Beta (β) is a commonly used indicator for measuring the risk associated with common stocks.  Beta measures the volatility of a stock’s price over time, relative to the volatility of the market as a whole.  If the average variation of a particular stock’s price is exactly the same as that of the market, its beta would be 1.0, whereas if the stock is twice as volatile as the market, the beta would be 2.0, etc.  It is even possible for stocks or ETF’s to have negative betas, if they typically move in the opposite direction of the market.

As a measure of the potential for short-term volatility in a particular stock, beta is a useful indicator.  However, a distinction needs to be made between past volatility and downside potential for a stock.  What you really want to know is what future volatility will be, and more importantly, whether that volatility will be the good kind, which makes a stock price go up quickly, or the bad kind that drives it down.

There are many cases in which risk to a particular position is the exact opposite of what beta would indicate.  United Rentals (URI) is a stock that we have done well in, despite buying it at a time when its beta was relatively high.  As you can see below, investors who owned the stock in mid-2007 might have believed they were in a low-risk position inURI, with a beta of only 0.6. 

 However, the reality was that the underlying business of United Rentals, the renting of equipment used in construction, is extremely cyclical in nature.  When the economy is strong, demand for rental equipment is high, but when the economy is weak, demand typically falls off dramatically.  So the risks associated with buying a highly cyclical company, at peak valuations, at the top of an economic cycle, weren’t properly reflected by beta.

What beta also didn’t tell you in July of 2007 was that the management of URI had recently borrowed a huge amount of money to buy back shares, leaving the company particularly vulnerable to an adverse change in economic circumstances.

In March of 2009, after URI had lost 90% of its value in only 18 months, beta was telling a very different story, having  doubled to 1.24.   A few months later, when the stock had doubled off of the bottom and still had 500% of upside in front of it (URI is priced $30.50 as of 2/4/11), beta was nearly triple its mid-2007 level, at 1.73.  Beta does a good job of telling us what has already happened, but not necessarily what is going to happen.

At other times, beta can remain relatively unchanged despite dramatic changes in the operating environment and risks to a particular business and stock.  The chart below shows the beta of Ford (F) at three different points in time over the past several years.  Despite dramatically different underlying risks to the company at these various points in time, beta remained relatively constant throughout the period.

We would argue that it is poor risk management to simply use beta as a proxy for long-term risk, and could cite numerous real-world examples supporting this view.  We have seen stocks with high betas despite clearly low fundamental risk, such as when cash per share is nearly equal to the current stock price and healthy, sustainably growing cash flows are present.  On the other hand, we often see investors lulled into a state of complacency with certain stocks while underlying risks are building, resulting in a low beta that understates (often by a wide margin) actual risk.

That said, beta is a useful indicator of likely, near-term volatility.  If the market makes a big move down on a given day, the high beta positions will be down more, on average, than the low beta positions.  However, in the long run what really matters is how much real, long-term downside risk exists.  The process of figuring that out is where true risk management begins.

… by Jon Gillett, Principal & Co-Portfolio Manager for Mission Capital Management.