Investing

Understanding Volatility: It’s Not Just in the Stock Price

Volatility usually means the tendency of a stock’s price to move within its trading range. If the trading range is narrow, volatility tends to be quite low. If the trading range is broader, so is volatility.

In the technical world of stocks, volatility is synonymous with risk. High volatility is an expression of high risk. This is a comfortable idea for those adhering to technical analysis of stocks, specifically tracking prices and price patterns. However, the fundamental analyst has a dilemma. The fundamentalist isn’t concerned with short-term price trends and recognizes that these trends are chaotic and unreliable. So short-term volatility is important, but only to the degree that it reflects something happening in the fundamentals, which consist of financial statements, earnings, and analysts’ predictions, for example.

What’s fundamental volatility

Fundamental analysts may focus on a different kind of volatility. This is fundamental volatility, the tendency for key financial trends to be predictable (low volatility) or quite erratic (high volatility). These key trends are revenues, profits, range of price-to-earnings ratio, dividend yield, and any other result or outcome on the company’s balance sheet and income statement.

The level of fundamental volatility varies substantially among companies. For example, Wal-Mart has reported highly reliable growth over many years. The fiscal years from 2007 through 2011 reported net income of 3.5 percent, 3.4 percent, 3.3 percent, 3.5 percent, and 3.6 percent. Wal-Mart’s tangible book value, cash flow, earnings, dividends and P/E ratio were all rock-steady and have been for many years.

In comparison, Sears Holdings reported dismal results for the last five fiscal years. For 2006 through 2010, net income was reported at 2.8 percent, 1.7 percent, 0.1 percent , 0.5 percent, and 0.3 percent.  Their levels of revenues and all of the financial indicators were erratic and volatile.

When fundamental volatility matters

This does not mean that by all measures, Wal-Mart is a “better” investment than Sears. It does mean that Wal-Mart’s fundamental volatility is as low as possible, meaning financially-based forecasts about future growth are very reliable. This translates to equally high reliability about long-term stock value for the company. In the short term, fundamental valuation of companies is a very difficult matter, but most fundamental investors are thinking long-term (at least one year ahead), whereas technical traders tend to think in terms of only days or weeks.

With this distinction in mind, it also makes sense to be aware of how volatility has separate definitions. Technical traders are rightly concerned with the popular definition of price volatility. Fundamental investors like to follow trends and are keenly aware of varying levels of reliability in the numbers (and also are aware of how the degree of volatility ultimately affects the stock price and its future growth). So the fundamental investor tends to be more conservative than the technical trader. Judging companies by their level of fundamental volatility is a smart method for making comparisons and narrowing down the selection process between companies.

Michael C. Thomsett is author of over 60 books, including Annual Reports 101 (Amacom Books Press), Trading with Candlesticks (FT Press) and the recently released new book, Getting Started in Stock Investing and Trading (John Wiley and Sons). He lives in Nashville, Tennessee and writes full time.