The term beta is often used when evaluating the suitability of stocks within a portfolio because it is the measure of a stock’s rates of return compared to that of the market as a whole.
A beta of 1.0 indicates that an equity closely follows the market, a beta greater than 1.0 indicates more volatility than the market and less than 1.0 means less volatility than the market.
Understanding beta has become more important because companies with higher beta scores have significantly outperformed the norm.
Consideration should now be given to switching some higher beta holdings into more conservative positions.
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Between April 1 and Sept. 30, the Standard and Poor’s Toronto Stock Exchange Composite Index rose 17 percent and the Standard and Poor’s 500 was up 17.4 percent. While the market is not as attractively valued as it was six months ago, there are opportunities within most sectors. Based on current economic data, it appears that we are headed for a gradual economic recovery and continued growth in equity markets. However, the higher beta companies have moved significantly higher regardless of valuations.
Companies with higher beta scores should lead during a market rally but fall faster when markets decline. After all, beta measures the sensitivity of the company’s share price to the overall market.
The criteria may differ when calculating beta. I use month-end closing prices, including dividends, for the past 60 months.
Canadian companies are compared to the S&P/TSX composite while U.S. companies are compared to the S&P 500. Your investment adviser should be able to provide you with the beta score for the stock holdings within your portfolio. Wire services such as Bloomberg also report these scores for public companies.
To provide a better sense of how well these high beta stocks have performed, we can look at the stocks that make up the S&P/TSX Composite Index by categorizing them into four groups, each representing 25 percent. The average six-month return at the end of September for the stocks in the group with the highest beta scores was an astounding 50.3 percent, compared to 28.3 percent for the second, 17.6 percent for the third and 14.5 percent for the quarter with the lowest beta scores.
Many individual and institutional investors have been chasing beta higher after being too defensive at the market bottom. During the three-year bear market, many portfolios migrated to higher weightings in defensive investments, which was appropriate at the time, considering equity markets suffered declines comparable to the 1930s. However, as the markets turned, many of these investors have been selling their defensive holdings.
Stocks that go up don’t necessarily have to come down, but the expansion in the price-to-earnings multiple of the higher beta companies in the past six months may cause some anxiety.
For example, in Canada about six months ago the group with the highest beta score had a median price-to-earnings ratio of 21.1X. Today the multiple has expanded to 30.4X. This compares to only minor expansion for the remaining beta groups.
While some high beta companies should be present in most portfolios, this may be an opportunity to reduce some holdings and switch to top dividend yielding and lower beta alternatives.
When looking at it on a sector basis, the information technology sector, with companies such as Nortel Networks Corp., contains the largest proportion of high beta companies. The financial and utility sectors contain lower beta and higher-yielding companies.
Some examples of high-yielding Canadian companies that could be considered as alternatives are utility TransAlta Corp., paper and forest Nexfor Inc. and financial National Bank of Canada. As of the close of Oct. 24, these low beta companies provided dividend yields of 5.47 percent, 4.04 percent 2.80 percent, respectively, based on 12 month trailing earnings.
Before making changes, discuss the concept of beta with your investment adviser and the impact of modifying your portfolio based on your investment objectives.
Ian Morrison is an investment adviser with Wood Gundy Private Client Investments in Calgary and is licensed to sell insurance products. His views do not necessarily reflect those of CIBC World Markets Inc. or The Western Producer. Morrison can be reached at 800-332-1407 or by e-mail at ian.morrison@cibc.ca.
