It’s amazing how a gut-wrenching market downturn can get people thinking about risk again.
Volatility doesn’t seem that dangerous during bull markets, and most investors like upward volatility. But the collapse of the credit and housing markets and the resultant carnage in the stock market last year served as a warning that everybody should pay attention to risk.
Of course, there are many types of risk. But when you bring up the topic of risk in a room full of stock investors, most of them will start thinking about volatility. And unless you have a time horizon of 20 years or more, you should indeed be concerned about the volatility of stock returns. The Forecasts developed Relative Risk ratings to help investors assess the risk of individual stocks. For more on the Relative Risk rating, see below.
Investments with lower volatility tend to generate lower returns. Investors who want high returns must in turn take on more risk.
We generated Relative Risk scores for stocks with five years of return history, classifying the riskiest one-fifth as High risk. In rolling 12-month periods since 1994, stocks classified as High risk averaged 18.6% returns, versus 10.4% for Low risk stocks. Stocks with High risk were more than twice as volatile as those with Low risk as measured by standard deviation.
In the 12 months ended October, stocks with High risk averaged a 57.7% return, versus a negative return of 1.1% for stocks with Low risk. Those sharp differences often occur when the market rallies. But while the absolute return numbers look good, shrewd investors will not simply load up on high-risk stocks.
Stocks that earn a Relative Risk score of High tend to be smaller and fundamentally weaker than the average stock. The median stock with High risk in the S&P 1500 Index has a stock-market value of $709 million, versus $1.79 billion for all of the stocks in the index. In addition, stocks with High risk averaged a poor Quadrix Overall score of 32 at the end of October. Speculative stocks with poor fundamentals often lead the market up during rallies. However, such stocks often have trouble holding onto gains, and it takes an advance of stronger companies to sustain a rally.
While stocks with High risk do offer excellent return potential, our research suggests Low-risk selections represent better options at this time. Here are three reasons for that conclusion:
Strong Overall scores. At the end of October, the average S&P 1500 stock with Low risk earned a Quadrix Overall score of more than 73, the highest level in at least 14 years and well above the average of 62 since 1994. Stocks with Low, Below-Average, or Average risk tend to earn higher Overall scores than higher-risk stocks, averaging scores between 60 and 64 since 1994. But stocks with Low risk have never before looked this attractive relative to more-risky names.
Attractive valuations. Stocks with Low risk averaged trailing P/E ratios of 17.4 and Quadrix Value scores of 66 at the end of October. All other Relative Risk groups have higher P/E ratios and lower Value scores. Historically, the difference in P/E and Value score between stocks with Low, Below Average, or Average risk has been quite small. But at the end of October, the Low-risk group looked markedly cheaper than the rest. Low-risk stocks average a P/E 20% below that of High-risk stocks, roughly in line with long-term norms.
Less volatility. We calculate Relative Risk ratings based on stock performance over the last five years. But our research suggests stocks that earn Low Relative Risk ratings tend to be less volatile than other stocks over the next three years. In other words, stocks classified as Low risk tend to remain less risky going forward.
AmerisourceBergen’s ($24; ABC) aggressive stock-repurchase program helps boost per-share growth numbers and support the stock price. In fiscal 2009 ended September, Amerisource spent $450 million on buybacks, lowering the share count by nearly 7%. Despite that spending, the company’s cash holdings jumped 15% to $1.01 billion, providing flexibility to invest in the business as well as keep buying back stock and raising the dividend. Management says it plans to spend $350 million on stock buybacks in fiscal 2010.
Amerisource sells home-health-care products and brand-name drugs, but its leverage to generics could prove to be its most compelling competitive advantage. Generic-drug volumes are rising faster than branded volumes, and the Obama administration’s policies could accelerate this trend.
For fiscal 2010, Wall Street foresees profits rising 8% to $2.07 per share on 3% higher revenue. The company seems capable of growing profits at an 11% to 14% clip over the next five years. At 14 times trailing earnings, the stock trades at an appealing 20% discount to the five-year average P/E ratio. Earning a Quadrix Overall score of 95, Amerisource is a Focus List Buy and a Long-Term Buy.
With operations in more than 30 countries, Hewitt Associates ($40; HEW) manages employee-benefit programs and advises clients on contribution plans, restructuring, and mergers. About 26% of revenue is generated outside of the U.S., headlined by a strong presence in India and China.
Outsourcing represents about 70% of Hewitt’s sales. Like many outsourcers, Hewitt generates steady cash inflows from long-term contracts. That consistent cash flow, coupled with a business model that focuses on boosting business with existing clients as well as growing through acquisitions, inspires some confidence in the company’s ability to provide steady profit growth in the years ahead.
Hewitt has delivered per-share-earnings growth of at least 15% in each of the past six quarters. Hewitt’s profits per share surged 39% to $0.68 excluding special items in the September quarter, topping the consensus by $0.05. Revenue fell 6% to $774 million as flat sales in benefits outsourcing partially offset double-digit declines in consulting and business-process outsourcing. Hewitt expects per-share profits of $2.85 to $2.95 in fiscal 2010 ending September, representing growth of 7% to 10% and above the $2.84 consensus. Hewitt Associates is a Buy.
Relative Risk ratings classify stocks in five categories: High risk, Above-Average risk, Average risk, Below-Average risk, and Low risk. You can find Relative Risk ratings for all of the Forecasts monitored stocks in the Monitored List supplement sent with the second newsletter of every month.
To access Relative Risk scores for about 3,400 U.S.-traded stocks, visit www.DowTheory.com/go/RiskScores.
To derive the Relative Risk rating, we consider five measures of risk based on 60 months of returns:
• Standard deviation measures the volatility of returns relative to the average return.
• Beta measures a stock’s sensitivity to market movements.
• Worst three-month performance considers a stock’s poorest period during the last 60 months.
• Bull-market performance looks at a stock’s performance during months when the market rose at least 2.4%.
• Bear-market performance looks at a stock’s performance during months when the market fell at least 2.4%.