Over long periods of time, a basket of stocks with a high beta will do better than a basket of stocks with a low beta. Put another way, a basket of stocks with predictable earnings will do worse than a basket of stocks with uncertain earnings. So what is a beta and why would a high best stock outperform a low beta stock?
Beta is a measure of relative volatility of a stock versus the market. If the market goes up 10%, a stock with a beta of 1.0 should also go up 10%, on average. If the market goes down 20%, a stock with a beta of 2 would go down 40%, while one with a beta of 0.5 would go down 10%. Betas are determined by looking at the volatility of a stock (the amount and extent of deviations in price) and comparing it to that of the market in general. In general, the reason for a high volatility is uncertainty in earnings.
Let’s say there are two companies, Sally Steamer and Roger Rollercoaster. Sally Steamer has very predictable earnings – one can look out ten years and predict the earnings growth rate with fairly good certainty. Roger Rollercoaster on the other hand is growing rapidly but is just as likely to lose money than make money. You have no idea what earnings will be in ten years. Both companies are expected to have a 7.1% growth rate, but one has much more confidence that Sally Steamer will double earnings in ten years than Roger Rollercoaster.
In making an investment and looking to lock in for a long period of time one considers the choice between Sally Steamer and a bank CD paying 4% per year. Looking at expected earnings, one could figure out what the future dividend payment from Sally Steamer would likely be. Let’s say that Sally Steamer is expected to be earning $1.20 per share in ten years and paying an $1.00 per share dividend. At a price of $20, one would be earning a 5% yield plus the retained earnings of $0.20 per share would be used to increase the value of the company, further adding value.
If one were almost certain of the company making the expected earnings, one would be likely to pay $18 per share or more now to lock in an effective yield of 6% or more on one’s money (including future dividends and perhaps a small capital gain as earning s are realized) ten years from now since one would be doing better doing that than investing in the bank CD. Note that if earnings were absolutely certain, one would determine how much one would earn from a bank CD over the next ten years and pay the price for the stock that would result in the same return. If the price were lower more people would come in bidding up the price until the returns were identical. Because there is some level of uncertainty, the price paid is slightly lower to provide a little extra gain to justify the risk taken.
In looking at an investment in Roger Rollercoaster vs. a bank CD paying 4%, one would also look at the expected earnings, but also understand that the company may very well not make those earnings. If the stock were expected to make $1.20 and pay a $1.00 dividend in ten years, but the chances of the company actually making those numbers was 50-50, one might only pay $10 per share for the company, locking in a yield of 10% if the company actually makes the future earnings numbers, plus leaving plenty of room for price appreciation should the company start performing as expected.
Because investors require the potential return be higher for more risky (less predictable) stocks, the prices will necessarily be lower, thereby increasing the potential return. For this reason, baskets of higher beta (less predictable) stocks will return more than those of low beta (predictable) stocks over long periods of time. Note that a basket of stocks is required however. There is a reason that higher beta stocks require a greater potential return: Compared to the less volatile stocks, fewer picks will pan out.
Buying a single biotech start-up can result in tremendous fortunes, but is most likely to result in a large loss. Buying a large, established company is more likely to provide a modest but steady return. The more risk one takes on in terms of earnings predictability and price volatility, the more diversification is needed to ameliorate the effects of those picks that do go South.