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The Flaw with Beta

Many investors use beta in a variety of ways to calculate the “risk” of a particular security. For simplicity sake, I am going to use stocks as the securities discussed in this article.

Many people know how to calculate beta, however, for an easy-to-understand way check out the following link (calculating beta). This is usually unnecessary anyway because beta for any stock can be found on many sites like Yahoo finance.

Where beta particular comes into the picture for even some value investor is in weighted average cost of capital. Beta is based on how volatile the stock is compared to an index, most commonly the S&P500. A beta of zero indicates that a security has no correlation to the S&P500. A beta of one indicates that the stock will be exactly as volatile as the S&P 500. A beta of two indicates that the security is double as volatile as the S&P500.

To understand these on a practical level consider the following: If a stock has a beta of 0.7 and the S&P increases by 10%, the stock will increase by 7%. If the stock has a beta of 2 it will increase by 14%. This is the basis of the theory that the more risk you take the better chance you have at making a profit.

This theory has been proven false, but people still believe it to be true. Stocks with low beta many times outperform higher beta stocks as stated in this article. Famous value investor, Paul Sonkin seemed to confirm this in an interview I conducted with him last year.

However, ignoring the fact that beta is not a good indicator of how a stock will perform, it is also a flawed metric for another reason. Beta only tells you about the past performance of a stock and not the future. It is very hard to get historic beta data on stocks, but I would state with confidence that the beta of financial stocks rose dramatically during the financial crisis and tech stocks during the bursting of the tech bubble.

In general, boring companies have lower beta, but they can jump following a crisis, in this case the crisis in Japan. Beta for a stock and a group of stocks can and does change following unexpected events.

I was able to pull some data from a Bloomberg Terminal regarding BBRG for all the major components of the ETF, Market Vectors Uranium + Nuclear Energy (NLR). BBRG Bloomberg's Raw Beta is defined as “volatility measure of the percentage price change of the security given a one percent change in a representative market index. The beta value is determined by comparing the price movements of the security and the representative market index for the past two years of weekly data.”

While not all the stocks had a large change in beta after the Japan tsunami/nuclear reactor crisis, many had massive jumps. Below is a brief description of each company followed by a chart of the BBRG from March 2011-mid-March 2011. The crisis in Japan started with a massive 9.0 earthquake on March 11. Look at the jump in the BBRG of some of the companies, and Market Vectors Nuclear Energy itself below:

Market Vectors Nuclear Energy is the ETF which tracks Market Vectors Uranium + Nuclear Energy stocks:

61447_1302029514lPzK.png

Constellation Energy Group, Inc., through its subsidiaries, offers energy products and services in North America. The companys Generation segment develops, owns, operates, and maintains fossil, nuclear, and renewable generating facilities

61447_1302029514UHTS.png

Exelon Corporation, a utility services holding company, through its subsidiaries, engages in the generation, transmission, distribution, and sale of electricity to residential, commercial, industrial, and wholesale customers in northern Illinois. The company generates electricity from nuclear, fossil, and hydroelectric generation facilities.

61447_1302030091Ovts.png

Universal Security Instruments Inc. (UUU) designs and markets various safety products. The company primarily offers smoke alarms, carbon monoxide alarms and related products. It markets a line of residential smoke and carbon monoxide alarms under the trade names of USI Electric and UNIVERSAL (note that this stock, which does not have operations related to nuclear energy, had a decrease in beta).

61447_130202951322mh.png

Paladin Energy Ltd operates as a uranium production company with projects in Australia and operating mines in Africa.


61447_1302029513rFeX.png

Uranium Resources Inc. (URRE) engages in the acquisition, exploration, development, and mining of uranium properties, using the in situ recovery or solution mining process.

61447_13020295125LBD.png

Uranium Corp is a Candian based company is involved in the purchase of Uranium. The primary investment objective of Uranium Corp is to achieve long-term appreciation in the value of its uranium holding.

61447_13020295127LA1.png

VFINX is the Vanguard S&P500 stock market index.

61447_13020295115540.png

In conclusion, be very wary when using beta.

Disclosure: None.

About the author:

Jacob Wolinsky
My investment ideas have been inspired by many of value investors including Benjamin Graham, Charles Royce, John Neff, Joel Greenblatt, Peter Lynch, Seth Klarman,Martin Whitman and Bruce Greenwald. .I live with my wife and daughter in Monsey, NY. I can be contacted jacobwolinsky(AT)gmail.com and my blog is www.valuewalk.com

Visit Jacob Wolinsky's Website


Rating: 3.6/5 (10 votes)

Comments

yswolinsky
Yswolinsky - 3 years ago
Sorry about the formatting please have patience while I insert the graphs now.
Alex Morris
Alex Morris - 3 years ago
Good article Jacob. The fact that anybody could use beta as a measure of risk really amazes me, considering (1) it is based on CAPM, which Fama and French said in 1991 had not accurately represented the markets of the past 40-50 years, and (2) even if CAPM did hold, volatility is NOT risk; it creates opportunity for investors.

But like they say: some people understand value investing right away (intuitively makes sense); for others, it just doesn't click for some reason...
jaumepared
Jaumepared - 3 years ago
Nice job. We have known BETA is basically a crude descriptor of little value. It is only scary when they teach it to MBA students or people studying for their Series 7. It can be a handy number to scan when trying to understand a companies past volatility, but not much more. It would be unfair to say that it has zero value, but it is a very limited tool.

Bill Smith
Bill Smith premium member - 3 years ago
Thanks, Jacob.

Volatility, as they say, is the friend of the net acquirer of stocks, because as Alex correctly pointed out it creates opportunities. I personally want the MBA programs to continue teaching this bunk, it suits my pocketbook just fine :-)

To paraphrase Buffett, risk is: (1) not knowing what you're doing; and (2) permanent capital impairment. When I took finance, I don't remember them teaching those two golden nuggets of wisdom.

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