"A risk-averse long-term investor should go for low beta stocks" Nimish Shah, Director, Parag Parikh Financial Advisory Services

When a stockmarket player bandies the V-word, don't naturally expect whoops of joy to follow. More often than not, V is for 'volatility', and this can be scary. Infosys' stock, for example, crashed by 27 per cent in one single day on April 10, 2003. And then made a comeback. Then down again. And up. Down. Up. And so on.

Did someone make money on it? Sure. Many saw a 'buy' opportunity. But many others got badly rattled. And telling them that risk is risk-it's in the very nature of equities-isn't any consolation.

As stock volatility increases, the real winners over a sustained period are likely to be those who've got their risks nicely worked out. The good news is that you could join the game too. You can start by getting a fix on risk and volatility.

Analyse Volatility

For the purpose of analysis, experts tend to divide all equity risk into two broad categories-systemic risk, which relates to the entire market, and unsystemic risk, which has to do with the individual firm.

The impact of firm-specific risks can be reduced, overall, through portfolio diversification. The more varied the stocks in a portfolio, the less likely that every firm will take a hit simultaneously. Also, rigorous company analysis can also help identify company-specific risk factors. So, an investor can use a carefully constituted and well-diversified portfolio to insulate (in theory, at least) the investment as a whole against unsystemic crashes.

"Betas can give wrong results if the security is not traded frequently" Errol D' Souza, Senior Vice President, DSP Merrill Lynch

The bigger headache, typically, is systemic risk-the classic example of which is the extreme case of a nuclear strike. Of course, it is mostly the much-less-ghoulish market shocks that an investor must deal with. Yet, regardless of how far 'ground zero' may be, there's no escaping the havoc systemic risk creates for stock prices.

Role Of Regression

Wait, did somebody say there's nothing you can do against systemic risk? That's true in theory. But in actual practice, it's impossible to make clear distinctions between the types of risk influencing a stock. Prices just go up and down, that's it, without the courtesy of an explanation for their behaviour.

What an investor can measure, however, is a stock's volatility-relative to the market index. This, according to Errol D' Souza, Senior Vice President, DSP Merrill Lynch, is precisely what the 'beta' measure does.

Simply put, a stock's 'beta' measures how much its price varies in step with the index, as a ratio of how much the index alone varies, over a period of time. Not so simply put, a stock's beta is the ratio of the stock-index 'co-variance' (average of the products of the stock's and index's deviations from their means), to the index's 'variance' (average of squared deviations from the index's mean).

Those acquainted with elementary statistics would recognise it as a tool called regression analysis. The data points are typically recorded daily, at the close of trading, with the total distribution period (for which the stock and index means must be calculated) ranging over several months. "It is better to take a long time period," says Nimish Shah, Director, Parag Parikh Financial Advisory Services, "but don't go too long as the old data points may lose relevance. In the Indian context, one to two years is ideal."

Now Get Discerning

In theory, a perfect beta of 1 implies that the stock moves precisely in step with the index. But this is not a correlation coefficient, mind you. It is a ratio. A beta can be more than 1, implying that the stock is more volatile than the index. Some stocks even have beta figures in excess of 2, such as Satyam, with a beta measure of 2.23 (with the BT-50 as the index). Hindustan Lever, however, has a beta value of 0.94. Stocks with beta values lower than, say 0.50 (example: Castrol), are stocks that are not only out of whack with the index, but are also relatively stable.

Now, an investor who prefers making picks on the basis of broad market conditions would prefer a portfolio of beta stocks rotating around 1, generally. A dedicated tracker of companies, however, would prefer investing in either high or low beta stocks of the particular firms he understands, with the high or low dependent on his risk-return preference. "If the investor is a risk-averse long-term player," advises Shah, "he should go for low beta stocks. But the high risk taking trader can go for high beta stocks."

Before you adopt the beta, bear in mind that it is based on historical data, always an imperfect predictor of the future. Also, low betas are often indicators of low liquidity as much as low volatility, and many of these can become dead stocks. In other words, as Jigar Shah, Head of Research at KRC Research, cautions, "Beta should not be used on a standalone basis." Being discerning involves more than statistics.

Lemon Analysis
Just who are these guys? What are these unheard of under-Rs 5 stocks that are sizzling away at the bourses? Investors, watch out.

Never mind the gateway boom, never mind the jewellery market boom-the bulls ain't heard nothin'. Stock after stock soars. It's a bull market, and a good time to look beyond the smokescreens. At all these unknown stocks, for instance, that've emerged from nowhere and are sizzling away.

You've heard of one Satyam Computer Services, yes, but Satyam Cement? It's losing money. But if you had put a 25-paise coin-its share price-on March 1, you could have turned it into Rs 4.07 by August end, a gain of 1,528 per cent. A lemon? Who knows?

And Satyam Cement is far from lonely. Of the 859-odd companies that traded below Rs 5 six months ago, as many as 612 have delivered returns of more than 20 per cent. No wonder they've seen their trading volumes zoom. Parag Parikh, CEO, Parag Parikh Financial Services, isn't surprised. "Everyone starts buying stocks in a bull market like there is no other place to invest," he sighs, sounding off a caveat emptor warning, "This can't be called 'investing'; it's crowd behaviour at work. And when retail investors burn their fingers, they blame everyone from brokers to the government."

The floor-scraping prices are often the chief attraction of these stocks. Even their performance reports seem suspiciously timed to capture market sentiment. Take Alka India. For the quarter ended March 2003, it reported a loss of Rs 31 lakh on sales of Rs 1.9 crore. The next quarter, it netted Rs 3.8 crore in profit on sales of Rs 25.8 crore! Traded volumes jumped from 50,000 to 1.6 million shares, and the price skyrocketed.

The under Rs 5 stocks have their uses. Promoters, for example, can cash in on a run on their stocks, and often use tricks such as stock-splits, just to make their scrips look cheap. Traders, meanwhile, are always aplenty willing to bet on the 'greater fool theory' (that once upward momentum is created, someone else will buy the shares off them). Smart. Except that this is a zero-sum game that will, ultimately, cause injury. It's always better to stick with scientific reality-even if the wise have diverse interpretations of the nitty-gritties.

-Shilpa Nayak