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Tuesday, February 05, 2013

Geeks and Bunny Rabbits

I have said on several occasions in the past that I am something of a geek. In addition to reading news, SEC filings and everything else I can get my hands on during the day I am find of reading academic studies on the markets. There is a subset of us that pass these things around like baseball cards looking for an additional edge or tool to help us succeed.  I skim a lot of these and a good number end up on the floor as a good deal of all academic research on every subject is a result of the publish or perish mentality. This tends to produce a lot of faulty work and erroneous conclusions by authors who are writing for tenure not for real financial research and gain. A few however produce exploitable edges that can make me a better investor.

One such that I ran across recently was the work of recently deceased pioneer off quantitative investor Robert Haugen. Along with Nardin Baker of Guggenheim Investments he published a study entitled “Low Risk Stocks Outperform within All Observable Markets of the World. “The paper was a follow up to early work by the two that showed higher risk did not necessarily equal higher reward. This study applied the principle of buying less volatile stock to 33 different markets around the world covering 1990 to 2011.
The paper flies in the face of a traditional Wall Street theory that the higher the risk the higher the reward. Haugen and baker express the opinion that the wdely held believe is the reason the low volatility stock outperform their high flying riskier brethren. Money mangers are all taught Efficient Market Theories and the capital asset pricing model in school and as a result tend to embrace higher risk stocks to chase higher returns.  Most mangers tend to favor stocks with the most analyst coverage and media attention and these are the most volatile issues on the stock market. According to the study it is exactly the wrong way to approach portfolio management.

This is a potentially important study with amazing results so I intend to spend some more time on this subject. To start with I sat down and ran some numbers and set up a screen   for the most and least volatile stocks in the S&P 500 to see if we could draw any conclusions. I am not a grand mathematician or statistical genius so I drew up my screens using simple measures like beta and monthly volatility that are easy to find or calculate.
The riskiest stocks in the index that should be avoided according to the study include some of the current darlings of traders and investors alike. Netflix (NFLX) has taken shareholders on a wild ride over the last year and is one of the most volatile stocks in the index. Investors have made good money in Tesoro (TSO) over the past few years but this study suggest it is now too risky to own for the long term investor. Fossil (FOSL) has recovered some from its earnings related price dump earlier this year but the shares are still on the too volatile to own list. I was disappointed to see that Micron Technology (MU) one of my holdings made the list of no-no stocks as well.

On the other end of the spectrum the lowest volatility names in the index produced some stocks that you do not hear discussed on the TV too much.  The list contains all the typical lower risk consumer products companies like Procter and Gamble (PG), Heinz (HNZ) and Kellogg’s (K) . Drug companies like Bristol Meyers (BMY) and Johnson and Johnson (JNJ) also makes the list of low volatility under owned issues that should outperform their more popular brethren in the index according to the study. Tobacco may not be a popular industry but Reynolds American (RAI) and Altria (MO) are on the list of potential lower risk winners. One real bonus to this approach to viewing the markets is all the low volatility stocks tend to pay relatively high dividend yields.

The research by Mr. Haugen and Mr. Baker ties in nicely with one of my favorite questions for investors and traders. Why are you doing what every eels is and expecting better results? Traders flock to stock like Apple with almost three times the market’s volatility. Now that the stock has risen sharply Bank of America (BAC) has become a market favorite in spite of the fact the volatility is actually greater r the index by a factor greater than 3. Market participants tend to all focus on the same sectors and subsets with higher volatility and lower returns as a result. The evidence seems to suggest that the opposite approach would be less popular but more profitable.

The research of Robert Haugen and Nardin Baker that basically blows an enormous hole in one the investment worlds most cherished believes. We have been taught almost from birth that risk equals reward in the markets and that to earn higher returns one must take additional risks. It seems that this is not the case and lower risk, lower volatility stocks actually outperform the higher risk more glamorous issues. The two find that this is the result of what they call agency issues. Everyone believes the same thing and everyone wants higher returns. As a result everyone owns the same high multiple more volatile stocks with subsequent substandard results.

It is no  secret that I firmly believe that the unpopular stocks that trade cheaply based on asset value also outperform glamour stocks as well as the broader stock market over time. Today I want to see if we can combine these two factors to fund stocks that can beat the market over time.  I ran a screen for cheap stocks with lower volatility than the broader stock market to see if I could reach any valid conclusions that might make us some money over the next few years.

The first impression that leaps off the page is that the Trade of the Decade is on the right track. A very large percentage of the names produced by this screen are small banks. Most of them are micro and nano cap banks that I expect to see taken over before too many more years go by. I own a bunch of them on the list as part of my TOD portfolio and was gratified they fit in with the research by Haugen and Baker.

Some of the larger banks that I won and have mentioned before also make the grade as cheap low risk stocks with the potential to outperform the markets. Westfield Financial (WFD) remains one of my favorite picks among banks that have undergone a mutual to stock conversion in the past five years. The Massachusetts bank trades at 80% of tangible book value and they have excess capital to spare with a tangible equity to assets ratio of over 15. They have a loan loss ratio of just .30% which is among the lowest I have seen in a long time. They are wildly over reserved with a reserve to Non-performing loan ratio of 2.77 compared to the industry average of .6.

Essa Financial (ESSA is on the list of low volatility cheap bank stocks as well. The stock trades at just 90% of tangible book value and also has a solid balance sheet with a tangible equity to assets ratio of 11 and not performing assets of less than 2%. Berkshire Bancorp (BERK) is also on the list trading at 90% of tangible book value as well. They also have excess capital and very low loan losses and the shares can be bought at the current level.

One somewhat surprising find was that several mortgage REITs are on the list. Hatteras Financial (HTS) invests in agency mortgage backed securities and is trading at 80% of tangible asset value right now. The shares yield a little over 10% at the current price. Institutions own less than 60% of the outstanding shares and the stock has been far less volatile than I would have expected. The same holds true for one of my favorite mortgage REITS right now. ARMOUR Residential (ARR) trades at about 90% of asset value and yield a generous 13%. Institutions own less than 40% of the company and the volatility is far less than some of the more well know names in the sector.

The more time I spent with the list of cheap low volatility stock the more comfortable I became with the idea that Haugen and Bakers were on exactly the right path for long term investors. I am familiar with many of the stock on the list and own a lot of them as well. These lower volatility issues tend to behave very much like bunny rabbits. They can sit still for long periods of time until something comes along in the form of a strong earnings report, takeover, or other positive surprise. Then they are capable of moving very far very fast. Using volatility to filter cheap stocks can help add another way to build a margin of safety into our investment activities.  Safe cheap and boring is still the best path to exciting profits.

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