Take A Little Risk

8/8/2016


Seldom has buying low-risk stocks been such a high-risk proposition.

Reflecting a flood of money going into low-volatility funds, low-volatility stocks now trade at premium valuations. In fact, the least volatile stocks have never been so expensive — and have never been so expensive relative to the rest of the market.

THE HIGH PRICE OF LOW VOLATILITY
For the tables below, we divided S&P 1500 stocks into five equal-numbered quintiles based on two measures of volatility — beta and standard deviation. On both measures, the safest stocks are the most expensive based on trailing price/earnings ratios. On both measures, the safest stocks have never been so expensive since at least 1994, when our data begin. Beta measures a stock's sensitivity to stock-market movements, while standard deviation measures the volatility of its monthly returns.
Quintiles By Beta
--------------------------- Average Trailing P/E Ratio ---------------------------
Least
Volatile
Second
Quintile
Third
Quintile
Fourth
Quintile
Most
Volatile
Recent trailing P/E
26.2
24.0
22.0
23.0
20.3
Norm since 1994
19.8
20.3
21.1
21.5
23.7
Maximum since 1994
26.2
25.6
27.8
29.3
36.3
Recent as % of norm
132
118
104
107
86
% of mos. since 1994
lower than recent
100
93
68
74
20
Quintiles By Standard Deviation
--------------------------- Average Trailing P/E Ratio ---------------------------
Least
Volatile
Second
Quintile
Third
Quintile
Fourth
Quintile
Most
Volatile
Recent trailing P/E
24.6
23.0
22.1
23.2
23.2
Norm since 1994
18.7
20.4
20.8
22.3
24.6
Maximum since 1994
24.6
26.1
27.3
27.8
33.9
Recent as % of norm
131
113
106
104
94
% of mos. since 1994
lower than recent
100
88
70
64
33

In the first half of 2016, the top five low-volatility exchange-traded funds added a net $12.5 billion in assets, even as about $52 billion came out of U.S. stock funds, according to Morningstar. Fans of the funds point to research that suggests investors have tended to overpay for stocks that move more than the market, and underpay for stable stocks.

While that may have been true historically, it is hard to argue that low-volatility stocks are underpriced today. The least volatile stocks based on beta have outperformed the average stock by the largest margin since our data begin in 1993. As a result, the safest one-fifth of stocks on beta now trade at more 26 times trailing earnings — higher than at any time since at least 2004, and 32% above the norm of less than 20 times. Beta measures a stock's sensitivity to market movements.

The picture is largely the same based on standard deviation, which measures the volatility of monthly returns. On both volatility measures, only the most volatile one-fifth of stocks trade at a discount to long-term norms.

Implications for investors

While you should not rush into the most volatile stocks, you should be wary of low-volatility funds. You should also be wary of low-risk individual stocks with stretched valuations. In the table below, we list 10 such stocks, all of which trade at a premium to five-year norms on P/E. We also list 10 stocks with above-average volatility and attractive valuations, five of which are profiled in the following paragraphs.

Citrix Systems ($85; CTXS) has a beta of 1.9, meaning its shares would be expected to fall 1.9% on a 1% decline in the S&P 500 Index. Yet its underlying operating growth has proved remarkably steady. Annual sales have increased in 13 straight years. Cash from operations rose in nine of the past 10 years and free cash flow in six of the past seven years; both climbed at least 15% in the first half of 2016. Management funnels much of its cash flow into stock buybacks, shaving 16% off the share count over the past three years. Citrix has also fortified its balance sheet, currently carrying $1.35 billion in cash, versus $1.33 billion in total debt.

Citrix designs application software, with a focus on virtual-computing products. Its shares have rallied 12% this year, despite some disappointment that the company's GoTo spin-off will create less value than some investors had originally anticipated. At 17 times trailing earnings, the shares trade 12% below the median S&P 500 technology stock and 50% below their five-year median. Citrix is a Focus List Buy and a Long-Term Buy.


D.R. Horton ($32; DHI) has claimed the title as the largest U.S. homebuilder in each of the past 14 years, most recently taking an 8% share of the market, up from 5% in fiscal 2009 ended September. But its industry is highly cyclical, reflected by D.R. Horton posting losses in fiscal years 2007 to 2009. CEO David Auld has taken steps to limit future downturns by favoring a more moderate growth plan that should help the company consistently generate positive cash flow.

Annual operating cash flow turned positive in fiscal 2015, a first since fiscal 2011. D.R. Horton remains on track for its second straight year of positive operating cash flow, projected to reach $300 million to $500 million. For fiscal 2017, D.R. Horton expects cash flow to stay within that same range. Sales are projected to rise 10% to 15% next year, which would mark the company's sixth straight year of double-digit growth. D.R. Horton is a Focus List Buy and a Long-Term Buy.


F5 Networks ($123; FFIV) is the most volatile stock we recommend, based on its beta and standard deviation of monthly stock returns over the past five years. The stock has rallied 12% since reports first surfaced in June that it was shopping itself to potential suitors. Steady operating growth and a robust balance sheet make F5 an attractive takeover target. Sales, up in each of the past 14 years, are on pace to climb 4% in fiscal 2016 ending September. The balance sheet contains $811 million in cash and no debt, translating to $12 per share, or 10% of the stock price.

F5 makes networking products, and many of its customers are migrating toward cheaper cloud-based applications and away from expensive hardware. These applications sell at lower prices, which could eventually curb sales growth. But management says gross profit margins should not be affected. Management has been right so far, with gross profit margins rising in six of the past seven quarters. The stock is a Buy and a Long-Term Buy.


Lam Research's ($91; LRCX) stability in Quadrix is striking, with its Overall score exceeding 80 in each of the past 24 months. But its share-price action can be prone to sharp swings, largely due to Lam's exposure to the cyclical semiconductor-equipment industry. In recent quarters, Lam has managed to generate growth in a flat environment. Encouragingly, the industry's outlook appears to be improving. Lam expects shipments to pick up in the second half of 2016, and spending on semiconductor equipment is projected to climb in 2017.

Lam delivered a strong June quarter, topping consensus estimates for both earnings per share and sales. The midpoint of management's September-quarter outlook also narrowly surpassed analyst expectations. Lam is known for issuing conservative guidance, evident in the company's ability to top the consensus profit estimate in each of the past 14 quarters. The stock has returned 15% including dividends this year. It trades at just 14 times trailing earnings, well below its sector and its own five-year median of 19. Lam is a Buy and a Long-Term Buy.


As a construction-materials supplier for residential and commercial buildings, Owens Corning's ($54; OC) fate hinges on the health of the U.S. economy. Amid the sluggish U.S. recovery, Owens has shown a knack for consistently generating higher cash flow. Cash from operations rose in each of the past four years and quadrupled to $326 million in the first half of 2016. Its return on equity is also marching higher. The stock scores above 60 for all six Quadrix categories, contributing to an Overall rank of 97.

Sales climbed 10% for the three months ended June, Owens' strongest growth since the December 2013 quarter. And profit estimates for both 2016 and 2017 have risen since the company reported its latest quarterly results. Shares look cheap versus other S&P 1500 building-products stocks, trading more than 30% below industry medians for trailing P/E ratio, forward P/E ratio, price/sales, and price/operating cash flow. Owens is a Focus List Buy and a Long-Term Buy.

INVESTORS BID UP STABLE STOCKS
A number of low-volatility stocks currently carry an unusually big price tag, while many volatile stocks look inexpensive relative to historical norms and sector peers. Beta represents a stock's sensitivity to stock-market moves. A beta above 1.0 means a stock tends to outperform in market rallies and lag in market declines. Standard deviation measures the dispersion of a stock's monthly returns. Stocks recommended for purchase are in bold.
5-Year
Standard
Deviation
---- Trailing P/E Ratio ----
Forward
--- P/E Ratio ---
YTD
Total
Return
(%)
Quadrix Scores
Company (Price; Ticker)
Beta
Stock
5-Year
Median
Sector
Median
Stock
Sector
Median
Value
Overall
Sector
Volatile but cheap
Amerco ($396; UHAL)
27
1.6
16
14
19
15
19
2
63
88
Industrials
Citrix Systems
($85; CTXS)
35
1.9
17
35
18
17
17
12
58
95
Technology
D.R. Horton ($32; DHI)
29
1.4
14
16
17
14
17
1
75
94
Discretionary
F5 Networks
($123; FFIV)
38
2.0
17
27
18
17
17
27
62
94
Technology
Gilead Sciences
($80; GILD)
27
1.1
6
15
20
7
19
(20)
97
84
Health care
J.P. Morgan Chase
($65; JPM)
26
1.6
12
10
16
11
15
0
86
58
Financials
Lam Research
($91; LRCX)
26
1.4
14
19
18
13
17
15
80
92
Technology
Lear ($111; LEA)
25
1.2
9
10
17
9
17
(9)
95
96
Discretionary
Mohawk Industries
($209; MHK)
24
1.3
19
22
17
17
17
10
60
95
Discretionary
Owens Corning
($54; OC)
34
1.7
16
20
19
16
19
16
89
97
Industrials
Steady but expensive
Altria ($66; MO)
16
0.5
22
16
24
24
23
16
22
52
Staples
AutoZone ($805; AZO)
14
0.3
20
17
17
20
17
8
45
70
Discretionary
Baxter International
($48; BAX)
17
0.6
29
16
20
28
19
27
50
75
Health care
Bristol-Myers Squibb
($75; BMY)
20
0.5
34
26
20
28
19
10
22
62
Health care
Colgate-Palmolive
($74; CL)
12
0.5
27
22
24
26
23
13
19
39
Staples
Costco Wholesale
($166; COST)
14
0.5
31
26
24
31
23
3
29
37
Staples
Duke Energy ($85; DUK)
14
0.5
19
16
21
19
20
22
52
56
Utilities
Lockheed Martin
($257; LMT)
14
0.6
22
15
19
21
19
20
39
68
Industrials
Philip Morris Int'l
($99; PM)
18
0.9
24
17
24
22
23
15
23
34
Staples
TJX ($81; TJX)
15
0.5
24
20
17
23
17
15
38
64
Discretionary
S&P 500 Median
23
1.1
19
18
19
10
50
60
Note: Quadrix scores are percentile ranks, with 100 the best.

 


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