Beta, MPT, KLCI, Genting and Resorts.

The chatbox were discussing Genting and Resorts this morning, and a regular chatter "bullbear" shared his observations below.

"seng, from my observation... genting and resorts are high beta stocks... their prices have always swing wildly..."

"surprisingly, i checked the beta (weekly) of these stocks in invest asia online.com site: Genting beta (weekly ) = 0.9... Resorts beta (weekly) = 1.12...."

Serious investors should know what is Beta, at least conceptually. If you don't know, you may read here - http://en.wikipedia.org/wiki/Beta_(finance). Beta is an important concept in Modern Portfolio Theory (MPT), and again, you may read more here - http://en.wikipedia.org/wiki/Modern_portfolio_theory. Both are taught in Finance courses in most if not all universities around the world, and any Finance graduate worth his salt should at least remember what is Beta and MPT.

However, despite being widely taught all over the world, ironically, the world's most successful investor of all time - Mr Warren Buffett - is a critic of MPT and Beta. Basically, he doesn't think that Beta is important for lifetime investment success.

To recap, Beta measures the extent the Expected Return (ER) of a stock correlates to the Expected Return of the Market. If Beta = 1, then, it means the stock ER should match the Market ER. If Beta <> 1, then, the stock ER is greater than Market ER.

Which means that the only way to calculate Beta of a stock is from historical data. The ass-u-me-tion is that the past predicts the future. So, you compare past prices of a stock against a Market index (often ass-u-me-d to represent Market Returns), and calculate your Beta.

And immediately, a problem arises - exactly how long in the past do you need to calculate Beta?

Won't you get different numbers if you use different past time-periods?

In short, the concept of Beta as a fixed constant is just plain wrong.

Beta is not a constant. Academically, we must acknowledge it is a Random Variable, meaning, the number can vary.

And again, if you want to study Beta further, you must make certain ass-u-mp-tions, that this Beta is a "Random Variable".

Don't let that phrase Random Variable turns you off. What it basically means is that academics don't really know anything about it. They ass-u-me it has a certain Mean and a certain Standard Deviation, following another ass-u-me-d underlying statistical distribution (such as a "Normal distribution" or "Poisson distribution" or another distribution with fancy names), and in the real world, no one knows whether this is actually true or not!

If you think academics likes to make a lot of ass-u-me-ptions, you are not wrong.

So, immediately, you can conceptually understand that the concept of Beta as a specific constant is flawed.

Anyway, for me, I prefer charts.

You see, charts can tell me quickly what words will take paragraphs and still won't be able to convey accurately.

As they say, a "picture paints a thousand words" and possibly more.

So, let me show you 2 charts.

The first chart compares the KLCI with Genting and Resorts during the recent "bull run".

The second chart compares the KLCI with Genting and Resorts during the current "bear market".

Chart 1 - "Bull Run"

Quick comments:

1. Blue line = KLCI. Red = GENTING. Green = RESORTS. Y-scale = % returns from same starting reference point 4 July 2005.

2. Looking at the blue line, you will notice that the KLCI was basically flat from July 2005 to June 2006, before the bull run begins.

3. From July 2005 to June 2006, GENTING outstripped RESORTS, but they caught up again by June 2006. "Beta" which the academics used will never be able to convey this picture to you.

4. From June 2006 to June 2007, GENTING outstripped RESORTS again in the bull run. The academics which obtain higher Beta numbers for GENTING will then point out to you that this is "proof" that GENTING has higher Beta than RESORTS but you won't find them in 3 above.

5. But interestingly, both GENTING and RESORTS outstripped KLCI. If you believe KLCI represents "market", then, it does put to question whether GENTING have a Beta of less than 1 ... hmmnn ....

Chart 2 - Bear Market

Quick Comments:

1. Same colouring codes. Same type of graph. The reason KLCI is showing negative returns because during this period, it is a bear market. I'm using the term "bear market" in a loose manner, meaning, it's a market in decline, and not necessarily one which academics pain-in-the-butt "bear market" definition must meet a minimum % fall.

2. Again, the most immediate observation is that both GENTING and RESORTS has fallen faster than KLCI. Again, I don't know and has never been interested to know whether GENTING Beta is less than 1 or greater than 1, but just from the charts, I know that GENTING falls faster than KLCI.

3. But in the business of making money (as opposed to being academics), I'm more interested in finding "exploitable opportunities". I noticed that usually, GENTING would fall faster than RESORTS. The Red Line leads the Green Line.

But interestingly, since last week, we appear to have seen a "divergence". The Red Line spikes up, but the Green Line continue to come down and is line with KLCI fall.

Is this a true divergence? Is this a temporary divergence? Is this difference exploitable? I don't know the answers, but some traders might take this opportunity to trade with tight stop loss and see what happens.