Dear Fellow Investors:

In a December 7, 2012 piece for Barrons.com, Mark Hulbert shared the research from a study called “Low Risk Stocks Outperform within All Observable Markets of the World.” The study, written by Nardin Baker and Robert Haugen, convincingly made the argument that boring stocks are wonderful for superior compounded returns regardless of which country you measure.

The researchers found that, in each of 33 countries’ stock markets between 1990 and 2011, an investor on average would have made far more money by buying low-volatility stocks than with issues having the highest historical volatilities. And not by just a small amount, either: A portfolio that held the 10% of stocks with lowest historical volatilities did 18% per year better, on average, than the decile containing the most volatile stocks.

As good research does many times, this raises as many questions as it answers. What premises are ruined by this information? Why do boring stocks outperform exciting ones as a group? Is there a good template in the research world for analyzing factors which identify boring? Are there any good ideas available today which fit the profile described by the research and the template?

Efficient Market Theory is refuted by this powerhouse research. These theorists believe higher risks and higher returns go hand in hand. Here is how Hulbert discusses this problem:

Note carefully that this result stands finance theory directly on its head. According to Investments 101, the riskiest stocks — which are, after all, the most volatile — should provide higher returns, on average, than the least risky issues.

What this new study shows, in contrast, is that, far from compensating investors for the countless sleepless nights, the highest volatility stocks tend to produce the worst returns. That’s adding insult to injury.

To be sure, Baker and Haugen aren’t asking us to throw academic orthodoxy out the window just because of one study, comprehensive as it otherwise is. They point to a series of additional studies over the last two decades, covering stock market history as far back as 1926, that have almost universally come to the same result.

In his book, Contrarian Investment Strategy, David Dreman and his researched group addressed why boring stocks outperform. He compared owning boring stocks as sitting in one side of a casino where things are quiet, the activity is low, but the participants are beating the house. On the quiet side, folks are getting wealthy very slowly, but in large numbers. The other side of the casino has unusual excitement and someone is becoming a multi-millionaire each day from among the thousands of daily visitors. The possibility of nearly instant success to humans with a finite life span is compelling. Humans are drawn by an intense urge to shorten the time frame of successful investing and are naturally drawn to exciting and highly volatile securities. Baker saw the same thing in his study:

As a result, Baker told me “we tend to overpay for the most volatile stocks” — and that, in turn, leads such stocks to be poor performers.

The researchers documented this by carefully measuring the relationship between the performance of a stock and the number of stories about it that had previously appeared on the Dow Jones News Wires. Sure enough, they found a stark inverse correlation: The most volatile stocks garnered by far the most stories and produced the lowest subsequent returns.

Fortunately, Ben Inker of GMO did research based on the S&P 500 Index from 1980 to 2003 and came up with a template for the high-quality characteristics of a company which are proven alpha providers. His research demonstrated that low leverage, high profit margins, low earnings volatility and low beta all added alpha to an equity portfolio over the long-term. Three of these characteristics qualify as boring (low leverage, low earnings volatility and low beta). Low leverage added 100 basis points per year, low earnings volatility added 170 basis points and low beta added 50 basis points compared to the average of the index (though these aren’t mutually exclusive).

At Smead Capital Management, we have numerous criteria in our eight proprietary criteria for stock selection which speak to boring. Our first criteria is that the company meets an economic need and we like to say that if we can’t explain what the company does in 45 seconds, we don’t want to own it. Simple has a tendency to be boring. Second, we demand companies with long histories of profitability. Those companies which have been around for ten to twenty years are typically more boring. Third, we like wide moats or companies which have a competitive position which is defendable. Many of the aspects of a business which make for a wide moat are a contributor to boredom. For example, the local mortuary is defended from competition by the fact that few people want to handle dead bodies for a living.

Fourth, we like companies which generate high free-cash flows. This means that they aren’t exciting enough to use all their cash flow to grow or are mature enough to be boring. Fifth, we like to buy cheaply because valuation matters dearly. Low PE ratio segments of the S&P 500 outperform higher PE segments in studies ranging from Francis Nicholson’s study to Bauman, Conover and Miller to David Dreman’s work. Price-to-earnings ratios have a tendency to be low among the more boring companies in the index. Out of favor gets boring fairly fast. Lastly, we like strong balance sheets with either no debt, as much cash as debt, or the ability to wipe out all debts through two years of free-cash flow. Low leverage is a proven source of boredom and high quality.

We love the fact that boring companies reduce the need for expensive frictional activity in our portfolios and allow us to benefit by long-term dividend growth. Also, the long-term psychology of holding boring companies is much easier on the stomach.

Based on these criteria and reflecting on Mark Hulbert’s interesting piece, here is a list of possibly wonderful boring companies which we think are attractive for purchase currently:

Aflac (AFL)
HR Block (HRB)
Gannett (GCI)
Merck (MRK)
Pfizer (PFE)
Walgreens (WAG)

We believe all six of these common stocks trade at relatively low PE ratios, stellar or rapidly improving balance sheets, have wide and growing moats, gush free cash flow, maintained consistently high levels of profitability for decades and have stock prices which have moved slowly over the years. We hope they bore us and make us wealthy over the long haul.

Best Wishes,

William Smead

The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. It should not be assumed that investing in any securities mentioned above will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.

 

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www.smeadcap.com