ITC, which is a low beta stock that has given a return higher than the Sensex over a period of the last six months, highlights the fact that it should actually be a high beta stock

The word beta is a very commonly used term in the Indian stock market. Analysts are often found recommending low beta stocks for conservative investors, while high beta stocks are recommended for risk-savvy investors. What is the logic for this recommendation?
 

By and large, beta is a measure of a stock's volatility in relation to the market. The market has a beta of 1.0, and individual stocks are ranked according to how much they deviate from the market. A stock that swings more than the market over time has a beta above 1.0. If a stock moves less than the market, the stock's beta is less than 1.0.  High-beta stocks are supposed to be riskier but provide a potential for higher returns; low-beta stocks pose less risk but also lower returns.
 

It is important to understand that though beta is a measure of risk, it also has return element built into it. This aspect gets validated by what is mentioned on National Stock Exchange (NSE) website (www.nseindia.com), “The Beta factor describes the movement in a stock’s or a portfolio’s returns in relation to that of the market returns. For all practical purposes, the market returns are measured by the returns on the index (Nifty, Mid-cap, etc.), since the index is a good reflector of the market.”
 

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Does this logic hold water in the case of all stocks? If an investor purchases a low beta stock, is he essentially going to get low return with low risk? Basically, how reliable is beta as a measure of risk? How can it be related to the movement of an underlying stock? To test this concept, I analysed the data of the ITC stock vis-à-vis BSE Sensex. It is pertinent to note that ITC is one of constituents of the Sensex and hence it can be used for the purpose of arriving at beta. The time-frame selected for this purpose was 24 August 2012 to 21 February 2013, which corresponds to the last six months of stock market movement and also this period has experienced good volatility.
 

The beta calculated for this period for ITC works out to be 0.58. The beta has been arrived by using the ‘slope’ function in Excel and also validated by ‘Covar’ and  ‘Varp’ functions, which are based on the derivation of beta value as “Covariance of return on stock, market/variance of market”. Regression analysis also gives the same result in case of beta to be derived for ITC. The result derived from the regression analysis is attached below:
 

The beta of ITC derived on the basis of each day’s closing price of ITC and closing value of the Sensex are good enough to prove that ITC is a low beta stock and no wonder ITC is often referred as an example for low beta stock suitable for risk-averse investors. But another interesting aspect that comes out from this analysis is little startling and challenges the concept of beta. ITC, which is a low beta stock that has given a return higher than the Sensex over a period of the last six months, highlights the fact that it should actually be a high beta stock. (This is not just the case for the six-month period but also holds valid for a longer term data analysis).
 

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Let us understand this with the help of a scenario analysis. The Sensex closed at 17,783 on 24 August 2012 and moved up 19,325 on 21 February 2013.This means that the Sensex has given return of 8.67% while ITC during the same period has moved from 265.15 to 296.50, which means the return given by ITC is 11.82%.  The daily average return given by the Sensex for the same period is 0.067%, while ITC for the same period gave a daily return of 0.09%. If ITC has given higher return than the Sensex during a period, its beta should be more than one and not less than one, which is the case practically.
 

What does the ITC experience suggest? An investor needs to look at not only beta but also standard deviation to understand stock price behavior. It is important to note that ITC for the same period has a standard deviation of 1.25%, while the Sensex has a standard deviation of 0.67%. This shows that ITC, which is a low beta stock, is actually having a high risk in terms of standard deviation and that is what explains the higher return provided by it over a period of six months. A higher standard deviation indicates that a stock will move more from the mean and hence, will have high risk and potential higher return compared to the benchmark. The ITC experience shows that a low beta stock need not be a less risky one and may defy the logic of beta itself.
 

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