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Beta Does Not Matter; The Risks That Do

November 07, 2012 | About:
Beta is a statistical concept, reflecting the magnitude and degree of share price movement in relation to the relevant stock market index.

Beta does not matter because:

- It is a historical measure, not forward looking.

- It does not differentiate between upside and downside movements.

- Share price movements and higher risk may be correlated, but there is no direct cause-effect relationship.

The Risks That Matter

- Financial Leverage Risk

A company with no debt will have the least financial risk, although the ideal optimal capital structure is usually not zero debt (more debt means higher bankruptcy risk but lower tax expense as interest expense is tax deductible and vice versa).

- Refinancing Risk

A difficult credit environment will make it tough for companies to refinance their debt when it is due. A longer or staggered debt maturity period will ease refinancing concerns.

- Interest Rate Risk

Floating rate debt is susceptible to interest rate fluctuations, creating variability and volatility in a company’s interest rate expense.

- Consumer Discretionary Risk

A simple example is Walmart (WMT) (selling groceries) and Tiffany (TIF) (selling luxury jewelry). In a recession, people will cut down on luxury or discretionary spending (things they do not need to buy to survive on) and Tiffany’s sales will likely fall to a greater extent than Walmart. Hence, Walmart is perceived to have lower business risk than Tiffany in that aspect.

- Operating Leverage Risk

A company with high proportion of fixed costs to variable costs (costs which increase or decrease in line with sales) is said to have high operating leverage, which is potentially damaging like financial leverage (high levels of debt). For example, a company with all its costs varying with sales (variable costs) will see its costs drop in line with a decline in sales. This will help to buffer the hit to the net profit from any drastic fall in revenue.

- Funding Risk

A company which requires a lot of capital in terms of working capital and capital expenditure to sustain the same level of sales growth will either draw on existing cash/credit lines or require new fund raising.

About the author:

Mark Lin
Mark is a private value investor and runs the Cheapskate Investing website which borrows from the wisdom of value investing giants, using a systematic quantitative screening approach to filter the global stock markets for cheap deep-value cigar-butts and wide-moat compounders. He publishes value investing case studies, investment checklists, and potential stock ideas on the Cheapskate Investing blog. He is also a regular contributor to various value investing communities.

Visit Mark Lin's Website

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