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Due to uncertainty in financial markets, low-volatility stocks are in high demand. According to Pim van Vliet, portfolio manager of Conservative Equities, a generic low-volatility strategy is getting more expensive. An enhanced approach is necessary to prevent buying too expensive stocks.
Yes low-volatility is expensive, but Robeco Conservative is not. We do find that generic low-volatility strategies are more expensive compared to the market index, based on valuation metrics such as price-earnings (P/E) ratio. But our Conservative Equity portfolios have better scores on these metrics since we also use valuation and dividend as selection criteria in our strategy. The average valuation gap of the global Robeco portfolios is currently 20%, which is a significant ‘margin of safety’ versus generic low-volatility indices.
The higher valuation of generic low-volatility stocks does not necessarily concern me. There is a good reason for the current popularity of low-volatility investing; investors have become more cautious after a series of crisis and crashes such as the Dotcom Crash in 2000, the Global Financial Crisis in 2008 followed by the euro-crisis. They want to avoid risk and prefer the safety of low-volatility stocks, and are willing to pay more for these.
The current market circumstances are similar to the 1940’s and 1950’s. With the memory of the Great Depression fresh in their minds, investors preferred low-volatility stocks.
Another reason why the higher valuation of low-volatility stocks compared to the market index does not overly concern me is that, in general, investors have been too optimistic about the prospects of high risk-stocks. A higher valuation of low-risk stocks should be the norm.
The valuation of our global portfolio based on P/E is 17.7, lower than the MSCI World index, which has a P/E of 20.3, and lower than the MSCI World Minimum Volatility index, which has a P/E of 22.6 (January 1st 2018). The dividend yield is also 1 percent higher compared to both indices.
In general, investors tend to be very optimistic about the prospects of high risk-stocks. During 2017 market excitement drove up mainly the prices of information technology stocks and cyclical material stocks.
For emerging markets, differences are even more pronounced. The P/E for market and minimum volatility indices are 14.6 and 16.1 respectively. Robeco Emerging Conservative Equities has a more attractive P/E ratio of only 10.8. So significantly ‘cheaper’. The dividend yield on our Emerging portfolio is 1.5 percent higher compared to both indices.
The reason that the valuation of our portfolios is lower is because our stock selection model does not just look at low-volatility, but also takes into account valuation. We enhance a generic low-volatility strategy by using several valuation factors, but also momentum factors. Since the start of our Conservative Equity strategies in 2006, we have used this enhanced approach.
In these circumstances where generic low-volatility is more expensive, it is important to make a good screening. Not all low-volatility stocks are equal. In periods like this it makes a big difference in returns. Our enhanced strategy works especially well when low-volatility is expensive. This is based on research of a deep historical database going back to 1929.
We choose a sample period that is as long as possible and split this sample into two sub-periods: one where low-volatility stocks have a relatively low P/B and one where they have a relatively high P/B. Within these groups, we looked at a market index, a generic low-volatility strategy and the enhanced low-volatility strategy. We compared how well the three groups performed. Our research shows that the return difference between the two low-volatility approaches is up to 6% per year on average in favor of the enhanced low-volatility strategy.
Valuation is a reasonably good predictor of long-term returns. Therefore beware of what you buy; especially now low-volatility investing is becoming more popular. Investors should pay attention to valuation when buying defensive stocks: not all low-volatility portfolios are equal. The lower valuation of our portfolios compared to generic low-volatility stocks, combined with the strength of our proven Conservative model, distinguishes us from the competition.
Another thing that investors should keep in mind is that when markets rise strongly as in 2017, low-volatility stocks tend to lag the broader market, however, still delivering good absolute returns and low-volatility investing leads to better risk adjusted returns in the long term.
Please note: this article was initially published on June 5th 2013. On January 4th 2018, we have updated the article's figures.
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