1. How to use GuruFocus - Tutorials
  2. What Is in the GuruFocus Premium Membership?
  3. A DIY Guide on How to Invest Using Guru Strategies
The Science of Hitting
The Science of Hitting
Articles (454) 

Value Investors on CAPM, Beta & Risk

December 22, 2011 | About:

Academia’s definition of risk: beta — a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Beta is used in the capital asset pricing model (CAPM), a model that calculates the expected return of an asset based on its beta and expected market returns (from Investopedia).

Another way of saying that: volatility = systematic risk.

By comparison, here is what value investors have said about risk/beta/MPT over the years:

Warren Buffett (“The Super Investors of Graham and Doddsville” speech): “One quick example: The Washington Post Company in 1973 was selling for $80 million in the market. At the time, that day, you could have sold the assets to any one of ten buyers for not less than $400 million, probably appreciably more. The company owned the Post, Newsweek, plus several television stations in major markets. Those same properties are worth $2 billion now, so the person who would have paid $400 million would not have been crazy.

Now, if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, its beta would have been greater. And to people that think beta measures risk, the cheaper price would have made it look riskier. This is truly Alice in Wonderland. I have never been able to figure out why it's riskier to buy $400 million worth of properties for $40 million than $80 million.”

Seth Klarman (“Margin of Safety”): “I find it preposterous that a single number reflecting past price fluctuations could be thought to completely describe the risk in a security. Beta views risk solely from the perspective of market prices, failing to take into consideration specific business fundamentals or economic developments. The price level is also ignored, as if IBM selling $50 per share would not be a lower-risk investment than the same IBM at $100 per share.

Beta fails to allow for the influence that investors themselves can exert on the riskiness of their holdings through such efforts as proxy contests, shareholder resolutions, communications with management, or the ultimate purchase of sufficient stock to gain corporate control and with it direct access to underlying value. Beta also assumes that the upside potential and downside risk of any investment are essentially equal, being simply a function of that investment's volatility compared with that of the market as a whole.

This too is inconsistent with the world as we know it. The reality is that past security price volatility does not reliably predict future investment performance (or even future volatility) and therefore is a poor measure of risk.”

Whitney Tilson & Glenn Tongue, T2 Partners (2006 Annual Report): "Risk to us has little to do with the short-term volatility of stock prices; rather, we define risk as the chance of permanent capital loss. Thus, we pay little attention to the short-term gyrations of the market, other than to take advantage of occasions when we believe the stocks of companies we own or would like to own become significantly undervalued, in which case, we buy. Conversely, periods of overvaluation are opportunities to sell.”

Charlie Munger (Stanford University Law Address, 1996): “But the whole law experience would be much more fun if the really basic ideas were integrated and pounded in with good examples for a month or so before you got into conventional law school material. I think the whole system of education would work better. But nobody has any interest in doing it.

And when law schools do reach out beyond traditional material, they often do it in what looks to me like a pretty dumb way. If you think psychology is badly taught in America, you should look at corporate finance. Modern portfolio theory? It’s demented! It’s truly amazing…”

Oh yeah, most importantly about beta — it doesn’t work:

James Montier (“CAPM is CRAP,” see article for chart): “The chart below plots the average return for each decile against its average beta. The straight line shows the predictions from the CAPM. The model's predictions are clearly violated. CAPM woefully under predicts the returns to low beta stocks, and massively overestimates the returns to high beta stocks. Over the long run there has been essentially no relationship between beta and return.”

Many people probably wondered whether or not they still teach this garbage considering that it is illogical and more importantly, doesn’t represent reality; unfortunately, as a recent college graduate, I can tell you it was a focal point of my education, which I received from a respected university.

Thankfully, admission to Buffett & Munger U is lifetime enrollment and not a four-year experience.

About the author:

The Science of Hitting
I'm a value investor with a long-term focus. As it relates to portfolio construction, my goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach to investing is "patience followed by pretty aggressive conduct". I run a concentrated portfolio, with a handful of equities accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

Rating: 4.2/5 (28 votes)

Voters:

Comments

sww
Sww - 5 years ago    Report SPAM
And then we have "A Random Walk Down Wall Street" Burton Malkiel, saying Buffett, Ben Graham and value investing is voodoo and doesn't exists, Sixth Sigma event or may be Eight Sigma because according to the MPT they can't be making above average for a long time.

Beta, CAPM, EMT, MPT and diversification are the worse thing happen to business student.

ramands123
Ramands123 - 5 years ago    Report SPAM


Good One
ry.zamora
Ry.zamora - 5 years ago    Report SPAM
Hmmm, I wouldn't really drop CAPM and diversification though. Those two have intuitive appeal. CAPM makes sense from the point of view of an opportunity cost or a "sales pitch" to the individual, while diversification stands so long as it is not excessive.

Everything else can go to hell. XD

Might as well let the academics have their fun and brainwash people with Beta, MPT, and EMT. All the better for value investors...
kidrod
Kidrod - 5 years ago    Report SPAM
CAPM isn't CRAP. CAPM should be used a tool to help you value an investment and not to make your decisions for you.
The Science of Hitting
The Science of Hitting - 5 years ago    Report SPAM
Kidrod,

You certainly are entitled to your opinion, but the historical data doesn't lie; Fama and French did research showing that CAPM doesn't work 20 years ago, yet academia continues to push EMT religiously... in the words often cited by Charlie Munger, "to the man with a hammer, everything looks like a nail".

My favorite part of EMH is the assumption that investors are rational and use Markowitz Optimization when building their portfolio; Harry Markowitz, the creator of Markowitz Optimization, said this about his own portfolio:

"I should have computed the historical covariances of the asset classes and drawn an efficient frontier. But I visualized my grief if the stock market went way up and I wasn’t in it—or if it went way down and I was completely in it. So I split my contributions 50/50 between stocks and bonds."

Even the guy who created it doesn't use it, but the assumption for EMT is that ALL investors use it...

onthefringe
Onthefringe - 5 years ago    Report SPAM
FYI, I'm a finance graduate student with a general business/journalism background. Not a finance pro. So take my input with a grain of salt...

Yeah, this is one place I don't 100% understand academia. I appreciate CAPM at a high level and as a frame of reference (and I was never smart enough to think of something like that on my own). But it seems SO important to understand its limitations, rather than to fully accept it as gospel truth.

Academia teaches us that the value of an individual equity is the current value of all future cash flows. We would think then that risk would be related to the reduction or postponement of any future cash flows. These cash flows, conceptually and in models, are directly tied to fundamental business drivers. There's no reason why a collection of equities (portfolio) shouldn't be regarded in the same way as an individual equity. In that sense, owning a portfolio of equities is much like owning a multi-industry conglomerate. All else equal, you gain cash flow (and/or time), you gain value. You lose cash flow (and/or time), you lose value.

Academia then teaches us that risk is pegged to a market index or some other benchmark, even if swings in that benchmark has nothing to do with the volatility of cash flows in an individual or collection of equities. Never understood this contradiction.

It would be interesting if beta were used to measure the volatility of income (FCF, OCF, OI, whatever...) as pegged to some benchmark, fundamentally (total FCF/OCF/OI of the S&P 500 for examples), or by index market value, instead of the current method of security price to benchmark. Although that's not perfect either (we are still measuring past correlation rather than future risk), and then there are all the necessary accounting/industry adjustments might make it tough to pull off.

I always thought a crude way to manage risk in a portfolio was to pay attention to 1) source/certainty of income/revenue, 2) macroeconomic issues, 3) the business, 4) asset value, and 5) dividends. Both at the individual and portfolio level. The more predictability and less #1 is likely to decrease due to the business in context and related to #2, the less risk you have. If, for example, a year or two ago you constructed a portfolio that limited company revenues from European companies and industries sensitive to macroeconomic conditions (and that your source of revenues were mainly from contractually bound or otherwise locked-in customers) you reduce your real fundamental risk of losing future cash flows at the macro level. It's simple stuff, but just takes a lot of work, a lot of reading. Unfortunately, it's not easy to measure or predict precisely with numbers.

Strong #3 business fundamentals (including business economics, competitive and industry dynamics, financials, margins, etc.) also reduce the likelihood of downward volatility in #1. Strong #4 asset value (although perhaps very subjective) and/or #5 dividends supported by a strong business and reasonable payout ratio put a hypothetical floor on the value of individual and collection of equities. Provided you don't think the business will face disruption any time soon. Because, like income cash flows, academia also tells us that any security is at least worth the total present value of future dividends, so long as those dividends are sustainable. So you limit your downside, irrespective of CAPM.

ry.zamora
Ry.zamora - 5 years ago    Report SPAM


It would be interesting if beta were used to measure the volatility of income (FCF, OCF, OI, whatever...) as pegged to some benchmark, fundamentally (total FCF/OCF/OI of the S&P 500 for examples), or by index market value, instead of the current method of security price to benchmark. Although that's not perfect either (we are still measuring past correlation rather than future risk), and then there are all the necessary accounting/industry adjustments might make it tough to pull off.

Fama and French added fundamental factors to the CAPM's equation. They added size (market cap) and market valuation (P/B). Others argued liquidity and some other factor I forgot should be added.

I read somewhere about a study that said the problem with beta is that "market" isn't adequately defined. S&P 500 is not equal to the market, and that in itself screws it up.

I always thought a crude way to manage risk in a portfolio was to pay attention to 1) source/certainty of income/revenue, 2) macroeconomic issues, 3) the business, 4) asset value, and 5) dividends. Both at the individual and portfolio level. The more predictability and less #1 is likely to decrease due to the business in context and related to #2, the less risk you have. If, for example, a year or two ago you constructed a portfolio that limited company revenues from European companies and industries sensitive to macroeconomic conditions (and that your source of revenues were mainly from contractually bound or otherwise locked-in customers) you reduce your real fundamental risk of losing future cash flows at the macro level. It's simple stuff, but just takes a lot of work, a lot of reading. Unfortunately, it's not easy to measure or predict precisely with numbers.

But isn't this why we conduct financial analysis in the first place?

You forgot #6: the price you pay. That matters, too. :)
ankitgu
Ankitgu - 5 years ago    Report SPAM
Really good article - thanks for posting this, I enjoyed it.
kfh227
Kfh227 - 5 years ago    Report SPAM
good article and very good comments.Regarding betalike FCF measures, you could always use standard deviation. if you use an excel sheet like I do,it's simple to calculate.
onthefringe
Onthefringe - 5 years ago    Report SPAM
Ry.zamora:Sorry about the delayed response. I was preoccupied with a fun and productive holiday and New Year's :).

Fama and French added fundamental factors to the CAPM's equation. They added size (market cap) and market valuation (P/B). Others argued liquidity and some other factor I forgot should be added.I vaguely remember this from class. Haven't memorized the equation or had a portfolio/risk/statistics heavy class in some months. I'd have to go back through the equation/data to really understand the relationship and give an adequate answer (hope that doesn't sound like a cop-out).

I read somewhere about a study that said the problem with beta is that "market" isn't adequately defined. S&P 500 is not equal to the market, and that in itself screws it up. I don't know really. It's near impossible to include every public equity in a benchmark. Whether using any broadly comparative benchmarks (say S&P 500 vs. Russell 1000) result in beta 0.1 vs. 0.2 seems negligible. If you use very different benchmarks (S&P 500 vs. a small cap index), you just have to be able to interpret why. "I'm using a small cap index as a benchmark for beta since I am managing a small cap only portfolio and the index represents my universe of investment alternatives." I see beta and CAPM as a general frame of reference that deserves context, a tool, rather than an absolutely definitive metric. Again, I might sound definitive, but I say all this as a student still learning this stuff.

But isn't this why we conduct financial analysis in the first place? Yes. But if I can read the 10-k (and other docs) and generally infer things like...

  • A high future customer defection rate or reduction in relative product utility
  • Similar or reduced revenues/units sold/favorable contracts at higher cost
  • An outsized dependency on favorable economic conditions vs. a solid business
  • Outsized income dependence on/exposure to risky economies (Greece, for example)
  • Substantial assets need to be replaced at high cost and reduced competitive position
  • A lot of debt
  • Etc.
.... then I'm not spending a lot of time on additional financial analysis. I don't care how good the current or historical ratios, cash flow, etc. looks. I'd consider it risky. I want a business I'd want to own myself. I want to make sure all the basics are taken care of. I want to be pretty sure about future retainment and potential increase in current value before I spend hours putting together a spreadsheet that tries to measure that value precisely. Again, I say all this as an investment novice and a finance student.

You forgot #6: the price you pay. That matters, too. :) Absolutely. Excuse the omission. In a value-oriented site no less.
onthefringe
Onthefringe - 5 years ago    Report SPAM
Kfh227:



Regarding betalike FCF measures, you could always use standard deviation. if you use an excel sheet like I do, it's simple to calculate.


Standard deviation of cash flows is good. But it is limited in that it is specific to the security and not relative to price changes in the market as represented by an index (or drivers, eg aggregate FCF, of the intrinsic value of the underlying securities in the index).

If beta can compare FCF of an individual security to FCF of an index (or if possible and even better aggregate price/market value of an index), than a historically low beta tells us that, in the past, when FCF or price/market value of the index drops, then FCF of the individual security is generally not effected. If we assume this relationship also remains in the future, this is more valuable in identifying gaps between intrinsic value of a security and market price or aggregate FCF reductions related to negative market sentiment than standard deviation of cash flows alone.

At least that's my opinion. But again it's all theoretical. I don't even know if you can do something like that.

Also standard deviation only measures deviation and not direction (positive/negative), whereas beta can be positive or negative. Say if in the last 3 years a company has a large increase in cash flows, it's standard deviation will increase, which supposedly represents more risk. But if increase in cash flows is due to the end of a multi-year long cap-ex project that increased permanent capacity utilization, for example, then this is misleading. The context still really matters.

Hope this doesn't sound like mumble jumble lol.... As a former freelance writer, I write everything out and edit it down to fewer words later. All the excess wording just means I didn't have the time to edit it.

ry.zamora
Ry.zamora - 5 years ago    Report SPAM


Hehe, well, it's okay. I've spent my time enjoying the New Year... got addicted to Skyrim too. :P Hm. That'll delay my work for a little bit. It's a shame I don't analyze stuff full-time.

I vaguely remember this from class. Haven't memorized the equation or had a portfolio/risk/statistics heavy class in some months. I'd have to go back through the equation/data to really understand the relationship and give an adequate answer (hope that doesn't sound like a cop-out).

IIRC those factors are still adjusted by a beta applicable to that company. As far as I know, the individual beta is still difficult, if not impossible, to determine. Estimates are probably going to be limited in usefulness, I can imagine.

I don't know really. It's near impossible to include every public equity in a benchmark

While it is near-impossible to include every public equity in a benchmark, don't forget that the "market" should be -- and ideally -- not just the equity markets globally, but also other asset markets including human capital. Burton Malkiel of Random Walk down Wall Street mentions a study that attempts to assess a beta estimate from such and test it for compliance to the academic POV that high beta = high return.

Of course, given that it's just not practical and the costs of regularly getting this beta might be too high even for the biggest data corporations like Factset or Value Line...

.... then I'm not spending a lot of time on additional financial analysis. I don't care how good the current or historical ratios, cash flow, etc. looks. I'd consider it risky. I want a business I'd want to own myself. I want to make sure all the basics are taken care of. I want to be pretty sure about future retainment and potential increase in current value before I spend hours putting together a spreadsheet that tries to measure that value precisely. But isn't that what Financial Analysis is? It appears we're operating on two different understanding of jargon here. To me, financial analysis includes quantitative and qualitative aspects, with its sole purpose, its very teleology, being the assessment of investment risk, which MUST flow into a discount rate for use in valuation.

It is an extremely subjective study, no matter how much academics would love to pull out the "it can be quantified" knife on people like us.

I spend days encoding information. Hours processing them. And more days on interpreting the numbers and gathering qualitative stuff online. Valuation takes only a day and I'm not surprised why.

If beta can compare FCF of an individual security to FCF of an index (or if possible and even better aggregate price/market value of an index), than a historically low beta tells us that, in the past, when FCF or price/market value of the index drops, then FCF of the individual security is generally not effected. If we assume this relationship also remains in the future, this is more valuable in identifying gaps between intrinsic value of a security and market price or aggregate FCF reductions related to negative market sentiment than standard deviation of cash flows alone.

Problem with FCF-derived beta is that it ignores changes in the business model and other fundamental factors. Think about it. Unlike market prices, you will not have "days and days" of FCF to crunch for a given year. No. You have at most, four. Most VI's are interested in YEARS rather than quarters.

onthefringe
Onthefringe - 5 years ago    Report SPAM
While it is near-impossible to include every public equity in a benchmark, don't forget that the "market" should be -- and ideally -- not just the equity markets globally, but also other asset markets including human capital.

Honestly I have never thought of it in those terms. Particularly "other asset markets including human capital." That's really something to consider.

But isn't that what Financial Analysis is? It appears we're operating on two different understanding of jargon here. To me, financial analysis includes quantitative and qualitative aspects, with its sole purpose, its very teleology, being the assessment of investment risk, which MUST flow into a discount rate for use in valuation.

You are correct in saying "we're operating on two different understanding of jargon." I generally considered financial analysis quantitative or otherwise some type of assessment of the numbers (quality of income/revenue that can't be quantified). Everything else that was qualitative and not directly tied to financials in numeric form, such as business model, fell into an "other" bucket.

I say this having only having put together discount rates occasionally in practice: I usually accept theory when using the discount rate, and might adjust upwards to be safe. Even if I see strong qualitative factors that will more than likely reduce risk. I always though it provides more room for error. And I have no idea how to appropriately adjust the discount rate for qualitative factors. But if you have a certain discount rate and and qualitative factors that's near-certain to reduce that risk, you can be more certain you are getting what you pay for. Or so the thinking goes.

It is an extremely subjective study, no matter how much academics would love to pull out the "it can be quantified" knife on people like us.... Valuation takes only a day and I'm not surprised why. [/i]

Yesssss!

[i]

Problem with FCF-derived beta is that it ignores changes in the business model and other fundamental factors. Think about it. Unlike market prices, you will not have "days and days" of FCF to crunch for a given year. No. You have at most, four. Most VI's are interested in YEARS rather than quarters.


Absolutely right. Another oversight on my part.

ry.zamora
Ry.zamora - 5 years ago    Report SPAM
I say this having only having put together discount rates occasionally in practice: I usually accept theory when using the discount rate, and might adjust upwards to be safe. Even if I see strong qualitative factors that will more than likely reduce risk. I always though it provides more room for error.

At my current level of experience, the only theory I would accept is the CAPM.

It's very simple, and if you look at it from the lens of an opportunity cost and personalize it, it'll make sense.

Think about it. Why the hell would you put your money in one particular horse when you can just easily switch to another one? Every business on sale in the market are competing against each other for YOUR money. Every trader willing to buy from you wants YOUR money, for profit or stop-loss. Industry, economy, whatever. It is a friggin' market and no one cares if you're the fool or the one doing the fooling.

So YOUR required returns matter. Not the market's. Not the investing community's. No. It's all on you. By going along with the academics and "professionals" out there you are forgoing your independence and submitting to what they think you should seek regardless of your risk appetite.

This is why Buffett's discount rate back in the day was the "risk-free" Treasury Rate. Who cares if there's an embedded default premium now with all the crap going on about sovereign debt? Consider it an additional premium for operating in a troubled economy, I say.

So let's assume I found a "low risk" company. And it's not a blue chip. Naturally, you're not going to demand that much higher than risk-free. But what if it's moderate? Or high? Why invest in it? Because you liked what it had historically? Yet you're unsure of its future because of the qualitative obstacles in its path?

You won't ask for the same return as the "low risk" business. Hell no. You'll ask for something much higher than both risk-free and the "low risk" required return, OR you can easily toss it out after all the work you did on assessing its investment profile and look for another company.

Right? Makes sense?

Ahhh, but there are two questions there. There's the whole "beta" thing and there's also the "required margin of safety".

For the first: don't use beta! CAPM fails because of this stupid thing. Studies have already confirmed its irrelevance, plus the guy who made Modern Portfolio Theory apparently doesn't eat his own cooking (or so some authors allege).

Value Investors like Montier, Klarman, Graham, and even Buffett, as you've seen in this post, point their middle fingers (backed by AUTHORITAH!) at the erroneous definitions of "risk" and revel in its unquantifiable nature, while people like Malkiel would shove their digits at the problems with defining the "market" on which volatility is benchmarked.

For the second: tell me which sounds more sensible: demanding a 60% margin of safety for a low-risk business, or the very same for a high-risk one?

Please leave your comment:


Performances of the stocks mentioned by The Science of Hitting


User Generated Screeners


nec5555Pat Dorsey Moat 5Y v1
nec5555Pat Dorsey Moat 5Y
alexbernal0$$SharYieldScore
alexbernal0$$FCFScore
alexbernal0$$EarnGrowScore
fluidityinglassShort%20Squeeze%20high%20F,%20
opadovaniP Median2 No DIV
cegdevelopmentthe best managers
cegdevelopmentprof managers
cegdevelopmentguru goals
Get WordPress Plugins for easy affiliate links on Stock Tickers and Guru Names | Earn affiliate commissions by embedding GuruFocus Charts
GuruFocus Affiliate Program: Earn up to $400 per referral. ( Learn More)

GF Chat

{{numOfNotice}}
FEEDBACK