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It's an immutable law of finance: There is no free ride investing in stocks and bonds — the safer you play it, the lower your returns.
Yet a substantial body of research suggests that playing it safer with stocks may actually pay off in the long run.
Numerous studies have found that lower-risk stocks — those with below-average volatility, or beta — tend to outperform the market's riskiest, high-beta stocks. This violates the conventional wisdom that taking more risk can bring higher returns and suggests you can match or beat the market's returns with less risk.
Common sense suggests that isn't possible. Investors would quickly snap up the least risky stocks and bet against the riskiest stocks, eliminating the extra return that low-beta stocks provide.
Yet this "low-risk paradox" has persisted for decades and has been confirmed in many studies across different markets and time periods. A study by AllianceBernstein found that, since 1973, the least volatile 20% of the world's stocks produced returns one-third higher than the market — with 20% less volatility.
On average, since 1990 the lowest-beta stocks returned 3 percentage points more a year than stocks with median volatility, says Nardin Baker, a portfolio manager with Guggenheim Investments who manages low-volatility investments.
Low-risk stocks do a better job cushioning blows from market downturns, he explains. These companies tend to have more stable sales, earnings and dividends that act like shock absorbers, reducing swings in their stock prices. They tend to lose less in market downturns, making it easier to recoup their losses.
"The compounding law of mathematics says lower volatility stocks compound at a higher rate," Baker says.
Of course, low-beta stocks don't always shine. They tend to lag when investors are buoyant about the economy and prefer riskier stocks with more upside. Indeed, the S&P 500 (.SPX) returned 32.4% last year while the iShares MSCI USA Minimum Volatility ETF (USMV) gained 25.1%.
By some measures, low-beta stocks aren't cheap now either. Investors have flocked to "safe-haven" sectors in recent years, bidding up prices for consumer staples, utilities and other more stable parts of the market. The upshot: the iShares ETF has a trailing P/E ratio of 23.7, compared to 18.5 for the S&P 500.
Still, some analysts argue that safer stocks aren't mispriced. The market's returns have been abnormally high in recent years — six times the historical average when adjusted for risk, says Baker, the fund manager. Returns for lower-risk equities have been above average too, but not by as much.
Further, traditional value stocks are no longer as dominant in the low-beta world. Many of the least volatile stocks are now high-quality growth companies that deserve higher multiples, Baker says.
"The false premise is that low-volatility investing has a static nature," he says. "It doesn't."
While the strategy may not always outperform, investors can still benefit in the long term from sticking with its principles: buying stocks or ETFs with low volatility, stable earnings and above-average dividends.
Adding other factors may also help improve returns. Companies that generate lots of cash and have shareholder-friendly management — emphasizing share buybacks — are likely to produce stronger gains than low-volatility stocks without those characteristics, says Chris Marx, a portfolio manager with AllianceBernstein who focuses on low-beta stocks.
In the ETF space, the PowerShares S&P 500 Low Volatility (SPLV) holds the 100 least volatile stocks in the S&P 500. Since launching in May 2011 it's delivered 98% of the return of the S&P 500 with only 74% of the volatility, according to Morningstar analyst Michael Rawson, who recommends it as a "core holding" for conservative investors.
The iShares MSCI All Country World Minimum Volatility ETF (ACWV) offers more international exposure. Around half its assets are in foreign markets such as Japan and Europe. It has 73% of the volatility of the S&P 500 and yields around 2.5%.
The downsides: Both ETFs are relatively defensive and likely to underperform in a strong bull market.
To find compelling stock ideas, we screened for stocks with below-average beta over the past year. We filtered for P/E ratios at or below the market median of 16, dividend yields above 2.6% and return on equity (a measure of profitability) of at least 10%. We also looked for companies with industry or company-specific tailwinds that could provide momentum for the shares.
The names that passed our screens are all big, stable dividend-payers that fluctuate less than the S&P 500. They each have risks, though, and would likely underperform in a strong bull market. Investors shouldn't view these ideas as buy recommendations, but as starting points for further research.
AT&T's (T) wireless business is growing as more video and data are consumed on its networks. The telecom giant is also catching up to rival Verizon (VZ) with a more robust 4G network to handle higher traffic, according to Barry Sine, an analyst with investment firm Drexel Hamilton.
With a number of growth initiatives in the works, the company is "well positioned both near term and into the future," he wrote in a recent note. Analysts expect earnings per share to grow 6% this year, providing ample cash to support the dividend, which has room to grow.
The downside: Telecom stocks have underperformed as interest rates have climbed, and they could continue to lag if rates keep rising.
Making products from Band-Aids to prescription drugs, Johnson & Johnson (JNJ) grew sales 6% last year to $71 billion. J&J is getting a lift from new pharmaceutical products, and CEO Alex Gorsky is placing a greater emphasis on innovation, according to Raymond James analyst Jayson Bedford.
Wall Street expects earnings per share to climb 5.6% this year and 7.7% in 2015. At around 16 times estimated earnings, the stock trades at a slight premium to the market, though it offers an above-average 2.8% yield.
The downside: J&J's drug pipeline could face setbacks. Profits could weaken due to cost-cutting efforts in health care.
With PC sales slowing, Microsoft's (MSFT) main software business may only eke out marginal growth. But incoming CEO Satya Nadella is likely to emphasize more attractive areas like cloud computing and software for mobile devices, according to Nomura analyst Rick Sherlund. Wall Street forecasts earnings-per-share growth of 4.6% this year and 7% in 2015. While those aren't spectacular numbers, the stock offers a healthy 3% dividend yield that has plenty of room to expand as earnings grow.
The downside: PC sales and technology spending could slow more than expected.
Demand for residential and commercial loans has picked up as the economy has improved, bolstering profits for regional bank PNC (PNC). Even if the economy weakens, the Pittsburgh-based bank can offset slower demand for consumer credit with a strong commercial lending business, according to FBR analyst Paul Miller. Analysts expect earnings per share to slump 5.1% this year, but rebound 7.5% in 2015.
At a P/E of 11, the stock trades at a discount to the average P/E of 12.8 for commercial banks. It also looks compelling according to StarMine's value-momentum model, which factors in a stock's valuation and earnings momentum, giving it a rating of 96 out of 100.
The downside: A slowdown in the economy would impact demand for loans and other banking services.
The world's largest retailer has historically traded at an 11% discount to the consumer staples sector. It's now trading at a 20% discount, offering a compelling entry point, according to Nomura analyst Robert Drbul.
Sales are expected to inch up 1.8% this year and 3.5% in 2015. But Wal-Mart (WMT) is buying back stock to boost earnings per share, which Walls Street expects will climb 8.7% next year. With its size, scale and buying power, the company has a major "competitive advantage" over rivals, Drbul wrote in a recent note.
The downside: Weaker consumer spending would Wal-Mart's sales and profits.
Daren Fonda is Senior Writer and Investing Columnist with Fidelity Interactive Content Services, a provider of objective investing content on Fidelity.com. He does not own any of the securities mentioned in this article.
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