Investment Philosophy:

The Secret Ingredient in Investment Success

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.
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.
 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)
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.
 The Investment Process
The Client
Utility Risk Tolerance/ Investment Horizon Tax Status Tax Code
Functions Aversion

The Portfolio Manager’s Job

Asset Allocation Views on Risk and Return

Views on Asset Classes: Stocks Bonds Real Assets - inflation - Measuring risk
markets - rates - Effects of
Countries: Domestic Non-Domestic
- growth diversification

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

Performance Evaluation Risk Models

Market 1. How much risk did the portfolio manager take? Stock - The CAPM
Timing 2. What return did the portfolio manager make? Selection - The APM
3. Did the portfolio manager underperform or outperform?
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.
 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
 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).
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 The APM Multi-Factor Models Proxy Models
If there is If there are no Since market risk affects In an efficient market,
1. no private information arbitrage opportunities most or all investments, differences in returns
2. no transactions cost then the market risk of it must come from across long periods must
the optimal diversified any asset must be macro economic factors. be due to market risk
portfolio includes every captured by betas Market Risk = Risk differences. Looking for
traded asset. Everyone relative to factors that exposures of any variables correlated with
will hold thismarket portfolio affect all investments. asset to macro returns should then give
Market Risk = Risk Market Risk = Risk economic factors. us proxies for this risk.
added by any investment exposures of any Market Risk =
to the market portfolio: asset to market Captured by the
factors Proxy Variable(s)
Beta of asset relative to Betas of asset relative Betas of assets relative Equation relating
Market portfolio (from to unspecified market to specified macro returns to proxy
a regression) factors (from a factor economic factors (from variables (from a
analysis) a regression) regression)
 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.
 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?
 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…)
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
Dividends versus Capital Gains Tax Rates for
Individuals: United States
The Tax Effect: Stock Returns before and after
taxes.. With one year time horizons
The Tax Effect and Dividend Yields
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
Tax Effect and Turnover Ratios
 The Investment Process
The Client
Utility Risk Tolerance/ Investment Horizon Tax Status Tax Code
Functions Aversion

The Portfolio Manager’s Job

Asset Allocation Views on Risk and Return

Views on Asset Classes: Stocks Bonds Real Assets - inflation - Measuring risk
markets - rates - Effects of
Countries: Domestic Non-Domestic - growth diversification

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

Performance Evaluation Risk Models

Market 1. How much risk did the portfolio manager take? Stock - The CAPM
Timing 2. What return did the portfolio manager make? Selection - The APM
3. Did the portfolio manager underperform or outperform?
 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.
 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.
 A. Efficient (Markowitz) Portfolios
Return MaximizationRisk Minimization
Maximize Expected Return Minimize return variance
i n i n j n

E(R p )   wi E(R i )     wi w j ij
2
p
i 1 i1 j 1

i  n j n i n
    wi wj  ij  
ˆ2 E(R p )   wi E(R i ) = E(R
2
p
ˆ)
i 1 j1 i 1
subject to
where,
s2 = Investor's desired level of variance
E(R) = Investor's desired expected returns
 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.
II. Just Diversify

QuickTime™ and a
TIFF (Uncompressed) decompressor
are needed to see this picture.
The Optimally Diversified Portfolio
Global Investable Capital: 1998

Venture
Capital
Emerging Markets
US Real Estate 3%
4%

Cash Equivalents US Equity

22%
5%

International Bonds
26%

International Equity
20%

US Bonds
19%
 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.
 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.
 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.
 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.
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
Number of occurrences
Priors % of positive returns Average return
 The last two
After two down years
years 19
have been down
57.90%
years 2.95%
None
After one downof
yearthe above 30 60.00% 7.76%
After one up year 30 83.33% 10.92%
After two up years 51 50.98% 2.79%
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.
 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.
A Normal Range for PE Ratios: S&P 500
 Sep-06
Aug-06
Jul-06
Jun-06
May-06
PE Ratios in Brazil…

Apr-06
Mar-06
Feb-06
Jan-06
Dec-05
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

18

16

14

12

10

0
 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.
 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.
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.
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%
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
1 2 3 4 5
Expected Dividends = $ 45.03 $ 48.63 $ 52.52 $ 56.72 $ 61.26
Expected Terminal Value = $ 1,598.68
Present Value = $ 41.54 $ 41.39 $ 41.24 $ 41.09 $ 1,109.55
Intrinsic Value of Index$= 1,274.82
 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
1 2 3 4 5
Expected Dividends = $ 1,859.00 $ 2,044.90 $ 2,249.39 $ 2,474.33 $ 2,721.76
Expected Terminal Value = $ 40,709.79
Present Value = $ 1,664.28 $ 1,638.95 $ 1,614.01 $ 1,589.44 $ 24,976.95
Intrinsic Value of Index = $ 31,483.63
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
6.00% Bond-Bill

4.00%

2.00%

0.00%
1964

1966

1968

1970

1976

1980
1960

1962

1972

1974

1978

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004
-2.00%
Year
 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%
How well does market timing work?
1. Mutual Funds
2. Tactical Asset Allocation Funds
Performance of Unsophisticated Strategies versus Asset
Allocation Funds

18.00%

16.00%

14.00%

12.00%
Average Annual Returns

10.00% Last 10 years

Last 15 years

8.00%

6.00%

4.00%

2.00%

0.00%
S & P 500 Couch Potato 50/50 Couch Potato 75/25 Asset Allocation
Type of Fund
3. Market Strategists provide timing advice…

Firm Strategist Stocks Bonds Cash

A.G. Edwards Mark Keller 65% 20% 15%
Banc of America Tom McManus 55% 40% 5%
Bear Stearns & Co. Liz MacKay 65% 30% 5%
CIBC World Markets Subodh Kumar 75% 20% 2%
Credit Suisse Tom Galvin 70% 20% 10%
Goldman Sach & Co. Abby Joseph Cohen 75% 22% 0%
J.P. Morgan Douglas Cliggott 50% 25% 25%
Legg Mason Richard Cripps 60% 40% 0%
Lehman Brothers Jeffrey Applegate 80% 10% 10%
Merrill L ynch & Co. Richard Bernstein 50% 30% 20%
Morgan Stanley Steve Galbraith 70% 25% 5%
Prudential Edward Yardeni 70% 30% 0%
Raymond James Jeffrey Saut 65% 15% 10%
Salomon Smith John Manley 75% 20% 5%
UBS Warburg Edward Kerschner 80% 20% 0%
Wachovia Rod Smyth 75% 15% 0%
But would your pay for it?
 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…
 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.
 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.
 The Investment Process
The Client
Utility Risk Tolerance/ Investment Horizon Tax Status Tax Code
Functions Aversion

The Portfolio Manager’s Job

Asset Allocation Views on Risk and Return

Views on Asset Classes: Stocks Bonds Real Assets - inflation - Measuring risk
markets - rates - Effects of
Countries: Domestic Non-Domestic
- growth diversification

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

Performance Evaluation Risk Models

Market 1. How much risk did the portfolio manager take? Stock - The CAPM
Timing 2. What return did the portfolio manager make? Selection - The APM
3. Did the portfolio manager underperform or outperform?
 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.
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.
 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.
I. Intrinsic Value Investors: The determinants
of intrinsic value
DISCOUNTED CASHFLOW VALUATION

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

Equity: Value of Equity

Length of Period of High Growth

Discount Rate
Firm:Cost of Capital

Equity: Cost of Equity

 DISCOUNTED CASHFLOW VALUATION

Cashflow to Firm Expected Growth

EBIT (1-t) Reinvestment Rate
- (Cap Ex - Depr) * Return on Capital
- Change in WC Firm is in stable growth:
Grows at constant rate
= FCFF
forever

Terminal Value= FCFF n+1 /(r-g n)

FCFF1 FCFF2 FCFF3 FCFF4 FCFF5 FCFFn
Value of Operating Assets .........
+ Cash & Non-op Assets Forever
= Value of Firm
- Value of Debt Discount at WACC= Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity))
= Value of Equity

Cost of Equity Cost of Debt Weights

(Riskfree Rate Based on Market Value
+ Default Spread) (1-t)

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
 Avg Reinvestment
rate = 25.08%
Embraer: Status Quo ($) 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%

Terminal Value5 = 288/(.0876-.0417) = 6272

$ Cashflows
Op. Assets $ 5,272 Term Yr
+ Cash: 795 Year 1 2 3 4 5 549
- Debt 717 EBIT(1-t) 426 449 474 500 527 - 261
- Minor. Int. 12 - Reinvestment 107 113 119 126 132 = 288
=Equity 5,349 = FCFF 319 336 355 374 395
-Options 28
Value/Share $7.47
R$ 21.75 Discount at$ Cost of Capital (WACC) = 10.52% (.84) + 6.05% (0.16) = 9.81%

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
0.27
X Premium
4% 7.67%

Unlevered Beta for Firm’s D/E Rel Equity

Sectors: 0.95 Ratio: 19% Country Default Mkt Vol
Spread X
6.01% 1.28
 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.
 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.
 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.
 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.
The Buffett Mystique
 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.
 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.
Low Price/BV Ratios and Excess Returns

Figure 8.2: PBV Classes and Returns - 1927-2001

25.00%

20.00%

15.00%

10.00%

5.00%

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

1927-1960 1961-1990 1991-2001

The lowest price to book stocks…

Company Name Book Value of Equity Price to Book Ratio

CEMAR 426.89 0.23
CEB 487.61 0.24
SERGEN 102.82 0.28
MELHOR SP 179.56 0.34
ELETROBRAS 75714.89 0.37
TELEBRAS SA 120.64 0.39
AMAZONIA 1630.88 0.49
SANEPAR-PREF 2132.52 0.52
MERC BRASIL 472.76 0.55
ALFA CONSORC 412.44 0.55
CELG 1230.56 0.55
ALFA HOLDING 369.11 0.56
COTEMINAS 1704.83 0.60
IENERGIA 307.09 0.61
JOAO FORTES ENG 80.47 0.64
MUNDIAL SA 105.02 0.64
BRASMOTOR 842.56 0.72
CACIQUE 188.49 0.75
WLM IND COMERCIO 222.42 0.75
 What drives price to book ratios?
• Going back to a simple dividend discount model,
DPS1
P0 
Cost of Equity g n
• This formulation can be simplified even further by relating
growth to the return on equity:

g = (1 - Payout ratio) * ROE
• Substituting back into the P/BV equation,
P0 ROE - g n
 PBV =
BV0
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.
Low Price to Book & High Return on Equity

4 HGTX3
CPSL3

FLCL3 EMBR3
CEGR3
AMBV3
3 CPFE3
DURA3 CSNA3

BBAS3 TMGC3

GRND3 BRSR3 CSRN3 ELUM3

2 BFIT3
ROMI3
ELEK3
PTIP3 RGEG3 PQUN3

FJTA3GEPA3
BRKM3 CSMG3
IGBR3
1
RNAR3 BNBR3
CGOS3
SGEN3 ENMA3
PBV

0
- 20 0 20 40 60 80 1 00

ROE
The Low PE Effect
The lowest PE stocks

Company name PE Ratio

CEMAR 0.27
AMAZONIA 3.15
CEMAT 3.89
CIA HERING 3.96
CEB 4.19
GRADIENTE 4.30
USIMINAS SA 4.37
CELULOSE IRANI 4.44
IPIRANGA DIS 4.87
MONTEIRO ARANHA 5.00
PETROFLEX 5.42
ACESITA SA 5.42
MET GERDAU SA 5.46
COELBA 5.57
COELBA-PREF A 5.57
SERGEN 5.65
TELEBRAS SA 5.75
SANEPAR-PREF 5.77
CELG 5.77
BANESTES 5.98
 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
 (1 + g) 
n

EPS * Payout Ratio *(1 + g)* 1 

can be made
P =
explicit fairly
0
 (1 + r)simply:
n
 EPS * Payout Ratio *(1 + g) *(1 + g )
+ 0 n
n
n
0 n
r-g (r -g n )(1 + r)

– For a firm that does not pay

Payout Ratio * (1 + g) * 1 
n what
(1 + g) 

it can afford to in
n
P  (1+ r)  Payout Ratio *(1+ g) * (1 + g )
n
dividends,
EPS
substitute
= 0
0
FCFE/Earnings
r -g
+ n
for the payout ratio.
n
(r - g )(1+ r)
n
n

• Dividing both sides by the earnings per share:

 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.
 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.
Excess Returns for Winner and Loser
Portfolios
 The Biggest Losers…

Company Name Return in last year Latest price

ELEKEIROZ SA -40.348 0.83
KEPLER WEBER SA -35.722 5.6
GRADIENTE ELETRONICA SA -33.571 9.3
CIA ENERGETICA DO MARANHAO -29.956 0.14
TELEMIG CELULAR PARTICIPACOE -23.361 7.95
BRASKEM SA -21.781 12.25
BANCO SUDAMERIS BRASIL SA -21.264 0.81
ITAUTEC SA - GRUPO ITAUTEC -18.115 36
UNIAO DE INDS PETROQUIMICAS -15.819 2.05
PORTOBELLO SA -13.966 1.53
GPC PARTICIPACOES SA -11.702 0.83
RENAR MACAS SA -8.219 0.7
AES ELPA SA -5.844 14.5
BRASIL TELECOM PART SA -1.799 27.85
CIA TECIDOS NORTE DE MINAS -1.158 170
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.
Good Companies are not necessarily Good
Investments…
Loser Portfolios and Time Horizon
 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
 Increase Cash Flows
Reduce the cost of capital

Make your
More efficient product/service less Reduce
operations and Revenues Operating
discretionary
cost cuttting: leverage
Higher Margins * Operating Margin

= EBIT Reduce beta

Divest assets that - Tax Rate * EBIT

have negative EBIT Cost of Equity * (Equity/Capital) +
= EBIT (1-t) Pre-tax Cost of Debt (1- tax rate) *
Live off past over- (Debt/Capital)
+ Depreciation investment
Reduce tax rate
- Capital Expenditures Shift interest
- moving income to lower tax locales - Chg in Working Capital
- transfer pricing = FCFF Match your financing expenses to
- risk management higher tax locales
to your assets:
Reduce your default
risk and cost of debt
Change financing
Better inventory mix to reduce
management and cost of capital
tighter credit policies
Firm Value

Increase Expected Growth Increase length of growth period

Reinvest more in Do acquisitions

projects Build on existing Create new
Reinvestment Rate
competitive competitive
* Return on Capital advantages advantages
Increase operating Increase capital turnover ratio
margins
= Expected Growth Rate
 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
=26.46% Reinvestment Rate=44.37%

Terminal Value5 = 104/(.0676-.03) = 2714

Op. Assets 2,472

+ Cash: 330 1 2 3 4 5 Term Yr
- Debt 1847 EBIT (1-t) $165 $167 $169 $173 $178 184
=Equity 955 - Reinvestment $44 $44 $51 $64 $79 82
-Options 0 FCFF $121 $123 $118 $109 $99 102
Value/Share $ 5.13
Discount atCost of Capital (WACC) = 8.50% (.486) + 3.97% (0.514) = 6.17%

Cost of Equity Cost of Debt

8.50 % (4.10%+2%)(1-.35) Weights
= 3.97% E = 48.6% D = 51.4%

Riskfree Rate : Risk Premium

Riskfree rate = 4.10% Beta 4%
+ 1.10 X

Unlevered Beta for Firm’s D/E Mature risk Country

Sectors: 0.80 Ratio: 21.35% premium Equity Prem
4% 0%
 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
=17.32% Reinvestment Rate=44.37%

Terminal Value5 = 156/(.0676-.03) = 4145

Op. Assets 3,840

+ Cash: 330 1 2 3 4 5 Term Yr
- Debt 1847 EBIT (1-t) $252 $255 $258 $264 $272 280
=Equity 2323 - Reinvestment $44 $44 $59 $89 $121 124
-Options 0 FCFF $208 $211 $200 $176 $151 156
Value/Share $ 12.47
Discount atCost of Capital (WACC) = 8.50% (.486) + 3.97% (0.514) = 6.17%

Cost of Equity Cost of Debt

8.50 % (4.10%+2%)(1-.35) Weights
= 3.97% E = 48.6% D = 51.4%

Riskfree Rate : Risk Premium

Riskfree rate = 4.10% Beta 4%
+ 1.10 X

Unlevered Beta for Firm’s D/E Mature risk Country

Sectors: 0.80 Ratio: 21.35% premium Equity Prem
4% 0%
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.
Value investors
focus assets in Growth Investing
place

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

Growth investors bet on growth

assets: They believe that they can
assess their value better than markets
Is growth investing doomed?
But there is another side ..
Adding on …
 Furthermore..
• And active growth investors seem to beat growth indices more often than
value investors beat value indices.
 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
I. Passive Growth Strategies
 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.
The Small Firm Effect
 A Note of caution…
Figure 9.7: Time Horizon and the Small Firm Premium

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
III. Activist Growth Investing..

1 Yr
Fund Type 3 Yr 5 Yr 10 Yr 20 Yr
Early/Seed Ven ture Capital -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 Capital -32.4 53.9 37.9 27.4 18.2
All Buyouts -16.1 2.9 8.1 12.7 15.6
Mezzanine 3.9 10 10.1 11.8 11.3
All Private Equity -21.4 16.5 17.9 18.8 16.9
 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
S&P 500 Index -2.70% 7.20% 190.80%   
 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
Information and Prices in an Efficient Market

Figure 10.1: Price Adjustment in an Efficient Market

Asset price
Notice that the price
adjusts instantaneously
to the information

Time
New information is revealed
A Slow Learning Market…

Figure 10.2 A Slow Learning Market

Asset price

The price drifts upwards after the

good news comes out.

Time
New information is revealed
An Overreacting Market
Figure 10.3: An Overreacting Market

The price increases too much on the Asset price

good news announcement, and then
decreases in the period after.

Time
New information is revealed
I. Earnings Reports
II. Acquisitions: Evidence on Target Firms
III. Analyst Recommendations…
 To be a successful information trader…
 Identify the information around which your strategy will be built: Since you have to trade on
the announcement, it is critical that you determine in advance the information that will
trigger a trade.
 Invest in an information system that will deliver the information to you instantaneous: Many
individual investors receive information with a time lag – 15 to 20 minutes after it reaches the
trading floor and institutional investors. While this may not seem like a lot of time, the
biggest price changes after information announcements occur during these periods.
• Execute quickly: Getting an earnings report or an acquisition announcement in real time is of
little use if it takes you 20 minutes to trade. Immediate execution of trades is essential to
succeeding with this strategy.
• Keep a tight lid on transactions costs: Speedy execution of trades usually goes with higher
transactions costs, but these transactions costs can very easily wipe out any potential you
may see for excess returns).
• Know when to sell: Almost as critical as knowing when to buy is knowing when to sell, since
the price effects of news releases may begin to fade or even reverse after a while.
 The Investment Process
The Client
Utility Risk Tolerance/ Investment Horizon Tax Status Tax Code
Functions Aversion

The Portfolio Manager’s Job

Asset Allocation Views on Risk and Return

Views on Asset Classes: Stocks Bonds Real Assets - inflation - Measuring risk
markets - rates - Effects of
Countries: Domestic Non-Domestic
- growth diversification

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

Performance Evaluation Risk Models

Market 1. How much risk did the portfolio manager take? Stock - The CAPM
Timing 2. What return did the portfolio manager make? Selection - The APM
3. Did the portfolio manager underperform or outperform?
 Trading and Execution Costs
 The cost of trading includes four components:
the brokerage cost, which tends to decrease as the size
of the trade increases
the bid-ask spread, which generally does not vary with
the size of the trade but is higher for less liquid stocks
the price impact, which generally increases as the size
of the trade increases and as the stock becomes less
liquid.
the cost of waiting, which is difficult to measure since it
shows up as trades not made.
The Magnitude of the Spread
Round-Trip Costs (including Price Impact) as a
Function of Market Cap and Trade Size

Dollar Value of Block ($ thoustands)

Sector 5 25 250 500 1000 2500 5000 10000 20000
Smallest 17.30% 27.30% 43.80%
2 8.90% 12.00% 23.80% 33.40%
3 5.00% 7.60% 18.80% 25.90% 30.00%
4 4.30% 5.80% 9.60% 16.90% 25.40% 31.50%
5 2.80% 3.90% 5.90% 8.10% 11.50% 15.70% 25.70%
6 1.80% 2.10% 3.20% 4.40% 5.60% 7.90% 11.00% 16.20%
7 1.90% 2.00% 3.10% 4.00% 5.60% 7.70% 10.40% 14.30% 20.00%
8 1.90% 1.90% 2.70% 3.30% 4.60% 6.20% 8.90% 13.60% 18.10%
Largest 1.10% 1.20% 1.30% 1.71% 2.10% 2.80% 4.10% 5.90% 8.00%
The Overall Cost of Trading: Small Cap versus
Large Cap Stocks
Market Total Trading Total Trading
Capitalization Implicit Cost Explicit Cost Costs (NYSE) Costs (NASDAQ)
Smallest 2.71% 1.09% 3.80% 5.76%
2 1.62% 0.71% 2.33% 3.25%
3 1.13% 0.54% 1.67% 2.10%
4 0.69% 0.40% 1.09% 1.36%
Largest 0.28% 0.28% 0.31% 0.40%
Many a slip…
Trading Costs and Performance...
Figure 13.16: Trading Costs and Returns: Mutual Funds

16.00%

14.00%

12.00%

10.00%

8.00%

6.00%

4.00%

2.00%

0.00%

-2.00%

-4.00%

-6.00%
1 (Lowest) 2 3 4 5 (Highest)
Total Cost Category

Total Return Excess Return

 The Trade Off on Trading
 There are two components to trading and execution - the cost of execution
(trading) and the speed of execution.
 Generally speaking, the tradeoff is between faster execution and lower costs.
 For some active strategies (especially those based on information) speed is of the
essence.
Maximize: Speed of Execution
Subject to: Cost of execution < Excess returns from strategy
 For other active strategies (such as those based on long term investing) the cost
might be of the essence.
Minimize: Cost of Execution
Subject to: Speed of execution < Specified time period.
 The larger the fund, the more significant this trading cost/speed tradeoff becomes.
 Arbitrage Investment Strategies
• An arbitrage-based investment strategy is based upon
buying an asset (at a market price) and selling an
equivalent or the same asset at a higher price.
• A true arbitrage-based strategy is riskfree and hence
can be financed entirely with debt. Thus, it is a
strategy where an investor can invest no money, take
no risk and end up with a pure profit.
• Most real-world arbitrage strategies (such as those
adopted by hedge funds) have some residual risk and
require some investment.
 a. Pure Arbitrage Strategies
• Mispriced Options when the underlying stock is traded
– Since you can replicate a call or a put option using the underlying asset
and borrowing/lending, you can create riskfree positions where you buy
(sell) the option and sell (buy) the replicating portfolio.
– This position should be riskless and costless and create guaranteed profits.
• Mis-priced Futures Contracts
– Riskless positions can be created using the underlying asset and borrowing
and lending (as long as the asset can be stored)
– Futures on currencies and storable commodities have to obey this
arbitrage relationship.
• Mispriced Default-free Bonds
– The cash flows on a default free bond are known with certainty.
– When default-free bonds are priced inconsistently, we should be able to
combined them to create riskfree arbitrage.
 b. Close to Arbitrage
• Corporate Bonds
– Corporate bonds of similar default risk should be priced consistently.
– “Similar” default risk may not be the same as identical default risk, and
this can create a residue of risk.
– This risk will increase as default risk increases
• Securities issued by same firm
– Debt and equity issued by the same firm should be priced consistently.
– If they are mispriced relative to each other, you can buy the cheaper one
and sell the more expensive one.
– The valuation is subjective and can be wrong, giving rise to risk.
• Options issued by firm
– If a company has convertible bonds, warrants and listed options
outstanding, they have to be priced consistently with each other and with
the underlying securities.
 c. Pseudo Arbitrage
• Quasi arbitrage is not really arbitrage since it is not even close
to riskless. You try to take advantage of what you see as
mispricing between two securities that you believe should
maintain a consistent pricing relationship.
• Examples include
– Locally listed stock and an ADR, where there are constraints on
buying the local listing and converting the ADR into local shares.
– Paired stocks (example GM and Ford) that have been around a long
time and have an established historical relationship.
– Listings of the same stock in multiple markets, though there are
differences between the listings and restrictions on
conversion/trading.
 Hedge Funds: What do they bring to the
market?
• At the heart of all arbitrage based strategies is the capacity to go long
and short and the use of leverage.
• If there is a common component to hedge funds, it is their capacity to
do both of these whereas conventional mutual funds are restricted
on both counts.
• Proposition 1: In down or flat markets, hedge funds will always look
good relative to conventional mutual funds because of their capacity
to short stocks and other assets.
• Proposition 2: The use of leverage will exaggerate the strengths and
weaknesses of investors. A good hedge fund will look better than a
good mutual fund and a bad hedge fund will look worse.
• Proposition 3: If the average hedge fund manager is not smarter or
dumber than an average mutual fund manager, history suggests that
the freedom they have been granted will hurt more than help.
The Performance of Hedge Funds

Year No of Arithmetic Median Return on Average Average

funds in Average Return S&P 500 Annual Fee Incentive
sample Return (as % of Fee (as %
money under of excess
management) returns)
1988-89 78 18.08% 20.30% 1.74% 19.76%
1989-90 108 4.36% 3.80% 1.65% 19.52%
1990-91 142 17.13% 15.90% 1.79% 19.55%
1991-92 176 11.98% 10.70% 1.81% 19.34%
1992-93 265 24.59% 22.15% 1.62% 19.10%
1993-94 313 -1.60% -2.00% 1.64% 18.75%
1994-95 399 18.32% 14.70% 1.55% 18.50%
Entire 13.26% 16.47%%
Period
 Looking a little closer at the numbers…
• The average hedge fund earned a lower return (13.26%)
over the period than the S&P 500 (16.47%), but it also had
a lower standard deviation in returns (9.07%) than the S &
P 500 (16.32%). Thus, it seems to offer a better payoff to
risk, if you divide the average return by the standard
deviation – this is the commonly used Sharpe ratio for
evaluating money managers.
• These funds are much more expensive than traditional
mutual funds, with much higher annual fess and annual
incentive fees that take away one out of every five dollars
of excess returns.
Returns by sub-category
 The Investment Process
The Client
Utility Risk Tolerance/ Investment Horizon Tax Status Tax Code
Functions Aversion

The Portfolio Manager’s Job

Asset Allocation Views on Risk and Return

Views on Asset Classes: Stocks Bonds Real Assets - inflation - Measuring risk
markets - rates - Effects of
Countries: Domestic Non-Domestic
- growth diversification

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

Performance Evaluation Risk Models

Market 1. How much risk did the portfolio manager take? Stock - The CAPM
Timing 2. What return did the portfolio manager make? Selection - The APM
3. Did the portfolio manager underperform or outperform?
 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
I. Against a Market Index

80%

70%

60%

50%

40%

30%

20%

10%

0%
1971
 II. Against Other Portfolio Managers

• In some cases, portfolio managers are

measured against other portfolio managers
who have similar objective functions. Thus, a
growth fund manager may be measured
against all growth fund managers.
• The implicit assumption in this approach is
that portfolio managers with the same
objective function have the same exposure to
risk.
 Value and Growth Funds…
Figure 13.7: Returns on Growth and Value Funds

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 Value Index

 III. Risk-Adjusted Returns
• The fairest way of measuring performance is to compare the actual returns earned
by a portfolio against an expected return, based upon the risk of the portfolio and
the performance of the market during the period.
• All risk and return models in finance take the following form:
Expected return = Riskfree Rate + Risk 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.
The Performance of Mutual Funds..
Figure 13.3: Mutual Fund Performance: 1955-64 - The Jensen Study

-0.08 -0.07 -0.06 -0.05 -0.04 -0.03 -0.02 -0.01 0 0.01 0.02 0.03 0.04 0.05 0.06
Intercept (Actual Return - E(R))
 IV. Tracking Error as a Measure of Risk
 Tracking error measures the difference between a
portfolio’s return and its benchmark index. Thus
portfolios that deliver higher returns than the
benchmark but have higher tracking error are
considered riskier.
 Tracking error is a way of ensuring that a portfolio
stays within the same risk level as the benchmark
index.
 It is also a way in which the “active” in active money
management can be constrained.
Enhanced Index Funds… Oxymoron?
So, why is it so difficult to win at this game?

• Is it a loser’s game?
– To win at a game, you need a ready supply of losers
– Unfortunately, losers leave the game early and you end up playing
with other winners.
– As markets develop and become deeper, this tendency is exaggerated.
• What is your investing edge?
– Getting an edge in investing is tough to do and even tougher to
sustain.
– Success at investing breeds imitation which makes future success
more difficult.
• Proposition 1: If you don’t bring anything to the table, don’t
expect to take anything away in the long term.
 What makes you special?
Institutional claims
• We are bigger : Size is relative. You may be big but someone is always bigger. Even
if you are the biggest investor, it is difficult to see what that gets you unless you are
big enough to move the market.
• Our computers are more powerful: Really?
• Our analysts are smarter: If they are, they will move elsewhere and claim the rents.
• We have better traders: See “Our analysts are smarter” and double it.
• Our information is better: What do you plan to do in jail?
Individual claims
• We can wait longer: Patience is rare and there is a payoff.
• Our tax structure is different: Tax avoidance versus tax evasion?
• We don’t bow to peer pressure: Contrarian to the core?
Finding an Investment Philosophy
Momentum
Short term (days to  Technical momentum
a few weeks) indicators – Buy stocks based
upon trend lines and high
trading volume.
 Information trading: Buying
after positive news (earnings
and dividend announcements,
acquisition announcements)
Medium term (few  Relative strength: Buy stocks  Market timing, based
months to a couple that have gone up in the last
of years) few months.
 Information trading: Buy small
cap stocks with substantial
insider buying.
Long Term (several  Passive growth investing:
years) Buying stocks where growth
trades at a reasonable price
(PEG ratios).
Contrarian Opportunisitic
 Technical contrarian  Pure arbitrage in
indicators – mutual fund derivatives and fixed
holdings, short interest. income markets.
These can be for  Tehnical demand
individual stocks or for indicators – Patterns in
overall market. prices such as head and
shoulders.
 Near arbitrage
upon normal PE or opportunities: Buying
normal range of interest discounted closed end
rates. funds
 Information trading:  Speculative arbitrage
Buying after bad news opportunities: Buying
(buying a week after paired stocks and
bad earnings reports merger arbitrage.
and holding for a few
months)
 Passive value investing:  Active growth
Buy stocks with low investing: Take stakes
PE, PBV or PS ratios. in small, growth
 Contrarian value companies (private
investing: Buying losers equity and venture
or stocks with lots of capital investing)
bad news.  Activist value investing:
Buy stocks in poorly
managed companies
and push for change.
 The Right Investment Philosophy
• Single Best Strategy: You can choose the one strategy that best suits
you. Thus, if you are a long-term investor who believes that markets
overreact, you may adopt a passive value investing strategy.
• Combination of strategies: You can adopt a combination of
strategies to maximize your returns. In creating this combined
strategy, you should keep in mind the following caveats:
– You should not mix strategies that make contradictory assumptions about
market behavior over the same periods. Thus, a strategy of buying on
relative strength would not be compatible with a strategy of buying stocks
after very negative earnings announcements. The first strategy is based
upon the assumption that markets learn slowly whereas the latter is
conditioned on market overreaction.
– When you mix strategies, you should separate the dominant strategy from
the secondary strategies. Thus, if you have to make choices in terms of
investments, you know which strategy will dominate.
 In closing…
• Choosing an investment philosophy is at the heart of
successful investing. To make the choice, though, you
need to look within before you look outside. The best
strategy for you is one that matches both your
personality and your needs.
• Your choice of philosophy will also be affected by what
you believe about markets and investors and how they
work (or do not). Since your beliefs are likely to be
affected by your experiences, they will evolve over time
and your investment strategies have to follow suit.
If you walk like a lemming, run like a
lemming… you are a lemming