High-beta stocks are often considered risky, and at times they are. However, investors should understand the difference between risk and beta, because while the risk level of a stock is sometimes reflected in its beta, there's more to the story. Let's take a closer look at what beta is and what purpose high-beta stocks can serve. As an investor, it's critically important that you really have a good grasp of this concept so that you can more effectively use the beta metric when evaluating a stock for your portfolio.
Before we dive into high-beta stocks, let's briefly go over what beta really means.
What beta means
Beta measures how much a stock price tends to move in either direction compared to a benchmark. Typically, that benchmark is the broader stock market or S&P 500, but it can also be an industry or an index of companies similar in size. Beta is a measure of volatility, not a measure of risk.
The beta scale works like this. A stock with a beta of 1 has moved in lockstep with its benchmark over the measured period of time. A beta of less than 1 means the stock was less volatile than its benchmark, while a number greater than 1 means it was more volatile, exaggerating the benchmark's moves. Meanwhile, a stock with a negative beta tends to move in the opposite direction of its benchmark.
It's also important to understand which beta measure you're looking at. The most typical beta metric listed with a stock quote is its three-year beta versus the market, but this can be different from one source to the next.
What are high-beta stocks?
A high-beta stock, quite simply, is a stock that has been much more volatile than the index it's being measured against. A stock with a beta above 2 -- meaning that the stock will typically move twice as much as the market does -- is generally considered a high-beta stock. High betas are typical of small, speculative companies -- e.g., biotech companies that are developing new treatments and small tech stocks with hot new technologies that have big potential but small market share. Because the price of these sorts of stocks can swing wildly, and often on little more than speculation, this volatility can make the shares seem risky if the shareholder reacts to the price movement and sells at a loss.
Beta is often used as a proxy for risk, and indeed high-beta stocks often carry more risk, but a high beta doesn't guarantee high risk any more than low beta guarantees low risk. Before we talk any more about beta and risk, let's define risk as the likelihood of a permanent loss of capital.
Here's an example of how risk and beta don't always align. Let's say you could invest in either of the following:
- Company A has been in business for almost 100 years, with expertise that makes it a leader in a fast-growing global market. The stock has been volatile, but the business' balance sheet is solid, and the company has a long history as a supplier to major players in this growing space. It has grown sales more than double since 2010.
- Company B faces stiff competition in its business, has few competitive advantages, and faces the threat of declining market share as consumer tastes shift away from its offerings, as evidenced by its minimal growth of sales -- only 26% since 2010, significantly lower than its peers. With similar revenue to Company A, Company B generates less than half the net income while carrying only about 40% as much cash on its balance sheet.
Which of these two would you expect to carry more risk of permanent loss of capital?
If you said Company B -- Red Robin Gourmet Burgers -- you'd probably be right. However, the restaurant chain had a beta of about 1.3 at the start of the year, while company A -- Chart Industries -- had a beta around 2.4 and has consistently carried a higher beta for years. Only in recent months have these companies' betas begun changing course:
Red Robin faces serious long-term competitive threats to the viability of its business, while Chart Industries is a recognized global leader in the industrial cryogenic liquids processing business. Those risks didn't just show up this year, either, so in many ways, beta is more of a trailing metric, reporting past volatility rather than today's risk.
Real-world business challenges are not factored into beta, but rather mere market volatility, which is a measure of the market's perception of risk and is short-term in nature.
A few words on business-focused investing
While beta can be a helpful metric when used in combination with other tools, remember that it's only a measure of past volatility against an index -- not a measure of safety. When researching any stock, study the whole business, looking for durable advantages. Never rely on metrics alone to tell you whether a company makes a good investment.
Jason Hall owns shares of 3D Systems, Apple, Google (A shares), Netflix, and Stratasys. The Motley Fool recommends 3D Systems, Apple, Google (A shares), Netflix, and Stratasys. The Motley Fool owns shares of 3D Systems, Apple, General Electric Company, Google (A shares), Netflix, and Stratasys. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.