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Busting Beta

December 26, 2012 | About:
eribari

eribari

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As an Investment analyst intern at Bulldog Investment Company (BIC) — a student-managed investment fund

— I gained experience in identifying, analyzing and valuing qualitative and quantitative success in companies according to Warren Buffett’s mindset and the “Value School of Investment Management.”

On April 18, 2012, BIC presented their work to the annual Student Academic Symposium at Texas Lutheran University. The audience consisted mostly of business professors, investment analysts and economists. Our team consisted of six students. We introduced the purpose of BIC and the measures we use in identifying companies that lead to strong long-term investments. In addition, we evaluated Wal-Mart Co. (WMT) based on the three main pillars that Buffett looks for in a company. These are: Can we understand the business, is the company predictable, and does it possess a sustainable competitive advantage or a “moat” protecting it?

After our presentation, one question asked was linked with the issue of risk, specifically with the concept of “beta.” Beta is discussed many times in academic textbooks as a method for measuring the “risk” of a stock’s share price. However, the formula for calculating beta compares the volatility of one specific asset relative to a given index — such as the volatility of Wal-Mart relative to the volatility of the S&P 500 Index.

A higher beta would indicate higher risk and lower beta would indicate lower risk. On the other hand, value investors’ perspective on beta is significantly different. Value investors recognize that beta only addresses the volatility of an asset. It fails to identify or measure the risk or impact coming from things such as leverage, currency, interest rates, politics, inflation, diversification or many other factors affecting every portfolio.

Further, consider this: Company A has $1 billion in debt on its balance sheet and more than $5 billion just in cash and short-term securities. As such, its net current asset value for the entire company would be $4 billion. However, assume we incur another event similar to March 9, 2009, in which the financial markets sell off irrationally. People may emotionally sell the stock of Company A which will depress its price. When the price sinks, the beta for the stock increases, therefore indicating a higher level of risk. However, an intelligent investor should ask himself whether or not Company A is really at great risk as this selloff occurs.

What if the price of the stock falls in such a manner that you could buy the whole company for $3 billion, or $2 billion or $1 billion? If an investor is smart enough to read a balance sheet and an income statement he has a much better chance of truly evaluating the worth of a company and therefore assess a fuller view of an investment's “riskiness.”

If he were able to buy all of Company A for $1 billion — even though it has net current assets of $4 billion — a smart investor would recognize that this is a low-risk proposition. In effect, he would be buying one dollar of liquid assets for a quarter.

As such, value investors recognize that beta is an accurate measure of volatility. However, past volatility of a stock’s price does not reliably predict future investment performance. Furthermore, beta does nothing to address the many other categories of factors that also produce “risk” to an investment. Therefore, beta is a poor technique for measuring the risk of long-term investments.

In situations such as this, it is very hard to decide which path to take on answering the question. Since the purpose of BIC is associated with value investing and our audience consisted mostly from the academia, our group incurred a slight dilemma in answering the raised question. Do we give professors the answer they are looking for or do we answer in the manner that makes the most sense — even though it may incur a professor’s wrath at grading time?

These situations make us realize that there can be a weak liaison between academic concepts and long-term investing. Students should be familiar with the real-world application of asset valuation, risk and investment concepts. This is the most promising path for successful investing in the long run given the issues they will face in the real world.

Rating: 3.8/5 (13 votes)

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