Volatility is a challenge that has vexed equity investors for decades, yet its root causes are often misunderstood. Understanding how a company’s business profile determines a stock’s risk can help investors prepare for uncertainty and make better decisions when market turbulence strikes.
Erratic market behavior often seems like a mystery. Bad economic news, political chaos, interest-rate moves or an industry crisis can trigger widespread anxiety among investors and inflict indiscriminate damage to equities. This volatility is the admission price that investors must pay to access the higher return potential of stocks and other risk assets. Yet volatility also reduces returns through risk drag, and often prompts emotional, financially destructive decisions that stem from the fear of loss.
Behind the headlines that incite volatility, market fluctuations are ultimately driven by the collective behavior of individual stocks. And the risk profile of a stock often stems from fundamental and researchable aspects of its business model and strategy.
Confidence in Cash Flows—the Source of Risk
For individual stocks, the source of volatility is derived from investor confidence in company cash flows. In finance textbooks, the value of an asset is defined as a function of its future cash flows and the discount rate, which itself is a function of interest rates. It’s also affected by the perceived variability of a company’s cash-flow potential; greater uncertainty around cash flows will raise the discount rate and lower a stock’s valuation. So, anything that can provoke uncertainty around a company’s cash flows may become a source of volatility. A company’s income statement may offer important clues about its resilience or underlying vulnerabilities.
Let’s start at the top, with revenues. Sales are an important driver of company earnings, but can be unpredictable. And sales volumes can be very sensitive to changes in economic cycles in industries like autos and retail; changes in supply/demand balances, which often get reflected in changing prices for commodities, for example; and changes in competition or technology, which can impact market shares. Other industries, such as consumer staples and utilities, typically see more stable demand and pricing, and thus more stable sales. Our research shows that sectors with more stable sales patterns tend to be less volatile (Display).
Within any sector, understanding a company’s business model and forecasting its cash flows is the cornerstone of active equity investing. Just as important, fundamental research must also identify the risks to a company’s cash flows. Our research shows that companies with a higher volatility of cash flows also tend to have more volatile stock returns (Display, left). This means that the structure of a company’s business model can also be a source of volatility—and its income statement may offer important clues about its resilience or underlying vulnerabilities.
Cost Structures Matter
Cash flows can also be profoundly affected by cost structures. Consider two companies with very different cost structures. One requires little capital to get started, so it has low operating leverage. The other requires a much bigger investment to get started and has high operating leverage. The company with lower operating leverage starts out in a much more profitable position, while the company with higher operating leverage starts off with losses and will need to sell more units to become profitable (Display above, right).
So how the company makes money can have a material impact on its profitability and consistency. Industries that generally exhibit lower operating leverage include services and retail. Companies with higher operating leverage tend to have high fixed costs, either from large upfront capital requirements in industries like mining and autos, or a fixed labor force. These types of companies also tend to be more sensitive to the economic cycle and to the changing tastes and habits of consumers.
Taking Calculated Risks, Avoiding Unintended Exposures
Of course, business models aren’t the only thing that determines a company’s risk profile. Company debt positions (or leverage) and sensitivity to exogenous shocks from the macroeconomy or politics will also influence the volatility of its stock. In future blogs, we will examine other sources of volatility and how to manage them. But we believe that with a clearer grasp of the way company-specific risks are at the heart of a stock’s volatility, active managers can better assess the risk-taking needed to achieve desired returns and reduce noise that can undermine confidence in an allocation.
By understanding the sources of volatility, portfolio managers can better drive their outcomes through intentional views—taking risk where insight identifies an opportunity for improved returns, while controlling the volatility of unintended exposures. This helps reduce the noise that interferes with an investing plan, and is the key to remastering portfolios and realizing the benefits of long-term equity returns.
This blog is based on a white paper that was published in October 2019 titled Remastering Volatility: Reducing Noise in Equity Allocations.
Chris Hogbin is Co-Head—Equities at AllianceBernstein
Chris Marx is Senior Investment Strategist—Equities at AllianceBernstein
Nelson Yu is Head of Quantitative Research—Equities at AllianceBernstein