Fool.com: Building a Better Mousetrap? (Workshop) September 10, 1998

Building a Better Mousetrap?

Alexandria, VA. (Sept. 10, 1998) -- Kids? Do you know what time it is? It's Howdy Sparfarkle time, Buffalo Bogey! Yes, indeedy. Last week, I formally introduced into this column an idea that was generated by a member of the Motley Fool community. Our friend Sparfarkle has developed a screen called the Spark5. You can check out the particulars here. The amazing thing about the Spark5 is that it claims annualized rates of 46% since 1986. Since then, there has been quite a bit of discussion about the Spark5 screen, the nature of risk, and how to possibly modify screens to avoid losing stock picks.

One of the traditional measures of risk is the "beta." For those of you unfamiliar with beta, read on. For those of you familiar with it, indulge me a moment or two to explain for everyone else. Beta is merely a measure of how risky any given stock is, relative to the market as a whole. In other words, all other things being equal, how much will my stock go up if the market is up 10%? How much will it go down if the market is down 10%?

By default, the market in this case has a beta of 1.0. All stocks are then given numbers in relationship to that 1.0 number. Right now, the beta on Dell Computer is 1.71. Basically, this means that for every 10% move in the market, Dell will theoretically move 17%. Keep in mind, that's both UP and DOWN. It doesn't matter. Now, we can argue until we're blue in the face about whether beta is an accurate measure of systematic risk, but the fact is, lots of people use it to manage the risk in their portfolios. What I'm wondering is this:

Is it possible to use beta as another element in a screen to enhance returns?

In an up market, you want very high betas. In a down market you want very low betas. Problem is, you don't ever know which way the market will go in any given year. Because most of these models suggest holding periods of a year, what's a Fool to do? I took a look at the Spark5 for this year. The newest list and their betas, as of August 4 were:

Dell <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: DELL)") else Response.Write("(Nasdaq: DELL)") end if %>            = 1.71 
 Sunamerica <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: SAI)") else Response.Write("(NYSE: SAI)") end if %>         = 1.64 
 Equitable Co. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: EQ)") else Response.Write("(NYSE: EQ)") end if %>       = 1.52 
 Staples <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: SPLS)") else Response.Write("(Nasdaq: SPLS)") end if %>         = 1.36 
 Warner-Lambert Co. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: WLA)") else Response.Write("(NYSE: WLA)") end if %> = 1.22 
 BMC Software <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: BMCS)") else Response.Write("(Nasdaq: BMCS)") end if %>    = 1.16 
 Tellabs <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: TLAB)") else Response.Write("(Nasdaq: TLAB)") end if %>         = 1.14 
 Ericsson <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: ERICY)") else Response.Write("(Nasdaq: ERICY)") end if %>       = 1.12 
 Waste Management <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: WMI)") else Response.Write("(NYSE: WMI)") end if %>   =  .90 
 EMC Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: EMC)") else Response.Write("(NYSE: EMC)") end if %>          =  .83

One possible way to manage your risk might be to pick the lowest beta stocks and see how they do. This might help avoid the real whoopings that occasionally get thrown in with a model. However, it might also keep you from owning superstars like Dell. I'd love to see some research done on the Spark5 going back to 1986 with Sparfarkle's stocks.

My guess is that over that period, you might have done well to buy the highest beta stocks of the 10 largest capitalized companies. We assume that on average, the market will rise, so it stands to reason that we want high beta stocks, yes? Right now, this is just a guess. I'm going to go to the library soon and see if I can't backtest this and see how things would have come out. If you have an opinion on this metric, drop a note into the Workshop message board and sound off!

I'll see you all on Monday.

Check out the latest file updates for the Workshop:
New Rankings | 1998 Returns | New Database

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