Low-Volatility Bubble Hasn't Popped

5/1/2017


Back in December, we wrote about the bubble in low-volatility stocks, which had become quite expensive relative to long-term norms. This week we decided to revisit the issue and determine whether the bubble has popped.

Our conclusion? Stay away from sharp points.

The least-volatile stocks remain pricey. For example: Stocks in the S&P 1500 Index earning a Risk Rating of Low trade at an average price/earnings ratio of 25.7, well above their norm of 20.4 since 1994, and above the 21.7 average for High-risk stocks.

We saw similar trends for the lowest-volatility quintile (one-fifth) of the index as measured by standard deviation and beta. Stocks as a group trade above their long-term average P/E ratios. However, low-volatility stocks, which typically trade at lower P/E multiples than riskier names, these days command higher-than-normal premiums to their own historical average valuations.

The anatomy of volatility

On average, low-volatility stocks in the S&P 1500 Index earn Quadrix Value scores well below the average for high-volatity stocks or for the average as a whole. Since 1994, such low-risk stocks have tended to earn P/E ratios and Value scores in line with the index average.

All of the numbers below represent averages, some with a few outliers excluded. Averages also exclude companies without five years of total-return history, a prerequisite for calculating Risk Ratings. The least-risky stocks earn Relative Risk ratings of Low, while most-volatile companies receive High ratings.

---------- Quintile ----------
Ave S&P
1500
Stock
Lowest
(Most Risk)
Highest
(Least Risk)
Valuation
     
Price/earnings ratio
25.7
21.7
23.1
P/E versus 5-yr. avg.
1.15
1.04
1.08
Price/sales ratio
3.3
1.7
2.5
P/S versus 5-yr. avg.
1.28
1.04
1.16
Price/book
4.1
2.4
3.3
P/B versus 5-yr. avg.
1.28
1.06
1.17
Growth (%)
Sales, last 12 months
5
(4)
4
Sales, last 5 yrs. (annual.)
5
1
5
Per-share profits, last 12 months
8
(4)
6
Per-share profits, last 5 yrs. (annual.)
10
(3)
6
Quadrix scores
Momentum
55
45
51
Value
47
60
57
Quality
67
43
62
Financial Strength
67
41
58
Earnings Estimates
54
45
52
Performance
53
43
49
Overall
57
49
59

In other words, the low-volatility bubble remains firmly inflated. From some angles, low-volatility stocks appear cheaper than they did last summer at the peak of equity valuations, but not by much. This doesn't mean you should avoid stocks with low historical volatility. But these companies warrant a closer examination before any purchases, with particular attention paid to valuation.

Of course, valuation and volatility aren't the only reasons to buy or sell a stock. While low-volatility stocks as a group have become expensive, high-volatility stocks are still not the cheapest on the block.

At the moment, beelining to either the most- or least-volatile stocks is probably not a wise investment move. As usual, start your analysis by requiring strong fundamentals (as evidenced by high Overall scores), then consider volatility as one of many tiles in the investment mosaic.

The table below groups all of our recommended stocks according to their risk level. Three are reviewed in the following paragraphs:

Applied Materials ($41; AMAT) falls in the Above Average-risk group. Keep in mind that Above Average risk doesn't mean you should avoid a stock, just that it's more volatile than the average stock. As long as you keep that risk level in mind — and won't be surprised if the shares may jump around sometimes — Applied Materials makes a solid addition to any equity portfolio.

The semiconductor-equipment maker earns an Overall score of 98, with no category score below 65. Momentum is the headliner. Applied Materials earns a 99 in that score, powered in part by growth of 16% in sales and 40% in per-share earnings over the last year. Operating cash flow per share more than doubled. For fiscal 2017 ending October, analysts expect growth of 22% in sales and 52% in per-share profits.

At less than 16 times the current-year estimate, you can buy that growth at an attractive price. Applied Materials, yielding 1.0%, is a Buy and a Long-Term Buy.


In the March quarter, Centene ($73; CNC) earned $1.12 per share excluding special items, up 51% and $0.07 above the consensus. Revenue surged 69% to $11.72 billion, also comfortably ahead of the consensus. Management issued 2017 guidance; both the sales and profit goals rose. The midpoint of the new guidance range for earnings is $4.70 per share, in line with the current consensus — and baking in what the company called $0.20 per share in "conservatism.”

Centene, a managed-care provider focusing on the Medicaid market, has adapted nicely to the Affordable Care Act. However, it has a history of growth (five-year annualized gains of 50% in sales and 28% in per-share profits) dating back to well before the ACA. If Congress alters or dismantles the law, we expect Centene to adapt once again and continue delivering industry-beating growth. Centene is a Focus List Buy and a Long-Term Buy.


Building-products retailer Lowe's ($85; LOW) is in our Below Average-risk group. With the housing market solid and consumers willing to spend on home-improvement products, the year ahead looks good for Lowe's — and we're not the only ones who've noticed. The consensus projects per-share-profit growth of 16% this year and 14% next year, with targets for both years up at least 1.5% over the last six months.

Lowe's earns a Quadrix Value score of 71, which seems appealing, given the company's operating momentum. Lowe's trades at 21 times trailing earnings, 6% below its three-year average. At 18 times expected year-ahead earnings, the shares offer a 14% discount to the industry median. Lowe's, already a Buy and a Long-Term Buy, is being added to the Focus List.

HOW RISKY ARE OUR STOCKS?
The table below groups our recommended stocks according to their Relative Risk score. Only stocks with five years of trading history receive Relative Risk scores, which explains why some of our stocks are not in the table.
------------ Valuation Ratios ------------
---- Sales Growth ----
--- Profit Growth ---
--------- Quadrix Scores ---------
Company (Price; Ticker)
Price/
Earnings
Vs. 5-
Yr. Avg
Price/
Sales
Vs. 5-
Yr. Avg.
12
Months
(%)
5 Year
(Annual.)
(%)
12
Months
(%)
5 Year
(Annual.)
(%)
Momen-
tum
Value
Overall
Low risk
Comcast ($39; CMCSa)
22
1.20
2.3
1.17
8
8
9
17
77
65
92
CVS Health ($82; CVS)
14
0.75
0.5
0.77
16
11
12
16
63
96
86
Foot Locker ($77; FL)
16
1.05
1.3
1.23
5
7
12
21
67
85
94
LabCorp of America
($139; LH)
16
0.98
1.5
0.97
5
12
11
5
51
79
79
Mohawk ($238; MHK)
19
0.88
2.0
1.35
11
10
23
35
75
65
95
Southwest Airlines
($57; LUV)
15
0.90
1.7
1.63
4
5
4
NA
49
85
93
Below Average risk
Alaska Air Group
($88; ALK)
12
1.00
1.9
1.49
6
7
12
31
30
89
80
Amgen ($165; AMGN)
14
0.83
5.3
1.06
6
8
13
16
82
82
91
Apple ($144; AAPL)
17
1.28
3.5
1.15
(7)
11
(11)
11
35
63
82
Carnival ($61; CCL)
17
0.80
2.6
1.27
4
1
68
12
90
83
99
D. R. Horton ($33; DHI)
13
0.69
0.9
0.81
16
27
17
44
74
85
98
Disney ($116; DIS)
20
1.06
3.3
1.15
2
6
0
16
25
56
77
FedEx ($190; FDX)
17
0.78
0.9
1.02
16
6
40
4
59
74
82
Ingersoll-Rand ($89; IR)
21
1.14
1.6
1.32
2
(2)
11
8
43
64
83
Lear ($141; LEA)
10
0.92
0.5
1.27
2
6
30
23
82
96
99
Lowe's ($85; LOW)
21
0.95
1.1
1.14
10
5
21
23
86
71
96
Average risk
Celgene ($125; CELG)
21
0.57
8.7
NA
21
18
69
20
92
50
89
Lam Research
($146; LRCX)
17
0.76
3.3
1.41
24
22
55
25
99
68
99
Owens Corning
($61; OC)
17
0.83
1.2
1.34
6
1
31
10
56
85
94
Above Average risk
Applied Materials
($41; AMAT)
19
0.80
3.7
1.45
24
3
NA
10
99
67
98
CBS ($67; CBS)
16
0.93
2.1
1.05
(5)
(2)
12
14
28
67
68
Centene ($73; CNC)
17
0.67
0.3
0.82
NA
NA
31
30
90
94
99
Citrix Systems
($84; CTXS)
16
0.45
3.8
0.93
4
9
64
16
46
74
87
F5 Networks
($137; FFIV)
18
0.70
4.4
0.92
4
11
11
13
59
67
90
J.P. Morgan Chase
($88; JPM)
14
1.41
2.9
1.40
8
0
4
9
83
80
95
High risk
VMware ($94; VMW)
19
0.51
5.4
0.85
7
13
7
13
67
56
88
Note: Quadrix scores are percentile ranks, with 100 the best.   NA Not available. 

 


How we measure up

Investors can view risk in many ways, such as volatility, worst-case scenario, and market sensitivity.

Our Relative Risk ratings look at risk from five different angles, all considering returns for the last 60 months:

• Worst three-month performance gauges potential downside risk.

• Performance in bull markets measures how a stock performed during months when the market rose at least 2.4%.

• Performance in bear markets measures how a stock performed during months when the market fell at least 2.4%.

• Standard deviation compares the variability of a stock's monthly returns.

• Beta reflects how the stock responds to moves in the broad market.


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