Investment Strategies For New Investors Amidst A Volatile UK Market

London Stock Exchange’s benchmark index of 100 large companies the FTSE 100 index is hanging right around 7,200. In late July 2019, it hit a then closing peak of 7,686. And since the Brexit referendum, which was held in June 2016, the broader index has struggled many times to eke out marginally new highs. But it has also registered some scary dips along the way.

Since the Brexit referendum held in June 2016, the benchmark indices at the London Stock Exchange witnessed a lot of ups and downs, and returns during the last three and half years were subdued against the global peer indices like the S&P 500, Hang Sang, KOSPI and others.

The broader FTSE 100 index, which is constituted by 100-large companies by market-cap listed on the London Stock Exchange, is widely considered as a global index. As the majority of the FTSE 100 companies are more global companies, they have a significant presence worldwide and hold market share across the globe in their respective industries. However, despite having a globally diversified revenue segment, their stock prices have failed to perform commensurate with that of their global peers.  This situation presents some value-buying opportunities for existing investors as well as for new investors, who want to make a debut in the stock market.

There are some time-tested strategies which could help new investors create a portfolio which, when optimised rationally and judiciously over a long-term horizon, could result in a decent amount of return at the time of redemption.  Some of these strategies are as follows:

  1. Identify fundamentally strong companies: The initial step towards creating a strong portfolio amidst an economic slowdown is to identify businesses which possess strong fundamentals, with their stocks trading way below their peak highs. Some of the filters which can be used in stock selection are a) Revenue growth above 10% on a YoY basis over the past 5 years, b) EBITDA margin above 15% YoY over the past 5-years c) Free Cash Flow Yield greater than the UK Government 10 year Bond Yield + 1 Year LIBOR+2% Inflation, d) Return on Capital Employed (ROCE) consistently above 10% YoY for the past five years and e) Return on Equity (ROE) also above 10% YoY over the past five years. There are very few companies in the UK which can match with these filters.

 

The reason why the ROCE is targeted be greater than 10% year on year over the past five years is because the Bank rate in the UK is 0.75%, 1 year LIBOR is 1.96%, inflation rate is around 2%, and the broader index dividend yield at the current trading level is approximately 4.5%. So, in order of satisfy both equity holders and creditors, a corporation has to deliver a ROCE above (0.75%+1.96%+2%+4.5%), or, 9.21%. If a company is not able to deliver a ROCE above 9.21% then it means that it is not generating enough value for its shareholders.

  1. High Dividend Stocks: One of the better strategies to approach a volatile market is to invest in dividend stocks because dividend provides cushion amidst a volatile stock market. Even though the price of the underlying stock may plummet, the investor will receive a steady dividend income. In a market in which a capital gain becomes less certain, the dividend income becomes more significant.

 

Here, there is a list four FTSE 100 stocks, which have surged above 15% on a YTD basis with dividend Yield above 5%: SSE Plc (YTD % Change 15.4% and dividend Yield 7.8%), Tui AG (YTD % Change 28.4% and dividend Yield 7.0%), Vodafone Group Plc (YTD % Change 19.8%, and dividend Yield 5.0%) and WPP Plc (YTD % Change 17.5%, and dividend yield 6.2%), respectively. This list is representative only and this discussion does not imply that past performance will be replicated in the future.

  1. Investing in Value Stocks: This investment strategy is followed closely by “Oracle of Omaha: Warren E Buffet”. The rationale behind this strategy is to identify stocks which are trading below their intrinsic value or fair value as these companies are generally out of favour with general investing class. They are usually considered to be undervalued stocks based on certain valuation metrices like industry average price-to-earnings or price-to-book value ratios, etc. It should be borne in mind that these value stocks must otherwise be fundamentally strong.

 

  1. Identify Sectors Carrying Potential to Outperform: Despite a downtrend in the broader indices, there are always sectorial pockets, which move against the overall market. These are considered as alpha sectors. One should perform a rigorous analysis to identify the alpha sectors in the present slowdown or sectors which carrying higher potential to outperform the broader indices return once the fortunes have reversed.

 

  1. Diversify Portfolio: As a new investor, one should avoid putting his all resources in a single basket; instead, investors should build a portfolio of large-cap, mid-cap and small-cap stocks belonging to diversified sectors. Higher weightage should be provided to the large-cap companies followed by mid-cap and small-cap stocks. Normally, small-caps stocks carry higher risks compared to mid and large-cap stocks. Many a time it has proven that higher risks are not always rewarded by a higher return. So, if a small-cap stock turns out to be a multi-bagger then it will change portfolio return dramatically. So, one should always try to hold these stocks in their portfolio, but exposure should be kept below that of large and mid-cap stocks as a whole.

Market Levels

At the time of writing (as on October 11, 2019, at 12:15 PM GMT, before the market close), the broader FTSE 100 index was trading 33.29 points or 0.46% above the previous trading levels at 7,219.65. In today’s trading session, the index was able to break its first resistance level, which is 10-day Simple Moving Average Price of 7,203.45 but still quoting below the mid-term and long-term resistance levels. In the year-ago period, the index has registered a 52-week high of 7,727.49 and a 52-week low of 6,536.53.

However, heightened uncertainties over the nature of Brexit as on October 31, 2019, will continue to keep market indices volatile; however, it is highly expected that Britain could seek for a further extension for Brexit from EU lawmakers.