We’re used to reading apocalyptic warnings and rants about gold from the boys from SocGen (Dylan Grice and Albert Edwards) so the latest note out from Grice is a true pleasure.
The title is: Why we overpay for excitement (and the secret pleasure of being boring), and it’s all about the appeal of high-quality, low-beta stocks.
The basic idea is: Investors systematically overpay for high-volatility, high-beta stocks because they like the thrill (kind of like gambling or buying a lotto ticket) leaving a large swath of the market undervalued and underowned.
This chart comparing a low-beta portfolio to a high-beta portfolio shows nicely how well the low-beta, boring names have done over the last several years.
But of course, that’s not really enough to go on.
This could be just one cycle, and we could be due for a regime change. The overvaluation of high-beta names might not really be anything systemic at all — just a passing fad.
But Grice concludes that it is (mostly) systemic, and that low beta investing should as a rule do better.
Crucial to his argument is this chart, which will take some explaining (below).
Some people might like to think that a high-beta stock is somehow the equivalent to buying a normal stock, but on leverage. So, for example, you might think that you can replicate the performance of a stock like Netflix (which will swing in exaggerated moves relative to the market) by buying some quiet stock (like Microsoft) on leverage.
But there’s a difference. With your leveraged position, you can lose up to 200% of your money (the principle investment, plus the amount your borrowed to go in extra-long). With the high beta stock, you can only lose 100% of your money. And since the upside is the same in both, you might think it’s a no-brainer: Duh! Buy the high beta stock.
Well, yes, this is what everyone thinks that buying the high beta stock offers a much more attractive risk-reward profile. And you know what: That’s what makes it overvalued.
Now we’re skipping some steps and charts from Grice, but a key idea is that you can replicate the payoff matrix of a high-beta stock by buying the market and by buying call options on the market. So you’ve supercharged your upside, while still limiting your downside to 100%.
And yes, just like with high beta stocks, this strategy is a dog.
The flipside to buying calls on top of buying stocks is selling a put option (which means selling someone an offer to buy their stock at a lower price if it falls).
For many, this is psychologically unattractive, since you have capped gains (the price you get for selling that put) but with huge downside (if a stock falls to $50 from $110, and you’ve sold someone the right to sell it to you at $100, you’ve just taken a bath). But actually a strategy of selling puts has consistently outperformed the market.
So ultimately, Grice’s bottom line is just that: While everyone wants a lottery ticket or a lottery ticket stock (because the downside seems small, with amazing upside) the real money is having a modest upside, because that area of the market is consistently so unappealing for human nature.
Boring is beautiful.