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Is Beta Still Useful Over a Longer-Horizon?

Despite the crucial role of the market factor in Fama and French's three-factor model, the market beta has failed to explain the cross-sectional differences in expected returns proxied by the future realized returns of individual stocks. However, current evidence does not necessarily reject the explanatory power of the market beta in expected returns over longer-horizons. We use the future implied costs of capital as the proxy instead of future realized returns in order to link beta to longer-horizon expected returns. In contrast to the current results we find that the future implied cost of capital is both positively and significantly related to the conventional beta estimate, implying that beta could still explain future cross-sectional expected return differences. Moreover, uncertainty risk could be important when focusing on longer-horizons. We propose using analyst dispersion as a proxy for the uncertainty risk, and find that it strongly predicts future implied cost of capital as well. Furthermore, some prior studies have shown that the failure of beta in explaining cross-sectional return differences over a shorter-horizon is due to the lack of forward-looking information. Since changes in the implied cost of capital contain such unique information, we propose a simple adjustment to the conventional beta measure. The explanatory power of the adjusted beta for future return differences is accordingly proved to be strong.