Why You Should Ignore Volatility, and What Stocks to Buy

Jelly Roll Capital Equity Research

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Does Volatility Matter: An Investor’s Perspective

Two days ago I wrote about how, with volatility near a historic high, you should consider speculating by being short volatility. The market conditions of late have been strange; if you are a quant and go strictly by statistics, then you likely have an even more interesting description of them. In sum, last week saw trading days that models predicted would happen only once in 10,000 years happen THREE consecutive days. Let’s give a +1 to risk managers and model builders everywhere. More importantly right now, though, is to focus on what this volatility means to you - how will it impact your portfolio?

If you choose to play short-term, then volatility is a very important statistic to keep track of. The CBOE Volatility Index (VIX) is measured using options pricing models and hence reflects the implied volatility of a basket of S&P 500 options. This is important to consider because the index is forward looking and represents expectations; so market participants have a very active role in setting the level of the VIX. The higher the VIX goes, the more scared/nervous/fearful the crowd of traders has become… but it means absolutely nothing about individual stocks, especially high-quality issues. A high VIX increases the likelihood that near-term returns will undergo high variability, and this can obviously create problems for investors who check their portfolio too often, watch CNBC, and/or are excessively nervous about their holdings. If this describes you, then you are either in a much more aggressive asset allocation than you should be, or you need a psychological tune-up to put you in the right state of mind about investing.

The best thing you can do is probably to sit tight and wait for the variability of returns to work in your favor. By that, I mean that you should look to buy high-quality stocks following big down days. I know I’ve mentioned this name several times and it has done absolutely nothing, but Johnson & Johnson (JNJ) is THE mega-cap stock you should be buying. Traders on the Street love nothing more than to overplay a story, carry a stock too far in one direction, and thereby build a cycle where all you hear is “JNJ down again on anemia drug fears.” Allow selling to continue, repeat headline, and short sellers smile. Procrit, Johnson & Johnson’s blockbuster anemia drug, comprised 13.8% of the revenue from the company’s pharmaceutical unit, which comprised 44% of overall sales. If Procrit was taken of the market tomorrow, it would eliminate 7% of JNJ’s total revenues. You might not realize the magnitude of that number until you consider that JNJ shares have literally never been cheaper; at 11.9x cash flows, JNJ is 60% below its historical average multiple there. JNJ trades at a 16% discount to the S&P 500 as a whole on a trailing earnings basis. Does any of this make sense? You can argue the stent point (which I actually believe is much more valid than the anemia drug point), but stents were $4 billion in sales last year; a relative drop in the bucket when you look at JNJ as a whole. The stock offers a 2.7% yield and that dividend is about as certain as they come. In short, there is no reason why - high variability of returns or not - you shouldn’t be buying JNJ on any weakness.

Pfizer (PFE) is another 52-week low story that seems to carry a lot of short-term negative thinking. PFE offers a 4.9% yield; this is equal to the yield on a 30 Year Treasury and Pfizer is another rock-solid dividend payer, so that dividend should be increasing year after year after year. Consider the historic multiples the stock commanded relative to the present; current price-to-cash-flow is half of the previous running average. Price-to-book is also at about half the historic multiple. Is Pfizer, like Johnson & Johnson, a huge risk? I would say no, both companies certainly present less risk than the market as a whole. On any more short-sighted selling, or variability of returns, I would be a buyer of PFE as the yield approaches a full 5%.
Another pharmaceutical bottom-hunting play that might be more appealing is Sanofi-Aventis (SNY), the French giant behind drugs like Ambien and Allegra. Consistently strong free cash flows and a relatively low payout ratio for the established pharmas of 36% leaves the company with a 2.5% dividend. If you guessed shares are at not just at a 52-week low but also at historical lows, you guessed right. Warren Buffett recently disclosed he has more than quadrupled his stake in the company

Although the market in general has come down from its highs, many stocks have been completely hammered down well under what I believe is fair value. My advice to investors is to focus on a few consistent performers and ignore the market volatility as the noise it is. Happy hunting!