Many investors believe that there is a big downside to investing in relatively safe “defensive” stocks—namely, a lower level of performance than if you invested in riskier, more aggressive stocks. But the opposite often is true, says portfolio manager Jay Kaufman, CFA, whose mutual fund concentrates on reducing volatility without sacrificing strong returns. Bottom Line Personal asked Kaufman how this works and how individual investors can adopt the same strategy…
Researchers have documented the anomaly of low-volatility stocks producing superior market returns for almost 90 years. It makes sense because of two powerful phenomena.
First, compounding is very powerful. If you can limit the losses in your portfolio, you don’t need huge gains to come out ahead of the overall market because your gains keep building. In contrast, when a more volatile portfolio plunges, it requires powerful advances just to make up for lost ground. For example, after the Standard & Poor’s 500 stock index dropped 57% in the 2007–2009 bear market, it had to gain more than 100% just to recover from those losses.
Second, low-volatility stocks often are undervalued because many investors consider them boring and so avoid them. In contrast, sexy stocks such as GoPro and Tesla often reach the point where they have become very overpriced because they tend to attract investors who are seeking home runs and so are willing to pay a lot. Many of these stocks crash and burn.
Over the past 10 years, an index of the least volatile stocks in the S&P 500 returned an annualized 9.2%, compared with 6.7% for the overall S&P 500. Extensive research shows that this type of stock may lag during market rallies but winds up beating the broad market over time.
My three comanagers and I look for companies that dominate their market niches and have strong balance sheets…higher profitability than their peers…predictable cash flows…and are able to do well in all kinds of economic environments.
We don’t require our stocks to pay dividends because throwing off income is not a priority for our portfolio. However, our process often identifies stocks with dividends because the dividends help cushion drops in a stock’s share price in market declines.
In addition to these fundamental qualities, we like to see several other characteristics…
Beta of less than one. Beta is a gauge of volatility that measures how closely a stock has historically risen and fallen compared with a benchmark such as the S&P 500. A beta of one essentially indicates that a stock’s price fluctuations equal the volatility of the index. The stocks in our portfolio have an average beta of 0.75, which means that we can expect them to drop about 25% less than the S&P 500 stock index in down markets and to rise 25% less in up markets.
Attractive valuations. We avoid low-volatility stocks if they have become much too popular. For example, nervous investors seeking safety have been driving up the stock prices of companies such as cigarette maker Reynolds American and spirits and wine seller Brown-Forman—companies that produce consumer staples (goods that are always in demand regardless of the economy’s performance).
Clear catalysts for earnings growth, as well as rising investor sentiment, such as analyst upgrades and heavy hedge-fund ownership.
The five stocks below all meet these criteria. They also have 10-year performance records superior to that of the S&P 500. Adding any or all of them to the typical stock portfolio can help improve returns over time and reduce volatility…
AutoZone (AZO): The largest aftermarket auto-parts retailer in the country operates nearly 5,200 stores in the US and more than 450 outside the US, mostly in Mexico. It dominates the do-it-yourself market, targeting owners of older vehicles that are no longer covered by manufacturer warranties. AutoZone, which has a beta of 0.67 according to the stock and fund research firm Morningstar, Inc., enjoys steadily growing earnings, thanks to the rising age of cars on the road, now at an all-time high of 11.4 years. The stock has particularly excelled in slow and recessionary economies when consumers are more likely to try to squeeze more life out of their old cars than purchase new ones. The stock rose 22% in the 2007–2009 bear market. Right now, AutoZone is ramping up the faster-growing part of its business—it runs more than 4,100 commercial centers in its US stores, delivering auto parts to professional garages and service stations. AutoZone has just a 3% share of this “do-it-for-me” market, leaving plenty of room for growth. Recent share price: $796.61.
Carter’s (CRI): One of the leading specialty retailers of merchandise for babies and young children has nearly 1,000 stores in the US and Canada and owns the two most recognized and trusted brand names—Carter’s and OshKosh B’gosh. Although many clothing retailers face intense competition and fickle consumers, Carter’s, which began in 1865, has been remarkably consistent, and its stock has a beta of 0.27. Reason: Many parents and grandparents who buy baby clothes stick with classic brands that they remember and trust. Carter’s has a 17% share of the $21 billion US children’s apparel market, so there is room to expand. The company will benefit this year by saving on one of its biggest expenses, cotton, because cotton prices have fallen sharply amid lower global demand. Recent yield: 1.3%. Recent share price: $102.23.
Costco Wholesale (COST): Costco is now the second-largest retailer in the world behind Wal-Mart, with $116 billion in sales for fiscal 2015 from nearly 700 warehouse clubs. Its distinctive business model generates consistently strong financial performance. Costco makes most of its profits from the annual fees that its 45 million members pay. Renewal rates run about 90%. The company also maximizes profits by doing almost no advertising and using no-frills warehouses. Unlike Wal-Mart, Costco carries a narrow range of products, many of which change often depending on the deals that it negotiates from vendors. Example: Costco is now one of the largest new-car sellers in the US, selling more than 465,000 vehicles at fixed, no-bargaining prices through partnerships with dealerships. In 2016, Costco, whose stock has been 14% less volatile than the S&P 500 over the past three years with a beta of 0.86, plans to open 32 new warehouses and continue expansion abroad in other countries including Japan and Spain. Recent yield: 1.1%. Recent share price: $152.67.
McDonald’s Corp. (MCD): The fast-food industry is challenged by a radical change in consumer tastes with the rise of more upscale fare from companies such as Shake Shack and Panera Bread. That has left McDonald’s playing catch up. But the iconic hamburger giant has historically adapted well to industry challenges. Its stock has risen an average of 12% annually over the past 15 years, compared with 5.4% for the S&P 500, and it has a beta of 0.58. CEO Steve Easterbrook’s turnaround strategy involves simplifying the crowded menu, using higher-quality ingredients, offering breakfast all day and testing the option of fancier, higher-priced burgers at some McDonald’s locations. Recent yield: 3.0%. Recent share price: $122.90.
Verizon Communications (VZ): The telecom giant is the largest and most profitable provider of wireless voice and data services in the US, with 138 million subscribers. Its reputation for superior call quality, reliability and comprehensive geographic coverage allows it to charge smartphone users more than competitors do and to post the highest retention rates for subscribers in the industry. The stock has a beta of 0.46, in part because the company’s revenues are so well-insulated. Although the US cell-phone market is saturated and revenue from data usage is slowing as competition drives down prices, Verizon still has avenues for growth. Example: It bought content provider AOL and mobile ad network Millennial Media last year so that it could generate ad revenue and deliver its own digital content, such as streaming video, to its mobile customers. Also, by 2020, Verizon plans to roll out 5G wireless connections—about 200 times faster than the speeds many of its current 4G users get. Recent yield: 4.3%. Recent share price: $52.54.
