How To Play Volatility In The FTSE 100

It’s pretty simple: traders need volatility to make a fast buck. As a long-term value investor, though, you’re also able to benefit from it. 

Short Sharp Shocks 

Chris Salmon, the Bank of England’s executive director for markets, said on Friday that “short sharp shocks” are likely in the next few months. In short, this could trigger panic trading.

On the same day, Nouriel Roubini noted that if “there was a Greek exit there would be massive contagion” and sovereign debt “spreads in the periphery would widen”. 

Europeans would race to withdraw cash from their bank accounts, the economist added. Mr Roubini has been predicting a Eurozone break-up and a subsequent market crash for quite some time now. 

“Britain’s top share index slipped on Friday to suffer its biggest weekly fall so far this year,” Reuters also reported on Friday. “Rising dollar, lower oil prices…and systemic risks (are) rising,” one senior banker in the US just warned me. 

In a challenging trading environment, you’d still be able to deliver strong returns: you just need to know how to read the signs from the business cycle, and combine that knowledge with fundamental analysis. 

Here’s how you could preserve your returns in three simple steps. 

1) Total Gross Debt

Quite simply, I suggest you currently avoid companies whose balance sheets carry too much debt. That’s the case for most utilities, for instance. Although their cash flows are rather stable, their yields may become less stainable over time. 

Consumer staples such as Unilever and Reckitt aren’t cheap, and carry some debt, but their capital structures are safe, and their stocks will likely continue to dictate a premium if risk-off trades prevail, I reckon. 

Pharmaceuticals companies such as Shire and GlaxoSmithKline — and even AstraZeneca, my least favourite stock in the field  — could also be the right names to look at. Their balance sheets are properly capitalised. 

Elsewhere, higher risks surround tobacco shares, so I certainly suggest caution if you are invested in them. Debts at British American Tobacco and Imperial Tobacco are manageable, but shrinking profitability could make debt repayments heavier, weighing on the future value of their shares. 

These are less cyclical stocks, so they should outperform those of miners, most of which rely on debt to finance their operations. In the resources space, I continue to prefer larger oil producers to smaller players, which represent an unlikely equity investment; neither is very appealing right now, however. 

Of course, higher volatility would put pressure on credit markets, so you’d do well to avoid the entire banking industry. In the insurance sector, Admiral is one risky stock. Finally, it’s difficult to gauge the fair value of food retailers, whose shares may continue to perform relatively well, even if the market turns south. 

2) Free Cash Flow

Some companies have low levels of debts or are debt free, but they need a steep growth rate to continue to generate healthy free cash flow, as measured by operating cash flow minus capital expenditure. Contagion fears would force investors to focus more on yield, and less on growth. As such, it could be tough times ahead for International Consolidated Airlines, whose cash flow profile has significantly improved in the recent years but is by no means reassuring. 

If panic spreads, cyclical businesses that have rallied in recent years on the back of a significant improvement in growth rates — such as most homebuilders in the UK — will inevitably struggle. Even defensive and cash-rich companies such as Next (4.5% free cash flow yield), Associated British Foods (3%) and Whitbread (1.2%) may find it more difficult to create value. 

3) Net Debt/Ebit and Working Capital 

More generally, stocks that could lag the market in a less stable trading environment include those of companies whose total gross debt minus cash and cash equivalents, or net debt, is more than four or five times their operating income. 

In this context, companies whose working capital (current assets minus current liabilities) is negative could have serious liquidity issues in less than a year, particularly if their average debt maturity profile is shorter than two or three years and their borrowings are not properly diversified. You can find all these details in any company’s annual result statement. 

I don't think that a market correction is on its way, but you ought to learn more about one stock that will likely offer you higher returns than those of most shares mentioned in my article. In fact, this could be the best 2015 investment by quite a long shot! 

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Alessandro Pasetti has no position in any shares mentioned. The Motley Fool UK has recommended shares in GlaxoSmithKline and owns shares in Unilever. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.