How to Find: Low-Volatility Stocks, Not Overpriced

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The marketing gods couldn’t have conjured up a better strategy for stock wary investors than the low volatility approach that favors old reliables such as General Mills (GIS), Procter & Gamble (PG) and Coca-Cola (KO). Not only does the term low volatility conjure warm feelings of safety, there’s solid research showing the approach delivers better returns over full market cycles than the overall market. So it’s no wonder that PowerShares S&P 500 Low Volatility ETF (SPLV) has ballooned from $2.5 billion last September to $5.5 billion today.

The thing is, low volatility, like the overall market, is increasingly expensive. Of the 100 stocks in the PowerShares S&P 500 Low Volatility ETF, 48 currently have trailing 12-month price earnings ratios of at least 20. The average PE for the portfolio has shimmied up from 15.4 a year ago to near 18 today; on a percentage basis the portfolio’s PE rise is slightly ahead of the valuation gain for the overall S&P 500.

New investors, thinking they are merely dipping a toe into the shallow end of the stock pool could be in for a rude awakening. Even if the lowest volatility segment of the S&P 500 does exactly what it is supposed to do - fall less in down markets -- that doesn’t mean the fall will be shallow. Especially given today’s elevated PE’s. During the worst of the financial crisis the three stocks that currently are the largest positions in the ETF -- Johnson & Johnson (JNJ), PepsiCo (PEP) and General Mills -- did indeed fare far better than the S&P 500 index, but they all suffered losses of at least 25% nonetheless, as seen in a stock chart.

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JNJ Chart

You have to wonder if the advisors pushing the stock-wary into this ETF are correctly explaining that lower volatility is anything but a free ride.

Moreover, the PowerShares S&P 500 Low Volatility ETF has 30% of its assets riding on the utilities sector. The sector represents less than 5% of the overall S&P 500. And as if this needs pointing out, the high-yielding utilities sector has been bid up to above-average valuations the past few years. Historically this slower-growth sector traded at a multiple in-line or below the market average. According to SAP Capital IQ consensus estimates, the forward PE for the utility sector within the S&P 500 is currently 15% higher than the market. Another 24% of the portfolio is invested in the consumer defensive sector, which trade at a forward PE of 17.6, a 20% premium to the market average.

The smaller $3.5 billion iShares MSCI Minimum Volatility ETF (USMV) applies constraints to keep any sector from being more than 5% out of line with the S&P 500 weightings. So that brings down its utility weight to 8%. Still, this too is a pricey proposition, with roughly half the 125-stock portfolio trading at a trailing PE above 20.

With the help of YCharts Stock Screener it’s easy to pull out the more compelling choices among the low-volatility universe. After pouring the PowerShares ETF into the screener, you can add a profit filter, for example, the 3-year growth in EBITDA (available to platinum subscribers under the Income Statement tab). Then for a valuation filter, comparing the trailing and forward PE to the stock’s 10-year cyclically adjusted PE (PE 10 in Ycharts-ese) can help suss out stocks that are trading below their historic norms.

Exxon Mobil (XOM) rises to the top of the screen with 31% EBITDA growth over the past three years, yet a forward PE ratio of 11.6 that remains well below its PE10 of 14.2. In a world where new resources are harder to come by, Exxon Mobil has increased capital expenditures by more than 50% since 2009, but has still managed to keep free cash flow and net income trending higher.

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XOM Net Income TTM Chart

For the income seekers, there’s even a decently priced utility to be had. PPL (PPL) has been making the transition to a regulated electric utility over the past few years. Its major markets are Pennsylvania and Kentucky (where it also delivers natural gas) , as well as Great Britain. PPL’s 13.7 trailing PE ratio is well below the 17.9 average for diversified utilities. It has one of the highest EBITDA margins for a diversified utility selling at a below market valuation. The 4.5% dividend yield satisfies even the greediest of yield hungers, and its 60% payout ratio is on the low end for utilities.

Carla Fried, a senior contributing editor at ycharts.com, has covered investing for more than 25 years. Her work appears in The New York Times, Bloomberg.com and Money Magazine. She can be reached at editor@ycharts.com.


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