The stock market’s outlook has deteriorated since the start of the year. High inflation, rising interest rates and increasingly uncertain economic prospects have combined to negatively impact investor sentiment towards a wide range of companies.
For example, the FTSE 250 index has declined by around 20% since the turn of the year. Similarly, the S&P 500, which includes the 500 largest listed companies in the US, is down approximately 25% year-to-date. Within both indexes, some stocks have fallen much further than the wider market. Investors have seemingly determined that their financial prospects are less attractive than they appeared to be just a handful of months ago.
Short-term uncertainty remains
Clearly, there is scope for further declines in stock prices in the short run. After all, the Bank of England expects inflation to continue to rise over the coming months so that it reaches 11% by year-end. This is forecast to prompt higher interest rates that, alongside a seemingly inevitable cost-of-living crisis, have caused a raft of downgrades to economic forecasts.
The Organization for Economic Co-Operation and Development (OECD), for example, now expects zero growth from the UK economy in 2023. It also forecasts that global economic growth will be lower than its previous forecast over the next two years, as the impact of war in Ukraine compounds the challenges facing the world economy.
Long-term recovery potential
Despite ongoing risks to share prices in the short run, buying a diverse range of companies on a long-term view could prove to be a shrewd move. After all, the stock market has a solid track record of recovering from its downturns to post new record highs. Indeed, the S&P 500 has generated an annualised total return of over 10% in the past 50 years, while the FTSE 250 has produced a compound annual growth rate of around 9% over the past 20 years. This is in spite of both indexes experiencing a number of downturns, corrections and bear markets since their inception.
Investors who take advantage of the stock market’s ‘boom/bust’ cycle through purchasing a wide range of shares while they trade at lower prices may have a better chance of generating high returns in the long run. Buying stocks when they are priced for a future of difficulty, rather than success, means they offer a wider margin of safety that offers greater scope for capital gain. As a result, now could be an opportune moment to ‘buy the dip’ to maximise returns over the coming years.
Focusing on large and mid-cap shares
Due to the uncertain economic outlook, large and mid-cap companies could be more attractive than their smaller peers. They often have relatively strong financial positions and could benefit from their size and scale during a period of weaker trading conditions. They may also enjoy a stronger competitive position than smaller firms because of their lower costs and wider range of products that allow them to deliver a more stable financial performance.
Indeed, large and mid-sized firms may be better able to withstand a longer period of economic turmoil. They could even strengthen their market position by making acquisitions and investments that smaller, financially less stable companies are unable to make. As a result, focusing on large and mid-cap shares, or funds that invest in them, could be a logical move that offers relatively low risk.
Aiming for low concentration risk
Buying a diverse range of shares following the stock market’s recent ‘dip’ could also reduce risk. As highlighted, indexes such as the S&P 500 and FTSE 250 have excellent track records of recovering from all of their previous downturns. However, investors who own a narrow range of shares that does not include a variety of companies in different sectors may fail to take part in a long-term recovery.
Therefore, it is important to check the concentration levels of any fund prior to purchase. Some funds run a highly concentrated portfolio that contains a small number of companies, or which is not representative of the range of sectors that make up an index. Although this can mean they offer higher profit potential if their holdings perform well, avoiding such funds in favour of those that offer greater diversity could reduce the risk of missing out on the stock market’s likely rebound.
Similarly, buying funds with holdings that operate across a range of countries could be worthwhile. The UK economy is expected to be the slowest growing economy in the G20 next year, with the exception of Russia, which means that investors who buy only UK-focused funds may miss out on superior opportunities elsewhere. Therefore, buying either globally-focused funds or a mixture of funds that focus on specific regions could allow investors to further reduce the risk of being tied to a slower-growing economy over the coming years.
Clearly, most companies conduct business in countries within and outside the location of their listing. Indeed, half of FTSE 250 index members’ profit is generated abroad, while the figures stands at over three quarters for the FTSE 100. However, ensuring that a fund’s holdings provide sufficient geographic diversity can further increase the prospect of taking part in a stock market recovery following the recent ‘dip’.
Seeking value for money
Investors can improve their chances of capitalising on a long-term stock market recovery by purchasing shares in an investment trust when they trade at a discount to their net asset value (NAV). This suggests that they offer good value for money and could benefit from a narrowing of their discount over the long run. In turn, this may further boost returns for investors while providing a margin of safety should the stock market’s outlook further deteriorate in the short run.
Of course, investment trusts are often able to borrow money to invest. This can mean that their performance is more volatile than would otherwise be the case. As such, a further downturn for equity markets could lead to relative underperformance of investment trusts that use gearing. In the long run, though, investment trusts could offer relatively attractive return potential because their gearing exaggerates positive returns.
A global focus
For many investors, purchasing both investment trusts and unit trusts that focus on mid and larger companies, while offering sufficient diversification, is likely to be a sound response to the stock market’s recent woes.
For example, the Schroder Global Equity fund has 148 holdings, with its ten largest positions accounting for less than a quarter of its portfolio. It is a top quartile performer over the past three and five years and holds a wide range of well-known global firms, including Visa, Nestle and Microsoft, that provide geographic and industry diversification.
Similarly, Alliance Trust holds 189 stocks from across North America, Europe, the UK and Asia in a variety of sectors. Its top quartile performance over the past three years and 6% discount to NAV suggest it offers long-term investment potential. As per the Schroder Global Equity fund, its largest holdings comprise global companies that may be in a relatively strong position to weather short-term economic difficulties.
In terms of UK-focused funds, the Allianz UK Listed Opportunities Trust has been a strong performer over the past five years. It has returned 43%, versus 10% for the Investment Association (IA) UK All Companies benchmark, which makes it a top quartile performer. Its 62 holdings comprise household large-cap names such as Shell and Unilever that operate across a broad range of countries.
Meanwhile, the Henderson Opportunities Trust holds 97 UK-listed equities including large-caps such as Barclays and Rio Tinto. Its discount to NAV has widened from zero to 13% since April 2021, which suggests it offers good value for money following the stock market’s recent decline. Its top quartile return of 36% over the past five years, albeit with above average volatility, highlights its long-term investment potential.
See also: Should you buy on a stockmarket dip?