SINGAPORE (Aug 28): The recent spurt in volatility in equity markets should give investors pause.

The extended period of calm that we have seen cannot be taken for granted and is certainly not a reflection of what could happen in the future.

Smaller-cap stocks were the hardest hit in the latest selloff (though they have also rebounded very quickly). I suspect this will always be the case in the future. Smaller-cap stocks typically have lower liquidity, which, in turn, tends to translate into higher short-term price volatility.

Indeed, the table below shows that mid- (market cap between $100 million and $900 million) and small-cap stocks (those with market cap of less than $100 million) as a whole have, historically, higher price volatility compared with the largest companies listed on the Singapore Exchange.

For instance, 96% of the 100 largest stocks by market cap have recorded low volatility compared with just 63% and 8% for mid- and small-caps, respectively. At the other end, small-caps as a group have the highest number of stocks (25%) with high volatility — compared with just 4% for mid-caps and none for large caps.

Statistically, volatility is measured as the standard deviation (the average amount by which individual data points differ from the mean).

In the investing world, volatility is the most widely accepted measure of risk. The basic idea is that the more a stock’s price/returns vary from its average, the more volatile the stock is and hence, the higher the risks.

I do not think this is necessarily true.

Take this simple example. Assume both stocks A and B have a price of $100 at the start.

Stock A goes up one cent a day for the next 200 trading days (about a year). By the end of the year, its price is $102, for a gain of 2%.

Stock B goes up by 10 cents a day for the same period and ends the year at $120, up 20%.

Mathematically, B has a higher standard deviation (5.8) than A (0.58). This means B has higher volatility and is therefore said to be more risky. But is it really? Volatility by itself tells us nothing about the company’s risks as a business and going concern and, in this case, only that its share price performed better.

For the investor, there are more pertinent risk factors, such as those concerning governance, earnings and profitability, the ability to service short- and long-term obligations and so on.

In other words, risks should be a function of the underlying fundamentals of the company (the cause), not the volatility of the stock price itself, which is just a reflection of risks (the effect).

AbsolutelyStocks measures these risk factors (those that are quantifiable) as the company’s Fundamental score.

In short, smaller-cap stocks do display greater price volatility compared with their larger peers, especially in the short term.

So, if you are going to buy these stocks, make sure they are fundamentally sound and be prepared to stay longer term. That means you should not be over-leveraged, or better yet, not at all. And if you are unleveraged, stock-price volatility is inconsequential to you, except for opportunity costs.

The two holy grails in investing are risks and returns. We want to extract the highest returns and, at the same time, minimise the risks.

One option is to pick stocks with high Fundamental scores (to minimise risks) and high Valuation scores (to maximise potential returns). You can filter the scores on absolutelystocks.com.

That is exactly what my Malaysian value investing portfolio has been doing for the last three years.

Remember, this is a real portfolio and its cumulative returns include all transaction costs. We publish this portfolio every week in The Edge Malaysia for full transparency.

It keeps us honest. Every stock bought and sold, all the gains and losses, are taken into account.

And the result is that this portfolio has outperformed all the benchmark indices by quite a distance.

Total portfolio returns now stand at 77.8% since inception.

Over the same period, the FBM KLCI and FBM EMAS indices are down 3% and 0.4% respectively.


Tong Kooi Ong is chairman of The Edge Media Group, which owns The Edge Singapore

This article appears in Issue 794 (Aug 28) of The Edge Singapore this week