Professional Documents
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Aswath Damodaran 1
What is an investment philosophy?
Aswath Damodaran 2
Ingredients of an Investment Philosophy
Step 1: All investment philosophies begin with a view about how human
beings learn (or fail to learn). Underlying every philosophy, therefore
is a view of human frailty - that they learn too slowly, learn too fast,
tend to crowd behavior etc….
Step 2: From step 1, you generate a view about markets behave and
perhaps where they fail…. Your views on market efficiency or
inefficiency are the foundations for your investment philosophy.
Step 3: This step is tactical. You take your views about how investors
behave and markets work (or fail to work) and try to devise strategies
that reflect your beliefs.
Aswath Damodaran 3
An Example..
Aswath Damodaran 4
Why do you need an investment philosophy?
If you do not have an investment philosophy, you will find yourself doing
the following:
1. Lacking a rudder or a core set of beliefs, you will be easy prey for
charlatans and pretenders, with each one claiming to have found the
magic strategy that beats the market.
2. Switching from strategy to strategy, you will have to change your
portfolio, resulting in high transactions costs and paying more in
taxes.
3. Using a strategy that may not be appropriate for you, given your
objectives, risk aversion and personal characteristics. In addition to
having a portfolio that under performs the market, you are likely to
find yourself with an ulcer or worse.
Aswath Damodaran 5
The Investment Process
The Client
Utility Risk Tolerance/ Investment Horizon Tax Status Tax Code
Functions Aversion
Valuation
based on Security Selection Private Market Efficiency
- Cash flows - Which stocks? Which bonds? Which real assets? Information - Can you beat
- Comparables the market?
- Technicals
Trading Execution
Costs Trading Trading Systems
- How often do you trade? Speed - How does trading
- Commissions - How large are your trades?
- Bid Ask Spread affect prices?
- Do you use derivatives to manage or enhance risk?
- Price Impact
Aswath Damodaran 7
I. Measuring Risk
Aswath Damodaran 8
What we know about investor risk preferences..
Aswath Damodaran 9
Risk and Return Models in Finance
Step 1: Defining Risk
T he 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
Aswath Damodaran 10
Some quirks in risk aversion…
Individuals are far more affected by losses than equivalent gains (loss
aversion), and this behavior is made worse by frequent monitoring (myopia).
The choices that people make (and the risk aversion they manifest) when
presented with risky choices or gambles can depend upon how the choice is
presented (framing).
Individuals tend to be much more willing to take risks with what they consider
“found money” than with money that they have earned (house money effect).
There are two scenarios where risk aversion seems to decrease and even be
replaced by risk seeking. One is when individuals are offered the chance of
making an extremely large sum with a very small probability of success (long
shot bias). The other is when individuals who have lost money are presented
with choices that allow them to make their money back (break even effect).
When faced with risky choices, whether in experiments or game shows,
individuals often make mistakes in assessing the probabilities of outcomes,
over estimating the likelihood of success,, and this problem gets worse as the
choices become more complex.
Aswath Damodaran 11
II. Time Horizon
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Investor Time Horizon
Aswath Damodaran 13
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
Aswath Damodaran 14
Dividends versus Capital Gains Tax Rates for
Individuals: United States
Aswath Damodaran 15
The Tax Effect: Stock Returns before and after
taxes.. With one year time horizons
Aswath Damodaran 16
The Tax Effect and Dividend Yields
Aswath Damodaran 17
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 Large Large Midcap Midcap Midcap Small Small Small
Value Blend Growth Value Blend Growth Value Blend Growth
Fund Style
Aswath Damodaran 18
Tax Effect and Turnover Ratios
Aswath Damodaran 19
The Investment Process
The Client
Utility Risk Tolerance/ Investment Horizon Tax Status Tax Code
Functions Aversion
Valuation
based on Security Selection Private Market Efficiency
- Cash flows - Which stocks? Which bonds? Which real assets? Information - Can you beat
- Comparables the market?
- Technicals
Trading Execution
Costs Trading Trading Systems
- How often do you trade? Speed - How does trading
- Commissions - How large are your trades?
- Bid Ask Spread affect prices?
- Do you use derivatives to manage or enhance risk?
- Price Impact
Aswath Damodaran 20
Asset Allocation
Aswath Damodaran 21
I. Passive Asset Allocation
Aswath Damodaran 22
A. Efficient (Markowitz) Portfolios
i 1 s wi w js ij
2
p
i1 j 1
i n j n i n
s wi wj s ij s
ˆ2 E(R p ) wi E(R i ) = E(R
2
ˆ)
subject to p
i 1 j1 i 1
where,
s2 = Investor's desired level of variance
E(R) = Investor's desired expected returns
Aswath Damodaran 23
Limitations of this Approach
Aswath Damodaran 24
II. Just Diversify
QuickTime™ and a
TIFF (Uncompressed) decompressor
are needed to see this picture.
Aswath Damodaran 25
The Optimally Diversified Portfolio
Venture
Capital
Emerging M arkets
US Real Estate 3%
4%
US Equity
Cash Equivalents
5% 22%
International Bonds
26%
International Equity
20%
US Bonds
19%
Aswath Damodaran 26
II. Active Asset Allocation (Market Timing)
Aswath Damodaran 27
Market Timing Strategies
Asset Allocation: Adjust your mix of assets, allocating more than you
normally would (given your time horizon and risk preferences) to
markets that you believe are under valued and less than you normally
would to markets that are overvalued.
Style Switching: Switch investment styles and strategies to reflect
expected market performance.
Sector Rotation: Shift your funds within the equity market from sector
to sector, depending upon your expectations of future economic and
market growth.
Market Speculation: Speculate on market direction, using either
financial leverage (debt) or derivatives to magnify profits.
Aswath Damodaran 28
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.
Aswath Damodaran 29
Non-financial indicators..
Spurious indicators that may seem to be correlated with the market but
have no rational basis. Almost all spurious indicators can be explained
by chance.
Feel good indicators that measure how happy are feeling - presumably,
happier individuals will bid up higher stock prices. These indicators
tend to be contemporaneous rather than leading indicators.
Hype indicators that measure whether there is a stock price bubble.
Detecting what is abnormal can be tricky and hype can sometimes feed
on itself before markets correct.
Aswath Damodaran 30
The past as an indicator of the future…
Number of occurrences
Priors % of positive returns Average return
After two down yea rs 19 57.90% 2.95%
After one down ye ar 30 60.00% 7.76%
After one up ye ar 30 83.33% 10.92%
After two up yea rs 51 50.98% 2.79%
Aswath Damodaran 31
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.
Aswath Damodaran 32
Trading Volume
Price increases that occur without much trading volume are viewed as less
likely to carry over into the next trading period than those that are
accompanied by heavy volume.
At the same time, very heavy volume can also indicate turning points in
markets. For instance, a drop in the index with very heavy trading volume is
called a selling climax and may be viewed as a sign that the market has hit
bottom. This supposedly removes most of the bearish investors from the mix,
opening the market up presumably to more optimistic investors. On the other
hand, an increase in the index accompanied by heavy trading volume may be
viewed as a sign that market has topped out.
Another widely used indicator looks at the trading volume on puts as a ratio of
the trading volume on calls. This ratio, which is called the put-call ratio is
often used as a contrarian indicator. When investors become more bearish,
they sell more puts and this (as the contrarian argument goes) is a good sign
for the future of the market.
Aswath Damodaran 33
A Normal Range for PE Ratios: S&P 500
Aswath Damodaran 34
35
Sep-06
Aug-06
Jul-06
Jun-06
May-06
Apr-06
Mar-06
Feb-06
Jan-06
Dec-05
PE Ratios in Brazil…
Nov-05
Oct-05
Sep-05
Aug-05
Bovespa: PE Ratio
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
0
18
16
14
12
10
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.
Aswath Damodaran 36
Fundamentals
Fundamental Indicators
• If short term rates are low, buy stocks…
• If long term rates are low, buy stocks…
• If economic growth is high, buy stocks…
Intrinsic value models
• Value the market using a discounted cash flow model and compare to
actual level.,
Relative value models
• Look at how market is priced, given fundamentals and given history.
Aswath Damodaran 37
The problem with fundamental indicators..
There are many indicators that market timers use in forecasting market
movements. They can be generally categorized into:
• Macro economic Indicators: Market timers have at various times claimed
that the best time to invest in stocks is when economic growth is picking
up or slowing down…
• Interest rate Indicators: Both the level of rates and the slope of the yield
curve have been used as predictors of future market movements. For
instance, short term rates exceeding long term rates ( a downward sloping
yield curve) has been considered anathema for stocks.
It is easy to show that markets are correlated with fundamental
indicators but it is much more difficult to find leading indicators of
market movements.
Aswath Damodaran 38
GDP Growth and Stock Returns: US
GDP Growth Class Number of years Average Return Standard deviation in returns Best Year Worst Year
>5% 23 10.84% 21.37% 46.74% -35.34%
3.5%-5% 22 14.60% 16.63% 52.56% -11.85%
2-3.5% 6 12.37% 13.95% 26.64% -8.81%
0-2% 5 19.43% 23.29% 43.72% -10.46%
<0% 16 9.94% 22.68% 49.98% -43.84%
Grand Total 72 12.42% 19.50% 52.56% -43.84%
Aswath Damodaran 39
An intrinsic value for the S&P 500: January 1,
2006
Aswath Damodaran 40
And for the Bovespa…
Aswath Damodaran 41
A short cut to intrinsic value: Earnings yield
versus T.Bond Rates
16.00%
14.00%
12.00%
10.00%
8.00%
Earnings Yield
T.Bond Rate
6.00% Bond-Bill
4.00%
2.00%
0.00%
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
-2.00%
Year
Aswath Damodaran 42
Regression Results
Aswath Damodaran 43
How well does market timing work?
1. Mutual Funds
Aswath Damodaran 44
2. Tactical Asset Allocation Funds
18.00%
16.00%
14.00%
12.00%
Average Annual Returns
8.00%
6.00%
4.00%
2.00%
0.00%
S & P 500 Couch Potato 50/50 Couch Potato 75/25 Asset Allocation
Type of Fund
Aswath Damodaran 45
3. Market Strategists provide timing advice…
Aswath Damodaran 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
• 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…
Aswath Damodaran 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
Aswath Damodaran 50
The Investment Process
The Client
Utility Risk Tolerance/ Investment Horizon Tax Status Tax Code
Functions Aversion
Valuation
based on Security Selection Private Market Efficiency
- Cash flows - Which stocks? Which bonds? Which real assets? Information - Can you beat
- Comparables the market?
- Technicals
Trading Execution
Costs Trading Trading Systems
- How often do you trade? Speed - How does trading
- Commissions - How large are your trades?
- Bid Ask Spread affect prices?
- Do you use derivatives to manage or enhance risk?
- Price Impact
Aswath Damodaran 52
Active investors come in all forms...
Aswath Damodaran 53
The Many Faces of Value Investing…
Aswath Damodaran 54
I. Intrinsic Value Investors: The determinants of
intrinsic value
Expected Growth
Cash flows Firm: Growth in
Firm: Pre-debt cash Operating Earnings
flow Equity: Growth in
Equity: After debt Net Income/EPS Firm is in stable growth:
Grows at constant rate
cash flows
forever
Terminal Value
CF1 CF2 CF3 CF4 CF5 CFn
Value .........
Firm: Value of Firm Forever
Discount Rate
Firm:Cost of Capital
Aswath Damodaran 55
DISCOUNTED CASHFLOW VALUATION
Riskfree Rate :
- No default risk Risk Premium
- No reinvestment risk Beta - Premium for average
- In same currency and + - Measures market risk X
risk investment
in same terms (real or
nominal as cash flows
Type of Operating Financial Base Equity Country Risk
Business Leverage Leverage Premium Premium
Aswath Damodaran 56
Avg Reinvestment Embraer: Status Quo ($)
rate = 25.08% Return on Capital
Reinvestment Rate 21.85%
25.08% Stable Growth
Current Cashflow to Firm Expected Growth g = 4.17%; Beta = 1.00;
EBIT(1-t) : $ 404 in EBIT (1-t) Country Premium= 5%
- Nt CpX 23 .2185*.2508=.0548 Cost of capital = 8.76%
- Chg WC 9 5.48 % ROC= 8.76%; Tax rate=34%
= FCFF $ 372 Reinvestment Rate=g/ROC
Reinvestment Rate = 32/404= 7.9% =4.17/8.76= 47.62%
On October 6, 2003
Cost of Equity Cost of Debt Embraer Price = R$15.51
10.52 % (4.17%+1%+4%)(1-.34) Weights
= 6.05% E = 84% D = 16%
Riskfree Rate :
$ Riskfree Rate= 4.17% Beta Mature market Country Equity Risk
+ 1.07 X premium + Lambda X Premium
4% 0.27 7.67%
Aswath Damodaran 57
To do intrinsic valuation right…
Aswath Damodaran 58
To make money on intrinsic valuation…
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:
The business the company is in should be simple and understandable.
The firm should have a consistent operating history, manifested in operating earnings that are
stable and predictable.
The firm should be in a business with favorable long term prospects.
Management Tenets:
The managers of the company should be candid. As evidenced by the way he treated his own
stockholders, Buffett put a premium on managers he trusted. The managers of the
company should be leaders and not followers.
Financial Tenets:
The company should have a high return on equity. Buffett used a modified version of what he
called owner earnings
Owner Earnings = Net income + Depreciation & Amortization – Capital Expenditures
The company should have high and stable profit margins.
Market Tenets:
Use conservative estimates of earnings and the riskless rate as the discount rate.
• In keeping with his view of Mr. Market as capricious and moody, even valuable companies can
be bought at attractive prices when investors turn away from them.
Aswath Damodaran 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
25.00%
20.00%
15.00%
10.00%
5.00%
0.00%
Lo we s t 1991-200 1
2
3 1961-199 0
4
5
6 1927-196 0
7
P BV Class 8
9
Hig h e s t
Aswath Damodaran 65
The lowest price to book stocks…
Aswath Damodaran 66
What drives price to book ratios?
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
FLCL3 EMBR3
CEGR3
AMBV3
3 CPFE3
DURA3 CSNA3
BBAS3 TMGC3
SGEN3 ENMA3
PBV
0
- 20 0 20 40 60 80 1 00
ROE
Aswath Damodaran 68
The Low PE Effect
Aswath Damodaran 69
The lowest PE stocks
Aswath Damodaran 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:
(1+ g) n
EPS0 * Payout Ratio *(1+ g) * 1
(1+ r) n EPS0 * Payout Ratio n *(1+ g) n *(1+ g n )
P0 = +
r-g (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 (1 + g)
Payout Ratio * (1 + g) * 1
P0 (1+ r) n Payout Ratio n *(1+ g) n * (1 + gn )
= +
EPS0 r -g (r - g n )(1+ r) n
Aswath Damodaran 71
Mismatches…The name of the game…
Aswath Damodaran 72
III. Contrarian Value Investing: Buying the
Losers
Aswath Damodaran 73
Excess Returns for Winner and Loser Portfolios
Aswath Damodaran 74
The Biggest Losers…
Aswath Damodaran 75
A variation on contrarian value investing…
Aswath Damodaran 76
Good Companies are not necessarily Good
Investments…
Aswath Damodaran 77
Loser Portfolios and Time Horizon
Aswath Damodaran 78
IV. Activist Value Investing
Aswath Damodaran 79
Increase Cash Flows
Reduce the cost of capital
Make your
More efficient product/service less Reduce
operations and Revenues discretionary Operating
cost cuttting: leverage
Higher Margins * Operating Margin
= EBIT Reduce beta
Aswath Damodaran 80
Blockbuster: Status Quo
Return on Capital
Reinvestment Rate 4.06%
Current Cashflow to Firm 26.46%
EBIT(1-t) : 163 Expected Growth
in EBIT (1-t) Stable Growth
- Nt CpX 39 g = 3%; Beta = 1.00;
- Chg WC 4 .2645*.0406=.0107
1.07 % Cost of capital = 6.76%
= FCFF 120 ROC= 6.76%; Tax rate=35%
Reinvestment Rate = 43/163
Reinvestment Rate=44.37%
=26.46%
Aswath Damodaran 81
Blockbuster: Restructured
Return on Capital
Reinvestment Rate 6.20%
Current Cashflow to Firm 17.32%
EBIT(1-t) : 249 Expected Growth
in EBIT (1-t) Stable Growth
- Nt CpX 39 g = 3%; Beta = 1.00;
- Chg WC 4 .1732*.0620=.0107
1.07 % Cost of capital = 6.76%
= FCFF 206 ROC= 6.76%; Tax rate=35%
Reinvestment Rate = 43/249
Reinvestment Rate=44.37%
=17.32%
Aswath Damodaran 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 Liabilities
Existing Investments Fixed Claim on cash flows
Generate cashflows today Assets in Place Debt Little or No role in management
Includes long lived (fixed) and Fixed Maturity
short-lived(working Tax Deductible
capital) assets
Expected Value that will be Growth Assets Equity Residual Claim on cash flows
created by future investments Significant Role in management
Perpetual Lives
Aswath Damodaran 84
Is growth investing doomed?
Aswath Damodaran 85
But there is another side ..
Aswath Damodaran 86
Adding on …
Aswath Damodaran 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
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.
Aswath Damodaran 91
The Small Firm Effect
Aswath Damodaran 92
A Note of caution…
16.00%
14.00%
Average Annual Return over Holding Period
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..
1 Yr
Fund Type 3 Yr 5 Yr 10 Yr 20 Yr
Early/Seed Venture Capit al -36.3 81 53.9 33 21.5
Balanced Ven ture Capital -30.9 45.9 33.2 24 16.2
Later Stage Venture Capital -25.9 27.8 22.2 24.5 17
All Venture Capit al -32.4 53.9 37.9 27.4 18.2
All Buyou ts -16.1 2.9 8.1 12.7 15.6
Mezzan ine 3.9 10 10.1 11.8 11.3
All Private Equit y -21.4 16.5 17.9 18.8 16.9
Aswath Damodaran 94
Are there great stock pickers?
Aswath Damodaran 95
Information Trading
Aswath Damodaran 96
Information and Prices in an Efficient Market
Asset price
Notice that the price
adjusts instantaneously
to the information
Time
New information is revealed
Aswath Damodaran 97
A Slow Learning Market…
Asset price
Time
New information is revealed
Aswath Damodaran 98
An Overreacting Market
Time
New information is revealed
Aswath Damodaran 99
I. Earnings Reports
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.
Valuation
based on Security Selection Private Market Efficiency
- Cash flows - Which stocks? Which bonds? Which real assets? Information - Can you beat
- Comparables the market?
- Technicals
Trading Execution
Costs Trading Trading Systems
- How often do you trade? Speed - How does trading
- Commissions - How large are your trades?
- Bid Ask Spread affect prices?
- Do you use derivatives to manage or enhance risk?
- Price Impact
16.00%
14.00%
12.00%
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%
-2.00%
-4.00%
-6.00%
1 (Lowest) 2 3 4 5 (Highest)
Total Cost Category
There are two components to trading and execution - the cost of execution
(trading) and the speed of execution.
Generally speaking, the tradeoff is between faster execution and lower costs.
For some active strategies (especially those based on information) speed is of
the essence.
Maximize: Speed of Execution
Subject to: Cost of execution < Excess returns from strategy
For other active strategies (such as those based on long term investing) the
cost might be of the essence.
Minimize: Cost of Execution
Subject to: Speed of execution < Specified time period.
The larger the fund, the more significant this trading cost/speed tradeoff
becomes.
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.
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.
Valuation
based on Security Selection Private Market Efficiency
- Cash flows - Which stocks? Which bonds? Which real assets? Information - Can you beat
- Comparables the market?
- Technicals
Trading Execution
Costs Trading Trading Systems
- How often do you trade? Speed - How does trading
- Commissions - How large are your trades?
- Bid Ask Spread affect prices?
- Do you use derivatives to manage or enhance risk?
- Price Impact
80%
70%
60%
50%
40%
30%
20%
10%
0%
1971
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
-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))
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.
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?
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.