Volatility is Your Friend

It hasn’t been an easy environment to invest in. Fundamentals seem not to mean anything. The market paints with a super broad and emotional brush. Everything seems to go up and down at the same time.

It’s fascinating to see how people cope with the volatility. Their choices and behavior lead to some very odd market price constellations.

A money manager friend of mine sent me a note from Noah Blackstein, the manager of the Dynamic Alpha Performance Fund. He notes that the market is seeking yield and low-beta securities. In English, this means that people are looking for income and for stocks that don’t move as much as the market.

Beta is the common measure of volatility. If a stock has a beta of 1, it means it moves in step with the overall market. A beta of 1.5 means it moves 50% more than the market. So if the market went up 10%, this stock went up 15%. A low beta of 0.50 means the stock moves only half as much as the market. It’s this last fish that is the choice catch in today’s market.

Because of that, stocks with the desired attributes have become expensive. Blackstein offers up a pair to show his point: Microsoft versus Southern Com… “Microsoft trades at 9 times EPS, has a five-year EPS growth of 13% and yields 3.1% and sits with a balance sheet full of cash. Southern Co. trades for 17.5 times earnings per share, has a five-year growth rate of 3% and yields 4.4% with a ton of debt.”

It’s worse if you look at Canadian companies compared with US companies. He offered up Enbridge, a pipeline company, with a 2.7% yield and a price-earnings ratio of 24 times. It has lots of debt. The stock is up 30% this year. Microsoft, by comparison, yields more (3.1%), offers a lower price-earnings ratio (9) and is stuffed with cash. The stock is down 9%.


Now, here is the key. Microsoft has a beta of 0.78, versus Southern’s 0.38 and Enbridge’s 0.15. Market participants are willing to pay up for a stock that won’t have them reaching for a bottle of Maalox when the overall market is extremely volatile. Low beta has won out. “How can this be anything other than a low-beta bubble?” Blackstein writes.

Here’s the thing, though: Though short-term market prices have all kinds of burps that make no sense, the market does sort things out rationally over the long haul. Stocks of bankrupt companies eventually hit zero. Undervalued stocks eventually become fully valued.

The fundamentals may not mean much in the day-to-day and week-to-week trading, but they get sifted out over the course of a few years. This is the basis of all intelligent investing.

I’ve written about Doug Barnett, who runs the Thai Focused Equity Fund, to my Mayer’s Special Situations readers before. His fund had phenomenal performance in a market that is very volatile. Stocks soar and dive on rumor and take emotional roller coasters that test the resolve of its shareholders. But over the long haul, the market does discriminate. Barnett’s record of 18% annualized returns proves it does. As Doug said, “You get compensated for having a more-volatile path to achieve your goals.”

The second pillar on which to build is the insight that you often make money taking the other side of popular trades. Or more specifically, you get very good prices to take the opposite of a popular trade. This is the bedrock of contrarian investing, which seeks out a hardened consensus and bets against it.

Therefore, if the market wants yield and low volatility, then it follows that you will get more value for your money by taking stocks with no or little yield and high volatility.

So… You would want to avoid utility stocks. Even though they look attractive based on the 10-year Treasury yield (which, frankly, is a Fed-manipulated number), they are the classic low-beta-yielding securities the market loves right now. They suffer in comparison to what else you might buy (see again the Microsoft versus Southern Co. comparison).

You would, instead, look at smaller-cap stocks, which are traditionally high beta. By the way, you can find betas easily. You’ll see it, for example, on Yahoo! Finance under the “Key Statistics” section.

Junior mining stocks and small-cap oil and gas producers are stocks that have been whacked hard of late. These are areas where pricing is good. For most of these, the betas are around 2. Most small-cap stocks have high betas, and hence, the market is shunning them.

I would also say you can still get good yield in high-beta stocks.

Of course, you have to wait it out. If you are going to fret short-term swings, you are going to fray your nerves, sell near bottoms and pretty much make yourself miserable and poorer. You have to decide whether you can play the game or not, and if you do, you have to be willing to suck it up and hold on…


Chris Mayer
for The Daily Reckoning

The Daily Reckoning