A New Look At Risk And Return


Modern portfolio theory requires the assumption that high risks tend to walk hand in hand with high returns. Unfortunately, while that tenet often holds when comparing different asset classes, it doesn’t work as well within the equity asset class. 

Based on stock-price action over the previous 60 months, our Relative Risk score separates stocks into five risk categories: High, Above Average, Average, Below Average, and Low. Stocks that meet our criteria for Low risk have averaged 12-month returns of 10.1% since the start of 1995, while High-risk stocks averaged a negative return of 2.1%. The riskier the stock, the poorer the returns over the last 17-plus years — and this despite riskier stocks’ higher average profit growth.

Low risk versus High risk

Large-cap stocks like the ones we favor tend to have lower risk than midcap or small-cap stocks. That fact, coupled with the generally higher Quadrix® Overall scores of lower-risk stocks (see the below for details), leaves higher-risk stocks underrepresented on our buy lists. Only 21% of our recommended stocks earn Relative Risk scores of Above Average or High, versus 71% that qualify as either Low or Below Average. 

However, investors have piled into lower-risk stocks over the last year, and many have become expensive. The average Low-risk stock earns a Quadrix Value score of 44, well below the long-run norm of 59. In contrast, High-risk stocks average Value scores of 56, versus the norm of 46 since the start of 1995.

As a group, lower-risk stocks have become expensive, and higher-risk stocks tend to have inferior fundamentals. Below we present recommended stocks with both value (as reflected by the Quadrix Value score) and solid fundamentals (Overall score).
-- Quadrix Scores --
Company (Price; Ticker)
Lower risk
CF Industries
($194; CF)
Below Avg.
Cisco Systems
($15; CSCO)
Below Avg.
Intel ($25; INTC)
Below Avg.
Southwest Airlines
($9; LUV)
Below Avg.
Higher risk
Aetna ($37; AET)
Above Avg.
Health Care
Aflac ($42; AFL)
Above Avg.
AGCO ($41; AGCO)
Above Avg.
($48; KLAC)
Above Avg.
Note: Quadrix scores are percentile ranks, with 100 the best.

We recommend that subscribers construct diversified portfolios of high-quality stocks, a strategy that should dip into all the risk pools. Of course, with higher-risk stocks unusually cheap but not fundamentally strong and lower-risk stocks fundamentally strong but atypically expensive, investors must be choosy. The table above lists lower-risk stocks with attractive values and higher-risk stocks with strong fundamentals; three of our favorites are reviewed below.

Health insurer Aetna ($37; AET) earns an Above Average risk score. The shares have performed poorly in recent months, falling more than 27% from spring highs, hurt by disappointing March-quarter results and concerns about slowing growth. But while Aetna shares may remain volatile, we see at least two reasons for optimism about the stock’s future.

First, the Supreme Court’s upholding of health-reform legislation looks like a long-term positive for Aetna. Managed-care providers’ profit margins may suffer, but the potential coverage of up to 30 million uninsured Americans should substantially boost revenue.

Second, at seven times trailing earnings, Aetna trades at a 27% discount to its five-year average P/E ratio and 29% below the median managed-care company in the S&P 1500 Index. Even if Aetna achieves no more than the $5.05 per share in profits expected this year, a return to the three-year average P/E of nine would equate to a gain of 22% six months from now.

Aetna, slated to release June-quarter earnings July 31, is a Buy and a Long-Term Buy.

With the U.S. in its worst drought since 1956, fears of a slowdown in farm-equipment purchases have weighed on AGCO ($41; AGCO). Add to that broader concerns about slowing economic growth in the U.S. and overseas, and cyclicals of all stripe have taken a beating. AGCO, down 25% from February highs, earns a Quadrix Performance score of 34.

Operationally, AGCO’s harvest has been rich; in each of the last seven quarters, sales rose at least 16% and per-share profits 31%. The consensus projects per-share-profit growth of 23% this year but less than 3% next year. In our view, the 2013 target doesn’t take into account the ongoing global agricultural build-out fueled by an increasing demand for grain in emerging markets. A worldwide recession in the agricultural sector is unlikely, and Asia, Africa, and South America should continue to expand the acreage used to grow crops.

Yet despite its growth history and potential, AGCO earns a Value score of 95 and trades at a discount to its peers based on several valuation ratios. AGCO was expected to post June-quarter earnings July 26, a day after this issue of the Forecasts went to press. AGCO is a Focus List Buy and a Long-Term Buy.

Cisco Systems ($15; CSCO) already swims in a lot of pools, selling far more than the switches and routers for which it is known. Cisco also makes products for home networking, data storage, and video, as well as networking and security software. But despite that broad reach, Cisco still has aggressive expansion goals. In March, the company announced plans for a $5 billion acquisition of NDS, a developer of TV software. In July, Cisco purchased Virtuata, a security-software maker.

Investors worry about the company’s inability to generate growth, as well as mounting competitive pressures. But Cisco’s size and financial strength ($32.04 billion, or $5.87 per share, in cash net of debt) give it the flexibility to wait out the economic storm and snap up smaller rivals, positioning itself for the future. The proliferation of smartphones and tablets boosts bandwidth requirements, which in turn should spark demand for networking equipment.

The consensus projects per-share-profit growth of 15% in the July quarter but 4% in the fiscal year ending July 2013. The latter target seems conservative. Cisco trades at less than nine times trailing earnings, well below the peer-group median of 14 and its own three-year average of 17. The stock is a Buy and a Long-Term Buy. 

Relative Risk ratings

Our Relative Risk ratings appear in the Monitored List supplement that accompanies the second newsletter of every month. You can find scores for about 3,400 stocks online at www.DowTheory.com/Go/RiskScores.

We derive the Relative Risk rating using five indicators of share-price volatility over the past 60 months:

• Standard deviation (volatility of returns relative to the average return).

• Beta (a stock’s sensitivity to market movements).

• Worst three-month performance (a stock’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 drops at least 2.4%).

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