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Posted 3/8/2001
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The Speculator
5 rewarding stocks from the ragged edge
The greater the risk, the higher the reward. We went in search of volatility and found opportunity.
By Victor Niederhoffer and Laurel Kenner
The Viennese were conditioned to the smooth, fluent style of a Mozart or Hummel. Here came young Beethoven, hands high, smashing the piano, breaking strings, aiming for a hitherto unexploited kind of orchestral sonority on the keyboard.
-- Harold Schonberg, "The Lives of the Great Composers"
Consider two stocks, both selling in the 20s, both up about 2 points from the end of 1998.
One, Baldor Electric (BEZ, news, msgs), makes electric motors and drives. Look at its closing price at the end of each month since the end of 1998, and its stock hasn't fallen lower than 16.19 or risen higher than 21.82.
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The other, Advanced Energy Industries (AEIS, news, msgs), might be termed a New Economy stock. It makes parts for manufacturing equipment that etches thin film layers on silicon and glass. Advanced Energy closed February 2000 at 72.75, then fell to 17.25 at the end of October.
Quantitatively speaking, the average monthly move -- up or down -- for Baldor is 4%, vs. 30% for Advanced Energy. Thus, Advanced Energy is 7.5 times more volatile than the Old Economy electric company.
While Value Line ranks both companies "4" for timeliness, the firm's write-ups reflect a world of difference. Baldor is expected to have "decent, modest improvement," while Advanced Energy has a "volatile, cyclical business with a handful of customers."
Which stock would you rather own?
If you're like most investors, you'd choose Baldor. While not too exciting, at least it doesn't take disturbing plunges. Most people prefer certainty to uncertainty. That's why the insurance industry accounts for 15% of the U.S. economy, and that's why we pay richly for information to reduce risk in all our endeavors.
But when it comes to stocks, this preference is very costly. A risky stock's price reflects the chance of great loss or great return. The expected return must be high, to compensate investors for the anxiety and uncertainty that holding such stocks creates.
The risk/reward ratio
If there is a cornerstone of the modern theory of portfolio analysis -- indeed, all of finance itself -- it is that the greater the risk, the higher the required return. This is just a variant of the economist's favorite adage, "There is no such thing as a free lunch."
Tradeoffs between risk and reward are found not just in finance, but everywhere in life. We asked our friends for some examples, and they obliged with manifold insights from their own experiences. A few samples:
- A skier risks losing control to go fast enough to win a race. (Vic's brother, Roy)
Regrettably, there is little, if any, empirical evidence to support the risk-reward relation for individual stocks. The major problem is that the relation is couched in terms of expectations. There is great uncertainty as to what these expectations should be.
Anecdotal examples can be called up on both sides. For example, Qualcomm (QCOM, news, msgs) was extremely volatile over 1996-1998, and went on to record a stunning 1,172% gain in 1998-2000. Stocks that barely budge, on the other hand, aren't necessary safe. AmSouth Bancorp (ASO, news, msgs) had very low volatility in 1996-1998 and then dived 48% over the next two years.
Yet high volatility doesn't necessarily mean a high return. Micron Electronics (MUEI, news, msgs) was among the most volatile stocks in 1996-1998, but proceeded to fall 78% in the subsequent two years, while Sysco (SYY, news, msgs) had relatively low volatility, and doubled. The question is which of the four results dominate, and that is where science comes in.
Past levels of risk and return are generally substituted for the expected levels.
The main empirical support for the relation is that risky assets such as stocks tend to show returns that are significantly higher than those on risk-free assets such as Treasury notes. For example, over the last 75 years, the average return has been 13% for common stocks, 18% for small caps and 3.8% for U.S. Treasury bills. However, ever since academics determined that small caps return more, they've been returning less -- thereby providing yet another instance of how the academics always lag the form, as they say on the racetrack.
The main reason for the scantiness of evidence showing that risk and return are related in some pragmatic way for individual stocks is that it's unwieldy to create a file of companies with past prices, compute regressions, take account of additions and withdrawals, and then compare the result with benchmarks.
Running the risk numbers
Fortunately, we were able to enlist the very able duo of Sam Eisenstadt and Tom Downing, chief quantitative researchers at Value Line, to implement this project. They do have past data on all Value Line stocks, and they do compute measures of risk on a prospective basis. With their kind assistance, we were able to conduct a comprehensive study of the relation between past risk and future return for the 1,060 companies in the Value Line universe as of year-end 1998.
We chose as the measure of risk the standard deviation of monthly percentage moves in 1996, 1997 and 1998. Because we suspected the risk-reward relation would vary a good deal, we divided the stocks into 10 groups of 106, based on how risky they were. Those with the lowest variability were in Group 1, and the highest were in Group 10. We then looked at the returns of these stocks in 1999 and 2000, a period during which the average stock changed relatively little and the S&P 500 advanced 7%.
In brief, we found definitive evidence -- the best available, in our opinion -- that rewards are greatest in risky stocks. The results are reported in the table below.
Companies with the lowest standard deviations (less than 3.7%) declined 5.5% over the next two years, on average. Stocks with the highest standard deviations (26%) returned 51%.
The results held up when we took the three highest-variability and three lowest-variability groups. The low-variability group, consisting of some 330 stocks with an average standard deviation of 6.6%, declined 6% over the next two years. The high-variability group, with average standard deviation of 11.2%, returned 36%.
The chance of such extreme differences happening by coincidence is one in 1 million.
Average Two-Year Price Appreciation for Stocks Ranked by Past Variability
(106 stocks in each class; 1 is lowest variability, 10 is highest)
| Variability class | Subsequent % move* | Subsequent % variability* |
| 1 | -5 | 26 |
| 2 | -8 | 34 |
| 3 | -9 | 41 |
| 4 | -5 | 55 |
| 5 | -8 | 53 |
| 6 | 3 | 65 |
| 7 | 6 | 70 |
| 8 | 15 | 78 |
| 9 | 43 | 175 |
| 10 | 51 | 177 |
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Always on the lookout for good stocks to buy, we took the 50 companies with the highest variabilities. Ten had recent insider buying, and five were ranked 3 or better for timeliness by Value Line. They are: Good Guys (GGUY, news, msgs); Laser Vision Centers (LVCI, news, msgs); QAD Inc. (QADI, news, msgs); Cygnus (CYGN, news, msgs); and Microvision (MVIS, news, msgs)
We hereby recommend the establishment of a second portfolio consisting of these stocks to supplement our previously recommended portfolio. We advise phasing in the investment 25% a week for the next four weeks.
If you're completely risk-averse, it might be a good idea to avoid MRV Communications (MRVC, news, msgs), New Era of Networks (NEON, news, msgs), Sharper Image (SHRP, news, msgs), Read-Rite (RDRT, news, msgs) and Incyte Genomics (INCY, news, msgs). They hold the distinction of having the highest variabilities of all.
It's appropriate to close a column on risk with a quote from Beethoven, one of music's greatest risk-takers.
The composer wrote in an 1801 letter to Dr. Franz Wegeler: "I want to seize fate by the throat."
At the time of publication, Victor Niederhoffer and Laurel Kenner owned none of the equities mentioned in this article.
MSN Money's editorial goal is to provide a forum for personal finance and investment ideas. Our articles, columns, message board posts and other features should not be construed as investment advice, nor does their appearance imply an endorsement by Microsoft of any specific security or trading strategy. An investor's best course of action must be based on individual circumstances.