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A price bubble in safe-haven stocks should continue to deflate this year, according to a recent analysis by Bank of America Merrill Lynch. However, there are good deals to be found among stocks that are less risky than they're generally perceived to be. Below are four examples.
One way investors judge the riskiness of a stock is to compare its past trading volatility with that of a benchmark, like the Standard & Poor's 500 index (.SPX). "Low-beta" stocks are those with relatively smooth histories, and the assumption is that if the market plunges, they'll fall less.
That's a flawed approach for at least two reasons. First, stock volatility can change quickly as companies or industries strengthen or deteriorate, so a beta based on, say, the past five years of trading could mislead. Second, beta says nothing about whether a stock's valuation is high or low, which most stock buyers would consider a key determinant of risk.
Simply put, low beta doesn't necessarily mean low risk. But investors have just the same poured money into low-beta stocks since the 2008 financial crisis, with the help of dozens of low-volatility mutual funds, many launched in recent years. That has led to higher valuations for "safe" stocks --and lately, muted price gains. The utility and telecom sectors of the S&P 500, rich with low-volatility shares, posted single-digit gains last year, not counting dividends, versus a 30% gain for the S&P 500 index. Adding in dividends, iShares MSCI U.S. Minimum Volatility ETF (USMV), an exchange-traded fund, returned 25% last year, versus 32% for the S&P 500.
As my colleague Brendan Conway warned last month, safe-haven funds still look expensive. In a Monday research note, Bank of America Merrill Lynch noted that low-beta stocks in the S&P 500 still trade near a record 30% premium to high-beta ones. It recommends that investors seek out companies with smooth earnings rather than smooth trading, citing the technology, industrial and energy sectors as good places to search. In other words, if investors are paying rich premiums for stocks with low price betas, and if stocks with higher price betas but low earnings betas are safer than investors give them credit for, then the latter group might be underpriced.
We ran a screen for companies in the tech, industrial and energy sectors whose five-year price betas show above-average trading volatility, but whose earnings over that period were statistically smooth (based on a measure called coefficient of variation).
Railroad CSX Corp. (CSX) has been hit by weak volumes for coal, as more power companies burn natural gas to generate electricity. But its earnings are nonetheless expected to increase 7% this year after an estimated 5% rise last year. An improving economy has increased rail traffic for other goods. And the recent expansion of oil-by-rail offloading facilities on the east coast should give CSX's oil volumes a boost this year.
DuPont (DD) has sold or announced plans to sell big business units with low margins, including coatings, performance chemicals and glass laminates. The overhaul is leading to peppy growth; earnings per share are expected to climb 12% in 2014 after an estimated 15% increase last year. It's also making the company safer by reducing the likelihood of losses during economic weak patches. Shares go for 15 times 2014 earnings.
Cisco (CSCO) has been hurt by the shift to pay-as-you-go computing services, which reduce the need for its traditional networking equipment. That trend and weak economic growth in overseas markets have caused earnings for Cisco to stall of late. The company has been increasing its exposure to data centers and security and wireless equipment, which should help it return to growth, according to investment bank William Blair. Shares have a price-to-earnings ratio in single digits, and Cisco sits on net cash equal to more than one-quarter of its stock market value.
Halliburton (HAL) shares have lost about 10% since mid-November, which JPMorgan attributes to profit-taking, worry over the future oil price and soft fourth-quarter results driven by bad weather. But the drilling services company is expected to increase profits more than 30% in 2014. Shares trade at 16 times this year's earnings forecast.
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