Why Beta Has Different Implications For Value And Growth Investors

by: Tom Au, CFA

Summary

Beta, or volatility, has different implications for value and growth investors.

Value investors want high beta so they can profit by buying and selling at cyclical lows and highs.

Growth investors want low beta so that the stock's performance reflects mainly underlying growth trends.

I've been a value investor for most of my career, at least until 2012 (when I stopped publishing on Seeking Alpha). That's when I began a stint with some growth investors for that year, and through 2013, before returning to my value roots in 2014. But at least I've seen the other side of the fence. And that taught me some lessons about the desirability of volatility.

The "beta" of a stock refers to the volatility of a stock, relative to the market. Specifically, it reflects the speed of investor reaction to developments at the company represented by the stock. Oddly enough, beta works in different, and opposite, ways for value and growth stocks.

A deep value investor wants stocks with high betas. That is stocks to which investors overreact on both the up and downsides. When e.g. cyclical stocks reach deep value levels (typically below book value), that's the time to buy; and when they return to "normal" levels, it's time to sell. My experience with cheap stocks with low betas is not nearly as satisfying; they would never go down enough to be truly cheap, and would not go up enough when things turned around.

Value and growth are not mutually exclusive. "Cheap" growth stocks in fact, form one leg of my value triad. (The other two are deep cyclicals and income issues.) After my stint as an investor in growth stocks, I fine tuned my description of suitable growth stocks for a value investor to be stocks with a company growth rate of 10% or more, selling at a market multiple, more or less. A growth rate of 10% is almost twice the historical market growth rate of 5.5% (nominal), and is actually three times the market growth rate in real terms (after subtracting 3% inflation from both numerator and denominator).

It is possible for a stock to be both a growth and value stock. Suppose there is a company growing at 15% a year, but whose stock is hated by the market, so that it sells at 80% of the market multiple. This is not a made-up example, but one that used to describe tobacco stocks (from the 1950s until the 1990s). As long as the stock stayed around 80% of the market, it would be no more volatile than the market as a whole, while its superior 15% growth rate would cause it to outperform over time. There was another advantage; with a valuation of 80% of the market multiple (instead of twice that for stocks of comparable growth in other industries), the stock would yield 5%, instead of 2%-3%, leading to a total return (growth plus yield) of 20%, assuming that the P/E multiple didn't change. That's why you want low betas with growth stocks.

But with growth stocks, a high beta is often an enemy rather than a friend. That is because the great danger of buying a growth stock is buying one that is priced too high and has nowhere to go but down. Put another way, a high beta means that downward changes in the valuation could easily offset the impact of upward earnings growth.

I believe that a market multiple or thereabouts is not "too high," for a value investor in most growth stocks, and would prefer that such a stock remains at such levels for many years, allowing for many entries. After the passage of "Obamacare" in 2010, this described many health care stocks, whose earnings prospects were barely dented, but whose P/E multiples were hammered. The opposite example was the story of high-flying tech stocks around the turn of the century.

To sum up: Value investors should buy cyclical stocks for relatively short holding periods (when a high beta makes them cheap). Along with growth stock investors, they should also buy growth stocks for long holding periods when they are cheap, and low betas suggest that they won't get cheaper. One wants to avoid cyclicals at the top of their cyclical trends, and growth stocks at the upper end of their secular valuation bands.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.