Over the next six months, there is a lot of potential for high volatility in the market. Factors like the election, the fiscal cliff, the sovereign debt crisis, and looming inflation have many analysts and investors worried. As many writers have advised, the best ways to directly be long market volatility are to buy VIX or buy a combination of long, out of the money puts and long, out of the money calls on the S&P 500. Although these derivative plays are good fundamental strategies, I am a big believer that for many investors, a better strategy may be an indirect approach. This approach involves taking long positions in equities and ETFs that aren't zero sum games or contain short positions, but still protect investors against potential volatility in the market. In this article, I make a bull case for two very strong discount retailers, Dollar General (DG) and Family Dollar (FDO), that accomplish this.
Protecting Against Market Volatility
Volatility in the market is usually a bad thing, but having a portfolio that is heavily exposed to market risk (stocks with a high beta) tend to generate higher average returns than stocks with low market risk. In volatile markets, low beta stocks are the better option since a market downturn will not hurt investors as badly. Currently, Dollar General has virtually no beta and Family Dollar has a beta of 0.24. Since the beta of a portfolio is equal to the weighted average of the betas of its individual components, adding these stocks to your portfolio can lower your portfolio's overall exposure to the market. In the event of a volatile market, a portfolio containing DG or FDO will have smaller fluctuations day to day, which makes investing in equities safer and easier.
Better Than A Zero Sum Game
Derivatives are obviously very important instruments in the financial world, but since their values are generated from other assets, the options market on the whole cannot provide any real returns. This sometimes makes options investing not optimal for small scale investors or investors looking to generate higher returns. Going long on Dollar General or Family Dollar can shore up market risk as previously mentioned, but like more volatile equities, the two companies are still experiencing very high growth that can add significant returns for investors. Analysts expect Dollar General's earnings per share to grow by 18.1 percent per year over the next five years and expect Family Dollar's earnings per share to grow by 14.5 percent per year over the same time period. Both companies currently have P/E ratios in the 18 to 18.5 range, so there is plenty of room for 12 to 14 percent annual gains along with a potential price adjustment that could add on another 10 to 12 percent in value.
Why DG and FDO In Particular?
Dollar General and Family Dollar are both companies with very bullish tendencies with a lot of growth potential. As small-scale discount retailers, they are able to reach more rural markets in the United States that Wal-Mart (WMT) (who is still doing well) is too big to reach. In addition, they can offer a slimmer, more profitable, line of products than Wal-Mart can offer, taking advantage of dis-economies of scale. Dollar General shares are up 16.12 percent on the year while Family Dollar is up 14.34 percent, and both companies have proven track records, consistently strong earnings, and the growth potential in both new store growth and same store sales in a quickly growing part of the country.
I've been bullish on Dollar General and Family Dollar for over a year now, and they have done nothing but impress. I personally prefer Dollar General as the company has higher growth expectations and a similar valuation, but both companies appear to be very strong buys right now. They can shore up volatility for portfolio investors while allowing them to hold positions in their favorite risky stocks. This can give smaller investors a lot more upside potential in a market where everyone is pushing to maximize returns.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in DG over the next 72 hours.