When building a portfolio, investors will often look at a stock’s valuation to determine whether or not it is a good investment.
The most common valuation measure – price-to-earnings ratio (P/E) – takes a stock’s market value and divides that number by the stock’s earnings per share from the previous four quarters. Often used as a tool to determine the value of an investment, the measure of a P/E ratio can suggest the future performance of a stock. This ratio can also help determine a stock’s value by providing a mathematical reference as to how much investors are willing to pay per dollar of earnings. For example, a stock with a P/E ratio of 15 indicates that investors are willing to pay $15 for $1 of earnings.
Typically, an investor will see a high P/E ratio and gather that the stock is expected to see higher earnings. The flipside is that it also may indicate the earnings are not keeping pass with the price and thus the stock is expensive and not be a good investment. Alternatively, when facing an investment with a low P/E ratio, an investor will assume the stock is undervalued and possibly a strategic buy.
While taking a stock’s P/E ratio into consideration can be useful when constructing a portfolio, by no means is it the ultimate indicator of market success. In fact, this measure can be a misrepresentation of value.
In determining P/E ratios, the odds of a miscalculation or misinterpretation are relatively high because the earnings figure that is used is reported directly from the organization itself. As such, the number can be manipulated and misreported, resulting in an inaccurate ratio.
Furthermore, even with a sufficient valuation, the measure is easily misinterpreted due to imbalanced comparisons when looking at other investments. Investors often evaluate a stock’s P/E ratio based on figures reported by other stocks across the entirety of the market. This hinders an investor’s judgment severely – growth and earnings vary drastically between sectors. By only looking at this single factor, investors wrongly evaluate a stock’s valuation by comparing the investment to stocks in unrelated industries. Investors essentially end up trying to compare apples to oranges.
Valuations – Factual or False?
Based off of valuation measures alone, market pundits have recently spoken out against certain investments with high P/E ratios, criticizing that these stocks are set to lose value. Particularly concerned with low volatility investments, skeptics note that these high valuations are likely to lead to an expensive low volatility space, hurting the sustainability of the investments.
Looking at a single, isolated factor – an investment’s P/E ratio – it could be interpreted that low volatility stocks are expensive and that the strategy will ultimately see lower returns.
However, a single factor does not dictate an investment’s future performance or value.
There are dozens of factors that can be taken into consideration when evaluating a stock. Unfortunately, though, these various elements are not given equal attention. Quantitative measures are often given priority over qualitative characteristics, leaving many relied-upon valuations inefficient in practice. This oversight in valuations presents a critical limitation when assessing an investment.
Although market commentators have spoken out on low volatility stocks and their rising valuations, a more comprehensive assessment, which includes qualitative characteristics of the investments, makes for a clearer evaluation. Aside from earnings, to determine if a stock is a sound investment, investors can look to other numerical measures – like covariance, standard deviation and beta. These metrics broaden the scope of a stock’s evaluation and calculate its volatility trends, price fluctuations, historical performance and relation to other assets within a portfolio.
Even though quantitative figures can be interpreted by investors as a gauge of future performance, the qualitative traits of an investment can be even more indicative and have just as dramatic of an impact on a stock’s value as earnings can. When determining a stock’s qualitative status, investors can evaluate the company’s management – assessing whether it’s up to par, if there’s a high turnover rate, etc. – any security risks or pending legal risks. All of these factors can act as a catalyst in the fluctuation of a stock’s value.
Just look at Viacom (VIAB): From July 28, 2016 to December 20, 2016, the company’s stock fell 24.97 percent, and since January 1, 2014 to December 20, 2016 the stock fell 54 percent. The tumbling loss coincides with Viacom’s seemingly never-ending leadership issues, a qualitative risk that could easily be overlooked when strictly investing based on P/E ratios. In VIAB’s shareholder letter dated Dec. 16, 2016, it stated in the first paragraph, “New executive and Board leadership is in place to guide [future growth], and advance our priorities of returning our operations back to growth”. The stock has since rallied – between Dec. 20, 2016 and Feb. 21, 2017, the stock went up 27 percent, which brings up the point that even though a stock may have a revolving management, it doesn’t mean that a stock can not have short-term gains. However, as of Feb. 22, VIAB announced more leadership turnover with the CEO of Viacom’s Paramount leaving and being replaced by an interim committee.
Factors like this, however, can be mitigated. Even though valuations seem to be raising concerns, when looking at the bigger picture and overlaying these quantitative factors with qualitative risk mitigation, low-risk stocks position investors for better long-term performance, protection in market downturns and capturing upside potential.
Low Volatility Valuations in Practice
Even if market commentary holds true and high valuations make for an expensive low volatility investment space, a 2016 study showed that valuations have no correlation with future performance. In fact, research from the study displayed evidence that investors who increased their low volatility exposure during periods of higher valuation did not fare worse than the market over the following five-year period. Low volatility investment strategies actually outperform the broad index, as well as high-risk investments, over time.
Most importantly of all, regardless of a stock’s valuation, the primary function of utilizing a low volatility investment strategy is to manage risk over a full market cycle. Investors looking to short-sell or obtain instant gratification on returns may not want to utilize a low volatility strategy. However, choosing to stay out of the low volatility space should not be because of valuation concerns. Instead, it should be because of an investor’s goals not aligning with what the strategy offers – risk management.
Ultimately, valuation does not always equate to future return value.
Aash M. Shah, CFA is a senior portfolio manager at Summit Global Investments, an SEC registered investment adviser specializing in low volatility investment strategies. Learn more at www.summitglobalinvestments.com.
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