Equity

Hedging against FAANG Optimism

Even though FAANGs are revered as pillars of the U.S. stock market, BMO Head of Disciplined Equities, David Corris, thinks there is a better way to out-distance the Index over the long term. According to David, targeting less trendy, low volatility companies that are typically – and systematically – undervalued is how risk-focused investors can achieve equity market exposure, while preserving downside protection.
October 2018

David Corris

Head of Disciplined Equities, Portfolio Manager

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Even though FAANGs are revered as pillars of the U.S. stock market, BMO Head of Disciplined Equities, David Corris, thinks there is a better way to out-distance the Index over the long term. According to David, targeting less trendy, low volatility companies that are typically – and systematically – undervalued is how risk-focused investors can achieve equity market exposure, while preserving downside protection.

 

Are FAANGs Low-Risk, Really?

A common argument in favour of FAANGs – the acronym bestowed on Facebook, Apple, Amazon, Netflix and Google – is that they are really modern-day utilities, facilitating the flow of information through digital pipelines they own and operate. This thesis resonates with many investors, particularly as Internet infrastructure grows more essential to life and business in the 21st century.

Being a portfolio manager for the BMO U.S. Low Volatility Equity Strategy, I regard stocks with low price variability as the driver of this strategy’s investment approach. So, when several technology companies started appearing in the least risky quintile of the Russell 1000 Index, my team and I investigated if FAANGs were truly evolving into lower-risk securities.

Our first step was to determine how much of the low-risk market tech stocks truly represent. The results were surprising: Silicon Valley went from virtually zero representation in the low-volatility segment of the market, to approximately one-third of all lower risk companies. We concluded that investors must be rapidly changing their perceptions of technology investing, even if reality lagged far behind.

For example, it is undoubtedly true that profit margins have been widening, and many firms have been expanding their business models to include software-as-a-service and recurring revenue via subscriptions, but these trends are slow and steady – not instant and transformative, as the dramatic shift in perceptions would suggest.

Silicon Valley went from virtually zero representation in the low-volatility segment of the market, to approximately one-third of all lower-risk companies.

Conclusion – It appears the market is overreacting to moderate improvements in tech companies’ risk profile, and there is a degree of complacency around the risk of technology companies.

 

Taking the Road Less Traveled

For added context, consider that our approach is grounded in research showing investors regularly overpay for high-beta stocks – an unsurprising assertion to anyone familiar with the “lottery effect.” This cognitive bias reveals itself whenever people misprice assets based on the promise of extraordinary payoffs, such as with lottery tickets and fast-growing tech equities, including FAANGs.

To avoid these pitfalls in human psychology, we focus our entire investment strategy around a principle known as the “lowvolatility anomaly.” It says that companies with comparatively low price variability outperform higher-risk securities over the long run, due to systematic mispricing, structural limitations in the market, and by harnessing the full power of compounding effects.

On this last point, imagine you have two stocks, with the same expected return over time, but at different levels of volatility – one at 10%, the other at 30%. Multiplying their Year 1 and Year 2 price movements reveals that high-beta assets are disproportionately penalized during their declines, which is why compounding leads lower risk assets to outperform over the long term.

Low-risk equity

Year 1 (+10%) x Year 2 (-10%) =

99% of Principal Value

High-risk equity

Year 1 (+30%) x Year 2 (-30%) =

91% of Principal Value

Using a Low Volatility Equity strategy, investors can capture three types of benefits. They are:

  • De-risking
  • Downside protection
  • Improved returns

 
De-Risking – For a risk-averse investor, it’s important to guard against adverse economic scenarios, while keeping an eye to upside growth. Low-volatility assets accomplish this dual-mandate by keeping the range of expected returns within a relatively tight bandwidth.

Downside Protection – By de-risking the portfolio early, investors can limit their drawdowns in the aftermath of a market correction, forestalling one of biggest drains on long-run returns.

Improved Returns – Low volatility portfolios help investors achieve higher returns in two ways. First, they provide higher returns over the long run through the mechanisms described above (harnessing the low volatility anomaly and improving returns via compounding). Second, they allow investors to build higher return portfolios by reducing risk in core asset classes and allowing larger allocations to higher risk, higher returning asset classes.

 

Case Study: An Overview of FAANGs’ Risks

Although we refer to FAANGs as a collective, there are important differences between its constituent members.

We hold shares in Apple because of their stable cashflows due to a loyal and captive consumer base, wide margins, generous dividend policy, brand power, significant cash reserves and rigorous attention to product quality that instills confidence in their ability to continually generate high-quality earnings.

Facebook and Google, meanwhile, derive cash flow from advertising revenues rather than hardware sales. It is difficult to pin appropriate valuations on them, considering uncertainty around the sustainability of their advertising models in light of privacy and regulatory concerns. For example, the implementation of the General Data Protection Regulation led to negative user growth for Facebook Europe, and several EU bodies fined Google for promoting products through its proprietary search engine.

Although we refer to FAANGs as a collective, there are important differences between its constituent members.

Investors appear indifferent to the possibility of antitrust actions being levelled against Amazon, or there being material changes to shipping prices, global supply chains, cybersecurity conditions, and so on. We believe Amazon is a great company, but view valuation risk at 110 times forward earnings, which makes it unsuitable for this strategy.

Similarly, for Netflix to justify its forward P/E ratio of 137, management would either need to execute a flawless marginexpansion plan, raising prices on consumers without relinquishing market share, or else continue down the path of rapid international expansion.

Ultimately, we believe that many technology stocks only gained low-volatility status through some degree of investor complacency, at a time when loose monetary policy was driving market gains.

Corrections have already begun – Facebook’s share price dropped in excess of 20% after revealing that user growth had faltered in the second quarter, and would likely continue to slow; Netflix plunged by double-digits for nearly identical reasons; and even Google’s seemingly invulnerable valuation sustained short-term damage. That Apple continues to prosper is a positive recommendation of our low-volatility strategy.

However, our position in Apple remains under 2% of total assets, meaning we continue to underweight the technology sector, not only in comparison to the index, but also to other low-volatility funds.

 

Why Low-Volatility Poses a BIG Opportunity

Classic finance theory, for all its wisdom, makes a bold and somewhat dubious claim in its depiction of the risk-reward relationship. It tells us that increased returns come at the expense of greater odds for failure, in an almost one-to-one equation. Market inefficiencies prove otherwise – and decades of ground-breaking research show that lower-risk securities can outperform by levering cognitive biases.

To put it in perspective, consider two hiking trails that meet at a common juncture. One goes through hilly terrain, where you’ll waste energy on steep inclines and declines; the other follows a gentle slope, which you can manage with ease and confidence. Most people would choose the latter, for efficiency, and to preserve their energy.

Classic finance theory, for all its wisdom, makes a bold and somewhat dubious claim in its depiction of the risk-reward relationship.

Even if you are not wholly committed to the strategy, hedging against your optimism is always a prudent decision. It’s possible FAANGs will evolve into secular utility stocks, channelling cash flows into your portfolio, compounding those returns quarter after quarter, until you trounce the index.

But are you willing to take that bet without covering your downside risk? We certainly aren’t – knowing the extraordinary power of our brains to rationalize desire via the “lottery effect,” we prefer to base our investments on the proven track record of the low-volatility anomaly.

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