If you aren’t familiar with beta, it is the measure of a stock’s volatility in relation to the rest of the market. If a stock has a beta of 1, it tends to move up and down at the same pace as the markets. Stocks with a beta greater than 1 move more quickly (up and down) than the markets as a whole.
Though conventional wisdom and Wall Street say high beta means high risk, well, “F” that. High beta is your friend. Let me explain.
The Setup
Let’s assume that the stock market is going to grow at 10% for the next year. Since the stock market has a beta of 1, let’s further assume that a stock with a beta of 1.5 should grow 15% over the next year. Today that stock is trading at $20 a share; next year, it should be trading at $23.00 (up 15%).
Not a bad return at all. Assuming this was a stellar business with an intrinsic value of $20 today and growing at 15%, there wouldn’t be a whole lot of risk involved in owning the company.
Calculating Beta
What if the company missed analysts expectations by a wide margin and the stock price plummeted to $10 (before you bought)? Assuming the markets did not move much, the beta for your company would shoot through the roof. Remember: Beta is a relative measure. If your stock price goes wildly up and down while the market stays flat, beta will be larger (perhaps much larger) than 1.
Now I ask you: Is a low-risk, $20 company any riskier because it is selling for $10?
Beta In Business
Remember: You are investing as if you owned the entire company. As such, you must realize that beta means nothing. In reality, no small business owner knows the beta of his or her company. It simply doesn’t exist.
Back To The Question
Is a low-risk, $20 company any riskier because it is selling for $10? It is not a question or price volatility, but of the risk of your valuation being off. If your valuation is rational, then the $10 price tag (and higher beta) would actually pose less risk.
If your $20 company had a net tangible book value (i.e., break up value) of $10 per share, and the stock price plummeted to $5, beta would be through the roof. Would your investment be at greater risk because you are buying $10 worth of assets for $5?
You Need High Beta
You can not beat the markets owning stocks that have a beta lower than 1. Why? Well, the markets have a beta of 1. If the markets return 10% and your goal is to earn 20%, you need a high beta. You need your stocks to move faster (or more) than the markets.
Keep in mind that beta says nothing about the price paid for the stock in relation to its future cash flows or its break-up value. It simply measures the past movement of the stock price in relation to other stock prices.
Put The Past Behind You
Finally, keep in mind that beta is a measure of past price movements. A stock’s beta can change in an instant, from well below 1 to well above 1, if the price begins to rapidly move up or down.
Should you screen for high beta stocks? Maybe. If you want to invest like Pabrai-looking for low-risk, high-uncertainty companies-you can see which stocks have plummeted and begin bottom feeding. If you want to invest in low-risk, high-certainty businesses, you want to look for low-beta stocks-companies that have grown considerably but have not seen stock price appreciation.
Both present great opportunities. So, look for stocks with a beta greater than, less than, or equal to one.
Filed under: How to Think About Stock Prices
Hey Robert,
Perhaps I wasn’t entirely clear and for that I appologize. My point was that beta means nothing when trying to analyze the risk of an investment. In fact, though Wall Street wants you to believe that high beta generally means high risk, the truth is that high beta is good for us.
Still, you shouldn’t judge the merit or riskiness of an investment based on beta. Beta is in the past. To beat the markets, the future beta needs to be higher than 1, but there is no way to judge that until after the fact.
I guess I could have explained it better. The last sentence can read: “Ignore beta altogether!!!”
Thanks for pointing that out.
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Beta simply measures a stock’s price change versus the market’s price change. If a stock rises or falls faster than the market, it wil have a beta greater than 1. If the stock doesn’t change as quickly and as severly as the market, it will have a beta lower than 1.
Stock prices can do wild things in the short-term. Because of that, you can’t judge the future health of your business or your investment based on the past price changes in relation to the market. That’s a long way of saying: Beta doesn’t matter when analyzing a business.
Sometimes opportunities arise in “low-beta” stocks because the value of the company grows considerably while the price (and markets) does not. Sometimes a great business will quickly fall in price – creating a high beta – and you have the opportunity to buy a wonderful business while it is on sale.
The long-and-short of it is that beta is a meaningless number. Make sense?
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Joe, I find several things in this article misleading, if not down right false. Maybe I’m just not seeing the big picture, and I am afraid I will not articulate myself well enough to be understood. You say “Is a low-risk, $20 company any riskier because it is selling for $10?” How is a stock that goes from $20 to $10 in a year low risk? Thats a -50% growth rate for the stock. Not very many times has the market done that. So that would be a high risk. So the beta is high, not because the value of the company is different, but because the stock moved much more than the markets, and is therefore riskier.
Also, it seems like you base either positive or negative growth on Beta. Your definition of Beta is correct, but your ’setup’, to me, is incorrect. A stock can go from $20 to $30 to $15 and end up at $22 at the end of the year, and have a crazy high beta depending on when you did looked at the beta, or if the market went up 10% for that year, that stock could have a beta of 1. You don’t need a high beta to indicate an undervalued stock. But thats the kicker, cause Beta only relates to stock prices and not the value of the company at all.
And your examples of valuation are off. If you value a company at $20, and it goes to $10, great. then it goes to $5, but then the value is $10? I know the example might be fictional, but how does this work out? Buying a dollar for .50 is great, but I don’t think you should even rely closely on Beta for being a guide.
Beta is just another fancy number to be thrown at an investor who doesn’t understand it. A true value investor should ignore Beta. I personally believe a stock or portfolio that has a low Beta can still give you very nice returns YOY, with less stock price movement, so less heart ache for the investor.
Basically, im getting from your post that your only saying high beta isn’t bad. Your last statement kinda erases most of the rest of your post besides ‘Though conventional wisdom and Wall Street say high beta means high risk, well, “F” that. High beta is your friend.’ From the beginning of the post it sounds like High beta is the only way to find ‘our’ kind of valuations. And then in the end you say ‘find any amount of Beta’. Were you trying to get a response? Or just not make yourself clear? Maybe you can show how low beta beats high beta, or vice versa, or just invest in index funds.
/rant
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