Balancing risk vs. return, income vs. growth and quality vs. value

Investing is all about risk and return.  In order to get higher returns, you usually need to take more risk, so there is a balance to be struck between what rate of return you would like and what level of risk you can live with.

As a defensive value investor, I have the following risk/return goals for my portfolio:

• High returns – More dividend income and capital growth than a market index such as the FTSE 100 or FTSE All-Share
• Low risk – Less month-to-month volatility in the value of the portfolio than the market, as well as smaller and shorter drawdowns during bear markets

Rather than focus on risk and return directly, I work towards my target risk/return trade-off by focusing on the underlying factors of income, growth, quality and value.

To search for high-income, high-growth, high-quality, low-risk opportunities, I’ll use various metrics that I’ve covered recently (use this worksheet and spreadsheet to calculate them for yourself).

Investing for high-income and growth

The Growth Rate score identifies companies that have a proven history of long-term growth.  In addition, the Growth Quality score takes that a step further by highlighting those companies where the growth is both reliable and relatively predictable.

Growth can also be boosted by systematically buying low and selling high.  The PE10 and PD10 ratios are a robust way of defining ‘high’ and ‘low’, especially for companies that have high Growth Quality scores.

A high income is obviously achieved by buying high-yield shares, and most low PE10 and low PD10 stocks have high yields relative to their peers.  By sticking to high-yield shares from companies that have high Growth Rate and Growth Quality scores, you’re also more likely to see that dividend rise over time.

Sticking with low-risk shares

Companies with high Growth Quality scores are, by definition, less volatile – i.e. less risky than average.  They are steady, stable companies that grow more reliably than most companies.

The second way to reduce risk is to look for companies where the cyclically adjusted Debt Ratio is low.  Companies with a low Debt Ratio and prudent pension liabilities are less likely to have problems with their financial obligations.   They’re less likely to carry out rights issues, and they’re less likely to divert shareholder’s cash towards other stakeholders such as banks or pension funds.

Buying shares on low valuations is another important way to reduce risk.  Buying on low valuations reduces valuation risk, which is the risk that your shares might fall in value due to a decrease in the ratio between the share price and the underlying company’s earnings and dividends.

Shares at high valuations typically have higher valuation risk, while shares at low valuations typically have lower valuation risk.

Pulling it all together

So how exactly do you go about combining these various metrics to find high-yield shares from high-quality, high-grow, low-risk companies?

There are lots of different ways you could do it, but here are a few suggestions.

Focus on stocks that are above average at everything

The ideal defensive value stock is one that has an above-average dividend yield with a below-average PE10 and/or PD10 ratio. The company should have an above average Growth Rate, above-average Growth Quality and prudent Debt Ratios and pension liabilities.

Because I use a checklist when analysing companies, I tend to call this “ticking the boxes”.  If a company has an above-average and market-beating Growth Rate score, then it ticks that particular box.

As you would probably expect, there aren’t too many stocks that tick every box.  When you do find one, the company is likely to be having a tough time at the moment.  After all, if everything looked rosy, the shares wouldn’t be cheap.

One current example of a stock that ticks all the boxes is Tesco.

Tesco has grown at around 9% a year through the last decade, with a Growth Quality score of 95%.  At £3.26, the shares have a dividend yield of 4.5%, while the PE10 ratio is 12.5 and the PD10 ratio is 27.8.  The company’s Debt Ratio is also reasonable at 2.7, as are its pension liabilities.

Each of those is better than the equivalent figures for the FTSE 100, which has grown earnings and dividends at just 2% a year over the last decade (which is quite slow growth, thanks to the great recession), while the Growth Quality is also low at 76%.  With the index at 6,634, the dividend yield is 3.5%, while the PE10 ratio is 14.1 and the PD10 ratio is 33.8.

So on that basis, I would describe Tesco shares as a high-yield share from a high-growth, high-quality, low-risk company.

Of course, in and of itself, this proves nothing.  Just because an investment looks good from its past history doesn’t mean it will work out well in the future.  But in my opinion, this is certainly a very sensible way to start looking for potential investments.

Widening the investment net

There are very few stocks that tick the growth box, the quality box, the valuation box and the yield box all at the same time.  If you can’t find something you like with a perfect score, then you might want to widen your search to look for stocks that tick three out of the four boxes.

For example, there are some companies, such as Reckitt Benckiser, which are growing so quickly (17% a year) and so consistently (100% Growth Quality) that you’re almost never going to see their shares cheap enough to have dividend yield and PE10 better than the market average.

The company is just too good to be priced so cheaply.

However, you may occasionally find it with an above-average dividend yield.  Under those circumstances, it could still be a good choice even if the PE10 is higher than the market’s.  After all, a low price for a Ferrari is still going to be higher than a high price for a Ford Mondeo, but that doesn’t mean the Ferrari isn’t a bargain.

This loosening off of the criteria allows you to invest in a wider range of companies.  You may end up with some very fast growers with high PEs but market-beating dividend yields, while others have average growth combined with low PEs and very high yields.

This is the balancing act that all investors have to take between risk and return, growth and income, quality and value.

Although it’s a good idea to accept some stocks that tick just three out of four boxes, the maximum Debt Ratio of 5 is still non-negotiable, regardless of quality or price.

Ticking two boxes out of four is usually not enough

Investments that only tick two out of the four boxes are best avoided in most cases.  There are many stocks that meet this standard, and most of them fall into the ‘good company – expensive stock’ category.

An example of this is Rolls-Royce.  It has a Growth Rate of 10.5% and a Growth Quality of 90%, both of which are above average.  It’s quite likely to be a high-quality company, at least on the basis of the limited information we’ve looked at so far.

With the shares currently at £11.72, the dividend yield is just 1.7% while the PE10 ratio is 32.7, both of which are far worse than average.

So here we have a case of an expensive but high-quality company.  The problem is that it isn’t obvious whether the shares are good value.  It’s a good company, but we’re being asked to pay top dollar for that quality.  Is it worth it?  Perhaps, but then again, perhaps not.

In the case of Tesco, we have a company with a track record similar to Rolls Royce’s, but where the shares appear to be much better value for money.  Tesco’s shares have lower valuation ratios and higher yields, higher even than the slower-growing market average.

On this evidence, I would look further into Tesco while putting Rolls Royce back on the shelf for now.

A more sophisticated approach

Another approach to balancing risk vs. return, income vs. growth and quality vs. value is to rank the whole universe of stocks (the FTSE All-Share in this case) by each metric and combine the individual ranks into a super-rank.

This is an approach that was popularised by Professor Joel Greenblatt of “Magic Formula” fame, where the Magic Formula is based on exactly that sort of ranking process but with different metrics.

Ranking various factors in this way gives a good balance, favouring each of them in equal measure and not allowing any one factor to dominate the others.

The stock screen that I use for my own buy and sell decisions is based on exactly the same system.

The main benefit is that it gives a much more precise indication of whether company X has a better balance of quality, growth, income and value than company Y.  It will work even if it’s comparing a wonderful company at a fair price with a fair company at a wonderful price.

Going beyond the numbers

In the real world, very few investors will buy or sell shares based purely on numbers, whether those numbers are dividend yield, growth rate or a ranking on a stock screen.

Most investors will want to have a look at what the company actually does, what its competitive position is and what problems it has faced, is facing and might face in the future, and that’s what I’ll cover in the next part of this defensive value investing series.