10 Stocks with Valuable Volatility

What makes an asset risky?

The standard answer is how much the asset bounces around in price--its volatility. And the most common way of measuring that is standard deviation. If an asset has returned 12% on an annual basis and has a standard deviation of 20%, then two thirds of the time its returns have been within one standard deviation on either side of 12%--specifically, between 32% and negative 8%. (For a quick refresher on standard deviation, click here.) The higher the standard deviation, the wilder historical returns have been.

For most purposes, volatility is a good proxy for risk. We use metrics like standard deviation all the time to analyze portfolios and to give investors a sense for how much their holdings are likely to bounce around. To give you a feel for the numbers, a blue-chip stock will typically have a standard deviation of 25% or thereabouts. A volatile small-cap stock might have one north of 50%. A large-cap domestic equity fund, which is simply a collection of large stocks, might have a standard deviation of 15%.

But volatility leaves out one crucial element of true risk, and that's valuation.

A krugerrand or a Napoleon III bronze clock has no intrinsic value. They're worth only what buyers are willing to pay at any given time. To judge the riskiness of such assets, historical volatility is all you have to work with.

But an asset like a stock has an intrinsic value. It represents a claim to the future cash flows of a business, and those cash flows can be totaled up and assigned a present value. The price of a stock may drift far from this intrinsic value--think Internet stocks in 1999 or, dare we say, energy stocks today--but over the long term, price and intrinsic value will drift along together. If they didn't, a smart buyer would snap up the entire company to capture all those undervalued cash flows. Or, if the stock is crazily overvalued, smart insiders would keep selling new shares until the price came back down.

When an asset is selling far above its intrinsic value, it's much more risky than past volatility suggests. We cover  42 stocks with standard deviations below 25%, but which we think are tremendously risky based on valuation. (They're all 1-star stocks.) If you own them, we think you stand a good chance of losing money. If that's not risk, we don't know what is.

Likewise, we think there are stocks trading far below intrinsic value, which can make them much less risky than their past volatility suggests. In fact, that very volatility may be what's now giving an investor the opportunity to buy at a discount. For the long-term investor, volatility is to be welcomed. It causes stocks to deviate from true value, creating bargain opportunities.

The table shows 10 stocks that we think fit this mold. These stocks all sport high standard deviations, so they're high-risk in the standard language of finance. These are not stocks to own if you can't stand volatility.  Solectron  has bounced around between $1.39 and $53 over the past five years. Steel behemoth  Mittal Steel  (MT) has traded below $1 and above $40.  CarMax (KMX) has bounced between $3 and $39.

Volatile Stocks Selling at a Discount
Company	Morningstar Rating	Standard Deviation	Market Cap ($ mil)
Solectron		76.97	3,588
Mittal Steel Co NV (MT)		53.92	16,809
Aeropostale		53.59	1,230
CarMax (KMX)		46.94	2,842
France Telecom (FTE)		45.66	64,866
Euronet Worldwide (EEFT)		43.37	1,016
Gap (GPS)		37.65	15,014
Petsmart		36.75	3,604
IAC/InterActiveCorp (IACI)		35.02	9,748
Pier 1 Imports		33.84	1,011
Data as of 11/04/05

But we don't think these stocks are quite as risky as all that--for two reasons. First, I limited the list to those stocks our analysts rate as having "average" business risk. Unlike some risk ratings, ours is not based on the volatility of the firm's shares, but rather on the strength and predictability of the underlying business. In most cases, these two risk measures--volatility versus fundamental--are highly correlated. Most stocks with high standard deviations also sport "speculative" or "above-average" risk ratings from our analysts. But as the 10 stocks in the table demonstrate, the correlation isn't perfect.

The second reason to question the true risk level of these stocks is valuation. These shares are selling at a deep discount to what we think is fair value--thus the 5-star ratings. The volatility in these share prices has created, in our view, some excellent buying opportunities. The lesson here: Use past volatility as a first approximation to risk. Just remember that it will sometimes overestimate, and sometimes underestimate, the true risk of owning an asset.