Chin calls me out: I am not experienced, knowledgeable, or secure in my thinking, even though sometimes for the sake of argument I may allow myself to appear that way. I just sent a reply to a friend much more intelligent than I am, and thought the subject of the email may fit in with what some of you may have some concerns with also, so I thought I would post it on the board here for discussion.

Thanks for the flattery but I'm just a guy with an opinion...and opinions are like ...oops, this is supposed to be a clean board.

Chin, as you've probably seen in the past, it's not that I'm a total nonbeliever in P/E, PEG, Beta, ROIC, CAPM, EMH, technical analysis, or dozens of other techniques.

What I am a firm believer in is that I want to work with what I know works...I prefer to work with methods that are proven, and that's why I'm highly critical of beta. To me, beta and derivatives based on beta should be able to beat "throwing darts", or the technique is no better than randomly picking stocks. In fact, things like "Vanguard Total Stock Market Index Fund" are in essence little more than dart-board stock picking techniques.

If you've seen some of my posts in Foolish Eight a quarter ago, I went after the Foolish Eight criteria with just that approach...to attempt as much as possible to validate the criteria in a numerical sense. Although there were some problems (the Value Line database is skewed to a degree towards certain stocks whereas the Foolish Eight criteria is skewed in a totally different direction), it elucidated some big surprises such as the real relationship of insider ownership and returns (statistically, insider ownership only seems to impact stock returns when the insiders have controlling interest in the company and can't be vetoed by common stockholders).

I made the point that in refereed literature, "standard" betas, most of the proposed derivatives, and the underlying assumptions don't work...to which I seem to have inadvertantly kicked up Chin's ire (sorry).

Dam himself listed several of the "anomalies" that seem to suggest that betas don't work in Chapter 6 of Investment Valuation 2nd ed., and the conclusion clearly states that there's something screwy going on that make betas fail in practice. He quoted roughly the same pile of literature I did but he didn't spell it out the same way. A classic demonstration of the problem is on page 6 in Chapter 8. Take a look at the graph. Anybody who has done modelling/curve fitting work will immediately tell you that your data set is so noisy that to make a linear (or other) fit to the data is meaningless. Dam's solution is to add additional factors to the beta calculation.

The factors for "market betas" are:
1. Market specific effects ("type of business" as Dam puts it).
2. Operating leverage, which is defined as the relationship between fixed and variable costs. High fixed costs will cause a higher beta since it causes higher fluctuations in profitability.
3. Financial leverage, which is defined as the relationship between debt and equity. Firms which are loaded down with debt will have a hard time reacting to market fluctuations since they are spending a lot of money paying down debt.

Dam also defines "Bottom-up" and "accounting" betas as well. In any case, these are specific variations on the "multi-factor beta" umbrella although as I have already mentioned, this type of beta also has already been tested and shown to fail to work in the real world.

This is where Dam stops. It would have been really nice if he had actually validated his beta calculation method with tests similar to those conducted on the other beta calculations.

Since the whole point of calculating a beta is to calculate the return on equity (the stock), we can easily test Dam's betas by calculating them and then comparing them to the actual return on the stocks since the return is equal to:
Stock return = risk free rate + beta * market index

Does anybody know if Dam's betas actually work in practice better than historical, APM, or the original multi-factor betas?