Remastering volatility: Reducing noise in equity allocations
By Christopher Hogbin, Christopher Marx and Nelson Yu/Guest Contributors
Volatility is a challenge that has vexed equity investors for
decades, yet its root causes are often misunderstood. Understanding how a
company’s business profile determines a stock’s risk can help investors prepare
for uncertainty and make better decisions when market turbulence strikes.
Erratic market behavior often seems like a mystery. Bad economic
news, political chaos, interest-rate moves or an industry crisis can trigger
widespread anxiety among investors and inflict indiscriminate damage to
equities. This volatility is the admission price that investors must pay to
access the higher return potential of stocks and other risk assets. Yet
volatility also reduces returns through risk drag, and often prompts emotional,
financially destructive decisions that stem from the fear of loss.
Behind the headlines that incite volatility, market fluctuations
are ultimately driven by the collective behavior of individual stocks. And the
risk profile of a stock often stems from fundamental and researchable aspects
of its business model and strategy.
Confidence in Cash Flows—the Source of Risk
For individual stocks, the source of volatility is derived from
investor confidence in company cash flows. In finance textbooks, the value of
an asset is defined as a function of its future cash flows and the discount
rate, which itself is a function of interest rates. It’s also affected by the
perceived variability of a company’s cash-flow potential; greater uncertainty
around cash flows will raise the discount rate and lower a stock’s valuation.
So, anything that can provoke uncertainty around a company’s cash flows may
become a source of volatility. A company’s income statement may offer important
clues about its resilience or underlying vulnerabilities.
Let’s start at the top, with revenues. Sales are an important
driver of company earnings, but can be unpredictable. And sales volumes can be
very sensitive to changes in economic cycles in industries like autos and
retail; changes in supply/demand balances, which often get reflected in
changing prices for commodities, for example; and changes in competition or
technology, which can impact market shares. Other industries, such as consumer
staples and utilities, typically see more stable demand and pricing, and thus
more stable sales. Our research shows that sectors with more stable sales
patterns tend to be less volatile (See chart below).
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| Click image to enlarge chart. |
Within any sector, understanding a company’s business model and forecasting its cash flows is the cornerstone of active equity investing. Just as important, fundamental research must also identify the risks to a company’s cash flows. Our research shows that companies with a higher volatility of cash flows also tend to have more volatile stock returns (see left chart, below). This means that the structure of a company’s business model can also be a source of volatility—and its income statement may offer important clues about its resilience or underlying vulnerabilities.
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| Click image to enlarge charts. |
Cost Structures Matter
Cash flows can also be profoundly affected by cost structures. Consider two companies with very different cost structures. One requires little capital to get started, so it has low operating leverage. The other requires a much bigger investment to get started and has high operating leverage. The company with lower operating leverage starts out in a much more profitable position, while the company with higher operating leverage starts off with losses and will need to sell more units to become profitable (see right chart, above).
So how the company makes money can have a material impact on its
profitability and consistency. Industries that generally exhibit lower
operating leverage include services and retail. Companies with higher operating
leverage tend to have high fixed costs, either from large upfront capital
requirements in industries like mining and autos, or a fixed labor force. These
types of companies also tend to be more sensitive to the economic cycle and to
the changing tastes and habits of consumers.
Taking Calculated Risks, Avoiding Unintended Exposures
Of course, business models aren’t the only thing that determines a
company’s risk profile. Company debt positions (or leverage) and sensitivity to
exogenous shocks from the macroeconomy or politics will also influence the
volatility of its stock. In future blogs, we will examine other sources of
volatility and how to manage them. But we believe that with a clearer grasp of
the way company-specific risks are at the heart of a stock’s volatility, active
managers can better assess the risk-taking needed to achieve desired returns
and reduce noise that can undermine confidence in an allocation.
By understanding the sources of volatility, portfolio managers can
better drive their outcomes through intentional views—taking risk where insight
identifies an opportunity for improved returns, while controlling the
volatility of unintended exposures. This helps reduce the noise that interferes
with an investing plan, and is the key to remastering portfolios and realizing
the benefits of long-term equity returns.
This blog post is based on a whitepaper that was published in October
2019 titled Remastering Volatility:
Reducing Noise in Equity Allocations.
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