財經觀察 2383: Low Beta Stocks Look Particularly Compelling Today

Low Beta Stocks Look Particularly Compelling Today

8 comments | by: SL Advisors March 13, 2011 | about: KFT

By Henry Hoffman

Within our hedged equity portfolio we have a few disparate strategies. One of these is a long-term low beta trade partially hedged with the S&P 500. Typically, companies with pricing power and strong underlying businesses generating secure cash flows trade at premium earnings multiples to the general market as well as show less volatility in their stock prices. These stocks usually boast lower betas. Although academics will suggest this lower risk translates into lower returns over time for low beta stocks, a recent analysis published in the Financial Analyst Journal shows that in contrast to the CAPM, low beta stocks have higher returns than high beta stocks over time. Today, many stable and growing businesses with strong pricing power currently sell at much lower multiples than more risky businesses and many even trade at a discount to the overall market despite their historical premium valuations, lower risk, and higher projected return. The current uncertain economic and interest rate environment makes these low stocks all the more attractive.

A recent analysis published in the Financial Analysts Journal titled “Benchmarks as Limits to Arbitrage: Understanding the Low-Volatility Anomaly,” show that in contrast to the Capital Asset Pricing Model (CAPM), low beta stocks have higher returns than high beta stocks over time. In fact, they found that a dollar invested in the lowest beta quintile in 1968 was worth $10.28 in 2008 adjusted for inflation. In stark contrast, a dollar invested in the highest beta quintile in 1968 was worth only $0.64 by 2008 adjusted for inflation. Using volatility instead of beta yields even more extreme divergences in return. The low volatility quintile would have earned you $10.12 versus just $0.10 for the 20% in the group with the highest volatility, both adjusted for inflation.

Baker, Bradley and Wurgler, authors of the article mentioned above, use behavior finance to attempt to explain this low beta anomaly. They suggest that overconfident market participants with a preference for high potential returns as well as portfolio managers aiming to beat a fixed benchmark but unwilling to accept tracking error deter arbitrage that would rectify this anomaly. Whatever the reason for this glitch in CAPM, its presence provides opportunities for other fundamental investors with longer horizons to get paid more to take less risk, in terms of beta. Intuitively, for fundamental investors, it seems that business that are low cost producers, have pricing power, and limited leverage should have less volatility in their stock price and also generate higher returns over the long-term (as long as you pay a reasonable price).

While it can be observed that beta is not a good predictor of return, as return is quantifiable, its utility as a gauge of risk is less certain as risk is immeasurable. To investors, as opposed to speculators, it seems that expected real return and expected likelihood of avoiding permanent loss should be directly related to a measure of risk taken, and for these investors (ones wishing to protect and enhance capital), beta seems to be a less than ideal calculation of risk. Seth Klarman highlights this is his 1991 book Margin of Safety, “The reality is that past security price volatility does not reliably predict future investment performance (or even future volatility) and therefore is a poor measure of risk.” Warren Buffett, in his 1993 chairman’s letter, states his preference for the Webster’s definition of risk as ‘the possibility of loss or injury’ over the academics inclination for a single statistic based on relative historical changes in price. He alerts us that the real risk to assess is whether purchasing power will be maintained plus an additional return. A better method may include analyzing the business’s competitive position, sustainability, capital structure, pricing power, and management to determine the risk to a business one is considering buying into. Then, focus on the price you pay for a slice of that business’s future incomes to decide what the risk and return of a potential investment is.

Generally, low-beta stocks are a good idea. Today, they appear particularly compelling. Over the last 6 months the equity market has become extremely bifurcated with more risky companies’ stocks fetching high multiples and many less risky businesses priced on sale. Historically, these less risky businesses trade at premium multiples to the overall market. Over time, we expect history will prove correct and the current disconnections will completely reverse. Accordingly, in our hedged equity strategy, we are betting that paying less for less risky cash flows makes sense to the market again. Using a beta calculated from recent price data to determine the hedge for low beta stocks should mitigate underperformance in strong equity markets as one will have substantially more dollars long than short. Within our long-only equity portfolio, we also strongly prefer low beta stocks that should outperform in all but strong up trending markets.

We own several low beta stocks of first-rate companies. Kraft, symbol KFT, is one. Kraft sells a diverse selection of foods and beverages all over the world and has great pricing power in a business that is largely resilient to economic downturns. This gives Kraft stable and predictable earnings over time which is reflected in the stock’s low volatility and beta. Kraft has a trailing twelve month (ttm) price beta of 0.54 to the S&P 500 and a trailing three month price beta of 0.05! Kraft’s stable earnings are growing quickly too. The recent acquisition of Cadbury has increased the company’s exposure to faster growing emerging markets to a quarter of total sales. Kraft earned $2/share of recurring income last year and expects earnings to grow double digits going forward through expanding margins to mid to high teens and organic revenue growth of 5%. Management aims to improve operating margins from last year’s 13.4% towards peers General Mills, Hershey (HSY), Campbell (CPB) and PepsiCo’s (PEP) 17%+ operating margins through cost reductions and realizing synergies from its Cadbury acquisition. Just 16% margins on an expected $54 billion in revenues in 2012 with interest expense of $1.5 billion and an expected tax rate of 30% yields $2.85 in EPS for 2012. At $31.75, KFT shares just over 11x that amount, a discount to the S&P 500 index which trades for around 13x 2012 expected earnings of $102 despite a long-term earnings growth rate for the S&P 500 of just 4%.

http://seekingalpha.com/article/257956-low-beta-stocks-look-part

particularly-compelling-today

or if you have time for the original,

http://www.slideshare.net/lmgemerge/low-risk-anomaly