© Copyright 2000 Rogers Media. The following article first appeared in the June 2000 edition of BENEFITS CANADA magazine.

Is Risk Dead?

Despite the belief in a perpetual bull market, risk is alive and well. In fact market valuations, volatility and index concentration demonstrate that it's on the rise.

By Larry Lunn and Martin Gerber

MORE AND MORE investors are concluding that risk is an outmoded concept, or at least they're acting that way. They have embraced the new economy, bought into the information technology (IT) revolution and plunged head first into the hot stock market. The driving force behind this behaviour is the realization that IT is fundamentally changing the way we live, work, conduct business and communicate.

Investors have been well rewarded. The Standard & Poor's (S&P) 500 index is up 515% over the past decade (trough to peak). This is the greatest bull market in U.S. history. However, this spectacular appreciation pales in comparison to the stunning returns produced by the technology-laden Nasdaq, up 1,450% or 33% compounded annually over the same period. These dramatic and consistent gains in equity values have changed investor psychology. The belief in a perpetual bull market has taken hold and the concept of always buying the dips has become conventional wisdom.

This new mindset has brought about the concept of a new economic and market paradigm, which in turn, has lead to the virtual disappearance of equity risk premiums. As a result, the earnings yield on the S&P 500 is now a scant 3.3% and nearly non-existent on the Nasdaq compared to a 6.5% yield on U.S. 10-year government treasury bonds.

The disparity between the risk-free rate and low-equity yields means that investors are expecting an economic environment in which real earnings growth remains in double-digit territory--twice the historical norm--while inflation stays well below 2%, or half its historical average. If this does occur, corporate profits as a percentage of U.S. gross domestic product (GDP) will remain well outside their historical range. This is probably not realistic because above-average profitability for any sustained period attracts attention--competitors willing to accept a lower return on capital through reduced margins begin to emerge, labour demands its fair share of the economic pie and government, through taxes or anti-trust issues, intercedes.

The new financial paradigm for low- or non-existent equity risk premium is based on the notion that business cycles are less volatile, inflation is under control, and profit growth will remain well above historical trends.

The flaws in this rationale are numerous. For example, equity volatility is higher than normal and has reached a level that has historically coincided with a peak in stock prices.

The risks inherent in the stock market, as measured by conventional means (standard deviation of returns), have doubled in the past decade. Operationally leveraged balance sheets are more sensitive to small changes in revenue growth and interest rates, while corporate profit growth in aggregate will not meaningfully exceed the long-term norm of approximately 7.8% (equates to nominal GDP growth + productivity; i.e., 2% inflation + 3.8% real growth + 2% productivity). Even in the new economy, the laws of economics have not been entirely repealed.

Another factor that has to be considered when assessing risk is market breadth. This measure has been deteriorating dramatically over the past five years and is now below the levels of the early 1970s when the term "nifty fifty" was applied to those few high-flying companies with 50+ price-earnings (P/E) multiples that captured the imagination of investors on Wall Street. Unfortunately the 1973-1974 bear market deflated the investment wisdom of the day as the average nifty fifty stock dropped 80% of its value from peak to trough. Most companies' share prices did not recover until well into the late 1980s--some never recovered.

An examination of the percentage of stocks that have outperformed the S&P 500 illustrates the most recent narrowing in market breadth (see "Wax and wane," left). Over the four-year period ended December 1999, only 26% of the stocks in the S&P 500 outperformed the index compared to 60% to 70% of stocks over the 1975 to 1985 period. This dramatic narrowing, which has also manifested itself in the TSE 300, is a global phenomenon. More and more money is going into fewer and fewer stocks and, as might be expected, the stocks being bought are increasingly just the high-flying, high-multiple, technology and Internet-based shares.

To compound matters for Canadian investors, the TSE 300 index has an extremely high concentration in one stock, Nortel Networks, which now effectively dominates the index at 32% (at its peak).

Due to its higher than average volatility, this stock accounts for 42% of TSE index risk (standard deviation of returns). At 30%, Nortel has a market capitalization approaching $300 billion, but only $2.4 billion in annual profits. This compares to the five largest chartered banks with a combined market cap of around $89 billion and annual profits of $8.5 billion, or 3.3 times the value for one-third of the profits. To put this into context, Canada's total annual GDP is about $950 billion.

This raises a couple of interesting issues pertaining to risk. First of all, the question of value, defined as the present value of future discounted earnings. Nortel is one of the premier companies in Canada, if not the world, and it has delivered faster growth (10% to 40%) than the overall market during the last five years. As a result, it has justifiably traded at a premium valuation to the overall market (100% to 130% of the forward S&P 500 P/E multiple).

Looking ahead, industry analysts expect that Nortel will continue to deliver faster earnings growth than the market. However, as optimistic as they are, the forecasts are not outside of the company's historical relative growth range. Notwithstanding this, the valuation premium has ballooned to over 300% of the market's forward P/E multiple (see "Nortel vs. S&P 500," page 62). This valuation issue, which has manifested itself in a big move in price but no dramatic change in relative earning trend forecasts, accentuates the index concentration problem and increases portfolio risk.

PORTFOLIO DIVERSIFICATION

There is also the question of portfolio diversification. As the number of stocks (equally weighted) increases in a portfolio, the amount of risk declines. For example, a portfolio of five stocks will have embedded in it, on average, 23 units of risk or the percentage of volatility. This declines dramatically to under 17% when the number of stocks is expanded above 25; afterwards the decrease in volatility levels out. More importantly, as stocks are added and the level of risk declines, return variability also becomes more predictable.

The level of risk rises when holdings are more concentrated. However, if we compare the expected variability of equally weighted portfolios holding the same number of stocks, but with one stock position fixed at a 10% weight, the median volatility is largely unchanged and the range of likely returns from the portfolios increases (see "Diversification and risk," page 67).

Taking the same approach, when the weighting of one stock in a portfolio is moved up to 25%, the range of probable risk soars, the median rises and the variability in risk grows dramatically (see "Diversification and risk," page 67). In other words, at this level of concentration--even with a portfolio of 60 stocks--most of the benefits of diversification are lost and risk becomes unpredictable.

This analysis has broad implications for both pension plan sponsors and investment managers who are guided by the prudent man rule. Any portfolio with a 25% or greater weighting in any one stock is no longer properly diversified. And by extension, the TSE 300 index is no longer a properly diversified benchmark.

There could also be a permanent impairment of capital because managers or sponsors ignore the inherent risks in not properly diversifying their portfolios. It's at this point that the question of prudence and liability comes into play. Finally, it is probably fair to say that Canadian index funds have become high risk portfolios, especially in light of the fact that Nortel Networks is not only a 25%-plus weighting in the index but also that its above-average volatility constitutes 42% of the entire risk in the TSE 300 index.

Indexing can have a meaningful role in the management of large pools of capital. Although indexing is considered a passive, low risk strategy, the timing of a move from active management to indexing or vise versa is an active decision, no different than a switch from a value to a growth style.

In hindsight, the best time to have indexed a portfolio was back in 1994, just before markets started to narrow. The extreme narrowness of markets today, compounded in Canada by the over-concentration in one stock, strongly suggests that the time is ripe for a switch from indexing to an active strategy--just don't buy yesterday's winner.

Larry Lunn is managing partner and Martin Gerber is partner at Vancouver-based Connor, Clark & Lunn Investment Management Ltd.

As the number of stocks (equally weighted) increases in a portfolio, the amount of risk declines, as illustrated by the solid line in the first chart which represents 16,000 random used portfolios. The level of risk rises when holdings are more concentrated. This is evident when we compare the expected variability of equally weighted portfolios with portfolios holding the same number of stocks, but where one stock position is fixed at a 10% weight.

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