Investment Philosophy: The Secret Ingredient in Investment Success

1
Investment PhilosophyThe Secret Ingredient in
Investment Success

• Aswath Damodaran

2
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.

3
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.

4
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)

5
Why do you need an investment philosophy?

• If you do not have an investment philosophy, you
  will find yourself doing the following
• 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.
• Switching from strategy to strategy, you will
  have to change your portfolio, resulting in high
  transactions costs and paying more in taxes.
• 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.

6
(No Transcript)
7
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.

8
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

9
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).

10
Risk and Return Models in Finance
11
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.

12
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 (lt 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?

13
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)

14
III. Tax Status and Portfolio Composition

• Investors can spend only after-tax returns. Hence
  taxes do affect portfolio composition.
• The portfolio that is right for an investor who
  pays no taxes might not be right for an investor
  who pays substantial taxes.
• Moreover, the portfolio that is right for an
  investor on one portion of his portfolio (say,
  his tax-exempt pension fund) might not be right
  for another portion of his portfolio (such as his
  taxable savings)
• The effect of taxes on portfolio composition and
  returns is made more complicated by
• The different treatment of current income
  (dividends, coupons) and capital gains
• The different tax rates on various portions of
  savings (pension versus non-pension)
• Changing tax rates across time

15
Dividends versus Capital Gains Tax Rates for
Individuals United States
16
The Tax Effect Stock Returns before and after
taxes.. With one year time horizons
17
The Tax Effect and Dividend Yields
18
Mutual Fund Returns The Tax Effect
19
Tax Effect and Turnover Ratios
20
(No Transcript)
21
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.

22
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.

23
A. Efficient (Markowitz) Portfolios

• Return Maximization Risk Minimization
• Maximize Expected Return Minimize return
  variance
• subject to
• where,
• s2 Investor's desired level of variance
• E(R) Investor's desired expected returns

24
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.

25
II. Just Diversify
26
The Optimally Diversified Portfolio
27
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.

28
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.

29
Market Timing Approaches

• Non-financial indicators
• Spurious Indicators Over time, researchers have
  found a number of real world phenomena to be
  correlated with market movements. (The winner of
  the Super Bowl, Sun Spots)
• Feel Good Indicators When people are feeling
  good, markets will do well.
• Hype Indicators When stocks become the topic of
  casual conversation, it is time to get out. The
  Cocktail party chatter measure (Time elapsed at
  party before talk turns to stocks, average age of
  chatterers, fad component)
• Technical Indicators
• Price Indicators Charting patterns and
  indicators give advance notice.
• Volume Indicators Trading volume may give clues
  to market future
• Volatility Indicators Higher volatility often a
  predictor or higher stock returns in the future
• Reversion to the mean Every asset has a normal
  range of value and things revert back to normal.
• Fundamentals There is an intrinsic value for the
  market.

30
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.

31
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

32
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.

33
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.

34
A Normal Range for PE Ratios SP 500
35
PE Ratios in Brazil
36
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.

37
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.

38
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.

39
GDP Growth and Stock Returns US
40
An intrinsic value for the SP 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

41
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)

42
A short cut to intrinsic value Earnings yield
versus T.Bond Rates
43
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

44
How well does market timing work?1. Mutual Funds
45
2. Tactical Asset Allocation Funds
46
3. Market Strategists provide timing advice
47
But would your pay for it?
48
IV. Timing other markets

• It is not just the equity and bond markets that
  investors try to time. In fact, it can be argued
  that there are more market timers in the currency
  and commodity markets.
• The keys to understanding the currency and
  commodity markets are
• These markets have far fewer investors and they
  tend to be bigger.
• Currency and commodity markets are not as deep as
  equity markets
• As a consequence,
• Price changes in these markets tend to be
  correlated over time and momentum can have a
  bigger impact
• When corrections hit, they tend to be large since
  investors suffer from lemmingitis.
• Resulting in
• Timing strategies that look successful and low
  risk for extended periods
• But collapse in a crisis

49
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.

50
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.

51
(No Transcript)
52
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.

53
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.

54
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.

55
I. Intrinsic Value Investors The determinants of
intrinsic value
56
(No Transcript)
57
(No Transcript)
58
To do intrinsic valuation right

• Check for consistency
• Are your cash flows and discount rates in the
  same currency?
• Are you computing cash flows to equity or the
  firm and are your discount rates computed
  consistently?
• Are your growth rate and reinvestment assumptions
  consistent?
• Focus on excess returns and competitive
  advantages success breeds competition.
• Recognize that as firms get larger, growth will
  get more difficult to pull off.
• Remember that you 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.

59
To make money on intrinsic valuation

• You have to be able to value a company, given its
  fundamental risk, cash flow and growth
  characteristics, without being swayed too much by
  what the market mood may be about the company and
  the sector.
• The market has to be making a mistake in pricing
  one or more of these fundamentals.
• The market has to correct its mistake sooner or
  later for you to make money.
• Proposition 1 For intrinsic valuation to work,
  you have to be willing to expend time and
  resources to understand the company you are
  valuing and to relate its value to its
  fundamentals.
• Proposition 2 You need a long time horizon for
  intrinsic valuation to pay off.
• Proposition 3 Your universe of investments has
  to be limited.

60
II. The Relative Value Investor

• In relative value investing, you compare how
  stocks are priced to their fundamentals (using
  multiples) to find under and over valued stocks.
• This approach to value investing can be traced
  back to Ben Graham and his screens to find
  undervalued stocks.
• In recent years, these screens have been refined
  and extended and the availability of data and
  more powerful screening techniques has allowed us
  to expand these screens and back-test them.

61
Ben Graham Screens

• 1. PE of the stock has to be less than the
  inverse of the yield on AAA Corporate Bonds
• 2. PE of the stock has to less than 40 of the
  average PE over the last 5 years.
• 3. Dividend Yield gt Two-thirds of the AAA
  Corporate Bond Yield
• 4. Price lt Two-thirds of Book Value
• 5. Price lt Two-thirds of Net Current Assets
• 6. Debt-Equity Ratio (Book Value) has to be less
  than one.
• 7. Current Assets gt Twice Current Liabilities
• 8. Debt lt Twice Net Current Assets
• 9. Historical Growth in EPS (over last 10 years)
  gt 7
• 10. No more than two years of negative earnings
  over the previous ten years.

62
The Buffett Mystique
63
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.

64
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.

65
Low Price/BV Ratios and Excess Returns
66
The lowest price to book stocks
67
What drives price to book ratios?

• Going back to a simple dividend discount model,
• This formulation can be simplified even further
  by relating growth to the return on equity
• g (1 - Payout ratio) ROE
• Substituting back into the P/BV equation,
• In short, a stock can have a low price to book
  ratio because it has a low return on equity, low
  growth or high risk.

68
Low Price to Book High Return on Equity
69
The Low PE Effect
70
The lowest PE stocks
71
The Determinants of PE

• The price-earnings ratio for a high growth firm
  can also be related to fundamentals. In the
  special case of the two-stage dividend discount
  model, this relationship can be made explicit
  fairly simply
• For a firm that does not pay what it can afford
  to in dividends, substitute FCFE/Earnings for the
  payout ratio.
• Dividing both sides by the earnings per share

72
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.

73
III. Contrarian Value Investing Buying the Losers

• The fundamental premise of contrarian value
  investing is that markets often over react to bad
  news and push prices down far lower than they
  should be.
• A follow-up premise is that they markets
  eventually recognize their mistakes and correct
  for them.
• There is some evidence to back this notion
• Studies that look at returns on markets over long
  time periods chronicle that there is significant
  negative serial correlation in returns, I.e, good
  years are more likely to be followed by bad years
  and vice versa
• Studies that focus on individual stocks find the
  same effect, with stocks that have done well more
  likely to do badly over the next period, and vice
  versa.

74
Excess Returns for Winner and Loser Portfolios
75
The Biggest Losers
76
A variation on contrarian value investing

• If you accept the premise that markets become
  over-enamored with companies that are viewed as
  good and well managed companies and over-sold on
  companies that are viewed as poorly run with bad
  prospects, the former should be priced too high
  and the latter too low.
• A particularly perverse value investing strategy
  is to pick badly managed, badly run companies as
  your investments and wait for the recovery.

77
Good Companies are not necessarily Good
Investments
78
Loser Portfolios and Time Horizon
79
IV. Activist Value Investing

• An activist value investor having acquired a
  stake in an undervalued company which might
  also be badly managed then pushes the
  management to adopt those changes which will
  unlock this value.
• If the value of the firm is less than its
  component parts
• push for break up of the firm, spin offs, split
  offs etc.
• If the firm is being too conservative in its use
  of debt
• push for higher leverage and recapitalization
• If the firm is accumulating too much cash
• push for higher dividends, stock repurchases ..
• If the firm is being badly managed
• push for a change in management or to be acquired
• If there are gains from a merger or acquisition
• push for the merger or acquisition, even if it is
  hostile

80
(No Transcript)
81
(No Transcript)
82
(No Transcript)
83
Determinants of Success at Activist Investing

• 1. Have lots of capital Since this strategy
  requires that you be able to put pressure on
  incumbent management, you have to be able to take
  significant stakes in the companies.
• 2. Know your company well Since this strategy is
  going to lead a smaller portfolio, you need to
  know much more about your companies than you
  would need to in a screening model.
• 3. Understand corporate finance You have to know
  enough corporate finance to understand not only
  that the company is doing badly (which will be
  reflected in the stock price) but what it is
  doing badly.
• 4. Be persistent Incumbent managers are unlikely
  to roll over and play dead just because you say
  so. They will fight (and fight dirty) to win. You
  have to be prepared to counter.
• 5. Do your homework You have to form coalitions
  with other investors and to organize to create
  the change you are pushing for.

84
Growth Investing
Value investors focus assets in place
Growth investors bet on growth assets They
believe that they can assess their value better
than markets
85
Is growth investing doomed?
86
But there is another side ..
87
Adding on
88
Furthermore..

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

89
Growth Investing Strategies

• Passive Growth Investing Strategies focus on
  investing in stocks that pass a specific screen.
  Classic passive growth screens include
• PE lt 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

90
I. Passive Growth Strategies
91
II. Small Cap Investing

• One of the most widely used passive growth
  strategies is the strategy of investing in
  small-cap companies. There is substantial
  empirical evidence backing this strategy, though
  it is debatable whether the additional returns
  earned by this strategy are really excess
  returns.
• Studies have consistently found that smaller
  firms (in terms of market value of equity) earn
  higher returns than larger firms of equivalent
  risk, where risk is defined in terms of the
  market beta. In one of the earlier studies,
  returns for stocks in ten market value classes,
  for the period from 1927 to 1983, were presented.

92
The Small Firm Effect
93
A Note of caution
94
III. Activist Growth Investing..
95
Are there great stock pickers?

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

96
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

97
Information and Prices in an Efficient Market
98
A Slow Learning Market
99
An Overreacting Market
100
I. Earnings Reports
101
II. Acquisitions Evidence on Target Firms
102
III. Analyst Recommendations
103
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.

104
(No Transcript)
105
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.

106
The Magnitude of the Spread
107
Round-Trip Costs (including Price Impact) as a
Function of Market Cap and Trade Size
108
The Overall Cost of Trading Small Cap versus
Large Cap Stocks
109
Many a slip
110
Trading Costs and Performance...
111
The Trade Off on Trading

• There are two components to trading and execution
  - the cost of execution (trading) and the speed
  of execution.
• Generally speaking, the tradeoff is between
  faster execution and lower costs.
• For some active strategies (especially those
  based on information) speed is of the essence.
• Maximize Speed of Execution
• Subject to Cost of execution lt Excess returns
  from strategy
• For other active strategies (such as those based
  on long term investing) the cost might be of the
  essence.
• Minimize Cost of Execution
• Subject to Speed of execution lt Specified time
  period.
• The larger the fund, the more significant this
  trading cost/speed tradeoff becomes.

112
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.

113
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.

114
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.

115
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.

116
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.

117
The Performance of Hedge Funds
118
Looking a little closer at the numbers

• The average hedge fund earned a lower return
  (13.26) over the period than the SP 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.

119
Returns by sub-category
120
(No Transcript)
121
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

122
I. Against a Market Index
123
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.

124
Value and Growth Funds
125
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.

126
The Performance of Mutual Funds..
127
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.

128
Enhanced Index Funds Oxymoron?
129
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.

130
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?

131
Finding an Investment Philosophy
132
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.

133
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.

134
If you walk like a lemming, run like a lemming
you are a lemming