Trim the risk, tweak the rewards

PORTFOLIO POINT: Attractive businesses with lower risk numbers in our formula offer a better chance of outperforming.

Many investors search for stocks by focusing on the normalised return on equity, looking for companies promising a high or rising ROE in coming years. There is nothing wrong with this, but searching for stocks solely from the return side can sometimes be misleading.

Investors concerned about capital preservation as much as capital growth should also consider the risks, the volatility and cyclical nature of the business.

High ROE levels are difficult to maintain for long periods and focusing on this metric will eventually lead to high portfolio turnover as profits slow and companies are affected by normal economic cycles.

However, I’ve found that the risks to a specific business do not vary significantly over a period and thus a “required return” approach may identify stocks with consistently high total returns over time. This “risk side” approach for an investor focuses on stocks that can and do justify a lower required return when compared to the market as a whole.

The 'risk’ approach to investing

At Clime we use a quantitative approach to determine the required rate of return, and employ more than 20 factors – half of which are internal and half external. From all these factors we derive the required return of each individual stock without considering its size or market liquidity.

In order to select stocks using the risk side of the equation, we have looked at more than 100 profitable companies. We then calculated the effect (represented by a value) of the internal and external factors for each company then aggregate these into just one number, called the risk number.

As there are more than 100 profitable companies’ spanning large and small capitalised stocks, we can then calculate the average risk number for this population.

So how do we identify the more “attractive businesses” from the “average businesses”?

Fortunately, mathematics has provided us with an answer. Standard deviation is a widely used measurement of variability or diversity used in statistics and probability theory. It shows how much variation or "dispersion" there is from the "average".

The idea is that in addition to the calculation of the “average business” risk number, we also calculate the standard deviation of this risk number from this population of more than 100 profitable companies. Therefore to identify the best companies we choose those in which the risk number is at least one standard deviation from the average risk number on the lower risk side.

In other words, we pick attractive businesses that stand out from the average ones. Under this approach, of the original 100 stocks, only 19 stocks satisfy these selection criteria.

-The 19 standouts
Company	ASX	Market cap	Close 7/4	52-wk high	52-wk low	P/E	Div yield
AGL Energy	AGK	$6.53 billion	$14.25	$16.92	$13.51	14.58	4.14%
ASX Limited	ASX	$5.86 billion	$33.48	$43.89	$28.02	17.18	5.20%
Ansell Limited	ANN	$1.86 billion	$14.02	$14.08	$11.68	15.26	2.25%
ANZ Bank	ANZ	$62.57 billion	$24.09	$26.23	$19.95	12.36	5.23%
Blackmores	BKL	$501.65 million	$29.96	$32.10	$27.55	19.45	3.81%
Commonwealth Bank	CBA	$81.4 million	$52.55	$60	$47.05	13.08	5.75%
Cochlear	COH	$4.78 billion	$84.07	$84.34	$67.03	29.34	2.50%
CSL Limited	CSL	$19.72 billion	$36.44	$38.07	$30.45	21.38	2.20%
Iress	IRE	$1.17 billion	$9.31	$9.51	$8.51	23.26	4.08%
Invocare	IVC	$726.17 million	$7.09	$7.73	$5.70	20.49	3.98%
Qube Logistics	QUB	$955.86 million	$1.72	$1.76	$0.77	15.04	1.98%
NAB Limited	NAB	$56.3 billion	$25.95	$29.03	$23.90	12.49	5.86%
Origin Energy	ORG	$16.3 billion	$16.77	$17.30	$13.85	29.13	2.90%
Oroton Group	ORL	$334 million	$8.17	$9.50	$5.91	14.55	5.88%
Ramsay Healthcare	RHC	$3.8 billion	$18.80	$19.22	$16.50	20.2	2.53%
SAI Global	SAI	$1 billion	$5.02	$5.11	$3.75	22.11	2.65%
Telstra	TLS	$35.34 billion	$2.84	$3.46	$2.57	10.92	9.86%
Westpac	WBC	$73.51 billion	$24.43	$28.43	$20.56	12.52	5.69%
Woolworths	WOW	$32.72 billion	$26.98	$30.18	$25.52	15.94	4.41%

One immediate observation of this list is that there are no resource or resource-related stocks. This is because resource stocks are much leveraged to the whims of the global growth cycle.

Resources booms come and go and therefore it is not possible to gauge with great confidence how long this cycle may last. This means that the required returns hurdle for holding resources companies are much higher.

It should also be emphasised that the above list is not the only possible selection of stocks one could arrive at using risk or required return as your key consideration. One may decide to segregate the external and internal factors and seek out stocks with good external and/or internal attributes separately and any other combinations to suit one’s strategy.

I should also stress I have not paid attention to the valuation or price here, but have merely tried to identifying good quality companies based on risk factors in our quantitative model. But to prove the value of this strategy, I can back-test the performance of these stocks over the past decade.

The one, three, five and 10 years performance return for these 19 stocks is displayed in table below alongside the average total return for the whole portfolio of 19 stocks, with equal weighting as well as three other accumulative indices; the All Ordinaries Accumulative (XAOAI); ASX200 Accumulative (XJOAI) and ASX200 Industrial Accumulative (XJIAI) indices.

As you can see that the one, three, five, and 10 year performance of these stocks has consistently outperformed the market even without the addition of the strong performing resource stocks. Our basket of 19 stocks outperformed the All Ordinaries Accumulative Index by 13.15% pa over one year, 11.29% pa over three years, 8.07% pa over five years and 4.63% pa over 10 years.

So, what have we learnt from this exercise? First, measuring risk or required rates of return helps us identify a portfolio of stocks that not only consistently outperform the market significantly in the short term but also for the long term.

Second, the price performance of these stocks pre and post the global banking crisis is consistently good. While it is clear that some of these stocks are trading at a premium, a portfolio of these stocks still managed to generate an absolute positive return against a negative market. This provides strong evidence that they are both resilient and sufficiently well diversified to provide a positive return.

Third, when the market took off again after the global financial crisis, we note that these investment-grade stocks once again outperformed a rising market.

While it is important to identify companies that are consistently profitable, it is also important to identify companies who over the longer term have a lower risk profile than the broader market. Many commentators and advisers fail to understand the importance of risk. Ultimately, it is those portfolios with a healthy exposure to both highly profitable and low risk companies that will outperform.

Vincent Chin is a senior investment analyst with Clime Asset Management.