In school, I learned that Beta should measure the volatility and risk, but it should also set expectations for how much you will receive in an investment. Nobody wants to invest in a risky company and not earn a higher return than investing in a lower-risk company. In an efficient stock market, the participants have access to the same information, and it should be almost impossible to create alpha over the long term. That's why a market-beating strategy should revolve around owning higher than average beta stocks, right?
Not really. High beta stocks are risky because they're often highly levered, in industries primarily affected by the world economy, or even both. You wouldn't buy a brand new car if you were afraid to lose your job in the next six months. You would rather wait and sit it out for a year or two. This creates a scenario with more unstable and unpredictable revenues and cash flows. In economic booms, the market expands and the demand for their products increases, margins improve, and share prices go up. Highly levered companies are always one mistake or one moment of unluck away from becoming bankrupt or needing a massive restructuring.
High margins high price targets
In cyclical upturns, the earnings of high beta stocks increase as demand increases and operating leverage works its way. Investors may put higher multiples on the stock as its earnings are growing fast, but remember this lasts only for some time before margins eventually go down to a more normalized level. A typical value investor might put ten times earnings as a reasonable number for the company. Still, if the margins are twice as high as the average over a typical business cycle, you're going to risk overpaying for that investment.
Just look at the picture below where analysts extrapolate the current earnings. Peak earnings rarely continue for a prolonged time, and you cannot use them to project future earnings.
Financial leverage and operating leverage
Companies like an airliner should not have a lot of interest-bearing debt on the balance sheet since the business model is highly affected by having operating leverage. Suppose the company can squeeze in a couple of extra passengers in an airplane. In that case, incremental revenue will do wonders for the bottom line since it will not materially affect fuel consumption or demand additional flight attendants and pilots. But if the airliner is consistently missing a few passengers per plane they’re into trouble.
The low-price airline business is low-margin because of the ticket value, but the capital intensity is enormous. Low margins and high capital intensity leave no room for generating good returns if you’re not the best operator in the business and are able to have full planes and high efficiency. Look at Southwest Airlines and Ryanair for inspiration.
Suppose you include some financial engineering to boost returns on equity you’re doomed to struggle at some point. Norwegian struggled years before the global pandemic and had several restructurings before shedding loads of debt and getting rid of airplanes in the latest restructuring. That cost the equity holders big time. The lesson should be that you cannot grow out of a profitability problem.
Avoid bad industries
If you want to enjoy good returns, look at the industries first and then find great companies within one of the preferable industries. The chances are not great that one of your high beta companies will outperform over a longer timeframe, they are high risk for a reason.
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Disclosure
Always do your own research before investing! I hope that you enjoyed this post but It should not be considered an encouragement to buy the companies that I include in my portfolio or be taken as financial advice. If you want to receive investment advice you should contact a professional.
Sources: Valuation seventh edition, Koller, Goedhart & Wessels