In my previous post I highlighted the flaws associated with Beta (β), in this post I would like to explore the proper use of Beta.
Studies have shown that managed portfolios only outperform the S&P500 Index about 1/3rd of the time in both bear and bull markets – this means that for 2/3rds of the time it is better to just invest your money in an index fund, and forget about it. So how do we get in this upper 1/3rd that beats the market index? One potential way is the proper use of Beta.
If Beta, when applied to the CAPM, gives us the required return assuming a well diversified portfolio (based on historic data), then we must earn above this required return in order to justify investing in an individual stock versus the market index. This means that we must determine what our expected (anticipated) return is for the stock in question.
To determine an expected return for a stock, one could use the DDM model, valuation multiples, or a fundamental FCF model. If using the DDM model, it is providing you the YTM of the stock already, but if using the valuation multiples or FCF model, remember to add the dividend yield to the capital gains being derived from these models, thus obtaining the YTM.
If the expected YTM exceeds the required return as provided by the CAPM, then the investment is expected to beat the market index, and an individual stock purchase may be desirable.
In closing, remember to apply other filtering techniques to screen your stocks such as a CV filter and Markowitz Portfolio Theory to truly optimize your individual stock selections, and to fully diversify your portfolio by investing about 40-50% into international stocks.
©2012 Ben Etzkorn