Beta, Revisited
The U.S. stock market has soared to $52 trillion from $33 trillion in value in the past two years, a 56% rise. Naturally, many are now worried about holding on to gains after such a historic rise. With a favorable tailwind behind us, we want to discuss an oft-misunderstood measure of risk, called “beta.”
Beta is a measure of a stock or portfolio’s relative risk compared to the overall market. For U.S. investors, the S&P 500 index of large company domestic stocks is usually the market proxy. A security whose price moves up and down exactly with the market is said to have a beta of one. A more volatile stock would have a beta greater than one, and a less volatile one would have a beta less than one. So, it is natural to look for lower beta stocks if you are worried about an overall market decline.
Not So Fast
Before putting together a low beta portfolio, we must understand that fundamentals and risk are related. Less consistent, leveraged, and unprofitable businesses tend to be riskier than consistent, well-capitalized, profitable businesses, all else being equal. We believe that companies with shakier fundamentals will also tend to produce greater risk in a portfolio over time too. If so, we should see evidence of this tendency in data involving stock betas and fundamental company quality.
To test our hypothesis, we analyzed thousands of companies over the past twenty years, assigning a proprietary “WCA Quality Score” to each one on a quarter-by-quarter basis. The fundamental criteria of leverage, consistency, and profitability was the basis of the evaluation. We then looked at betas for the companies grouped by quality grade during the financial crisis of 2007-2009.
Table A below presents a summary distribution of betas by quality grade at the start and end of the financial crisis. Notice that lower-quality company betas tended to be higher than high quality during the crisis, indicating greater risk. But much more importantly, notice how the betas behaved during the period. The betas for low-quality companies shot up during the crisis, while betas for high-quality companies fell. Sharply rising risk is exactly what we do not want when the going gets tough, which is why we think investing in low-quality companies is potentially more dangerous than one might expect. By contrast, the relative risk of higher-quality companies fell when the going got tough, a positive defensive attribute.
Table A
What Happens to Beta During Stress?
Median Beta by WCA Fundamental Quality Grade (Large U.S. Stock Universe)
Evaluation Period | A-Grade | B-Grade | C-Grade | D-Grade | F-Grade |
=============== | ======= | ======= | ======= | ======= | ======= |
Start of 2007-2009 Financial Crisis | 1.00 | 1.15 | 1.02 | 1.05 | 1.15 |
End of 2007-2009 Financial Crisis | 0.91 | 1.00 | 1.16 | 1.22 | 1.66 |
======= | ======= | ======= | ======= | ======= | |
Percent Change: | -9.0% | -13.0% | 13.7% | 16.2% | 44.3% |
Where are we Today?
We see that the percentage of companies with above-average betas are now at cycle highs. Chart A below shows that 70% of large U.S. companies now carry betas above 1, indicating a market of stocks with higher company-specific risk. The risk-on market environment of recent months rewarded the highest relative risk, lowest quality stocks. With market risk acceptance already high and the concentration of high-beta stocks in the market also at highs, a lapse into a more challenging environment could prove especially painful for high-risk, low-quality investors should such an environment emerge.
Chart A
Conclusion
We think now is not the time to chase risk but instead to stick with higher-quality companies. This does not mean blindly loading up on “low beta” stocks, however. While beta may be a valuable measure of past fluctuations of common stocks, in our view, it is an incomplete one. We believe marrying “beta” with an evaluation of fundamental quality is a much better way of addressing risk.
As lower quality, high-beta stocks lead the U.S. equity market valuations to new highs, now might be the right time to reexamine portfolio holdings focusing on higher fundamental quality.
Disclosures:
WCA Barometer – We regularly assess changes in fundamental conditions to help guide near-term asset allocation decisions. Analysis incorporates approximately 30 forward-looking indicators in categories ranging from Credit and Capital Markets to U.S. Economic Conditions and Foreign Conditions. From each category of data, we create three diffusion-style sub-indices that measure the trends in the underlying data. Sustained improvement that is spread across a wide variety of observations will produce index readings above 50 (potentially favoring stocks), while readings below 50 would indicate potential deterioration (potentially favoring bonds). The WCA Fundamental Conditions Index combines the three underlying categories into a single summary measure. This measure can be thought of as a “barometer” for changes in fundamental conditions.
Standard & Poor’s 500 Index (S&P 500) is a capitalization-weighted index that is generally considered representative of the U.S. large capitalization market.
The S&P 500 Equal Weight Index is the equal-weight version of the widely regarded Standard & Poor’s 500 Index, which is generally considered representative of the U.S. large capitalization market. The index has the same constituents as the capitalization-weighted S&P 500, but each company in the index is allocated a fixed weight of 0.20% at each quarterly rebalancing.
The Washington Crossing Advisors’ High Quality Index and Low Quality Index are objective, quantitative measures designed to identify quality in the top 1,000 U.S. companies. Ranked by fundamental factors, WCA grades companies from “A” (top quintile) to “F” (bottom quintile). Factors include debt relative to equity, asset profitability, and consistency in performance. Companies with lower debt, higher profitability, and greater consistency earn higher grades. These indices are reconstituted annually and rebalanced daily. For informational purposes only, and WCA Quality Grade indices do not reflect the performance of any WCA investment strategy.
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