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