There has been a lot of noise recently that the market is overdue for a correction. Investors are thinking about going to cash or that maybe the bond market is not actually as overvalued as it looks. Well, this article offers a third path; riding out any short-term storms in low volatility stocks while still squirreling away a dividend for the long term.
The reasoning for wanting low volatility stocks when facing a potential downturn is obvious. They tend to go down less than the market, which means you lose less money. However, they tend to go up less than the market in good times, so you make less money. I would say you only actually make the money when you're smart enough to sell; if the stock goes down again, you just have a nice story. This perceived lack of upside is what turns many investors against low volatility stocks.
However, you are not actually sacrificing long-term returns by purchasing low beta stocks. There is fairly clear historical evidence that low volatility stocks actually generate excess returns over pure index investing.
Table taken from here.
What we can see from this table is that low volatility stocks not only suffer less volatility than the index as a whole, they actually generate better returns than the index -- 2% better in absolute terms, 3% in risk-adjusted terms (CAPM alpha) . Yes, value stocks and momentum stocks do better in the long run, but we're looking for low volatility here, so any bad times don't hurt as much.
The low volatility portfolio in this study consisted of an equal weight of the 30% lowest volatility "large" stocks (the largest 50% by market cap). So, let's start the screen there. I used the Google Finance screener for this, but there are many alternatives that may or may not be better.
There are 7415 stocks included in the screener for the United States. Setting a minimum market cap of above $420M gets us down to 3500, which is a nice round number. Looking for a beta between -0.5 and +0.5 leaves us with 1041 stocks, which is about the lowest 30% of that largest 50%.
If the stock is paying a dividend, that should give us a nice income even during the bad times. Asking for a 2% yield drops our stock universe to 262. That is much better, but still too many to look at individually.
This is where things get a little subjective, but we are looking for safety, so my next step was to look at total debt / equity. Setting that to 50% shareholder equity is at least twice total debt got us down to 128 companies. This should mean the company is in a stable financial position.
There are a lot of income / bond funds in this list at the moment. They are not quite what we're looking for. They may be very good ways of getting bond exposure and avoiding market downturns, but we're looking for actual businesses in this screen. So, if we set the 10 year EPS growth rate to 0.05% or higher, then we're left with a much more promising list of just 20. Three income funds managed to slip through our net, so we have 17 companies to look at.
This is where we are at right now:
Div yield (%)
Total debt/equity (Recent yr) (%)
10y EPS growth rate
Agnico-Eagle Mines Limited
China Mobile Ltd. (ADR)
Chunghwa Telecom Co., Ltd (ADR)
Computer Programs & Systems, Inc.
Exxon Mobil Corporation
Newmont Mining Corp
People's United Financial, Inc.
Spectra Energy Partners, LP
Sturm, Ruger & Company
Sunoco Logistics Partners L.P.
Symetra Financial Corporation
The Chubb Corporation
The Clorox Company
The Procter & Gamble Company
Vector Group Ltd
Wacoal Holdings Corporation (ADR)
Some are familiar names and a few I had to look up, but I think we should whittle the field down one last time. I will use the gross margin, as this number is more consistent than the net margin. It also gives us an idea about the profitability of the company's core business without the noise introduced by depreciation and so on. Asking for a gross margin of 30% gets us down to a top ten which I will now look at quickly (in alphabetical order).
Agnico-Eagle Mines Limited (AEM) owns and operates five gold mines in Canada, Mexico, and Finland. It has another fifteen or so exploration sites, some in fairly advanced stages. The mines generated a billion dollars of gross profit last year. AEM does not hedge production, so they will benefit from the price of gold going up (as it tends to in bad times). The downside is that if gold declines, then so too will revenue. AEM had a bad year last year - having to shut down the Goldex mine in Quebec for safety reasons (a $161m write-down) - but the future looks bright.
China Mobile Ltd. (CHL) - The name explains this one pretty well - mobile phones and China. CHL is actually the world's largest telecommunications company by market cap. CHL has over 700 million subscribers and its network covers over 97% of the Chinese population. However, its share of the new customers has been falling as competition increases, so its position may not be as dominant as previously. CHL has a lot of cash and short-term investments, which it is using to fund the rollout of the 4G network. Price / Earnings ratio looks like a bargain at 10.4, but this reflects the market's skepticism when it comes to Chinese numbers. Nobody really knows if the economy is actually strong enough to support all this telecom's growth.
Chunghwa Telecom Co. Ltd (CHT) is about a tenth the size of CHL and operates in the other China (Taiwan). As such, it suffers from few of the drawbacks CHT does (Taiwan is a much more democratic and transparent country) but also offers few of the benefits (Taiwan is a much smaller and more developed country). The payout ratio is slightly high at 90%, but CHT is considering a special dividend to reduce the cash position, so management seems confident they can continue to cover it, and with a 5.8% yield, even if the dividend remains flat, you will be happy for a while.
Computer Programs & Systems Inc. (CPSI) are the number one vendor of Electronic Health Records systems to small (rural and community) hospitals. Modern Healthcare magazine reported last year that CPSI:
had attained the No.1 position among vendors whose hospital clients have achieved ... systems certified as 'complete EHRs'
This is a strong position to be in, as inertia is very powerful in the software world, especially for records systems. Healthcare is also an industry I like the macro factors for (aging population, Obamacare, etc). Except for one hiccup (-5%) in 2007, it has grown revenue steadily for the last ten years, and it is now over twice what it was in 2003. Gross Margin is consistently in the 40-45% range. They yield 3.6%, which does not include a $1 per share (about 2%) special dividend it paid last year.
Newmont Mining Corp (NEM) is the only gold producer in the S&P500 index (it also produces some copper). NEM operates mines in Canada, the USA, Mexico, Australia, Indonesia, and Ghana. It offers an attractive 3.8% dividend yield (its highest in ten years), although it carries more debt (46% of equity) and has a slower earnings growth rate than Agnico-Eagle. NEM does not hedge against the gold or copper price, so you will be getting exposure to the gold market by buying this stock. I prefer buying stable gold producers to physical gold for exposure to the gold price, because it gets the gold out of the ground cheaper than you can buy it on the open market.
Spectra Energy Partners (SEP) are a natural gas pipeline / storage company. It's yielding 5.3% and has increased the dividend every year since 2007. In the 2012 annual report, the CEO stated the company's commitment to raising the dividend every year. Pipelines are a much more stable way to get exposure to the energy sector than explorers or even producers. Whoever finds the gas and gets it out of the ground, and no matter how much it is worth, it is going to need to get it to the markets somehow, and that is where SEP makes its money.
Sturm Ruger & Company (RGR) makes guns. Specifically, it makes rifles, pistols, and revolvers for sale to private consumers. Its dividend policy is to pay about 40% of earnings as dividends, so it will fluctuate with the company's quarterly performance, but is currently 3%. It paid a special dividend of $4.50 per share in December last year (about 10%), so it is clearly more than able to fund any expansion and capex from cash flow. Obviously, if you own shares in a firearms manufacturer, you would likely be negatively affected if major gun control laws are passed. On the other hand, the panic buying that happens whenever such laws are discussed is a plus, and the NRA is a powerful political lobby, so the discussions usually amount to nothing.
Clorox (CLX) manufactures a wide range of consumer staples. As such, it is somewhat protected from economic downturns; people will always be buying bleach and garbage bags and are reluctant to switch to own brand alternatives. Clorox has 35 year history of increasing dividends, which is impressive by anyone's standards. It currently yields 2.9%, and its annual increases have been significant (9% last year, 10% the year before, 9% the year before that) - between 2003 and 2012 the dividend per share rose from $0.88 to $2.40 (an increase of 170%).
Procter & Gamble (PG) is another consumer staples company. It makes everything from Ariel detergent to Wella hair coloring (do not mix the two up). It is yielding 2.9% and has averaged just over 10% annual increases in the dividend over the last five years. One possible concern with PG is that its research and development budget has been dropping over the last ten years, and apart from Tide pods, it has not really launched a truly innovative product in the last ten years. Still, it has paid a dividend for the last 122 years and increased it for the last 56 years, so it is very definitely a dividend aristocrat, if not dividend royalty. The shares may be a touch on the expensive side at the moment, but you are paying for safety.
Wacoal Holdings Corporation (WACLY) mostly makes "intimate apparel" for Japanese women. Unfortunately WACLY isin the process of delisting their ADRs from NASDAQ - complete delisting on April 25th. Management says that they intend to maintain the ADR program and anticipate that the ADRs will continue to be traded in the US. They also say they will continue to prepare consolidated financial statements in accordance with GAAP. It is a potentially interesting company, but delisting introduces more uncertainty than would allow it be included in a list of safe shares, so it will have to go on the wait and see list for now.
So, our top ten safe shares is quite a varied group of companies. At first glance, they are all potentially appealing investments depending on your personal goals and preferences. I am likely to be looking in to some or all of these stocks more closely in the coming weeks, because I am looking for a slightly more defensive portfolio. I hope this article has given you at least a couple of stocks to research further and an idea for possible future screens.