25 per cent a year or less, becoming available.
Be warned though that while this passive approach is theoretically and academically "pure", in practical terms, it can dish out a rough ride at times. You need to be willing to track the market all the way up in good times, AND all the way down during tough times.
The alternative to a passive approach is an active approach where you put together a diverse portfolio of stocks that are handpicked for their quality and dividend profile.
A portfolio like this may edge ahead of the sharemarket over time. Whether it will indeed beat the market or not will depend on how well the stocks perform.
There is much research that shows that your odds of beating the sharemarket improve if your portfolio"s focus on high quality companies that pay dividends, as stocks with these characteristics tend to deliver better returns than the market.
Two recent research notes from the US provide empirical evidence showing that a portfolio made up of high quality stocks that provide sustainable dividends has outperformed the market.
In his latest quarterly report, Jeremy Grantham, chairman of US fund manager GMO included a chart that showed the significant outperformance of quality stocks over the market since 1965. He headed the chart with the title "The One Free Lunch", which we thought was a gutsy sort of heading - he must be confident of the data.
So, what's quality? A quality stock tends to be big, have a clear and defendable market position, have strong leadership, a strong balance sheet, generate strong cashflow and have a track record of dividend and earnings growth.
Another interesting recent report we have come across lately, this one from US fund manager Tweedy, Browne Fund Inc, brings together a series of studies and empirical data that prove that stocks that pay sustainable dividends (a "sustainable" dividend is one that is delivered via a prudent payout ratio) also, on average, deliver higher returns than the market over the longer term.
A share portfolio made of up of higher quality companies that pay dividends should also be less volatile than the market during tough times, and should also generate more income, and income-growth than the market.
To be very clear, this approach is not a silver bullet. There will still inevitably be problem stocks, and the market will continue to heavily influence the portfolio"s performance. But a portfolio modelled on this framework should, over time, deliver incremental outperformance over the market.
Even small gains make a big difference over the long haul. If the sharemarket returns 8%pa over the next 30 years and you can eek out another 2% a year, your share portfolio"s total return, come 2040, will be almost double that of the market, and of a passive portfolio.
by: Cam Watson
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