Key points

• Long-term investors need to be more tactical in this market to lift returns. One technique for active investors is to buy the market using exchange-traded funds.
• Buying high-quality Australian blue-chip stocks with a large proportion of offshore earnings also makes sense.
• And the market’s best trade in the past three years – buying high-quality blue-chip stocks with above-average yield – still has legs.

First, the good news, heavy falls in global equities are an opportunity to buy Australian equities and position portfolios for a double-digit total return this financial year.

Now, the bad, after a 17% peak to trough decline, the S&P/ASX 200 index is fairly valued rather than outright cheap. Also, it is too soon to conclude the worst of the selling is over as fears about China’s growth linger.

The Australian market’s trailing average Price Earnings (PE) multiple (excluding resources) has fallen from 17.6 times at its recent peak valuation to 15.2 times, or in line with its long-term average, using Macquarie Group numbers.

That implies the correction has removed the market’s overvaluation. But the market will be exceptionally uncertain over the next six months as the extent of China’s slowdown become more apparent and the first US interest-rate rise occurs.

Bullish medium-term outlook

I’m more bullish over three years and expect the bull market in equities to resume by year’s end or into the New Year. But the risk of capital destruction in the next few months is high.

My sense is the market has over-reacted to China. BHP Billiton believes China’s economy has bottomed and Apple Inc says Chinese demand has remained firm. China has plenty of levers left to stimulate the economy, as evidenced by its interest-rate cut this week.

Also, China-related volatility increases the odds of the US Federal Reserve moving the first interest-rate increase from September to December. The likelihood of another interest-rate cut in Australia by year’s end has also strengthened recently, and there is scope for further cuts or, in a worst-case scenario, to add fiscal stimulus.

Add in a lower Australian dollar, falling energy prices, and tepid wages growth, and there are plenty of tailwinds for corporate earnings in the next few years. And enough reason to add to portfolios as value emerges in the next six months.

But for now, the global economy is grinding towards a higher gear, the Australian share market is grinding towards the next phase of the bull market, and valuations are grinding towards their historic average. Gains are hard won as the market moves sideways, in a longer-term context, and the global economy works off its excesses from the previous cycle.

In that context, long-term investors must eke out every percentage of return they can, and use corrections to top up on high-quality companies when they offer better value. Here are five strategies to consider.

1. Capitalise on a short-term over-reaction in domestic equities

Long-term investors need to be more tactical in this market to lift returns. One technique for active investors is to buy the market using exchange-traded funds, such as the SPDR S&P/ASX 200, at the bottom of corrections, in anticipation of relief rallies.

Granted, the Australian share market is not cheap and the risk of further volatility is high. But as we get through the seasonally weak third quarter, and into the stronger fourth quarter and beyond, a double-digit gain from the SPDR ASX 200 ETF (more after dividends) by June 2015 is a reasonable bet, from the current level.

Chart 1: S&P/ASX 200 index over five years

2. Capitalise on Chinese contagion

As mentioned, the market has over-reacted to China’s slowdown and it still has strong medium-term growth prospects as it morphs from investment- to consumption-led demand. However, buying mainland Chinese equities is too risky.

I prefer Hong Kong, which is a natural beneficiary of rising wealth in China, is considerably cheaper than other developed markets, and better regulated than emerging market exchanges.

The ASX-listed iShares MSCI Hong Kong ETF was on a trailing PE of about 8 times (at August 25) after China’s sell-off. In contrast, the iShares S&P 500 Core ETF, which provides exposure to US equities, has a trailing PE of about 18 times.

Chart 2: Hang Seng Index over one year

3. Focus on winners from a lower Australian dollar

Fears about China’s economy reinforce that the Australian dollar needs to fall further as commodity prices decline and domestic interest rates are cut again.

Buying high-quality Australian blue-chip stocks with a large proportion of offshore earnings makes sense because they benefit as profits earned overseas are translated into Australian dollars. (And is a strategy long-promoted by the Switzer Super Report)

Key beneficiaries of this trend, Macquarie Group, James Hardie Industries, CSL, and Westfield Corporation have further to run as the Australian dollar eases and the US economy expands. None are cheap, but the correction has improved value.

Chart 3: Australia dollar versus US dollar over five years

4. Don’t give up on the yield trade

The market’s best trade in the past three years – buying high-quality blue-chip stocks with above-average yield – still has legs.

Yes, the latest profit-reporting seasons had mixed news on yield: more companies signalled a cautious outlook for dividend growth, and a handful paid a special dividend in a good sign of confidence. As banks hold more capital, which weighs on their return on equity, and as utilities look overvalued, yield stocks are less attractive.

But yield is always relative. A 7% grossed-up yield from the Commonwealth Bank or Telstra Corporation (after franking) and a modest double-digit total return (assuming dividends) is an acceptable risk-adjusted return in this market.

Stick to the household names for yield in this market: they will be among the first bought by income investors if the market drops below 5,000 points.

Chart 4: Telstra sold off this month

5. Special situations

Market corrections provide opportunities to buy outstanding growth stocks that always look overvalued in rising markets. One of my favoured strategies over the past five years has been buying the internet advertising stocks – Seek, REA Group and Carsales.com.

Seek has a one-year total shareholder return of minus 29% and trades on a forecast PE of about 21 times, according to consensus estimates. REA is off 11% and trades on 24 times 2015-16 earnings. Carsales.com’s total return is down 9% and it is on a forecast PE of 21 times. By their standards, the valuation metrics appeal.

These are three genuine industry “disruptors”. Seek disappointed with weaker-than-expected earnings guidance in its latest result. REA Group’s result was below market expectation and Carsales’ was just in line. Trading conditions for these companies have softened, but it’s way too soon to suggest they cannot continue to deliver hyper growth as they expand overseas.

Chart 5. Portals under pressure (Seek compared to REA and Carsales.com over one year)

* All charts sources at Yahoo!7 Finance, 27 August 2015

Tony Featherstone is a former managing editor of BRW and Shares magazines. All prices and analysis at August 25 2015.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.