A basic belief of investing states that the higher the risk, the higher the reward. Unfortunately, it may be just the opposite. According to a white paper (link opens PDF) from the investment firm GMO, stocks showcasing safer characteristics outperform riskier choices. Is it time to throw your money into proven stalwarts and give up on Cinderella stories?
The ingredients of a risky asset
Risk can be calculated a variety of ways, and commonly is summarized by a single number: beta, which measures the price volatility of a stock compared to an overall index. But GMO argues for a more holistic view of risk, which focuses on the ability for a company to continue to deliver corporate profits. As Ben Graham, the forefather of value investing, said, "Real investment risk is measured not by the percent that a stock may decline in price in relation to the general market in a given period, but by the danger of a loss of quality and earnings power through economic changes or deterioration in management."
In short, a company that struggles to maintain high and sustainable profits is risky, even if its stock price isn't volatile. How does a company avoid being risky?
Build a moat, and it will stay built
To avoid worsening profits, a business must have a competitive edge, or moat, that protects its profits. Brand, patents, regulations, talent, and management all can keep a business' profits high and less risky, which will allow it to continue to give shareholders returns. And interestingly, GMO found evidence that past high profits usually meant future high profitability, and past low profits meant future low profitability.
Given this, you'd think that the market would price risky companies cheaper compared to those who report sustainable profits. Not so...
Paying more for risk
According to GMO, companies that report negative net incomes underperform the market by 8 percentage points per year. So, not only is it risky investing in companies with struggling profitability, but also you are likely paying more than a fair price for that risk. And while you overpay for troubled companies, companies with sustained high profitability and low leverage outperform the market, by 0.7 percentage points for U.S. large-cap stocks and 2.2 percentage points for those in the MSCI EAFE.
Why would the market overpay for risk while selling quality investments cheaply? GMO states that the quality companies' profits "are not quite high enough to command the attention of a market in thrall to the possibility of the next big jackpot." Risky companies are exciting -- exciting to invest in, watch, and cheer on -- but you pay for that entertainment when you sell them at a loss.
Quality companies for cheap
The GMO Quality funds invest in companies that minimize the above risks, and remained flat over the past five years while the S&P 500 lost over 14%. You probably won't be excited by the companies that make up the fund, but I believe that's all the more reason they represent excellent opportunities.
Microsoft (NAS: MSFT) , Johnson & Johnson (NYS: JNJ) , and Philip Morris International (NYS: PM) each make up over 5% of the GMO Quality III fund, with Coca-Cola (NYS: KO) and Apple (NAS: AAPL) rounding out the top five holdings. What do these companies have in common?
Double-digit profit margins, from Microsoft's 2011 profit margin of 33% to Philip Morris' 11.6%.
Profits that went fairly unscathed through the last recession:
Brand names known worldwide, from Band-Aid to Marlboro.
Operations worldwide, protecting them from any one regional slowdown.
Dividend yields all currently over 2.5%, and they all can likely afford dividends into the future with the highest payout ratio of the group Johnson & Johnson's 62%.
It's all about your risk profile
You won't get multibagger gains with these $100 billion-plus companies, but if you're looking for sustained returns in bull or bear times, these are a few great selections. And, if GMO's research is right, companies like these can be bought at a discount.
If you're looking for more quality companies, read our free report on "3 Stocks That Will Help You Retire Rich". This report gives you the habits you need to build long-term wealth, along with three stocks that can help you along your way, and best of all, it's free.
At the time thisarticle was published Fool contributor Dan Newman holds no position in any of the above companies. Follow him @TMFHelloNewman.
The Motley Fool owns shares of Microsoft, Johnson & Johnson, and Coca-Cola. The Fool owns shares of Apple. Motley Fool newsletter services have recommended buying shares of Coca-Cola, Microsoft, Johnson & Johnson, and Apple, as well as creating bull call spread positions in Apple and Microsoft and a diagonal call position in Johnson & Johnson. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.
Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.