After a brisk start to the year, the stockmarket took a breather over the summer. But while the index averages have flattened out, many investors still worry that a sharp downturn is around the corner. After a few years of rising prices, there’s a sense that we’re simply owed a correction.
While predicting these events is impossible, one option for risk-averse investors is to consider stocks that are less sensitive to potentially painful swings in the market.
Periods of high and low price volatility tend to be cyclical. In calm conditions it’s the higher volatility stocks that catch the eye of investors. It’s these that tend to offer stronger returns when confidence is high and markets are on a roll.
This is exactly why high momentum and fast-growth investing strategies have worked so well this year. Stockopedia research suggests that value and bargain strategies almost completely stopped working in the third quarter. That’s partly because investment flows are sweeping into exciting, fast moving (and ultimately very popular) growth stocks. That certainly won’t last, as any hardened value investor will tell you.
In downturns, shares that are less sensitive to the market mood can often be a much better bet. While low volatility shares don’t tend to outperform in bull markets, they do much better in periods of uncertainty. In fact, over the long term, low volatility – which essentially means taking less risk – has been shown to be the superior approach.
This ‘low-vol anomaly’ was a finding of the late Professor Robert Haugen, who wrote in detail about low-volatility outperformance existed. He concluded that investor behaviour was behind the it and that there was a misconception that high risk equals high reward.
Haugen believed that investors were overconfident in their own stock selection abilities and naturally attracted to risky shares. As a result, these shares would become overpriced, while lower risk shares would actually become cheap to buy. And while these cheaper, low-vol stocks are slower to rise in bull markets they don’t fall as far in bear markets.
Now let’s put this in context. In the United States, the S&P 500 has been rising in value for more than eight years straight. That’s enough for some to call it “the most hated bull market in history”. Why? Because there’s a sense that prices have been driven by monetary policy rather that corporate earnings. And that increases the fear that equity prices could be impacted badly when policy changes.
We’ve felt similar effects in the UK, although nowhere near as extreme. So there’s an argument that investors should be concerned about future high volatility.
Figuring out what makes a low volatility stock
Calculating volatility in the stockmarket is not simple. One of the measures used is called Beta. This is a direct measure – often taken over several years – of how sensitive a stock price is to the movement of the wider market. If a stock’s price tends to rise more than the market on up-days and fall more than the market on down days, it will have a Beta greater than 1. But if it isn’t as sensitive to market movements, rising, or falling, less than the market, then it will have a Beta of less than 1.
Another option is to look at a stock’s standard deviation. This is a mathematical way of understanding how much a company’s share price moves away from its average over a period of time.
To simplify all this, we’ve built a low volatility screen this week which focuses on three-year standard deviation. But, instead of numbers, we’re using something called RiskRatings, which score stocks as either Highly Speculative, Speculative, Adventurous, Balanced or Conservative. For our purposes, we’ve focused on FTSE (UKX) companies using the following rules:
– Low bankruptcy risk (using the Altman Z-Score)
– Attractive valuation, quality and momentum – scored by the StockRank: from zero (poor) to 100 (excellent)
– A Beta of less than 0.8
– Only Conservative and Balanced RiskRatings
The result of this approach is a list of stocks that tend to be solid, reliable but occasionally unremarkable. These are low Beta, low volatility shares with no obvious bankruptcy risk. While some have seen sharp price rises in the current bull run – particularly names like Games Workshop (GAW), Cranswick (CWK) and JD Wetherspoon (JDW) – most here have been making robust but unremarkable progress. They include big companies like BAE Systems (BA.) and Croda (CRDA) as well as smaller stocks like Rank (RNK), Costain (COST) and Halfords (HFD).
Name Mkt Cap £m Risk Rating Stock Rank Beta Industry Group Rank 864.6 Balanced 87 -0.29 Hotels & Entertainment Costain 465.8 Balanced 98 -0.068 Construction & Engineering Halfords 684.4 Balanced 85 0.056 Specialty Retailers J D Wetherspoon 1,301 Balanced 89 0.29 Hotels & Entertainment Cranswick 1,523 Balanced 82 0.31 Food & Tobacco Games Workshop 639.9 Balanced 94 0.37 Leisure Products Bloomsbury Publishing 120 Conservative 96 0.58 Media & Publishing Headlam 503.5 Conservative 97 0.58 Household Goods Croda International 5,093 Conservative 85 0.74 Chemicals BAE Systems 19,749 Conservative 81 0.79 Aerospace & Defense
With the price of many growth stocks roaring ahead, it’s no surprise that some investors are wondering whether the bull run for equities could hit trouble in the near future. Calm conditions combined with increased optimism have conspired to payoff for riskier stocks.
But, if events change, it could be worth planning for how to deal with a period of uncertainty by exploring where lower volatility can be found. Low volatility stocks are often better placed to withstand the challenges of market turmoil, which means they’re a useful way of diversifying risk in a portfolio.
Interactive Investor’s Stock Screening series is written by Ben Hobson of Stockopedia.com, the rules-based stockmarket investing website. You can click here to read Richard Beddard’s review of Stockopedia.com and learn more about the site.
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It’s worth remembering that these and other investment articles on Interactive Investor are simply for generating ideas and if you are thinking of investing they should only ever be a starting point for your own in-depth research before making a decision.
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About the Author
Ben Hobson is Investment Strategies Editor at Stockopedia.com. His background is in business analysis and journalism. Ben researches and writes regularly on investment strategy performance and screening ideas for Stockopedia.com. He is the author of several ebooks including “How to Make Money in Value Stocks” and “The Smart Money Playbook”
This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.