Beta measures the volatility of a particular stock relative to the broader market -- typically, investors use the S&P 500 to calculate the measure. Stocks that have a beta greater than 1 tend to be more volatile (and risky) than the broader market. Those with a beta less than 1 tend to be slower-moving stocks.
The theory is simple: Every stock carries its own unique risks.
While risks may be high for any individual company, they should balance out across a portfolio containing dozens of companies from different industry groups. Sure, there will be a few laggards in a large portfolio that underperform, but you're also likely to hit a few home runs -- and individual stock risks can be largely diversified away over the long run.
And while you can't eliminate systemic risk through diversification, investors can reduce their exposure amid weak markets by building a portfolio with a beta of less than 1. Such a portfolio would tend to fall less than the market during extreme selloffs.
Of course, there's a trade-off. When the market does recover, stocks with a beta of less than 1 tend to rise at a slower pace than the S&P 500 as well.
The basic choice is simple. Select a low-beta portfolio that's less volatile than the broader market but also produces lower returns over time, or shoot for strong returns by owning more volatile stocks and accepting the greater risks.
But, the market never works as smoothly or neatly as financial models would predict -- there's a lot more to successful investing than balancing risk and return. Some stocks outperform consistently on a risk-adjusted basis.
These are exactly the kinds of stocks I like to own.
Another way to calculate beta is to consider how volatile a particular stock is in rising markets as compared with falling markets. Investors can calculate a bull market beta by examining a stock's volatility only on days the broader market rises; similarly, one can calculate a bear market beta by looking only at performance on days the market falls.
Companies with a bull market beta higher than their bear market beta tend to rise more than the broader market on days when the market rises and fall less when the broader market takes a tumble.
This technique can be used to spot best-of-breed stocks in various industries. For example, using the past five years' worth of data to calculate beta for stocks in the S&P 500, Dollar Tree (Nasdaq: DLTR) and Discover Financial (NYSE: DFS) stand out as two stocks with bull betas far higher than their bear betas.
Dollar stores have been among the best-performing stocks in the United States over the past few years as more budget-conscious U.S. consumers shop for value. Dollar Tree was one of the only stocks in the index to turn in a positive performance in 2008, and the stock has seen only modest corrections over the past four years, even when the broader market is weak.
Credit card company Discover Financial is up more than 396% since the end of 2008, far outpacing the 97% gain in the S&P 500 over the same time. And the stock has seen only two modest corrections since the 2009 broader market lows.
Both of these stocks are fine options for investors to consider. But the mission of my newly rebranded newsletter, High-Yield PRO, is to go off the beaten path in search of big-time yields. And if I have to go outside the U.S. to do it, then so be it.
With these points in mind, I scanned StreetAuthority's vast database of stocks looking for firms domiciled outside the United States with U.S.-traded ADRs (American depository receipts) and a dividend yield over 3%. I screened for firms with a five-year bull beta at least 20% higher than their bear market beta. In addition, I required that the firm's bear market beta be less than 1.25, limiting my universe to stocks with relatively low overall volatility.
Action to Take --> Telecommunications stocks, a group that I've profiled before, screen well on this basis. While I'm not ready to add any of the stocks in this table to my High-Yield PRO portfolios, a number appear to be worthy of further research.