If you are new to investing, you may be inclined to agree with the Fama-French research that claims that the pursuit of superior returns must be accompanied by taking on additional risk, and the pursuit of low returns is best accomplished by taking on little risk. Here's a nice summary of the Fama-French conclusion, explained here and here:
One thing that's interesting is that Fama and French still see high returns as a reward for taking on high risk; in particular that means that if returns increase with book/price, then stocks with a high book/price ratio must be more risky than average… if you do believe in EMT then you believe cheap stocks can only be cheap for a good reason, namely that investors think they're risky...
This finding was not new and reflected what other researchers had concluded in earlier papers. Fama and French, however, decided to turn the problem on its head. Rather than build an alternative risk and return model, which is what others had tried to do with the arbitrage pricing and multi factor models, with all their baggage, they decided to start with the data on returns and work backwards. In other words, they went looking for other company characteristics that would do a better job of explaining differences in returns across stocks, than betas did. Their search led them to two variables - the market capitalization of the company and its price to book ratio - that together explained a large portion of the differences in returns. Small market cap companies and low price to book value companies consistently earned higher returns than large market cap companies and high price to book value companies. Rather than view this as an inefficiency (which other papers had in the past), Fama and French considered these variables as proxies (stand ins) for risk. In effect, they concluded that small companies must be riskier than large companies and low price to book companies must be riskier than high price to book companies.
When I first started to study investing, I thought the Fama French conclusions passed the common sense test, and seemed like a reasonable framework for making investment decisions. There is no such thing as a free lunch and all that, and it seemed intuitive to me that I would have to "go out on a limb more" to try and achieve 12% returns compared to say, 6% returns.
But then I read Benjamin Graham's The Intelligent Investor and realized that there are two kinds of ways to achieve superior returns.
The first is the conventional way to think about the relationship between risk and reward: if you want to achieve high returns, you have to take on high risk (with risk being defined as the likelihood of not achieving your targeted capital + dividend gain over your contemplated holding period). Simple as that.
Amazon (NASDAQ:AMZN) is the classic example of this. Everything about purchasing Amazon stock right now is high risk/high reward. The company trades at $261 in relation to the analyst estimate of $1.50 in 2013 "normalized earnings." That means Amazon is trading at a P/E ratio of 174 (for reference, Graham warned against ever buying a stock with a P/E ratio above 20). Analysts are projecting 35% annual earnings growth over the medium term. If the company grows earnings at a 20-35% clip for 6-7 years, the investment might work out quite well for shareholders. If Amazon experiences anemic earnings growth, boy, will it be painful. This is an example of the traditional understanding of risk and reward.
But Professor Graham's writings introduce us to a second form of investing: low risk/high return. Namely, Graham points out that, all else being equal, each dollar decline in share price for a company represents an increased likelihood of earning a satisfactory return on the investment. It can completely change your orientation towards investing because, instead of thinking that stock market declines represent a risky time to purchase securities, they may actually represent less risk because the higher initial earnings yield takes some pressure off the future growth to meet your long-term investing needs.
In 2008, you could have paid $72 to buy a share of Johnson & Johnson (NYSE:JNJ) that generated $4.57 in earnings. You would have a starting earnings yield of 6.34%. In 2009, you could have paid $47 for a share of Johnson & Johnson stock that generated $4.63 in earnings. That is an earnings yield of 9.85%. If you are targeting a 10% return on your investment, it is a lot easier to get there when you're starting from a 9.85% earnings yield than a 6.34% earnings yield, all else equal. If the long-term prospects for the business remained intact, each dollar decline in price makes it easier for you to reach your projected goals because your starting earnings yield is higher.
That is why I do not get caught up in the research from Fama-French or worry about the perceived risk associated with buying a security at a certain price to book value. I'm interested in buying the greatest amount of future profits at the lowest price, on a risk-adjusted basis. Graham gives us two ways to pursue those future profits. The first option indeed relies upon taking more risk to pursue more rewards. But the other option is quite attractive: if we can find falling stock prices that are not accompanied by commensurate declines in the business, then we have found a company that is becoming less risky as the price falls. That's why you don't have to get hung up on beta and volatility. Extreme volatility downward only matters if the business is deteriorating. If that is not the case, then you can increase your returns by taking on less risk. That framework can make all the difference.
Disclosure: I am long JNJ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.