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Share market volatility - A new perspective

1 July 2011

Here at Boyce Financial Services we recognise that there are two main categories of reactions from clients in times of price declines and volatility in the share market. 

One category sees volatility as an opportunity to buy shares in quality companies at a discount to their normal price. The other category sees the short term price movement as scary, and avoids buying shares when they are cheap. They worry about losing their money in a volatile market. 

It is a natural reaction to worry if you are focused on the short term share price and you see it move downwards, sometimes dramatically. You may feel that you are actually losing money. This is because you equate the share price of the company with the actual economic value of the company.

In the short term, however, there is often little or no correlation between the share price of a company and its actual ability to make money for its shareholders. 

It should be remembered that the share price of a company is reflective of people’s reactions, rational or not, to news in the media and anything else happening in the world at the time. The short term share price can be driven by many other elements outside of the actual profit making ability of the company.

These short term reactions can create a bumpy share price and cause investors worry if focused on it regularly. We encourage clients to avoid focusing primarily on the short term share prices because it can distract from their long term goals by the prevailing headline of the day. 

Diversification is Key 

We cannot predict share prices in the short term; however what we can do is identify those companies who have a demonstrated history of generating good returns for shareholders in a sustainable, reliable fashion. Over time the share prices of a company who can continually reward shareholders through increasing returns will trend upwards as demand for its shares increase. 

One way to take the emphasis off the share price is to focus on the dividend stream which the company generates over time. In times of uncertainty the importance of owning a diversified portfolio of companies is reinforced, as this diversification is what can shield you from loss on any one company. Well run companies can normally maintain their dividend in times of volatility even if the share price may be decreasing in the short term. 

By investing in a range of companies, whose goods and services remain in demand for the whole business cycle, investors’ can gain confidence their dividend stream is a stable form of income.
 
Focus on Dividends 

There is no direct link between the share price and the ability of a company to pay a dividend. If the dividend is maintained and the share price continues to decrease, the yield or income return to the investor actually increases, this is because the investor has to invest less money per share to access the dividend, see the example following. 

You have identified Company A as a good long term business whose shares normally trade at $30. Company A pays a dividend of $1.50 per share so the investor is normally receiving a dividend yield of 5% (Dividend yield = Share price/dividend income, $30/$1.50 = 5%). 

If you are relying on the dividends to fund your retirement and pay your living costs your goal should be to buy that dividend of $1.50 for the cheapest price possible. 

Assume the price of a share in Company A has dropped from $30 to $15 and the dividend level is maintained at $1.50 per share. You would then be getting a dividend yield of 10% if you were to buy the shares ($15/$1.50 = 10%). 

If during the price decrease nothing has changed to the underlying company’s structure and management and you are confident in its ability to continue operations, then you could buy their shares at $15 each and receive a higher dividend yield than normal, by effectively paying half price for the shares. 

Market Fluctuations 

These price reductions or “market crashes” occur regularly and will likely continue to occur into the future. They are mostly through a lack of confidence which drives down share prices on otherwise well run companies. 

Seasoned investors have been through these times and recognise them for the fantastic buying opportunity that they present. These periods enable investors to buy quality shares at a cheaper price. 

Some people can be lucky enough to spend 30 years in retirement; they will see many price corrections in the share market over this period. By teaching our clients how to look at these inevitable occurrences differently we can reduce any worry and make them a profitable period for long term investors. 

The main points to remember are not to get too wrapped up in a company’s share price in the short term, focus on a diversified portfolio of good companies that pay sustainable dividends and take the opportunity to buy the shares when they are cheapest. 

Luke Carr, Advisor—Boyce Financial Services, Dubbo 

Luke Carr and Boyce Financial Services Pty Limited are Authorised Representatives of Lonsdale Financial Group Limited ABN 76 006 637 225 AFS Licence No. 246934.

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