Risky Business

5/25/2015


The stock market has taken investors for a bumpy ride so far this year. The S&P 500 Index rose or fell more than 1% in 26% of trading days in the first four months of 2015, the most to start any year since 2009. We see signs that investors, queasy from a choppy market, are seeking the calm waters of less-volatile stocks.

To evaluate volatility, we devised Relative Risk ratings, which parse stocks into five risk categories — Low, Below Average, Average, Above Average, and High — based on the following five volatility measures:

Worst three-month performance in the past 60 months to reflect a stock's potential downside risk.

Performance in bull markets, defined by how a stock fares in months when the market rises at least 2.4%.

Performance in bear markets, defined by how a stock behaves in months when the market falls at least 2.4%.

Standard deviation to assess the volatility of a stock's monthly returns relative to its average return.

Beta to indicate a stock's sensitivity to market movements.

The lower-risk groups tend to contain a higher percentage of larger stocks. High risk stocks tend to be fundamentally inferior to lower-risk stocks, as evidenced by higher average Quadrix Overall and Quality scores.

Stocks in the High risk group average Quadrix Overall scores of 51, lowest of any group but higher than the group's long-run average of 45, driven by unusually high Value scores. The group's robust Value rank in part reflects investors' flight from the riskiest stocks. Stocks in the High risk group averaged negative total returns of 4% over the past year, while Low and Below Average both averaged positive total returns of 14%.

Based on back-tests of rolling 12-month returns since December 1994, riskier stocks produced higher returns, as shown on page 1. However, standard deviation, a measure of return volatility, was higher for riskier stocks. Note that the ratio of return to risk, calculated at right by dividing total return by standard deviation, is highest for stocks with risk ratings of Low or Below Average.

Bringing Quadrix into the mix improves returns across the board. Stocks scoring above 80 Overall score have averaged higher 12-month returns than the average stock in all risk groups except High, as indicated below. Notably, the return/risk ratios also improved for the Average and Above Average groups.

WHAT WORKS IN QUADRIX FOR EACH RISK GROUP
Based on rolling average 12-month total returns for S&P 1500 stocks since December 1994, the Quadrix Overall score boosts returns for all Relative Risk groups except High risk. Value, unlike Overall and Momentum, is especially effective for High risk stocks, though the standard deviation of returns in that category is also notably higher. In most cases, limiting the portfolio to stocks that also earned high Earnings Predictability scores improved results.
------------------ Risk Group ------------------
Full
Set
Low
Risk
Below
Avg.
Avg.
Above
Avg.
High
Risk
S&P 1500 Index
Average 12-month return (%)
14
11
13
14
14
19
Stand. deviation of 12-mo. ret. (%)
20
14
16
19
23
36
Return/risk ratio
0.7
0.8
0.8
0.7
0.6
0.5
Overall above 80
Average 12-month return (%)
16
13
16
18
17
16
Stand. deviation of 12-mo. ret. (%)
19
17
19
22
23
28
Return/risk ratio
0.8
0.7
0.8
0.9
0.8
0.6
Overall & Earnings Predictability above 80
Average 12-month return (%)
16
13
16
19
20
18
Stand. deviation of 12-mo. ret. (%)
20
19
21
22
24
29
Return/risk ratio
0.8
0.7
0.8
0.8
0.8
0.6
Momentum above 80
Average 12-month return (%)
14
11
15
16
17
15
Stand. deviation of 12-mo. ret. (%)
20
16
18
21
25
31
Return/risk ratio
0.7
0.7
0.8
0.8
0.7
0.5
Momentum & Earnings Predictability above 80
Average 12-month return (%)
15
11
15
18
20
19
Stand. deviation of 12-mo. ret. (%)
20
19
20
23
27
33
Return/risk ratio
0.7
0.6
0.8
0.8
0.7
0.6
Value above 80
Average 12-month return (%)
16
12
14
16
16
23
Stand. deviation of 12-mo. ret. (%)
26
16
20
23
28
38
Return/risk ratio
0.6
0.7
0.7
0.7
0.6
0.6
Value & Earnings Predictability above 80
Average 12-month return
17
13
17
18
19
22
Stand. deviation of 12-mo. ret. (%)
26
26
26
29
30
38
Return/risk ratio
0.7
0.5
0.6
0.6
0.7
0.6
Note: Quadrix scores are percentile ranks, with 100 the best.

We then added an extra layer to our analysis by factoring in Earnings Predictability, a Quadrix factor that measures the variability of quarterly earnings growth over the past five years. In the Average, Above Average, and High groups, stocks that score above 80 for Overall and Earnings Predictability produced higher average returns than just strong Overall scorers.

Below we highlight three intriguing stocks from different risk groups:

Aetna ($114; AET), which has Below Average risk, scores an 81 for Quadrix Overall. Based on rolling three-month periods, Aetna produced a positive return 78% of the time over the past five years. The stock's last three-month decline occurred one-and-a-half years ago.

Earlier this month, speculation surfaced that Aetna might acquire Humana ($179; HUM) or Cigna ($134; CI) to bolster its position in government health plans. Commercial plans account for 85% of Aetna's membership, though 2015 growth was driven by government plans, such as Medicare Advantage and Medicaid.

Aetna has raised its 2015 profit guidance twice this year, causing analysts to ratchet estimates higher. The current consensus calls for 10% profit growth in 2015 and 11% growth in 2016. At 14 times estimated 2015 earnings, the stock trades about 19% below the median for S&P 1500 managed-care stocks. Aetna is a Focus List Buy and a Long-Term Buy.


F5 Networks ($127; FFIV) earns a 95 Overall and 84 in Momentum, particularly effective Quadrix scores for stocks in the Above Average Risk group. The stock also scores above 80 for Earnings Predictability, which has proved highly effective in conjunction with Overall and Momentum for stocks with risk ratings of Above Average.

F5 makes equipment and software for computer networks. To address the migration toward cloud computing, F5 launched a virtual subscription service. Management says these products, though cheaper than traditional hardware products, are additional, not cannibalistic. In each of the past six quarters, F5 has grown sales by double-digits and increased cash from operations. Free cash flow jumped 22% to $604 million in the 12 months ended March. F5 is a Focus List Buy and a Long-Term Buy.


Kroger ($74; KR) took an 8% slice of the U.S. grocery market last year, second only to Wal-Mart Stores' ($76; WMT) 26% share. Economies of scale provide a huge advantage in food retail, an industry typified by narrow profit margins. Kroger could face increased competition if two big rivals merge. European grocers Royal Ahold and Delhaize Group have entered preliminary discussions for a merger that could be worth around $26 billion. Both have significant U.S. operations — Royal Ahold owns Giant and Peapod, while Delhaize runs Food Lion — and together would become the fourth-largest U.S. grocer with a share of nearly 5%.

Kroger scores above 85 for both Overall and Quality, two Quadrix scores that work particularly well for Low Risk stocks. The stock is remarkably steady, experiencing few major sell-offs in recent years. In the past five years, Kroger has had just two three-month periods when losses exceeded 10% — neither of those periods saw losses exceed 16%. Kroger has generated a 29% annualized return over the past five years. Kroger is a Focus List Buy and a Long-Term Buy.

RECOMMENDED STOCKS FROM EVERY RISK GROUP
For the following 13 recommended stocks, we highlight Quadrix ranks above 80 for key scores that perform especially well for a given risk group. Beta measures the sensitivity of a stock to movements in the entire market. Standard deviation measures the dispersion of monthly returns around the historical average for that stock.
Beta
5-Year
Total
Return
(Annual.)
(%)
5-Year
Standard
Deviation
Of Monthly
Returns
(%)
Worst
3-Mo.
Return,
Last 5
Years
(%)
--------------- Quadrix Scores ---------------
Company (Price; Ticker)
Trailing
P/E
Earnings
Predict-
ability
Momen-
tum
Value
Overall
Relative
Risk
Lincoln National
($59; LNC)
2.0
18
9
(45)
10
72
70
94
93
High Risk
United Rentals
($103; URI)
2.8
52
14
(39)
14
54
84
81
96
High Risk
Ameriprise Financial
($128; AMP)
1.7
28
7
(31)
15
84
70
87
89
Above Avg.
F5 Networks
($127; FFIV)
1.9
13
12
(36)
21
96
84
58
95
Above Avg.
Affiliated Managers
($226; AMG)
1.7
24
7
(23)
19
96
44
67
85
Average
Lam Research
($80; LRCX)
1.3
16
8
(22)
17
72
84
70
94
Average
Aetna ($114; AET)
0.9
32
6
(25)
16
94
47
66
81
Below Avg.
Apple ($130; AAPL)
0.8
31
7
(24)
16
95
95
77
99
Below Avg.
Comcast ($58; CMCSa)
1.2
30
6
(17)
19
92
77
84
97
Below Avg.
Skyworks Solutions
($104; SWKS)
1.2
48
11
(29)
24
95
98
34
94
Below Avg.
Southwest Airlines
($37; LUV)
0.9
28
8
(30)
15
88
88
80
97
Below Avg.
Gilead Sciences
($110; GILD)
0.8
41
8
(25)
12
83
100
93
100
Low Risk
Kroger ($74; KR)
0.8
29
6
(15)
21
95
87
53
88
Low Risk
Note: Quadrix scores are percentile ranks, with 100 the best.

 


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