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Investment Philosophy: The Secret Ingredient in Investment Success

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Title: Investment Philosophy: The Secret Ingredient in Investment Success


1
Investment PhilosophyThe Secret Ingredient in
Investment Success
  • Aswath Damodaran

2
What is an investment philosophy?
  • An investment philosophy is a coherent way of
    thinking about markets, how they work (and
    sometimes do not) and the types of mistakes that
    you believe consistently underlie investor
    behavior.
  • An investment strategy is much narrower. It is a
    way of putting into practice an investment
    philosophy.
  • For lack of a better term, an investment
    philosophy is a set of core beliefs that you can
    go back to in order to generate new strategies
    when old ones do not work.

3
Ingredients of an Investment Philosophy
  • Step 1 All investment philosophies begin with a
    view about how human beings learn (or fail to
    learn). Underlying every philosophy, therefore is
    a view of human frailty - that they learn too
    slowly, learn too fast, tend to crowd behavior
    etc.
  • Step 2 From step 1, you generate a view about
    markets behave and perhaps where they fail. Your
    views on market efficiency or inefficiency are
    the foundations for your investment philosophy.
  • Step 3 This step is tactical. You take your
    views about how investors behave and markets work
    (or fail to work) and try to devise strategies
    that reflect your beliefs.

4
An Example..
  • Market Belief Investors over react to news
  • Investment Philosophy Stocks that have had bad
    news announcements will be under priced relative
    to stocks that have good news announcements.
  • Investment Strategies
  • Buy (Sell short) stocks after bad (good) earnings
    announcements
  • Buy (Sell short) stocks after big stock price
    declines (increases)

5
Why do you need an investment philosophy?
  • If you do not have an investment philosophy, you
    will find yourself doing the following
  • Lacking a rudder or a core set of beliefs, you
    will be easy prey for charlatans and pretenders,
    with each one claiming to have found the magic
    strategy that beats the market.
  • Switching from strategy to strategy, you will
    have to change your portfolio, resulting in high
    transactions costs and paying more in taxes.
  • Using a strategy that may not be appropriate for
    you, given your objectives, risk aversion and
    personal characteristics. In addition to having a
    portfolio that under performs the market, you are
    likely to find yourself with an ulcer or worse.

6
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7
Understanding the Client (Investor)
  • There is no one perfect portfolio for every
    client. To create a portfolio that is right for
    an investor, we need to know
  • The investors risk preferences
  • The investors time horizon
  • The investors tax status
  • If you are your own client (i.e, you are
    investing your own money), know yourself.

8
I. Measuring Risk
  • Risk is not a bad thing to be avoided, nor is it
    a good thing to be sought out. The best
    definition of risk is the following
  • Ways of evaluating risk
  • Most investors do not know have a quantitative
    measure of how much risk that they want to take
  • Traditional risk and return models tend to
    measure risk in terms of volatility or standard
    deviation

9
What we know about investor risk preferences..
  • Whether we measure risk in quantitative or
    qualitative terms, investors are risk averse.
  • The degree of risk aversion will vary across
    investors at any point in time, and for the same
    investor across time (as a function of his or her
    age, wealth, income and health)
  • There is a trade off between risk and return
  • To get investors to take more risk, you have to
    offer a higher expected returns
  • Conversely, if investors want higher expected
    returns, they have to be willing to take more
    risk.
  • Proposition 1 The more risk averse an investor,
    the less of his or her portfolio should be in
    risky assets (such as equities).

10
Risk and Return Models in Finance
11
Some quirks in risk aversion
  • Individuals are far more affected by losses than
    equivalent gains (loss aversion), and this
    behavior is made worse by frequent monitoring
    (myopia).
  • The choices that people make (and the risk
    aversion they manifest) when presented with risky
    choices or gambles can depend upon how the choice
    is presented (framing).
  • Individuals tend to be much more willing to take
    risks with what they consider found money than
    with money that they have earned (house money
    effect).
  • There are two scenarios where risk aversion seems
    to decrease and even be replaced by risk seeking.
    One is when individuals are offered the chance of
    making an extremely large sum with a very small
    probability of success (long shot bias). The
    other is when individuals who have lost money are
    presented with choices that allow them to make
    their money back (break even effect).
  • When faced with risky choices, whether in
    experiments or game shows, individuals often make
    mistakes in assessing the probabilities of
    outcomes, over estimating the likelihood of
    success,, and this problem gets worse as the
    choices become more complex.

12
II. Time Horizon
  • As an investor, how would you categorize your
    investment time horizon?
  • Long term investor (3-5 years or more)
  • Short term investor (lt 1 year)
  • Opportunistic investor (long term when you have
    to be long term, short term when necessary)
  • Dont know
  • If you were a portfolio manager, would your
    answer be different?

13
Investor Time Horizon
  • An investors time horizon reflects
  • personal characteristics Some investors have the
    patience needed to hold investments for long time
    periods and others do not.
  • need for cash. Investors with significant cash
    needs in the near term have shorter time horizons
    than those without such needs.
  • Job security and income Other things remaining
    equal, the more secure you are about your income,
    the longer your time horizon will be.
  • An investors time horizon can have an influence
    on both the kinds of assets that investor will
    hold in his or her portfolio and the weights of
    those assets.
  • Proposition 2 Most investors actual time
    horizons are shorter than than their stated time
    horizons. (We are all less patient than we think
    we are)

14
III. Tax Status and Portfolio Composition
  • Investors can spend only after-tax returns. Hence
    taxes do affect portfolio composition.
  • The portfolio that is right for an investor who
    pays no taxes might not be right for an investor
    who pays substantial taxes.
  • Moreover, the portfolio that is right for an
    investor on one portion of his portfolio (say,
    his tax-exempt pension fund) might not be right
    for another portion of his portfolio (such as his
    taxable savings)
  • The effect of taxes on portfolio composition and
    returns is made more complicated by
  • The different treatment of current income
    (dividends, coupons) and capital gains
  • The different tax rates on various portions of
    savings (pension versus non-pension)
  • Changing tax rates across time

15
Dividends versus Capital Gains Tax Rates for
Individuals United States
16
The Tax Effect Stock Returns before and after
taxes.. With one year time horizons
17
The Tax Effect and Dividend Yields
18
Mutual Fund Returns The Tax Effect
19
Tax Effect and Turnover Ratios
20
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21
Asset Allocation
  • The first step in portfolio management is the
    asset allocation decision.
  • The asset allocation decision determines what
    proportions of the portfolio will be invested in
    different asset classes - stocks, bonds and real
    assets.
  • Asset allocation can be passive,
  • It can be based upon the mean-variance framework
    trading off higher expected return for higher
    standard deviation.
  • It can be based upon simpler rules of
    diversification or market value based
  • When asset allocation is determined by market
    views, it is active asset allocation.

22
I. Passive Asset Allocation
  • In passive asset allocation, the proportions of
    the various asset classes held in an investors
    portfolio will be determined by the risk
    preferences of that particular investor. These
    proportions can be determined in one of two ways
  • Statistical techniques can be employed to find
    that combination of assets that yields the
    highest return, given a certain risk level
  • The proportions of risky assets can mirror the
    market values of the asset classes. Any deviation
    from these proportions will lead to a portfolio
    that is over or under weighted in some asset
    classes and thus not fully diversified. The risk
    aversion of an investor will show up only in the
    riskless asset holdings.

23
A. Efficient (Markowitz) Portfolios
  • Return Maximization Risk Minimization
  • Maximize Expected Return Minimize return
    variance
  • subject to
  • where,
  • s2 Investor's desired level of variance
  • E(R) Investor's desired expected returns

24
Limitations of this Approach
  • This approach is heavily dependent upon three
    assumptions
  • That investors can provide their risk preferences
    in terms of variance
  • They do not care about anything but mean and
    variance.
  • That the variance-covariance matrix between asset
    classes remains stable over time.
  • If correlations across asset classes and
    covariances are unstable, the output from the
    Markowitz portfolio approach is useless.

25
II. Just Diversify
26
The Optimally Diversified Portfolio
27
II. Active Asset Allocation (Market Timing)
  • The payoff to perfect timing In a 1986 article,
    a group of researchers raised the shackles of
    many an active portfolio manager by estimating
    that as much as 93.6 of the variation in
    quarterly performance at professionally managed
    portfolios could be explained by the mix of
    stocks, bonds and cash at these portfolios.
  • Avoiding the bad markets In a different study in
    1992, Shilling examined the effect on your annual
    returns of being able to stay out of the market
    during bad months. He concluded that an investor
    who would have missed the 50 weakest months of
    the market between 1946 and 1991 would have seen
    his annual returns almost double from 11.2 to
    19.
  • Across funds Ibbotson examined the relative
    importance of asset allocation and security
    selection of 94 balanced mutual funds and 58
    pension funds, all of which had to make both
    asset allocation and security selection
    decisions. Using ten years of data through 1998,
    Ibbotson finds that about 40 of the differences
    in returns across funds can be explained by their
    asset allocation decisions and 60 by security
    selection.

28
Market Timing Strategies
  • Asset Allocation Adjust your mix of assets,
    allocating more than you normally would (given
    your time horizon and risk preferences) to
    markets that you believe are under valued and
    less than you normally would to markets that are
    overvalued.
  • Style Switching Switch investment styles and
    strategies to reflect expected market
    performance.
  • Sector Rotation Shift your funds within the
    equity market from sector to sector, depending
    upon your expectations of future economic and
    market growth.
  • Market Speculation Speculate on market
    direction, using either financial leverage (debt)
    or derivatives to magnify profits.

29
Market Timing Approaches
  • Non-financial indicators
  • Spurious Indicators Over time, researchers have
    found a number of real world phenomena to be
    correlated with market movements. (The winner of
    the Super Bowl, Sun Spots)
  • Feel Good Indicators When people are feeling
    good, markets will do well.
  • Hype Indicators When stocks become the topic of
    casual conversation, it is time to get out. The
    Cocktail party chatter measure (Time elapsed at
    party before talk turns to stocks, average age of
    chatterers, fad component)
  • Technical Indicators
  • Price Indicators Charting patterns and
    indicators give advance notice.
  • Volume Indicators Trading volume may give clues
    to market future
  • Volatility Indicators Higher volatility often a
    predictor or higher stock returns in the future
  • Reversion to the mean Every asset has a normal
    range of value and things revert back to normal.
  • Fundamentals There is an intrinsic value for the
    market.

30
Non-financial indicators..
  • Spurious indicators that may seem to be
    correlated with the market but have no rational
    basis. Almost all spurious indicators can be
    explained by chance.
  • Feel good indicators that measure how happy are
    feeling - presumably, happier individuals will
    bid up higher stock prices. These indicators
    tend to be contemporaneous rather than leading
    indicators.
  • Hype indicators that measure whether there is a
    stock price bubble. Detecting what is abnormal
    can be tricky and hype can sometimes feed on
    itself before markets correct.

31
The past as an indicator of the future
  • Which of the following is the best predictor of
    an up-year next year?
  • The last year was an up year
  • The last two years have been up years
  • The last year was a down year
  • The last two years have been down years
  • None of the above

32
The January Effect, the Weekend Effect etc.
  • As January goes, so goes the year if stocks are
    up, the market will be up for the year, but a bad
    beginning usually precedes a poor year.
  • According to the venerable Stock Traders Almanac
    that is compiled every year by Yale Hirsch, this
    indicator has worked 88 of the time.
  • Note, though that if you exclude January from the
    years returns and compute the returns over the
    remaining 11 months of the year, the signal
    becomes much weaker and returns are negative only
    50 of the time after a bad start in January.
    Thus, selling your stocks after stocks have gone
    down in January may not protect you from poor
    returns.

33
Trading Volume
  • Price increases that occur without much trading
    volume are viewed as less likely to carry over
    into the next trading period than those that are
    accompanied by heavy volume.
  • At the same time, very heavy volume can also
    indicate turning points in markets. For instance,
    a drop in the index with very heavy trading
    volume is called a selling climax and may be
    viewed as a sign that the market has hit bottom.
    This supposedly removes most of the bearish
    investors from the mix, opening the market up
    presumably to more optimistic investors. On the
    other hand, an increase in the index accompanied
    by heavy trading volume may be viewed as a sign
    that market has topped out.
  • Another widely used indicator looks at the
    trading volume on puts as a ratio of the trading
    volume on calls. This ratio, which is called the
    put-call ratio is often used as a contrarian
    indicator. When investors become more bearish,
    they sell more puts and this (as the contrarian
    argument goes) is a good sign for the future of
    the market.

34
A Normal Range for PE Ratios SP 500
35
PE Ratios in Brazil
36
Interest rates
  • The same argument of mean reversion has been made
    about interest rates. For instance, there are
    many economists who viewed the low interest rates
    in the United States in early 2000 to be an
    aberration and argued that interest rates would
    revert back to normal levels (about 6, which was
    the average treasury bond rate from 1980-2000).
  • The evidence on mean reversion on interest rates
    is mixed. While there is some evidence that
    interest rates revert back to historical norms,
    the norms themselves change from period to period.

37
Fundamentals
  • Fundamental Indicators
  • If short term rates are low, buy stocks
  • If long term rates are low, buy stocks
  • If economic growth is high, buy stocks
  • Intrinsic value models
  • Value the market using a discounted cash flow
    model and compare to actual level.,
  • Relative value models
  • Look at how market is priced, given fundamentals
    and given history.

38
The problem with fundamental indicators..
  • There are many indicators that market timers use
    in forecasting market movements. They can be
    generally categorized into
  • Macro economic Indicators Market timers have at
    various times claimed that the best time to
    invest in stocks is when economic growth is
    picking up or slowing down
  • Interest rate Indicators Both the level of rates
    and the slope of the yield curve have been used
    as predictors of future market movements. For
    instance, short term rates exceeding long term
    rates ( a downward sloping yield curve) has been
    considered anathema for stocks.
  • It is easy to show that markets are correlated
    with fundamental indicators but it is much more
    difficult to find leading indicators of market
    movements.

39
GDP Growth and Stock Returns US
40
An intrinsic value for the SP 500 January 1,
2006
  • Level of the index 1248.24
  • Dividends plus Stock buybacks in most recent year
    3.34 of index
  • Expected growth rate in earnings/ cash flows -
    next 5 years 8
  • Growth rate after year 5 4.39 (Set T.Bond
    Rate)
  • Risk free Rate 4.39 Risk Premium 4

41
And for the Bovespa
  • Level of the index on 10/11/06 38,322
  • Dividends on the index 4.41 in last year
  • Expected growth in earnings/ dividends in US
    terms 10
  • Growth rate beyond year 5 4.70 (US treasury
    bond rate)
  • Riskfree Rate 4.70 Risk Premium 4 3
    (Brazil) 7)

42
A short cut to intrinsic value Earnings yield
versus T.Bond Rates
43
Regression Results
  • There is a strong positive relationship between
    E/P ratios and T.Bond rates, as evidenced by the
    correlation of 0.70 between the two variables.,
  • In addition, there is evidence that the term
    structure also affects the PE ratio.
  • In the following regression, using 1960-2005
    data, we regress E/P ratios against the level of
    T.Bond rates and a term structure variable
    (T.Bond - T.Bill rate)
  • E/P 2.10 0.744 T.Bond Rate - 0.327 (T.Bond
    Rate-T.Bill Rate) (2.44) (6.64)
    (-1.34)
  • R squared 51.35

44
How well does market timing work?1. Mutual Funds
45
2. Tactical Asset Allocation Funds
46
3. Market Strategists provide timing advice
47
But would your pay for it?
48
IV. Timing other markets
  • It is not just the equity and bond markets that
    investors try to time. In fact, it can be argued
    that there are more market timers in the currency
    and commodity markets.
  • The keys to understanding the currency and
    commodity markets are
  • These markets have far fewer investors and they
    tend to be bigger.
  • Currency and commodity markets are not as deep as
    equity markets
  • As a consequence,
  • Price changes in these markets tend to be
    correlated over time and momentum can have a
    bigger impact
  • When corrections hit, they tend to be large since
    investors suffer from lemmingitis.
  • Resulting in
  • Timing strategies that look successful and low
    risk for extended periods
  • But collapse in a crisis

49
Summing Up on Market Timing
  • A successful market timer will earn far higher
    returns than a successful security selector.
  • Everyone wants to be a good market timer.
  • Consequently, becoming a good market timer is not
    only difficult to do, it is even more difficult
    to sustain.

50
To be a successful market timer
  • Understand the determinants of markets
  • Be aware of shifts in fundamentals
  • Since you are basing your analysis by looking at
    the past, you are assuming that there has not
    been a significant shift in the underlying
    relationship. As Wall Street would put it,
    paradigm shifts wreak havoc on these models.
  • ? Even if you assume that the past is prologue
    and that there will be reversion back to historic
    norms, you do not control this part of the
    process..
  • And respect the market
  • You can believe the market is wrong but you
    ignore it at your own peril.

51
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52
Security Selection
  • Security selection refers to the process by which
    assets are picked within each asset class, once
    the proportions for each asset class have been
    defined.
  • Broadly speaking, there are three different
    approaches to security selection.
  • The first to focus on fundamentals and decide
    whether a stock is under or overvalued relative
    to these fundamentals.
  • The second is to focus on charts and technical
    indicators to decide whether a stock is on the
    verge o changing direction.
  • The third is to trade ahead of or on information
    releases that will affect the value of the firm.

53
Active investors come in all forms...
  • Fundamental investors can be
  • value investors, who buy low PE or low PBV stocks
    which trade at less than the value of assets in
    place
  • growth investors, who buy high PE and high PBV
    stocks which trade at less than the value of
    future growth
  • Technical investors can be
  • momentum investors, who buy on strength and sell
    on weakness
  • reversal investors, who do the exact opposite
  • Information traders can believe
  • that markets learn slowly and buy on good news
    and sell on bad news
  • that markets overreact and do the exact opposite
  • They cannot all be right in the same period and
    no one approach can be right in all periods.

54
The Many Faces of Value Investing
  • Intrinsic Value Investors These investors try to
    estimate the intrinsic value of companies (using
    discounted cash flow models) and act on their
    findings.
  • Relative Value Investors Following in the Ben
    Graham tradition, these investors use multiples
    and fundamentals to identify companies that look
    cheap on a relative value basis.
  • Contrarian Investors These are investors who
    invest in companies that others have given up on,
    either because they have done badly in the past
    or because their future prospects look bleak.
  • Activist Value Investors These are investors who
    invest in poorly managed and poorly run firms but
    then try to change the way the companies are run.

55
I. Intrinsic Value Investors The determinants of
intrinsic value
56
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57
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58
To do intrinsic valuation right
  • Check for consistency
  • Are your cash flows and discount rates in the
    same currency?
  • Are you computing cash flows to equity or the
    firm and are your discount rates computed
    consistently?
  • Are your growth rate and reinvestment assumptions
    consistent?
  • Focus on excess returns and competitive
    advantages success breeds competition.
  • Recognize that as firms get larger, growth will
    get more difficult to pull off.
  • Remember that you dont run the firm, if you are
    a passive investor. So, do not be cavalier about
    moving to target debt ratios, higher margin
    businesses and better dividend policy.

59
To make money on intrinsic valuation
  • You have to be able to value a company, given its
    fundamental risk, cash flow and growth
    characteristics, without being swayed too much by
    what the market mood may be about the company and
    the sector.
  • The market has to be making a mistake in pricing
    one or more of these fundamentals.
  • The market has to correct its mistake sooner or
    later for you to make money.
  • Proposition 1 For intrinsic valuation to work,
    you have to be willing to expend time and
    resources to understand the company you are
    valuing and to relate its value to its
    fundamentals.
  • Proposition 2 You need a long time horizon for
    intrinsic valuation to pay off.
  • Proposition 3 Your universe of investments has
    to be limited.

60
II. The Relative Value Investor
  • In relative value investing, you compare how
    stocks are priced to their fundamentals (using
    multiples) to find under and over valued stocks.
  • This approach to value investing can be traced
    back to Ben Graham and his screens to find
    undervalued stocks.
  • In recent years, these screens have been refined
    and extended and the availability of data and
    more powerful screening techniques has allowed us
    to expand these screens and back-test them.

61
Ben Graham Screens
  • 1. PE of the stock has to be less than the
    inverse of the yield on AAA Corporate Bonds
  • 2. PE of the stock has to less than 40 of the
    average PE over the last 5 years.
  • 3. Dividend Yield gt Two-thirds of the AAA
    Corporate Bond Yield
  • 4. Price lt Two-thirds of Book Value
  • 5. Price lt Two-thirds of Net Current Assets
  • 6. Debt-Equity Ratio (Book Value) has to be less
    than one.
  • 7. Current Assets gt Twice Current Liabilities
  • 8. Debt lt Twice Net Current Assets
  • 9. Historical Growth in EPS (over last 10 years)
    gt 7
  • 10. No more than two years of negative earnings
    over the previous ten years.

62
The Buffett Mystique
63
Buffetts Tenets
  • Business Tenets
  • ? The business the company is in should be simple
    and understandable.
  • ? The firm should have a consistent operating
    history, manifested in operating earnings that
    are stable and predictable.
  • ? The firm should be in a business with favorable
    long term prospects.
  • Management Tenets
  • ? The managers of the company should be candid.
    As evidenced by the way he treated his own
    stockholders, Buffett put a premium on managers
    he trusted. ? The managers of the company should
    be leaders and not followers.
  • Financial Tenets
  • ? The company should have a high return on
    equity. Buffett used a modified version of what
    he called owner earnings
  • Owner Earnings Net income Depreciation
    Amortization Capital Expenditures
  • ? The company should have high and stable profit
    margins.
  • Market Tenets
  • ? Use conservative estimates of earnings and the
    riskless rate as the discount rate.
  • In keeping with his view of Mr. Market as
    capricious and moody, even valuable companies can
    be bought at attractive prices when investors
    turn away from them.

64
Be like Buffett?
  • ? Markets have changed since Buffett started his
    first partnership. Even Warren Buffett would have
    difficulty replicating his success in todays
    market, where information on companies is widely
    available and dozens of money managers claim to
    be looking for bargains in value stocks.
  • ? In recent years, Buffett has adopted a more
    activist investment style and has succeeded with
    it. To succeed with this style as an investor,
    though, you would need substantial resources and
    have the credibility that comes with investment
    success. There are few investors, even among
    successful money managers, who can claim this
    combination.
  • ? The third ingredient of Buffetts success has
    been patience. As he has pointed out, he does not
    buy stocks for the short term but businesses for
    the long term. He has often been willing to hold
    stocks that he believes to be under valued
    through disappointing years. In those same years,
    he has faced no pressure from impatient
    investors, since stockholders in Berkshire
    Hathaway have such high regard for him.

65
Low Price/BV Ratios and Excess Returns
66
The lowest price to book stocks
67
What drives price to book ratios?
  • Going back to a simple dividend discount model,
  • This formulation can be simplified even further
    by relating growth to the return on equity
  • g (1 - Payout ratio) ROE
  • Substituting back into the P/BV equation,
  • In short, a stock can have a low price to book
    ratio because it has a low return on equity, low
    growth or high risk.

68
Low Price to Book High Return on Equity
69
The Low PE Effect
70
The lowest PE stocks
71
The Determinants of PE
  • The price-earnings ratio for a high growth firm
    can also be related to fundamentals. In the
    special case of the two-stage dividend discount
    model, this relationship can be made explicit
    fairly simply
  • For a firm that does not pay what it can afford
    to in dividends, substitute FCFE/Earnings for the
    payout ratio.
  • Dividing both sides by the earnings per share

72
MismatchesThe name of the game
  • A perfect under valued stock would have a
  • Low PE ratio
  • High expected earnings per share growth
  • Low risk
  • High return on equity (and high dividends)
  • In reality, we will have to make compromises on
    one or more of these variables.

73
III. Contrarian Value Investing Buying the Losers
  • The fundamental premise of contrarian value
    investing is that markets often over react to bad
    news and push prices down far lower than they
    should be.
  • A follow-up premise is that they markets
    eventually recognize their mistakes and correct
    for them.
  • There is some evidence to back this notion
  • Studies that look at returns on markets over long
    time periods chronicle that there is significant
    negative serial correlation in returns, I.e, good
    years are more likely to be followed by bad years
    and vice versa
  • Studies that focus on individual stocks find the
    same effect, with stocks that have done well more
    likely to do badly over the next period, and vice
    versa.

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Excess Returns for Winner and Loser Portfolios
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The Biggest Losers
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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.

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Good Companies are not necessarily Good
Investments
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Loser Portfolios and Time Horizon
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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

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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.

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Growth Investing
Value investors focus assets in place
Growth investors bet on growth assets They
believe that they can assess their value better
than markets
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Is growth investing doomed?
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But there is another side ..
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Adding on
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Furthermore..
  • And active growth investors seem to beat growth
    indices more often than value investors beat
    value indices.

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Growth Investing Strategies
  • Passive Growth Investing Strategies focus on
    investing in stocks that pass a specific screen.
    Classic passive growth screens include
  • PE lt Expected Growth Rate
  • Low PEG ratio stocks (PEG ratio PE/Expected
    Growth)
  • Earnings Momentum Investing (Earnings Momentum
    Increasing earnings growth)
  • Earnings Revisions Investing (Earnings Revision
    Earnings estimates revised upwards by analysts)
  • Small Cap Investing
  • Active growth investing strategies involve taking
    larger positions and playing more of a role in
    your investments. Examples of such strategies
    would include
  • Venture capital investing
  • Private Equity Investing

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

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

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Information Trading
  • Information traders dont bet on whether a stock
    is under or over valued. They make judgments on
    whether the price changes in response to
    information are appropriate.
  • There are two classes of information traders
  • Those that believe that markets learn slowly
  • Those that believe that markets over react

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Information and Prices in an Efficient Market
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A Slow Learning Market
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An Overreacting Market
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I. Earnings Reports
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II. Acquisitions Evidence on Target Firms
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III. Analyst Recommendations
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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.

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Trading and Execution Costs
  • The cost of trading includes four components
  • the brokerage cost, which tends to decrease as
    the size of the trade increases
  • the bid-ask spread, which generally does not
    vary with the size of the trade but is higher for
    less liquid stocks
  • the price impact, which generally increases as
    the size of the trade increases and as the stock
    becomes less liquid.
  • the cost of waiting, which is difficult to
    measure since it shows up as trades not made.

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The Magnitude of the Spread
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Round-Trip Costs (including Price Impact) as a
Function of Market Cap and Trade Size
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The Overall Cost of Trading Small Cap versus
Large Cap Stocks
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Many a slip
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Trading Costs and Performance...
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The Trade Off on Trading
  • There are two components to trading and execution
    - the cost of execution (trading) and the speed
    of execution.
  • Generally speaking, the tradeoff is between
    faster execution and lower costs.
  • For some active strategies (especially those
    based on information) speed is of the essence.
  • Maximize Speed of Execution
  • Subject to Cost of execution lt Excess returns
    from strategy
  • For other active strategies (such as those based
    on long term investing) the cost might be of the
    essence.
  • Minimize Cost of Execution
  • Subject to Speed of execution lt Specified time
    period.
  • The larger the fund, the more significant this
    trading cost/speed tradeoff becomes.

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Arbitrage Investment Strategies
  • An arbitrage-based investment strategy is based
    upon buying an asset (at a market price) and
    selling an equivalent or the same asset at a
    higher price.
  • A true arbitrage-based strategy is riskfree and
    hence can be financed entirely with debt. Thus,
    it is a strategy where an investor can invest no
    money, take no risk and end up with a pure
    profit.
  • Most real-world arbitrage strategies (such as
    those adopted by hedge funds) have some residual
    risk and require some investment.

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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.

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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.

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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.

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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.

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The Performance of Hedge Funds
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Looking a little closer at the numbers
  • The average hedge fund earned a lower return
    (13.26) over the period than the SP 500
    (16.47), but it also had a lower standard
    deviation in returns (9.07) than the S P 500
    (16.32). Thus, it seems to offer a better payoff
    to risk, if you divide the average return by the
    standard deviation this is the commonly used
    Sharpe ratio for evaluating money managers.
  • These funds are much more expensive than
    traditional mutual funds, with much higher annual
    fess and annual incentive fees that take away one
    out of every five dollars of excess returns.

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Returns by sub-category
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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

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I. Against a Market Index
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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.

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Value and Growth Funds
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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.

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The Performance of Mutual Funds..
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IV. Tracking Error as a Measure of Risk
  • Tracking error measures the difference between a
    portfolios return and its benchmark index. Thus
    portfolios that deliver higher returns than the
    benchmark but have higher tracking error are
    considered riskier.
  • Tracking error is a way of ensuring that a
    portfolio stays within the same risk level as the
    benchmark index.
  • It is also a way in which the active in active
    money management can be constrained.

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Enhanced Index Funds Oxymoron?
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So, why is it so difficult to win at this game?
  • Is it a losers game?
  • To win at a game, you need a ready supply of
    losers
  • Unfortunately, losers leave the game early and
    you end up playing with other winners.
  • As markets develop and become deeper, this
    tendency is exaggerated.
  • What is your investing edge?
  • Getting an edge in investing is tough to do and
    even tougher to sustain.
  • Success at investing breeds imitation which makes
    future success more difficult.
  • Proposition 1 If you dont bring anything to the
    table, dont expect to take anything away in the
    long term.

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What makes you special?
  • Institutional claims
  • We are bigger Size is relative. You may be big
    but someone is always bigger. Even if you are the
    biggest investor, it is difficult to see what
    that gets you unless you are big enough to move
    the market.
  • Our computers are more powerful Really?
  • Our analysts are smarter If they are, they will
    move elsewhere and claim the rents.
  • We have better traders See Our analysts are
    smarter and double it.
  • Our information is better What do you plan to do
    in jail?
  • Individual claims
  • We can wait longer Patience is rare and there is
    a payoff.
  • Our tax structure is different Tax avoidance
    versus tax evasion?
  • We dont bow to peer pressure Contrarian to the
    core?

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Finding an Investment Philosophy
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The Right Investment Philosophy
  • Single Best Strategy You can choose the one
    strategy that best suits you. Thus, if you are a
    long-term investor who believes that markets
    overreact, you may adopt a passive value
    investing strategy.
  • Combination of strategies You can adopt a
    combination of strategies to maximize your
    returns. In creating this combined strategy, you
    should keep in mind the following caveats
  • You should not mix strategies that make
    contradictory assumptions about market behavior
    over the same periods. Thus, a strategy of buying
    on relative strength would not be compatible with
    a strategy of buying stocks after very negative
    earnings announcements. The first strategy is
    based upon the assumption that markets learn
    slowly whereas the latter is conditioned on
    market overreaction.
  • When you mix strategies, you should separate the
    dominant strategy from the secondary strategies.
    Thus, if you have to make choices in terms of
    investments, you know which strategy will
    dominate.

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In closing
  • Choosing an investment philosophy is at the heart
    of successful investing. To make the choice,
    though, you need to look within before you look
    outside. The best strategy for you is one that
    matches both your personality and your needs.
  • Your choice of philosophy will also be affected
    by what you believe about markets and investors
    and how they work (or do not). Since your beliefs
    are likely to be affected by your experiences,
    they will evolve over time and your investment
    strategies have to follow suit.

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