Can Something Good Be Cheap Too?

by Charles Lahr of PIMCO, 4/8/13
  • Over the last eight years, the least volatile components of the MSCI World Index tended to have lower valuations, higher profit margins and higher dividend yields.
  • This anomaly, which appears to be among the most persistent in all of equity space, is rooted in speculative human behavior such as the “lottery ticket phenomenon.”
The potential benefits of investing in high quality/low volatility equities have been documented in both academia and industry (see "When Quality Pays: A Fundamental Approach to Pursuing Lower Risk and Higher Returns"). Historically, lower risk has led to higher equity returns, contrary to conventional belief and what many of us learned in school. (We measure risk using the periodic standard deviation of stock price returns.) This anomaly, in fact, appears to be one of the most persistent in all of equity space. Further, the data associated with low volatility stocks clearly tie them to businesses that exhibit attributes of high quality, such as higher operating margins and dividend yields.
Given the nature of the return premium typically found in low volatility stocks, some investors may ask if this phenomenon is the same as the value anomaly, where investing in low-multiple equities may produce substantial excess returns over time. In short, the answer is no. But another question follows: Can quality even be found in the value universe? After all, many investors associate quality with growth equities.
The answer is yes, and in fact, it appears that quality stocks can be found in both high and low valuation segments of the market. While different market cycles might affect the quantity of quality stocks across the market’s valuation range, the quality phenomenon appears to be independent of valuation; low volatility equities exist across the valuation spectrum. However, data show that, on average, there is a bias for quality stocks to reside in the lower valuation universe.
To demonstrate the prevalence of high quality, low volatility stocks in the value universe, consider the following time series, which shows that the least volatile components of the MSCI World Index have tended to have lower valuations during the past eight years:
Fundamentals don’t lie
Furthermore, the least volatile components of the MSCI World Index tend to be of higher quality. Figure 2 shows that the least volatile stocks in the MSCI World Index have historically been more profitable than the most volatile components:
Dividend yields show the same phenomena:
We’re only human
If you’re asking why the market doesn’t pay up for better fundamentals and lower volatility, you’re confronting the crux of the low volatility anomaly. As demonstrated in “Stock Volatility: Not What You Might Think,” deeply rooted behaviors such as the “lottery ticket phenomena” often drive investors to favor lower quality over higher quality.
In short, it’s human nature to make speculative bets. Consider two payoffs: one with a 50% chance of making $105 and a 50% chance of losing $100 (call it the “boring winner”), and another with a 99.999% chance of losing $1 but a 0.001% (1 in 100,000) chance of making $10,000 (the “exciting loser”). To most people, the second bet is much more attractive than the first. But the arithmetic shows that the first will make more than twice what the second loses on an expected value basis.
Arguably, similar dynamics are at work in the stock market. Think of dotcom stocks that were bid up to extreme valuations in the late ‘90s. These were businesses with no cash flow, broken business models and highly volatile shares. It was the boring stocks with decidedly lower valuations that turned out to be the real winners.

To the boring go the spoils

To recap, first let’s consider the outlook for quality stocks. Investor behavior should allow the high quality/low volatility equities phenomena to persist. As the lottery ticket effect shows, investors are frequently not interested in payoff profiles with boring outcomes. And the low volatility traits typically shown by quality stocks put them squarely in the category of boring.

Second, it’s not inconsistent for high quality stocks to have low absolute and relative valuation levels. This is also related to the absence of characteristics that attract fast money investors who bid up valuation multiples – and a reason to expect an ample supply of such stocks to persist.

Third, as chronicled in “Stock Volatility: Not What You Might Think,” we expect that alpha from this anomaly would be realized over a market cycle due to both the behavioral and empirical reasons rooted in these stocks.

Finally, the importance of the long-term return advantage derived by buying less expensive equities and the avoidance of downside that can arise when overpaying for a stream of cash flows should not be underestimated. By focusing on quality companies, an investor may substantially increase the potential to earn more returns with less risk and can do so while buying stocks with valuation multiples below the market.

Past performance is not a guarantee or a reliable indicator of future results. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Investments in value securities involve the risk the market’s value assessment may differ from the manager and the performance of the securities may decline. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.

The MSCI World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets. The MSCI World Index consists of the following 24 developed market country indices: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom, and the United States. It is not possible to invest directly in an unmanaged index.

This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. © 2013, PIMCO.

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