Over the last two weeks, investors have been reminded of the stock market’s often-volatile ways. Harvey S. Katz’s August 10th Market Commentary summed up a particularly tempestuous day in the market quite nicely:
“…an oversold stock market raced out of the starting gate yesterday, with the Dow Jones Industrial Average posting triple-digit gains in short order. The averages then maintained much of that momentum right on up to the conclusion of the Fed's FOMC meeting just after 2:00 (EDT). Then, at first, Wall Street seemed to react positively to the Fed statement that it would keep the present historically low level of the federal funds rate—now 0 to 1/4 percent—through mid-2013, a period of some two years. That acknowledgement replaced some less-definitive language that had said the Fed would keep borrowing costs low for an extended, but not specific, time. However, as the Fed did not initiate a third quantitative easing program at this time, although some are now speculating that such an effort could well lie ahead, the market started to sell off. In a matter of minutes, in fact, the Dow was down by more than 200 points, a swing of better than 300 points, while the other averages fell into the red as well. Then, after a series of buying programs and subsequent selling squalls, the market finally went on to a buying binge for good shortly after 3:00 (EDT).
Then from there to the close, the market was electric, seemingly with each passing moment adding to the day's gains. Finally, by the end of trading, the Dow had added 430 points…”
It would be nice if one could say such market gyrations are a one-time event, but they aren’t. The truth is that markets behave in this way frequently enough to cause many sleepless nights for more conservative types. The last two weeks alone have likely led to a few such nights.
Part of the problem is that investors don’t properly account for the risks they are taking on. For example, a stock that is going up doesn’t normally cause anyone a sleepless night. However, what goes up can, and often does, come down—usually at an equal or quicker pace. So, investors who own fast-rising stocks feel good about those gains, but usually don’t consider the other side of the equation. This is true for individual stocks, portfolios, and entire markets.
How, then, can investors mitigate the inherent risks of owning stocks? Diversification is one way, but individual stock selection is another—pick from a list of more “boring” stocks! Of course, that is easier said than done and buying boring stocks isn’t going to remove all volatility from the equation, but it is a start.
Value Line provides a number of tools for subscribers to use when examining stocks, a few of them can help in the selection of less volatile (boring?) shares. From a “big picture” perspective subscribers can look at the proprietary Value Line Safety rank. This rank appears in the Ranks box at the top left of Value Line equity reports and is a measurement of potential risk associated with individual common stocks.
The Safety rank is computed by averaging two other proprietary indexes, the Price Stability index and the Financial Strength rating. Both of these measures are found at the bottom right of a Value Line report in the Ratings box. Safety ranks range from 1 (Highest) to 5 (Lowest). Conservative investors would be well served if they limited their purchases to equities ranked 1 (Highest) and 2 (Above Average) for Safety.
To see a concrete example examine the United Technologies (UTX – Free Value Line Research Report for United Technologies) stock report. The Ranks box shows the Safety rank of 1 and the Ratings box shows a Financial Strength rating of A++ and a Price Stability score of 95.
The Financial Strength rating is a relative measure of financial strength of the companies reviewed by Value Line. The relative ratings range from A++ (Highest) down to C (Lowest), in nine steps. They are assigned by Value Line’s team of analysts and editors based on such factors as debt load, company size, and earnings history, among others. Stock Price Stability is a relative ranking of the standard deviation of weekly percent changes in the price of a stock over the past five years. The ranks go from 100 for the most stable to 5 for the least stable. In plain English, companies with more stable share prices get a better score here.
Also included in the Ratings box are Price Growth Persistence and Earnings Predictability. These, too, can help subscribers find companies that won’t keep them up at night. Both of these ratings range from 100 (Highest) to 5 (Lowest). Price Growth Persistence is a measurement of the historic tendency of a stock to show persistent price growth compared to the average stock. Note that this isn’t a measure of the size of the change, as it only tracks the regularity with which a stock’s price has gone up.
Earnings Predictability is a measure of the reliability of an earnings forecast. Predictability is based upon the stability of year-to-year comparisons, with recent years being weighted more heavily than earlier ones. The earnings stability is derived from the standard deviation of percentage changes in quarterly earnings over an eight-year period. Special adjustments are made for comparisons around zero and from plus to minus.
Moving back to the Ranks box at the top of each Value Line report, subscribers might also consider looking at beta. Beta is statistical measure of relative performance. In this case, it is a relative measure of the historical sensitivity of a stock’s price to overall fluctuations in the broader market. A beta of 1.50 indicates a stock tends to rise (or fall) 50% more than the New York Stock Exchange Composite Index. The ‘‘Beta coefficient’’ is derived from a regression analysis of the relationship between weekly percentage changes in the price of a stock and weekly percentage changes in the broader market over a period of five years. In the case of shorter price histories, a shorter-time period is used, but two years is the minimum. The betas are adjusted for their long-term tendency to converge toward 1.00.
Clearly, investors seeking to sleep well at night should avoid betas of 1.50 and focus their attention on stocks with betas below one. Although such shares shouldn’t be expected to fully participate in a market advance, neither should they be expected to fully participate in a market decline. United Technologies, for its part, has a beta of 0.95—suggesting that it will move about in line with the broader market. Procter & Gamble (PG – Free Value Line Research Report for Procter & Gamble), meanwhile, has a beta of just 0.60—well below 1.00.
Procter & Gamble’s Price Growth Persistence score, however, isn’t as impressive as that of United Technologies. This brings up the issue of trade offs. There are few stocks that score well on every measure mentioned above. Subscribers need to pick which metrics are most important to them and give those figures more weight. As is so often the case in life, investing requires making a final decision from a collection of often imperfect, and sometimes contradictory, facts.
At the time of this article's writing, the author did not have positions in any of the companies mentioned.