However, what if we approach the issue from another direction and ask: does the infrastructure that serves investors in a developed financial market, such as London's, permit assertive, risk-seeking investors to do what they really want?
Possibly not. To see why, take the following proposition. Imagine Bearbull is really bullish and wants to maximise his investment returns, which of the two following investment plans would he prefer? Either he can select shares in a youngish fast-growing company that's difficult to value and put just his own capital into the situation. Alternatively, he can select shares in a really high-quality company that look moderately undervalued and commit a combination of his own capital and fixed-cost capital that he has borrowed.
So the generic proposition he faces is this: which is it better to choose, the low chance of high returns (that's shares in the youngish company) or the high chance of low returns (that's the high-quality company)? While lots of naive investors will take the first option, usually the second course is better (though, true, it does depend on assessing the probable outcomes of each situation).
Yet in this theoretical proposition, Bearbull can use other people's capital to lever up the returns he hopes to make from the high-quality company's shares. That's a game changer. It means that by using a combination of equity and debt to buy shares in the high-quality company he can make the same returns as he would from the youngish company, though with less risk of loss. Sure, he is taking on a separate risk by choosing this path - that his investment returns won't cover his borrowing costs. Still, we assume that Bearbull is sensible enough to have calculated his cost of borrowed capital weighted by the probability of outcomes and reckoned that whatever combination of equity and debt he chooses is suitable for the job.
The trouble is - as if I even have to spell it out - in the real world the debt-and-equity option isn't fully available. Institutional investors can - and do - use borrowings, but probably not as much as they would like and that is surely true of hedge funds. As for retail investors, well, forget it.
The implication of this failure of the financial system is that aggressive investors have to opt for the second best while trying to secure their target returns. In our simplified version of possibilities, they take the high-risk solution - the youngish company whose shares might just deliver. True, no one forces them to do this; they are motivated only by their own bullishness/greed/stupidity (delete as you think appropriate). Even so, if this scenario is playing throughout the financial system then large numbers of investors are systematically buying the wrong sort of stocks. And that may cause a pricing distortion that smart investors can exploit.
In the jargon of investment theory, it means that 'beta' is overpriced. In other words, the price of high-beta shares - the ones whose price changes magnify movements in the stock market - get pushed to levels from which it is difficult for them to deliver the returns that gung-ho investors expect.
The corollary of this - and this is the nub of the issue - is that low-beta shares are underpriced; they get forgotten, ignored, pushed to the margins as investors surge for sexier plays. As a result, in the long run low beta outperforms high beta, a phenomena that has been observed and puzzled over for decades.
True, it may be a variation of the more familiar investment theme of 'value' versus 'growth', where value outperforms in the long run. What it means in theory is that an investor should 'short sell' high beta stocks and borrow funds to buy low beta ones. In the real world, it means that an investor uses his own equity to buy a portfolio of low-beta stocks.
That's what the table is all about. It shows the 10 stocks of the FTSE 350 index that have the lowest beta (based on monthly returns over five years) with the proviso that the dividend yield must be at least 3.0 per cent from a dividend that cost a half of available earnings or less.
| Is low beta better? | ||||||
| Company | Ticker | Price (p) | 5-year beta | Price/5-yr high (%) | Div yield (%) | Payout ratio (%) |
| Wm. Morrison Supermarkets | MRW | 293 | 0.21 | 86 | 4.0 | 42 |
| National Grid | NG. | 742 | 0.25 | 87 | 5.5 | 35 |
| RSA Insurance | RSA | 119 | 0.29 | 69 | 6.1 | 47 |
| British Sky Broadcasting | BSY | 850 | 0.32 | 94 | 3.5 | 45 |
| The Berkeley Group | BKG | 2141 | 0.35 | 90 | 3.5 | 9 |
| Royal Dutch Shell | RDSB | 2162 | 0.39 | 85 | 7.3 | 32 |
| Beazley | BEZ | 201 | 0.50 | 82 | 4.2 | 35 |
| WH Smith | SMWH | 850 | 0.51 | 99 | 3.3 | 39 |
| Fidessa | FDSA | 2146 | 0.54 | 97 | 3.8 | 46 |
| Tate & Lyle | TATE | 807 | 0.55 | 91 | 3.3 | 42 |
| Average value | 88 | 4.5 | 37 |
It makes a defensive-looking list and provides food for thought; indeed, even something a bit odd to chew on. On average, these 10 are priced at 88 per cent of their five-year high. In contrast, the 20 stocks of the 350 index with the highest beta - the ones that should be overpriced - on average trade at just 65 per cent of their five-year high. Maybe not what you'd expect.
