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Alpha and Beta – Is It All Greek To You?

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I had a couple of interesting conversations today that gave me the idea that I should explain the practical aspects (as opposed to the theoretical ones) of Alpha and Beta in investing.

Investment markets move in cycles – sometimes the market seems to be going up no matter what ( sort of like the past couple of years with the impact of the Fed’s monetary policy – see the previous blog post for more on that) – and sometimes it seems like the market is going nowhere, but certain stocks are going up in spite of it.

This latter time frame is sometimes called a stock picker’s market because the successful investor concentrates their investments in the company’s with fundamentals that will grow their stock price when other companies are faltering – and they are able to buy and sell stocks at the right time to protect the gains they have made and avoid the losses inherent with the market.

This is exactly the concept of Alpha and Beta. Beta is the amount of total return that comes from movements in the market and Alpha is the amount of total return that comes from an investor being able to pick stocks with the right fundamentals at the right times in the proper allocation between capitalization and geographic distribution.

We have been in a Beta-driven market for the past few years – index funds have outperformed active management consistently during this time because: (1) index funds do not keep cash on hand and are 100% invested at all times; and (2) the rising tide lifts all boats, even those with some leaks – and the rising market lifts all stocks so the index goes up in spite of market fundamentals and macroeconomic forces.

Beta-driven markets tend to see: (1) people who don’t invest in stocks want to jump in near market highs; (2) people who are otherwise cautious tend to throw caution to the wind and forget about fundamentals like valuation, financial strength, and earnings growth in order to be 100% invested (or more if they are investing on margin) at times when risk management is a much better strategy; and (3) the S&P 500 Index outperforms all other indices, making a diversified portfolio’s return look bad even if it is performing better than indices of its component parts.

In an Alpha-driven market, the investor needs to focus on valuation, financial strength, and earnings growth as well as macro issues that are driving swings in the market.

I often write here on the blog about the Alpha issues that we focus on in picking stocks: Earnings Growth, Free Cash Flow Growth, Book Value, Debt-to-Equity, Return on Equity, Return on Invested Capital, Weighted Average Cost of Capital, Earnings Yield, Free Cash Flow Yield, PEG Ratio, Enterprise Value, EBITDA, Discounted Cash Flow, Dividends, and many others.

These factors are all part of the process we use to analyze a company and determine if it has the investment characteristics we view as providing superior long-term investment returns. If you have missed posts on this in the past, I promise to make my next post an analytical one showing how we tear apart a company’s financials and determine a target price for it.

But even in an Alpha driven market, your Beta is always there. Some portion of total return is always attributable to the movement of the market itself. So, a successful investor will employ a risk management process that takes advantage of the statistically significant points in the market cycle. Today, let’s focus on that Beta part of the process which I allude to often here on the blog but rarely explicitly explain.

In this part of the process, an investment manager has to focus on being invested at the right times, raising cash when the market moves to statistically unsupportable levels, and investing cash at levels that are statistically risk managed instead of passively allowing the market to dictate that portion of total return.

This Beta management is actually an Alpha activity because it requires active investment management to be a successful investor. Beta itself is the passive movement of the market and your job as an investor is to capitalize on those movements to maximize your returns. This is not timing the market, but rather a risk management activity to lessen equity exposure when the market is extended (check out the Shiller P/E10 chart from the previous post so you can see where we are now) and increase equity exposure when the market has moved below the mean.

So, just so you understand it – Beta is the passive movement of the market and Alpha is the activities the investment manager employs to manage the movements of the market and to pick the companies with the best fundamentals and allocating properly between large/mid/small-cap companies, domestic/foreign/emerging markets, and alternate investments like gold miners or real estate investment companies. It really is as simple as that, no matter how confusing the talking heads on TV and the internet try to make it.

There is so much noise associated with investment management these days perpetuated by the never ending news cycle, business TV, the internet, and all the celebrity “experts” who are eager to tell you what to do. There is so much focus on the short-term that it keeps many people from profiting from the long-term value creation of being in the stock market. They tend to hear someone on TV shout “Sell, Sell, Sell” at the bottom of a stock market cycle and liquidate their holdings at fire sale prices. Instead they should be buying based upon valuations and the statistically significant market levels that have proven to provide for long-term profits while managing risk.

Too much focus is now placed on what has happened in the past month or even year instead of what has happened over the course of the investment cycle, from bull-to-bear-to-bull-again in terms of risk adjusted returns. Maybe I believe this because I’ve been through it and have seen how you make real money – and keep it – through equity investing, but it is truly the only way to survive and thrive in the markets through crashes and new highs over the long term.

So in my 31 years of experience in this business (I can pinpoint it to that number because I have my 30-year Class Reunion from Illinois Wesleyan in 10 days and I started as an intern at the First National Bank of Normal’s Trust Department in 1982) I can tell you certain key buy and sell points that have survived multiple market crashes and blow-off tops to provide for compound annual growth rates much better than the broader market.

Check out the graph above of the S&P 500 Index since 12/31/1999. During this time, we started with a market top, experienced the NASDAQ Crash, peaked to a new market top, experienced the Subprime Mortgage Crash, and have returned to a peak.

During this time, if you remained a true Beta investor and kept your money in an S&P 500 Index Mutual Fund, your Compound Annual Growth Rate for that investment would have been a bit over 2.5%. The crashes tended to offset the returns to market tops, and as in investor you were virtually shaking hands with yourself.

If however, you had employed some simple Beta management tools and raised cash when the market told you that it was statistically ahead of itself and redeployed that cash when it showed you prices that can provide statistically significant risk adjusted returns, you would have done a whole lot better, much like my clients experienced. In this process, you make most of your profits during the low risk parts of the cycle and you get more conservative when the bulk of the investing community is buying near the top.

This is much like how Warren Buffet built Berkshire Hathaway and his multi-Billion dollar wealth. Here are a few bon mots from Warren that follow this thread of logic:

>Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results. [As quoted in Roger Lowenstein, Buffett: The Making of an American Capitalist, p. 77 (1995)]

>Investors making purchases in an overheated market need to recognize that it may often take an extended period for the value of even an outstanding company to catch up with the price they paid. [1998 Berkshire Hathaway Annual Meeting, quoted in The Essays of Warren Buffett: Lessons for Corporate America (1998), p. 92]

>Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy when others are fearful. [2004 Berkshire Hathaway Chairman’s Letter]

>Long ago, Ben Graham taught me that “Price is what you pay; value is what you get.” Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down. [2008 Chairman’s Letter]

>Success in investing doesn’t correlate with I.Q. once you’re above the level of 125. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing. [Quoted in Amy Stone, Homespun Wisdom from the “Oracle of Omaha” ((June 5, 1999), BusinessWeek]

>The stock market is a no-called-strike game. You don’t have to swing at everything—you can wait for your pitch. The problem when you’re a money manager is that your fans keep yelling, “Swing, you bum!” [1999 Berkshire Hathaway Annual Meeting, quoted in Mary Buffett and David Clark, The Tao of Warren Buffett, p. 145]

and, finally,

>The most common cause of low prices is pessimism—some times [sic] pervasive, some times[sic] specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It’s optimism that is the enemy of the rational buyer. [1990 Chairman’s Letter]

Getting back on topic, if you examine the graph, you will see some familiar lines that we discuss here: the red 50-day moving average (since this is a weekly chart, we are using the 10-week moving average) and the green 200-day moving average (here its the 40-week moving average), and the two blue lines that represent a band +/- 10% around the 200-day average.

Just by looking at the graph, you can see that the market mostly cycles up and down in relation to those red, green, and blue lines. So, if you keep the following rules of thumb in mind you can manage the market cycle and focus instead on the fundamentals of the companies you buy and sell.

In an up-trending market or one that is set to turn from down to up:

1. A very safe point to buy stocks is whenever the market drops below the blue line representing the level that is 10% below the 200-day moving average. It is pretty rare that this occurs – once a year or less – but when it does you should be a buyer confident that over time you will make more than acceptable profits (as long as what you buy is fundamentally sound).

The market dropped below the lower blue band because of pessimism and fear – so like Warren, that is the time to be a buyer when everyone else is yelling “Sell, Sell, Sell.” It is what we did in March of 2009, entering at a low risk buy point at 100% invested; it is only now that valuations are up and everyone else is jumping in that we are more cautious.

2. The Green 200-day moving average itself is a great buy point. You need to watch the market internals (things like the Bullish Percent Index, the HiLo Index, and the Advance/Decline line and others – all of which we’ve discussed here before) to make sure they are turning positive to give you a feel for whether the 200-day acts as support or whether it will likely be broken.

If your indicators tell you that buyers are entering the market at the 200-day, you can confidently commit capital to the market knowing that over the long-term profits are in your future.

3. The Red 50-day moving average line is a good place to commit money, again if the market internal indicators tell you buyers are entering the market and the 50-day will likely act as support for a new leg higher.

4. The Blue line that represents 10% above the 200-day moving average is consistently the place where you want to raise some cash. When the passive market moves to that level, sellers emerge to push prices down – it isn’t immediate, so you always have some trading days to formulate your plan and determine which of your holdings are sale candidates (maybe they have hit the price targets you’ve set, maybe there is a news related issue that you anticipate impacting the company’s share price, or maybe they just didn’t execute their operations and didn’t hit their earnings targets).

In a down-trending market, things are different – fortunately, you will have already raised cash by this point and you are simply waiting for the points to deploy it:

1. Instead of most instances of the market moving above the 200-day moving average and you using the 10% above blue line as your sale candidate, the 200-day moving average itself becomes your upper threshold for making sales. Based upon the internal market indicators, you can tell if the 200-day will act as resistance or whether the market is set to turn from down-trending to up-trending (see March 2009 for an example).

2. You will see many instances of the market falling to and below the blue line representing 10% below the 200-day moving average. You will want to buy selectively here, picking up shares of severely beaten down companies but making your purchases small, building a full position over time during the down market.

We often get questions about why we bought 25 shares of something – the reason is we were at a buy point and it allowed us to get exposure to a company at a good price, but given uncertainties in the market we could potentially pick up the other 75 shares of our target position size at a better price. This is a strategy that works in down-trending markets, even short-term ones like the +20% correction in 2011 (check out the move from the top blue line to the bottom blue line during 2011 on the graph).

3. Always keep cash on hand during the down-trending market until the market tells you it is ready to turn higher (see March 2009 on the graph). That turning point is the point of maximum fear and sellers have exhausted themselves moving to cash, selling shares of companies that they bought near the market top at prices significantly lower. The internal indicators we follow tell us when that is happening.

Here are links to a few of the blog posts from 2009 as the market was changing course to give you a feel for what we were doing/seeing as the market was turning. As I re-read them now, I see that we were all-in on the rally but cautious that the 200-day average might act as resistance and when resistance was broken confirming the change in trend, hopeful that it would act as support (good to know our thought process is consistent over the years):

Its a Rally – Here is what we are Doing and Thinkig

Perfect Action in our Rally

The Rally Continues

S&P Pattern Continues

Market Ready to Test 200-day Moving Average

There are many others in the archives that you can read.

I hope this helps you understand a bit about the Alpha and Beta of the stock market. The concepts are actually pretty easy – their application is trickier so I hope that this post provided some insight into how to manage a stock portfolio as the market is rolling through its various cycles.


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Mark