How to Design a Less Volatile Stocks Portfolio

Designing a less volatile equities portfolio requires an approach that blends macroeconomic insights with strategic cash flow management. 

The crux of this approach involves focusing on stable cash flow streams and incorporating macroeconomic overlays to better control the short-term volatility.

This way, an equities portfolio can reduce downside exposure while maintaining resilience across varying market environments. 

We outline an approach to building a portfolio that withstands market volatility while providing steady returns over the long term.

Key Takeaways – How to Design a Less Volatile Stocks Portfolio

• Over the short-run, macro factors influence stock prices more than the earnings/cash flow produced by the company.
  • (Over the long-run, the cash flow matters more than the macro cycles.)
• Can you design a portfolio that isolates the cash flow from the pricing to create a more predictable return stream?
• If you determine what the underlying drivers of the volatility are (e.g., changes in discount rates, risk premiums, and changes in discounted growth and inflation), you can help create such a portfolio by hedging against unfavorable changes in these variables.

The Need for a Cash Flow-Oriented Equities Portfolio

Addressing Low Bond Yields

Historically, bonds provided a stable return source, balancing equity risk and being a fundamentally different type of exposure.

However, with bond yields sometimes providing inadequate return, the reliability of bonds as a stable return varies.

And this is especially true with cash, which often has had long durations where it yields zero or simply below the rate of inflation.

Consequently, the focus then shifts to constructing equity portfolios that can provide a steady cash flow stream akin to bonds, albeit at a higher level due to the equity risk premium.

The goal is to create a portfolio that could mimic bond-like stability while leveraging equities’ long-term growth potential.

Importance of Stable Cash Flow Streams

A key component in achieving portfolio resilience is generating a stable cash flow stream.

By separating the cash flow stream from price fluctuations, traders/investors can manage both the income/cash flow and price components independently – e.g., focusing on the sustainability of cash flows.

This method offers better resilience to market downturns, allowing the portfolio to better benefit from the power of compounding over time.

When structured correctly, these consistent cash flows can ultimately deliver higher returns due to the effects of reinvestment and compounding.

Portfolio Construction: Steps to Building Stability and Resilience

Designing a stable equities portfolio involves three primary steps:

• identifying reliable compounders
• assessing valuation, and
• incorporating a macro overlay to manage external risks

Step 1: Selecting Reliable Compounders

The foundation of a resilient portfolio lies in selecting companies that act as “reliable compounders.”

This subset you might think of as approximately the top 30-50% of the market – i.e., however you might want to draw the line between quality and having sufficient diversification.

They’re characterized by stable earnings, consistent revenue growth, and strong balance sheets. Eseentially good stores of value.

Reliable compounders are typically companies that have demonstrated their ability to endure economic downturns while maintaining positive cash flow.

The Dividend Aristocrats would be one example of where to look, but also stock screeners could work as well.

Criteria for Reliable Compounders

Reliable compounders generally have:

• Stable earnings – Companies with earnings stability are better able to handle less-than-ideal economic conditions.
• Consistent revenue growth – Predictable revenue streams enhance the likelihood of consistent cash flows.
• Strong balance sheets – Firms with low debt and ample liquidity are less vulnerable to interest rate increases and economic slowdowns.

By filtering out the bottom 50-70% of the market, which consists of companies with less consistent cash flows or higher volatility, traders/investors can build a portfolio of high-quality equities likely to endure and grow over time.

Companies you might expect to be part of the “quality” contingent might be more concentrated toward sectors like consumer staples and utilities simply because they sell stuff that people need to physically live.

So, they will tend to have more stable earnings and revenues, and the balance sheet situation (good assets with comparatively low debt and liabilities) depends on the specific companies.

Step 2: Valuation Assessment

The second step involves conducting a classic valuation assessment within the pool of reliable compounders.

This step focuses on identifying companies with high free cash flow and favorable earnings relative to their prices.

These undervalued stocks can boost the portfolio’s returns and add resilience by providing potential upside during economic recoveries.

Adding a Layer of Resilience Through Valuation

Incorporating undervalued stocks with strong fundamentals provides:

• Potential for upside capture – The portfolio gains when these undervalued stocks rebound in price.
• Downside protection – By selecting stocks with favorable cash flow projections, the portfolio is buffered against significant declines during downturns.

With this two-tiered approach you might expect the portfolio to capture roughly 100% of the stock market’s upside while experiencing only about 65%-70% of the downside.

Step 3: Macro Overlay for Short-Term Risk Management

Despite security selection and valuation assessments, portfolios remain vulnerable to broader macroeconomic shifts.

If stocks fall they all tend to fall together.

So, the third step addresses this by implementing a macro overlay to hedge against short-term risks associated with interest rate changes, discount rates (a function of interest rates), and risk premiums.

Other important variables include changes in discounted growth and inflation.

The macro overlay is important in reducing volatility that stems from macroeconomic events rather than company fundamentals.

Targeted Down Market Protection

Macro overlays serve as targeted protection in down markets, where equity markets often experience synchronized declines.

Rather than attempting to hedge by shorting individual stocks, which can be inefficient and costly (e.g., shorting and borrowing costs), the overlay strategy uses liquid markets that respond to macroeconomic conditions, such as interest rate hedges or credit spreads.

And doing it in a way that isn’t negative carry (i.e., paying to have hedges where the cost is in excess of the protection it provides).

For example, the trader could measure the duration of the portfolio and use interest rate derivatives or bond futures to hedge out the interest rate risk.

So, if the portfolio were to fall because rates increased by more than whatever is discounted into markets, the fall in stocks (due to that influence) is offset by the rise in the value of their hedge.

For the risk premium factor, this is where shorting credit spreads in the appropriate amount can be helpful.

This, in turn, helps to better isolate the influence of the cash flow from the stocks themselves – i.e., what the company is earning.

Brokers are also increasingly offering growth and inflation derivatives.

So, overall, using macro overlays allows the portfolio to:

• Neutralize short-term market volatility – The overlay can hedge against risks like interest rate increases or spikes in risk premiums.
• Improve transaction efficiency – Targeting macro sources of volatility is typically more efficient than hedging individual stocks.
• Stabilize long-term returns – Addressing macro-level risks the portfolio achieves greater consistency in returns over time.

Extending Resilience Through Diversification

Geographic Diversification

Incorporating global equities diversifies the portfolio across different economic cycles and reduces the impact of region-specific risks.

Traders/investors can manage exposure to economic trends and policies that vary by region.

This approach allows market participants to take advantage of the strengths of various markets while minimizing exposure to country-level economic/market risks.

Sector Diversification

And while the portfolio may be concentrated in stable companies, sector diversification adds another layer of protection.

Different sectors respond uniquely (but not totally uniquely) to economic conditions, so spreading investments across sectors such as technology, healthcare, consumer goods, and utilities provides balance.

As mentioned, consumer goods and utilities, as well as some healthcare sub-sectors with stable earnings, tend to be more resilient during recessions/market falls.

On the other hand, technology and industrials – due to the duration of their cash flows or their discretionary nature – often excel during periods of economic expansion but perform poorly in down markets.

Building Liquidity into the Portfolio

Maintaining liquidity is important, as it allows traders to reposition as necessary.

A portfolio balanced between liquid and income-generating assets – such as dividend-paying stocks – ensures that there’s sufficient liquidity to take advantage of buying opportunities during downturns or adjust the portfolio in response to economic shifts.

Income-Generating Assets

Investing in high cash flow or dividend-paying companies provides ongoing income, which can be reinvested or used to adjust the portfolio during economic shocks.

Dividends act as a buffer during periods of price decline, offering returns to investors even when stock prices are under pressure.

Time Horizon Considerations

The impact of cash flows versus price changes varies significantly depending on the time horizon.

Short-Term

In the short term, equity returns are often driven by price fluctuations, which reflect immediate market sentiment and macroeconomic changes.

For example, let’s say a company is trading at a 15x P/E ratio.

Evaluated quarterly, it’s earning 1/60th of the company’s value per quarter.

That’s less than 2%. It’s not much.

If you go up to a 25x P/E ratio, then it’s just 1%.

Of course, it depends on the growth of the company.

So, in the short-run, the price dominates the return stream.

Long-Term

However, over a long-term horizon, the compounding effect of cash flows becomes the dominant driver of returns, reducing the impact of price volatility.

If you go out 10 years, for example, then:

• a 15x P/E company – even assuming no growth – has made ~67% of its value in earnings and
• a 25x P/E company (which for purposes of this exercise you might reject on value considerations unless you’re getting commensurate growth) has earned 40%

Short-Term vs. Long-Term Cash Flow Dynamics

So, to sum up:

• Short-Term – Quarterly returns are often dictated by price, which is highly sensitive to market conditions and investor sentiment.
• Long-Term – Over a ten-year horizon, cash flow stability takes precedence, creating a duration that reflects the long-term performance of the underlying businesses rather than short-term price fluctuations.

So, by aligning the portfolio’s time horizon with the compounding benefits of cash flow, the equities portfolio becomes less sensitive to short-term market shocks and more resilient over time.

Systematizing the Process

If/when possible, consider systematizing the process.

A systematic approach to this involves continual reassessment of security selection, and ensures the portfolio remains aligned with the stability goal.

Conclusion

Focusing on high-quality, stable cash flow companies and using valuation and macro overlays, a portfolio can reduce exposure to downside risks while capturing growth potential. 

Geographic and sector diversification, combined with liquidity management and long-term compounding, further stabilize the portfolio. 

Ultimately, this approach is designed to allow traders to deal with both short-term volatility and long-term economic shifts, so you have a more resilient and dependable equities portfolio.