Volatile stocks tend to bring higher returns. But not everyone has the stomach to hold an unstable portfolio
There are good reasons to be cynical about investing in stocks or mutual funds, or exchange traded funds that hold stocks. Investing is about buying low and selling high. But just what is low and what, precisely, is high is usually clouded in uncertainty.
To a cynic, the idea of judging companies’ values by their balance sheets, income statements, price to earnings ratios, price to sales ratios and the other bits of arithmetic that are supposed to guide the investor between the pillars of greed and fear is foolish. Some companies trade for huge multiples of earnings, some for low ones, some at high prices in spite of crummy balance sheets, and some at low prices though they have good balance sheets.
Look at volatility
There is another way. Analysts who crunch numbers and, often, have no particular interest or even knowledge of a business in which they invest, like to evaluate risk as measured by volatility. The more a stock jumps up and down, the more volatile and therefore the more risky it is. The less it jumps, the less risky it is. All this is sensible. If a stock followed a smooth path, investing would be almost risk free apart from worries about inflation and taxes.
Let’s take some examples. Research in Motion (RIM) was a $10 stock ten years ago, a $140 stock in 2008, and is down to $15 — with no dividends to cushion the pain. Worse is Yellow Media Inc. (YLO), publisher of the Yellow Pages. It was $10 at its initial public offering in 2003, hit $16 in 2006 and is now down to about a dime — one per cent of its price when it went public — as its business model has been crushed by web search engines such as Google. It would take a miracle for either company to return to its former highs. Each is a victim of downward price mobility. And a source of pain for those who bought it on the theory that, if it was a good buy at $100 for RIM or $5 for Yellow Pages, it must be a great one at $50 or $3, respectively.
How about companies with upward mobility? A good example is Apple Inc. (AAPL), which was virtually a penny stock in 2002 and, as I write this story, is trading at about US$500, up about US$80 since early January. Apple is now a colossus with the sum of the value of its shares greater than that of Exxon Mobil, formerly the biggest stock on Wall Street. But how long will it last? Remember Nokia (NOK), the Finnish cell phone company? Its shares were US$40 in 2008 and trade for US$5 today.
Celebrities come and go, but volatility is forever.
Each of these stocks has or had celebrity status and each, save for Apple, today’s wonder child of the market, fell because investors saw its prospects dim. Sharp analysts may have seen the trouble coming, but predicting the future — whether it’s cell phone sales or the wreckage Google would cause to Yellow Media — isn’t easy. But each stock had a volatile past and, as the old saying goes, the faster they rise, the harder they fall. Volatility is the tale.
Let’s take some plodding stocks. Pipelines are plodders. Save for missteps (such as TransCanada Corporation’s (TRP) disastrous halving of its dividend in 1999 that caused its share price to drop by two-thirds), most pipelines have a steady business unaffected by the price of the oil they carry. Enbridge Inc. (ENB), for example, has gone from $20 in the fall of 2009 to $40 today with few wobbles along the way. TransCanada Corp. has risen from $30 in early 2009 to $40 or so today with relatively minor wiggles, though more than Enbridge’s wobbles.
Some of these price moves can be explained by how much companies owe on the balance sheets and their equity-to-debt leverage, and others by public reaction to oil spills. In the case of uranium producer Cameco Inc. (CCO-TSX), $50 in 2007 and $23 today, problems with a leaky mine in Saskatchewan and the Japanese disaster last year explain much of the loss. But Cameco has a solid asset the world needs and its price will recover. Yet the uranium business, which has political overtones as well as all the other problems that go with mining, is never going to be as steady as the steady business of moving oil.
Choose your risk level
We come now to the essence of the problem: How much risk do you want in your portfolio?
The old saying is that risk and return go together. Take on more risk and you should have a higher return. That theory has no clock on it. You could buy a portfolio of jumpy small caps and have to wait decades to see a good return. For example, global small- to mid-cap equity mutual funds lost 12 per cent in the 12 months ended Jan. 31, 2012. They made 13.8 per cent per year compounded annually for the three years ended Jan. 31, lost 3.9 per cent per year for the five years ended Jan. 31 compounded annually, and made 4.2 per cent per year compounded annually for the 10 years ended Jan. 31, 2012. In the end, they beat global equity funds — the large capitalization companies — which made a humble 0.4 per cent per year for the 10 years ended Jan. 31, 2012.
But along the way, small caps rocketed and swooned far more than large caps. An average investor watching his or her asset soar and plummet might have been tempted to sell either type of fund, but the temptation would surely have been greater for the more acrobatic small cap funds.
The astute investor can save a lot of grief by checking a couple of vital measures of stock volatility. First, look at “beta,” which is the amount by which the price of a stock or a mutual fund or other asset fluctuates compared to its benchmark. Many websites such as globefund.com show beta for each mutual fund. A fund with a beta of one fluctuates as much as the market, for example, the Toronto Stock Exchange, but no more. If beta is less than one, it fluctuates less. If beta is more than one, it fluctuates more than its benchmark.
The PEG ratio (price/earnings over growth of earnings) is also worth considering. If a stock has a price to earnings ratio of 10 and is growing its earnings at 20 per cent per year, its PEG ratio will be 10/20 or 0.5. When the ratio is below 1.0, the stock looks like a good deal and often is, though the reason needs to be explored. Some companies with undependable earnings have low PEG ratios because investors just don’t feel that their rates of growth of earnings are dependable.
Put beta together with the PEG ratio and you should be able to tell which stocks will keep you awake at night. Volatility is risk and the premium or discount you pay to buy into risk is a measure of what you can win or lose. †