We are going to discuss stock beta as a risk measurement tool in today’s mail bag question.
I had a quick question that, as a college student, I think would help me out in a debate I’ve had in a class. I mentioned in a paper that the use of beta was not logic in company valuation but the professor disagreed, and I wasn’t able to fully defend my point to my liking.
You’ve mentioned a couple of times on the site that, according to beta, a stock would be riskier at $50 than at $100. I agree that beta is not an appropriate measure of risk, but I was wondering how exactly you arrive at the calculation in that example.
Stock beta has some utility when it comes to certain derivatives, such as short-term call options or put options. When it comes to long-term business ownership, such as buying common stocks, stock beta is bull. It is worthless. It is a meaningless metric that makes people feel better about their risk exposure, serving only as an emotional security blanket that has no real world value at all, driven by the need of the human brain to recognize patterns and remove uncertainty.
The implicit thesis supporting stock beta is that the stock market is rational; that the stock price reflects all known factors at any given time. Unfortunately, that view is flawed. In the long-run, asset prices are rational. In the short-to-intermediate, that is not always true. This has been illustrated in past 15 years especially well, during which time the United States economy has experienced a dot-com bubble and a real estate bubble.
Stock Beta Is a Conclusion Built on a Faulty Assumption, Built on Other Faulty Assumptions
Implicit in the assumption that the stock market is rational are several other assumptions, such as that all individuals behave in economically rational ways, set to maximize their own personal good. This is not entirely true. The relatively new field of financial behavioral psychology illustrates that people have all sorts of mental quirks resulting from brain wiring that result in sub-optimal decisions unless protected against by a disciplined strategy; e.g., experiencing much greater financial pain by losing $1 than joy from making $2.
The irrationality doesn’t stop there. Believing stock beta accurately measures risk also requires one to deny the presence of powerful psychological forces such as the bandwagon effect, the fear of loss of resources for genetic survival, envy, and workplace incentives. Otherwise sane people see their friends and family getting rich from, say, gold prices skyrocketing. Suddenly, they start piling into gold, buying more and more, driven in part by confirmation bias as their actions create a self-reinforcing feedback mechanism. A portfolio manager who doesn’t want to lose his job may know that a stock is overpriced, but everyone else is buying it and he doesn’t want to be second-guessed by short-sighted managers who are interested in quarterly, rather than 5-year-rolling, figures. He “window dresses” the portfolio and buys the stock to protect his job and income, which is rational on a micro-view but blows the presuppositions supporting stock beta to hell. Your cousin throws his entire net worth into a hot start-up stock in an industry about which he knows nothing. These sorts of things go on all the time.
A Financial Example of How Stock Beta Doesn’t Always Accurately Measure Investment Risk
To give you a financial nuts-and-bolts argument as to the stupidity of stock beta, as applied to common stocks, imagine that you woke up and found yourself a successful institutional portfolio manager. You have one client, a pension fund. The fund’s portfolio consists of a giant pile of $200 billion in cash. It is your job to invest the money.
You want to own businesses that have a very good chance of being around in 25 years, still churning out dividends for owners. You look at Procter & Gamble, which makes everything from Tide laundry detergent to Gillette razors and shaving cream. The whole company is for sale, lock, stock, and barrel, for $183 billion. It generated $15.8 in profits before taxes, or $11.8 billion in profit after taxes, last year. Based on those figures, you would be paying 15.5x earnings, or collecting a 6.45% earnings yield on your money plus any growth from price raises, volume gains, cost cutting, etc.
Tomorrow, investors get swept up in a new industry that is being revolutionized, just like the Internet in the 1990′s or electric utility companies half a century before that. They sell their “boring” stocks that make things like dish soap and shampoo and throw all of their cash into this new industry. Stocks in the new, exciting industry skyrocket as more money chases a finite supply of shares. Stocks in the boring businesses fall as people unload them. In short order, the price to buy all of Procter & Gamble falls to $91.5 billion. That is an 12.9% earnings yield.
To put it more starkly, Procter & Gamble is still the same company. It still has the same profits. It still has the same prospects. Yet, today, because of the psychological influences that we discussed, every $100 you invest throws off $12.9 in annual after-tax profit. Earlier, that same $100 invested would have only thrown off $6.45 in annual after-tax profit.
According to stock beta, Procter & Gamble would be riskier after having fallen to $91.5 billion, despite earning twice as much money for every dollar invested, giving you twice as large of a buffer against disaster. Why? How? Because stock beta is built upon the assumption that market participants know something and that stock price volatility reflects it. We’ve already talked about how that assumption can be seriously flawed, especially in times of great economic turmoil or excitement. For a long-term investor, do you really think P&G is riskier at the lower price?
Stock Beta Assumes That Risk Comes from Volatility Rather Than Declines in Purchasing Price
The utter stupidity of stock beta is in its asinine definition of risk. Beta assumes that volatility is bad or the enemy. As Warren Buffett brilliantly stated in a recent Fortune magazine article called Why Stocks Beat Gold and Bonds, “The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the probability – the reasoned probability – of that investment causing its owner a loss of purchasing power over his contemplated holding period. Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period.” Buffett goes on to say, “a nonfluctuating asset can be laden with risk.”
To prove the point, consider two investments. This is a simplified example but it illustrates the point.
- John buys $1,000,000 worth of bonds that generate a 5% return, or $50,000, each year, over long periods of time. His holdings never fluctuate in market value. Inflation is running 4%, or $40,000 per year. That leaves a pre-tax cushion of $10,000 per year, or 1%, on his investment. If he pays 35% in taxes, that leaves a cushion of only $6,500 per year, or 0.65% in return. That is his increase in purchasing power.
- James buys $1,000,000 worth of a blue chip stock that generates a 10% return, or $100,000 each year, over long periods of time. Of this, $40,000 comes from dividend income, which is taxed at 15%, leaving net dividends of $34,000. The remaining $60,000 comes from capital gains as profit is reinvested, used to repurchase shares, expand into markets, etc. This leaves an annual net return of $94,000 per year, or 9.4%. Backing out the $40,000 he needs to earn just to keep pace with inflation, James has a real net return of $54,000, or 5.4%. (At some point, possibly decades in the future, you would have to take the capital gains taxes paid and retroactively calculate the compound annual growth rate, or CAGR, which would drop that figure a little bit). That is his increase in purchasing power. If inflation increases, the business James owns can increase prices to end consumers, maintaining profit margins. On a year-to-year basis, the stock, though, fluctuates by 50% or more as buyers and sellers acquire and unload their positions.
With a stock beta calculation, the stock James hold looks vastly more dangerous than the “safe” bonds owned by John. Looking at true risk, John is in a very dangerous financial position. He cannot increase the bond coupon he earns, meaning he is surviving on a razor thin margin of 0.65%, or 65 basis points, after which he starts to lose real purchasing power. He is not increasing his purchasing power, no matter how many “dollars” or “Euros”, “Yen” or “Pounds Sterling” he shows on the brokerage account statement. The only thing that counts is the total goods and services you can employ. Purchasing power counts. Purchasing power is the only thing that matters in the investing game.
James, on the other hand, does see the quoted value of his holdings fluctuate all the time. But the underlying business? Not so much. Businesses don’t change nearly as often as their stocks do. If he paid a fair price for his ownership stake, James has the satisfaction of knowing that not only does he have a 5.4% real gain in purchasing power each year, a much larger buffer than 0.65%, but that he has some protection against inflation because a good business can always raise prices to offset higher costs.
Over a 10+ year holding period, James has a vastly better chance at increasing his purchasing power as long as his initial purchase price was rational. I’ve talked about this a lot in the past. Some poor fools like to point out that over the past 10 years bonds beat stocks and the answer is: Of course they did. A decade ago, stocks of mega-capitalization companies were trading at 50x earnings, or a 2% earnings yield, when Treasury bond yields were more than 5%. That is now, has always been, and will always be, a recipe for bad returns (to learn more, read Earnings Yields vs Treasury Bond Yields). Someone buying Johnson & Johnson at 50x earnings is not investing – they are gambling, hoping to offload their position to the next sucker down the line. A true investor is in the business of buying profit. The lower the price you pay for every $1 in profit, the higher the return you earn on your money. That is a fundamental truth.
In fact, I would look at the seemingly “safe” portfolio John is holding and lay awake at night in terror if I were forced to have my whole net worth invested that way. I’ve point blank told you I believe we are living in the midsts of one of the biggest bond bubbles in history, on par with the stock bubble of the late 1990′s. You, quite literally, couldn’t pay me to have most of my net worth in fixed income investments at current prices with the current governmental deficits at the unsustainable levels they are.
Some People Still Cling to the Irrational Notion That Stock Beta Reflects True Risk
It is entirely possible that your professor will continue to insist – and actually believe – that stock beta reflects true risk. I once had an accounting professor who insisted preferred stock was the best investment possible because it combined stocks and bonds, apparently ignoring the fact that it combined the worst things about the two securities; namely, the subordinate position of stocks in the capitalization structure, meaning very little hope of any recovery in the event of bankruptcy, with the limited income potential of a bond, meaning very little inflation protection or growth potential. Even Benjamin Graham talked about these very structural limitations of most preferred stock issues 80+ years prior!
If you are interested in some of the specific math problems with using stock beta to measure risk, check out this article by John Price, Ph.D. It does a good point illustrating the logical fallacies of beta, including the total inability to look through the underlying business (e.g., two companies with identical betas a century ago might have included a horse and buggy manufacturer right before the rise of the automobile and IBM. A reasonably intelligent man could have told you the risk profiles weren’t the same.)