Get Solid Returns Without High-Risk Stocks
A fundamental tenet of investing holds that investors must hold riskier assets to boost expected returns. In contrast, low-risk investments are expected to produce lower, less-volatile returns.
While this maxim generally holds true, our research suggests you can improve your odds by using the QuadrixÂ® stock-rating system.
Our Relative Risk score separates stocks into five risk categories: high, above-average, average, below-average, and low. These ratings appear in the Monitored List supplement that accompanies the second newsletter of every month. You can find risk scores for about 3,400 stocks online at DowTheory.com/Go/RiskScores.
We derive the Relative Risk score using five indicators of share-price volatility over the past 60 months:
• Standard deviation (volatility of monthly returns relative to the average return).
• Beta (a stockâ€™s sensitivity to market movements).
• Worst three-month performance (a stockâ€™s poorest period in the past 60 months).
• Bull-market performance (how a stock fares in months when the market rises at least 2.4%).
• Bear-market performance (performance in months when the market pulls back at least 2.4%).
The bar chart below shows returns of stocks in the five risk categories. In 12-month periods since 1994 for S&P 1500 Index components, riskier stocks generated the highest and most-volatile returns.
The table below shows average returns for S&P 1500 stocks in the five Relative Risk categories, including periods when the market rose or fell. The bottom section is limited to stocks with Quadrix Overall scores above 80. In most cases, high-scoring stocks delivered superior returns compared to the average stock regardless of market direction. Interestingly, stocks with average or below-average risk generally benefited the most from high Overall scores.
High-risk stocks tend to outperform when the market is rising. In bear markets, when investors scamper for cover, low-risk stocks tend to perform best.
Donâ€™t be misled by the high average returns of risky stocks. Massive gains from a fairly small number of stocks skew the results and hide the poor returns of a large body of high-risk underperformers.
Investors can improve their returns by using Quadrix to screen out stocks with Overall scores below 80. This works particularly well for less-risky stocks.
Quadrix Overall leaders outperform in four of the five risk categories. But high-risk stocks with scores above 80 tend to perform worse than the average high-risk stock. Thatâ€™s likely due to Quadrix assigning lower scores to low-quality, speculative stocks â€” the high-risk stocks that skew the average with huge returns.
Our investment strategy tilts toward less-risky stocks. Such stocks tend to be less volatile and earn higher Quadrix scores. They also tend to produce more predictable earnings, the result of better visibility and the slower profit growth typical of larger companies.
Still, shrewd investors pick stocks based on how they fit into a portfolio, rather than focusing exclusively on their risk. For example, our Focus List portfolio, presented in the table below, emphasizes lower-risk stocks but does take on additional risk in an effort to gain exposure to a variety of sectors. Two stocks from that portfolio are reviewed below:
Shares of CSX ($62; CSX), a stock with below-average risk, have risen 28% this year, though an above-average Value score suggests the shares arenâ€™t yet overpriced. CSXâ€™s primary rail competitor is Norfolk Southern ($62; NSC), and the two companies share assets even as they compete for customers. Other rivals include truckers, shippers, and providers of pipeline transportation.
The companyâ€™s productivity gains stem from cost controls and higher volume, up 9% in the first nine months of 2010. Average revenue per carload grew 6% in the September quarter, lifted by higher prices and fuel surcharges. CSX is benefiting from the auto industryâ€™s resurgence; the companyâ€™s automotive volume has jumped 56% this year.
Although CSX plans to hire 2,000 workers by the end of the year and 3,000 more in 2011, its operating profit margins are poised to expand for the seventh consecutive year. Earning an Overall score of 94, CSX is a Focus List Buy and Long-Term Buy.
In the September quarter, DirecTV ($43; DTV) grew its profits 49% to $0.55, meeting the consensus estimate. Revenue advanced 10% to $6.03 billion on gains of 7% for the U.S. business (85% of sales in the nine months ended September) and 22% in Latin America (15%). In the U.S., average revenue per user rose 4% as DirecTV added 174,000 net subscribers, up 28% from the year-earlier subscriber additions. By comparison, Time Warner Cable ($62; TWC) lost 155,000 net video customers. DirecTVâ€™s domestic customer attrition, or churn, dipped to 1.70%, down from 1.72% a year earlier.
Shares slipped on the earnings report, partly on account of the higher costs incurred to attract new customers. The low-risk stock slipped just 1% in 2008, when the S&P 500 Index plunged 38%. Since then, the stockâ€™s price momentum has more closely resembled that of higher-risk stocks. DirecTV was out in front of the marketâ€™s rally, surging 46% in 2009 and another 28% so far this year. Wall Street projects per-share-profit growth of 64% this year, followed by another 34% jump in 2011. The 2011 estimate has risen $0.03 in the last week. DirecTV is a Focus List Buy and a Long-Term Buy.