Aswath Damodaran1 Investment Philosophy: The Secret Ingredient in Investment Success Aswath Damodaran

Aswath Damodaran 1

Investment Philosophy:The Secret Ingredient in Investment

SuccessAswath Damodaran

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What is an investment philosophy?

An investment philosophy is a coherent way of thinking about markets, how they work (and sometimes do not) and the types of mistakes that you believe consistently underlie investor behavior.

An investment strategy is much narrower. It is a way of putting into practice an investment philosophy.

For lack of a better term, an investment philosophy is a set of core beliefs that you can go back to in order to generate new strategies when old ones do not work.

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Ingredients of an Investment Philosophy

Step 1: All investment philosophies begin with a view about how human beings learn (or fail to learn). Underlying every philosophy, therefore is a view of human frailty - that they learn too slowly, learn too fast, tend to crowd behavior etc….

Step 2: From step 1, you generate a view about markets behave and perhaps where they fail…. Your views on market efficiency or inefficiency are the foundations for your investment philosophy.

Step 3: This step is tactical. You take your views about how investors behave and markets work (or fail to work) and try to devise strategies that reflect your beliefs.

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An Example..

Market Belief: Investors over react to news Investment Philosophy: Stocks that have had bad news

announcements will be under priced relative to stocks that have good news announcements.

Investment Strategies:• Buy (Sell short) stocks after bad (good) earnings announcements

• Buy (Sell short) stocks after big stock price declines (increases)

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Why do you need an investment philosophy?

If you do not have an investment philosophy, you will find yourself doing the following:

1. Lacking a rudder or a core set of beliefs, you will be easy prey for charlatans and pretenders, with each one claiming to have found the magic strategy that beats the market.

2. Switching from strategy to strategy, you will have to change your portfolio, resulting in high transactions costs and paying more in taxes.

3. Using a strategy that may not be appropriate for you, given your objectives, risk aversion and personal characteristics. In addition to having a portfolio that under performs the market, you are likely to find yourself with an ulcer or worse.

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The Investment ProcessThe ClientRisk Tolerance/AversionTax StatusInvestment HorizonThe Portfolio Manager’s JobAsset AllocationRisk and Return- Measuring risk- Effects of diversification

Security Selection- Which stocks? Which bonds? Which real assets?Valuation based on- Cash flows- Comparables- Technicals

Private InformationExecution- How often do you trade?- How large are your trades?- Do you use derivatives to manage or enhance risk?

Asset Classes:StocksBondsReal AssetsCountries:DomesticNon-DomesticTradingCosts- Commissions- Bid Ask Spread- Price Impact

Trading SpeedMarket Efficiency- Can you beatthe market?

Views on marketsPerformance Evaluation1. How much risk did the portfolio manager take?2. What return did the portfolio manager make?3. Did the portfolio manager underperform or outperform?

MarketTimingStockSelectionUtilityFunctionsTax CodeViews on- inflation- rates- growth

Trading Systems- How does trading affect prices?

Risk Models- The CAPM- The APM

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Understanding the Client (Investor)

There is no “one” perfect portfolio for every client. To create a portfolio that is right for an investor, we need to know:• The investor’s risk preferences

• The investor’s time horizon

• The investor’s tax status If you are your own client (i.e, you are investing your own money),

know yourself.

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I. Measuring Risk

Risk is not a bad thing to be avoided, nor is it a good thing to be sought out. The best definition of risk is the following:

Ways of evaluating risk• Most investors do not know have a quantitative measure of how much

risk that they want to take

• Traditional risk and return models tend to measure risk in terms of volatility or standard deviation

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What we know about investor risk preferences..

Whether we measure risk in quantitative or qualitative terms, investors are risk averse. • The degree of risk aversion will vary across investors at any point in

time, and for the same investor across time (as a function of his or her age, wealth, income and health)

There is a trade off between risk and return• To get investors to take more risk, you have to offer a higher expected

returns

• Conversely, if investors want higher expected returns, they have to be willing to take more risk.

Proposition 1: The more risk averse an investor, the less of his or her portfolio should be in risky assets (such as equities).

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Risk and Return Models in Finance

The risk in an investment can be measured by the variance in actual returns around an expected returnE(R)Riskless InvestmentLow Risk InvestmentHigh Risk InvestmentE(R)E(R)Risk that is specific to investment (Firm Specific) Risk that affects all investments (Market Risk)Can be diversified away in a diversified portfolio Cannot be diversified away since most assets1. each investment is a small proportion of portfolio are affected by it.2. risk averages out across investments in portfolioThe marginal investor is assumed to hold a “diversified” portfolio. Thus, only market risk will be rewarded and priced.

The CAPMThe APMMulti-Factor ModelsProxy ModelsIf there is 1. no private information2. no transactions costthe optimal diversified portfolio includes everytraded asset. Everyonewill hold this market portfolioMarket Risk = Risk added by any investment to the market portfolio:

If there are no arbitrage opportunities then the market risk ofany asset must be captured by betas relative to factors that affect all investments.Market Risk = Risk exposures of any asset to market factors

Beta of asset relative toMarket portfolio (froma regression)

Betas of asset relativeto unspecified marketfactors (from a factoranalysis)

Since market risk affectsmost or all investments,it must come from macro economic factors.Market Risk = Risk exposures of any asset to macro economic factors.

Betas of assets relativeto specified macroeconomic factors (froma regression)

In an efficient market,differences in returnsacross long periods mustbe due to market riskdifferences. Looking forvariables correlated withreturns should then give us proxies for this risk.Market Risk = Captured by the Proxy Variable(s)

Equation relating returns to proxy variables (from aregression)

Step 1: Defining RiskStep 2: Differentiating between Rewarded and Unrewarded RiskStep 3: Measuring Market Risk

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Some quirks in risk aversion…

Individuals are far more affected by losses than equivalent gains (loss aversion), and this behavior is made worse by frequent monitoring (myopia).

The choices that people make (and the risk aversion they manifest) when presented with risky choices or gambles can depend upon how the choice is presented (framing).

Individuals tend to be much more willing to take risks with what they consider “found money” than with money that they have earned (house money effect).

There are two scenarios where risk aversion seems to decrease and even be replaced by risk seeking. One is when individuals are offered the chance of making an extremely large sum with a very small probability of success (long shot bias). The other is when individuals who have lost money are presented with choices that allow them to make their money back (break even effect).

When faced with risky choices, whether in experiments or game shows, individuals often make mistakes in assessing the probabilities of outcomes, over estimating the likelihood of success,, and this problem gets worse as the choices become more complex.

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II. Time Horizon

As an investor, how would you categorize your investment time horizon? Long term investor (3-5 years or more) Short term investor (< 1 year) Opportunistic investor (long term when you have to be long term, short

term when necessary) Don’t know

If you were a portfolio manager, would your answer be different?

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Investor Time Horizon

An investor’s time horizon reflects • personal characteristics: Some investors have the patience needed to

hold investments for long time periods and others do not.

• need for cash. Investors with significant cash needs in the near term have shorter time horizons than those without such needs.

• Job security and income: Other things remaining equal, the more secure you are about your income, the longer your time horizon will be.

An investor’s time horizon can have an influence on both the kinds of assets that investor will hold in his or her portfolio and the weights of those assets.

Proposition 2: Most investors’ actual time horizons are shorter than than their stated time horizons. (We are all less patient than we think we are…)

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III. Tax Status and Portfolio Composition

Investors can spend only after-tax returns. Hence taxes do affect portfolio composition.

• The portfolio that is right for an investor who pays no taxes might not be right for an investor who pays substantial taxes.

• Moreover, the portfolio that is right for an investor on one portion of his portfolio (say, his tax-exempt pension fund) might not be right for another portion of his portfolio (such as his taxable savings)

The effect of taxes on portfolio composition and returns is made more complicated by:

• The different treatment of current income (dividends, coupons) and capital gains

• The different tax rates on various portions of savings (pension versus non-pension)

• Changing tax rates across time

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Dividends versus Capital Gains Tax Rates for Individuals: United States

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The Tax Effect: Stock Returns before and after taxes.. With one year time horizons

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The Tax Effect and Dividend Yields

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Mutual Fund Returns: The Tax Effect

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

LargeValue

LargeBlend

LargeGrowth

MidcapValue

MidcapBlend

MidcapGrowth

SmallValue

SmallBlend

SmallGrowth

Fund Style

Figure 5.10: Pre-tax and After-tax Returns at U.S. equity mutual funds- 1999-2001

Pre-tax ReturnAfter-tax Return

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Tax Effect and Turnover Ratios

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Asset Allocation

The first step in portfolio management is the asset allocation decision. The asset allocation decision determines what proportions of the

portfolio will be invested in different asset classes - stocks, bonds and real assets.

Asset allocation can be passive, It can be based upon the mean-variance framework: trading off higher

expected return for higher standard deviation. It can be based upon simpler rules of diversification or market value

based When asset allocation is determined by market views, it is active asset

allocation.

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I. Passive Asset Allocation

In passive asset allocation, the proportions of the various asset classes held in an investor’s portfolio will be determined by the risk preferences of that particular investor. These proportions can be determined in one of two ways:• Statistical techniques can be employed to find that combination of assets

that yields the highest return, given a certain risk level

• The proportions of risky assets can mirror the market values of the asset classes. Any deviation from these proportions will lead to a portfolio that is over or under weighted in some asset classes and thus not fully diversified. The risk aversion of an investor will show up only in the riskless asset holdings.

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A. Efficient (Markowitz) Portfolios

Return Maximization Risk Minimization

Maximize Expected Return Minimize return variance

subject to

where,

= Investor's desired level of variance

E(R) = Investor's desired expected returns

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Limitations of this Approach

This approach is heavily dependent upon three assumptions:• That investors can provide their risk preferences in terms of variance

• They do not care about anything but mean and variance.

• That the variance-covariance matrix between asset classes remains stable over time.

If correlations across asset classes and covariances are unstable, the output from the Markowitz portfolio approach is useless.

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II. Just Diversify

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The Optimally Diversified Portfolio

Global Investable Capital: 1998

Venture Capital

Emerging Markets3%US Real Estate

4%

Cash Equivalents5%

International Bonds26%

US Bonds19%

International Equity20%

US Equity22%

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II. Active Asset Allocation (Market Timing)

The payoff to perfect timing: In a 1986 article, a group of researchers raised the shackles of many an active portfolio manager by estimating that as much as 93.6% of the variation in quarterly performance at professionally managed portfolios could be explained by the mix of stocks, bonds and cash at these portfolios.

Avoiding the bad markets: In a different study in 1992, Shilling examined the effect on your annual returns of being able to stay out of the market during bad months. He concluded that an investor who would have missed the 50 weakest months of the market between 1946 and 1991 would have seen his annual returns almost double from 11.2% to 19%.

Across funds: Ibbotson examined the relative importance of asset allocation and security selection of 94 balanced mutual funds and 58 pension funds, all of which had to make both asset allocation and security selection decisions. Using ten years of data through 1998, Ibbotson finds that about 40% of the differences in returns across funds can be explained by their asset allocation decisions and 60% by security selection.

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Market Timing Strategies

Asset Allocation: Adjust your mix of assets, allocating more than you normally would (given your time horizon and risk preferences) to markets that you believe are under valued and less than you normally would to markets that are overvalued.

Style Switching: Switch investment styles and strategies to reflect expected market performance.

Sector Rotation: Shift your funds within the equity market from sector to sector, depending upon your expectations of future economic and market growth.

Market Speculation: Speculate on market direction, using either financial leverage (debt) or derivatives to magnify profits.

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Market Timing Approaches

Non-financial indicators• Spurious Indicators: Over time, researchers have found a number of real world

phenomena to be correlated with market movements. (The winner of the Super Bowl, Sun Spots…)

• Feel Good Indicators: When people are feeling good, markets will do well.• Hype Indicators: When stocks become the topic of casual conversation, it is time to

get out. The Cocktail party chatter measure (Time elapsed at party before talk turns to stocks, average age of chatterers, fad component)

Technical Indicators• Price Indicators: Charting patterns and indicators give advance notice.• Volume Indicators: Trading volume may give clues to market future• Volatility Indicators: Higher volatility often a predictor or higher stock returns in

the future Reversion to the mean: Every asset has a normal range of value and things

revert back to normal. Fundamentals: There is an intrinsic value for the market.

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Non-financial indicators..

Spurious indicators that may seem to be correlated with the market but have no rational basis. Almost all spurious indicators can be explained by chance.

Feel good indicators that measure how happy are feeling - presumably, happier individuals will bid up higher stock prices. These indicators tend to be contemporaneous rather than leading indicators.

Hype indicators that measure whether there is a stock price bubble. Detecting what is abnormal can be tricky and hype can sometimes feed on itself before markets correct.

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The past as an indicator of the future…

Which of the following is the best predictor of an up-year next year? The last year was an up year The last two years have been up years The last year was a down year The last two years have been down years None of the above

PriorsNumber of occurrences

% of positive returns Average returnAfter two down years 19 57.90% 2.95%After one down year 30 60.00% 7.76%After one up year 30 83.33% 10.92%After two up years 51 50.98% 2.79%

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The January Effect, the Weekend Effect etc.…

As January goes, so goes the year – if stocks are up, the market will be up for the year, but a bad beginning usually precedes a poor year.

According to the venerable Stock Trader’s Almanac that is compiled every year by Yale Hirsch, this indicator has worked 88% of the time.

Note, though that if you exclude January from the year’s returns and compute the returns over the remaining 11 months of the year, the signal becomes much weaker and returns are negative only 50% of the time after a bad start in January. Thus, selling your stocks after stocks have gone down in January may not protect you from poor returns.

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Trading Volume

Price increases that occur without much trading volume are viewed as less likely to carry over into the next trading period than those that are accompanied by heavy volume.

At the same time, very heavy volume can also indicate turning points in markets. For instance, a drop in the index with very heavy trading volume is called a selling climax and may be viewed as a sign that the market has hit bottom. This supposedly removes most of the bearish investors from the mix, opening the market up presumably to more optimistic investors. On the other hand, an increase in the index accompanied by heavy trading volume may be viewed as a sign that market has topped out.

Another widely used indicator looks at the trading volume on puts as a ratio of the trading volume on calls. This ratio, which is called the put-call ratio is often used as a contrarian indicator. When investors become more bearish, they sell more puts and this (as the contrarian argument goes) is a good sign for the future of the market.

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A Normal Range for PE Ratios: S&P 500

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PE Ratios in Brazil…

Bovespa: PE Ratio

0

2

4

6

8

10

12

14

16

18

Jan-04Feb-04Mar-04Apr-04May-04Jun-04Jul-04Aug-04Sep-04Oct-04Nov-04Dec-04Jan-05Feb-05Mar-05Apr-05May-05Jun-05Jul-05Aug-05Sep-05Oct-05Nov-05Dec-05Jan-06Feb-06Mar-06Apr-06May-06Jun-06Jul-06Aug-06Sep-06

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Interest rates…

The same argument of mean reversion has been made about interest rates. For instance, there are many economists who viewed the low interest rates in the United States in early 2000 to be an aberration and argued that interest rates would revert back to normal levels (about 6%, which was the average treasury bond rate from 1980-2000).

The evidence on mean reversion on interest rates is mixed. While there is some evidence that interest rates revert back to historical norms, the norms themselves change from period to period.

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Fundamentals

Fundamental Indicators• If short term rates are low, buy stocks…

• If long term rates are low, buy stocks…

• If economic growth is high, buy stocks… Intrinsic value models

• Value the market using a discounted cash flow model and compare to actual level.,

Relative value models• Look at how market is priced, given fundamentals and given history.

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The problem with fundamental indicators..

There are many indicators that market timers use in forecasting market movements. They can be generally categorized into:• Macro economic Indicators: Market timers have at various times claimed

that the best time to invest in stocks is when economic growth is picking up or slowing down…

• Interest rate Indicators: Both the level of rates and the slope of the yield curve have been used as predictors of future market movements. For instance, short term rates exceeding long term rates ( a downward sloping yield curve) has been considered anathema for stocks.

It is easy to show that markets are correlated with fundamental indicators but it is much more difficult to find leading indicators of market movements.

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GDP Growth and Stock Returns: US

GDP Growth Class Number of years Average Return Standard deviation in returns Best Year Worst Year>5% 23 10.84% 21.37% 46.74% -35.34%3.5%-5% 22 14.60% 16.63% 52.56% -11.85%2-3.5% 6 12.37% 13.95% 26.64% -8.81%0-2% 5 19.43% 23.29% 43.72% -10.46%<0% 16 9.94% 22.68% 49.98% -43.84%Grand Total 72 12.42% 19.50% 52.56% -43.84%

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An intrinsic value for the S&P 500: January 1, 2006

Level of the index = 1248.24 Dividends plus Stock buybacks in most recent year = 3.34% of index Expected growth rate in earnings/ cash flows - next 5 years = 8% Growth rate after year 5 = 4.39% (Set = T.Bond Rate) Risk free Rate = 4.39%; Risk Premium = 4%;

1 2 3 4 5Expected Dividends = 45.03$ 48.63$ 52.52$ 56.72$ 61.26$ Expected Terminal Value = 1,598.68$ Present Value = 41.54$ 41.39$ 41.24$ 41.09$ 1,109.55$ Intrinsic Value of Index = 1,274.82$

Intrinsic Value Estimate

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And for the Bovespa…

Level of the index on 10/11/06 = 38,322 Dividends on the index = 4.41% in last year Expected growth in earnings/ dividends in US $ terms = 10% Growth rate beyond year 5 = 4.70% (US treasury bond rate) Riskfree Rate = 4.70%; Risk Premium = 4% + 3% (Brazil) = 7%)

1 2 3 4 5Expected Dividends = 1,859.00$ 2,044.90$ 2,249.39$ 2,474.33$ 2,721.76$ Expected Terminal Value = 40,709.79$ Present Value = 1,664.28$ 1,638.95$ 1,614.01$ 1,589.44$ 24,976.95$ Intrinsic Value of Index = 31,483.63$

Intrinsic Value Estimate

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A short cut to intrinsic value: Earnings yield versus T.Bond Rates

EP Ratios and Interest Rates: S&P 500 - 1960-2005

-2.00%

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1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

Year

Earnings Yield

T.Bond Rate

Bond-Bill

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Regression Results

There is a strong positive relationship between E/P ratios and T.Bond rates, as evidenced by the correlation of 0.70 between the two variables.,

In addition, there is evidence that the term structure also affects the PE ratio.

In the following regression, using 1960-2005 data, we regress E/P ratios against the level of T.Bond rates and a term structure variable (T.Bond - T.Bill rate)E/P = 2.10% + 0.744 T.Bond Rate - 0.327 (T.Bond Rate-T.Bill Rate)

(2.44) (6.64) (-1.34)

R squared = 51.35%

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How well does market timing work?1. Mutual Funds

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2. Tactical Asset Allocation Funds

Performance of Unsophisticated Strategies versus Asset

Allocation Funds

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18.00%

S & P 500 Couch Potato 50/50 Couch Potato 75/25 Asset Allocation

Type of Fund

Last 10 years

Last 15 years

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3. Market Strategists provide timing advice…

Firm Strategist Stocks Bonds CashA.G. Edwards Mark Keller 65% 20% 15%Banc of America Tom McManus 55% 40% 5%Bear Stearns & Co. Liz MacKay 65% 30% 5%CIBC World Markets Subodh Kumar 75% 20% 2%Credit Suisse Tom Galvin 70% 20% 10%Goldman Sach & Co. Abby Joseph Cohen 75% 22% 0%J.P. Morgan Douglas Cliggott 50% 25% 25%Legg Mason Richard Cripps 60% 40% 0%Lehman Brothers Jeffrey Applegate 80% 10% 10%Merrill Lynch & Co. Richard Bernstein 50% 30% 20%Morgan Stanley Steve Galbraith 70% 25% 5%Prudential Edward Yardeni 70% 30% 0%Raymond James Jeffrey Saut 65% 15% 10%Salomon Smith John Manley 75% 20% 5%UBS Warburg Edward Kerschner 80% 20% 0%Wachovia Rod Smyth 75% 15% 0%

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But would your pay for it?

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IV. Timing other markets

It is not just the equity and bond markets that investors try to time. In fact, it can be argued that there are more market timers in the currency and commodity markets.

The keys to understanding the currency and commodity markets are• These markets have far fewer investors and they tend to be bigger.

• Currency and commodity markets are not as deep as equity markets As a consequence,

• Price changes in these markets tend to be correlated over time and momentum can have a bigger impact

• When corrections hit, they tend to be large since investors suffer from lemmingitis. Resulting in

• Timing strategies that look successful and low risk for extended periods

• But collapse in a crisis…

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Summing Up on Market Timing

A successful market timer will earn far higher returns than a successful security selector.

Everyone wants to be a good market timer. Consequently, becoming a good market timer is not only difficult to

do, it is even more difficult to sustain.

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To be a successful market timer

Understand the determinants of markets Be aware of shifts in fundamentals

Since you are basing your analysis by looking at the past, you are assuming that there has not been a significant shift in the underlying relationship. As Wall Street would put it, paradigm shifts wreak havoc on these models.

Even if you assume that the past is prologue and that there will be reversion back to historic norms, you do not control this part of the process..

And respect the market You can believe the market is wrong but you ignore it at your own peril.

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Security Selection

Security selection refers to the process by which assets are picked within each asset class, once the proportions for each asset class have been defined.

Broadly speaking, there are three different approaches to security selection.• The first to focus on fundamentals and decide whether a stock is under or

overvalued relative to these fundamentals.

• The second is to focus on charts and technical indicators to decide whether a stock is on the verge o changing direction.

• The third is to trade ahead of or on information releases that will affect the value of the firm.

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Active investors come in all forms...

Fundamental investors can bevalue investors, who buy low PE or low PBV stocks which trade at less than

the value of assets in placegrowth investors, who buy high PE and high PBV stocks which trade at less

than the value of future growth Technical investors can be

momentum investors, who buy on strength and sell on weaknessreversal investors, who do the exact opposite

Information traders can believethat markets learn slowly and buy on good news and sell on bad newsthat markets overreact and do the exact opposite

They cannot all be right in the same period and no one approach can be right in all periods.

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The Many Faces of Value Investing…

Intrinsic Value Investors: These investors try to estimate the intrinsic value of companies (using discounted cash flow models) and act on their findings.

Relative Value Investors: Following in the Ben Graham tradition, these investors use multiples and fundamentals to identify companies that look cheap on a relative value basis.

Contrarian Investors: These are investors who invest in companies that others have given up on, either because they have done badly in the past or because their future prospects look bleak.

Activist Value Investors: These are investors who invest in poorly managed and poorly run firms but then try to change the way the companies are run.

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I. Intrinsic Value Investors: The determinants of intrinsic value

Cash flowsFirm: Pre-debt cash flowEquity: After debt cash flows

Expected GrowthFirm: Growth in Operating EarningsEquity: Growth in Net Income/EPS

CF1CF2CF3CF4CF5ForeverFirm is in stable growth:Grows at constant rateforever

Terminal ValueCFn.........Discount RateFirm:Cost of Capital

Equity: Cost of Equity

ValueFirm: Value of Firm

Equity: Value of Equity

DISCOUNTED CASHFLOW VALUATIONLength of Period of High Growth

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Cashflow to FirmEBIT (1-t)- (Cap Ex - Depr)- Change in WC= FCFF

Expected GrowthReinvestment Rate* Return on Capital

FCFF1FCFF2FCFF3FCFF4FCFF5ForeverFirm is in stable growth:Grows at constant rateforever

Terminal Value= FCFF n+1/(r-gn)FCFFn.........Cost of EquityCost of Debt(Riskfree Rate+ Default Spread) (1-t)

WeightsBased on Market ValueDiscount at WACC= Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity))Value of Operating Assets+ Cash & Non-op Assets= Value of Firm- Value of Debt= Value of Equity

Riskfree Rate :- No default risk- No reinvestment risk- In same currency andin same terms (real or nominal as cash flows

+Beta- Measures market riskXRisk Premium- Premium for averagerisk investment

Type of BusinessOperating LeverageFinancialLeverageBase EquityPremiumCountry RiskPremiumDISCOUNTED CASHFLOW VALUATION

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Current Cashflow to FirmEBIT(1-t) : $ 404- Nt CpX 23 - Chg WC 9= FCFF $ 372Reinvestment Rate = 32/404= 7.9%

Expected Growth in EBIT (1-t).2185*.2508=.05485.48%

Stable Growthg = 4.17%; Beta = 1.00;Country Premium= 5%Cost of capital = 8.76% ROC= 8.76%; Tax rate=34%Reinvestment Rate=g/ROC

=4.17/8.76= 47.62%

Terminal Value5= 288/(.0876-.0417) = 6272Cost of Equity10.52 %Cost of Debt(4.17%+1%+4%)(1-.34)= 6.05%

WeightsE = 84% D = 16%Discount at $ Cost of Capital (WACC) = 10.52% (.84) + 6.05% (0.16) = 9.81%Op. Assets $ 5,272+ Cash: 795- Debt 717- Minor. Int. 12=Equity 5,349-Options 28Value/Share $7.47

R$ 21.75

Riskfree Rate :$ Riskfree Rate= 4.17%+Beta 1.07XMature market premium 4 %

Unlevered Beta for Sectors: 0.95Firm’s D/ERatio: 19%Embraer: Status Quo ($) Reinvestment Rate 25.08%Return on Capital21.85%Term Yr 549 - 261= 288

Avg Reinvestment rate = 25.08%Year 1 2 3 4 5EBIT(1-t) 426 449 474 500 527 - Reinvestment 107 113 119 126 132 = FCFF 319 336 355 374 395

+ Lambda0.27XCountry Equity RiskPremium7.67%

Country Default Spread6.01%

XRel Equity Mkt Vol1.28On October 6, 2003Embraer Price = R$15.51$ Cashflows

Aswath Damodaran 58

To do intrinsic valuation right…

Check for consistency:• Are your cash flows and discount rates in the same currency?

• Are you computing cash flows to equity or the firm and are your discount rates computed consistently?

• Are your growth rate and reinvestment assumptions consistent? Focus on excess returns and competitive advantages; success breeds

competition. Recognize that as firms get larger, growth will get more difficult to

pull off. Remember that you don’t run the firm, if you are a passive investor.

So, do not be cavalier about moving to target debt ratios, higher margin businesses and better dividend policy.

Aswath Damodaran 59

To make money on intrinsic valuation…

You have to be able to value a company, given its fundamental risk, cash flow and growth characteristics, without being swayed too much by what the market mood may be about the company and the sector.

The market has to be making a mistake in pricing one or more of these fundamentals.

The market has to correct its mistake sooner or later for you to make money.

Proposition 1: For intrinsic valuation to work, you have to be willing to expend time and resources to understand the company you are valuing and to relate its value to its fundamentals.

Proposition 2: You need a long time horizon for intrinsic valuation to pay off.

Proposition 3: Your universe of investments has to be limited.

Aswath Damodaran 60

II. The Relative Value Investor

In relative value investing, you compare how stocks are priced to their fundamentals (using multiples) to find under and over valued stocks.

This approach to value investing can be traced back to Ben Graham and his screens to find undervalued stocks.

In recent years, these screens have been refined and extended and the availability of data and more powerful screening techniques has allowed us to expand these screens and back-test them.

Aswath Damodaran 61

Ben Graham’ Screens

1. PE of the stock has to be less than the inverse of the yield on AAA Corporate Bonds:

2. PE of the stock has to less than 40% of the average PE over the last 5 years.

3. Dividend Yield > Two-thirds of the AAA Corporate Bond Yield

4. Price < Two-thirds of Book Value

5. Price < Two-thirds of Net Current Assets

6. Debt-Equity Ratio (Book Value) has to be less than one.

7. Current Assets > Twice Current Liabilities

8. Debt < Twice Net Current Assets

9. Historical Growth in EPS (over last 10 years) > 7%

10. No more than two years of negative earnings over the previous ten years.

Aswath Damodaran 62

The Buffett Mystique

Aswath Damodaran 63

Buffett’s Tenets

Business Tenets: The business the company is in should be simple and understandable. The firm should have a consistent operating history, manifested in operating earnings that are

stable and predictable.The firm should be in a business with favorable long term prospects.

Management Tenets:The managers of the company should be candid. As evidenced by the way he treated his own

stockholders, Buffett put a premium on managers he trusted. The managers of the company should be leaders and not followers.

Financial Tenets: The company should have a high return on equity. Buffett used a modified version of what he

called owner earningsOwner Earnings = Net income + Depreciation & Amortization – Capital Expenditures

The company should have high and stable profit margins. Market Tenets:

Use conservative estimates of earnings and the riskless rate as the discount rate.• In keeping with his view of Mr. Market as capricious and moody, even valuable companies

can be bought at attractive prices when investors turn away from them.

Aswath Damodaran 64

Be like Buffett?

Markets have changed since Buffett started his first partnership. Even Warren Buffett would have difficulty replicating his success in today’s market, where information on companies is widely available and dozens of money managers claim to be looking for bargains in value stocks.

In recent years, Buffett has adopted a more activist investment style and has succeeded with it. To succeed with this style as an investor, though, you would need substantial resources and have the credibility that comes with investment success. There are few investors, even among successful money managers, who can claim this combination.

The third ingredient of Buffett’s success has been patience. As he has pointed out, he does not buy stocks for the short term but businesses for the long term. He has often been willing to hold stocks that he believes to be under valued through disappointing years. In those same years, he has faced no pressure from impatient investors, since stockholders in Berkshire Hathaway have such high regard for him.

Aswath Damodaran 65

Low Price/BV Ratios and Excess Returns

Lowest2

34

56

78

9Highest

1927-1960

1961-1990

1991-2001

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

PBV Class

Figure 8.2: PBV Classes and Returns - 1927-2001

1927-1960 1961-1990 1991-2001

Aswath Damodaran 66

The lowest price to book stocks…

Company Name Book Value of Equity Price to Book RatioCEMAR 426.89 0.23CEB 487.61 0.24SERGEN 102.82 0.28MELHOR SP 179.56 0.34ELETROBRAS 75714.89 0.37TELEBRAS SA 120.64 0.39AMAZONIA 1630.88 0.49SANEPAR-PREF 2132.52 0.52MERC BRASIL 472.76 0.55ALFA CONSORC 412.44 0.55CELG 1230.56 0.55ALFA HOLDING 369.11 0.56COTEMINAS 1704.83 0.60IENERGIA 307.09 0.61JOAO FORTES ENG 80.47 0.64MUNDIAL SA 105.02 0.64BRASMOTOR 842.56 0.72CACIQUE 188.49 0.75WLM IND COMERCIO 222.42 0.75

Aswath Damodaran 67

What drives price to book ratios?

Going back to a simple dividend discount model,

This formulation can be simplified even further by relating growth to the return on equity:

g = (1 - Payout ratio) * ROE Substituting back into the P/BV equation,

In short, a stock can have a low price to book ratio because it has a low return on equity, low growth or high risk.

€

P0 =DPS1

Cost of Equity − gn

€

P0

BV0

= PBV = ROE - gn

Cost of equity-gn

Aswath Damodaran 68

Low Price to Book & High Return on Equity

ROE

100806040200- 20

PBV

4

3

2

1

0

TMGC3

BFIT3

CSNA3

SGEN3

RGEG3

RNAR3

PQUN3

BNBR3

PTIP3

ROMI3

GRND3

IGBR3

FJTA3

FLCL3 EMBR3

ELUM3

ELEK3

DURA3

GEPA3

CPFE3

CSRN3

CPSL3

CSMG3

HGTX3

ENMA3

CGOS3

CEGR3

BRKM3

BBAS3

BRSR3

AMBV3

Aswath Damodaran 69

The Low PE Effect

Aswath Damodaran 70

The lowest PE stocks

Company name PE RatioCEMAR 0.27AMAZONIA 3.15CEMAT 3.89CIA HERING 3.96CEB 4.19GRADIENTE 4.30USIMINAS SA 4.37CELULOSE IRANI 4.44IPIRANGA DIS 4.87MONTEIRO ARANHA 5.00PETROFLEX 5.42ACESITA SA 5.42MET GERDAU SA 5.46COELBA 5.57COELBA-PREF A 5.57SERGEN 5.65TELEBRAS SA 5.75SANEPAR-PREF 5.77CELG 5.77BANESTES 5.98

Aswath Damodaran 71

The Determinants of PE

The price-earnings ratio for a high growth firm can also be related to fundamentals. In the special case of the two-stage dividend discount model, this relationship can be made explicit fairly simply:

• For a firm that does not pay what it can afford to in dividends, substitute FCFE/Earnings for the payout ratio.

Dividing both sides by the earnings per share:

P0 =

EPS0 * Payout Ratio *(1+ g)* 1−(1+ )g n

(1+ )r n

⎛ ⎝ ⎜ ⎞

⎠

r-g+

EPS0 * Payout Ration * (1+ )g n * (1+gn)(r-gn )(1+ )r n

P0

EPS0=

Payout Ratio * (1 + g) * 1−(1+g)n

(1+ r)n ⎛

⎝ ⎜ ⎞

⎠ ⎟

r -g+

Payout Ration * (1+g)n* (1 +gn )(r -gn)(1+ r)n

Aswath Damodaran 72

Mismatches…The name of the game…

A perfect under valued stock would have a • Low PE ratio

• High expected earnings per share growth

• Low risk

• High return on equity (and high dividends) In reality, we will have to make compromises on one or more of these

variables.

Aswath Damodaran 73

III. Contrarian Value Investing: Buying the Losers

The fundamental premise of contrarian value investing is that markets often over react to bad news and push prices down far lower than they should be.

A follow-up premise is that they markets eventually recognize their mistakes and correct for them.

There is some evidence to back this notion:• Studies that look at returns on markets over long time periods chronicle

that there is significant negative serial correlation in returns, I.e, good years are more likely to be followed by bad years and vice versa…

• Studies that focus on individual stocks find the same effect, with stocks that have done well more likely to do badly over the next period, and vice versa.

Aswath Damodaran 74

Excess Returns for Winner and Loser Portfolios

Aswath Damodaran 75

The Biggest Losers…

Company Name Return in last year Latest priceELEKEIROZ SA -40.348 0.83KEPLER WEBER SA -35.722 5.6GRADIENTE ELETRONICA SA -33.571 9.3CIA ENERGETICA DO MARANHAO -29.956 0.14TELEMIG CELULAR PARTICIPACOE -23.361 7.95BRASKEM SA -21.781 12.25BANCO SUDAMERIS BRASIL SA -21.264 0.81ITAUTEC SA - GRUPO ITAUTEC -18.115 36UNIAO DE INDS PETROQUIMICAS -15.819 2.05PORTOBELLO SA -13.966 1.53GPC PARTICIPACOES SA -11.702 0.83RENAR MACAS SA -8.219 0.7AES ELPA SA -5.844 14.5BRASIL TELECOM PART SA -1.799 27.85CIA TECIDOS NORTE DE MINAS -1.158 170

Aswath Damodaran 76

A variation on contrarian value investing…

If you accept the premise that markets become over-enamored with companies that are viewed as good and well managed companies and over-sold on companies that are viewed as poorly run with bad prospects, the former should be priced too high and the latter too low.

A particularly perverse value investing strategy is to pick badly managed, badly run companies as your investments and wait for the recovery.

Aswath Damodaran 77

Good Companies are not necessarily Good Investments…

Aswath Damodaran 78

Loser Portfolios and Time Horizon

Aswath Damodaran 79

IV. Activist Value Investing

An activist value investor having acquired a stake in an “undervalued” company which might also be “badly” managed then pushes the management to adopt those changes which will unlock this value. • If the value of the firm is less than its component parts:

– push for break up of the firm, spin offs, split offs etc.

• If the firm is being too conservative in its use of debt:– push for higher leverage and recapitalization

• If the firm is accumulating too much cash:– push for higher dividends, stock repurchases ..

• If the firm is being badly managed:– push for a change in management or to be acquired

• If there are gains from a merger or acquisition– push for the merger or acquisition, even if it is hostile

Aswath Damodaran 80

Revenues

* Operating Margin

= EBIT

- Tax Rate * EBIT

= EBIT (1-t)

+ Depreciation- Capital Expenditures- Chg in Working Capital= FCFF

Divest assets thathave negative EBITMore efficient operations and cost cuttting: Higher Margins

Reduce tax rate- moving income to lower tax locales- transfer pricing- risk management

Live off past over- investmentBetter inventory management and tighter credit policies

Increase Cash FlowsReinvestment Rate

* Return on Capital

= Expected Growth Rate

Reinvest more inprojectsDo acquisitionsIncrease operatingmarginsIncrease capital turnover ratioIncrease Expected GrowthFirm ValueIncrease length of growth periodBuild on existing competitive advantages

Create new competitive advantages

Reduce the cost of capitalCost of Equity * (Equity/Capital) + Pre-tax Cost of Debt (1- tax rate) * (Debt/Capital)

Make your product/service less discretionary

Reduce Operating leverage

Match your financing to your assets: Reduce your default risk and cost of debt

Reduce betaShift interest expenses to higher tax locales

Change financing mix to reduce cost of capital

Aswath Damodaran 81

Current Cashflow to FirmEBIT(1-t) : 163- Nt CpX 39 - Chg WC 4= FCFF 120Reinvestment Rate = 43/163

=26.46%


Stable Growthg = 3%; Beta = 1.00;Cost of capital = 6.76% ROC= 6.76%; Tax rate=35%Reinvestment Rate=44.37%

Terminal Value5= 104/(.0676-.03) = 2714Cost of Equity8.50%Cost of Debt(4.10%+2%)(1-.35)= 3.97%

WeightsE = 48.6% D = 51.4%Discount at Cost of Capital (WACC) = 8.50% (.486) + 3.97% (0.514) = 6.17%Op. Assets 2,472+ Cash: 330- Debt 1847=Equity 955-Options 0Value/Share $ 5.13

Riskfree Rate :Riskfree rate = 4.10%+Beta 1.10XRisk Premium4%Unlevered Beta for Sectors: 0.80Firm’s D/ERatio: 21.35%Mature riskpremium4%

Country Equity Prem0%

Blockbuster: Status Quo Reinvestment Rate 26.46%Return on Capital4.06%Term Yr184 82102

1 2 3 4 5EBIT (1-t) $165 $167 $169 $173 $178 - Reinvestment $44 $44 $51 $64 $79 FCFF $121 $123 $118 $109 $99

Aswath Damodaran 82

Current Cashflow to FirmEBIT(1-t) : 249- Nt CpX 39 - Chg WC 4= FCFF 206Reinvestment Rate = 43/249

=17.32%


Stable Growthg = 3%; Beta = 1.00;Cost of capital = 6.76% ROC= 6.76%; Tax rate=35%Reinvestment Rate=44.37%

Terminal Value5= 156/(.0676-.03) = 4145Cost of Equity8.50%Cost of Debt(4.10%+2%)(1-.35)= 3.97%

WeightsE = 48.6% D = 51.4%Discount at Cost of Capital (WACC) = 8.50% (.486) + 3.97% (0.514) = 6.17%Op. Assets 3,840+ Cash: 330- Debt 1847=Equity 2323-Options 0Value/Share $ 12.47

Riskfree Rate :Riskfree rate = 4.10%+Beta 1.10XRisk Premium4%Unlevered Beta for Sectors: 0.80Firm’s D/ERatio: 21.35%Mature riskpremium4%

Country Equity Prem0%

Blockbuster: Restructured Reinvestment Rate 17.32%Return on Capital6.20%Term Yr280124156

1 2 3 4 5EBIT (1-t) $252 $255 $258 $264 $272 - Reinvestment $44 $44 $59 $89 $121 FCFF $208 $211 $200 $176 $151

Aswath Damodaran 83

Determinants of Success at Activist Investing

1. Have lots of capital: Since this strategy requires that you be able to put pressure on incumbent management, you have to be able to take significant stakes in the companies.

2. Know your company well: Since this strategy is going to lead a smaller portfolio, you need to know much more about your companies than you would need to in a screening model.

3. Understand corporate finance: You have to know enough corporate finance to understand not only that the company is doing badly (which will be reflected in the stock price) but what it is doing badly.

4. Be persistent: Incumbent managers are unlikely to roll over and play dead just because you say so. They will fight (and fight dirty) to win. You have to be prepared to counter.

5. Do your homework: You have to form coalitions with other investors and to organize to create the change you are pushing for.

Aswath Damodaran 84

Growth Investing

Assets Liabilities

Assets in Place Debt

Equity

Fixed Claim on cash flows

Little or No role in management

Fixed Maturity

Tax Deductible

Residual Claim on cash flows

Significant Role in management

Perpetual Lives

Growth Assets

Existing Investments

Generate cashflows today

Includes long lived (fixed) and

short-lived(working

capital) assets

Expected Value that will be

created by future investments

Growth investors bet on growth assets: They believe that they can assess their value better than markets

Value investors focus assets in place

Aswath Damodaran 85

Is growth investing doomed?

Aswath Damodaran 86

But there is another side ..

Aswath Damodaran 87

Adding on …

Aswath Damodaran 88

Furthermore..

And active growth investors seem to beat growth indices more often than value investors beat value indices.

Aswath Damodaran 89

Growth Investing Strategies

Passive Growth Investing Strategies focus on investing in stocks that pass a specific screen. Classic passive growth screens include:• PE < Expected Growth Rate• Low PEG ratio stocks (PEG ratio = PE/Expected Growth)• Earnings Momentum Investing (Earnings Momentum: Increasing

earnings growth)• Earnings Revisions Investing (Earnings Revision: Earnings estimates

revised upwards by analysts)• Small Cap Investing

Active growth investing strategies involve taking larger positions and playing more of a role in your investments. Examples of such strategies would include:• Venture capital investing• Private Equity Investing

Aswath Damodaran 90

I. Passive Growth Strategies

Aswath Damodaran 91

II. Small Cap Investing

One of the most widely used passive growth strategies is the strategy of investing in small-cap companies. There is substantial empirical evidence backing this strategy, though it is debatable whether the additional returns earned by this strategy are really excess returns.

Studies have consistently found that smaller firms (in terms of market value of equity) earn higher returns than larger firms of equivalent risk, where risk is defined in terms of the market beta. In one of the earlier studies, returns for stocks in ten market value classes, for the period from 1927 to 1983, were presented.

Aswath Damodaran 92

The Small Firm Effect

Aswath Damodaran 93

A Note of caution…

Figure 9.7: Time Horizon and the Small Firm Premium

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

1 5 10 15 20 25 30 35 40

Time Horizon

0.00%

20.00%

40.00%

60.00%

80.00%

100.00%

120.00%

Large Cap

Small Cap

% of time small caps win

Aswath Damodaran 94

III. Activist Growth Investing..

Fund Type1 Yr

3 Yr 5 Yr 10 Yr 20 YrEarly/Seed Venture Capital -36.3 81 53.9 33 21.5Balanced Ven ture Capital -30.9 45.9 33.2 24 16.2Later Stage Venture Capital -25.9 27.8 22.2 24.5 17All Venture Capital -32.4 53.9 37.9 27.4 18.2All Buyouts -16.1 2.9 8.1 12.7 15.6Mezzanine 3.9 10 10.1 11.8 11.3All Private Equity -21.4 16.5 17.9 18.8 16.9

Aswath Damodaran 95

Are there great stock pickers?

Firm Latest qtr. One- year Five- yearCredit Suisse F.B. -3.60% 36.90% 253.10%Prudential Sec. -12.3 36.2 216.1U.S. Bancorp Piper J. -1.4 28.5 208.8Merrill Lynch -1.9 28.1 162.2Goldman Sachs 0 27.4 220.3Lehman Bros. -11.7 18.3 262.4J.P. Morgan Sec. 2.9 11.6 N.A.Bear Stearns -6.4 11.4 184.9A.G. Edwards -1.7 9.8 194.8Morgan Stanley D.W. -2.8 9.5 148.8Raymond James -0.4 6.9 164.4Edward Jones -0.5 4.8 204.3First Union Sec. -12.3 1.8 N.A.PaineWebber -13.2 -3.2 153.6Salomon S.B. -1.8 -17 101.7S&P 500 Index -2.70% 7.20% 190.80%

Aswath Damodaran 96

Information Trading

Information traders don’t bet on whether a stock is under or over valued. They make judgments on whether the price changes in response to information are appropriate.

There are two classes of information traders• Those that believe that markets learn slowly

• Those that believe that markets over react

Aswath Damodaran 97

Information and Prices in an Efficient Market

Time

New information is revealed

Asset price

Figure 10.1: Price Adjustment in an Efficient Market

Notice that the price

adjusts instantaneously

to the information

Aswath Damodaran 98

A Slow Learning Market…

Time


Asset price

Figure 10.2 A Slow Learning Market

The price drifts upwards after the

good news comes out.

Aswath Damodaran 99

An Overreacting Market

Time


Asset price

Figure 10.3: An Overreacting Market

The price increases too much on the

good news announcement, and then

decreases in the period after.

Aswath Damodaran 100

I. Earnings Reports


II. Acquisitions: Evidence on Target Firms


III. Analyst Recommendations…


To be a successful information trader…

Identify the information around which your strategy will be built: Since you have to trade on the announcement, it is critical that you determine in advance the information that will trigger a trade.

Invest in an information system that will deliver the information to you instantaneous : Many individual investors receive information with a time lag – 15 to 20 minutes after it reaches the trading floor and institutional investors. While this may not seem like a lot of time, the biggest price changes after information announcements occur during these periods.

Execute quickly: Getting an earnings report or an acquisition announcement in real time is of little use if it takes you 20 minutes to trade. Immediate execution of trades is essential to succeeding with this strategy.

Keep a tight lid on transactions costs: Speedy execution of trades usually goes with higher transactions costs, but these transactions costs can very easily wipe out any potential you may see for excess returns).

Know when to sell: Almost as critical as knowing when to buy is knowing when to sell, since the price effects of news releases may begin to fade or even reverse after a while.












Trading and Execution Costs

The cost of trading includes four components: the brokerage cost, which tends to decrease as the size of the trade increases

the bid-ask spread, which generally does not vary with the size of the trade but is higher for less liquid stocks

the price impact, which generally increases as the size of the trade increases and as the stock becomes less liquid.

the cost of waiting, which is difficult to measure since it shows up as trades not made.


The Magnitude of the Spread


Round-Trip Costs (including Price Impact) as a Function of Market Cap and Trade Size

Dollar Value of Block ($ thoustands)

Sector 5 25 250 500 1000 2500 5000 10000 20000

Smallest 17.30% 27.30% 43.80%

2 8.90% 12.00% 23.80% 33.40%

3 5.00% 7.60% 18.80% 25.90% 30.00%

4 4.30% 5.80% 9.60% 16.90% 25.40% 31.50%

5 2.80% 3.90% 5.90% 8.10% 11.50% 15.70% 25.70%

6 1.80% 2.10% 3.20% 4.40% 5.60% 7.90% 11.00% 16.20%

7 1.90% 2.00% 3.10% 4.00% 5.60% 7.70% 10.40% 14.30% 20.00%

8 1.90% 1.90% 2.70% 3.30% 4.60% 6.20% 8.90% 13.60% 18.10%

Largest 1.10% 1.20% 1.30% 1.71% 2.10% 2.80% 4.10% 5.90% 8.00%


The Overall Cost of Trading: Small Cap versus Large Cap Stocks

MarketCapitalization Implicit Cost Explicit Cost

Total TradingCosts (NYSE)

Total TradingCosts (NASDAQ)

Smallest 2.71% 1.09% 3.80% 5.76%2 1.62% 0.71% 2.33% 3.25%3 1.13% 0.54% 1.67% 2.10%4 0.69% 0.40% 1.09% 1.36%

Largest 0.28% 0.28% 0.31% 0.40%


Many a slip…


Trading Costs and Performance...

-6.00%

-4.00%

-2.00%

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

1 (Lowest) 2 3 4 5 (Highest)

Total Cost Category

Figure 13.16: Trading Costs and Returns: Mutual Funds

Total Return Excess Return


The Trade Off on Trading

There are two components to trading and execution - the cost of execution (trading) and the speed of execution.

Generally speaking, the tradeoff is between faster execution and lower costs. For some active strategies (especially those based on information) speed is of

the essence.Maximize: Speed of Execution

Subject to: Cost of execution < Excess returns from strategy For other active strategies (such as those based on long term investing) the

cost might be of the essence.Minimize: Cost of Execution

Subject to: Speed of execution < Specified time period. The larger the fund, the more significant this trading cost/speed tradeoff

becomes.


Arbitrage Investment Strategies

An arbitrage-based investment strategy is based upon buying an asset (at a market price) and selling an equivalent or the same asset at a higher price.

A true arbitrage-based strategy is riskfree and hence can be financed entirely with debt. Thus, it is a strategy where an investor can invest no money, take no risk and end up with a pure profit.

Most real-world arbitrage strategies (such as those adopted by hedge funds) have some residual risk and require some investment.


a. Pure Arbitrage Strategies

Mispriced Options when the underlying stock is traded• Since you can replicate a call or a put option using the underlying asset

and borrowing/lending, you can create riskfree positions where you buy (sell) the option and sell (buy) the replicating portfolio.

• This position should be riskless and costless and create guaranteed profits. Mis-priced Futures Contracts

• Riskless positions can be created using the underlying asset and borrowing and lending (as long as the asset can be stored)

• Futures on currencies and storable commodities have to obey this arbitrage relationship.

Mispriced Default-free Bonds• The cash flows on a default free bond are known with certainty.• When default-free bonds are priced inconsistently, we should be able to

combined them to create riskfree arbitrage.


b. Close to Arbitrage

Corporate Bonds• Corporate bonds of similar default risk should be priced consistently.• “Similar” default risk may not be the same as identical default risk, and

this can create a residue of risk.• This risk will increase as default risk increases

Securities issued by same firm• Debt and equity issued by the same firm should be priced consistently.• If they are mispriced relative to each other, you can buy the cheaper one

and sell the more expensive one.• The valuation is subjective and can be wrong, giving rise to risk.

Options issued by firm• If a company has convertible bonds, warrants and listed options

outstanding, they have to be priced consistently with each other and with the underlying securities.


c. Pseudo Arbitrage

Quasi arbitrage is not really arbitrage since it is not even close to riskless. You try to take advantage of what you see as mispricing between two securities that you believe should maintain a consistent pricing relationship.

Examples include• Locally listed stock and an ADR, where there are constraints on buying

the local listing and converting the ADR into local shares.

• Paired stocks (example GM and Ford) that have been around a long time and have an established historical relationship.

• Listings of the same stock in multiple markets, though there are differences between the listings and restrictions on conversion/trading.


Hedge Funds: What do they bring to the market?

At the heart of all arbitrage based strategies is the capacity to go long and short and the use of leverage.

If there is a common component to hedge funds, it is their capacity to do both of these whereas conventional mutual funds are restricted on both counts.

Proposition 1: In down or flat markets, hedge funds will always look good relative to conventional mutual funds because of their capacity to short stocks and other assets.

Proposition 2: The use of leverage will exaggerate the strengths and weaknesses of investors. A good hedge fund will look better than a good mutual fund and a bad hedge fund will look worse.

Proposition 3: If the average hedge fund manager is not smarter or dumber than an average mutual fund manager, history suggests that the freedom they have been granted will hurt more than help.


The Performance of Hedge Funds

Year No offunds insample

ArithmeticAverageReturn

MedianReturn

Return onS&P 500

AverageAnnual Fee(as % ofmoney undermanagement)

AverageIncentiveFee (as %of excessreturns)

1988-89 78 18.08% 20.30% 1.74% 19.76%1989-90 108 4.36% 3.80% 1.65% 19.52%1990-91 142 17.13% 15.90% 1.79% 19.55%1991-92 176 11.98% 10.70% 1.81% 19.34%1992-93 265 24.59% 22.15% 1.62% 19.10%1993-94 313 -1.60% -2.00% 1.64% 18.75%1994-95 399 18.32% 14.70% 1.55% 18.50%EntirePeriod

13.26% 16.47%%


Looking a little closer at the numbers…

The average hedge fund earned a lower return (13.26%) over the period than the S&P 500 (16.47%), but it also had a lower standard deviation in returns (9.07%) than the S & P 500 (16.32%). Thus, it seems to offer a better payoff to risk, if you divide the average return by the standard deviation – this is the commonly used Sharpe ratio for evaluating money managers.

These funds are much more expensive than traditional mutual funds, with much higher annual fess and annual incentive fees that take away one out of every five dollars of excess returns.


Returns by sub-category












Performance Evaluation: Time to pay the piper!

Who should measure performance?• Performance measurement has to be done either by the client or by an objective

third party on the basis of agreed upon criteria. It should not be done by the portfolio manager.

How often should performance be measured?• The frequency of portfolio evaluation should be a function of both the time horizon

of the client and the investment philosophy of the portfolio manager. However, portfolio measurement and reporting of value to clients should be done on a frequent basis.

How should performance be measured?Against a market index (with no risk adjustment)Against other portfolio managers, with similar objective functionsAgainst a risk-adjusted return, which reflects both the risk of the portfolio and market

performance.Based upon Tracking Error against a benchmark index


I. Against a Market Index

0%

10%

20%

30%

40%

50%

60%

70%

80%

Year

Figure 13.5: Percent of Money Managers who beat the S&P 500


II. Against Other Portfolio Managers

In some cases, portfolio managers are measured against other portfolio managers who have similar objective functions. Thus, a growth fund manager may be measured against all growth fund managers.

The implicit assumption in this approach is that portfolio managers with the same objective function have the same exposure to risk.


Value and Growth Funds…

Figure 13.7: Returns on Growth and Value Funds

-30.00%

-20.00%

-10.00%

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

1987 1988 1989 1990 1991 1992 1993 1987 - 1993

Year

Growth Funds Growth index Value funds Value Index


III. Risk-Adjusted Returns

The fairest way of measuring performance is to compare the actual returns earned by a portfolio against an expected return, based upon the risk of the portfolio and the performance of the market during the period.

All risk and return models in finance take the following form:

Expected return = Riskfree Rate + Risk PremiumRisk Premium: Increasing function of the risk of the portfolio

The actual returns are compared to the expected returns to arrive at a measure of risk-adjusted performance:

Excess Return = Actual Return - Expected Returns The limitation of this approach is that there are no perfect (or even good risk

and return models). Thus, the excess return on a portfolio may be a real excess return or just the result of a poorly specified model.


The Performance of Mutual Funds..

Figure 13.3: Mutual Fund Performance: 1955-64 - The Jensen Study

-0.08 -0.07 -0.06 -0.05 -0.04 -0.03 -0.02 -0.01 0 0.01 0.02 0.03 0.04 0.05 0.06

Intercept (Actual Return - E(R))


IV. Tracking Error as a Measure of Risk

Tracking error measures the difference between a portfolio’s return and its benchmark index. Thus portfolios that deliver higher returns than the benchmark but have higher tracking error are considered riskier.

Tracking error is a way of ensuring that a portfolio stays within the same risk level as the benchmark index.

It is also a way in which the “active” in active money management can be constrained.


Enhanced Index Funds… Oxymoron?


So, why is it so difficult to win at this game?

Is it a loser’s game?• To win at a game, you need a ready supply of losers

• Unfortunately, losers leave the game early and you end up playing with other winners.

• As markets develop and become deeper, this tendency is exaggerated. What is your investing edge?

• Getting an edge in investing is tough to do and even tougher to sustain.

• Success at investing breeds imitation which makes future success more difficult.

Proposition 1: If you don’t bring anything to the table, don’t expect to take anything away in the long term.


What makes you special?

Institutional claims We are bigger We are bigger : Size is relative. You may be big but someone is always

bigger. Even if you are the biggest investor, it is difficult to see what that gets you unless you are big enough to move the market.

Our computers are more powerful: Really? Our analysts are smarter: If they are, they will move elsewhere and claim the

rents. We have better traders: See “Our analysts are smarter” and double it. Our information is better: What do you plan to do in jail?Individual claims We can wait longer: Patience is rare and there is a payoff. Our tax structure is different: Tax avoidance versus tax evasion? We don’t bow to peer pressure: Contrarian to the core?


Finding an Investment PhilosophyMomentum Contrarian Opportunisitic

Short term (days toa few weeks)

• Technical momentumindicators – Buy stocks basedupon trend lines and hightrading volume.

• Information trading: Buyingafter positive news (earningsand dividend announcements,acquisition announcements)

• Technical contrarianindicators – mutual fundholdings, short interest.These can be forindividual stocks or foroverall market.

• Pure arbitrage inderivatives and fixedincome markets.

• Tehnical demandindicators – Patterns inprices such as head andshoulders.

Medium term (fewmonths to a coupleof years)

• Relative strength: Buy stocksthat have gone up in the lastfew months.

• Information trading: Buy smallcap stocks with substantialinsider buying.

• Market timing, basedupon normal PE ornormal range of interestrates.

• Information trading:Buying after bad news(buying a week afterbad earnings reportsand holding for a fewmonths)

• Near arbitrageopportunities: Buyingdiscounted closed endfunds

• Speculative arbitrageopportunities: Buyingpaired stocks andmerger arbitrage.

Long Term (severalyears)

• Passive growth investing:Buying stocks where growthtrades at a reasonable price(PEG ratios).

• Passive value investing:Buy stocks with lowPE, PBV or PS ratios.

• Contrarian valueinvesting: Buying losersor stocks with lots ofbad news.

• Active growthinvesting: Take stakesin small, growthcompanies (privateequity and venturecapital investing)

• Activist value investing:Buy stocks in poorlymanaged companiesand push for change.


The Right Investment Philosophy

Single Best Strategy: You can choose the one strategy that best suits you. Thus, if you are a long-term investor who believes that markets overreact, you may adopt a passive value investing strategy.

Combination of strategies: You can adopt a combination of strategies to maximize your returns. In creating this combined strategy, you should keep in mind the following caveats:• You should not mix strategies that make contradictory assumptions about

market behavior over the same periods. Thus, a strategy of buying on relative strength would not be compatible with a strategy of buying stocks after very negative earnings announcements. The first strategy is based upon the assumption that markets learn slowly whereas the latter is conditioned on market overreaction.

• When you mix strategies, you should separate the dominant strategy from the secondary strategies. Thus, if you have to make choices in terms of investments, you know which strategy will dominate.


In closing…

Choosing an investment philosophy is at the heart of successful investing. To make the choice, though, you need to look within before you look outside. The best strategy for you is one that matches both your personality and your needs.

Your choice of philosophy will also be affected by what you believe about markets and investors and how they work (or do not). Since your beliefs are likely to be affected by your experiences, they will evolve over time and your investment strategies have to follow suit.


If you walk like a lemming, run like a lemming… you are a lemming

Documents

Aswath Damodaran1 Investment Philosophy: The Secret Ingredient in Investment Success Aswath Damodaran