The ideal strategy for this dodgy economy and wobbly stock market.
Investors have incredibly short memories. In the blink of an eye, they've quickly forgotten many of the lessons of the two most recent stock market crashes, namely the dot-com bust and the subprime blowup.
Think back to the dot-com era. Shares like ARM Holdings (LSE: ARM), Logica (LSE: LOG), and Sage (LSE: SGE) were valued at huge multiples of their earnings. The theory was the Internet was going to change the world, and these companies were going to generate massive profits far, far into the future.
Well, as we now know, the Internet did change the world. Can you imagine life without it? Without the Internet, how would we find the answers to such questions as "Daddy, if the Earth is round, how come we don't fall off it?"
But what the Internet didn't change were the fundamentals of investing. Sure, it made it much easier for us to gather timely information about a particular company, read annual reports, and listen to conference calls, but it didn't change the two core tenets of investing, namely...
Did you buy stocks at the height of the dot-com bubble? If you did, hopefully you learned a very valuable lesson. Valuation always matters.
The same greedy mistake
Fast-forward to the subprime crash. This one was a little different and somewhat harder to predict. Pre crash, many shares, including financials like Royal Bank of Scotland (LSE: RBS) and Lloyds Banking Group (LSE: LLOY) didn't appear overvalued based on their reported earnings at the time.
But the warning signs were there. It started in the US, where house prices had peaked in 2006. Adjustable-rate mortgages had begun to reset at higher rates. Subprime borrowers were unable to refinance. Delinquencies were soaring.
Then, in mid-2007, Bear Sterns announced that two of its mortgage investment funds had collapsed, wiping out more than $1.6 billion in capital.
Yet, despite a wobble in the face of the first Bear Sterns shock, the stock market continued on its merry way. The FTSE 100 peaked at just over 6,700 in July 2007 and was still close to 6,400 in May 2008.
Collectively, we ignored what was staring us right in the face. Were we stupid? Or naive? Or just plain greedy?
I say we were greedy. And I also say, right now, we're in danger of making the same greedy mistake.
A market riding for a fall
Since its March 2009 bottom, the FTSE 100 has jumped more than 50% higher. Shares like Barclays (LSE: BARC) have positively flown into the stratosphere, up more than 300% in the same period of time. In short, it has been a fantastic time to be invested in the stock market.
But the easy money has already been made. Now comes the really hard part: making money in a stock market I think could be in for a sticky patch.
My reasons are simple ...
- Outside influences -- first we had the Chinese deciding to slow things down a little. Then we had Barack Obama's shock announcement about how he intends to regulate the banks. What's next? With the global economy being fuelled by government stimulus packages, we are somewhat beholden to the whims and wishes of others.
- Unemployment -- it's still running at close to 8%. Worse, when you include people who have taken early retirement or given up looking for work, a fifth of working-age Britons, or 8 million people, are not in jobs. With unemployment riding so high, I expect the economic recovery to be tepid.
- Interest rates -- although the Bank of England base rate remains effectively at 0.5%, 10-year Gilt yields are riding much higher, at 3.9%. When the base rate does rise, as it inevitably must, any economic recovery will likely be dampened.
Margin of safety
Lest you think I'm a big, bad grizzly bear without a bone of bull in my body, let me assure you otherwise.
I'm bearish on the economy, yet still bullish on certain shares. Not all stocks, mind you. For example, I'm steering well clear of economically sensitive sectors like financials and most retailers.
I'm also steering clear of highly valued stocks, even if they are quality players like Autonomy (LSE: AU) and Michael Page International (LSE: MPI). Paying 20 and 45 times their respective forecast earnings is not my idea of a margin of safety.
Juice your returns
Where I am seeing value is in higher-yielding stocks. For example, take a look at these "boring" value shares...
In this low interest rate environment, the valuations of these large blue chip companies set my pulse racing.
But it gets even better when you consider the dividends. Share price appreciation is definitely a strong possibility for such lowly-rated companies, but add in the dividends, and you can see how you could really boost your investment returns.
I see it as a strategy ideally suited to today's unique stock market and economic conditions.
More on the economy and the markets:
> Juice your returns with Champion Shares PRO. Our £50,000 real-money portfolio shows you how to build a solid investing strategy for the long term. We're offering a 30-day free trial for just a few more days. Apply today and you'll also get a complimentary special report.
> A version of this article was published originally on Fool.com. It has been updated.
