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TORONTO (GlobeinvestorGOLD)—You always wish you could have seen it coming. A minor fluctuation in earnings, or maybe something as simple as a contract announcement, sends a stock into tailspin—or launches it into the stratosphere.
While you can never really predict what a stock will do, the more tools you use to make your investing decision the more likely you are to get it right. And when you're kicking the tires of a company before investing, there is one tool that will give you a sense of just how much the stock likely to jump around. It's called the beta coefficient, or more simply, the beta.
No, it has nothing to do with Sony's defunct home-video format. Beta for investors is alive and kicking. In stock terms, beta measures volatility, which is simply the tendency to fluctuate in price. It does this by comparing to a benchmark, usually a major index, because an index is a basic way of measuring the behaviour of a large group of other stocks.
The idea with beta is that "1" represents the benchmark—let's say the Standard & Poor's/TSX composite index. If your stock fluctuates less than the benchmark, then the beta falls below "1." If it fluctuates more, then it will rise above "1."
Penny stocks will almost yield a beta well above "1," because a move of just a few pennies translates into a gain or loss of several percentage points.
A stock such as Research In Motion Ltd. offers a good example. Like many that rode the technology wave, RIM saw some heady days. It reached almost $260 a share in the early spring of 1999, then took the long ride down, settling into a zone. If you are looking at RIM as investment now, you need to know how much it's likely to jump around—and it does jump. The beta on RIM stock is quite high at more than "2" (compared with the S&P/TSX composite index). If you had bought RIM a month ago, checking the beta first, you wouldn't have been surprised by the share performance in the past couple of weeks.
The company announced earlier this month it would be licensing software for use in Nokia phones. On that news, the stock shot up 27 per cent in one session, pushing it almost to the $26 mark. But once investors got past the headlines and started to evaluate the deal, the shine came off a little. Then, barely a week after the Nokia announcement, RIM said it was going to lay off about 10 per cent of its workforce. The stock dropped 6% that day on the Toronto Stock Exchange.
On the other hand, look at Onex Corp. The Canadian conglomerate released third-quarter earnings Nov. 18, and thanks to its U.S. movie business, it posted a 48 per cent increase in profit. The news drove the stock a mere 4 per cent higher. For Onex, that is a fairly big one-day change. Even though the shares have had a lacklustre year, their decline has been steady. So it should come as no surprise that Onex's beta is 0.97 (compared with the S&P/TSX composite index), showing relatively little volatility.
The comparison between these two companies really highlights the fact that beta works best when showing you how much risk is involved with a stock. Typically, the more volatile a stock is, the more its risk is being assessed by the markets. And we've become conditioned to ignore risk as a composite in our own portfolios. We figure either we're going to make a million or lose it all—when in fact most risk is somewhere in the middle.
If beta becomes one of your investing tools, it should help factor out some of the surprises.
Norm Barnett is a producer at Report on Business Television.