Value average quality shares to hedge risk and FOMO

Consistency is one hallmark of quality and our large cap UK quality shares screen proves the point this month with all the same names as before plus defence and engineering group BAE Systems (BA.) ranking highly. The negative 3-mth share price momentum experienced by most of the top rankers, with accounting software business Sage (SGE) a notable exception, is a reminder, however, of the price sensitivity these highly valued shares exhibit when interest rate expectations rise. Most of the companies aren’t cheap, relative to the history of their enterprise earnings yields versus UK 10-year government bond (gilt) yields,  so a circumspect approach is necessary when building holdings. 

It is best to drip-feed or value average, which means investing an amount at regular intervals  based on performance against a pre-set target rate of growth for the holding. When the total return undershoots, buy more (at a cheaper price) to get to the target and when the total return outperforms buy less (when the shares are more expensive).  This may seem counterintuitive in some respects, but with a target, there is a pre-set ceiling on how much to invest should negative momentum continue. 

Risk can be managed further by reducing the target relative to the long-run strategic asset allocation for shares in your portfolio. In other words, you hold more cash in uncertain times anyway but you keep building positions in quality companies when they are cheap but in a systematic and controlled way: it’s all about controlling downside risk and hedging against missing out on upside from cheaper valuations. 

In the case of the US market, some of those valuations aren’t cheap by any stretch. The Blackrock Investment Institute drew attention recently to the relative underperformance of the S&P 500 equally weighted versus the standard market capitalisation weighted version of the index. This demonstrates that the performance of the index has become ever more concentrated in a few strong names.

Our quality screen filters out the very highest valued stocks so misses some of the tech names, but interestingly the likes of Microsoft (US:MSFT) and Alphabet (US:GOOGL) make it. Both companies are worth owning at the right price, but deciding what that price is becomes more difficult (in a good way) because we don’t really know how much AI will boost their profits. Using a method like value averaging here would be very useful to get the balance right between not getting caught up in mania and managing the fear of missing out (FOMO). 

Of course, there could also be a significant market pull-back at some stage but having a bit more cash set aside strategically allows investors some dry powder to up their value averaging targets at really great prices in the future.