Risk vs. reward — a new look at an old story
In volatile times, investors must be able to measure risk, says a U.S. advisory that reveals its risk ratings and two stocks that measure up.
Risk is nothing new.
The first guy (supposedly it was a Scandinavian) who put the first wad of money in the first joint-stock company was going out on a limb.
It does seem, however, that there has been more risk than is absolutely necessary these past two years. It does get nerve-wracking.
How to deal with all this risk? Look it square in the face, says one U.S. advisory. And remind yourself rewards do not come without risk.
But that doesn’t mean throwing caution to the winds. Some risks are worth taking, but others are only for those who might find hang gliding in the Andes a bit dull.
And there’s a way to measure just how much risk is worth taking, says Dow Therory Forecasts, which specializes in market measurements.
The advisory comes to a definite conclusion as to how much risk investors should be taking on in this market — and recommends two stocks that look good on the risk scale.
High returns, more risk
“Volatility doesn’t seem that dangerous during bull markets,” says this advisory, “and most investors like upward volatility. But the collapse of the credit and housing markets and the resultant carnage in the stock market last year served as a warning that everybody should pay attention to risk.”
So it came up with Relative Risk ratings. There are five — High risk, Above-average risk, Average risk, Below-Average risk and Low risk.
To arrive at these ratings, the advisory considered five measures of risk over 60 months. They are:
Standard deviation, which measures the volatility of returns against the average return; Beta, which measures a stock’s sensitivity to market movements; Worst three-month performance, which looks at a stock’s poorest period during the past 60 months; Bull market performance, which looks at its performance during months in which the market rose at least 2.4 per cent; and Bear market performance, which looks at performance in months when the market fell at least 2.4 per cent.
As a rule, the advisory states, lower risk means lower returns. “Investors who want high returns must in turn take on more risk.” But it’s not a hard-and-fast rule, as we shall see.
Sharp differences
Measuring stocks on the S&P 1500 with five years of return history, the advisory found that since 1994, stocks with High risk had average returns of 18.6 per cent, while stocks with Low risk averaged 10.4 per cent. High-risk stocks were also twice as volatile as their Low-risk counterparts.
In the 12 months ended this October, the contrast is astonishing — High-risk stocks averaged a 57.7 return, while Low-risk stocks had a negative return of 1.1 per cent.
“Those sharp differences often occur when the market rallies,” explains the advisory. “But while the absolute return numbers look good, shrewd investors will not simply load up on High-risk stocks.”
Stocks that score High on the risk ratings tend to be smaller and less fundamentally sound than those that score Low.
“Speculative stocks with poor fundamentals often lead the market up during rallies,” says the advisory. “However, such stocks often have trouble holding on to gains, and it takes an advance of stronger companies to sustain a rally.”
So while High-risk stocks promise higher returns, “our research suggests Low-risk selections represent better options at this time.”
Markedly cheaper
Dow Theory Forecasts has three reasons for preferring Low-risk stocks. The first is simply the strong fundamental values of these stocks. As a group, they score higher in the benchmarks the advisory applies — Momentum, Quality, Value, Financial Strength, Earnings Estimates and Performance — than the High-risk stocks.
Their market valuations are also more attractive. In a market that many people consider fully valued or even overbought, the Low-risk stocks looked markedly cheaper than those in any other risk category, with an average trailing price/earnings ratio of 17.4.
Not surprisingly, Low-risk stocks are also less volatile. The advisory’s research suggests that, based on their history, they will be less risky than those in any other risk rating category for the next three years.
Here is how two of those stocks measure up.
Most compelling advantage
AmeriSourceBergen (NYSE-ABC) sells home health care products and brand-name drugs, but its “most compelling advantage” could be its strong presence in generic drugs. Their sales are rising faster than those of brand names, and that trend could accelerate in the wake of the Obama administration’s health care initiatives.
The company is buying back its shares aggressively, pushing up its per-share growth. Despite those purchases, its cash holdings keep going up and so does the dividend.
Wall Street expects this stock to increase its profits by 11 to 14 per cent over the next five years. And it trades at just 14 times trailing earnings. It is rated a Focus Buy (best buy for the next 12 months).
Hewitt Associates (NYSE-HEW) manages employee-benefit programs and advises clients on contribution plans, restructuring and mergers. It has a lot of overseas work, in India, China and elsewhere. Outsourcing accounts for 70 per cent of its sales.
The company generates steady cash from long-term contracts. There’s more where that came from, as it should be able to boost business with existing clients and grow through acquisition. Hewitt has seen its profits grow by at least 15 per cent in the last six quarters. Wall Street expects growth of seven to 10 per cent over the next year. It’s a buy.
There may never be a perfect balance between risk and reward. But this advisory makes its point firmly. High-risk stocks may have led the chase up the charts, but those with lower risk should stay the course a whole lot longer.
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