Transcript 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.

Investment Philosophy:
The Secret Ingredient in Investment
Success
Aswath Damodaran
Aswath Damodaran
1
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 Process
The Clie nt
Utility
Functions
Risk Tolerance/
Aversion
Investment Horizon
Tax Status
Tax Code
The Por tfolio Manage r’s Job
View s on
markets
Asset Classes:
Countries:
Asset All ocation
Stocks
Bonds
Domestic
Real Assets
Non-Domestic
Valuation
based on
- Cash flow s
- Comparables
- Technicals
- Which stocks? Which bonds? Which real assets?
Trading
Costs
- Commissions
- Bid Ask Spread
- Price Impact
Execution
- How of ten do you trade?
- How large are your trades?
- Do you use derivatives to manage or enhance risk?
Market
Timing
Security Sel ection
Pe r for m ance Evaluation
1. How much risk did the portfolio manager take?
2. What return did the portfolio manager make?
3. Did the portfolio manager underperform or outperf orm?
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View s on
- inf lation
- rates
- grow th
Risk and Return
- Measuring risk
- Eff ects of
diversif ication
Private
Inf ormation
Market Ef f iciency
- Can you beat
the market?
Trading
Speed
Trading Systems
- How does trading
aff ect prices?
Stock
Selection
Risk Models
- The CAPM
- The APM
6
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
Step 1: Defining Risk
The risk in an investment can be measured by the variance in actual returns around an
expected return
Riskless Investment
Low Risk Investment
High Risk Investment
E(R)
E(R)
E(R)
Step 2: Differentiating between Rewarded and Unrewarded Risk
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 assets
1. each investment is a small proportion of portfolio
are affected by it.
2. risk averages out across investments in portfolio
The marginal investor is assumed to hold a “diversified” portfolio. Thus, only market risk will
be rewarded and priced.
Step 3: Measuring Market Risk
The CAPM
If there is
1. no private information
2. no transactions cost
the optimal diversified
portfolio includes every
traded asset. Everyone
will hold this market portfolio
Market Risk = Risk
added by any investment
to the market portfolio:
Beta of asset relative to
Market portfolio (from
a regression)
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The APM
If there are no
arbitrage opportunities
then the market risk of
any asset must be
captured by betas
relative to factors that
affect all investments.
Market Risk = Risk
exposures of any
asset to market
factors
Multi-Factor Models
Since market risk affects
most or all investments,
it must come from
macro economic factors.
Market Risk = Risk
exposures of any
asset to macro
economic factors.
Betas of asset relative
to unspecified market
factors (from a factor
analysis)
Betas of assets relative
to specified macro
economic factors (from
a regression)
Proxy Models
In an efficient market,
differences in returns
across long periods must
be due to market risk
differences. Looking for
variables correlated with
returns should then give
us proxies for this risk.
Market Risk =
Captured by the
Proxy Variable(s)
Equation relating
returns to proxy
variables (from a
regression)
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Some quirks in risk aversion…


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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:
•
•
•
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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
Figure 5.10: Pre-tax and After-tax Returns at U.S. equity mutual funds- 1999-2001
16.00%
14.00%
12.00%
10.00%
8.00%
Pre-tax Return
After-tax Return
6.00%
4.00%
2.00%
0.00%
Large
Value
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Large
Blend
Large
Growth
Midcap
Value
Midcap Midcap
Blend Growth
Fund Style
Small
Value
Small
Blend
Small
Growth
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Tax Effect and Turnover Ratios
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The Investment Process
The Clie nt
Utility
Functions
Risk Tolerance/
Aversion
Investment Horizon
Tax Status
Tax Code
The Por tfolio Manage r’s Job
View s on
markets
Asset Classes:
Countries:
Asset All ocation
Stocks
Bonds
Domestic
Real Assets
Non-Domestic
Valuation
based on
- Cash flow s
- Comparables
- Technicals
- Which stocks? Which bonds? Which real assets?
Trading
Costs
- Commissions
- Bid Ask Spread
- Price Impact
Execution
- How of ten do you trade?
- How large are your trades?
- Do you use derivatives to manage or enhance risk?
Market
Timing
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Security Sel ection
Pe r for m ance Evaluation
1. How much risk did the portfolio manager take?
2. What return did the portfolio manager make?
3. Did the portfolio manager underperform or outperf orm?
View s on
- inf lation
- rates
- grow th
Risk and Return
- Measuring risk
- Eff ects of
diversif ication
Private
Inf ormation
Market Ef f iciency
- Can you beat
the market?
Trading
Speed
Trading Systems
- How does trading
aff ect prices?
Stock
Selection
Risk Models
- The CAPM
- The APM
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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
n
MaximizeiExpected
Return
E(R p )   wi E(R i )
i 1
i  n j n
ˆ2
s    wi wj s ij  s
Risk Minimization
Minimize return variance
i n j n
s    wi w js ij
2
p
i1 j 1
i n
ˆ)
E(R p )   wi E(R i ) = E(R
subject to
i 1 j1
i 1
where,
s2 = Investor's desired level of variance
E(R) = Investor's desired expected returns
2
p
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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
QuickTime™ and a
TIFF (Uncompressed) decompressor
are needed to see this picture.
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The Optimally Diversified Portfolio
Global Inv estable 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%
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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

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
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
•
•
•

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.
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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
Priors
After two down years
After one down year
After one up year
After two up years
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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%
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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
18
16
14
12
10
8
6
4
2
0
Sep-06
Aug-06
Jul-06
Jun-06
May-06
Apr-06
Mar-06
Feb-06
Jan-06
Dec-05
Nov-05
Oct-05
Sep-05
Aug-05
Jul-05
Jun-05
May-05
Apr-05
Mar-05
Feb-05
Jan-05
Dec-04
Nov-04
Oct-04
Sep-04
Aug-04
Jul-04
Jun-04
May-04
Apr-04
Mar-04
Feb-04
Jan-04
35
Aswath Damodaran
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 C lass Number of years A verage Return Standard deviation in returnsBes t Y ear Worst Y ear
>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 T otal
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%;
Intrinsic Value Estimate
Expected Dividends =
$
Expected Terminal Value =
P resent Value =
$
Intrinsic Value of Index = $
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1
45.03 $
2
48.63 $
3
52.52 $
41.54 $
1,274.82
41.39 $
41.24 $
4
56.72 $
$
41.09 $
5
61.26
1,598.68
1,109.55
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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%)
Intrinsic Value Estimate
Expected Dividends =
$
Expected Terminal Value =
P resent Value =
$
Intrinsic Value of Index = $
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1
1,859.00 $
2
2,044.90 $
3
2,249.39 $
1,664.28 $
31,483.63
1,638.95 $
1,614.01 $
4
2,474.33 $
$
1,589.44 $
5
2,721.76
40,709.79
24,976.95
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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
16.00%
14.00%
12.00%
10.00%
8.00%
Earnings Yield
T.Bond Rate
Bond-Bill
6.00%
4.00%
2.00%
2004
2002
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
1978
1976
1974
1972
1970
1968
1966
1964
1962
1960
0.00%
-2.00%
Year
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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
18.00%
16.00%
Average Annual Returns
14.00%
12.00%
Last 10 years
Last 15 years
10.00%
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
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45
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%
46
But would your pay for it?
Aswath Damodaran
47
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…
48
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
49
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
50
The Investment Process
The Clie nt
Utility
Functions
Risk Tolerance/
Aversion
Investment Horizon
Tax Status
Tax Code
The Por tfolio Manage r’s Job
View s on
markets
Asset Classes:
Countries:
Asset All ocation
Stocks
Bonds
Domestic
Real Assets
Non-Domestic
Valuation
based on
- Cash flow s
- Comparables
- Technicals
- Which stocks? Which bonds? Which real assets?
Trading
Costs
- Commissions
- Bid Ask Spread
- Price Impact
Execution
- How of ten do you trade?
- How large are your trades?
- Do you use derivatives to manage or enhance risk?
Market
Timing
Security Sel ection
Pe r for m ance Evaluation
1. How much risk did the portfolio manager take?
2. What return did the portfolio manager make?
3. Did the portfolio manager underperform or outperf orm?
Aswath Damodaran
View s on
- inf lation
- rates
- grow th
Risk and Return
- Measuring risk
- Eff ects of
diversif ication
Private
Inf ormation
Market Ef f iciency
- Can you beat
the market?
Trading
Speed
Trading Systems
- How does trading
aff ect prices?
Stock
Selection
Risk Models
- The CAPM
- The APM
51
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
52
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
53
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
54
I. Intrinsic Value Investors: The determinants of
intrinsic value
DISCOUNTED CASHFLOW VALUATION
Expecte d Gr ow th
Firm: Grow th in
Operating Earnings
Equity: Grow th in
Net Income/EPS
Cas h flow s
Firm: Pre-debt cash
f low
Equity: After debt
cash flow s
Firm is in stable grow th:
Grow s at constant rate
f orever
Terminal Value
Value
Firm: V alue of Firm
CF 1
CF 2
CF 3
CF 4
CF 5
CF n
.........
Forever
Equity: Value of Equity
Le ngth of Pe r iod of High Gr ow th
Dis count Rate
Firm:Cost of Capital
Equity: Cost of Equity
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55
DISCOUNTED CASHFLOW VALUATION
Cas hflow to Fir m
EBIT (1-t)
- (Cap Ex - Depr)
- Change in WC
= FCFF
Value of Operating Assets
+ Cash & Non-op Assets
= Value of Firm
- Value of Debt
= Value of Equity
FCFF 1
FCFF 3
FCFF 4
Terminal Value= FCFF n+1/(r-gn)
FCFF 5
FCFF n
.........
+
Cos t of De bt
(Riskf ree Rate
+ Default Spread) (1-t)
Be ta
- Measures market risk X
Type of
Business
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FCFF 2
Firm is in stable grow th:
Grow s at constant rate
f orever
Forever
Discount at WACC= Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity))
Cos t of Equity
Ris k fre e Rate :
- No default risk
- No reinvestment risk
- In same currency and
in same terms (real or
nominal as cash flow s
Expecte d Gr ow th
Reinvestment Rate
* Return on Capital
Operating
Leverage
We ights
Based on Market Value
Ris k Pre m ium
- Premium for average
risk investment
Financial
Leverage
Base Equity
Premium
Country Risk
Premium
56
Avg Reinvestment
rate = 25.08%
Embraer: Status Quo ($)
Cur re nt Cas hflow to Firm
EBIT(1-t) :
$ 404
- Nt CpX
23
- Chg WC
9
= FCFF
$ 372
Reinvestment Rate = 32/404= 7.9%
Reinvestment Rate
25.08%
Year
EBIT(1-t)
- Reinvestment
= FCFF
1
426
107
319
Terminal Value5= 288/(.0876-.0417) = 6272
2
449
113
336
3
474
119
355
4
500
126
374
Term Yr
549
- 261
= 288
5
527
132
395
Discount at$ Cost of Capital (WACC) = 10.52% (.84) + 6.05% (0.16) = 9.81%
Cos t of Equity
10.52 %
Ris k fre e Rate:
$ Riskfree Rate= 4.17%
On October 6, 2003
Embraer Price = R$15.51
Cos t of De bt
(4.17% +1% +4% )(1-.34)
= 6.05%
+
Be ta
1.07
Unlevered Beta f or
Sectors: 0.95
Aswath Damodaran
Stable Grow th
g = 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%
Expecte d Gr ow th
in EBIT (1-t)
.2185*.2508=.0548
5.48 %
$ Cashflow s
Op. Assets $ 5,272
+ Cash:
795
- Debt
717
- Minor. Int.
12
=Equity
5,349
-Options
28
Value/Share $7.47
R$ 21.75
Return on Capital
21.85%
X
We ights
E = 84% D = 16%
Mature m ar ke t
+
pr e m ium
4%
Firm’s D/E
Ratio: 19%
Lam bda
0.27
X
Country Equity Risk
Premium
7.67%
Country Def ault
Spread
6.01%
X
Rel Equity
Mkt Vol
1.28
57
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
58
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
59
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
60
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
61
The Buffett Mystique
Aswath Damodaran
62
Buffett’s Tenets

Business Tenets:




Management 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.
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:

•
Aswath Damodaran
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.
63
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
64
Low Price/BV Ratios and Excess Returns
Figure 8.2: PBV Classes and Ret urns - 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
8
1927-1960
9
Highest
1991-2001
65
The lowest price to book stocks…
C ompany N ame
B ook V alue of E quity P ric e
C EMA R
4 2 6 .8 9
C EB
4 8 7 .6 1
S E RG E N
1 0 2 .8 2
M E LH O R SP
1 7 9 .5 6
E L E T R O B RA S
7 5 7 1 4 .8 9
T E L E B RA S S A
1 2 0 .6 4
A M A ZO N I A
1 6 3 0 .8 8
S A N E P A R- P RE F
2 1 3 2 .5 2
M E RC B RA S I L
4 7 2 .7 6
A L FA C O N S O RC
4 1 2 .4 4
C E LG
1 2 3 0 .5 6
A L FA H O L D I N G
3 6 9 .1 1
C O T EM INA S
1 7 0 4 .8 3
I E NE RGI A
3 0 7 .0 9
J O A O FO RT E S E N G
8 0 .4 7
M U N D IA L SA
1 0 5 .0 2
B RA S M O T O R
8 4 2 .5 6
C A CIQ UE
1 8 8 .4 9
WL M I N D C O M E RC I O
2 2 2 .4 2
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to B ook Ratio
0 .2 3
0 .2 4
0 .2 8
0 .3 4
0 .3 7
0 .3 9
0 .4 9
0 .5 2
0 .5 5
0 .5 5
0 .5 5
0 .5 6
0 .6 0
0 .6 1
0 .6 4
0 .6 4
0 .7 2
0 .7 5
0 .7 5
66
What drives price to book ratios?


Going back to a simple dividend
DPSdiscount model,
P0 
1
Cost of Equit y 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 - gn
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
67
Low Price to Book & High Return on Equity
4
HGTX3
CPSL3
EMBR3
FLCL3
CEGR3
AMBV3
CPFE3
3
CSNA3
DURA3
BBAS3
GRND3
BRSR3
BFIT3
ROMI3
2
ELEK3
TMGC3
CSRN3
PTIP3
FJTA3GEPA3
ELUM3
RGEG3
PQUN3
BRKM3
CSMG3
IGBR3
1
BNBR3
RNAR3
PBV
CGOS3
SGEN3
ENMA3
0
- 20
0
20
40
60
80
1 00
ROE
Aswath Damodaran
68
The Low PE Effect
Aswath Damodaran
69
The lowest PE stocks
C ompany name
C EMAR
A M A ZO N IA
C EMAT
C I A H E RI N G
C EB
G RA D I E N T E
U SI M I N A S SA
C E L U L O S E I RA N I
I P IRA N GA DI S
M O N T E I RO A RA N H A
P E T RO FL E X
A C E SI T A SA
M E T G E RD A U S A
C O E LBA
C O E L B A - P RE F A
S E RG E N
T E L E B RA S S A
S A N E P A R- P RE F
C E LG
BA N E ST E S
Aswath Damodaran
P E R atio
0 .2 7
3 .1 5
3 .8 9
3 .9 6
4 .1 9
4 .3 0
4 .3 7
4 .4 4
4 .8 7
5 .0 0
5 .4 2
5 .4 2
5 .4 6
5 .5 7
5 .5 7
5 .6 5
5 .7 5
5 .7 7
5 .7 7
5 .9 8
70
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:
P0 =
 (1+ g)n 
EPS0 * Payout Rat io*(1+ g)* 1 
 (1+ r)n 
r-g
EPS0 * Payout Rat ion *(1+ g)n *(1+ g n )
+
(r-g n )(1+ r)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
Aswath Damodaran
 (1 + g) 

Payout Rat io* (1 + g) * 1 
 (1+ r) n  Payout Rat ion *(1+ g) n * (1 + gn )
P0
=
+
EPS0
r -g
(r - g n )(1+ r) n
71
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
72
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
73
Excess Returns for Winner and Loser Portfolios
Aswath Damodaran
74
The Biggest Losers…
Return in las t year L ates t pric e
C ompany N ame
0 .8 3
- 4 0 .3 4 8
E L E KE I RO Z S A
5 .6
- 3 5 .7 2 2
KE P L E R WE B E R S A
9 .3
- 3 3 .5 7 1
G RA D I E N T E E L E T RO N I C A S A
0 .1 4
- 2 9 .9 5 6
C I A E N E R G E T I C A D O M A RA N H A O
7 .9 5
- 2 3 .3 6 1
T E L E M I G C E L U L A R P A RT I C I P A C O E
1 2 .2 5
- 2 1 .7 8 1
B RA S KE M S A
0 .8 1
- 2 1 .2 6 4
B A N C O S U D A M E R I S B RA S I L S A
36
- 1 8 .1 1 5
I T A U T E C S A - G RU P O I T A U T E C
2 .0 5
- 1 5 .8 1 9
U N I A O D E I N D S P E T RO Q U I M I C A S
1 .5 3
- 1 3 .9 6 6
P O RT O B E L L O S A
0 .8 3
- 1 1 .7 0 2
G P C P A RT I C I P A C O E S S A
0 .7
- 8 .2 1 9
RE N A R M A C A S S A
1 4 .5
- 5 .8 4 4
A E S E L P A SA
2 7 .8 5
- 1 .7 9 9
B RA S I L T E L E C O M P A RT S A
170
- 1 .1 5 8
C I A T E C I D O S N O RT E D E M I N A S
Aswath Damodaran
75
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
76
Good Companies are not necessarily Good
Investments…
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77
Loser Portfolios and Time Horizon
Aswath Damodaran
78
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
79
Increase Cash Flows
More ef f icient
operations and
cost cuttting:
Higher Margins
Reduce the cost of capi tal
Make your
product/service less
discretionary
Revenues
* Operating Margin
Reduce beta
= EBIT
Divest assets that
have negative EBIT
- Tax Rate * EBIT
Cost of Equity * (Equity/Capital) +
Pre-tax Cost of Debt (1- tax rate) *
(Debt/Capital)
= EBIT (1-t)
Reduce tax rate
- moving income to low er tax locales
- transf er pricing
- risk management
Reduce
Operating
leverage
+ Depreciation
- Capital Expenditures
- Chg in Working Capital
= FCFF
Live off past overinvestment
Better inventory
management and
tighter credit policies
Shif t interest
expenses to
Match your financing
higher tax locales
to your assets:
Reduce your def ault
risk and cost of debt
Change f inancing
mix to reduce
cost of capital
Firm Value
Increase Expected Growth
Reinvest more in
projects
Increase operating
margins
Aswath Damodaran
Increase l ength of growth peri od
Do acquisitions
Reinvestment Rate
* Return on Capital
Increase capital turnover ratio
Build on existing
competitive
advantages
Create new
competitive
advantages
= Expected Grow th Rate
80
Blockbuster: Status Quo
Cur re nt Cas hflow to Firm
EBIT(1-t) :
163
- Nt CpX
39
- Chg WC
4
= FCFF
120
Reinvestment Rate = 43/163
=26.46%
Reinvestment Rate
26.46%
Return on Capital
4.06%
Expecte d Gr ow th
in EBIT (1-t)
.2645*.0406=.0107
1.07 %
Stable Grow th
g = 3% ; Beta = 1.00;
Cost of capital = 6.76%
ROC= 6.76%; Tax rate=35%
Reinvestment Rate=44.37%
Terminal Value5= 104/(.0676-.03) = 2714
Op. Assets
2,472
+ Cash:
330
- Debt
1847
=Equity
955
-Options
0
Value/Share $ 5.13
EBIT (1-t)
- Reinvestment
FCFF
1
$165
$44
$121
2
$167
$44
$123
3
$169
$51
$118
4
$173
$64
$109
5
$178
$79
$99
Term Yr
184
82
102
Discount atCost of Capital (WACC) = 8.50% (.486) + 3.97% (0.514) = 6.17%
Cos t of Equity
8.50 %
Ris k fre e Rate:
Riskfree rate = 4.10%
Cos t of De bt
(4.10% +2% )(1-.35)
= 3.97%
+
Be ta
1.10
Unlevered Beta f or
Sectors: 0.80
Aswath Damodaran
We ights
E = 48.6% D = 51.4%
X
Ris k Pre m ium
4%
Firm’s D/E
Ratio: 21.35%
Mature risk
premium
4%
Country
Equity Prem
0%
81
Blockbuster: Restructured
Cur re nt Cas hflow to Firm
EBIT(1-t) :
249
- Nt CpX
39
- Chg WC
4
= FCFF
206
Reinvestment Rate = 43/249
=17.32%
Reinvestment Rate
17.32%
Return on Capital
6.20%
Expecte d Gr ow th
in EBIT (1-t)
.1732*.0620=.0107
1.07 %
Stable Grow th
g = 3% ; Beta = 1.00;
Cost of capital = 6.76%
ROC= 6.76%; Tax rate=35%
Reinvestment Rate=44.37%
Terminal Value5= 156/(.0676-.03) = 4145
Op. Assets
+ Cash:
- Debt
=Equity
-Options
Value/Share $
3,840
330
1847
2323
0
12.47
EBIT (1-t)
- Reinvestment
FCFF
1
$252
$44
$208
2
$255
$44
$211
3
$258
$59
$200
4
$264
$89
$176
5
$272
$121
$151
Term Yr
280
124
156
Discount atCost of Capital (WACC) = 8.50% (.486) + 3.97% (0.514) = 6.17%
Cos t of Equity
8.50 %
Ris k fre e Rate:
Riskfree rate = 4.10%
Cos t of De bt
(4.10% +2% )(1-.35)
= 3.97%
+
Be ta
1.10
Unlevered Beta f or
Sectors: 0.80
Aswath Damodaran
We ights
E = 48.6% D = 51.4%
X
Ris k Pre m ium
4%
Firm’s D/E
Ratio: 21.35%
Mature risk
premium
4%
Country
Equity Prem
0%
82
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
83
Value investors
focus assets in
place
Growth Investing
Assets
Existing Investments
Assets in P lace
Generate cashflows today
Includes long lived (fixed) and
short-lived(working
capital) assets
Expected Value that will be Growth Assets
created by future investments
Liabilities
Debt
Equity
Fixed Claim on cash flows
Little or No role in management
Fixed M aturity
Tax Deductible
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
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84
Is growth investing doomed?
Aswath Damodaran
85
But there is another side ..
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86
Adding on …
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87
Furthermore..

And active growth investors seem to beat growth indices more often than
value investors beat value indices.
Aswath Damodaran
88
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
89
I. Passive Growth Strategies
Aswath Damodaran
90
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.
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91
The Small Firm Effect
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92
A Note of caution…
Figure 9.7: Time Horizon and the Small Firm Premium
16.00%
Average Annual Return over Holding Period
14.00%
12.00%
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%
1
5
10
15
20
25
30
35
40
Time Horizon
Aswath Damodaran
93
III. Activist Growth Investing..
Fund Type
Early/Seed Venture Capital
Balanced Venture Capital
Later Stage Venture Capital
All Venture Capital
All Buyouts
Mezzanine
All P rivate 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
53.9
33.2
22.2
37.9
8.1
10.1
17.9
10 Yr 20 Yr
33
21.5
24
16.2
24.5
17
27.4 18.2
12.7 15.6
11.8 11.3
18.8 16.9
94
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%
95
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
96
Information and Prices in an Efficient Market
Figure 10.1: Price Adjustment in an Efficient Market
Notice that the price
adjusts instantaneously
to the information
New information is revealed
Aswath Damodaran
Asset price
Time
97
A Slow Learning Market…
Figure 10.2 A Slow Learning Market
Asset price
The price drifts upwards after the
good news comes out.
New information is revealed
Aswath Damodaran
Time
98
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.
New information is revealed
Aswath Damodaran
Time
99
I. Earnings Reports
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100
II. Acquisitions: Evidence on Target Firms
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101
III. Analyst Recommendations…
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102
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
103
The Investment Process
The Clie nt
Utility
Functions
Risk Tolerance/
Aversion
Investment Horizon
Tax Status
Tax Code
The Por tfolio Manage r’s Job
View s on
markets
Asset Classes:
Countries:
Asset All ocation
Stocks
Bonds
Domestic
Real Assets
Non-Domestic
Valuation
based on
- Cash flow s
- Comparables
- Technicals
- Which stocks? Which bonds? Which real assets?
Trading
Costs
- Commissions
- Bid Ask Spread
- Price Impact
Execution
- How of ten do you trade?
- How large are your trades?
- Do you use derivatives to manage or enhance risk?
Market
Timing
Security Sel ection
Pe r for m ance Evaluation
1. How much risk did the portfolio manager take?
2. What return did the portfolio manager make?
3. Did the portfolio manager underperform or outperf orm?
Aswath Damodaran
View s on
- inf lation
- rates
- grow th
Risk and Return
- Measuring risk
- Eff ects of
diversif ication
Private
Inf ormation
Market Ef f iciency
- Can you beat
the market?
Trading
Speed
Trading Systems
- How does trading
aff ect prices?
Stock
Selection
Risk Models
- The CAPM
- The APM
104
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.
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105
The Magnitude of the Spread
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106
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%
107
The Overall Cost of Trading: Small Cap versus
Large Cap Stocks
Market
Capitalization
Smallest
2
3
4
Largest
Aswath Damodaran
Im plicit 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%
108
Many a slip…
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109
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
Total Cost Category
Total Return
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4
5 (Highest)
Excess Return
110
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
111
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.
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112
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
113
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
114
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
115
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
116
The Performance of Hedge Funds
Year
No of
funds in
sample
Arithm etic
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
m oney under
m anagement)
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%%
117
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
118
Returns by sub-category
Aswath Damodaran
119
The Investment Process
The Clie nt
Utility
Functions
Risk Tolerance/
Aversion
Investment Horizon
Tax Status
Tax Code
The Por tfolio Manage r’s Job
View s on
markets
Asset Classes:
Countries:
Asset All ocation
Stocks
Bonds
Domestic
Real Assets
Non-Domestic
Valuation
based on
- Cash flow s
- Comparables
- Technicals
- Which stocks? Which bonds? Which real assets?
Trading
Costs
- Commissions
- Bid Ask Spread
- Price Impact
Execution
- How of ten do you trade?
- How large are your trades?
- Do you use derivatives to manage or enhance risk?
Market
Timing
Security Sel ection
Pe r for m ance Evaluation
1. How much risk did the portfolio manager take?
2. What return did the portfolio manager make?
3. Did the portfolio manager underperform or outperf orm?
Aswath Damodaran
View s on
- inf lation
- rates
- grow th
Risk and Return
- Measuring risk
- Eff ects of
diversif ication
Private
Inf ormation
Market Ef f iciency
- Can you beat
the market?
Trading
Speed
Trading Systems
- How does trading
aff ect prices?
Stock
Selection
Risk Models
- The CAPM
- The APM
120
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
121
I. Against a Market Index
80%
70%
60%
50%
40%
30%
20%
10%
1971
0%
Aswath Damodaran
122
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
123
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 Growth index Value funds
Aswath Damodaran
Value Index
124
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
125
The Performance of Mutual Funds..
Fig ure 13.3: Mutual Fund Perfo rma nce: 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
126
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.
Aswath Damodaran
127
Enhanced Index Funds… Oxymoron?
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128
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.
Aswath Damodaran
129
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 don’t bow to peer pressure: Contrarian to the core?
Aswath Damodaran
130
Finding an Investment Philosophy
Short term (days to
a few weeks)
M edium term (few
months to a couple
of years)
Long Term (several
years)
Aswath Damodaran
Momentum
Contrarian
 Technical momentum
 Technical contrarian
indicators – Buy stocks based
indicators – mutual fund
upon trend lines and high
holdings, short interest.
trading volume.
These can be for
 Information trading: Buying
individual stocks or for
after positive news (earnings
overall market.
and dividend announcements,
acquisition announcements)
 Relative strength: Buy stocks
 M arket timing, based
that have gone up in the last
upon normal PE or
few months.
normal range of interest
 Information trading: Buy small
rates.
cap stocks with substantial
 Information trading:
insider buying.
Buying after bad news
(buying a week after
bad earnings reports
and holding for a few
months)
 Passive growth investing:
 Passive value investing:
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.
Opportunisitic
 Pure arbitrage in
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.
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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
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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
133
If you walk like a lemming, run like a lemming…
you are a lemming
Aswath Damodaran
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