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The current market turbulence is breeding uncertainty, so how can investors beat the storm now? Dan Coatsworth braves the waves and seeks out strategies for a new world order

The stock market has been doing a pretty good impression of a bouncing ball lately: up sharply one day, hefty slumps the next. Intense volatility has made hundred-point-plus movements on the FTSE 100 relatively commonplace. This has already happened 11 times since the start of the year, based on closing prices, while intraday the figure is even higher. Getting used to this type of unpredictability can be tough but there are ways to read the market based on past experience and current performance trends to survive the erratic winds.

Data mining is essential to understanding which stocks and sectors are the most resilient during tough times. We are, without doubt, in a new era for the stock market. That means history may not repeat itself, which appears to be the case with the switch from a bull to bear market failing to repeat the previous trend of favouring large-cap, defensive stocks.

Companies that supply goods and services used in everyday life should in theory do well regardless of economic conditions. Unfortunately, we can no longer assume that defensives will be the best performers in volatile markets.

Several defensive sectors have suddenly found themselves struck off the list due to adverse incidents. Banks are under scrutiny over bad debts and credit policies, while food producers are facing a sharp increase in raw material costs, significantly diluting profits. As Russ Mould points out in this week’s Headlines story, (see page 12) even telecoms could be shown the door if a price war on mobile phone packages wipes out margins.

The bear market has also spurned large-cap stocks, instead giving preference to small caps. Indeed, the junior market has done even better, with Aim having outperformed the FTSE All Share so far in 2008 – or rather not having fallen as much.

With the sub-prime meltdown and credit crunch being the main contributors to the volatile investment landscape, our investigation into which are the most resilient stocks and sectors needs to start with last summer’s market slump.

The FTSE dropped 4% on 16 August 2007, knocking 250 points off the headline index. This dramatic decline wiped millions of pounds off the valuation of UK-listed stocks. Not ones to miss a bargain-hunting opportunity, investors used this as a chance to sift through for solid companies that may have suddenly looked cheap but still had the potential to deliver growing profit, revenue and cash.

Information on resilience

Analysis of the market subsequent to the August crash shows a steady market gain until late October, when the City took a breather and share prices slipped back. This two-and-a-half-month period contains vital information for spotting the most resilient stocks.

The clear winners were resource companies – mining, oil & gas producers, and equipment manufacturers serving this sector, essentially among the market leaders throughout the entire year.

While there is an ongoing debate about how long the bear market will last, you can be certain that it won’t bottom out until the resource stocks lose their shine. The catalyst for a new bull market will be the next hot sector. With resources showing no sign of floundering, we could be in for a long wait. The answer to this situation? Buy more resource stocks as the sector continues to surprise on the upside.

The current South African power crisis has given commodity prices a new strength. As the country is a major source of metals and mining, the threat to new supplies has raised commodity selling prices. State energy group Eskom has experienced power problems before, but few expected the current supply outages to have affected the mining industry so severely.

Theoretically, the weakening of global economies should be a negative influence on mining. Yet the ongoing infrastructure investments in China, India and the Middle East has shielded miners, to an extent, from economic woes. Labour strikes and equipment shortages have also caused delays to new mining projects, which actually works in the sector’s favour, to a point. The biggest threat to mining stocks is an oversupply of commodities. Any disruption to supply gives mining that bit longer to retain its stock market crown.

Another bounce?

Fast forward to 21 January 2008, where the FTSE sees an even-bigger one-day slump than last August. The headline index fell 5.5% or 323 points to 5,578.23, the largest one-day fall since 9/11. The FTSE All Share was down 5% to 3,031.91.

Given the relatively quick recovery by many sectors following August’s market slump, let’s assume that a similar trend is emerging from the post-January index drop.

In the subsequent three weeks’ trading to 15 February, the FTSE All Share fell by 0.9%. In contrast, the mining sector beat the market by 13.4%. While this is certainly influenced by takeover activity concerning several FTSE 100 mining companies – Rio Tinto (RIO) and Xstrata (XTA) being the targets – ongoing commodity price strength is also a key driver.

After the August slump, we learned that industrial engineering was quick to recover, and that trend is repeated following January’s blues. Along with resource stocks, engineering is proving to be one of the most resilient sectors. The Confederation of British Industry claims manufacturers are seeing the longest run of sustained demand for 12 years. ‘While manufacturing is not going to be immune to weaker demand at home and abroad, the recent depreciation in sterling will be a helpful boost for exporters over coming months,’ says CBI chief economic adviser Ian McCafferty.

While resource companies remain market leaders, you’ll see that the (historically) defensive sectors of food and drug retailers, tobacco and beverages have dropped out of the top performers’ list after January’s hiccup.

In replacement, chemicals takes strong billing, having outperformed the market by 11.6%, predominantly driven by Johnson Matthey’s (JMAT) trading update. Analysts at Credit Suisse say that the performance didn’t stack up against its forecasts and advised investors to sell out before possible share price weakness. There’s a reversal of fortunes for aerospace and defence. Having outperformed the market by 8.3% following August’s market crash, the sector has recently become weaker, underperforming the FTSE All Share by 2.4%. The once-lauded industry has suffered from cuts in defence spending and major project delays.

The electronic and electrical sector was already a complete dog in 2007 before August’s market re-rating. This left it reeling with ridiculously low valuations and, on paper, looking very cheap. Investors picked up stock in the hope of finding a bargain but they could have their fingers burnt before too long. The sector may have seen strong performance recently, outperforming the market by 5.9% since late January, but this is a classic example of investors buying without reason.

It’s like going into a branch of Woolworths (WLW) and seeing a bucket of mega-cheap DVDs. You eagerly put two or three in your shopping basket on impulse but get home only to realise how poor quality the products are. It won’t take investors long to realise their mistakes when the shares fall after many electronic and electrical stocks publish their next financial results and expose their weak positions because of dilution from weak foreign exchange rates, namely the dollar.

Growth versus value

Over the past 20 years, value has significantly outperformed growth. Investors have been rewarded with capital gains, including healthy dividend yields. For example, value ruled after the UK equity market had bottomed in March 2003. Companies whose earnings power and market valuations have been weakened by the economic slowdown in the two preceding years experienced strong recovery.

Value has outperformed growth by 45% since 1988, according to research by stockbroker Charles Stanley. ‘With a long period of benign economic conditions and more easily available growth, this is not really that surprising,’ says head of equities Richard Hickinbotham. ‘A growth style is now likely to be in the ascendancy but great care needs to be exercised to identify that growth. It remains to be seen whether the market has yet fully discounted the outlook.’

Banks have historically been value plays, driven by their large dividend yields. Bad debts and sub prime-related investment problems has seen the FTSE All Share banking index recently hit a four-year low. If banks such as Barclays (BARC) and Lloyds TSB (LLOY) can address the credit problems quickly and have more risk controls in the business, there’s no reason why the sector as a whole won’t outperform over time again. Just remember that the current banking results season has thrown up more negative issues, so tread cautiously for now.

The software sector was certainly oversold following the credit crunch-induced market crash last August. Investors who picked up stock in the aftermath of the weakened FTSE have done well, as it is now back in fashion. Companies have reassured the market that yes, the economy looks uncertain, but so far their business hasn’t been negatively effected.

Fidessa (FDSA) is a good example. Having reported solid half-year earnings in July, shares in the software group stood their ground during the August market crash, but eventually weakened in November for no particular reason. Its share price then fell 41% to 696.5p by January. It took a 20% rise in pre-tax profit and positive comments on solid market conditions announced earlier this month to trigger a revival in the stock.

Change

While many investors have been right to seek value-led buying opportunities from sharp falls in the wider marketplace, there is no denying that momentum – namely growth – investing is leading the agenda.

Short trading has become omnipresent among investors – both retail and institutional. You buy stocks that are rising and short on those that are falling. That can lead to rising stocks becoming overvalued (stand up, aerospace & defence) and falling stocks becoming undervalued (hello, banks). Momentum investing has paid off for several years but industry commentators are starting to suggest its days are numbered, with investors eventually switching back to value.

The trouble with momentum is that you are chasing the latest trend, and trends don’t always last forever. In volatile times you could be better off spotting cheap (and reliable) stocks that look oversold and buying them for the long term. Remember to seek companies with a strong cash balance, quality management and saleable assets – to ensure they won’t go broke.

Investment bank ABN Amro conducted its own analysis into the aftermath of January’s market drop. It ran the numbers on stocks that had lost more than 35% in the three months prior to the sharp index fall, but had traded positively in the week after the event.

It concluded that valuations ‘arguably’ discounted a US recession following the 5.5% FTSE 100 drop and it was worth buying into the new share price levels.

Among those finding new price resilience were Whitbread (WTB), Marks & Spencer (MKS) and Punch Taverns (PUB). All have one thing in common – high levels of debt. The City showed grave concerns last summer towards any company with large borrowings, in the wake of rising interest rates and less appetite from investors towards financing debt, prompting stocks to fall. With UK interest rates having started to retreat, it appears that these ‘debt’ stocks have rebounded on the hope that the cost of borrowing will be cheaper and the economy is not as bad as everyone feared. There could be tears ahead as the credit market is still in tatters.

Pair trading

Hedge funds were designed to thrive in volatile markets by pairing up trades. ABN Amro believes this investment strategy could suit current conditions. To mitigate the risk to the oil price, for example, it suggests going long on utilities and short on the oil sector. ‘Fundamentals and statistical trading suggest utilities present the better risk/reward trade-off,’ it says.

The idea is to spot two similar shares whose prices often move in tandem but have temporarily diverged. Typically, you buy the laggard and short sell the leader, with profit coming from the prices converging again.

Pairs trading can be risky and is only suitable for investors confident in spread betting or contracts for difference. But those eager to test the water could consider gold against the dollar as the two tend to move in opposite directions; Morrison (MRW) versus Tesco (TSCO) supermarkets; and banks versus real estate.

Beating market volatility will depend on your investment strategy. Momentum looks like the current favourite but don’t be afraid to take a contrarian view and pursue value investing.

While there is no single correct investment method to combat volatility, follow the current sector trends closely and refine down to pick individual stocks. Spend time researching companies and running numbers through stock screening programmes, and it could throw up some interesting selections. Above all, be reassured that many stocks are still going up in price despite the troubled market conditions.

Volatility beater – Mining major

Anglo American (AAL) BUY

Share price: £32.26

3-month relative strength: 12.5%

1-year relative strength: 27.2%

One of the few mining majors not seeking a corporate tie-up with its rivals, Anglo wants to enjoy the independent life. There’s a delay in selling off the Tarmac subsidiary, but mining operations are full steam ahead. It has partnered with the China Development Bank to collaborate on mining ventures and earmarked a $29 billion pipeline of projects for consideration, with $12 billion worth already under development. Iron ore is the hot commodity of the moment and operations will soon expand dramatically. Its goal to remain independent may see Anglo lose out on M&A-fuelled share price gains, but it would be a safe bet that its share price will become less volatile than its peers and have more stamina to keep climbing at a steady pace.

Volatility beater – Engineering

Goodwin (GDWN) BUY

Share price: £10.70

3-month relative strength: 24.1%

1-year relative strength: 55%

The specialist engineer has a good record of growing profit, reflected in a steady share price gain. The company is doing a roaring business supplying valves to oil & gas companies and has expanded successfully so that over half of sales come from fast-growing economies. The downside is limited analyst coverage, but Goodwin is a solid company worth buying.

Volatility beater – IT

Detica (DCA) BUY

Share price: 249p

3-month relative strength: 4%

1-year relative strength: -28.6%

Gave a reassuring trading update last week saying that market conditions in financial services had stabilised while the rest of its business is making good progress. The IT security consultant issued a shock profit warning in November, blaming a slowdown in spending at investment banking clients. A key US acquisition has bedded down after a slow start and a UK e-borders win highlights the firm’s strong positioning for the long term. Net debt fell by nearly a third in the recent trading quarter. Analysts have trimmed back forecasts because of the financial sector issues but are still positive on the long-term prospects. There are still economic risks to its success, but sentiment has improved on the stock, which should feed through to its share price.