Friday, October 31, 2014

Quality Stocks & the Risk-Return Tradeoff

Roughly five years ago, Jeremy Grantham said the following about what he calls "quality stocks".

"Quality stocks have outperformed the market since 1965 (when our quality data begins)..."

When Grantham talks about "quality stocks", he is referring to those that produce a "high and stable return".

He then adds:

"...Fama and French adopted a circular argument rather typical of finance academics in the 1970 to 2000 era: the market is efficient; P/B and small cap outperform, ergo they must be risk factors. That the result in this case happens to get to the right result is luck. The real behavioral market is perfectly happy not rewarding 'risk' when it feels like it, as is shown by the 70-year underperformance of high beta stocks. But this time it worked. Price-to-book, despite its low beta, is a risk factor because of its low fundamental quality and its vulnerability to failure in a depression. This is true with small cap as well. But what about 'Quality?' This factor has outperformed forever. (The S&P had a High Grade Index that started in 1925 and handsomely outperformed the S&P 500 to the end of 1965 when our data starts.) Since the market is efficient, to Fama and French quality must be a risk factor! So, by protecting you in the 1929 Crash and in 2008, and by having a low beta for that matter, Quality as represented by Coca-Cola and Johnson & Johnson must be a hidden risk factor. Oh, I know: 'The real world is merely an inconvenient special case!'"

The bad news is, unlike when Grantham wrote the above, quality stocks aren't at all cheap these days. Still, the above makes an important broader point about risk and return even if the stocks themselves -- at current prices -- are far less attractive.*

So let's start by looking at a rather conventional explanation of the tradeoff between risk and return.

From Investopedia:

"...potential return rises with an increase in risk. Low levels of uncertainty (low-risk) are associated with low potential returns, whereas high levels of uncertainty (high-risk) are associated with high potential returns."

So many assume that more risk must be taken to produce greater rewards. That might at first glance seem very reasonable but, well, it's just not.

Brett Arends explains it this way:

"Conventional wisdom will often tell you that the only way to earn higher returns than the overall stock market — the only way to 'beat the market' — is to take more risk.

This idea is at the heart of the 'modern portfolio theory' that is probably practiced by your investment manager. It sounds plausible. It sounds credible. Everyone can understand it, and it is a generally accepted assumption.

The only problem? It's wrong. New research has found that you could have earned higher returns than the market in the past while taking on lower risk. This isn't a minor detail. This turns conventional finance upside-down."

Howard Marks put forward two useful and relevant charts on risk and return (at the bottom of page 6 of this memo). The first presents risk and return the traditional way (with risk and return positively correlated).

The second chart explains the relationship between risk and reward in a way that, to me, much more closely represents the world as it is.

Here's how Howard Marks explains it:

"We hear it all the time: 'Riskier investments produce higher returns' and 'If you want to make more money, take more risk.'

Both of these formulations are terrible. In brief, if riskier investments could be counted on to produce higher returns, they wouldn't be riskier."

Howard Marks on Risk

So risk and return need not be positively correlated.

It's simple, important, and too often ignored.

In the past I've referred to the following quote from the Superinvestors of Graham-and-Doddsville but it's worth repeating here:**

"Sometimes risk and reward are correlated in a positive fashion. If someone were to say to me, 'I have here a six-shooter and I have slipped one cartridge into it. Why don't you just spin it and pull it once? If you survive, I will give you $1 million.' I would decline -- perhaps stating that $1 million is not enough. Then he might offer me $5 million to pull the trigger twice -- now that would be a positive correlation between risk and reward!

The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it's riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case. The greater the potential for reward in the value portfolio, the less risk there is."

The math is obviously pretty simple but let's quickly walk through this:

A dollar bill is found on the ground by two people.

It's probably real.

It might not be.

One person is willing to pay 60 cent (i.e. less than the face value because, if not real, it might be worth zero).

The second is willing to pay 40 cents.

Well, the first person can make 67% if the dollar bill is real and, of course, can lose the 60 cents if it's a fake.

The second person can make 150%, if real, and lose the 40 cents, if not.

Two-thirds the possible loss; more than twice the return. Reduced risk of permanent capital loss; greater reward. Things like the capital asset pricing model (CAPM) and the three factor model are not built for the possibility of a negative correlation between risk and reward. So the higher return produced at less risk ends up as alpha. Well, at least it does for those who buy into modern finance theory.

To me, this makes alpha the ultimate fudge factor because, in a scenario like the above, it masks what's really going on.

It masks the reality that, sometimes, risk and reward need not be positively correlated. This might seem harmless but I think the relationship between risk and reward as it is (whether positive or negative) should be explained in clear terms (i.e. instead of calling it an abnormal rate of return compared to what's predicted by an equilibrium model like CAPM).

So the assumption more risk must be taken to get more reward is an incorrect one. This idea is not exactly new -- considering that Buffett's comments, for example, were made roughly 30 years ago -- even if frequently ignored.

Somehow, that more risk must be taken to increase rewards remains at the core of modern finance to this day.


Related posts:
-Howard Marks on Risk
-Altria: Timing Isn't Everything, Part II
-Altria: Timing Isn't Everything
-Grantham on Efficient Markets, Bubbles, and Ignoble Prizes
-Efficient Markets - Part II
-Risk and Reward Revisited
-Boring Stocks
-Efficient Markets
-Modern Portfolio Theory, Efficient Markets, and the Flat Earth Revisited
-Buffett on Risk and Reward
-Buffett: Why Stocks Beat Bonds
-Beta, Risk, & the Inconvenient Real World Special Case
-Howard Marks: The Two Main Risks in the Investment World
-Black-Scholes and the Flat Earth Society
-Buffett: Indebted to Academics
-Friends & Romans
-Superinvestors: Galileo vs The Flat Earth
-Max Planck: Resistance of the Human Mind
-Defensive Stocks?

* The higher quality stocks mostly are not selling at a discount to value these days. At least that is my view. They're still good businesses but the shares just don't provide any protection against what might go wrong. It's, of course, impossible to predict when shares are going to sell at attractive prices. The risk of not owning a good stock at a fair price is a real one (error of omission) that sometimes doesn't get enough consideration. It's why buying what becomes cheap (for those comfortable buying individual stocks) when the opportunity arise is so important. It wasn't tough to buy shares in some of the highest quality businesses at a nice discount to per share intrinsic value several years ago. The situation is very different now. Unfortunately, it's just not possible to know if/when they'll be available at a discount in the future. So decisive action with an eye toward the long-term (i.e. that means mostly ignoring the near-term and even intermediate-term price action after purchase) is required whenever they happen to get cheap enough. The time to buy with a big margin of safety, at least for now, seems to have passed.
** See toward the end of the Superinvestors of Graham-and-Doddsville for more on risk and reward and why it need not be correlated in a positive manner. That more risk must be taken to achieve greater rewards, along with efficient markets and rational expectations, still somehow take center stage within much modern finance theory. They remain at the heart of modern financial and economic theory though, fortunately, some of these theories have taken a real hit. Their influence over time -- sometimes quietly, sometimes less so -- can do real world economic damage.
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