Current investment theory is based on the premise that the higher the risk, the greater the potential returns. And yet … lower-risk stocks often outperform in the long run. A thorough analysis of companies’ historical yield and a check on their basic background are major prerequisites of equity portfolio construction.
To understand current investment theory, we have to go back to the ’50s, and US economist Harry Markowitz’s words to the effect that the more an investor seeks potential returns, the higher the risk (i.e., volatility) they have to countenance. Theoretically, the best returns (depending on the risk) are secured through investment in the market, i.e., in a market index based on market capitalisation. Practically, however, capitalisation-based market indices deliver lower returns for higher risk. Theoretically, too, the so-called “high-beta” equities (i.e., stocks with higher systematic market risk) outperform “low-beta” equities. Again, however, in practical terms, low market-risk equities are often the better performers.
Bond investors seeking to diversify their portfolio with other asset classes – even equities, given the low interest rate – are advised to go after more defensive equity investments. Lower-risk equities afford them this opportunity. A Candriam study on historical performance (in consideration of the risk taken) showed that lower-risk equities often outperform, in the long run, higher-risk equities (cf. chart: low- versus high-risk historical performance). Investors seeking to invest in higher-risk equities have to pay an expensive premium for the pleasure.
It is, however, not enough just to seek less risky equities with a strong track record, as the past cannot necessarily predict the future. Accordingly, a stable equity can, in time, become more volatile, in the event of any restructuring of the underlying market in which a company may be active. Take, for example, Nokia, put under serious pressure by the changing mobile telephony market. Shares also have their ups – and downs, should management implement the wrong strategy or when there are problems with the balance sheet, as was the case in the banking sector during the credit crunch. By the same token, more volatile stocks can also stabilise.
Equally, lower risk offers no natural guarantee of performance, a good illustration being the European utilities sector, which, in spite of its reputation as a ‘prudent man’ sector, has, since 2009 and only until recently, failed to live up to that reputation in terms of performance.
Equity investors should not, nonetheless, focus just on past performances. Any equity investor worthy of the name always starts off by carrying out the kind of basic, thorough analysis required to unearth quality companies. A recent Candriam study showed that, in the long run, quality companies outperform their lesser-quality counterparts; this, however, begs the question of how to define ‘quality’. We based our study on three basic criteria: profitability, cashflow generation and the firm’s financial situation.
The long-term performance of the equities that scored highest in terms of the criteria evaluated is clearly better than that of lower-scoring listed companies.
Defensive investors seeking stocks that fluctuate less than the broader market clearly benefit from a thorough analysis of the basic background of the equities in which they wish to invest. Indeed, when we subject a selection of low-risk equities to in-depth fundamental analysis, performance improves even further. The combination of low risk and high quality creates a portfolio with a higher expected return and lower risk profile.
Ken Van Weyenberg
Investment Specialist - Asset Allocation & Private Clients