Why volatility can be an investor’s best friend
Stock market volatility is often held up as an investing bugaboo, but it should not be feared since it creates opportunities to generate some pretty healthy returns.
But investors will have to pick their spots given the valuation run-up in recent years and the possibility of significant equity market pullbacks as interest rates rise.
Andrew Hamlin and Vivian Lo, portfolio managers at Aston Hill Asset Management, for example, are staying away from high multiple stocks, since history shows this group experiences the biggest losses during a rising rate environment.
The pair, who focus on dividend-paying stocks for the $330-million Aston Hill Growth & Income Fund, also have a couple of other basic rules.
The first is not to secondguess a rising market because you’ll miss out on returns, but do have a process in place to take risk off the table. The other is to keep a healthy cash cushion and be disciplined about putting that money to work when stocks become cheaper.
“In this environment, investors should own equities and, on any pullback, they should be adding to their positions,” Hamlin said, noting the fund is still very much long risk in both their equity and bond exposure even though cash levels are higher than normal.
The fund’s only bond exposure is in high yield due to the managers’ concerns about rising interest rates and because high yield has a much shorter duration than investment grade.
One of the fund’s biggest equity weightings at roughly eight per cent is the consumer discretionary sector. The portfolio managers have hedged some of this exposure with a short position of roughly one per cent in the Consumer Discretionar y SPDR ETF. They also use put and call options to protect against broad market selloffs or weakness in sectors they’re overweight.
“The valuation levels across almost every sector — except energy and materials — have been elevated,” Lo said, highlighting the significant multiple expansion in consumer staples and consumer discretionary names in particular.
Hamlin and Lo became bullish on the consumer discretionary space last year as oil prices started falling, because lower gasoline prices should translate into more disposable income, and wages started increasing as major employers such as Wal-Mart Stores Inc. and Target Corp. increased their minimum pay rates.
In Canada, they only own Gildan Activewear Inc. (GIL/ TSX) and Alimentation Couche-Tard Inc. (ATD.B/ TSX), which they believe have outsized growth opportunities compared to most peers.
“As we see money flow back into the energy space, the consumer sectors will be a source of funds, so we wanted to avoid that, especially with elevated multiples,” Lo said.
Another theme the managers are keying in on is technology. Hamlin expects U.S. GDP growth will start accelerating in the second quarter, with cyclical sectors such as technology leading the way.
The managers particularly like large-cap enterprise technology and semiconductor companies.
“Investors can view the semi space very much as an industrial — and certainly a cyclical sector,” Hamlin said, highlighting holdings such as NXP Semiconductors NV (NXPI/Nasdaq) and Avago Technologies Ltd. (AVGO/ Nasdaq).
Unlike other cyclical stocks, semis are not really impacted by sharp declines in energy prices or big currency swings, and demand tends to grow at 2x GDP growth.
“This is a perfect environment to have some semiconductor exposure due to increasing demand for mobile data and devices, big growth in automotive connectivity and active safety, and cloud computing and data centres,” Hamlin said.
A short-term trading theme the managers like is in steel, because the changing dynamics of the North American industry, such as the U.S. dollar’s recent pullback, will slow down the pace of cheaper Chinese imports.
“Small price hikes are starting to be announced and are sticking,” Hamlin said. “Inventories in North America are also coming down, which means lead times to get new steel are getting pushed out, and that should turn into higher utilization rates.”
The managers’ exposure includes names such as Steel Dynamics Inc. (STLD/Nasdaq) and Nucor Corp. (NUE/NYSE).
Lo also highlighted the attractive long-term trends in the health-care space, due to aging populations and associated rising costs.
“Governments are trying to reduce costs everywhere they can, which provides more opportunities for the private sector,” she said, noting that ObamaCare boosted the number of insured Americans by 30 million.
One of the fund’s larger weightings is specialty pharma company Actavis PLC (ACT/NYSE), which recently bolstered its portfolio by buying Allergan Inc. and should now generate about US$9 billion of free cash flow in 2016
“No one drug can make or break the company’s profitability,” Lo said.