For most investors who have grown up on the diet of high stock beta = high risk, this statement will come as a surprise. Beta means nothing for a stock. And beta explains nothing about the investment merits of a stock.
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Let me start with two thought experiments to drive this point home.
Thought Experiment 1: High Stock Beta, Undervalued Stock
Let’s say you are interested in a stock that has declined significantly in the recent months. So much so that at this time, after you have done your research and due diligence, you come to a conclusion that the stock presents a compelling value. In fact, you conclude, that this investment is as sure a bet as any one is ever likely to get. The market has over done its selling, as it generally does when there is a investor panic. This is a classic undervalued stock.
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Let’s also spice it up a little and inject some specifics. This company, even though its stock has taken a beating, continues to generate more in free cash flow per year, than its entire market value, even after servicing its debt. You look deeper and find that after you clear away all the accounting clutter and GAAP mandated non sense, the stock is priced at about 1 times net earnings per share (earnings per share definition).
In short, this is a bargain unlike any other.
Heck, if this level of undervaluation continues, the company can just decide to buy itself out and go private. That would be a very wise decision on their part. Alternatively, it is a very good acquisition for a smart corporate buyer. There is no way this kind of undervaluation will be allowed to continue. Sanity eventually returns.
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Now the question is, if you decide to invest in this stock, are you taking enormous amounts of risk? The market thinks you are. The recent falling over the cliff of the stock price has pushed the stock’s beta to beyond the threshold a rational investor would contemplate investing at. When the price starts moving up, it is likely going to be very volatile as well.
But you know that the risk here is close to zero. Just like Buffett thought the risk of investing in Washington Post was close to zero.
What do you think?
Thought Experiment 2: Low Stock Beta, Undervalued Stock
Let’s say you found a stock that no one cares about. It is a small company in the middle of nowhere in a boring industry. There is no analyst coverage, they have never been part of the Inc 500 and CEO owns so much of the company stock that it is almost like his family business. Which it was at one time.
In a quaint departure from the norm, the company management makes decisions that are decidedly long term. Some of these decisions involve capital expenses that will kill their next quarter’s earnings, were it not for the fact that they do not worry about issuing guidance and there is no analyst breathing down their necks.
The company’s balance sheet is like Fort Knox. Their margins lead the industry. It is a real gem. And the dividend is to die for. The management takes care of its shareholders.
You realize that the stock price today is much below where it ought to be given the company fundamentals. It is a great buy. And when some of the past capital investments start paying off, the company and the stock will be noticed. For the past few years, though, the stock has stayed sleepy and its beta is less than half of the market.
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So you buy the stock.
You know your risk is low, and the beta is low, so it all matches up. Right? But that is not why you bought the stock. You bought this stock because you expect the stock to provide a return that is significantly better than the market. And as the stock gets discovered, this return will come to you in fits and starts. The price may become volatile, but you know in the long run you will make handsome profits.
You bought the stock because you know you are buying it at a low and your downside is protected, but you want the beta to be high on the upside and you want to capture that upside.
- Price =/= Value, and
- Volatility (stock beta) =/= Risk
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Besides, stock prices over the short term are essentially random and over long term are dictated by the fundamentals and the company performance in the future. The beta measures the past volatility of the stock and has no bearing on what the stock does in the future. A stock is not born with a beta assigned to it. Every stock moves through periods of high beta and low beta. The trick is to focus on the business fundamentals and find great opportunities to invest.
Where Does Stock Beta Make Sense?
Beta makes sense in the context of a portfolio. You want to have enough diversity in your stock picks that your overall portfolio becomes less volatile by reducing correlation between your holdings. One way to do this is to get exposure to different industries that are not tied to each other. However, unless you are buying a mutual fund, you will still actively manage your investments based on their own individual investment merit. And if you are a value investor, you have already taken pains to not over pay and have therefore cut down a good chunk of your downside risk on each stock that you buy.
As Warren Buffett points out, cash and other “currency” investments are some of the lowest beta investments available, and they are the riskiest ones for preserving or enhancing your future purchasing power. What is more important is to judge the risk of capital loss before making any investment.
This article is quoted and referenced in the book Mezzanine Financing: Tools, Applications and Total Performance by Professor Luc Nijs and published by Wiley Finance. Look for it in Chapter 3 which deals with the Intrinsic Cost of the Mezzanine Finance Products.