MOTLEY FOOL: Beta and volatility

Sun | Your Money

Q: What is beta?

- W.S., Gloucester, Mass.

A: We largely disregard beta, but we're happy to explain it. Beta measures volatility. A stock with a beta of 1.0 generally rises and falls in sync with the overall market. More volatile stocks have betas greater than 1.0, while steadier ones sport betas under 1.0.

Let's say Scrunchie Manufacturing (ticker: SCRNCH) has a beta of 1.2. When the market advances 10 percent in a given period, we can expect SCRNCH to advance 12 percent (1.2 times 10 percent equals 12 percent). If the market falls 20 percent, we'd expect SCRNCH to fall 24 percent. A beta of 0.50 suggests a stock roughly half as volatile as the market.

Such short-term volatility doesn't matter to us, though. We focus on the long-term potential of a business.

Q: Am I imagining it, or is there some conflict of interest when a brokerage keeps upgrading and downgrading a stock, and its brokers are recommending buying and selling it?

- I.J., Edgewood, N.M.

A: We've also noticed that. When brokerage analysts announce rating changes, such as from "Buy" to "Outperform," it creates an opportunity for brokers to call clients and recommend purchases or sales. Furthermore, since many of these financial institutions either do business with or want to do business with the companies they cover, they're unlikely to ever give bad ratings. (We bet you've rarely seen a "Sell" rating.) "Hold" is the closest you'll usually see to a poor rating.

The ratings changes often strike us as weird, too. Consider the difference between "Buy" and "Outperform." If a company will outperform, shouldn't you buy? We usually ignore analysts' ratings and consider instead the meat of their reports and their earnings estimates for companies.


Insider and institutional holdings

When investigating small companies as possible investments, it's good to learn who else owns shares.

For example, insider holdings are generally a good thing. Executives who own 30 percent of a company are motivated to make it succeed. Insiders buying shares is also usually good, as it means they expect the shares to rise. Don't be alarmed by insider sales, though. Company stock is a major component of many executives' compensation. It's natural for them to occasionally sell some shares to send a kid to college or pay for skydiving lessons. (Lots of executives selling might be a red flag, though.)

With small companies, we like to see insiders owning 15 percent or more, and little institutional ownership.

Institutions are the major players, like mutual funds and pension funds. They buy or sell in enormous chunks, and whether a stock is in or out of their favor can have a big effect on its price.


Institutions that might typically buy $10 million worth of shares cannot do so with BUKBUK without buying fully 10 percent of the entire company, something they're often prohibited from doing.

Here's where opportunity creeps in for Fools who discover Scruffy's and snap up shares. In time, Scruffy's grows, and Wall Street takes notice. Institutions begin buying shares, in their usual big way. All that demand pushes up the price of the stock - and Fools clap their hands in glee. (This has happened recently with many Internet stocks.)

Discovering a small but growing company with significant insider ownership and low institutional ownership is a promising prelude to finding a rewarding investment - provided all the financial measures are sound. You can call any public company and ask its investor relations department about insider and institutional ownership. Just remember that small companies are best suited to investors with a few years of experience.


High-flying investing

While still a teenager flying Boeing PT-17s in the old Army Air Corps in 1942, I somehow realized the potential of Boeing as a company, even though the Douglas Aircraft Corp. seemed to be dominant at the time. I bought stock in Boeing in the early 1950s, and the rest is history.

- R.W.S., Queen Valley, Ariz.

The Fool Responds: You present two great lessons here: buying into companies that you understand well and hanging on for decades. Unfortunately, Boeing stock has fluctuated widely and struggled in recent years. If you hung on from 1956 through today, you're up some 2,570 percent - without factoring in dividends. That sounds good until you realize it's about 8 percent per year. Not bad, but not amazing.


Internet logic

We keep hearing about how incredibly overpriced Internet stocks are. But the hype from some bearish commentators can be as misleading as the exuberance of irrationally bullish investors. Both paint with a broad brush, and neither appears to have done enough homework. The key to investing is to know what you are buying.

For instance, many individual investors have bought shares of E*Trade Group, the online brokerage that says, "Someday, we'll all invest this way." Its shares have ascended into the stratosphere over the last year, rising from just under $23 to the high $80s recently. Some commentators are quick to write off its nearly fourfold rise, but investors must look inside the numbers that are driving such a company.

On the day the company moved up 31 percent to $8812, E*Trade reported a 24 percent increase in customer accounts compared to the quarter that closed just 90 days prior. On an annual basis, that's a 136 percent increase. When a company can grow at that rate, $30 million in quarterly revenues becomes $168 million in just two years - and $15 billion in customer assets under management becomes $84 billion.

It takes an offline brokerage company growing at 10 percent per year more than 18 years to achieve the same total growth. Before listening to the knee-jerk dismissals of these sorts of companies from so-called expert commentators, assess the data for yourself.