Investment Philosophies

Transcription

1 Ivestmet Philosophies Aswath Damodara Aswath Damodara 1

2 What is a ivestmet philosophy? A ivestmet philosophy is a coheret way of thikig about markets, how they work (ad sometimes do ot) ad the types of mistakes that you believe cosistetly uderlie ivestor behavior. A ivestmet strategy is much arrower. It is a way of puttig ito practice a ivestmet philosophy. For lack of a better term, a ivestmet philosophy is a set of core beliefs that you ca go back to i order to geerate ew strategies whe old oes do ot work. Aswath Damodara 2

3 Igrediets of a Ivestmet Philosophy Step 1: All ivestmet philosophies begi with a view about how huma beigs lear (or fail to lear). Uderlyig every philosophy, therefore is a view of huma frailty - that they lear too slowly, lear too fast, ted to crowd behavior etc. Step 2: From step 1, you geerate a view about markets behave ad perhaps where they fail. Your views o market efficiecy or iefficiecy are the foudatios for your ivestmet philosophy. Step 3: This step is tactical. You take your views about how ivestors behave ad markets work (or fail to work) ad try to devise strategies that reflect your beliefs. Aswath Damodara 3

4 Why do you eed a ivestmet philosophy? If you do ot have a ivestmet philosophy, you will fid yourself: 1. Lackig a rudder or a core set of beliefs, you will be easy prey for charlatas ad preteders, with each oe claimig to have foud the magic strategy that beats the market. 2. Switchig from strategy to strategy, you will have to chage your portfolio, resultig i high trasactios costs ad you will pay more i taxes. 3. With a strategy that may ot be appropriate for you, give your objectives, risk aversio ad persoal characteristics. I additio to havig a portfolio that uder performs the market, you are likely to fid yourself with a ulcer or worse. Aswath Damodara 4

5 Figure 1.1: The Ivestmet Process The Cliet Utility Fuctios Risk Tolerace/ Aversio Ivestmet Horizo Tax Status Tax Code The Portfolio Maager s Job Views o markets Asset Allocatio Asset Classes: Stocks Bods Real Assets Coutries: Domestic No-Domestic Views o - iflatio - rates - growth Risk ad Retur - Measurig risk - Effects of diversificatio Valuatio based o - Cash flows - Comparables - Charts & Idicators Security Selectio - Which stocks? Which bods? Which real assets? Private Iformatio Market Efficiecy - Ca you beat the market? Tradig Costs - Commissios - Bid Ask Spread - Price Impact Executio - How ofte do you trade? - How large are your trades? - Do you use derivatives to maage or ehace risk? Tradig Speed Tradig Systems - How does tradig affect prices? Market Timig Performace Evaluatio 1. How much risk did the portfolio maager take? 2. What retur did the portfolio maager make? 3. Did the portfolio maager uderperform or outperform? Stock Selectio Risk Models - The CAPM - The APM Aswath Damodara 5

6 Categorizig Ivestmet Philosophies Market Timig versus Asset Selectio: With market timig, you bet o the movemet of etire markets - fiacial as well as real assets. With asset selectio, you focus o pickig good ivestmets withi each market. Activist Ivestig versus Passive Ivestig: With passive ivestig, you take positios i compaies ad hope that the market corrects its mistakes. With activist ivestig, you play a role (or provide the catalyst) i correctig market mistakes. Time Horizo: Some philosophies require that you ivest for log time periods. Others are based upo short holdig periods. Aswath Damodara 6

7 Ivestmet Philosophies i Cotext Figure 1.2: Ivestmet Philosophies Market Timig Strategies Asset Allocatio Asset Classes: Stocks Bods Real Assets Coutries: Domestic No-Domestic Asset Selectors - Chartists - Value ivestors - Growth ivestors Arbitrage based strategies Security Selectio - Which stocks? Which bods? Which real assets? Executio - Tradig Costs - Tradig Speed Iformatio Traders Aswath Damodara 7

8 Developig a Ivestmet Philosophy Step 1: Uderstad the fudametals of risk ad valuatio Step 2: Develop a poit of view about how markets work ad where they might break dow Step 3: Fid the philosophy that provides the best fit for you, give your Risk aversio Time Horizo Portfolio Size Tax Status Aswath Damodara 8

9 Ivestmet Strategies: Why they work o paper ad fail i practice Risk, Tradig Costs ad Taxes.. Aswath Damodara 9

10 We do t have a good grasp of risk Risk, i traditioal terms, is viewed as a egative. Webster s dictioary, for istace, defies risk as exposig to dager or hazard. The Chiese symbols for risk, reproduced below, give a much better descriptio of risk The first symbol is the symbol for dager, while the secod is the symbol for opportuity, makig risk a mix of dager ad opportuity. Aswath Damodara 10

11 We uder estimate tradig costs Brokerage Cost: This is the most explicit of the costs that ay ivestor pays but it is by far the smallest compoet. Bid-Ask Spread: The spread betwee the price at which you ca buy a asset (the dealer s ask price) ad the price at which you ca sell the same asset at the same poit i time (the dealer s bid price). Price Impact: The price impact that a ivestor ca create by tradig o a asset, pushig the price up whe buyig the asset ad pushig it dow while sellig. Opportuity Cost: There is the opportuity cost associated with waitig to trade. While beig a patiet trader may reduce the previous two compoets of tradig cost, the waitig ca cost profits both o trades that are made ad i terms of trades that would have bee profitable if made istataeously but which became uprofitable as a result of the waitig. Aswath Damodara 11

12 Roud-Trip Costs (icludig Price Impact) as a Fuctio of Market Cap ad Trade Size Dollar Value of Block ($ thoustads) Sector Smallest 17.30% 27.30% 43.80% % 12.00% 23.80% 33.40% % 7.60% 18.80% 25.90% 30.00% % 5.80% 9.60% 16.90% 25.40% 31.50% % 3.90% 5.90% 8.10% 11.50% 15.70% 25.70% % 2.10% 3.20% 4.40% 5.60% 7.90% 11.00% 16.20% % 2.00% 3.10% 4.00% 5.60% 7.70% 10.40% 14.30% 20.00% % 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% Aswath Damodara 12

13 The Overall Cost of Tradig: Small Cap versus Large Cap Stocks Market Capitalizatio Total Tradig Implicit Cost Explicit Cost Costs (NYSE) Smallest 2.71% 1.09% 3.80% 5.76% % 0.71% 2.33% 3.25% % 0.54% 1.67% 2.10% % 0.40% 1.09% 1.36% Largest 0.28% 0.28% 0.31% 0.40% Total Tradig Costs (NASDAQ) Aswath Damodara 13

14 We igore taxes: Stock Returs before ad after taxes Aswath Damodara 14

15 Mutual Fud Returs: The Tax Effect Figure 5.10: Pre-tax ad After-tax Returs at U.S. equity mutual fuds % 14.00% 12.00% 10.00% 8.00% 6.00% Pre-tax Retur After-tax Retur 4.00% 2.00% 0.00% Large Value Large Bled Large Growth Midcap Value Midcap Bled Fud Style Midcap Growth Small Value Small Bled Small Growth Aswath Damodara 15

16 Tax Effect ad Turover Ratios Aswath Damodara 16

17 Market Timig Aswath Damodara Aswath Damodara 17

18 The Payoff to Market Timig I a 1986 article, a group of researchers raised the shackles of may a active portfolio maager by estimatig that as much as 93.6% of the variatio i quarterly performace at professioally maaged portfolios could be explaied by the mix of stocks, bods ad cash at these portfolios. I a differet study i 1992, Shillig examied the effect o your aual returs of beig able to stay out of the market durig bad moths. He cocluded that a ivestor who would have missed the 50 weakest moths of the market betwee 1946 ad 1991 would have see his aual returs almost double from 11.2% to 19%. Ibbotso examied the relative importace of asset allocatio ad security selectio of 94 balaced mutual fuds ad 58 pesio fuds, all of which had to make both asset allocatio ad security selectio decisios. Usig te years of data through 1998, Ibbotso fids that about 40% of the differeces i returs across fuds ca be explaied by their asset allocatio decisios ad 60% by security selectio. Aswath Damodara 18

19 The Cost of Market Timig I the process of switchig from stocks to cash ad back, you may miss the best years of the market. I his article o market timig i 1975, Bill Sharpe suggested that uless you ca tell a good year from a bad year 7 times out of 10, you should ot try market timig. This result is cofirmed by Chua, Woodward ad To, who use Mote Carlo simulatios o the Caadia market ad cofirm you have to be right 70-80% of the time to break eve from market timig. These studies do ot cosider the additioal trasactios costs that ievitably flow from market timig strategies, sice you will trade far more extesively with these strategies. At the limit, a stock/cash switchig strategy will mea that you will have to liquidate your etire equity portfolio if you decide to switch ito cash ad start from scratch agai the ext time you wat to be i stocks. A market timig strategy will also icrease your potetial tax liabilities. You will have to pay capital gais taxes whe you sell your stocks, ad over your lifetime as a ivestor, you will pay far more i taxes. Aswath Damodara 19

20 Market Timig Approaches No-fiacial idicators Techical idicators such as price charts ad tradig volume. Mea reversio idicators, where stocks ad bods are viewed as mispriced if they trade outside what is viewed as a ormal rage. Macro ecoomic variables, such as the level of iterest rates or the state of the ecoomy. Fudametals such as earigs, cashflows ad growth. Aswath Damodara 20

21 1. No-fiacial Idicators Spurious idicators that may seem to be correlated with the market but have o ratioal basis. Almost all spurious idicators ca be explaied by chace. Feel good idicators that measure how happy are feelig - presumably, happier idividuals will bid up higher stock prices. These idicators ted to be cotemporaeous rather tha leadig idicators. Hype idicators that measure whether there is a stock price bubble. Detectig what is abormal ca be tricky ad hype ca sometimes feed o itself before markets correct. Aswath Damodara 21

22 2. Techical Idicators Past prices Sell after two good years.. Or is it. Buy after two good years Priors Number of occurreces % of positive returs Average retur After two dow years % 2.95% After oe dow year % 7.76% After oe up year % 10.92% After two up years % 2.79% The Jauary Idicator: As Jauary goes, so goes the year or does it? Accordig to Yale Hirsch, it works 88% of the time. If you exclude Jauary, it works oly 50% of the time Tradig Volume: Market up movemets accompaied by heavy volume: Is it a buyig opportuity or is it a sellig opportuity? Market Volatility: High stock price volatility accompaied by low stock returs but followed by high stock returs. Aswath Damodara 22

23 Stock Returs ad Volatility Figure 12.1: Returs aroud volatility chages 2.00% 1.50% 1.00% 0.50% 0.00% -0.50% Volatility Iceases Volatility Decreases -1.00% -1.50% -2.00% -2.50% -3.00% I period of chage Retur o Market I period after Aswath Damodara 23

24 3. Mea Reversio Measures: A Normal Rage of PE Ratios? Aswath Damodara 24

25 4. Fudametals The simplest way to use fudametals is to focus o macroecoomic variables such as iterest rates, iflatio ad GNP growth ad devise ivestig rules based upo the levels or chages i macro ecoomic variables. Itrisic valuatio models: Just as you value idividual compaies, you ca value the etire market. Relative valuatio models: You ca value markets relative to how they were priced i prior periods or relative to other markets. While there are some studies that show promise i all of these, they are all very oisy idicators Aswath Damodara 25

26 A Example: Buy whe the earigs yield is high, relative to the T.Bod rate.. Stock Retur durig the year Earigs yield - T.Bod Rate (at begiig of year) Number of years Average Stadard Deviatio Maximum Miimum > 2% % 16.89% 31.55% % 1-2% % 20.38% 18.89% % 0-1% % 0.79% 20.26% 19.15% -1-0% % 12.93% 27.25% % -2-1% % 17.33% 34.11% % < -2% % 8.40% 12.40% % Aswath Damodara 26

27 Aother Example: Comparisos across Time Aswath Damodara 27

28 More o the time compariso This strog positive relatioship betwee E/P ratios ad T.Bod rates is evideced by the correlatio of betwee the two variables. I additio, there is evidece that the term structure also affects the E/P ratio. I the followig regressio, we regress E/P ratios agaist the level of T.Bod rates ad the yield spread (T.Bod - T.Bill rate), usig data from 1960 to E/P = T.Bod Rate (T.Bod Rate-T.Bill Rate) R 2 = (1.93) (6.08) (-1.37) Other thigs remaiig equal, this regressio suggests that Every 1% icrease i the T.Bod rate icreases the E/P ratio by %. This is ot surprisig but it quatifies the impact that higher iterest rates have o the PE ratio. Every 1% icrease i the differece betwee T.Bod ad T.Bill rates reduces the E/P ratio by %. Flatter or egative slopig term yield curves seem to correspod to lower PE ratios ad upwards slopig yield curves to higher PE ratios. Aswath Damodara 28

29 Usig the Regressio to gauge the market We ca use the regressio to predict E/P ratio at the begiig of 2001, with the T.Bill rate at 4.9% ad the T.Bod rate at 5.1%. E/P 2000 = (0.051) ( ) PE 2000 = or 5.99% 1 1 = = E/P = Sice the S&P 500 was tradig at a multiple of 25 times earigs i early 2001, this would have idicated a over valued market. Aswath Damodara 29

30 To be a successful market timer This approach has two limitatios: Sice you are basig your aalysis by lookig at the past, you are assumig that there has ot bee a sigificat shift i the uderlyig relatioship. As Wall Street would put it, paradigm shifts wreak havoc o these models. Eve if you assume that the past is prologue ad that there will be reversio back to historic orms, you do ot cotrol this part of the process.. How ca you improve your odds of success? You ca try to icorporate ito your aalysis those variables that reflect the shifts that you believe have occurred i markets. You ca have a loger time horizo, sice you improve your odds o covergece. Aswath Damodara 30

31 The Evidece o Market Timig Mutual Fud Maagers costatly try to time markets by chagig the amout of cash that they hold i the fud. If they are bullish, the cash balaces decrease. If they are bearish, the cash balaces icrease. Ivestmet Newsletters ofte take bullish or bearish views about the market. Market Strategists at ivestmet baks make their forecasts for the overall market. Aswath Damodara 31

32 1. Mutual Fud Cash Positios Aswath Damodara 32

33 Tactical Asset Allocatio Fuds: Are they better at market timig? Performace of Usophisticated Strategies versus Asset Allocatio Fuds 18.00% 16.00% 14.00% 12.00% Average Aual Returs 10.00% 8.00% 6.00% % 2.00% 0.00% S & P 500 Couch Potato 50/50 Couch Potato 75/25 Asset Allocatio Type of Fud Aswath Damodara 33

34 2. Ivestmet Newsletters Campbell ad Harvey (1996) examied the market timig abilities of ivestmet ewsletters by examiig the stock/cash mixes recommeded i 237 ewsletters from 1980 to If ivestmet ewsletters are good market timers, you should expect to see the proportio allocated to stocks icrease prior to the stock market goig up. Whe the returs eared o the mixes recommeded i these ewsletters is compared to a buy ad hold strategy, 183 or the 237 ewsletters (77%) delivered lower returs tha the buy ad hold strategy. Oe measure of the ieffectuality of the market timig recommedatios of these ivestmet ewsletters lies i the fact that while equity weights icreased 58% of the time before market upturs, they also icreased by 53% before market dowturs. There is some evidece of cotiuity i performace, but the evidece is much stroger for egative performace tha for positive. I other words, ivestmet ewsletters that give bad advice o market timig are more likely to cotiue to give bad advice tha are ewsletters that gave good advice to cotiue givig good advice. Aswath Damodara 34

35 Some hope? Professioal Market Timers Professioal market timers provide explicit timig recommedatios oly to their cliets, who the adjust their portfolios accordigly - shiftig moey ito stocks if they are bullish ad out of stocks if they are bearish. A study by Chace ad Hemler (2001) looked at 30 professioal market timers who were moitored by MoiResearch Corporatio, a service moitors the performace of such advisors, ad foud evidece of market timig ability. It should be oted that the timig calls were both short term ad frequet. Oe market timer had a total of 303 timig sigals betwee 1989 ad 1994, ad there were, o average, about 15 sigals per year across all 30 market timers. Notwithstadig the high trasactios costs associated with followig these timig sigals, followig their recommedatios would have geerated excess returs for ivestors. Aswath Damodara 35

36 3. Market Strategists provide timig advice Firm Strategist Stocks Bods Cash A.G. Edwards Mark Keller 65% 20% 15% Bac of America Tom McMaus 55% 40% 5% Bear Stears & Co. Liz MacKay 65% 30% 5% CIBC World Markets Subodh Kumar 75% 20% 2% Credit Suisse Tom Galvi 70% 20% 10% Goldma Sach & Co. Abby Joseph Cohe 75% 22% 0% J.P. Morga Douglas Cliggott 50% 25% 25% Legg Maso Richard Cripps 60% 40% 0% Lehma Brothers Jeffrey Applegate 80% 10% 10% Merrill Lych & Co. Richard Berstei 50% 30% 20% Morga Staley Steve Galbraith 70% 25% 5% Prudetial Edward Yardei 70% 30% 0% Raymod James Jeffrey Saut 65% 15% 10% Salomo Smith Joh Maley 75% 20% 5% UBS Warburg Edward Kerscher 80% 20% 0% Wachovia Rod Smyth 75% 15% 0% Aswath Damodara 36

37 But how good is it? Aswath Damodara 37

38 Market Timig Strategies Asset Allocatio: Adjust your mix of assets, allocatig more tha you ormally would (give your time horizo ad risk prefereces) to markets that you believe are uder valued ad less tha you ormally would to markets that are overvalued. Style Switchig: Switch ivestmet styles ad strategies to reflect expected market performace. Sector Rotatio: Shift your fuds withi the equity market from sector to sector, depedig upo your expectatios of future ecoomic ad market growth. Market Speculatio: Speculate o market directio, usig either fiacial leverage (debt) or derivatives to magify profits. Aswath Damodara 38

39 Coectig Market Timig to Security Selectio You ca be both a market timer ad security selector. The same beliefs about markets that led you to become a security selector may also lead you to become a market timer. I fact, there are may ivestors who combie asset allocatio ad security selectio i a coheret ivestmet strategy. There are, however, two caveats to a ivestmet philosophy that icludes this combiatio. To the extet that you have differig skills as a market timer ad as a security selector, you have to gauge where your differetial advatage lies, sice you have limited time ad resources to direct towards your task of buildig a portfolio. You may fid that your attempts at market timig are uder cuttig your asset selectio ad that your overall returs suffer as a cosequece. If this is the case, you should abado market timig ad focus exclusively o security selectio. Aswath Damodara 39

40 Chartig ad Techical Aalysis Aswath Damodara Aswath Damodara 40

41 The Radom Walk Hypothesis Iformatio All iformatio about the firm is publicly available ad traded o. New iformatio comes out about the firm. Market Expectatios Price Assessmet Implicatios for Ivestors Curret Ivestors form ubiased expectatios about the future Stock price is a ubiased estimate of the value of the stock. No approach or model will allow us to idetify uder or over valued assets. Next period Sice expectatios are ubiased, there is a 50% chace of good or bad ews. The price chages i accordace with the iformatio. If it cotais good (bad) ews, relative to expectatios, the stock price will icrease (decrease). Reflectig the 50/50 chace of the ews beig good or bad, there is a equal probability of a price icrease ad a price decrease. Aswath Damodara 41

42 The Basis for Price Patters Price chages themselves may provide iformatio to markets. Thus, the fact that a stock has goe up strogly the last four days may be viewed as good ews by ivestors, makig it more likely that the price will go up today the dow. Ivestors are ot always ratioal i the way they set expectatios. These irratioalities may lead to expectatios beig set too low for some assets at some times ad too high for other assets at other times. Thus, the ext piece of iformatio is more likely to cotai good ews for the first asset ad bad ews for the secod. Aswath Damodara 42

43 The Empirical Evidece o Price Patters Ivestors have used price charts ad price patters as tools for predictig future price movemets for as log as there have bee fiacial markets. The first studies of market efficiecy focused o the relatioship betwee price chages over time, to see if i fact such predictios were feasible. Evidece ca be classified ito two classes studies that focus o short-term (itraday, daily ad weekly price movemets) price behavior ad research that examies log-term (aual ad five-year returs) price movemets. Aswath Damodara 43

44 Short Term Serial Correlatio: Evidece Serial correlatios i most markets is small. While there may be statistical sigificace associated with these correlatios, it is ulikely that there is eough correlatio to geerate excess returs. The serial correlatio i short period returs is also affected by price measuremet issues ad the market micro-structure characteristics. No-tradig i some of the compoets of the idex ca create a carry-over effect from the prior time period, this ca result i positive serial correlatio i the idex returs. The bid-ask spread creates a bias i the opposite directio, if trasactios prices are used to compute returs, sice prices have a equal chace of edig up at the bid or the ask price. The bouce that this iduces i prices will result i egative serial correlatios i returs. Bid-Ask Spread = - 2 (Serial Covariace i returs) where the serial covariace i returs measures the covariace betwee retur chages i cosecutive time periods. Aswath Damodara 44

45 Log Term Serial Correlatio: Evidece Aswath Damodara 45

46 Seasoal ad Temporal Effects o Prices Empirical studies idicate a variety of seasoal ad temporal irregularities i stock prices. Amog them are: The Jauary Effect: Stocks, o average, ted to do much better i Jauary tha i ay other moth of the year. The Weeked Effect: Stocks, o average, seem to do much worse o Modays tha o ay other day of the week. The Mid-day Swoo: Stocks, o average, ted to do much worse i the middle of the tradig day tha at the begiig ad ed of the day. While these empirical irregularities provide for iterestig coversatio, it is ot clear that ay of them ca be exploited to ear excess returs. Aswath Damodara 46

47 Returs i Jauary vs Other Moths - Major Fiacial Markets Aswath Damodara 47

48 The Weeked Effect i Iteratioal Markets Aswath Damodara 48

49 There is a iterrelatioship betwee volume ad price chages Aswath Damodara 49

50 Are ivestors ratioal? Historias who have examied the behavior of fiacial markets over time have challeged the assumptio of ratioality that uderlies much of efficiet market theory. They poit out to the frequecy with speculative bubbles have formed i fiacial markers, as ivestors buy ito fads or get-rich-quick schemes, ad the crashes with these bubbles have eded, ad suggest that there is othig to prevet the recurrece of this pheomeo i today's fiacial markets. There is some evidece i the literature of irratioality o the part of market players. Aswath Damodara 50

51 A Soberig Thought for Believers i Ratioality Aswath Damodara 51

52 a. Experimetal Studies of Ratioality While most experimetal studies suggest that traders are ratioal, there are some examples of irratioal behavior i some of these studies. Oe such study was doe at the Uiversity of Arizoa. I a experimetal study, traders were told that a payout would be declared after each tradig day, determied radomly from four possibilities - zero, eight, 28 or 60 cets. The average payout was 24 cets. Thus the share's expected value o the first tradig day of a fiftee day experimet was $3.60 (24*15), the secod day was $ The traders were allowed to trade each day. The results of 60 such experimets is summarized i the followig graph. Aswath Damodara 52

53 Tradig Price by Tradig Day Aswath Damodara 53

54 Results of Experimetal Study There is clear evidece here of a 'speculative bubble' formig durig periods 3 to 5, where prices exceed expected values sigificatly, The bubble ultimately bursts, ad prices approach expected value by the ed of the period. If this is feasible i a simple market, where every ivestor obtais the same iformatio, it is clearly feasible i real fiacial markets, where there is much more differetial iformatio ad much greater ucertaity about expected value. Some of the experimets were ru with studets, ad some with Tucso busiessme, with 'real world' experiece. The results were similar for both groups. Furthermore, whe price curbs of 15 cets were itroduced, the booms lasted eve loger because traders kew that prices would ot fall by more tha 15 cets i a period. Thus, the otio that price limits ca cotrol speculative bubbles seems misguided. Aswath Damodara 54

55 b. A Real Bubble? Aswath Damodara 55

56 What about this bubble? Figure 7.12: The Tech Boom Iteractive Iteret Idex : I 1994: II 1994: III 1994: IV 1995: I 1995: II 1995: III 1995: IV 1996: I 1996: II 1996: III 1996: IV 1996: I 1997: II 1997: III 1997: IV 1998: I Quarter Iteret Idex 1998: II 1998: III 1998: IV 1999: I NASDAQ 1999: II 1999: III 1999: IV 2000: I 2000: II 2000: III 2000: IV 2001: I 2001: II 2001: III NASDAQ Aswath Damodara 56

57 Or this oe? Aswath Damodara 57

58 I. Markets overreact: The Cotraria Idicators Basis: Research i experimetal psychology suggests that people ted to overreact to uexpected ad dramatic ews evets. I revisig their beliefs, idividuals ted to overweight recet iformatio ad uderweight prior data. Empirical evidece: If markets overreact the (1) Extreme movemets i stock prices will be followed by subsequet price movemets i the opposite directio. (2) The more extreme the price adjustmet, the greater will be the subsequet adjustmet Tradig Rules 1. Odd-lot tradig: The odd-lot rule gives us a idicatio of what the ma o the street thiks about the stock 2. Mutual Fud Cash positios: Historically, the argumet goes, mutual fud cash positios have bee greatest at the bottom of a bear market ad lowest at the peak of a bull market. 3. Ivestmet Advisory opiio: This is the ratio of advisory services that are bearish. Whe this ratio reaches the threshold (eg 60%) the cotraria starts buyig. Aswath Damodara 58

59 II. Detectig shifts i Demad & Supply: The Lessos i Price Patters Aswath Damodara 59

60 III. Market lear slowly: The Mometum Ivestors Basis: The argumet here is that markets lear slowly. Thus, ivestors who are a little quicker tha the market i assimilatig ad uderstadig iformatio will ear excess returs. I additio, if markets lear slowly, there will be price drifts (i.e., prices will move up or dow over exteded periods) ad techical aalysis ca detect these drifts ad take advatage of them. The Evidece: There is evidece, albeit mild, that prices do drift after sigificat ews aoucemets. For istace, followig up o price chages after large earigs surprises provides the followig evidece. Tradig Rules 1. Relative Stregth: I both prices ad volume 2. Tred Lies Aswath Damodara 60

61 IV. Followig the Smart Ivestors: The Followers Basis: This approach is the flip side of the cotraria approach. Istead of assumig that ivestors, o average, are likely to be be wrog, you assume that they are right. To make this assumptio more palatable, you do ot look at all ivestors but oly at the smartest ivestors, who presumably kow more tha the rest of us. Evidece: Some iformed ivestors (isiders especially) do trade ahead of price movemets. Tradig Rules: 1. Ratio of isider buyig to sellig 2. Short Sales by Specialists Aswath Damodara 61

62 V. Markets are cotrolled by exteral forces: The Mystics The Elliot Wave: Elliot's theory is that the market moves i waves of various sizes, from those ecompassig oly idividual trades to those lastig ceturies, perhaps loger. "By classifyig these waves ad coutig the various classificatios it is possible to determie the relative positios of the market at all times". "There ca be o bull of bear markets of oe, seve or ie waves, for example. The Dow Theory:" The market is always cosidered as havig three movemets, all goig at the same time. The first is the arrow movemet (daily fluctuatios) from day to day. The secod is the short swig (secodary movemets) ruig from two weeks to a moth ad the third is the mai movemet (primary treds) coverig at least four years i its duratio. Aswath Damodara 62

63 To be a successful chartist, you eed to.. Uderstad ivestor behavior: If you decide to use a chartig patter or techical idicator, you eed to be aware of the ivestor behavior that gives rise to its success. You ca modify or abado the idicator if the uderlyig behavior chages. Test the idicator: It is importat that you back-test your idicator to esure that it delivers the returs that are promised. I ruig these tests, you should pay particular attetio to the volatility i performace over time ad how sesitive the returs are to holdig periods. Trade quickly: The excess returs o may of the strategies seem to deped upo timely tradig. I other words, to succeed at some of these strategies, you may eed to moitor prices cotiuously, lookig for the patters that would trigger tradig. Be disciplied: Buildig o the theme of time horizos, success at chartig ca be very sesitive to how log you hold a ivestmet. Cotrol tradig costs: The strategies that come from techical idicators are geerally short-term strategies that require frequet ad timely tradig. Not surprisigly, these strategies also geerate large tradig costs that ca very quickly eat ito ay excess returs you may have. Aswath Damodara 63

64 Small Cap ad Growth Ivestig Aswath Damodara Aswath Damodara 64

65 Who is a growth ivestor? The Covetioal defiitio: A ivestor who buys high price earigs ratio stocks or high price to book ratio stocks. The Geeric defiitio: A ivestor who buys growth compaies where the value of growth potetial is beig uder estimated. I other words, both value ad growth ivestors wat to buy uder valued stocks. The differece lies mostly i where they thik they ca fid these bargais ad what they view as their stregths. Aswath Damodara 65

66 The may faces of growth ivestig The Small Cap ivestor: The simplest form of growth ivestig is to buy smaller compaies i terms of market cap, expectig these compaies to be both high growth compaies ad also expectig the market to uder estimate the value of growth i these compaies. The IPO ivestor: Presumably, stocks that make iitial public offerigs ted to be smaller, higher growth compaies. The Passive Screeer: Like the passive value screeer, a growth screeer ca use screes - low PE ratios relative to expected growth, earigs mometum - to pick stocks. The Activist Growth ivestor: These ivestors take positios i youg growth compaies (eve before they go public) ad play a active role ot oly i how these compaies are maaged but i how ad whe to take them public. Aswath Damodara 66

67 I. Small Cap Ivestig Aswath Damodara 67

68 The Size ad Jauary Effects Aswath Damodara 68

69 Small Firm Effect Over Time Aswath Damodara 69

70 Has the small firm premium disappeared? The small stock premium has largely disappeared sice Whether this is a log term shift i the small stock premium or just a temporary dip is still beig debated. Jeremy Siegel otes i his book o the log term performace of stocks that the small stock premium ca be almost etirely attributed to the performace of small stocks i the 1970s. Sice this was a decade with high iflatio, could the small stock premium have somethig to do with iflatio? Aswath Damodara 70

71 Difficulties i Replicatig Small Firm Effect Figure 9.5: Returs o CRSP Small Stocks versus DFA Small Stock Fud 15.00% 10.00% 5.00% 0.00% -5.00% % DFA Small Firm Fud CRSP Small Aswath Damodara 71

72 Risk Models ad the Size Effect The capital asset pricig model may ot be the right model for risk, ad betas uder estimate the true risk of small stocks. Thus, the small firm premium is really a measure of the failure of beta to capture risk. The additioal risk associated with small stocks may come from several sources. First, the estimatio risk associated with estimates of beta for small firms is much greater tha the estimatio risk associated with beta estimates for larger firms. The small firm premium may be a reward for this additioal estimatio risk. Secod, there may be additioal risk i ivestig i small stocks because far less iformatio is available o these stocks. I fact, studies idicate that stocks that are eglected by aalysts ad istitutioal ivestors ear a excess retur that parallels the small firm premium. Aswath Damodara 72

73 There is less aalyst coverage of small firms Aalyst Coverage 120% % 20 80% 15 60% % covered by aalysts Average umber of aalysts 10 40% 20% 5 0% Large Cap Mid Cap Small Micro-cap 0 Aswath Damodara 73

74 To be a successful small cap ivestor The importace of disciplie ad diversificatio become eve greater, if you are a small cap ivestor. Sice small cap stocks ted to be cocetrated i a few sectors, you will eed a much larger portfolio to be diversified with small cap stocks. I additio, diversificatio should also reduce the impact of estimatio risk ad some iformatio risk. Whe ivestig i small cap stocks, the resposibility for due diligece will ofte fall o your shoulders as a ivestor, sice there are ofte o aalysts followig the compay. You may have to go beyod the fiacial statemets ad scour other sources (local ewspapers, the firm s customers ad competitors) to fid relevat iformatio about the compay. Have a log time horizo. Aswath Damodara 74

75 The importace of a log time horizo.. Figure 9.7: Time Horizo ad the Small Firm Premium 16.00% % Average Aual Retur over Holdig Period 14.00% 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% % 80.00% 60.00% 40.00% 20.00% % of time Small Cap Portfolio does better Large Cap Small Cap % of time small caps wi 0.00% Time Horizo 0.00% Aswath Damodara 75

76 II. Iitial Public Offerigs Figure 9.9: Average Iitial Retur ad Issue Size 18.00% 16.00% 14.00% 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% >500 Proceeds of IPO (i millios) Aswath Damodara 76

77 More o IPO pricig The average iitial retur is 15.8% across a sample of 13,308 iitial public offerigs. However, about 15% of all iitial public offerigs are over priced. Iitial public offerigs where the offerig price is revised upwards prior to the offerig are more likely to be uder priced tha iitial public offerigs where the offerig price is revised dowwards. Table 9.1: Average Iitial Retur Offerig Price Revisio Offerig price Number of IPOs Average iitial retur % of offerigs uderpriced Revised dow % 53% Revised up % 95% Aswath Damodara 77

78 What happes after the IPO? Aswath Damodara 78

79 The IPO Cycle Aswath Damodara 79

80 To be a successful IPO ivestor Have the valuatio skills to value compaies with limited iformatio ad cosiderable ucertaity about the future, so as to be able to idetify the compaies that are uder or over priced. Sice this is a short term strategy, ofte ivolvig gettig the shares at the offerig price ad flippig the shares o the offerig date, you will have to gauge the market mood ad demad for each offerig, i additio to assessig its value. I other words, a shift i market mood ca leave you with a large allotmet of over-priced shares i a iitial public offerig. Play the allotmet game well, askig for more shares tha you wat i compaies which you view as severely uder priced ad fewer or o shares i firms that are overpriced or that are priced closer to fair value. Aswath Damodara 80

81 III. The Passive Screeer I passive screeig, you look for stocks that possess characteristics that you believe idetify compaies where growth is most likely to be uder valued. Typical screes may iclude Buyig stocks with high PE ratios Buyig stocks that trade at low PE ratios relative to growth Aswath Damodara 81

82 High PE Ratio Stocks uderperform low PE ratio stocks Aswath Damodara 82

83 But growth outperforms value whe earigs growth is low.. Aswath Damodara 83

84 Ad whe the yield curve is flat or dowward slopig.. Aswath Damodara 84

85 Furthermore.. Ad active growth ivestors seem to beat growth idices more ofte tha value ivestors beat value idices. Aswath Damodara 85

86 GARP Strategies Strategy 1: Buy stocks that trade at PE ratios that are less tha their expected growth rates. While there is little evidece that buyig stocks with PE ratios less tha the expected growth rate ears excess returs, this strategy seems to have gaied credece as a viable strategy amog ivestors. It is ituitive ad simple, but ot ecessarily a good strategy. Strategy 2: Buy stocks that trade at a low ratio of PE to expected growth rate (PEG), relative to other stocks. O the PEG ratio frot, the evidece is mixed. A Morga Staley study foud that ivestig i stocks with low PEG ratios did ear higher returs tha the S&P 500, before adjustig for risk. Aswath Damodara 86

87 A Low PEG Ratio = udervalued? Aswath Damodara 87

88 But low PEG stocks ted to be risky Aswath Damodara 88

89 To be a successful passive growth ivestor.. Superior judgmets o growth prospects: Sice growth is the key dimesio of value i these compaies, obtaiig better estimates of expected growth ad its value should improve your odds of success. Log Time Horizo: If your uderlyig strategy is soud, a log time horizo icreases your chaces of earig excess returs. Market Timig Skills: There are exteded cycles where the growth screes work exceptioally well ad other cycles where they are couter productive. If you ca time these cycles, you could augmet your returs substatially. Sice may of these cycles are related to how the overall market is doig, this boils dow to your market timig ability. Aswath Damodara 89

90 Activist Growth Ivestig The first are veture capital fuds that trace their lieage back to the 1950s. Oe of the first was America Research ad Developmet that provided seed moey for the foudig of Digital Equipmet. The secod are leveraged buyout fuds that developed durig the 1980s, usig substatial amouts of debt to take over publicly traded firms ad make them private firms. Private equity fuds that pool the wealth of idividual ivestors ad ivest i private firms that show promise. This has allowed ivestors to ivest i private busiesses without either givig up diversificatio or takig a active role i maagig these firms. Pesio fuds ad istitutioal ivestors, attracted by the high returs eared by ivestmets i private firms, have also set aside portios of their overall portfolios to ivest i private equity. Aswath Damodara 90

91 The Payoff to Private Equity ad Veture Capital Ivestig: Thru 2001 Fud Type 1 Yr 3 Yr 5 Yr 10 Yr 20 Yr Early/Seed Veture Capital Balaced Veture Capital Later Stage Veture Capital All Veture Capital All Buyouts Mezzaie All Private Equity Aswath Damodara 91

92 To be a successful activist growth ivestor Pick your compaies (ad maagers) well: Good veture capitalists seem to have the capacity to fid the combiatio of ideas ad maagemet that make success more likely. Diversify: The rate of failure is high amog private equity ivestmets, makig it critical that you spread your bets. The earlier the stage of fiacig seed moey, for example the more importat it is that you diversify. Support ad supplemet maagemet: Veture capitalists are also maagemet cosultats ad strategic advisors to the firms that they ivest i. If they do this job well, they ca help the maagers of these firms covert ideas ito commercial success. Protect your ivestmet as the firm grows: As the firm grows ad attracts ew ivestmet, you as the veture capitalist will have to protect your share of the busiess from the demads of those who brig i fresh capital. Kow whe to get out: Havig a good exit strategy seems to be as critical as havig a good etrace strategy. Kow how ad whe to get out of a ivestmet is critical to protectig your returs. Aswath Damodara 92

93 Value Ivestig Aswath Damodara Aswath Damodara 93

94 The Differet Faces of Value Ivestig Today Passive Screeers: Followig i the Be Graham traditio, you scree for stocks that have characteristics that you believe idetify uder valued stocks. Examples would iclude low PE ratios ad low price to book ratios. Cotraria Ivestors: These are ivestors who ivest i compaies that others have give up o, either because they have doe badly i the past or because their future prospects look bleak. Activist Value Ivestors: These are ivestors who ivest i poorly maaged ad poorly ru firms but the try to chage the way the compaies are ru. Aswath Damodara 94

95 I. The Passive Screeer This approach to value ivestig ca be traced back to Be Graham ad his screes to fid udervalued stocks. I recet years, these screes have bee refied ad exteded. The followig sectio summarizes the empirical evidece that backs up each of these screes. Aswath Damodara 95

96 A. Be Graham Screes 1. PE of the stock has to be less tha the iverse of the yield o AAA Corporate Bods: 2. PE of the stock has to less tha 40% of the average PE over the last 5 years. 3. Divided Yield > Two-thirds of the AAA Corporate Bod Yield 4. Price < Two-thirds of Book Value 5. Price < Two-thirds of Net Curret Assets 6. Debt-Equity Ratio (Book Value) has to be less tha oe. 7. Curret Assets > Twice Curret Liabilities 8. Debt < Twice Net Curret Assets 9. Historical Growth i EPS (over last 10 years) > 7% 10. No more tha two years of egative earigs over the previous te years. Aswath Damodara 96

97 How well do Graham s scree s perform? A study by Oppeheimer cocluded that stocks that passed the Graham screes would have eared a retur well i excess of the market. Mark Hulbert who evaluates ivestmet ewsletters cocluded that ewsletters that used screes similar to Graham s did much better tha other ewsletters. However, a attempt by James Rea to ru a actual mutual fud usig the Graham screes failed to deliver the promised returs. Graham s best claim to fame comes from the success of the studets who took his classes at Columbia Uiversity. Amog them were Charlie Muger ad Warre Buffett. Aswath Damodara 97

98 The Buffett Mystique Aswath Damodara 98

99 Buffett s Teets Busiess Teets: The busiess the compay is i should be simple ad uderstadable. The firm should have a cosistet operatig history, maifested i operatig earigs that are stable ad predictable. The firm should be i a busiess with favorable log term prospects. Maagemet Teets: The maagers of the compay should be cadid. As evideced by the way he treated his ow stockholders, Buffett put a premium o maagers he trusted. The maagers of the compay should be leaders ad ot followers. Fiacial Teets: The compay should have a high retur o equity. Buffett used a modified versio of what he called ower earigs Ower Earigs = Net icome + Depreciatio & Amortizatio Capital Expeditures The compay should have high ad stable profit margis. Market Teets: Use coservative estimates of earigs ad the riskless rate as the discout rate. I keepig with his view of Mr. Market as capricious ad moody, eve valuable compaies ca be bought at attractive prices whe ivestors tur away from them. Aswath Damodara 99

100 Be like Buffett? Markets have chaged sice Buffett started his first partership. Eve Warre Buffett would have difficulty replicatig his success i today s market, where iformatio o compaies is widely available ad dozes of moey maagers claim to be lookig for bargais i value stocks. I recet years, Buffett has adopted a more activist ivestmet style ad has succeeded with it. To succeed with this style as a ivestor, though, you would eed substatial resources ad have the credibility that comes with ivestmet success. There are few ivestors, eve amog successful moey maagers, who ca claim this combiatio. The third igrediet of Buffett s success has bee patiece. As he has poited out, he does ot buy stocks for the short term but busiesses for the log term. He has ofte bee willig to hold stocks that he believes to be uder valued through disappoitig years. I those same years, he has faced o pressure from impatiet ivestors, sice stockholders i Berkshire Hathaway have such high regard for him. Aswath Damodara 100

101 Value Screes Price to Book ratios: Buy stocks where equity trades at less tha or at least a low multiple of the book value of equity. Price earigs ratios: Buy stocks where equity trades at a low multiple of equity earigs. Price to sales ratio: Buy stocks where equity trades at a low multiple of reveues. Divided Yields: Buy stocks with high divided yields. Aswath Damodara 101

102 1. Low Price to Book Ratios Figure 8.2: PBV Classes ad Returs % 20.00% 15.00% 10.00% 5.00% 0.00% Lowest PBV Class Highest Aswath Damodara 102

103 2. The Low PE Effect Aswath Damodara 103

104 3. Price/Sales Ratio Screes Sechack ad Marti (1987) compared the performace of low price-sales ratio portfolios with low price-earigs ratio portfolios, ad cocluded that the low price-sales ratio portfolio outperformed the market but ot the low priceearigs ratio portfolio. Jacobs ad Levy (1988a) cocluded that low price-sales ratios, by themselves, yielded a excess retur of 0.17% a moth betwee 1978 ad 1986, which was statistically sigificat. Eve whe other factors were throw ito the aalysis, the price-sales ratios remaied a sigificat factor i explaiig excess returs (together with price-earigs ratio ad size) Aswath Damodara 104

105 4. Divided Yields Aswath Damodara 105

106 To be a successful passive value ivestor 1. Have a log time horizo. All the studies quoted above look at returs over time horizos of five years or greater. I fact, low price-book value stocks have uderperformed high price-book value stocks over shorter time periods. 2. Choose your screes wisely: Too may screes ca udercut the search for excess returs sice the screes may ed up elimiatig just those stocks that create the positive excess returs. 3. Be diversified: The excess returs from these strategies ofte come from a few holdigs i large portfolio. Holdig a small portfolio may expose you to extraordiary risk ad ot deliver the same excess returs. 4. Watch out for taxes ad trasactios costs: Some of the screes may ed up creatig a portfolio of low-priced stocks, which, i tur, create larger trasactios costs. Aswath Damodara 106

107 II. Cotraria Value Ivestig: Buyig the Losers I cotraria value ivestig, you begi with the propositio that markets over react to good ad bad ews. Cosequetly, stocks that have had bad ews come out about them (earigs declies, deals that have goe bad) are likely to be uder valued. Evidece that Markets Overreact to News Aoucemets Studies that look at returs o markets over log time periods chroicle that there is sigificat egative serial correlatio i returs, I.e, good years are more likely to be followed by bad years ad vice versal. Studies that focus o idividual stocks fid the same effect, with stocks that have doe well more likely to do badly over the ext period, ad vice versa. Aswath Damodara 107

108 I. Wier ad Loser Portfolios Aswath Damodara 108

109 More o Wier ad Loser Portfolios This aalysis suggests that loser portfolio clearly outperform wier portfolios i the sixty moths followig creatio. This evidece is cosistet with market overreactio ad correctio i log retur itervals. There are may, academics as well as practitioers, who suggest that these fidigs may be iterestig but that they overstate potetial returs o 'loser' portfolios. There is evidece that loser portfolios are more likely to cotai low priced stocks (sellig for less tha $5), which geerate higher trasactios costs ad are also more likely to offer heavily skewed returs, i.e., the excess returs come from a few stocks makig pheomeal returs rather tha from cosistet performace. Studies also seem to fid loser portfolios created every December ear sigificatly higher returs tha portfolios created every Jue. Fially, you eed a log time horizo for the loser portfolio to wi out. Aswath Damodara 109

110 Loser Portfolios ad Time Horizo Aswath Damodara 110

111 2. Good Compaies are ot ecessarily Good Ivestmets Ay ivestmet strategy that is based upo buyig well-ru, good compaies ad expectig the growth i earigs i these compaies to carry prices higher is dagerous, sice it igores the reality that the curret price of the compay may reflect the quality of the maagemet ad the firm. If the curret price is right (ad the market is payig a premium for quality), the biggest dager is that the firm loses its lustre over time, ad that the premium paid will dissipate. If the market is exaggeratig the value of the firm, this strategy ca lead to poor returs eve if the firm delivers its expected growth. It is oly whe markets uder estimate the value of firm quality that this strategy stads a chace of makig excess returs. Aswath Damodara 111

112 1. Excellet versus Uexcellet Compaies There is evidece that well maaged compaies do ot always make great ivestmets. For istace, there is evidece that excellet compaies (usig the Tom Peters stadard) ear poorer returs tha uexcellet compaies. Aswath Damodara 112

113 2. Risk/Retur by S&P Quality Idices Covetioal ratigs of compay quality ad stock returs seem to be egatively correlated. S & P Ratigs ad Stock Returs 20.00% 18.00% 16.00% Average Aual Retur ( ) 14.00% 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% A+ A A- B+ B B- C/D S & P Commo Stock Ratig Aswath Damodara 113

114 To be a successful cotraria value ivestor 1. Self Cofidece: Ivestig i compaies that everybody else views as losers requires a self cofidece that comes either from past success, a huge ego or both. 2. Cliets/Ivestors who believe i you: You either eed cliets who thik like you do ad agree with you, or cliets that have made eough moey of you i the past that their greed overwhelms ay trepidiatio you might have i your portfolio. 3. Patiece: These strategies require time to work out. For every three steps forward, you will ofte take two steps back. 4. Stomach for Short-term Volatility: The ature of your ivestmet implies that there will be high short term volatility ad high profile failures. 5. Watch out for trasactios costs: These strategies ofte lead to portfolios of low priced stocks held by few istitutioal ivestors. The trasactios costs ca wipe out ay perceived excess returs quickly. Aswath Damodara 114

115 III. Activist Value Ivestig A activist value ivestor havig acquired a stake i a udervalued compay which might also be badly maaged the pushes the maagemet to adopt those chages which will ulock this value. For istace, If the value of the firm is less tha its compoet parts: push for break up of the firm, spi offs, split offs etc. If the firm is beig too coservative i its use of debt: push for higher leverage ad recapitalizatio If the firm is accumulatig too much cash: push for higher divideds, stock repurchases.. If the firm is beig badly maaged: push for a chage i maagemet or to be acquired If there are gais from a merger or acquisitio push for the merger or acquisitio, eve if it is hostile Aswath Damodara 115

116 a. Breakig up is hard to do Effects of Spi offs, Split offs, Divestitures o Value Li ad Rozeff (1984) examied the price reactio to aoucemets of divestitures by firms ad reported a average excess retur of 1.45% for 77 divestitures betwee 1977 ad Markets view firms that are evasive about reasos for ad proceeds from divestitures with skepticism. Li ad Rozeff report the followig - Market Reactio to Divestiture Aoucemets Price Aouced Motive Aouced Yes No Yes 3.92% 2.30% No 0.70% 0.37% Schipper ad Smith (1983) examied 93 firms that aouced spi offs betwee 1963 ad 1981 ad reported a average excess retur of 2.84% i the two days surroudig the aoucemet. Further, there is evidece that excess returs icrease with the magitude of the spu off etity. The excess returs are greater for firms i which the spi off is motivated by tax ad regulatory cocers Aswath Damodara 116

117 b. Some firms have too little debt Effects of Leverage Icreasig ad Decreasig Trasactios The overall empirical evidece suggest that leverage icreasig trasactios icrease value whereas leverage reducig trasactios decrease value. Type of trasactio Security Issued Security Retired Sample Size 2-Day Retur Leverage-Icreasig Trasactios Stock Repurchase Debt Commo % Exchage Offer Debt Commo % Exchage Offer Preferred Commo 9 8.3% Exchage Offer Debt Preferred % Exchage Offer Bods Preferred % Trasactios with o chage i leverage Exchage Offer Debt Debt % Security Sale Debt Debt % Leverage-Reducig Trasactios Coversio-forcig call Commo Covertible % Coversio-forcig call Commo Preferred % Security Sale Cov. Debt Cov. Debt % Exchage Offer Commo Debt % Exchage Offer Preferred Preferred 9-7.7% Security Sale Commo Debt % Exchage Offer Commo Debt % Aswath Damodara 117

118 c. Effects of Maagemet Chages o Firm Value The overall empirical evidece suggests that chages i maagemet are geerally are viewed as good ews. Returs Aroud Maagemet Chages 5.00% 0.00% Abormal Returs -5.00% % % Pre-Aoucemet Returs Returs o Aoucemet of chage % % Forced Resigatios Normal Retiremets Type of Maagemet Chage All Chages Aswath Damodara 118

119 d. The Effects of Hostile Acquisitios o the Target Firm Badly maaged firms are much more likely to be targets of acquisitios tha well maaged firms Target Characteristics - Hostile vs. Friedly Takeovers 20.00% Target ROE - Idustry ROE Target 5- yr Stock Returs - Market % of Stock Held by Isiders 15.00% 10.00% 5.00% 0.00% -5.00% Hostile Takeovers Friedly Takeovers Aswath Damodara 119

120 Ad acquisitios are clearly good for the target firm s stockholders Aswath Damodara 120

121 To be a successful activist value ivestor 1. Have lots of capital: Sice this strategy requires that you be able to put pressure o icumbet maagemet, you have to be able to take sigificat stakes i the compaies. 2. Kow your compay well: Sice this strategy is goig to lead a smaller portfolio, you eed to kow much more about your compaies tha you would eed to i a screeig model. 3. Uderstad corporate fiace: You have to kow eough corporate fiace to uderstad ot oly that the compay is doig badly (which will be reflected i the stock price) but what it is doig badly. 4. Be persistet: Icumbet maagers are ulikely to roll over ad play dead just because you say so. They will fight (ad fight dirty) to wi. You have to be prepared to couter. 5. Do your homework: You have to form coalitios with other ivestors ad to orgaize to create the chage you are pushig for. Aswath Damodara 121

122 Iformatio Tradig Aswath Damodara Aswath Damodara 122

123 Iformatio ad Prices i a Efficiet Market Figure 10.1: Price Adjustmet i a Efficiet Market Notice that the price adjusts istataeously to the iformatio Asset price New iformatio is revealed Time Aswath Damodara 123

124 A Slow Learig Market Figure 10.2 A Slow Learig Market The price drifts upwards after the good ews comes out. Asset price New iformatio is revealed Time Aswath Damodara 124

125 A Overreactig Market Figure 10.3: A Overreactig Market The price icreases too much o the good ews aoucemet, ad the decreases i the period after. Asset price New iformatio is revealed Time Aswath Damodara 125

126 Tradig o Private Iformatio Isiders are maagers, directors or major stockholders i firms. Aalysts operate at the exus of private ad public iformatio. Oe way to examie whether private iformatio ca be used to ear excess returs is to look at whether isiders ad aalysts ear excess returs. Aswath Damodara 126

127 Isider Tradig as a Leadig Idicator of Stock prices.. Aswath Damodara 127

128 Ca you follow isiders ad make moey? 4% 3% 2% 1% 0% -1% -2% Isider Official Reportig Summary Date Date Days aroud evet date Aswath Damodara 128

129 Are some isiders more iside tha others? Not all isiders have equal access to iformatio. Top maagers ad members of the board should be privy to much more importat iformatio ad thus their trades should be more revealig. A study by Bettis, Vickrey ad Vickery fids that ivestors who focus oly o large trades made by top executives, rather tha total isider tradig may, i fact, be able to ear excess returs. As ivestmet alteratives to tradig o commo stock have multiplied, isiders have also become more sophisticated about usig these alteratives. As a outside ivestor, you may be able to add more value by trackig these alterative ivestmets. For istace, Bettis, Bizjak ad Lemmo fid that isider tradig i derivative securities (optios specifically) to hedge their commo stock positios icreases immediately followig price ru-ups ad prior to poor earigs aoucemets. I additio, they fid that stock prices ted to go dow after isiders take these hedgig positios. Aswath Damodara 129

130 Illegal Isider Tradig: Is it profitable? Whe isiders are caught tradig illegally, they almost ivariably have made a killig o their ivestmet. Clearly, some isiders made sigificat returs off their privileged positios. Almost all major ews aoucemets made by firms are preceded by a price ru-up (if it is good ews) or a price drop (if it is bad ews). While this may idicate a very presciet market, it is much more likely that someoe with access to the privileged iformatio (either at the firm or the itermediaries helpig the firm) is usig the iformatio to trade ahead of the ews. I fact, the other idicator of isider tradig is the surge i tradig volume i both the stock itself ad derivatives prior to big ews aoucemets. I additio to havig access to iformatio, isiders are ofte i a positio to time the release of relevat iformatio to fiacial markets. Oe study fid that isiders sell stock betwee 3 ad 9 quarters before their firms report a break i cosecutive earigs icreases. They also fid, for istace, that isider sellig icreases at growth firms prior to periods of decliig earigs. Aswath Damodara 130

131 Aalysts Aalysts have access to public iformatio ad to the maagers of the firm (ad thus to private iformatio). Aalysts make earigs forecasts for firms (ad revise them) ad recommedatios o buy ad sell. Aswath Damodara 131

132 I. Earigs Forecasts The geeral cosesus from studies that have looked at short-term forecasts (oe quarter ahead to four quarters ahead) of earigs is that aalysts provide better forecasts of earigs tha models that deped purely upo historical data. The mea relative absolute error, which measures the absolute differece betwee the actual earigs ad the forecast for the ext quarter, i percetage terms, is smaller for aalyst forecasts tha it is for forecasts based upo historical data. A study i 1978 measured the squared forecast errors by moth of the year ad computed the ratio of aalyst forecast error to the forecast error from timeseries models of earigs. It foud that the time series models actually outperform aalyst forecasts from April util August, but uderperform them from September through Jauary. The other study by O'Brie (1988) foud that aalyst forecasts outperform the time series model for oe-quarter ahead ad two-quarter ahead forecasts, do as well as the time series model for three-quarter ahead forecasts ad do worse tha the time series model for four-quarter ahead forecasts. Aswath Damodara 132

133 Aalyst Errors seem to be related to macroecoomic coditios Aswath Damodara 133

134 How about log term forecasts? There is little evidece to suggest that aalysts provide superior forecasts of earigs whe the forecasts are over three or five years. A early study by Cragg ad Malkiel compared log-term forecasts by five ivestmet maagemet firms i 1962 ad 1963 with actual growth over the followig three years to coclude that aalysts were poor log term forecasters. This view was cotested i 1988 by Vader Weide ad Carleto who foud that the cosesus predictio of five-year growth i the I/B/E/S was superior to historically orieted growth measures i predictig future growth. Aswath Damodara 134

135 II. Earigs Revisios The evidece suggests that buyig stocks where earigs have bee revised upwards by aalysts is a profitable strategy. For example, Hawkis reported that a portfolio of stocks with the 20 largest upward revisios i earigs o the I/B/E/S database would have eared a aualized retur of 14% as opposed to the idex retur of oly 7%. I aother study, Cooper, Day ad Lewis report that much of the excess returs is cocetrated i the weeks aroud the revisio 1.27% i the week before the forecast revisio, ad 1.12% i the week after, ad that aalysts that they categorize as leaders (based upo timeliess, impact ad accuracy) have a much greater impact o both tradig volume ad prices. Aswath Damodara 135

136 Potetial Pitfalls ad possible use The limitatio of a earigs mometum strategy is its depedece o two of the weakest liks i fiacial markets earigs reports that come from firms (where accoutig games skew earigs)ad aalyst forecasts of these earigs (which are ofte biased). To the extet that aalysts ifluece trades made by their cliets, they are likely to affect prices whe they revise earigs. The more ifluetial they are, the greater the effect they will have o prices, but the questio is whether the effect is lastig. It is a short-term strategy that yields fairly small excess returs over ivestmet horizos ragig from a few weeks to a few moths. Oe way you may be able to ear higher returs from this strategy is to idetify key aalysts ad build a ivestmet strategy aroud forecast revisios made by them, rather tha lookig at cosesus estimates made by all aalysts. While forecast revisios ad earigs surprises by themselves are ulikely to geerate lucrative portfolios, they ca augmet other more log-term screeig strategies. Aswath Damodara 136

137 III. Aalyst Recommedatios Aswath Damodara 137

138 Tempered by fears of bias Aswath Damodara 138

139 Usig Aalyst Recommedatios Eve if there were o ew iformatio cotaied i recommedatios, there is the selffulfillig prophecy created by cliets who trade o these recommedatios, pushig up stock prices after buy recommedatios ad pushig them dow after sell recommedatios. If this is the oly reaso for the stock price reactio, though, the returs are ot oly likely to be small but could very quickly dissipate, leavig you with large trasactios costs ad little to show for them. You should begi by idetifyig the aalysts who are ot oly the most ifluetial but also have the most cotet (private iformatio) i their recommedatios. I additio, you may wat to scree out aalysts where the potetial coflicts of iterest may be too large for the recommedatios to be ubiased. You should ivest based upo their recommedatios, preferably at the time the recommedatios are made. Assumig that you still attach credece to the views of the recommedig aalysts, you should watch the aalysts for sigals that they have chaged or are chagig their mids. Sice these sigals are ofte subtle, you ca easily miss them. Aswath Damodara 139

140 Tradig o Public Iformatio There is substatial iformatio that comes out about stocks. Some of the iformatio comes from the firm - earigs ad divided aoucemets, acquisitios ad other ews - ad some comes from competitors. Prices geerally react to this iformatio. Aswath Damodara 140

141 I. Earigs Reports Aswath Damodara 141

142 By day of the week.. Figure 10.11: Earigs ad Divided Reports by Day of the Week Moday Tuesday Wedesday Thursday Friday % Chg(DPS) % Chg(EPS) Aswath Damodara 142

143 The Cosequece of Delays Aswath Damodara 143

144 The Itraday reactio.. Aswath Damodara 144

145 Ad earigs quality matters As firms play the earigs game, the quality of earigs has also diverged across compaies. A firm that beats earigs estimates because it has more efficiet operatig should be viewed more favorably tha oe that beats estimates because it chaged the way it valued ivetory. Cha, Cha, Jegadeesh ad Lakoishok examied firms that reported high accruals i.e. the differece betwee accoutig earigs ad cash flows ad argued that firms report high earigs without a matchig icrease i cashflow have poorer quality earigs. Whe they tracked a portfolio composed of these firms, they discovered that the high accrual year was usually the turig poit i the fortues of this firm, with subsequet years brig decliig earigs ad egative stock returs. Aswath Damodara 145

146 Ca you make moey of earigs aoucemets? Oe strategy is to buy stocks that report large positive earigs surprises, hopig to beefit from the drift. The evidece idicates that across all stocks, the potetial for excess returs from buyig after earigs aoucemets is very small. You ca cocetrate oly o earigs aoucemets made by smaller, less liquid compaies where the drift is more proouced. I additio, you ca try to direct your moey towards compaies with higher quality earigs surprises by avoidig firms with large accruals. Your biggest payoff is i ivestig i compaies before large positive earigs surprises. You may be able to use a combiatio of quatitative techiques (time series models that forecast ext quarter s earigs based upo historical earigs) ad tradig volume (isiders do create blips i the volume) to try to detect these firms. Eve if you are right oly 55% of the time, you should be able to post high excess returs. Aswath Damodara 146

147 II. Acquisitios: Evidece o Target Firms Aswath Damodara 147

148 The Effect o Acquirers.. Jese ad Ruback report excess returs of 4% for biddig firm stockholders aroud teder offers ad o excess returs aroud mergers. Jarrell, Brickley ad Netter, i their examiatio of teder offers from 1962 to 1985, ote a declie i excess returs to biddig firm stockholders from 4.4% i the 1960s to 2% i the 1970s to -1% i the 1980s. Other studies idicate that approximately half of all biddig firms ear egative excess returs aroud the aoucemet of takeovers, suggestig that shareholders are skeptical about the perceived value of the takeover i a sigificat umber of cases. Aswath Damodara 148

149 After the acquisitio Operatig Evidece McKisey ad Co. examied 58 acquisitio programs betwee 1972 ad 1983 for evidece o two questios: (1) Did the retur o the amout ivested i the acquisitios exceed the cost of capital? (2) Did the acquisitios help the paret compaies outperform the competitio? They cocluded that 28 of the 58 programs failed both tests, ad six failed at least oe test. I a follow-up study of 115 mergers i the U.K. ad the U.S. i the 1990s, McKisey cocluded that 60% of the trasactios eared returs o capital less tha the cost of capital, ad that oly 23% eared excess returs. I 1999, KPMG examied 700 of the most expesive deals betwee 1996 ad 1998 ad cocluded that oly 17% created value for the combied firm, 30% were value eutral ad 53% destroyed value. Aswath Damodara 149

150 After the acquisitio Divestitures The most damagig piece of evidece o the outcome of acquisitios is the large umber of acquisitios that are reversed withi fairly short time periods. Mitchell ad Leh ote that 20.2% of the acquisitios made betwee 1982 ad 1986 were divested by I a study published i1992, Kapla ad Weisbach foud that 44% of the mergers they studied were reversed, largely because the acquirer paid too much or because the operatios of the two firms did ot mesh. Studies that have tracked acquisitios for loger time periods (te years or more) have foud the divestiture rate of acquisitios rises to almost 50%, suggestig that few firms ejoy the promised beefits from acquisitios do ot occur. I aother study, Aswath Damodara 150

151 Takeover based ivestmet strategies The first ad most lucrative, if you ca pull it off, is to fid a way to ivest i a target firm before the acquisitio is aouced. The secod is to wait util after the takeover is aouced ad the try to take advatage of the price drift betwee the aoucemet date ad the day the deal is cosummated. This is ofte called risk arbitrage. The third is also a post-aoucemet strategy, but it is a log-term strategy where you ivest i firms that you believe have the pieces i place to deliver the promised syergy or value creatio. Aswath Damodara 151

152 Preaoucemet Tradig Research idicates that the typical target firm i a hostile takeover has the followig characteristics: It has uder performed other stocks i its idustry ad the overall market, i terms of returs to its stockholders i the years precedig the takeover. It has bee less profitable tha firms i its idustry i the years precedig the takeover. It has a much lower stock holdig by isiders tha do firms i its peer groups. It has a low price to book ratio & a low ratio of value to replacemet cost. There are two ways i which we ca use the fidigs of these studies to idetify potetial target firms. Develop a set of screes that icorporate the variables metioed above. You could, for istace, ivest i firms with market capitalizatios below $ 5 billio, with low isider holdigs, depressed valuatios (low price to book ratios) ad low returs o equity. The secod ad slightly more sophisticated variat is to estimate the probability of beig take over for every firm i the market usig statistical techiques Aswath Damodara 152

153 Post-Aoucemet Tradig I this strategy, you buy compaies after acquisitios or mergers are completed because you believe that they will be able to deliver what they promise at the time of the merger higher earigs growth ad syergy. The likelihood of success seems to be greater I hostile acquisitios, where the maagemet is replaced. I mergers of like busiesses tha i coglomerate mergers I cost-savig mergers tha i growth-orieted mergers I mergers where plas for syergy are made before the merger I acquisitios of small compaies by larger compaies (as opposed to mergers of equals) Aswath Damodara 153

154 To be a successful iformatio trader Idetify the iformatio aroud which your strategy will be built: Sice you have to trade o the aoucemet, it is critical that you determie i advace the iformatio that will trigger a trade. Ivest i a iformatio system that will deliver the iformatio to you istataeous: May idividual ivestors receive iformatio with a time lag 15 to 20 miutes after it reaches the tradig floor ad istitutioal ivestors. While this may ot seem like a lot of time, the biggest price chages after iformatio aoucemets occur durig these periods. Execute quickly: Gettig a earigs report or a acquisitio aoucemet i real time is of little use if it takes you 20 miutes to trade. Immediate executio of trades is essetial to succeedig with this strategy. Keep a tight lid o trasactios costs: Speedy executio of trades usually goes with higher trasactios costs, but these trasactios costs ca very easily wipe out ay potetial you may see for excess returs). Kow whe to sell: Almost as critical as kowig whe to buy is kowig whe to sell, sice the price effects of ews releases may begi to fade or eve reverse after a while. Aswath Damodara 154

155 Arbitrage Aswath Damodara Aswath Damodara 155

156 The Essece of Arbitrage I pure arbitrage, you ivest o moey, take o risk ad walk away with sure profits. You ca categorize arbitrage i the real world ito three groups: Pure arbitrage, where, i fact, you risk othig ad ear more tha the riskless rate. Near arbitrage, where you have assets that have idetical or almost idetical cash flows, tradig at differet prices, but there is o guaratee that the prices will coverge ad there exist sigificat costraits o the ivestors forcig covergece. Speculative arbitrage, which may ot really be arbitrage i the first place. Here, ivestors take advatage of what they see as mispriced ad similar (though ot idetical) assets, buyig the cheaper oe ad sellig the more expesive oe. Aswath Damodara 156

157 Pure Arbitrage For pure arbitrage, you have two assets with idetical cashflows ad differet market prices makes pure arbitrage difficult to fid i fiacial markets. There are two reasos why pure arbitrage will be rare: Idetical assets are ot commo i the real world, especially if you are a equity ivestor. Assumig two idetical assets exist, you have to woder why fiacial markets would allow pricig differeces to persist. If i additio, we add the costrait that there is a poit i time where the market prices coverge, it is ot surprisig that pure arbitrage is most likely to occur with derivative assets optios ad futures ad i fixed icome markets, especially with default-free govermet bods. Aswath Damodara 157

158 Markets where pure arbitrage may be feasible Futures Markets:The basic arbitrage relatioship ca be derived fairly easily for futures cotracts o ay asset, by estimatig the cashflows o two strategies that deliver the same ed result the owership of the asset at a fixed price i the future. I the first strategy, you buy the futures cotract, wait util the ed of the cotract period ad buy the uderlyig asset at the futures price. I the secod strategy, you borrow the moey ad buy the uderlyig asset today ad store it for the period of the futures cotract. Optios Markets: There are three kids of arbitrage opportuities Exercise arbitrage: Whe the optio price is less tha the exercise value. Pricig arbitrage: Whe optios are mispriced relative to the uderlyig asset or to each other. Fixed Icome Markets: Fixed icome securities led themselves to arbitrage more easily tha equity because they have fiite lives ad fixed cash flows. This is especially so, whe you have default free bods, where the fixed cash flows are also guarateed. Aswath Damodara 158

159 Evidece o pure arbitrage opportuities They are ucommo: I the futures ad the optios markets, studies idicate that there are sometimes pricig errors, but they ted to be few ad far betwee. The pricig errors ted to be small: Eve whe there are pricig errors, they are miiscule. They are fleetig: Whe these small ad ucommo pricig errors surface, they very quickly disappear. They occur most ofte whe a ew security is itroduced ito the market - mortgage backed bods ad stock idex futures market i the early 1980s, the treasury strip market i the late 1980s, iflatio idexed treasuries i the 1990s. Aswath Damodara 159

160 To succeed at pure arbitrage The ature of pure arbitrage two idetical assets that are priced differetly makes it likely that it will be short lived. I other words, i a market where ivestors are o the look out for riskless profits, it is very likely that small pricig differeces will be exploited quickly, ad i the process, disappear. Cosequetly, the first two requiremets for success at pure arbitrage are access to real-time prices ad istataeous executio. It is also very likely that the pricig differeces i pure arbitrage will be very small ofte a few hudredths of a percet. To make pure arbitrage feasible, therefore, you ca add two more coditios. The first is access to substatial debt at favorable iterest rates, sice it ca magify the small pricig differeces. Note that may of the arbitrage positios require you to be able to borrow at the riskless rate. The secod is ecoomies of scale, with trasactios amoutig to millios of dollars rather tha thousads. Aswath Damodara 160

161 Near Arbitrage I ear arbitrage, you either have two assets that are very similar but ot idetical, which are priced differetly, or idetical assets that are mispriced, but with o guarateed price covergece. No matter how sophisticated your tradig strategies may be i these scearios, your positios will o loger be riskless. Aswath Damodara 161

162 1. Same Stock listed i Multiple Markets If you ca buy the same stock at oe price i oe market ad simultaeously sell it at a higher price i aother market, you ca lock i a riskless profit. Two examples: Dual or Multiple listed stocks: May large compaies trade o multiple markets o differet cotiets. Sice there are time periods durig the day whe there is tradig occurrig o more tha oe market o the same stock, it is coceivable (though ot likely) that you could buy the stock for oe price i oe market ad sell the same stock at the same time for a differet (ad higher price) i aother market. Depository receipts: Depository receipts create a claim equivalet to the oe you would have had if you had bought shares i the local market ad should therefore trade at a price cosistet with the local shares. What makes them differet ad potetially riskier tha the stocks with dual listigs is that ADRs are ot always directly comparable to the commo shares traded locally oe ADR o Telmex, the Mexica telecommuicatios compay, is covertible ito 20 Telmex shares. Aswath Damodara 162

163 a. Dual Listed Stocks: Evidece of Mispricig? Swaicki ad Hric examie 84 Czech stocks that trade o the two Czech exchages the Prague Stock Exchage (PSE) ad the Registratio Places System (RMS)- ad fid that prices adjust slowly across the two markets, ad that arbitrage opportuities exist (at least o paper) the prices i the two markets differ by about 2%. These arbitrage opportuities seem to icrease for less liquid stocks. While the authors cosider trasactios cost, they do ot cosider the price impact that tradig itself would have o these stocks ad whether the arbitrage profits would survive the tradig. Aswath Damodara 163

164 b. Depository Receipts: Evidece o Pricig I a study coducted i 2000 that looks at the lik betwee ADRs ad local shares, Ki, Szakmary ad Mathur coclude that about 60 to 70% of the variatio i ADR prices ca be attributed to movemets i the uderlyig share prices ad that ADRs overreact to the U.S, market ad uder react to exchage rates ad the uderlyig stock. They also coclude that ivestors caot take advatage of the pricig errors i ADRs because covergece does ot occur quickly or i predictable ways. With a loger time horizo ad/or the capacity to covert ADRs ito local shares, though, you should be able to take advatage of sigificat pricig differeces. Aswath Damodara 164

165 2. Closed Ed Fuds: Discouts ad Premiums o Net Asset Value Figure 11.7: Discouts/Premiums o Closed Ed Fuds- Jue Discout > 15% Discout: 10-15% Discout: % Discout: 5-7.5% Discout: 2.5-5% Discout: 0-2.5% Premium: 0-2.5% Premium: 2.5-5% Premium: 5-7.5% Premium: % Premium: 10-15% Premium > 15% Discout or Premium o NAV Aswath Damodara 165

166 What is the catch? I practice, takig over a closed-ed fud while payig less tha et asset value for its shares seems to be very difficult to do for several reasos- some related to corporate goverace ad some related to market liquidity. The potetial profit is also arrowed by the mispricig of illiquid assets i closed ed fud portfolios (leadig to a overstatemet of the NAV) ad tax liabilities from liquidatig securities. There have bee a few cases of closed ed fuds beig liquidated, but they remai the exceptio. Aswath Damodara 166

167 A Ivestmet Strategy of buyig discouted fuds Aswath Damodara 167

168 3. Covertible Arbitrage Whe compaies have covertible bods or covertible preferred stock outstadig i cojuctio with commo stock, warrats, preferred stock ad covetioal bods, it is etirely possible that you could fid oe of these securities mispriced relative to the other, ad be able to costruct a ear-riskless strategy by combiig two or more of the securities i a portfolio. I practice, there are several possible impedimets. May firms that issue covertible bods do ot have straight bods outstadig, ad you have to substitute i a straight bod issued by a compay with similar default risk. Compaies ca force coversio of covertible bods, which ca wreak havoc o arbitrage positios. Covertible bods have log maturities. Thus, there may be o covergece for log periods, ad you have to be able to maitai the arbitrage positio over these periods. Trasactios costs ad executio problems (associated with tradig the differet securities) may prevet arbitrage. Aswath Damodara 168

169 Determiats of Success at Near Arbitrage These strategies will ot work for small ivestors or for very large ivestors. Small ivestors will be stymied both by trasactios costs ad executio problems. Very large ivestors will quickly drive discouts to parity ad elimiate excess returs. If you decide to adopt these strategies, you eed to refie ad focus your strategies o those opportuities where covergece is most likely. For istace, if you decide to try to exploit the discouts of closed-ed fuds, you should focus o the closed ed fuds that are most discouted ad cocetrate especially o fuds where there is the potetial to brig pressure o maagemet to ope ed the fuds. Aswath Damodara 169

170 Pseudo or Speculative Arbitrage There are a large umber of strategies that are characterized as arbitrage, but actually expose ivestors to sigificat risk. We will categorize these as pseudo or speculative arbitrage. Aswath Damodara 170

171 1. Paired Arbitrage I paired arbitrage, you buy oe stock (say GM) ad sell aother stock that you view as very similar (say Ford), ad argue that you are ot that exposed to risk. Clearly, this strategy is ot riskless sice o two equities are exactly idetical, ad eve if they were very similar, there may be o covergece i prices. The covetioal practice amog those who have used this strategy o Wall Street has bee to look for two stocks whose prices have historically moved together i.e., have high correlatio over time. Aswath Damodara 171

172 Evidece o Paired Tradig Screeig first for oly stocks that traded every day, the authors foud a matchig parter for each stock by lookig for the stock with the miimum squared deviatio i ormalized price series. Oce they had paired all the stocks, they studied the pairs with the smallest squared deviatio separatig them. If you use absolute prices, a stock with a higher price will always look more volatile. You ca ormalize the prices aroud 1 ad use these series. With each pair, they tracked the ormalized prices of each stock ad took a positio o the pair, if the differece exceeded the historical rage by two stadard deviatios, buyig the cheaper stock ad sellig the more expesive oe. Over the 15 year period, the pairs tradig strategy did sigificatly better tha a buyad-hold strategy. Strategies of ivestig i the top 20 pairs eared a excess retur of about 6% over a 6-moth period, ad while the returs drop off for the pairs below the top 20, you cotiue to ear excess returs. Whe the pairs are costructed by idustry group (rather tha just based upo historical prices), the excess returs persist but they are smaller. Cotrollig for the bid-ask spread i the strategy reduces the excess returs by about a fifth, but the returs are still sigificat. Aswath Damodara 172

173 Two Caveats o Paired Arbitrage The study quoted foud that the pairs tradig strategy created egative returs i about oe out of every six periods, ad that the differece betwee pairs ofte wideed before it arrowed. I other words, it is a risky ivestmet strategy that also requires the capacity to trade istataeously ad at low cost. By the late 1990s, the pickigs for quatitative strategies (like pairs tradig) had become slim because so may ivestmet baks were adoptig the strategies. As the ovelty has wor off, it seems ulikely that the pairs tradig will geerate the kids of profits it geerated durig the 1980s. Aswath Damodara 173

174 2. Merger Arbitrage The stock price of a target compay jumps o the aoucemet of a takeover. However, it trades at a discout usually to the price offered by the acquirig compay. The differece betwee the post-aoucemet price ad the offer price is called the arbitrage spread, ad there are ivestors who try to profit off this spread i a strategy called merger or risk arbitrage. If the merger succeeds, the arbitrageur captures the arbitrage spreads, but if it fails, he or she could make a substatial loss. I a more sophisticated variat i stock mergers (where shares of the acquirig compay are exchaged for shares i the target compay), the arbitrageur will sell the acquirig firm s stock i additio to buyig the target firm s stock. Aswath Damodara 174

175 Evidece from merger arbitrage Mitchell ad Pulvio (2000) use a sample of 4750 mergers ad acquisitios to examie this questio. They coclude that there are excess returs associated with buyig target compaies after acquisitio aoucemets of about 9.25% aually, but that you lost about two thirds of these excess returs if you factor i trasactios costs ad the price impact that you have whe you trade (especially o the less liquid compaies). The strategy ears moderate positive returs much of the time, but ears large egative returs whe it fails. The strategy has payoffs that resemble those you would observe if you sell puts whe the market goes up, you keep the put premium but whe it goes dow, you lost much more. Aswath Damodara 175

176 Determiats of Success at Speculative Arbitrage The use of fiacial leverage has to be scaled to reflect the riskiess of the strategy. With pure arbitrage, you ca borrow 100% of what you eed to put the strategy ito play. I futures arbitrage, for istace, you borrow 100% of the spot price ad borrow the commodity. Sice there is o risk, the leverage does ot create ay damage. As you move to ear ad speculative arbitrage, this leverage has to be reduced. How much it has to be reduced will deped upo both the degree of risk i the strategy ad the speed with which you thik prices will coverge. The more risky a strategy ad the less certai you are about covergece, the less debt you should take o. These strategies work best if you ca operate without a market impact. As you get more fuds to ivest ad your strategy becomes more visible to others, you ru the risk of drivig out the very mispricig that attracted you to the market i the first place. Aswath Damodara 176

177 Log Short Strategies: Hedge Fuds While hedge fuds come i all varieties, they geerally share a commo characteristic. They ca go both buy ad sell short assets. You ca have value ad growth ivestig hedge fuds, hedge fuds that specialize i market timig, hedge fuds that ivest o iformatio ad hedge fuds that do covertible arbitrage. Aswath Damodara 177

178 The Performace of Hedge Fuds Year No of fuds i sample Arithmetic Average Retur Media Retur Retur o S&P 500 Average Aual Fee (as % of moey uder maagemet) Average Icetive Fee (as % of excess returs) % 20.30% 1.74% 19.76% % 3.80% 1.65% 19.52% % 15.90% 1.79% 19.55% % 10.70% 1.81% 19.34% % 22.15% 1.62% 19.10% % -2.00% 1.64% 18.75% % 14.70% 1.55% 18.50% Etire Period 13.26% 16.47%% Aswath Damodara 178

179 Lookig a little closer at the umbers The average hedge fud eared a lower retur (13.26%) over the period tha the S&P 500 (16.47%), but it also had a lower stadard deviatio i returs (9.07%) tha the S & P 500 (16.32%). Thus, it seems to offer a better payoff to risk, if you divide the average retur by the stadard deviatio this is the commoly used Sharpe ratio for evaluatig moey maagers. These fuds are much more expesive tha traditioal mutual fuds, with much higher aual fess ad aual icetive fees that take away oe out of every five dollars of excess returs. Aswath Damodara 179

180 Returs by sub-category Aswath Damodara 180

181 There is substatial survival risk.. Liag examied 2016 hedge fuds from 1990 to While his overall coclusios matched those of Brow et al., i.e. that these hedge fuds eared a lower retur tha the S&P 500 (14.2% versus 18.8%), they were less risky ad had higher Sharpe ratios (0.41 for the hedge fuds versus 0.27 for the S&P 500), he also oted that there a large umber of hedge fuds die each year. Of the 2016 fuds over the period for istace, oly 1407 remaied live at the ed of the period. Aswath Damodara 181

182 The Case For Passive Ivestig Aswath Damodara Aswath Damodara 182

183 The Case for Idexig The case for idexig is best made by active ivestors who try to beat the market ad fail. I the followig pages, we will cosider whether Idividual ivestors who are active ivestors beat the market Professioal moey maagers beat the market Aswath Damodara 183

184 Idividual Ivestors The average idividual ivestor does ot beat the market, after ettig out tradig costs. Betwee 1991 ad 1996, for istace, the aual et (of trasactios costs) retur o a S&P 500 idex fud was 17.8% whereas the average ivestor tradig at the brokerage house had a et retur of 16.4%. The more idividual ivestors trade, the lower their returs ted to be. I fact, the returs before trasactios costs are accouted for are lower for more active traders tha they are for less active traders. After trasactios costs are accouted for, the returs to active tradig get worse. Poolig the talet ad stregths of idividual ivestors ito ivestmet clubs does ot result i better returs. Barber ad Odea examied the performace of 166 radomly selected ivestmet clubs that used the discout brokerage house. Betwee 1991 ad 1996, these ivestmet clubs had a et aual retur of 14.1%, uderperformig the S&P 500 (17.8%) ad idividual ivestors (16.4%). Aswath Damodara 184

185 Professioal Moey Maagers Professioal moey maagers operate as the experts i the field of ivestmets. They are supposed to be better iformed, smarter, have lower trasactios costs ad be better ivestors overall tha smaller ivestors. Studies of mutual fuds do ot seem to support the propositio that professioal moey maagers each excess returs. Aswath Damodara 185

186 Jese s Results Figure 13.3: Mutual Fud Performace: The Jese Study Itercept (Actual Retur - E(R)) Aswath Damodara 186

187 A Eve Simpler Measure: Relative to the Market Figure 13.5: Percet of Moey Maagers who beat the S&P % 70% 60% 50% 40% 30% 20% 10% 0% Year Aswath Damodara 187

188 The same holds true for bod fuds as well Lehma Bod Idex 300 Active Bod fuds Aswath Damodara 188

189 More Fidigs o Moey Maagers These results have bee replicated with mild variatios i the coclusios. I the studies that are most favorable for professioal moey maagers, they break eve agaist the market after adjustig for trasactios costs, ad i those that are least favorable, they uder perform the market eve before adjustig for trasactios costs. Moey maagers uder perform the market o matter what category of maagers you look at. Aswath Damodara 189

190 1. Categorized by Style Aswath Damodara 190

191 2. Emergig Market ad Iteratioal Fuds Figure 13.8: Emergig Market Fuds versus Idices 30.00% 25.00% 20.00% 15.00% Average Fud Retur Retur o idex 10.00% 5.00% 0.00% Lati America Diversified Asia- Pacific Asia Excludig Japa Diversified Emergig Market Category of fud Aswath Damodara 191

192 3. Load versus No-load Fuds Figure 13.9: Jese's Alpha: Load versus No-load Fuds 0.00% -0.50% -1.00% -1.50% -2.00% Load fuds No-load fuds -2.50% -3.00% -3.50% -4.00% Pre-load Retur Post-load retur Aswath Damodara 192

193 4. Ad fud age Aswath Damodara 193

194 5. Istitutioal versus Retail Fuds Figure 13.11: Istitutioal versus Retail Fuds: Aualized Excess Returs 0.50% 0.00% -0.50% -1.00% -1.50% -2.00% -2.50% -3.00% -3.50% Retail fuds Big Stad-aloe Istitutioal Big Istitutioal with retail mate Small Stad-aloe Isitutioal Small Istitutioal with retail mate Excess Retur (CAPM) Excess Retur (4-factor model) Aswath Damodara 194

195 Performace Cotiuity Fud maagers argue that the average is brought dow by poor moey maagers. They argue that good maagers cotiue to be good maagers whereas bad maagers drag the average dow year after year. The evidece idicates otherwise. Aswath Damodara 195

196 1. Trasitio Probabilities Quartile rakig this period Quartile rakig ext period % 24% 23% 27% 2 20% 26% 29% 25% 3 22% 28% 26% 24% 4 32% 22% 22% 24% Aswath Damodara 196

197 2. The Value of Rakigs Aswath Damodara 197

198 Though there is some evidece of hot hads.. Aswath Damodara 198

199 Why active moey maagers fail High Trasactios Costs High Taxes Too much activity Failure to stay fully ivested i equities Behavioral factors Aswath Damodara 199

200 1. High Trasactios Costs Figure 13.14: Expese Ratios at Equity Mutual Fuds <0.25% % % % % % % % Expese Ratio % % 2.5-3% 3-4% >4% Aswath Damodara 200

201 Tradig Costs ad Returs Figure 13.16: Tradig Costs ad Returs: Mutual Fuds 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) (Highest) Total Cost Category Total Retur Excess Retur Aswath Damodara 201

202 2. High Tax Burdes Figure 13.17: Tax Effects at Idex ad Actively Maaged Fuds 12.00% 10.00% Average Aual Retur % 6.00% 4.00% 2.00% Pre-tax retur After-tax retur 0.00% 10 largest active fuds 5 largest idex fuds Type of Fud Aswath Damodara 202

203 3. Too Much Activity Aswath Damodara 203

204 4. Failure to stay fully ivested Idex Fuds versus Active Fuds: Market Dowturs 0.00% 7/17/98-9/4/98 10/7/97-10/27/97 6/5/96-7/24/96 2/2/94-4/20/94 7/12/90-10/11/90 8/13/87-12/3/ % % Returs % % S&P 500 Active Fuds % % % Dowtur Aswath Damodara 204

205 Ad stayig i cash too log.. Aswath Damodara 205

206 5. Behavioral Factors Lack of cosistecy: Brow ad Va Harlow examied several thousad mutual fuds from 1991 to 2000 ad categorized them based upo style cosistecy. They oted that fuds that switch styles had much higher expese ratios ad much lower returs tha fuds that maitai more cosistet styles. Herd Behavior: Oe of the strikig aspects of istitutioal ivestig is the degree to which istitutios ted to buy or sell the same ivestmets at the same time. Widow Dressig: It is a well documeted fact that portfolio maagers try to rearrage their portfolios just prior to reportig dates, sellig their losers ad buyig wiers (after the fact). O Neal, i a paper i 2001, presets evidece that widow dressig is most prevalet i December ad that it does impose a sigificat cost o mutual fuds. Aswath Damodara 206

207 Alteratives to Idexig Exchage Traded Fuds such as SPDRs provide ivestors with a way of replicatig the idex at low cost, while preservig liquidity. Idex Futures ad Optios Ehaced Idex Fuds that attempt to deliver the low costs of idex fuds with slightly higher returs. Aswath Damodara 207

208 Exchage Traded Fuds SPDR NAV 8.92% 1.15% 37.20% 22.72% 33.06% 28.28% 21.90% S & P % 1.32% 37.56% 22.97% 33.40% 28.57% 22.17% Shortfall -0.27% -0.17% -0.36% -0.25% -0.34% -0.29% -0.28% Aswath Damodara 208

209 Mechaics of Ehaced Idex Fuds I sythetic ehacemet strategies, you build o the derivatives strategies that we described i the last sectio. Usig the whole rage of derivatives futures, optios ad swaps- that may be available at ay time o a idex, you look for mispricig that you ca use to replicate the idex ad geerate additioal returs. I stock-based ehacemet strategies, you adopt a more covetioal active strategy usig either stock selectio or allocatio to geerate the excess returs. I quatitative ehacemet strategies, you use the mea-variace framework that is the foudatio of moder portfolio theory to determie the optimal portfolio i terms of the trade-off betwee risk ad retur. Aswath Damodara 209

210 Ehaced Idex Fuds The Returs Promise.. Aswath Damodara 210

211 Ehaced Idex Fuds The Risk Aswath Damodara 211

212 Coclusio There is substatial evidece of irregularities i market behavior, related to systematic factors such as size, price-earigs ratios ad price book value ratios. While these irregularities may be iefficiecies, there is also the soberig evidece that professioal moey maagers, who are i a positio to exploit these iefficiecies, have a very difficult time cosistetly beatig fiacial markets. Read together, the persistece of the irregularities ad the iability of moey maagers to beat the market is testimoy to the gap betwee empirical tests o paper ad real world moey maagemet i some cases, ad the failure of the models of risk ad retur i others. The performace of active moey maagers provides the best evidece yet that idexig may be the best strategy for may ivestors. Aswath Damodara 212

213 The Grad Fiale: Choosig a Ivestmet Philosophy Aswath Damodara Aswath Damodara 213

214 A Self Assessmet To chose a ivestmet philosophy, you first eed to uderstad your ow persoal characteristics ad fiacial characteristics, as well as as your beliefs about how markets work (or fail). A ivestmet philosophy that does ot match your eeds or your views about markets will ultimately fail. Aswath Damodara 214

215 Sigs of a misfit 1. You lie awake at ight thikig about your portfolio. Ivestors who choose ivestmet strategies that expose them to more risk tha they are comfortable takig will fid themselves facig this plight. It is true that your expected returs will be lower with low risk strategies, but the cost of takig o too much risk is eve greater. 2. Day to day movemets i your portfolio lead to reassessmets of your future: While log term movemets of your portfolio should affect your plas o whe you will retire ad what you will do with your future, day-to-day movemets should ot. It is commo i every market dowtur to read about older ivestors, o the verge or retiremet, havig to put off retirig because of the damage created to their portfolios. While some of them may have o choice whe it comes to where they ivest, most ivestors do have the choice of shiftig ito low-risk ivestmets (bods) as they approach retiremet. 3. Secod guessig your ivestmet decisios: If you fid yourself secod guessig your ivestmet choices every time you read a cotrary opiio, you should recosider your strategy. Aswath Damodara 215

216 Market Beliefs So much of what we believe about markets comes from aecdotal evidece from frieds, relatives ad experts i the field. We also have looked at the prevailig empirical evidece ad disagreemets amog researchers o what works ad does ot i fiacial markets. Your views about market behavior ad the performace of ivestmet strategies will udoubtedly chage over time, but all you ca do is make your choices based upo what you kow today. While stayig cosistet to a ivestmet philosophy ad core market beliefs may be cetral to success i ivestig, it would be foolhardy to stay cosistet as the evidece accumulates agaist the philosophy. Aswath Damodara 216

217 Fidig a Ivestmet Philosophy Short term (days to a few weeks) Medium term (few moths to a couple of years) Log Term (several years) Mometum Cotraria Opportuisitic Techical cotraria idicators mutual fud holdigs, short iterest. These ca be for idividual stocks or for overall market. Techical mometum idicators Buy stocks based upo tred lies ad high tradig volume. Iformatio tradig: Buyig after positive ews (earigs ad divided aoucemets, acquisitio aoucemets) Relative stregth: Buy stocks that have goe up i the last few moths. Iformatio tradig: Buy small cap stocks with substatial isider buyig. Passive growth ivestig: Buyig stocks where growth trades at a reasoable price (PEG ratios). Market timig, based upo ormal PE or ormal rage of iterest rates. Iformatio tradig: Buyig after bad ews (buyig a week after bad earigs reports ad holdig for a few moths) Passive value ivestig: Buy stocks with low PE, PBV or PS ratios. Cotraria value ivestig: Buyig losers or stocks with lots of bad ews. Pure arbitrage i derivatives ad fixed icome markets. Tehical demad idicators Patters i prices such as head ad shoulders. Near arbitrage opportuities: Buyig discouted closed ed fuds Speculative arbitrage opportuities: Buyig paired stocks ad merger arbitrage. Active growth ivestig: Take stakes i small, growth compaies (private equity ad veture capital ivestig) Activist value ivestig: Buy stocks i poorly maaged compaies ad push for chage. Aswath Damodara 217

218 The Right Ivestmet Philosophy Sigle Best Strategy: You ca choose the oe strategy that best suits you. Thus, if you are a log-term ivestor who believes that markets overreact, you may adopt a passive value ivestig strategy. Combiatio of strategies: You ca adopt a combiatio of strategies to maximize your returs. I creatig this combied strategy, you should keep i mid the followig caveats: You should ot mix strategies that make cotradictory assumptios about market behavior over the same periods. Thus, a strategy of buyig o relative stregth would ot be compatible with a strategy of buyig stocks after very egative earigs aoucemets. The first strategy is based upo the assumptio that markets lear slowly whereas the latter is coditioed o market overreactio. Whe you mix strategies, you should separate the domiat strategy from the secodary strategies. Thus, if you have to make choices i terms of ivestmets, you kow which strategy will domiate. Aswath Damodara 218

219 I closig Choosig a ivestmet philosophy is at the heart of successful ivestig. To make the choice, though, you eed to look withi before you look outside. The best strategy for you is oe that matches both your persoality ad your eeds. Your choice of philosophy will also be affected by what you believe about markets ad ivestors ad how they work (or do ot). Sice your beliefs are likely to be affected by your experieces, they will evolve over time ad your ivestmet strategies have to follow suit. Aswath Damodara 219