Recent weakness in financial markets makes me nervous because I already hold shares. It always does when there’s a market pullback — I’ll never stop feeling like that no matter how long I carry on investing.
However, I’ve been investing long enough to know that my best investments start when I buy at lower valuations, when there’s fear and anxiety in the air — such as right now.
Why I’m avoiding the FTSE 100
I’ve written before about why a FTSE 100 index-tracking fund is unappealing. A tracker fund allocates investments by weighting, so too much of my FTSE 100 investment would go to large, mainly cyclical firms. To me, the most promising firms in the index reside among the 70 smallest constituents, and a weighted FTSE 100 index tracker would only allocate about 30% of my funds there. That seems like a missed opportunity and a risky strategy.
We’ve seen collapsing share prices of commodity firms and oil companies lately with big banks not far behind. That raises the possibility of a contrarian approach with the aim of catching the next upleg for these highly cyclical sectors. Yet investing in the cyclicals is problematic, and misjudged timing can hammer a portfolio. I agree with ace fund manager Neil Woodford who wrote that we’re likely to see a lot of dividend carnage this year and beyond. When I see dividend yields of 8% and higher, as now with some of the big banks, oilers and miners, and particularly when those dividends aren’t fully covered by earnings, I can’t help thinking they have ‘slice me, dice me’ written all over them.
However, a trimmed dividend isn’t necessarily a bad thing for cyclicals. Stock markets look forward, beyond immediate macroeconomic concerns, and the share prices of cyclical firms could move up even as the directors cut their dividends. In fact, it could take a dividend cut to catalyse a change in trend for the cyclicals — perhaps investors will see it as a signal that the worst is behind the firm in the current cycle and earnings could then begin to recover. I remember Aviva rocketing skywards a few years back when it cut its dividend.
What I would buy
I’m not keen on revisiting the cyclicals yet though. It’s hard to judge the timing of an investment in them, and to my mind we don’t have a clear enough signal that economies are going to tank completely around the world. Because the signal isn’t loud enough, it’s possible the cyclicals could charge lower still if the general economic outlook worsens, and I don’t want to risk my capital gambling on that.
Instead, I’m likely to use the current market sell-off to focus on the smallest 70% of firms in the FTSE 100 index with an emphasis on businesses with defensive characteristics. Firms with as little cyclicality as possible inherent in their business models could make good investments, particularly if their share prices are dragged down with the wider market. In particular, I’m thinking of consumer goods firms with strong cash flow due to a product offering that customers tend to use and repeat-purchase, whatever the economic weather. Cleaning products, foods, personal care, tobacco products, alcoholic drinks, and medicines fit the bill. There are also some good cash-generating and evergreen businesses to be found in the utilities, defence, and technology sectors.