The Problem With Beta by Sui Chuan, ValueEdge
Beta, through its place in the Capital Asset Pricing Model (CAPM) and the Discounted Cash Flow (DCF) model, forms the foundation of modern day security valuation. Today, we will talk about the problem with beta. As a business student, I find this to be something that is seldom covered in academic finance.
What is beta?
Beta is a measure of the risk arising from exposure to general market movements. Mathematically, it indicates the correlation of a security to a market benchmark. A security whose price exactly mirrors the market benchmark will have a beta of 1. Similarly, a beta below 1 indicates that the security is less volatile than the market and less correlated to the market. Under the CAPM model, the expected return of a security return is directly proportional to the value of beta, as an investor should be better rewarded for taking on more risk.
Introducing the Efficient Market Hypothesis
In order to understand the problem with beta, investors also have to be familiar with the Efficient Market Hypothesis (EMH). The EMH states that it is impossible to “beat the market” because the stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. Consequently, stocks always trade at their fair value, making it impossible for investors to purchase undervalued stocks. This is merely the theory of EMH; seasoned investors know that individual stocks outperform the market all the time. This leads to the three major versions of the hypothesis, each with differing degrees of efficiency, which has been summarised below.
Warren Buffett: If You Own A Good Business, Keep It
|Weak-form||Prices follow a random walk. Technical analysis will not reliably produce excess returns, but fundamental analysis may.|
|Semi-strong form||Share prices reflect public information. Both fundamental and technical analysis will not reliably produce excess returns.|
|Strong-form||Share prices reflect both public and private information. No one can earn excess returns.|
Deficiencies of beta as a function of risk
Beta is a function of price. In a paper written by Bruce Grantier, Benjamin Graham is quoted in the following words.
“Beta is a more or less useful measure of past price fluctuations of common stocks. What bother me is that authorities now equate the beta idea with the concept of risk. Price variability yes; risk no. Real investment risk is measured not by the percent that a stock might decline in price in relation to the general market in a given period but by the danger of a loss of quality and earnings power through economic changes or deterioration in management.”
The argument that beta is an appropriate proxy for a firm’s underlying business risk is centered on the efficient market hypothesis. Under the efficient market hypothesis, changes in fundamental business risk are reflected accurately in price changes. But even the most die-hard of proponents cannot deny that there are varying degrees of efficiency in the market. This is reflected in the 3 forms of the efficient market hypothesis – weak, semi-strong and strong. Financial markets in general are often thought to abide by the semi-strong form of the hypothesis. However, individual securities exhibit a range of efficiency and it is the weak form that allows for portfolio outperformance – alpha. Therefore, the quest for undervalued stocks by nature inherently assumes that they have been inefficiently priced by the market, contravening the efficient market hypothesis. By that virtue, an undervalued stock’s beta will not be an accurate reflection of fundamental business risk.
Does this mean beta is useless? Personally, I believe beta is an accurate proxy of risk for highly liquid, well-covered stocks. To put it simply, the greater the extent to which EMH holds for a security price, the more accurate beta is. The implication is that valuation of lesser-known stocks using CAPM or DCF will be considerably more inaccurate. While I do not have any alternatives to offer, I nevertheless believe it will be beneficial for investors to keep this at the back of their minds in their quest to beat the market.