Stocks with lower volatility profiles and those of higher quality have typically behaved more defensively than the overall market, doing best during slowdowns and contractions as opposed to times of recoveries and expansions. Over the last year, however, the positive relationship between these investment themes has broken down as high-quality stocks outperformed the market significantly and low-volatility stocks underperformed.
What’s Driving Quality Higher?
A look at earnings growth rates provides insight into the higher expected growth of high-quality stocks. With the current cycle getting older, investors have been willing to pay up for growth. The recent multiple expansion of quality from one year ago offers evidence of this behavior, as quality now commands a 22.79x price-to-earnings (P/E) ratio, relative to 21.74x a year ago. Meanwhile, quality’s expected earnings growth increased to 13.31% versus 11.56% a year ago.
On the other hand, low volatility lagged during the last year as a result of concerns about rising rates and the continued shift to growth-oriented names, partially at the expense of these stable business models. However, the factor does have lower expected earnings growth than the broader market and multiples have not increased in-line with other stocks. Subsequently, the factor is actually cheaper on a P/E ratio basis than it was a year ago, and cheap compared with the broad market.
A primary driver of the difference in earnings growth between the two factors comes from quality’s 35% weight to information technology (IT) stocks, compared with low volatility’s 22% allocation.2 IT stocks generated 22% earnings growth in the most recent earnings season, compared to 15% for the Russell 1000 Index.3
Quality stocks exhibit lower leverage and considerably higher profitability than stocks with lower historical volatility. This further illustrates why investors may have favored quality at the expense of low volatility as the characteristics of high quality differ markedly from low-volatility stocks.
What Can Investors Make of This?
While recent price action may prove transitory, investors may feel the need for more defensiveness today as we move later in the cycle. With low volatility challenged by high interest rate exposure and quality potentially undermined by its exposure to IT, the challenge for nervous investors is that being defensive through traditional means may be riskier today than in the past.
Rather than counting on a single factor to buffer portfolios, adopting a multi-factor approach may be prudent in that it offers diversification during the times when defensive factors behave atypically. Further, a multi-factor approach that adjusts exposures based on current macro trends could help by tilting toward more cyclical factors should market sentiment accelerate or by remaining in more defensive factors should deceleration continue. Because high-quality and low-volatility stocks currently exhibit low correlations to each other, maintaining exposure to both may ultimately prove more effective than relying on only one factor.
Alternative weighting approaches (i.e., using factor weighting as a measure), while designed to enhance potential returns, may not produce the desired results.
OppenheimerFunds is not undertaking to provide impartial investment advice or to provide advice in a fiduciary capacity.