How To Defend Your Portfolio

portfolioThe stock market has done well these past few weeks, and slowly investors are regaining a measure of optimism. But I would caution against over-confidence, as I think the eurozone debt crisis is nowhere near being resolved.

There is still a risk of a break-up of the euro and, even if this doesn't happen, it is certain that Europe is going to plunge into a deep recession. This is colouring my approach towards investing.

I hope you've been wearing your trunks

Warren Buffett once said, "You only find out who is swimming naked when the tide goes out".

Since August of last year, the stock market has been extremely volatile. And this is the time when we have seen who has been wearing their trunks, and who has been swimming naked.

In volatile times, people are encouraged to buy defensive shares. These are companies that operate in fields such as pharmaceuticals, consumer goods, utilities and telecoms.

Even if the economy were to dive into a deep recession, people would still be buying their washing powder, they'd still be heating their home and they would still be using their phone and their broadband.

This strategy has worked pretty well so far. Many of the best performers over the past six months have been defensives. Defensive stalwarts such as GlaxoSmithKline, Unilever and Vodafone have all risen since August.

So clearly if you think there is more trouble ahead, you should keep your portfolio largely defensive. And maintain a good margin of safety -- don't buy anything that looks even remotely overvalued.

The shorters attack

In the febrile atmosphere of recent months, many shares that have reported any bad news have got trashed.

A plunge in the value of a company can be made worse by shorters. Sometimes this can be warranted. For example, online grocer Ocado has yet to turn a profit, and if you are not even making a profit it is very difficult to defend your valuation. From a peak of 285p, the company's shares now sell for 74p.

I have recently written about fashion retailer SuperGroup, and this is another share that the shorters have had a field day over. The company was shorted from a peak of £18 to a trough of 440p.

But the key difference between SuperGroup and Ocado is that SuperGroup is actually making bucket-loads of money; what's more, it is growing its profits at something like 40% a year. And the reasons why the company was shorted were relatively minor and easily rectified, mainly focusing around stock management.

At 440p this company was, quite simply, ridiculously cheap. Anyone who bought in at the trough would have made 40% in six weeks. Plus I feel this share has more to come.

A two-pronged strategy

The strategy for investing in these troubled times has two prongs to it. The investments that you already own should be largely high-yielding defensives, and should maintain a good margin of safety. But I would suggest that you shouldn't be fully invested, but should keep some cash sitting on the sidelines. And then, just wait.

As you wait, opportunities start to appear. Some shares will tumble, but don't rush to catch the falling knife. The key is to be patient. A share price fall can gather momentum and can go on much longer than you would expect.

And if the share hits what looks like a bottom, wait some more. There may be a 'dead cat bounce', and then the share will bump along the bottom for a while. Once you are confident that this is a real bottom, buy in. In a previous article, I have suggested some companies to buy using this approach.

If you do take this strategy, just make sure you are investing in a sound company -- like SuperGroup -- instead of a firm with a rather dubious business model -- like Ocado. What you are doing is looking for cases of clear undervaluation, where momentum and fear have driven a company's shares to ridiculously low levels. After all, if Mr Market is offering you a crazy deal, why refuse it?

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