Wednesday, June 12, 2013

Boring Stocks

This recent MarketWatch article notes that so-called 'boring' stocks tend to more than hold their own compared to those that provide more excitement as far as price action goes:

"...'boring' stocks — those that have exhibited the least historical volatility — on average outperform the most 'exciting' issues — those that have been the most volatile."

The article also points out that Nardin Baker, manager of global equity for Guggenheim Partners, conducted research that revealed the following:

"Consider a portfolio that invested in the 10% of U.S. stocks that had the lowest historical volatility. According to Baker, this portfolio from 1990 through 2012 did 19 percentage points a year better than the 10% of stocks with the greatest historical volatility. He says that he found nearly identical results in each of 20 developed-country stock markets outside the U.S. as well as in 12 emerging markets."

The extent of the outperformance may be somewhat surprising to some, but there happens to be at least some evidence to support the idea that these kind of companies produce very solid returns.

Of course, what really matters is what's likely to happen going forward. Still, it's worth trying to understand why the tendency has existed in past, and whether it's likely to apply in the future.

Robert A. Haugen and his former professor A. James Heins created a working paper with the title "On the Evidence Supporting the Existence of Risk Premiums in the Capital Market" back in 1972.

In the paper they conclude:

"...over the long run stock portfolios with less variance in monthly returns have experienced greater average returns than their 'riskier' counterparts."

So, even if this has been ignored by many over the years, it's not exactly a new idea. In this interview from a bit more than a year ago, Nardin Baker said the following:

"Low volatility stocks have outperformed consistently through time and across the world."

He later added...

"Essentially, the difference between high and low volatility stocks is their excitement factor. High volatility stocks are exciting and in demand. Investors, including institutional fund managers, tend to invest in exciting stocks in an attempt to outperform. So, high risk stocks have underperformed in the past because of these behavioral and agency problems.

We believe the low volatility anomaly will persist because investors and fund managers will only modify their behavior slowly, if at all."

Essentially, it's the tendency to pay too much relative to intrinsic value due to the "excitement factor".

To this I would add that some (not all, of course) of the lower volatility stocks are lower volatility in the first place simply because they are shares of higher quality businesses (durable competitive advantages, high returns on capital). Their range of outcomes are narrower and generally good or better. In other words, the potential relative performance* comes, in part, from having durable competitive advantages that lead to the business producing higher and more sustainable return on capital (and, ultimately, propels the increases to per share intrinsic value).

Whether there's more or less volatility isn't really what's important.

What's important is the fact that the underlying business has attractive core economic characteristics (and that capital is generally allocated wisely or, at a minimum, reasonably well). What's important is that, at the very least, a reasonable price was paid in the first place.

It just so happens that many higher quality businesses trade with reduced volatility. That's not a coincidence, of course, but it's the "high quality" characteristics and price paid that matters.

Over the long haul, the price paid relative to value along with attractive and sustainable returns on capital, end up being the key drivers of investor returns.**

If nothing else, that boring or defensive stocks (or whatever else one chooses to call them) tend to, in the long run, do just fine in terms of risk and reward is a subject that has been covered quite a bit over the years on this blog.

The boring companies with leading consumer brands, strong distribution, tend to experience little change. They sell nearly the same products, year after year, and can maintain their advantages. They also tend to be built to last so, combined with attractive and durable core economics, the compounded effects work to the long-term advantage of those who stick around. On the other hand, while innovation is critical for the world, picking the winning innovative companies beforehand is usually not easy. For every winner there are many losers, and avoiding the losses associated with those losers is easy only in theory. In addition, those with the most exciting prospects tend to have market valuations that seem to assume nothing can go wrong.

Well, if things do go wrong -- and the price that's paid should always assume things will -- the end result is permanent capital loss or, at least, an undesirable result in terms of risk and reward.

Picking the winners among the more boring companies is, by comparison, a whole lot less challenging.

Of course, what the higher quality boring businesses have done in the past promises nothing about the future. Even the best businesses have specific challenges going forward that are likely very different than the past.

Yet, as far as the investment process goes, the boring stuff sure doesn't seem like a bad place to start.

Over the shorter run -- less than five years or so -- anything can happen as far as price action and relative performance goes, of course. Also, the so-called boring stocks are just not likely to do particularly well in bull markets. Anyone buying them expecting to outperform during a bull market is likely to be disappointed.

That is, in part, how they have earned the reputation of being "defensive".

Yet, this defensive reputation isn't quite correct when you look at their historic returns over long enough time horizons.

It's generally when they're looked at over longer time frames -- more than a full business cycle or two -- that the picture becomes more clear.


Related posts:
Nifty Fifty - Part II - Nov 2012
Nifty Fifty - Nov 2012
The Cost of Complexity - Aug 2012
The Quality Enterprise, Part II - Aug 2012
The Quality Enterprise - Aug 2012
Consumer Staples: Long-term Performance, Part II - Dec 2011
Consumer Staples: Long-term Performance - Dec 2011
Grantham: What to Buy? - Aug 2011
Defensive Stocks Revisited - Mar 2011
KO and JNJ: Defensive Stocks? - Jan 2011
Altria Outperforms...Again - Oct 2010
Grantham on Quality Stocks Revisited - Jul 2010
Friends & Romans - May 2010
Grantham on Quality Stocks - Nov 2009
Best Performing Mutual Funds - 20 Years - May 2009
Staples vs Cyclicals - Apr 2009
Best and Worst Performing DJIA Stock - Apr 2009
Defensive Stocks? - Apr 2009

* Of course, anyone expecting stocks of the more boring variety to do well over shorter time horizons -- especially during a bull market -- will probably be disappointed (and, unfortunately, unlike a few years back shares of the highest quality businesses these days seem anything but cheap). Some will no doubt be tempted to jump in and out based upon the market environment to improve results. Well, good luck with that. It sounds reasonable enough in theory, but those extra moves create their own risks that are too often underestimated. Not impossible to do, maybe, but there are plenty of reasons to be skeptical that it will work in the real world. It's easy to overweight the upside potential of a particular move while not weighing appropriately the downside...that being things like the possibility of increased errors of omission and commission, as well as the higher frictional costs. An illusion of control at work. Obtaining part ownership of a fine business that one understands well at a great price is difficult enough -- patience, discipline, sound business judgment, and awareness of limits required. If the share price subsequently more fully reflects value the core economics of a good business are still at work for the partial owner. There's only so many industries and businesses one can develop real competency in and that is necessarily specific to each investor. If willing to sell part of one good business to buy another, the reasons ought to be very plain. Extreme overvaluation. A vastly superior and cheaper well understood alternative. Now, if business quality was misjudged or its prospects have materially and permanently changed for the worse that's another story. Investing well is not necessarily about being very smart. It's about wisely allocating limited time and an awareness of individual capabilities. 
** While trading excessively usually just adds frictional costs and mistakes. Otherwise, it's learning to ignore near-term -- and even intermediate-term -- price action once shares of a good business are bought at an attractive price. In this ethos, it is increases to per share intrinsic value of the business itself -- what it's capable of producing over time -- that primarily determines investment results. It's not unusual trading acumen.
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