If you are a shareholder in ERM Power Limited’s (ASX:EPW), or are thinking about investing in the company, knowing how it contributes to the risk and reward profile of your portfolio is important. Every stock in the market is exposed to market risk, which arises from macroeconomic factors such as economic growth and geo-political tussles just to name a few. This is measured by its beta. Not every stock is exposed to the same level of market risk, and the market as a whole represents a beta value of one. A stock with a beta greater than one is considered more sensitive to market-wide shocks compared to a stock that trades below the value of one.
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An interpretation of EPW’s beta
ERM Power’s beta of 0.3 indicates that the stock value will be less variable compared to the whole stock market. The stock will exhibit muted movements in both the downside and upside, in response to changing economic conditions, whereas the general market may move by a lot more. EPW’s beta implies it may be a stock that investors with high-beta portfolios might find relevant if they wanted to reduce their exposure to market risk, especially during times of downturns.
Does EPW’s size and industry impact the expected beta?
EPW, with its market capitalisation of AU$430.69M, is a small-cap stock, which generally have higher beta than similar companies of larger size. But, EPW’s industry, electric utilities, is considered to be defensive, which means it is less volatile than the market over the economic cycle. Therefore, investors can expect a high beta associated with the size of EPW, but a lower beta given the nature of the industry it operates in. This is an interesting conclusion, since its size suggests EPW should be more volatile than it actually is. There may be a more fundamental driver which can explain this inconsistency, which we will examine below.
Is EPW’s cost structure indicative of a high beta?
An asset-heavy company tends to have a higher beta because the risk associated with running fixed assets during a downturn is highly expensive. I test EPW’s ratio of fixed assets to total assets in order to determine how high the risk is associated with this type of constraint. Given a fixed to total assets ratio of over 30%, EPW seems to be a company which invests a big chunk of its capital on assets that cannot be scaled down on short-notice. Thus, we can expect EPW to be more volatile in the face of market movements, relative to its peers of similar size but with a lower proportion of fixed assets on their books. This outcome contradicts EPW’s current beta value which indicates a below-average volatility.