After the adrenaline rush, a look at market beta

Friday, 17th July 2015 09:10 - by David Harbage

Against the backdrop of higher volatility, and a roller coaster ride, in the UK equity market over the past three weeks, a number of newspapers and financial commentators have highlighted the merits of 'defensive' shares. These are typically companies who operate in non-cyclical industries, where demand for their product or services is typically stable and inelastic, like the electricity and water utilities, pharmaceuticals and tobacco. However, such businesses tend to be priced at a premium to the overall market, and appear rich especially compared to more economically sensitive stocks, because of their perceived resilience to a downturn. Certainly, if one believes that we are about to experience another recession in the near future, then paying up for such firms can make sense.

By contrast, when markets are weak because of a political or financial event which the investor perceives to be a near term concern - such as the recent worries surrounding Greece - then shorter term investors might choose a different tack. Over the past three weeks the FTSE100 index has fallen from 6,845 to 6,432 (on 7 July), before recovering to close at 6,796 yesterday. Bullish traders seeking to take advantage of what they perceived to be an oversold (as geared investors may have been forced to close their long positions) and less logical, more emotional (fear, not least of the unknown, driven) market will have been looking for suitable beneficiaries of a rebound.

 That search would have begun with high beta stocks. Beta refers to the performance relationship that a company share is historically perceived to have with the wider equity market. A beta score of 1 means that the stock in question is likely to rise, or fall, by the same magnitude as the overall market; a score or rating of 2 implies performance will be twice (higher or lower) that of the market. A beta rating of 0.5 indicates an expectation that the share price will only move by half that of the wider market; company stocks with defensive business activities - for instance, Severn Trent Water - will have a low, sub 1 beta rating and may even move in the opposite direction to the overall market.

Besides many economically sensitive companies, high beta stocks will often include life assurance companies and fund managers, whose revenue and profits will depend in no small way to the value of the stock exchange assets they possess and manage. When share prices rise or fall, the value of FTSE100 index constituents like Aviva or Schroders tend to rise or fall further than the index or the overall market. Accordingly, these are the sort of stocks and sectors that have rebounded furthest over the past ten days - and have been favoured by equity fund managers and professional traders.

The Budget provided a further positive catalyst to the UK retail savings market, via the withdrawal of higher rate tax relief on Buy-to-Let property - so reducing the relative attractions of property investment to such citizens. The share prices of companies which provide funds for UK private clients' retirement or other investment needs, such as Legal & General and fund manager Henderson Group, received a welcome boost.

Following the Greek government's agreement to the Eurozone's terms for further financial support, it would seem that the financial markets can relax a little from its recent heightened state of excitement. Smart traders have made the so-called 'easy money' (only 'easy' with the benefit of hindsight, of course: it could have been very different, upon a Grexit and Euro contagion scenario) and may settle for a slower heartbeat. However, ahead of half year trading results which are about to take centre stage, investors could study other high beta stocks which have missed out on the recent rally in the market.

 For example, the shares of Close Brothers have retreated from 1625p on 25 June and, at 1512p yesterday, have not made progress from the wider market's low point on 7 July. Smaller firms, with illiquid market capital, could be overlooked by the market but this cannot apply to £2.2 billion market cap. More probably, while categorised as a financial stock, Close is best known as a merchant bank (accounting for 85% of operating profits) which does not necessarily imply a direct relationship with stock market valuations. However, its wealth management (Close Asset Management) and securities (Winterflood) businesses have been making good progress this year, and a trading update due on 24 July could suggest that a higher beta is appropriate.

Another financial stock which might merit a second look is Aberdeen Asset Management, a fund manager which specialises in the world's emerging markets, given that its shares have fallen 20% over the past three months. In valuation terms, little is expected and the shares may have further to recover given its dividend yield support and an improving outlook for earnings in 2016.

By contrast, the shares of fellow FTSE100 fund manager Schroders look to be 'up with events' - on a price earnings multiple of 16.2 times brokers' consensus forecasts for 2016's earnings, with single digit growth in profit growth this year and next. Unless you anticipate stock markets to progress by 10%+ per annum for the next three years - in which case the stock is likely to maintain the outperformance seen over the past three years.

The sensible long term investor, giving some credence to market efficiency in pricing future profits and asset worth, will seek to maintain a balance between cyclical and defensive business activities within a diversified list of industry leaders. Shorter term, inevitable market gyrations can provide opportunities to finesse exposures and add to experience, if not necessarily one's portfolio.