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 PeriodA-GradeB-GradeC-GradeD-GradeF-Grade
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Start of 2007-2009 Financial Crisis1.001.151.021.051.15
End of 2007-2009 Financial Crisis0.911.001.161.221.66
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Percent Change:-9.0%-13.0%13.7%16.2%44.3%
Table Notes: WCA Fundamental Quality Grade is a proprietary measure of company quality based on our fundamental quantitative analysis of profitability, balance sheet strength, and business consistency. Beta is a measure of relative stock price variability vs. S&P 500 which often serves as a proxy for risk compared to a market benchmark. In this example, beta is measured using weekly returns over a 2-year lookback period.

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.

Kevin R. Caron, CFA
Senior Portfolio Manager
973-549-4051

Chad Morganlander
Senior Portfolio Manager
973-549-4052

Matthew Battipaglia
Portfolio Manager
973-549-4047

Steve Lerit, CFA
Senior Risk Manager
973-549-4028

Paul Clark, CFA
Senior Portfolio Manager
Municipal Fixed Income
415-364-2635

Rick Marrone
Senior Portfolio Manager
Municipal Fixed Income
415-364-2917

Daniel Urbanowicz
Senior Portfolio Manager
Municipal Fixed Income
973-549-4335

Suzanne Ashley
Internal Relationship Manager
973-549-4168

Eric Needham
Director, External Sales and Marketing
312-771-6010

Jeffrey Battipaglia
External Sales and Marketing
973-549-4031

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