An area that’s not often discussed by new investors is volatility. Broadly speaking, volatility measures the range of fluctuations in stock prices. The larger the range is, the higher the volatility, and vice-versa.
But, what does low volatility stocks mean? What is low volatility investing and does it work? Last, but not least, how to find low volatility stocks?
In this article, we will address those questions and more. We start by talking about the types of volatility and what it means when it comes to your investment process.
What is volatility?
As we alluded to earlier, volatility measures the range of fluctuation of stock price returns. In mathematical terms, usually quoted as an annualized number, volatility is the standard deviations of stock price returns. Phrasing it in a more familiar concept, volatility can be thought of stock beta.
Consequently, the market tend to associate volatility and risk. In a perfect world, the higher the volatility, the higher the risk. While we think there are some simplifications in that statement, using volatility as the sole statistic to measure risk is inspirational at best, in our view.
The VIX index, also known as the ‘Fear Index’, the popular Volatility Index, which measures the stock market’s expectation of volatility based on S&P index options is a good example. As a result, heightened uncertainty in general leads to stocks falling and VIX Index spiking. This is evident during the 2007/08 Global Financial Crisis and the 2020 COVID-19 pandemic.
Types of volatility
In the context of equities, the two key types of volatility investors should be aware are historical and implied volatility.
- Historical volatility. As its name suggest, this is the volatility calculated based on historical data. For example, calculating the standard deviation of a stock’s daily return over a year.
- Implied volatility. This measure is also pretty much self-explanatory, where volatility calculated is an output “implied by the market”. Implied volatility (IV) is extremely useful in analyzing options. Theoretically, implied volatility is calculated by plugging in market observables into the Black-Scholes formula, and back solving the value of the volatility.
Broadly, historical and implied can be thought of as “experienced” and “expected”, respectively.
Why stocks have different volatility?
Clearly, one can argue that stocks move randomly. But, why do stocks have different volatility even if it operates in the same industry?
Fundamentals aside, we can offer a few key factors that explains / drives stock volatility, based on our years of trading the markets.
- Liquidity: Liquidity (or volume traded) of the stock measures the number of shares / dollar value the stock is traded. For instance, this can be thought of as a % of its market cap. Generally, the more illiquid a stock is the higher the volatility tends to be. This is largely exemplified by the wide bid-offer spread.
- Free float: Free float relates to the amount of stock that are in the hands of the public market, rather than those who are held by insiders, brokers or locked-in shareholders. A stock with low free float (usually expressed as a % of total shares outstanding) affects the stock volatility in the sense that there is less available for the market to transact, hence, affecting liquidity, all else being equal. Consequently, low free float correlates with high volatility.
- Short interest: Short interest is the number of shares that have been sold short that has not been covered yet. Usually, short interest is an indicator of market sentiment of a stock. Broadly speaking, a stock with high short interest is often associated with high volatility. This is instinctive given the negative sentiment (potential positive surprises) and possible short squeezes.
- Market cap: Intuitively, a company with smaller market cap implies a higher volatility for the stock. Consequently, this translates into a smaller free float and hence negatively affecting its liquidity. A good example is penny stocks, or small cap bio-tech companies, where outcomes are often binary.
Low volatility stocks
In an ideal world, volatility correlates with the magnitude of returns. The higher the volatility of a stock, the higher return (both positive and negative) one should expect. There is no free lunch! Perhaps?
For the reasons discussed above, low volatility stocks generally have the a few key traits: large market cap, diversified business and highly liquid. Companies such as Procter and Gamble (PG), Coca Cola (KO) and Lockheed Martin (LMT) are just some examples of low volatility stocks that possessed such characteristics.
The defensive nature of low volatility stocks stands out during market sell-offs and market crashes, giving the much needed downside protection.
Low volatility investing
Low volatility investing is an investment strategy that focuses its investable universe on low volatility stocks. This particular investment style exploits the low volatility anomaly.
To put it simply, there has been numerous research that over the long-term, low volatility stocks outperform those that are of high volatility stocks. Hence, the breakdown of the relationship between risk and return.
Frequently associated investing in low beta stocks, this strategy has been studied and researched extensively since Frazzini and Pedersen’s research entitled “Betting against beta”.
While this strategy works more suitably on a long short equity strategy, low volatility investing has been highlighted as a credible winner according to the paper.
The graph below illustrate the low volatility investing strategy and its paradox. Contrary to textbook theories, high volatility portfolio did not equate to high return over the long run!
How to find low volatility stocks
Screening for low volatility stocks is made simple today with the amount of screeners freely available today. In finding low volatility stocks, there are a few thing investors should take note.
Firstly, volatility and beta can be used interchangeably, since beta of a stock measures the changes in its stock relative to a benchmark. This is helpful as some screeners only provide one of the other.
Secondly, select the time period that best suit your investment time horizon. For example, as long term investors, we would be looking average annualized volatility over the past 3 years. We would caution investors not to look at anything less than 3 months / 90 days volatility, as this can be potentially misleading.
Lastly, a sense check on the stock itself. With stocks going through various business cycles, stock splits, dividends and rights issue can cause complications in volatility calculation in most free screeners today.
Additionally, it is important to understand what drives stock volatility as well. Consequently, it is not uncommon for stocks to alter from low volatility to high volatility in a short time period and vice-versa.
Over the past articles, we discussed about various investing strategies. We find the concept of low volatility investing still baffles most investors today. The theory that “Higher risk is correlated with higher returns” doesn’t necessary hold in this strategy, it seems.
As for most investing strategies, we strive to build a bottom-up approach complemented with a top-down approach. Low volatility investing strategy is no exception. In our view, investors should use this as a screening tool complemented with bottom-up analysis, rather than the sole decider in your investment decision.
Finding quality stocks with low volatility is only possible with proper fundamental analysis. Inevitably, this should remain the core element of any investment process. Check out our portfolio and research here.