Beta of a Stock is a Meaningless Measure – Value Stock Guide 03-01-12

Salient to Investors:

Shailesh Kumar writes:

  • Beta means nothing for a stock and explains nothing about the investment merits of a stock.
  • Example: Stock 1 has declined significantly in the recent months to where it is a bargain at 1 times net earnings per share – the company continues to generate more in free cash flow per year than its entire market value, even after debt service. This kind of undervaluation will never be allowed to continue: the company can go private or be acquired at this value. This falling over a cliff has pushed the stock’s beta to beyond the threshold at which a rational investor would buy, plus when the price starts rising, it will likely be very volatile. However the risk of investing in the stock here is close to zero. just as Buffett thought the risk of investing in Washington Post was close to zero.
  • Example: Stock 2 is a small company in a boring industry with no analyst coverage and a CEO who owns so much company stock to be almost a family business. Management makes long-term decisions, some of which involve capital expenses that will hurt next quarter’s earnings. The balance sheet is like Fort Knox, with margins that lead the industry, and the dividend is to die for. On company fundamentals the stock is a bargain, but its beta is half of the market.
  • Stock prices over the short-term are essentially random and over long-term are dictated by the fundamentals and company performance. Beta measures the past volatility of the stock and has no bearing on what the stock does in the future. 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.
  • Beta makes sense in the context of the overall portfolio. Warren Buffett says cash and other “currency” investments are some of the lowest beta investments available, but are the riskiest ones for preserving or enhancing your future purchasing power. More important is to judge the risk of capital loss before making any investment.
  • Most of the Modern Portfolio Theory is an attempt to shoe-horn math to describe how the capital markets function. It comes close but not close enough.

Daniel Murray responded on 05-08-13

  • Beta does not equal total risk or volatility. A stock declining over a given period of time does not imply a high beta, which will only be high if the decline is correlated with a decline in the stock market and/or risk assets in general. Beta only represents that part of a stock’s risk that cannot be removed through diversification.  A stock’s total risk equals its idiosyncratic and systematic (beta) risk.

Peter responded on 05-11-13:

  • The Efficient Market Hypothesis does not assume that stock price returns are random, which they are not, only that they can be reasonably modeled as if they were random.
  • The one universal principle of investing is that combining an increasing number of uncorrelated, multi-disciplinary indicators will give progressively better results on an ever decreasing set of investable opportunities.
  • Beta becomes much more meaningful at the diversified portfolio level when the firm specific risks have canceled each other out.

Read the full article at http://valuestockguide.com/all/beta-of-a-stock-is-a-meaningless-measure/?utm_source=taboola

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