Equity Investments 35

EQUITY INVESTMENTS

Bad Beta, Good Beta

John Y. Campbell and Tuomo Vuolteenaho American Economic Review vol. 94, no. 5 (December 2004):124975
Research on the performance of the capital asset pricing model (CAPM) has shown a failure to adequately describe the relationship between realized stock returns and beta. The authors address these issues by using an intertemporal CAPM with two betas: a cash flow beta and a discount rate beta. A unique characteristic of the two-beta framework is that good (discount rate) betas carry a low premium for risk whereas bad (cash flow) betas carry a higher premium. The authors find that from 1963 to 2000, the two-beta model greatly improved the performance of the traditional CAPM. Value stocks and small stocks had higher cash flow betas than growth stocks, which had predominantly good betas and, therefore, lower returns.

Traditionally, investors have used the capital asset pricing model (CAPM) of Sharpe (Journal of Finance, 1964) and Lintner (Review of Economics and Statistics, 1965) as the basis for projecting expected returns: The higher the beta, the higher the expected return. Since the early 1960s, however, the CAPM has not provided a satisfactory way to project asset returns because small stocks and value stocks have provided higher returns than growth stocks. Also, stocks with high historical betas have had returns no higher than similar-sized stocks with low historical betas. One can go back to basics and recognize that value or return to investors is driven by two important factors when modeled in a present value framework: expected cash flows and the discount rate used to discount those cash flows to the present. Values and returns should change in response to news about either cash flows or discount rates, or both.
John Y. Campbell and Tuomo Vuolteenaho are at Harvard University. The summary was prepared by Frank T. Magiera, CFA.

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The authors argue that these factors have different significance for long-term, risk-averse investors. In particular, investors may want higher returns for assets that covary with market cash flows than for assets that vary with market discount rates. They argue that although increases in discount rates cause expected returns to decrease, hope for improved prospects in the future exists. In such a case, the single beta of the traditional CAPM can be divided into two separate betas: a cash flow beta that demands a high price for bearing risk and a discount rate beta that demands a lower premium. The authors label the former as bad beta and the latter as good beta. The authors develop and test a two-beta intertemporal capital asset pricing model (ICAPM) that captures risk in cash flows and discount rates. The model improves on the traditional model and is an attempt to operationalize the ICAPM developed by Merton (Econometrica, 1973). The authors perform empirical tests of their model by using data from 1929 to 2001. They find that value stocks and small-cap stocks had higher cash flow betas than growth stocks and large-cap stocks. Thus, these stocks tended to exhibit higher returns. Growth stocks in the latter period had betas that were primarily of the good variety, and thus growth stocks earned returns that were relatively low. In the 19632001 period, the two-beta model improved the explanation of returns compared with the traditional CAPM. One implication of these results is that high returns to value and growth stocks should be viewed as appropriate compensation for holding cash flow risk rather than as a justification for any systematic tilt toward these types of stocks.
Keywords : Equity Investments: fundamental analysis and valuation models; Investment Theory: CAPM, APT, and other pricing theories

2005, CFA Institute