For decades, the investment world operated under two key assumptions – that risk is defined by volatility, and that taking on greater risk leads to greater reward. Buy stocks that are risky and, over the long run, the market will reward you with greater returns, the thinking went.
Recently, however, that thinking has been turned on its head. Last year, at least two academic studies found that low-beta stocks – that is, those that have lower volatility than their benchmarks – have outperformed more volatile high-beta stocks over the long run.
In Betting Against Beta, published in the Swiss Finance Institute Research Paper Series, Andrea Frazzini and Lasse Pedersen found that Warren Buffett's Berkshire Hathaway has beaten the market over the long haul by focusing on low-beta stocks, and using leverage – other people’s money – when buying them.
Most investors can't use large amounts of leverage, however. Instead, they turn to volatile stocks in search of high return, Mr. Pederson and Ms. Frazzini said. In doing so, they bid up the prices of those stocks, which has led to high-beta assets underperforming among U.S. equities, 20 international equity markets, Treasury bonds, corporate bonds, and futures.
Another study, published in the Financial Analysts Journal, looked at the 1,000 largest stocks from 1968-2008, breaking them down into five quintiles based on their betas. Malcolm Baker, Brendan Bradley, and Jeffrey Wurgler found that investing a dollar in the quintile of stocks with the lowest betas would have produced a gain of $10.12, after inflation, by the end of the 41-year period. A dollar invested in the stocks with the highest betas? It would have left you with less than 10 cents!
The authors hypothesize that a number of behavioural factors, including overconfidence, tend to push investors into high-beta stocks, making them overvalued.
James O'Shaughnessy, one of the investors upon whom I base my Guru Strategy investing models, also revealed some interesting beta-related data last year. In an updated version of his What Works on Wall Street, he found that from 1968-2009, the top-performing sector in the U.S. market was the decidedly unsexy, low-volatility consumer staples sector.
These firms produce solid, steady earnings through the entire economic cycle because people buy staple items even in tough times. In addition, many consumer staples firms don't have to deal with the competition that dogs flashier companies. “There are probably not three guys in a garage out in Palo Alto trying to think up a new formula to beat Coke,” Mr. O’Shaughnessy said. “There's all sorts of people out there trying to beat Google.”
The common observation among all these researchers is that sexy companies and stocks more often than not lose out to solid, steady Eddies. For every Google or Microsoft, there are dozens of hyped-up stocks that end up floundering.
While most investors are loading up on those high-risk plays, you should consider focusing on less volatile stocks of companies with attractive valuations and solid balance sheets. Here are three that get approval from my models. Investing in low-beta plays like these could help you generate market-beating long-term returns – and get a good night's sleep during tough times.
The Atlanta-based beverage giant has a beta of just 0.52 over the past five years. (A beta of 1.0 would mean it was as volatile as the S&P 500 benchmark; a figure below that level indicates lower volatility.)
Coke is a long-time holding of Mr. Buffett's Berkshire Hathaway, and not surprisingly it gets high marks from my Buffett-based strategy. The model likes its history of increasing earnings per share in a variety of climates, the fact that it has enough annual earnings ($8.7-billion U.S.) that it could, if need be, pay off all its debt ($16.4-billion) in less than two years, and its 30-per-cent average return on equity over the past 10 years.
Procter & Gamble Co.
Cincinnati-based Procter is a power in the consumer goods arena, with such famous brands as Pampers, Bounty, Swiffer, Gillette, Old Spice, and Ivory. Its size ($84-billion in annual sales) and those staple brands have made it much less volatile than the broader market, with a beta of just 0.45 over the past five years. My O'Shaughnessy-based value model likes its fundamentals, including its strong cash flow per share and solid 3.4 per cent dividend yield.
This Montreal-based food and drugstore operator's shares have a beta of just 0.32, and win approval from two of my models.
My Peter Lynch-inspired strategy considers it a “stalwart” – the type of large, steady firm that tends to fare well in tough times – because of its large sales and steady growth in earnings per share. My O'Shaughnessy-based growth model likes Metro’s decade-long history of increasing its annual earnings per share.