Surviving volatile markets

Six years ago, Stephanie Holmes-Winton, a Halifax-based author and financial adviser, developed a test to help her clients figure out just how much risk they are willing to take on.

“I put a paper bag in the middle of the table,” she says. “Then I ask them, if they gave me $100,000 last year, and it’s $90,000 today, would they need the bag?” For what, they always ask. “To vomit in,” she tells them. The line of questioning continues. What if the assets drop to $80,000, or $70,000? Do they need the bag now? “This tells me how much volatility a person can handle before they freak out,” she explains with a chuckle.

It’s clear from the market crash in 2008 and the wild stock market swings we saw in August that most people reach for that paper bag quicker than they might have expected. If the experts warn against anything, though, it’s dumping stocks in a panic. A volatile market offers investors a chance to beef up their portfolio with new, often discounted investments. But what to buy depends on what type of investor you are: conservative, middle-of-the-road or aggressive. Take the paper bag test, determine what style of investor you are and then you’ll know where to put your money.

Conservative

For the majority of investors nearing or past the end of their working lives, preserving capital is the main objective in shaky markets, says Michael Sprung, president of Toronto-based Sprung & Co. Investment Counsel. To do that, investors should hold their investments for the long term and be prepared to ride out business cycles. But you’ll still want to adjust your portfolio to either take advantage of the depressed market or to protect your wealth. Start with buying more fixed income and keeping 5% to 10% of assets in cash. “You want to have some funds ready to invest should an opportunity arise,” Sprung explains. A conservative portfolio today, says Sprung, should have a 55% allocation to fixed income, 40% to stocks and 5% in cash.

Investors should look to short-term bonds, three years or under. You won’t earn much—yield on a three-year government bond is a little more than 1%—but if interest rates rise, and bond prices fall, your capital won’t shrink. Michael White, a vice-president and portfolio manager with AGF Investments, suggests investors stick to low-yielding but safe government bonds. But, says Gareth Watson, vice-president of investment management and research at Toronto’s Richardson GMP, even conservative investors need some yield. Look at corporate bonds for that extra income.

There are plenty of highly rated corporates that conservative investors can choose from. Many have a AA rating, but four non-financial American companies—Microsoft, Exxon Mobil, Johnson & Johnson and Automatic Data Processing—have the coveted AAA stamp from Standard & Poor’s. Corporate debt is, generally, riskier than government bonds, hence the higher yield, but according to Moody’s these bonds are at a 2% risk of default, far below the double-digit risk during the recession. Purchasing individual bonds is difficult for retail investors—they’re expensive and hard to come by—so experts recommend buying bond funds, including both managed and exchange-traded funds (ETFs).

On the equities side, conservative investors need to play it safe. Hold blue-chip, dividend-paying companies in defensive sectors. “The more conservative you are, the more defensive you’ll be,” says Watson. Blue-chip stocks mean large companies that grow slowly but, because they’re so big and often have exposure to growing emerging markets, they aren’t hit as badly during downturns. Between April 2006 and the end of 2008 U.S. small-cap stocks lost 32% of their value, compared to 24% for large caps. Investors want dividends because even if the market falls, the company payouts can keep a portfolio growing. Dividend payments are also a good indication of a company’s strength, especially if those dividends increase every year. The additional cash will make up for low bond yields.

When choosing sectors, buy assets in defensive, non-cyclical sectors such as telecommunications, consumer staples, utilities and, in the U.S., health care. These are sectors that have products or services people will buy in any economic climate. Businesses like Coca-Cola, Home Depot or Kraft are attractive, says John Pitfield, vice-president at Toronto’s Jones Collombin Investment.

If you’d rather buy ETFs, stick to ones that track Canadian or U.S. indexes, or a global ETF that holds numerous companies around the world. “The basic ETF is a good tool,” says Pitfield. Buy some gold, too. It does well when the economy sours, so it can be used as a hedge, but it’s volatile—its soaring price is largely driven by sentiment—so make it no more than 5% of your portfolio.

When buying companies, Sprung advises people to make sure they’re buying businesses with clean balance sheets, specifically a low debt-to-equity ratio the less debt the better. Also, the firm should still be earning money; dividends need to be covered. Try to find companies with lower price-to-earnings and price-to-book ratios. Regular dividend growth – preferably on an annual basis – is also a must, adds Watson.

Ultimately, conservative investors want to hang on to their capital “and never lose sight of their long-term goals,” says Sprung.

Conservative picks

COCA-COLA CO. (NYSE: KO)

People’s love for Coke doesn’t disappear during rough economic times. That’s why Goldman Sachs recently upgraded the stock to a “conviction” Buy from a Buy and gave it a US$77 price target, nearly 12% higher than the current price. Its 2.82% yield tastes good too.

McDONALD’S CORP. (NYSE: MCD)

Many investors turn to McDonald’s during downturns; it’s a multinational company, and the world needs to eat. In August, three firms upgraded the company’s stock to Buy or Outperform, and they think it should climb to between US$98 and $100 from the $90 it’s at today. It also pays a 2.69% yield.

SPDR S&P 500 (NYSE: SPY)

This ETF gives people exposure to the S&P 500, a broad index with loads of large-caps in numerous sectors. Its top holdings include Exxon Mobil, AT&T, Johnson & Johnson, Coca-Cola and other defensive companies in non-cyclical industries. Its expense ratio is a laughably cheap 0.1%, and it pays a 2.06% yield.

CLAYMORE 1- TO 5-YEAR LADDERED

CORPORATE BOND ETF (TSX: CBO)

Claymore’s laddered bond ETF holds 25 bonds with durations of between one and five years. Every year, five of the bonds mature and then five new ones get bought. Investors like it because it spreads out interest rate risk. It also holds debt of stable companies like TD Bank, Tim Hortons and Thomson Reuters.

Middle-of-the-road

Most people at the height of their careers fall into the category of middle-of-the-road or balanced investors. Their objectives are usually a mix of the other two investing types; they want to preserve what they’ve saved so far, but they’re also looking for growth. “They’re willing to tolerate something a little closer to what market volatility would be,” says Watson.

These investors, says Holmes-Winton, will buy stable, dividend-paying companies, but they’ll buy some more aggressive, cyclical stocks, too. Watson says the financial sector is a good bet for more risk-tolerant investors. While most people think of banks as conservative – they’re big and pay a decent dividend – their share price often fluctuates with market conditions. U.S. financials in particular took a big hit during the recent market turmoil – Bank of America fell about 16% in August – but Canadian banks have also experienced ups and downs. Many banks also stopped paying dividends or have only increased them one or two times since the recession, making them less attractive to conservative investors.

The volatility has made many banks cheap. Bank of Montreal, for instance, has a price-to-earnings ratio of about 12; its five-year average is 13.45 times. American banks are even cheaper.

Middle-of-the-road investors should typically own a broader basket of stocks than their conservative counterparts. “They’ll buy something more representative of the broader index,” says White. That means owning a variety of sectors inside and outside of Canada in order to get exposure to all, or most, sectors. At its simplest, there are 10 sectors on the market, so an investor can allocate 10% of his equity in each one. It’s not as easy as that but, says Watson, “diversification means exactly what it is: a mix of sectors where the weakness in one can be offset by the others.” ETFs are a good option for medium-risk investors, as there are a lot of broad-based offerings from which to choose.

For bonds, look to corporates and provincial government bonds, says Watson. Both offer a higher yield than federal government bonds. Depending on the province, provincials can offer 1% to 2% more than their Government of Canada counterparts. A four-year Ontario bond currently has a yield of 3.26%, versus a yield of 1.51% for a Canadian four-year bond. When buying bonds, look at who’s backing the bond, says Watson. Buying higher-yielding fixed income can work, but make sure the company you’re buying isn’t going to default.

While stock pickers will want to choose their investments based on many of the same metrics as conservative investors, Sprung says middle-of-the-road types are able to tolerate a less pristine balance sheet. Consider paying a higher price-to-book for a lower return on equity than your conservative friends. That often means a company is growing.

Whatever you buy, it’s wise to use dollar cost averaging—spending the same amount of money on an investment on a fixed schedule, such as every two weeks—when getting into this kind of market, says White. This strategy takes a lot of the emotions out of investing and allows people to take some risks without sweating over the volatility. “The minute someone commits capital to a volatile market, they’ll be hyper aware of risk and return on a daily basis,” he says. “Do yourself some good and be more pragmatic.” Dollar cost averaging means you won’t be buying at the bottom – and White thinks the market could drop further – but you aren’t risking as much capital since you’re buying in increments. It also means you won’t miss the recovery since you’ll always be buying some stock. “My main advice,” he says, “is don’t pick one day to go all in.”

Middle-of-the-road picks

MANULIFE FINANCIAL CORP. (TSX: MFC)

Toronto insurance company Manulife was badly bruised during the financial crisis, but it’s cleaned up its balance sheet and is now less vulnerable to market swings. The company cut its dividend during the downturn but, Sprung says, will likely increase it again. It’s had a negative return on equity, but Sprung thinks it’ll rebound to about 14%.

SHERRITT INTERNATIONAL CORP. (TSX: S)

Resource company Sherritt is a more aggressive play for middle-of-the-road investors, but one that could pay off big, says Sprung. A new mine in Madagascar, to produce 60,000 tonnes of nickel a year, is where most people are looking for growth. It’s got a 2.8% yield, and it’s trading at just nine times earnings.

ISHARES MSCI EAFE INDEX FUND (NYSE: EFA)

Risk-tolerant investors looking to buy equities outside of North America should look at this ETF (or its Canadian-dollar equivalent, TSX: XIN). It’s based on an index that tracks stocks in Europe, Australasia and the Far East. Its top holdings include Nestlé, HSBC, Vodafone and BHP Billiton. It also pays a 2.85% dividend and its management fee is 0.35%.

ISHARES DEX SHORT-TERM BOND INDEX FUND (TSX: XSB)

This ETF tracks the DEX Short Term Bond Index, which includes a range of bond types from AAA-rated Government of Canada debt to BBB corporates. Almost all of the bonds mature in one to five years, which gives investors income rate protection. The management fee is a cheap 0.25%.

Aggressive

Investors with time, fallback assets or steely nerves on their side are looking for one thing: growth. These people are not as concerned with the usual metrics, such as price-to-earnings ratios or price-to-book. They’re buying stocks with the hope that at some point soon the company, and its share price, will soar. What will make that company succeed, though, is often unclear. “Risky investors are willing to pay higher multiples for growth, for intangibles,” says Sprung.

Aggressive investors—people who are willing to lose a lot of cash in the hope of making it back and more on the rebound—should look to small-cap stocks for opportunities during market swings. Small caps tend to be hit hardest during a downturn, but it’s the asset class that recovers quickest. Watson says that more growth-oriented investors are “probably sniffing” around smaller-cap resource plays, which have been hit hard in recent months. “You’re trying to enter at a price point that’s cheap enough,” says Watson.

Pitfield says that the best small-cap opportunities are in the mining, oil and gas and technology sectors. These sectors have loads of small companies with a lot of growth potential. But because small-caps are so volatile, investors need to stick with sectors they know best. “Use your expertise,” Pitfield cautions. “If you’re not an expert in a sector, then stay away.”

When it comes to bonds, aggressive investors should seek out the highest-yielding products in the asset class they’re most comfortable with. If you like Government of Canada bonds, go for a longer term. A 10-year bond pays 2.4%, about 140 basis points more than a two-year issue. Buying corporate debt will give you the highest yield; the lower the credit rating, the larger the payment. Sprung suggests sticking to BBB or higher, but says the really aggressive investor will look for even lower-rated debt, often called junk bonds. Also take a look at preferred shares, which have characteristics of both bonds and stocks. They’re far more volatile than bonds because they fluctuate with the markets and interest rate movements, but they can pay a yield of 5%.

Aggressive investors should also take a close look gold bars or ETFs, but only buy if you think the yellow metal is going up. Gold went from US$1,620 an ounce at the beginning of August to $1,880 by the third week and experienced some wild swings late in the month which, Pitfield says, is a concern. But many people still think gold will hit $3,000. If you’re a believer, you might as well take a chance. Sprung says it wouldn’t be unusual for aggressive investors to have 20% of their portfolio in gold.

Buy more complex ETFs too. A country-specific, emerging-market ETF is a smart play; even risk-tolerant investors will have trouble choosing foreign-based stocks, says Watson. Geographic ETFs give you exposure to a specific country – India, with its young population and growing middle class, is one of Watson’s favourites – while keeping some level of diversification. For adrenalin junkies, Sprung suggests leveraged ETFs, an extremely risky security that allows people to double the gains (and losses) of the underlying investment. If you spend $100 on a Horizons BetaPro ETF and it gains 5%, you have $110, he says. “Make as much money as you can on the upswing.”

For stock pickers, looking at a company’s balance sheet is less important than it is for more conservative investors. “This has more to do with strategy and future opportunities than anything else,” says Watson. People have to take a position as to where they think the market is headed. If it’s a tech firm you’re after, try and determine if their technology has a good chance of getting control of the consumer market. The key word to keep in mind is “potential.”

“You’d look at potential for revenue increase or potential for margin expansion,” says Sprung. There is one thing investors will want to see on the balance sheet: debt. “People say, ‘I don’t want debt,’ but that’s the conservatives talking,” says Watson.

Debt is a cheaper form of capital than equity right now, so these smaller companies could borrow money to pay dividends or tap into a line of credit, or the bond market, to grow through acquisitions. “They may be taking on more leverage, but if the cost of capital is cheaper than equity, then why not?”

Whatever type of investor you are, the idea is to do what you can to protect or grow your investments without feeling queasy. Holmes-Winton says it’s important not to confuse risk profile with return expectations. “A lot of people say they’re high risk, but they mean they want a high return,” she says. “Many people don’t actually want to be high risk, and no matter what type of investor you are, high returns are never guaranteed.”

Aggressive picks

FIRST NATIONAL FINANCIAL LP (TSX: FN)

First National, a Toronto-based mortgage company, has the broadest access to independent mortgage brokers in Canada. That makes it a likely takeover target by one of the big banks, says Sprung. It also pays a hefty 8% yield – it used to be an income trust – and has a return on equity of about 30%.

ANGLE ENERGY (TSX: NGL)

This Calgary-based oil and gas company, which drills in four sites in Alberta, has “significant” growth potential, says Sprung. Its oil and gas revenues have steadily increased over the past few quarters—revenues grew 115% in Q2 over the year before – and its price-to-book ratio is a cheap (for the sector) 1.79 times.

ISHARES S&P INDIA NIFTY 50 (NASDAQ: INDY)

This relatively new ETF is made up of the largest companies on India’s National Stock Exchange, so investors get exposure to blue-chip stocks across all sectors of the country’s economy.

PH&N HIGH YIELD BOND FUND

This bond fund has everything an aggressive investor would want – 52% of its holdings mature in less than five years, while 44% matures in less than 10 and the fund holds mostly BB-rated debt. Morningstar gives it a five-star rating and says its risk is relatively low, while return potential is high.

This article was originally published in Canadian Business.