Low Volatility Index Is Due For Some High Volatility

Investors who have been frantically searching for yield have bid up the S&P 500 Low Volatility Index (SPLV-NYSE) so much that… guess what… There’s going to be some volatility here shortly. 

Full of utilities and REITs and some financial stocks, the SPLV now trades at 24x earnings — trading like a growth stock! Except that this is much worse than a growth stock.

This is what happens when non-thinking investors put money into non-thinking investments.

Here’s how a pitch would sound if SPLV was an actual company:

With respect to sales, there isn’t much to brag about. Over the last five years sales actually haven’t increased at all. In fact they have shrunk at a rate of 2% per year.

Earnings are better. By aggressively slashing costs (and with some help from lower taxes) earnings have been able to grow at a rate of 3%. Cost-cutting is a short term solution, so you probably can’t expect that to continue much longer.

Dividends meanwhile have grown by 9% per year over the past five years (not bad), but only because the percentage of profits being distributed has been cranked up (not great).

Maybe the least appealing trend is that the company’s net debt position has been increasing by 14% per year just to allow the meager amount of earnings growth that has been achieved.

Would you describe it as thriving? Or perhaps a bit stretched?

And we’re going to pay 24x EPS for this stock today.

What do you think?

I’m asking these questions, but the answers are all pretty obvious.

These aren’t the characteristics of a thriving business, these are the characteristics of a business that is stuck in the mud.

Stable yes, thriving no.

Yet These Are The Characteristics Of

The Hottest Investment In The Market

 

The numbers that I’ve laid out for you in the paragraph above are for the S&P 500 Low Volatility Index (SPLV).

This index is made up of the 100 least volatile stocks in the S&P 500 — with the least volatile stocks getting the heaviest weightings, the most volatile the lightest weightings.

The companies that make up this low-volatility index are exactly what you would expect. Predictable, boring businesses that don’t do much of anything.

Utilities are the heaviest weighting in the index at almost one-third, followed by financials and real estate (mostly REITs). (1)

It is obviously no surprise that this group of boring companies would combine to exhibit the no-growth characteristics that I laid out.

They are known as steady cash generating, dividend payers.

What is surprising is the very rich valuation the market is willing to pay for this group of companies today… as noted in the recently quarterly commentary from Orbis Investment Management (one of my favorite hedge funds to follow):

“Over the past five years, US low-volatility shares have enjoyed good returns and buoyant investor sentiment. A year ago, they traded at a 45% premium to stocks outside the US, and to value shares globally.

Today, at 24 times earnings, they are even more expensive in relative terms.” (2)

Yikes… 24 times earnings for a bunch of no-growth companies that are rapidly growing their balance sheet debt!

There once was a time that 24 earnings would be appropriate only for a high-growth company that was looking at a long run of 20 percent plus annualized earnings growth in front of it.

Apparently not anymore… mediocre is the new marvelous!

Low Volatility Does Not Mean Low Risk

The reason why these stocks with little growth have become so expensive is no mystery.

Investors have been funneling a massive amount of cash into them.

Low-volatility index funds and ETFs really only started operating eight years ago. As of the end of September 2019, the 57 ETFs and funds with “low or minimum volatility” in their name had assets of $101.57 billion — up $32 billion from the prior year.

The appeal of this group is that since the trading price of these stocks is less volatile, that means that they are also less risky.

I do not agree!

What makes a stock risky is not how much it moves around from day to day, but rather the valuation of the stock when you buy it.

Remember….earnings aren’t growing so that can’t drive share prices. The only driver of share price has to be the valuation multiple assigned by investors.

At a valuation 24 times earnings these low-volatility stocks really have only one direction to go… AND THAT DIRECTION ISN’T UP.

At these valuations this group of stocks is all-risk and no-reward. 

Earlier this year Pzena Asset Management also pointed out the absurdity of the valuation of these low-volatility stocks. More specifically, Pzena showed that these no-growth companies were actually being more richly valued than growth stocks (4):

“The more defensive investors have been moving into stocks that they view as stable, and they’ve been willing to pay a premium for the privilege.

Low-volatility shares within the MSCI ACWI Index, for instance, are trading at an aggregate P/E of 18.9x, slightly higher than that of the MSCI’s broad ACWI Growth Index.

 Is it sensible that low-volatility shares have a multiple that’s on par with growth stocks without the possibility of much earnings growth?”

Is it sensible… no of course it isn’t!

While the businesses underlying these stocks are still safe and predictable, the valuations are simply too expensive.

As for why these stocks continue to attract investor dollars, we can look to our friendly Central Bankers.

With interest rates on Government bonds at all-time lows, people need to find investment yield from somewhere else. The safest perceived place to do that in the stock market is through these boring, low-volatility stocks that offer some yield.

Instead…

At best, investors buying these no-growth businesses at these valuations are going to break-even or get out with some modest income.

At worst, valuations for these companies return to their historical norms — which suggests at least 30 percent downside and perhaps more.

All risk and no reward equals a bad combination.

 

Sources:

1) https://ca.spindices.com/indices/strategy/sp-500-low-volatility-index

2) https://www.orbis.com/bm/institutional/insights/insights/good-behaviour-is-overrated

3) https://www.wsj.com/articles/low-volatility-funds-are-in-demand-once-again-11572836820

4) http://www.pzena.com/CustomPage/Index?keyGenPage=471692