European equities : Why low-volatility

The sudden spike in bund yields between April and June was a wake-up call for investors in lower-yielding government bonds. Investors have long known that these bonds have an asymmetric risk-profile: yields could still decline further, but not much further, whereas portfolios simultaneously bear the risk of a sharp upward move in yields.

Some investors will now inevitably be tempted to reduce some of their lower-yielding bond holdings. But which asset classes can provide them with the appropriate risk-return profile? Many euro zone bond classes have undergone yield compression to levels that make them attractive only to seasoned stockpickers. Investors are inevitably coming to the conclusion that the only liquid assets that provide sufficient yield to complement their bond holdings and meet their return expectations are equities.

Equities vs bonds

The argument for bond investors to shift to higher weightings of equities is based on substantial and long-standing market mispricing. Markets today apply a discount rate of about 7%-8% to equities but just 1% to corporate bonds with a 10-year maturity.

It is hard to reconcile those valuations with reality. Blue-chip companies have amassed huge debt piles while paying bond investors historically low rates of interest. Equity investors are the main beneficiaries of bondholders’ rare generosity. Companies can use the proceeds of their bond sales to invest for growth, to buy back shares, or to grow by acquisition. In all of these cases, value is created which is passed to investors in the shares of the company, rather than to the bondholders. This is not a rational state of affairs.

Low-volatility, high-quality investing

In the wake of the financial crisis, the desire to avoid high volatility is strong among investors. Many are not willing to introduce higher levels of volatility into their portfolios even if long-term portfolio returns are likely to be enhanced, and do not seek exposure to the broad equity market. These investors may look for pockets of the market which are relatively sheltered from volatility – namely low-volatility stocks.

Portfolios of low-volatility stocks perform well in times of market stress, but they also produce higher returns than high-risk stocks over the longer-term. Why is this? Firstly, some investors are paid for outperformance against a benchmark, so they overweight stocks with higher beta and higher volatility to achieve higher returns. While volatile stocks are likelier to produce higher short-term returns, they are also more popular and so become over-valued, leading to lower long-term returns. Second, the less volatile nature of low-risk stocks reduces the discount rate at which equity analysts derive a target stock price, justifying higher returns.

In search of suitable stocks

Research by Candriam⁽¹⁾ shows that an equity portfolio combining low-risk investing with a quality filter enables investors to benefit from lower absolute risk, while retaining the potential to match returns from the broad equity market. The research contains the surprising finding that over the long term (1992-2014), portfolios of low-risk stocks outperform high-risk stocks. A combined portfolio of low-risk, high-quality stocks is expected to have a higher Sharpe Ratio than other standard equity investments.

So how do we find these low-volatility, high-quality stocks? The definition for them differs among asset managers, but we define it as companies that are profitable, growing, well-managed, have low financial leverage and a competitive advantage over peers. In essence, they are in good shape to outperform in most economic environments.

It is also important to make sure the portfolio is liquid. Although many small- and mid-cap names meet the definition of quality, an over-emphasis on the smaller end of the market can lead to a squeeze and potential portfolio losses during market crises.

The potential for future outperformance

Low-volatility, high-quality stocks have further upside potential, despite outperformance of this market sub-sector over many years.

Even though high-quality stocks are more expensive than the index average, they still outperform over the long-term because investors are willing to pay a premium for higher quality. In other words, the stocks will benefit from a further decline in the discount rate, or risk premium. A lower discount rate is justified by the nature of low-volatility quality stocks: they have a steadier cash flow profile, so in severe economic downturns they have less need to raise extra capital and dilute existing shareholders.

The fact that both low-risk and high-quality indicators are not overvalued by markets (see graph below) provides evidence that these types of stocks can still outperform. Compared with their long-run averages, neither indicator appears overpriced. This may seem strange given the current market environment of very low yields and subdued expected returns on bonds, and is further evidence that active investment managers tend to overweight stocks with high market beta.

In addition, the price-earnings to growth (PEG) ratio of the strategy is still below that of the broad market (see graph). This points to further rerating potential.

Market sentiment may provide support

Further support for low-volatility, high-quality companies comes in the shape of investor sentiment. Some investors, including large institutional investors, were disconcerted to see losses rack up in their bund holdings after the recent yield spike. They are now likely to start increasing their allocations to equity markets, focusing on high-quality names with predictable and repeatable business models. In addition, retail platforms and advisers are likely to direct their clients to multi-asset funds in the search for yield and diversification. Inevitably, some of this money will find its way into the less risky part of the equity spectrum.

Conclusion

Low-volatility, high-quality stock portfolios will be increasingly attractive to equity investors who are worried about rising volatility in markets as central banks continue to intervene and market behaviour becomes more unpredictable. These portfolios will equally be attractive to bond investors seeking higher yields. With many bonds producing low, or negative, yields and spreads tight on corporate bonds, low volatility equities offer the potential for alternative and sustainable sources of return.

Geoffroy Goenen, Head of Fundamental European Equity 
Koen Van de Maele, Global Head of Investment Engineering, CFA

⁽¹⁾A New Way to Invest in Stocks, Aiming for Lower Risk and Higher Quality, Candriam, February 2015