Friday, July 23, 2010

Betting on Beta

Since portfolio diversification can only disseminate some of the vagaries of being in business and the impact fundamental disappointments have on stock prices, keeping a careful eye on beta is worthwhile for investors in small capitalization companies. While the regression equation is not so easy to calculate (fortunately, a number of services offer to do the heavy lifting), beta as a measure of a stock’s volatility in relation to the greater market. Investors should be compensated for taking the chance on a stock. Thus the stock’s price performance should be sufficient to justify the added risk reflected in owning that stock rather than the so-called market basket.

We looked at several of the stocks in the Crystal Equity Research coverage universe to determine if they provided adequate price performance against the S&P 500, which offered a price return of negative 12% over the past three years. Darling International (DAR: NYSE) has a beta of 1.75, suggesting that over the past three years as the market fell down around our ears, DAR shares could have swung to a minus 20%. Instead DAR shares have appreciated by 6.3% over that period of time. Likewise shares of Health Grades (HGRD: Nasdaq) returned 4% price appreciation over the past three years (July 2008 to July 2010). The disappointment came from Dynamic Materials (BOOM: Nasdaq) which lost 60.8% of its value over the three-year period during a time we would have expected BOOM to fall by as much as 21.6% given its beta measure of 1.80.

Indeed, the industrial sector as a whole, of which Dynamic Materials is a part, outperformed the S&P 500 in the past few months, along with materials, consumer staples, consumer discretionary, financials and information technology. However, over the last three years only the health care, consumer staples and information technology sectors have been able to stay ahead of the greater market.

The problem with beta is that is looks backward, telling us only how the stock has moved relative to the greater market - usually the S&P 500. It says nothing about value and it says nothing about how the stock could perform in the future. Thus our comparisons of DAR, HGRD and BOOM are really meaningless in terms of making a decision now that we already hold positions in these stocks.

Beta may not be entirely useless. Consider using it as a test of fundamental analysis. First begin with the potential return implied by a stock target price derived from some exercise involving fundamental analysis and projections of sales and earnings. Back into an implied market return (on price only) and compare that to consensus forecasts for the S&P 500. If the implied market return is lower than forecast for the index, the stock could be consider the bull case argument as adequate to compensate investors for the beta risk in the stock.

Neither the author of the Small Cap Strategist web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein. Crystal Equity Research has a buy rating on HGRD and DAR and a hold rating on BOOM.

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