Is It Time To Play Beta?

A stock’s beta is one easily available parameter which can be helpful as a gauge of a stock’s volatility relative to the broader market or a particular portfolio. Armaan Madhani delves deeper to obtain a better understanding of beta, its merits, demerits and sheds light on how to analyse the market risk associated with a particular stock along with its effect on the generation of respective returns 

Before investing in a stock, investors study several parameters such as valuation, EPS, ROE, ROCE, dividend history, growth levers, leverage, shareholding pattern, and much more. These parameters no doubt help filter the best opportunities available at a given point of time. However, there are some other important tools that can be utilised along with the above-mentioned parameters to enhance returns. A stock’s beta is one such easily available parameter which can be helpful as a gauge of a stock’s volatility relative to the broader market or a particular portfolio. 

Decoding Beta

The contribution each stock makes to the total risk of a well-diversified portfolio depends on the particular stock’s covariance with other stocks in the portfolio. Needless to say, this depends on how each stock responds to changes in the overall financial markets. Volatility is the most common measure to evaluate a stock’s potential risk as well as reward. All stocks have a peculiar characteristic volatility that explains the up and down movements in the security’s price and historical returns. It is not constant and tends to vary over time for each stock. It also differs depending on the range of the historical period it is calculated from. 

However, one of the key determinants of a stock’s volatility is the nature of the company’s business. Certain types of businesses are simply more stable over time, while others are erratic and prone to dynamic circumstances. While the concept of risk is rather challenging to factor in stock analysis and valuation, one of the most popular and easy measures of risk is beta. This is a statistical measure that compares the volatility of returns on a specific stock to those of the overall stock market or a relevant broad market index. 

The formula for calculating beta is the covariance of the return of an asset with the return of the benchmark divided by the variance of the return of the benchmark over a certain period. Beta is calculated using regression analysis and gives a sense of a stock’s risk compared to the stock market as a whole. Often referred to as financial elasticity, beta expresses the trade-off between minimising risk and maximising return. 

Conventionally, investors on several instances take note of the fact that despite the broader indices moving upward, their stock does not rise in tandem or vice-versa. 

Of course, this could be on the back of the fundamentals or technical parameters of the stock which an investor holds. However, an important factor that one should look at is the beta of the stock. Theoretically, the beta value of the overall stock market or a benchmark index is considered to be 1. A stock with a beta of 1 indicates that stock returns fluctuate in proportion with the markets while moving in the same direction. Typically, Large-Cap stocks tend to have a beta of 1 as they are the constituents of frontline benchmark indices. 

A beta greater than 1 indicates that the stock’s price will be more volatile in comparison to the market. For example, if a stock’s beta is 1.2, it is theoretically 20 per cent more volatile than the market. Meanwhile, stocks that move in the same direction as the markets but are proportionately less volatile have a beta of less than 1 but more than 0. Investors should also note that there are certain stocks which have beta of less than 0 and in that case the direction of the stock is completely opposite to that of the financial markets. A negative beta indicates an inverse relation between the stock and the overall market. 

Pros and Cons of Beta

The notion of beta is clear, fairly straightforward, quantifiable and easy to work with. Beta elucidates the past performance of a stock with regards to the performance of the stock market via a given benchmark index. This assists investors in better analysing the expected return of the stock. Beta furnishes a good indication of whether a particular stock will move more or less with respect to the market movements. It also helps manage the volatility of an investor’s overall portfolio and adjusts to accommodate the changing market conditions. 

A major drawback of beta is that it fails to capture unsystematic risk (i.e. risks stemming from internal company-specific issues). It solely considers the effects of market-wide risks on the stock. Beta is a historical measure of a stock’s volatility and hence is a poor predictor of what lies in the future. In addition, beta is unstable and ever-changing as a consequence of the company’s evolving business model, overall markets and macroeconomics. For traders looking to buy or sell stocks over short time periods, beta represents a useful risk metric. However, for investors with long-term horizons, beta is unreliable. Depending on the benchmark and time period, beta is also susceptible to estimation error. 

High-Beta Stocks

High-beta stocks are very sensitive to market movements. When the broad market index soars, high-beta stocks outperform the index. Therefore, these stocks are often perceived to be a good hedge against volatility along with a higher probability of beating the market returns. However, on the flipside, high-beta stocks also witness sharper falls and underperform broader markets in a correction phase. Generally, Mid-Cap and Small-Cap companies fall under this category. 

These stocks typically belong to cyclical sectors such as financial services, real estate, automobile, capital goods, metals, power, and others. High-beta stocks are traders’ favourite as the nature of high momentum helps them to make quick bucks. Steep falls and rises are often viewed by short-term investors as opportunities to time the market. Empirically, the link between a firm’s future growth opportunities and its beta has been established by various researches. Since future growth is associated with uncertainty and risk, companies with more growth opportunities tend to have higher betas. 

Investors should also take note that a company’s debt level impacts its beta. Increasing a company’s total debt will increase the risk and in turn the value of its levered beta. Hence, investing in high-beta stocks is a ‘high risk, high reward’ game suitable for investors with a high-risk appetite. Below is a list of some fundamentally strong high beta-stocks and their historical returns.

Low-Beta Stocks

Low-beta stocks help protect invested capital against market downturns to a certain extent, and also potentially outperform the broader market during times of recession. Usually, defensive sector bets such as IT, FMCG and pharmaceuticals fall in this category. A strategy of investing in low-beta stocks can provide risk-averse investors with ways to maintain a few of the upside potential from equities, while also managing the overall risk of their portfolio. Below is a list of a few fundamentally strong low-beta stocks and their historical returns. In recent years, low-beta stocks have been among the top wealth creators in Indian markets. 

"You get recession, you have stock market declines. If you don’t understand that’s going to happen, then you’re not ready, you won’t do well in the markets." 

– Peter Lynch 

"When it comes to investing, we want our money to grow with the highest rates of return, and the lowest risk possible. While there are no shortcuts to getting rich, there are smart ways to go about it."

– Phil Town

Conclusion 

The Indian stock markets in 2022 have been one of the most volatile markets. The markets got off to a running start in September but failed to sustain gains and significantly underperformed on account of weak global cues, 75-basis point rate hike with hawkish commentary by the US Federal Reserve, dollar index touching multi-year high levels, rupee hitting fresh lows coupled with continued inflation concerns. In such a scenario, it has become rather a risky proposition for investors and traders to bet on high-beta stocks. 

FIIs have resumed their selling streak in the Indian equity markets and therefore we are seeing selling pressure in large-cap stocks. Low-beta stocks could do the trick in the current market situation. There is a strong case for investing in low-levered fundamental strong defensive stocks available at attractive valuation to take market leadership and lead the next rally. There are abundant stock-picking opportunities in defensive sectors such as FMCG, IT and pharmaceuticals. Time and again we have seen defensive low-beta stocks come to the rescue of investors whenever the markets have been faced with high volatility.