Investment Philosophies: An Overview

Investment Philosophies: An Overview

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

Aswath Damodaran 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) Aswath Damodaran 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. Aswath Damodaran The Investment Process Investment The

Risk Security Valuation -Private Execution Asset Real Bonds Stocks Non-Domestic Domestic Countries: Performance 1. Market Stock Utility Tax Views Trading Which How How Status Code Client Portfolio Tolerance/ and Models Assets Allocation Classes: often on Efficiency much Systems

stocks? Selection Return Horizon dorisk Evaluation Managers you Which did trade? the bonds? portfolio Job Which manager real assets? take? Aversion based Information Costs Speed markets 2. Timing Selection -Functions The Measuring Can inflation How What CAPM you large does

onreturn beat trading are risk did your thetrades? portfolio manager make? the 3. -affect The Effects Cash Do Commissions rates Did market? you APM prices? the flows of use portfolio derivatives manager to manage underperform or enhance or outperform? risk? -diversification Comparables Bid

growth Ask Spread - Technicals Price Impact Aswath Damodaran 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 investors risk preferences The investors time horizon The investors tax status If you are your own client (i.e, you are investing your own money), know yourself. Aswath Damodaran 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 Aswath Damodaran

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). Aswath Damodaran Risk and Return Models in Finance Riskless Low High Risk E(R) The Multi-Factor Proxy If Beta Since Betas

In Equation Step there anAPM risk CAPM Risk that Risk of 1: 2: 3: efficient market of Models is are asset Defining Differentiating Measuring asset assets Investment in is relating Investment Investment no specific anModels risk relative market,

relative investment relative Risk affects to Market to investment between can Riskbe Rewarded (Firm measured Specific) and by Unrewarded the variance Risk that Risk in actual affectsreturns all investments around an (Market Risk) expected Can 1. arbitrage Market most to differences returns nobe unspecified specified

or private portfolio to diversified allopportunities return proxy investments, in macro information returns market (from away in a diversified portfolio Cannot be diversified away since most assets 1.must 2. then a itfactors economic across variables regression) each no the transactions long come (from investment market (from factors periods

afrom factor arisk (from cost ismust ofa small proportion of portfolio are affected by it. 2.regression) the any analysis) macro a be regression) risk due optimal asset averages economic to market must diversified be out factors. riskacross investments in portfolio The marginal portfolio captured Market differences. Risk includes by Looking betas

= investor Risk every for is assumed to hold a diversified portfolio. Thus, only market risk will be rewarded traded relative exposures variables asset. tocorrelated factors ofEveryone and anythat priced. with will hold affect asset returns all toshould this investments. macro market then give portfolio Market economic us proxies Risk for factors. =this Risk

risk. added by exposures Market Risk any of=any investment to the to asset Captured market market by the portfolio: factorsVariable(s) Proxy Aswath Damodaran 1 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. Aswath Damodaran 1 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) Dont know If you were a portfolio manager, would your answer be different? Aswath Damodaran 1 Investor Time Horizon An investors 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 investors 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) Aswath Damodaran 1 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:

Aswath Damodaran 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 1 Dividends versus Capital Gains Tax Rates for Individuals: United States Aswath Damodaran 1 The Tax Effect: Stock Returns before and after taxes.. With one year time horizons Aswath Damodaran 1 The Tax Effect and Dividend Yields Aswath Damodaran 1 Mutual Fund Returns: The Tax Effect Figure 5.10: Pre-tax and After-tax Returns at U.S. equity mutual funds- 1999-2 16.00% 14.00% 12.00% 10.00% 8.00% Pre-tax Return

After-tax Return 6.00% 4.00% 2.00% 0.00% Aswath Damodaran Large Large Large MidcapMidcapMidcapSmall Small Small Value Blend GrowthValue Blend GrowthValue Blend Growth Fund Style 1 Tax Effect and Turnover Ratios Aswath Damodaran 1 The Investment Process Investment The Risk Security Valuation -Private Execution Asset Real Bonds Stocks Non-Domestic Domestic Countries: Performance

1. Market Stock Utility Tax Views Trading Which How How Status Code Client Portfolio Tolerance/ and Models Assets Allocation Classes: often on Efficiency much Systems stocks? Selection Return Horizon dorisk Evaluation Managers you Which did trade? the bonds?

portfolio Job Which manager real assets? take? Aversion based Information Costs Speed markets 2. Timing Selection -Functions The Measuring Can inflation How What CAPM you large does onreturn beat trading are risk did your thetrades? portfolio manager make? the 3. -affect The

Effects Cash Do Commissions rates Did market? you APM prices? the flows of use portfolio derivatives manager to manage underperform or enhance or outperform? risk? -diversification Comparables Bid growth Ask Spread - Technicals Price Impact Aswath Damodaran 2 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. Aswath Damodaran 2 I. Passive Asset Allocation In passive asset allocation, the proportions of the various asset classes held in an investors 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. Aswath Damodaran

2 A. Efficient (Markowitz) Portfolios Return Maximization Maximize Expected Return i = Risk Minimization Minimize return variance n i E ( R ) = w p E ( R

= = 1 p = n j = i w = 1 j w i = j

ij 1 = n subject to where, = Investor's desired level of variance E(R) = Investor's desired expected returns w w i j ij E (

R p i Aswath Damodaran n 2 = p = n 2 j i i n 2 i

i = ) i = 1 j = ) = w E i ( R ) = E

( R ) i 1 i = 1 2 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. Aswath Damodaran 2 II. Just Diversify

QuickTime and a TIFF (Uncompressed) decompressor are needed to see this picture. Aswath Damodaran 2 The Optimally Diversified Portfolio Global Investable Capital: 1998 Venture Capital Emerging Markets US Real Estate 3% 4% US Equity 22% Cash Equivalents 5% International Bonds 26% International Equity 20% US Bonds 19% Aswath Damodaran 2 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. Aswath Damodaran 2 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. Aswath Damodaran 2 Market Timing Approaches Non-financial indicators Technical 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) 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. Aswath Damodaran 2 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. Aswath Damodaran 3 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 Priors After two down years After one down year After one up year After two up years Aswath Damodaran Number of occurrences 19 30 30 51 % of positive returns Average return 57.90% 2.95% 60.00% 7.76% 83.33% 10.92% 50.98% 2.79% 3 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 Traders 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 years 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. Aswath Damodaran 3 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. Aswath Damodaran 3 A Normal Range for PE Ratios: S&P 500 Aswath Damodaran 3 PE Ratios in Brazil Bovespa: PE Ratio 18 16 14 12 10 8 6 4 2 0 Aswath Damodaran

Jan-04 Feb-04 Mar-04 Apr-04 May-04 Jun-04 Jul-04 Aug-04 Sep-04 Oct-04 Nov-04 Dec-04 Jan-05 Feb-05 Mar-05 Apr-05 May-05 Jun-05 Jul-05 Aug-05 Sep-05 Oct-05 Nov-05 Dec-05 Jan-06 Feb-06 Mar-06 Apr-06 May-06 Jun-06 Jul-06 Aug-06 Sep-06 3 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. Aswath Damodaran 3 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. Aswath Damodaran

3 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. Aswath Damodaran 3 GDP Growth and Stock Returns: US GDP Growth Class >5% 3.5%-5% 2-3.5% 0-2% <0% Grand Total Aswath Damodaran Number of years Average Return 23

10.84% 22 14.60% 6 12.37% 5 19.43% 16 9.94% 72 12.42% Standard deviation in returns 21.37% 16.63% 13.95% 23.29% 22.68% 19.50% Best Year Worst Year 46.74% -35.34% 52.56% -11.85% 26.64% -8.81% 43.72% -10.46% 49.98% -43.84% 52.56% -43.84% 3 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%; Intrinsic Value Estimate Expected Dividends = Expected Terminal Value = Present Value = Intrinsic Value of Index = Aswath Damodaran $ $ $ 1 45.03 $ 41.54 1,274.82 $ 2 48.63 $ 3 52.52 $ 41.39 41.24 $

$ 4 56.72 $ $ 41.09 $ 5 61.26 1,598.68 1,109.55 4 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%) Intrinsic Value Estimate Expected Dividends = Expected Terminal Value = Present Value = Intrinsic Value of Index = Aswath Damodaran $ $ $

1 1,859.00 $ 1,664.28 31,483.63 $ 2 2,044.90 $ 3 2,249.39 $ 1,638.95 1,614.01 $ $ 4 2,474.33 $ $ 1,589.44 $ 5 2,721.76 40,709.79 24,976.95 4 A short cut to intrinsic value: Earnings yield versus T.Bond Rates EP Ratios and Interest Rates: S&P 500 - 1960-2005 16.00%

14.00% 12.00% 10.00% 8.00% Earnings Yield T.Bond Rate Bond-Bill 6.00% 4.00% 2.00% 0.00% 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 -2.00% Year Aswath Damodaran 4 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% Aswath Damodaran 4 How well does market timing work? 1. Mutual Funds Aswath Damodaran 4 2. Tactical Asset Allocation Funds Performance of Unsophisticated Strategies versus Asset Allocation Funds 18.00% 16.00% 14.00% 12.00% Last 10 years 10.00%

Last 15 years 8.00% 6.00% 4.00% 2.00% 0.00% S & P 500 Couch Potato 50/50 Couch Potato 75/25 Asset Allocation Type of Fund Aswath Damodaran 4 3. Market Strategists provide timing advice Firm A.G. Edwards Banc of America Bear Stearns & Co. CIBC World Markets Credit Suisse Goldman Sach & Co. J.P. Morgan Legg Mason Lehman Brothers

Merrill Lynch & Co. Morgan Stanley Prudential Raymond James Salomon Smith UBS Warburg Wachovia Aswath Damodaran Strategist Mark Keller Tom McManus Liz MacKay Subodh Kumar Tom Galvin Abby Joseph Cohen Douglas Cliggott Richard Cripps Jeffrey Applegate Richard Bernstein Steve Galbraith Edward Yardeni Jeffrey Saut John Manley Edward Kerschner Rod Smyth Stocks Bonds Cash 65% 20% 15% 55% 40% 5% 65% 30% 5% 75% 20%

2% 70% 20% 10% 75% 22% 0% 50% 25% 25% 60% 40% 0% 80% 10% 10% 50% 30% 20% 70% 25% 5% 70% 30% 0% 65% 15% 10% 75% 20% 5% 80% 20% 0% 75% 15% 0% 4 But would your pay for it? Aswath Damodaran

4 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 As a consequence, These markets have far fewer investors and they tend to be bigger. Currency and commodity markets are not as deep as equity markets 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 Aswath Damodaran Timing strategies that look successful and low risk for extended periods But collapse in a crisis

4 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. Aswath Damodaran 4 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. Aswath Damodaran

5 The Investment Process Investment The Risk Security Valuation -Private Execution Asset Real Bonds Stocks Non-Domestic Domestic Countries: Performance 1. Market Stock Utility Tax Views Trading Which How How Status Code Client Portfolio Tolerance/ and Models Assets

Allocation Classes: often on Efficiency much Systems stocks? Selection Return Horizon dorisk Evaluation Managers you Which did trade? the bonds? portfolio Job Which manager real assets? take? Aversion based Information Costs Speed markets 2. Timing Selection -Functions The Measuring Can

inflation How What CAPM you large does onreturn beat trading are risk did your thetrades? portfolio manager make? the 3. -affect The Effects Cash Do Commissions rates Did market? you APM prices? the flows of use portfolio derivatives manager to manage

underperform or enhance or outperform? risk? -diversification Comparables Bid growth Ask Spread - Technicals Price Impact Aswath Damodaran 5 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. Aswath Damodaran 5

Active investors come in all forms... Fundamental investors can be value investors, who buy low PE or low PBV stocks which trade at less than the value of assets in place growth 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 weakness reversal investors, who do the exact opposite Information traders can believe that markets learn slowly and buy on good news and sell on bad news that 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. Aswath Damodaran 5 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. Aswath Damodaran 5 I. Intrinsic Value Investors: The determinants of intrinsic value Length Cash Expected Firm Forever Terminal CF Discount ......... Value inof Value stable Rate Growth Period growth:

of High Growth 1 isflows 2 3 4 5 n DISCOUNTED CASHFLOW GrowsValue Firm:Cost Firm: Pre-debt Growth at constant ofofCapital inFirm cashrate flow Operating forever Earnings Equity: After Growth Cost Value debt ofofEquity inEquity cashIncome/EPS Net flows Aswath Damodaran VALUATION

5 Country Cashflow Expected Firm Forever Terminal FCFF ......... Cost Weights Discount Value Riskfree Beta R X Type Operating Financial Base of of Equity ofinDebt Equity Risk Operating Value= at Rate stable to Growth WACC= Firm :growth:

FCFF Assets Cost of /(r-g Equity + Equity)) + Cost of Debt (Debt/(Debt+ Equity)) 1 2 3 4 5 n n+1 n) (Equity/(Debt +isk isPremium DISCOUNTED CASHFLOW VALUATION EBIT Reinvestment Grows (Riskfree Based -+ Business Leverage Premium No Measures Premium Cash default (1-t) on at & constant Rate

Non-op Market for market risk average Rate Value Assets rate risk * No forever + -= risk (Cap Return Default Value investment reinvestment Ex of on Spread) -Firm Depr) Capital(1-t) risk - In Change Value same of in currency Debt WC and

= Value in FCFF same of terms Equity (real or nominal as cash flows Aswath Damodaran 5 $ Current Expected Stable Terminal Cost Weights Discount Op. Riskfree Beta M Unlevered Firms Reinvestment Return Term Avg Year Lambda + C Country R X

On 1.28 ountry el ature Cashflows October Equity Assets Reinvestment Yr ofD/E Growth on market Equity Debt Equity Default Cashflow Value at Rate Capital Growth Beta $$6,Cost 5,272 Rate :2003 Risk =for 288/(.0876-.0417) ofto 1Capital Firm (WACC) 2 ==6272

10.52% 3 (.84) + 6.05%4(0.16) = 9.81% 5 5 + Embraer: Status Quo ($) in g 10.52 (4.17%+1%+4%)(1-.34) E + $ 1.07 premium Sectors: Ratio: 21.85% rate EBIT(1-t) 0.27 Premium Spread Mkt Embraer 25.08% = Riskfree Cash: =549 EBIT 4.17%; 84% Vol =%

25.08% 19% (1-t) 0.95 D Price : Rate= =Beta 16% = 795 R$15.51 = 4.17% 1.00; 426 $ 404 449 474 500 527 .2185*.2508=.0548 Country -= 4 7.67% 6.01% --Debt Nt % 6.05% Reinvestment 261 CpXPremium= 717 5% 10723 113 119

126 132 5.48 -Cost = =Minor. Chg FCFF 288 % ofWC capital Int. = 8.76% 12319 9 336 355 374 395 = FCFF8.76%; Tax ROC= =Equity 5,349 rate=34% $ 372 Reinvestment Rate=g/ROC -Options Rate28 = 32/404= 7.9% Value/Share =4.17/8.76= $7.47 47.62% R$ 21.75 Aswath Damodaran 5

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 dont 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 5 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 5 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 6 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 6 The Buffett Mystique Aswath Damodaran 6 Buffetts 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 earnings Owner 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 6 Be like Buffett? Markets have changed since Buffett started his first partnership. Even Warren Buffett would have difficulty replicating his success in todays 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 Buffetts 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 6 Low Price/BV Ratios and Excess Returns Figure 8.2: PBV Classes and Returns - 1927-2001 25.00% 20.00%

15.00% 10.00% 5.00% 0.00% Lowest 2 1991-2001 3 4 5 1961-1990 6 PBV Class 1927-1960 Aswath Damodaran 1961-1990 7 1927-1960 8 9 Highest

1991-2001 6 The lowest price to book stocks Company Name CEMAR CEB SERGEN MELHOR SP ELETROBRAS TELEBRAS SA AMAZONIA SANEPAR-PREF MERC BRASIL ALFA CONSORC CELG ALFA HOLDING COTEMINAS IENERGIA JOAO FORTES ENG MUNDIAL SA BRASMOTOR CACIQUE WLM IND COMERCIO Aswath Damodaran Book Value of Equity 426.89 487.61 102.82 179.56 75714.89 120.64 1630.88 2132.52

472.76 412.44 1230.56 369.11 1704.83 307.09 80.47 105.02 842.56 188.49 222.42 Price to Book Ratio 0.23 0.24 0.28 0.34 0.37 0.39 0.49 0.52 0.55 0.55 0.55 0.56 0.60 0.61 0.64 0.64 0.72 0.75 0.75 6 What drives price to book ratios?

Going back to a simple dividend DPSdiscount model, P0 = 1 Cost of Equity g n 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, P0 = PBV = BV0 ROE - g n Cost of equity-g n 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. Aswath Damodaran 6 Low Price to Book & High Return on Equity 4


PQUN3 BRKM3 IGBR3 1 TMGC3 RNAR3 CSMG3 BNBR3 CGOS3 SGEN3 V B P0 - 20 0 ENMA3 20 40 60 80 1 00 ROE


3.89 3.96 4.19 4.30 4.37 4.44 4.87 5.00 5.42 5.42 5.46 5.57 5.57 5.65 5.75 5.77 5.77 5.98 7 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: (1+ g)) EPS 0 * Payout Ratio *(1 + g)* 1 n (1+ r))n EPS0 * Payout Ratio n *(1+ g)) *(1+ g) n ) P0 = + r)- g) (r)-g)n )(1+ r))n

n 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: n P0 = EPS 0 Aswath Damodaran (1 + g)) Payout Ratio * (1 + g) * 1 (1+ r)) n r)- g) + n Payout Ratio n *(1+ g)) * (1 + g)n ) (r)- g) n )(1+ r)) n 7 MismatchesThe 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 7 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.


9.3 -29.956 0.14 -23.361 7.95 -21.781 12.25 -21.264 0.81 -18.115 36 -15.819 2.05 -13.966 1.53 -11.702 0.83 -8.219 0.7 -5.844 14.5 -1.799 27.85 -1.158 170 7 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 7 Good Companies are not necessarily Good Investments Aswath Damodaran 7 Loser Portfolios and Time Horizon Aswath Damodaran 7 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 7 Change Revenues Divest More Live Better Reinvestment Reinvest Do Increase Build Create Cost Make Match Reduce Shift acquisitions off interest of on efficient your inventory your assets new Equity past tax

the beta financing existing Cash operating capital Expected length more financing rate cost overthat Rate *in Flows of (Equity/Capital) turnover ofgrowth Growth capitalratio period+ Firm Value have -operations investment management projects margins competitive Pre-tax product/service Operating to expenses

mix moving your tonegative reduce assets: Cost income toand of and EBIT Debt less to lower (1- tax taxrate) locales * - transfer *tighter advantages (Debt/Capital) discretionary leverage Reduce higher cost Operating Return cuttting: of tax credit capital your on pricing

locales Margin Capital policies default -Higher risk riskand management Margins cost of debt = Expected EBIT Growth Rate - Tax Rate * EBIT = EBIT (1-t) + Depreciation - Capital Expenditures - Chg in Working Capital = FCFF Aswath Damodaran 8 Return Current Expected Stable Terminal Cost Weights Discount Op. Riskfree Beta R X

Unlevered Firms Mature Country Reinvestment iskAssets Premium ofD/E Growth on risk Equity Debt Cashflow Value at Rate Capital Growth Beta Cost Rate 2,472 : =for of104/(.0676-.03) Capital to 1 Firm(WACC) =2 = 2714 8.50% (.486) 3 + 3.97% (0.514) 4 = 6.17% 5 5 + Blockbuster:

Status Quo EBIT(1-t) in g 8.50 (4.10%+2%)(1-.35) E + Riskfree 1.10 4% Sectors: Ratio: premium Equity Term 4.06% EBIT 26.46% = Cash: =EBIT 3%; 48.6% % (1-t) Yr 21.35% Prem (1-t) 0.80 rate Beta : D ==51.4% 4.10% 1.00; 330163

$165 $167 $169 $173 $178 .2645*.0406=.0107 Cost -= 4% 0% 184 -Debt Nt 3.97% Reinvestment CpX of capital =1847 6.76% 39 $44 $44 $51 $64 $79 - 82 1.07 ROC= =Equity FCFF Chg%WC 6.76%; Tax955 rate=35% $121 4 $123 $118 $109 $99

= FCFF Reinvestment -Options 102 Rate=44.37% 0 120 Reinvestment$Rate Value/Share 5.13= 43/163 =26.46% Aswath Damodaran 8 Return Current Expected Stable Terminal Cost Weights Discount Op. Riskfree Beta R X Unlevered Firms Mature Country Reinvestment iskAssets Premium ofD/E Growth on

risk Equity Debt Cashflow Value at Rate Capital Growth Beta Cost Rate 3,840 : =for of156/(.0676-.03) Capital to 1 Firm(WACC) =2 = 4145 8.50% (.486) 3 + 3.97% (0.514) 4 = 6.17% 5 5 + Blockbuster: Restructured EBIT(1-t) in g 8.50 (4.10%+2%)(1-.35) E + Riskfree 1.10

4% Sectors: Ratio: premium Equity Term 6.20% EBIT 17.32% = Cash: =EBIT 3%; 48.6% % (1-t) Yr 21.35% Prem (1-t) 0.80 rate Beta : D ==51.4% 4.10% 1.00; 330249 $252 $255 $258 $264 $272 .1732*.0620=.0107 Cost -= 4% 0% 280

-Debt Nt 3.97% Reinvestment CpX of capital =1847 6.76% 39 $44 $44 $59 $89 $121 - Chg%WC 1.07 ROC= =Equity 124 FCFF 6.76%; Tax 2323 rate=35% $208 4 $211 $200 $176 $151 = FCFF Reinvestment -Options 156 Rate=44.37% 0206 Reinvestment$ Rate Value/Share 12.47= 43/249 =17.32%

Aswath Damodaran 8 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 8 Value investors focus assets in place Growth Investing Assets Liabilities Existing Investments Fixed Claim on cash flows Assets in Place

Generate cashflows today Debt Includes long lived (fixed) and Little or No role in management Fixed Maturity short-lived(working Tax Deductible capital) assets Expected Value that will be Growth Assets created by future investments Equity Residual Claim on cash flows Significant Role in management Perpetual Lives Growth investors bet on growth assets: They believe that they can assess their value better than markets Aswath Damodaran 8 Is growth investing doomed? Aswath Damodaran

8 But there is another side .. Aswath Damodaran 8 Adding on Aswath Damodaran 8 Furthermore.. And active growth investors seem to beat growth indices more often than value investors beat value indices. Aswath Damodaran 8 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 8 I. Passive Growth Strategies Aswath Damodaran 9 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 9 The Small Firm Effect

Aswath Damodaran 9 A Note of caution Figure 9.7: Time Horizon and the Small Firm Premium 16.00% 120.00% 14.00% 100.00% 12.00% 80.00% 10.00% Large Cap 8.00% 60.00% Small Cap % of time small caps win 6.00% 40.00% 4.00% 20.00% 2.00% 0.00% 0.00% 1 5 10

15 20 25 30 35 40 Time Horizon Aswath Damodaran 9 III. Activist Growth Investing.. Fund Type Early/Seed Ven ture Capital Balanced Ven ture Capital Later Stage Ven ture Capital All Venture Capital All Buyouts Mezzanine All Private Equity Aswath Damodaran 1 Yr -36.3 -30.9 -25.9 -32.4 -16.1

3.9 -21.4 3 Yr 81 45.9 27.8 53.9 2.9 10 16.5 5 Yr 10 Yr 20 Yr 53.9 33 21.5 33.2 24 16.2 22.2 24.5 17 37.9 27.4 18.2 8.1 12.7 15.6 10.1 11.8 11.3 17.9 18.8 16.9 9 Are there great stock pickers? Firm Credit Suisse F.B. Prudential Sec. U.S. Bancorp Piper J. Merrill Lynch Goldman Sachs Lehman Bros. J.P. Morgan Sec. Bear Stearns A.G. Edwards Morgan Stanley D.W.

Raymond James Edward Jones First Union Sec. PaineWebber Salomon S.B. S&P 500 Index Aswath Damodaran Latest qtr. -3.60% -12.3 -1.4 -1.9 0 -11.7 2.9 -6.4 -1.7 -2.8 -0.4 -0.5 -12.3 -13.2 -1.8 -2.70% One- year 36.90% 36.2 28.5 28.1 27.4 18.3 11.6 11.4 9.8 9.5

6.9 4.8 1.8 -3.2 -17 7.20% Five- year 253.10% 216.1 208.8 162.2 220.3 262.4 N.A. 184.9 194.8 148.8 164.4 204.3 N.A. 153.6 101.7 190.80% 9 Information Trading Information traders dont 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 9 Information and Prices in an Efficient Market Figure 10.1: Price Adjustment in an Efficient Market Asset price Notice that the price adjusts instantaneously to the information Time New information is revealed Aswath Damodaran 9 A Slow Learning Market Figure 10.2 A Slow Learning Market Asset price The price drifts upwards after the good news comes out. Time New information is revealed Aswath Damodaran

9 An Overreacting Market Figure 10.3: An Overreacting Market The price increases too much on the Asset price good news announcement, and then decreases in the period after. Time New information is revealed Aswath Damodaran 9 I. Earnings Reports Aswath Damodaran 10 II. Acquisitions: Evidence on Target Firms Aswath Damodaran 10 III. Analyst Recommendations Aswath Damodaran 10

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. Aswath Damodaran 10 The Investment Process Investment The Risk

Security Valuation -Private Execution Asset Real Bonds Stocks Non-Domestic Domestic Countries: Performance 1. Market Stock Utility Tax Views Trading Which How How Status Code Client Portfolio Tolerance/ and Models Assets Allocation Classes: often on Efficiency much Systems stocks?

Selection Return Horizon dorisk Evaluation Managers you Which did trade? the bonds? portfolio Job Which manager real assets? take? Aversion based Information Costs Speed markets 2. Timing Selection -Functions The Measuring Can inflation How What CAPM you large does onreturn

beat trading are risk did your thetrades? portfolio manager make? the 3. -affect The Effects Cash Do Commissions rates Did market? you APM prices? the flows of use portfolio derivatives manager to manage underperform or enhance or outperform? risk? -diversification Comparables Bid growth

Ask Spread - Technicals Price Impact Aswath Damodaran 10 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. Aswath Damodaran 10 The Magnitude of the Spread Aswath Damodaran 10 Round-Trip Costs (including Price Impact) as a Function of Market Cap and Trade Size Sector Smallest 2 3 4

5 6 7 8 Largest Aswath Damodaran Dollar Value of Block ($ thoustands) 5 25 250 500 1000 2500 5000 10000 20000 17.30% 27.30% 43.80% 8.90% 12.00% 23.80% 33.40% 5.00% 7.60% 18.80% 25.90% 30.00% 4.30% 5.80% 9.60% 16.90% 25.40% 31.50% 2.80% 3.90% 5.90% 8.10% 11.50% 15.70% 25.70% 1.80% 2.10% 3.20% 4.40% 5.60% 7.90% 11.00% 16.20% 1.90% 2.00% 3.10% 4.00% 5.60% 7.70% 10.40% 14.30% 20.00% 1.90% 1.90% 2.70% 3.30% 4.60% 6.20% 8.90% 13.60% 18.10% 1.10% 1.20% 1.30% 1.71% 2.10% 2.80% 4.10% 5.90% 8.00% 10 The Overall Cost of Trading: Small Cap versus Large Cap Stocks Market Capitalization Smallest 2 3 4

Largest Aswath Damodaran Implicit Cost Explicit Cost 2.71% 1.09% 1.62% 0.71% 1.13% 0.54% 0.69% 0.40% 0.28% 0.28% Total Trading Costs (NYSE) 3.80% 2.33% 1.67% 1.09% 0.31% Total Trading Costs (NASDAQ) 5.76% 3.25% 2.10% 1.36% 0.40% 10 Many a slip Aswath Damodaran

10 Trading Costs and Performance... Figure 13.16: Trading Costs and Returns: Mutual Funds 16.00% 14.00% 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% -2.00% -4.00% -6.00% 1 (Lowest) 2 3 4 5 (Highest) Total Cost Category Total Return Aswath Damodaran Excess Return 11 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: Subject to: For other active strategies (such as those based on long term investing) the cost might be of the essence. Minimize: Subject to: Speed of Execution Cost of execution < Excess returns from strategy Cost of Execution Speed of execution < Specified time period. The larger the fund, the more significant this trading cost/speed tradeoff becomes. Aswath Damodaran 11 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. Aswath Damodaran 11 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. Aswath Damodaran 11 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. Aswath Damodaran 11 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. Aswath Damodaran 11 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. Aswath Damodaran 11 The Performance of Hedge Funds Year No of funds in sample Arithmetic Average Return Median Return 1988-89 1989-90 1990-91 1991-92 1992-93 1993-94 1994-95 Entire Period 78 108 142 176 265

313 399 18.08% 4.36% 17.13% 11.98% 24.59% -1.60% 18.32% 13.26% 20.30% 3.80% 15.90% 10.70% 22.15% -2.00% 14.70% Aswath Damodaran Return on S&P 500 Average Annual Fee (as % of money under management) 1.74% 1.65% 1.79% 1.81% 1.62% 1.64% 1.55%

Average Incentive Fee (as % of excess returns) 19.76% 19.52% 19.55% 19.34% 19.10% 18.75% 18.50% 16.47%% 11 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. Aswath Damodaran 11 Returns by sub-category

Aswath Damodaran 11 The Investment Process Investment The Risk Security Valuation -Private Execution Asset Real Bonds Stocks Non-Domestic Domestic Countries: Performance 1. Market Stock Utility Tax Views Trading Which How How Status Code Client Portfolio Tolerance/ and Models

Assets Allocation Classes: often on Efficiency much Systems stocks? Selection Return Horizon dorisk Evaluation Managers you Which did trade? the bonds? portfolio Job Which manager real assets? take? Aversion based Information Costs Speed markets 2. Timing Selection -Functions The Measuring

Can inflation How What CAPM you large does onreturn beat trading are risk did your thetrades? portfolio manager make? the 3. -affect The Effects Cash Do Commissions rates Did market? you APM prices? the flows of use portfolio derivatives manager

to manage underperform or enhance or outperform? risk? -diversification Comparables Bid growth Ask Spread - Technicals Price Impact Aswath Damodaran 12 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 functions Against a risk-adjusted return, which reflects both the risk of the portfolio and market performance.

Based upon Tracking Error against a benchmark index Aswath Damodaran 12 I. Against a Market Index Figure 13.5: Percent of Money Managers who beat the S&P 500 80% 70% 60% 50% 40% 30% 20% 10% 0% Year Aswath Damodaran 12 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. Aswath Damodaran 12 Value and Growth Funds Figure 13.7: Returns on Growth and Value Funds 60.00% 50.00% 40.00% 30.00% 20.00% 10.00% 0.00% 1987 1988 1989 1990 1991 1992 1993

1987 - 1993 -10.00% -20.00% -30.00% Year Growth Funds Aswath Damodaran Growth index Value funds Value Index 12 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 Premium Risk 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. Aswath Damodaran 12 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)) Aswath Damodaran 12 IV. Tracking Error as a Measure of Risk Tracking error measures the difference between a portfolios 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. Aswath Damodaran 12 Enhanced Index Funds Oxymoron? Aswath Damodaran 12 So, why is it so difficult to win at this game?

Is it a losers 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 dont bring anything to the table, dont expect to take anything away in the long term. Aswath Damodaran 12 What makes you special? Institutional claims 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 dont bow to peer pressure: Contrarian to the core?

Aswath Damodaran 13 Finding an Investment Philosophy Momentum Technical momentum indicators Buy stocks based upon trend lines and high trading volume. Information trading : Buying after positive news (earnings and dividend announcements, acquisition announcements) Medium term (few Relative strength : Buy stocks months to a couple that have gone up in the last of years) few months. Information trading : Buy small cap stocks with substantial insider buying. Short term (days to a few weeks) Contrarian Technicalcontrarian indicators mutual fund holdings, short interest. These can be for individual stocks or for

overall market. Market timing, based upon normal PE or normal range of interest rates. Information trading : Buying after bad news (buying a week after bad earnings reports and holding for a few months) Long Term (several Passive growth investing : Passive value investing : years) Buying stocks where growth Buy stocks with low trades at a reasonable price PE, PBV or PS ratios. (PEG ratios). Contrarian value investing: Buying losers or stocks with lots of bad news. Aswath Damodaran Opportunisitic Pure arbitragein derivatives and fixed income markets. Tehnical demand

indicators Patterns in prices such as head and shoulders. Near arbitrage opportunities: Buying discounted closed end funds Speculative arbitrage opportunities: Buying paired stocks and merger arbitrage. Active growth investing: Take stakes in small, growth companies (private equity and venture capital investing) Activist value investing : Buy stocks in poorly managed companies and push for change. 13 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. Aswath Damodaran 13 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. Aswath Damodaran 13 If you walk like a lemming, run like a lemming you are a lemming Aswath Damodaran 13

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