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Investment Philosophies: Overview With a focus on “ value ” investing. Aswath Damodaran www.damodaran.com. What is an investment philosophy?.
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Investment Philosophies: OverviewWith a focus on “value” investing Aswath Damodaran www.damodaran.com
What is an investment philosophy? • What is it? An investment philosophy is a coherent way of thinking about markets, how they work (and sometimes do not) and the types of mistakes that you believe consistently underlie investor behavior. • Investment philosophy vs. Investment strategy: An investment strategy is much narrower. It is a way of putting into practice an investment philosophy. • In brief: An investment philosophy is a set of core beliefs that you can go back to in order to generate new strategies when old ones do not work.
Ingredients of an Investment Philosophy • Step 1: All investment philosophies begin with a view about how human beings learn (or fail to learn). Underlying every philosophy, therefore, is a view of human frailty - that they learn too slowly, learn too fast, tend to crowd behavior etc…. • Step 2: From step 1, you generate a view about how markets behave and perhaps where they fail…. Your views on market efficiency or inefficiency are the foundations for your investment philosophy. • Step 3: This step is tactical. You take your views about how investors behave and markets work (or fail to work) and try to devise strategies that reflect your beliefs.
Why do you need an investment philosophy? If you do not have an investment philosophy, you will find yourself: • Lacking a rudder or a core set of beliefs, you will be easy prey for charlatans and pretenders, with each one claiming to have found the magic strategy that beats the market. • Switching from strategy to strategy, you will have to change your portfolio, resulting in high transactions costs and you will pay more in taxes. • With a strategy that may not be appropriate for you, given your objectives, risk aversion and personal characteristics. In addition to having a portfolio that under performs the market, you are likely to find yourself with an ulcer or worse.
Categorizing Investment Philosophies • Market Timing versus Asset Selection: With market timing, you bet on the movement of entire markets - financial as well as real assets. With asset selection, you focus on picking good investments within each market. • Activist Investing and Passive Investing: With passive investing, you take positions in companies and hope that the market corrects its mistakes. With activist investing, you play a role (or provide the catalyst) in correcting market mistakes. • Time Horizon: Some philosophies require that you invest for long time periods. Others are based upon short holding periods.
Developing an Investment Philosophy • Step 1: Acquire the tools of the trade • Be able to assess risk and incorporate into investment decisions • Understand financial statements • Be aware of the frictions and the costs of trading • Step 2: Develop a point of view about how markets work and where they might break down • Step 3: Find thephilosophy that provides the best fit for you, given your • Risk aversion • Time Horizon • Tax Status
I. Investor Risk Preferences • The trade off between Risk and Return • Most, if not all, investors are risk averse • To get them to take more risk, you have to offer higher expected returns • Conversely, if investors want higher expected returns, they have to be willing to take more risk. • - Ways of evaluating risk • Most investors do not know have a quantitative measure of how much risk that they want to take • Traditional risk and return models tend to measure risk in terms of volatility or standard deviation
Summing Up on Risk • Whether we measure risk in quantitative or qualitative terms, investors are risk averse. • The degree of risk aversion will vary across investors at any point in time, and for the same investor across time (as a function of his or her age, wealth, income and health) • Proposition 1: The more risk averse an investor, the less of his or her portfolio should be in risky assets (such as equities).
II. Investor Time Horizon • An investor’s time horizon reflects • personal characteristics: Some investors have the patience needed to hold investments for long time periods and others do not. • need for cash. Investors with significant cash needs in the near term have shorter time horizons than those without such needs. • An investor’s time horizon will have an influence on both the kinds of assets that investor will hold in his or her portfolio and the weights of those assets. • Proposition 2: The longer the time horizon of an investor, the greater the proportion of the portfolio that should be in “risky” investments (such as equities).
III. Tax Status and Portfolio Composition • Investors can spend only after-tax returns. Hence taxes do affect portfolio composition. • The portfolio that is right for an investor who pays no taxes might not be right for an investor who pays substantial taxes. • Moreover, the portfolio that is right for an investor on one portion of his portfolio (say, his tax-exempt pension fund) might not be right for another portion of his portfolio (such as his taxable savings) • The effect of taxes on portfolio composition and returns is made more complicated by: • The different treatment of current income (dividends, coupons) and capital gains • The different tax rates on various portions of savings (pension versus non-pension) • Changing tax rates across time
I. Intrinsic Valuation Investors Value versus Growth Investing Intrinsic value investors believe that growth is inherently speculative and that prudent investors should try to buy companies where the market value < intrinsic value of assets in place Intrinsic growth investors believe that growth is more likely to be misvalued because most investors give up. Consequently, they believe that there is more money to be had betting on the value of growth.
The valuer’s dilemma and ways of dealing with it… • Uncertainty about the magnitude of the gap: Your estimate of value may be incorrect, making the gap a “fiction of your mind” • Even the best intrinsic valuers know that they can be wrong (and sometimes very much so) about their estimates of value. • Consequently, they may see gaps that don’t exist and will therefore never close. • Uncertainty about gap closing: Even if you are right about value, you still may be uncertain about whether the gap will close and if so, when. • You can be right about value, but without a catalyst, the gap may get bigger, rather than smaller.
II. Pricing Investors • Chartists and Technicians: If price is set by demand and supply (and it is), these investors believe that the clues to future price movements lie in past prices and/or volume. In effect, they believe that poring over a stock’s trading history can give you early notice of coming shifts in demand/supply and therefore prices. • Arbitrageurs: To the extent that the price of an asset is the only known variable, these investors believe that a true bargain requires you to be able to buy an asset at a price today in one market, while selling the same asset in a different market at exactly the same point in time.
The “pricers” dilemma.. • No anchor: If you do not believe in intrinsic value and make no attempt to estimate it, you have no moorings when you invest. You will therefore be pushed back and forth as the price moves from high to low. In other words, everything becomes relative and you can lose perspective. • Reactive: Without a core measure of value, your investment strategy will often be reactive rather than proactive. • Crowds are fickle and tough to get a read on: The key to being successful as a pricer is to be able to read the crowd mood and to detect shifts in that mood early in the process. By their nature, crowds are tough to read and almost impossible to model systematically.
III. The Melded Strategy • Information Traders: While both intrinsic valuation and pricing investors try to make judgments on the level of the price, information traders adopt a more agnostic (and what they feel is a less risky strategy). Rather then guess whether a stock is cheap or expensive, they try to make money by guessing the change in the price, in response to new information. This can take the form of either: • Guessing whether the next information announcement will be good or bad news to the market (Example: Trading ahead of earnings reports) • Evaluating whether the price response to the latest information announcement was appropriate. (Example: Betting that stocks over react to “bad” earnings reports…)
The information trader’s dilemma • The value danger: If the intrinsic valuation investors are right and a stock is mispriced relative to intrinsic value, the change in the price in response to new information can be drowned out by the overall price correcting towards value. • The price danger: To the extent that the pricing process has its own dynamics, the effect of information on prices can be unpredictable (and costly).
IV. The Market Timers • As market timers see it, the big money to be made on investing is not in picking individual stock winners but in getting the direction of the overall market right. • Market timers come in all forms, and in fact you can have market timers who are • Intrinsic valuation investors, who value the entire market, compare to the price and hope that the gap closes. • Pricing investors, who believe that the future direction of the market can be gauged by looking at past price movements/ trading volume • Information traders, who feel that there is money to be made in looking at the overall market’s reactions to news events (usually macro).
The market timers dilemma… • Everyone does it: Everyone who invests is a market timer, with the only difference being one of degree. We all have views of the market, though me never admit to them, and those views mold how much we invest, in which markets we invest and when we invest. Consequently, it is a game that is played by tens of millions, making it much more difficult to win. • No competitive advantage: To win at a game, you have to bring something to the table that is unique and difficult to replicate. It is not clear what “that” is, with market timing.
V. The Efficient Marketer • The true believers: There are a few efficient marketers who took a look at the random walk, read financial market theory and were convinced immediately that there is little or no chance that any of the afore mentioned philosophies had any chance of success. • The school of hard knocks: There are far more efficient marketers who have got there after years of experimenting with different philosophies, with little success with each. They are believers that nothing works because nothing has worked for them.
So, what are you? • If you were asked to classify your investment philosophy, what would you classify yourself as? • Intrinsic value investor • Intrinsic growth investor • Technical Analyst/ Chartist • Arbitrageur • Information trader • Market Timer • Efficient Marketer
Where is the “value” in value investing? Aswath Damodaran
Three faces of value investing… • Passive Screeners: Following in the Ben Graham tradition, you screen for stocks that have characteristics that you believe identify under valued stocks. • Contrarian Investors: These are investors who invest in companies that others have given up on, either because they have done badly in the past or because their future prospects look bleak. • Activist Value Investors: These are investors who invest in poorly managed and poorly run firms but then try to change the way the companies are run.
I. The Passive Screener • This approach to value investing can be traced back to Ben Graham and his screens to find undervalued stocks. • With screening, you are looking for companies that are cheap (in the market place) without any of the reasons for being cheap (high risk, low quality growth, low growth).
Ben Graham’ Screens 1. PE of the stock has to be less than the inverse of the yield on AAA Corporate Bonds: 2. PE of the stock has to less than 40% of the average PE over the last 5 years. 3. Dividend Yield > Two-thirds of the AAA Corporate Bond Yield 4. Price < Two-thirds of Book Value 5. Price < Two-thirds of Net Current Assets 6. Debt-Equity Ratio (Book Value) has to be less than one. 7. Current Assets > Twice Current Liabilities 8. Debt < Twice Net Current Assets 9. Historical Growth in EPS (over last 10 years) > 7% 10. No more than two years of negative earnings over the previous ten years.
How well do Graham’s screen’s perform? • Graham’s best claim to fame comes from the success of the students who took his classes at Columbia University. Among them were Charlie Munger and Warren Buffett. However, none of them adhered to his screens strictly. • A study by Oppenheimer concluded that stocks that passed the Graham screens would have earned a return well in excess of the market. Mark Hulbert who evaluates investment newsletters concluded that newsletters that used screens similar to Graham’s did much better than other newsletters. • However, an attempt by James Rea to run an actual mutual fund using the Graham screens failed to deliver the promised returns.
Buffett’s Tenets • Business Tenets: The business the company is in should be simple and understandable. The firm should have a consistent operating history, manifested in operating earnings that are stable and predictable. The firm should be in a business with favorable long term prospects. • Management Tenets: The managers of the company should be candid. As evidenced by the way he treated his own stockholders, Buffett put a premium on managers he trusted. The managers of the company should be leaders and not followers. • Financial Tenets: The company should have a high return on equity. Buffett used a modified version of what he called owner earnings Owner Earnings = Net income + Depreciation & Amortization – Capital Expenditures The company should have high and stable profit margins. • Market Tenets: Use conservative estimates of earnings and the riskless rate as the discount rate. • In keeping with his view of Mr. Market as capricious and moody, even valuable companies can be bought at attractive prices when investors turn away from them.
So, what happened? • Imitators: His record of picking winners has attracted publicity and a crowd of imitators who follow his every move, buying everything be buys, making it difficult for him to accumulate large positions at attractive prices. • Scaling problems: At the same time the larger funds at his disposal imply that he is investing far more than he did two or three decades ago in each of the companies that he takes a position in, creating a larger price impact (and lower profits) • Macro game? The crises that have beset markets over the last few years have been both a threat and an opportunity for Buffett. As markets have staggered through the crises, the biggest factors driving stock prices and investment success have become macroeconomic unknowns and not the company-specific factors that Buffett has historically viewed as his competitive edge (assessing a company’s profitability and cash flows).
Be like Buffett? Markets have changed since Buffett started his first partnership. Even Warren Buffett would have difficulty replicating his success in today’s market, where information on companies is widely available and dozens of money managers claim to be looking for bargains in value stocks. In recent years, Buffett has adopted a more activist investment style and has succeeded with it. To succeed with this style as an investor, though, you would need substantial resources and have the credibility that comes with investment success. There are few investors, even among successful money managers, who can claim this combination. The third ingredient of Buffett’s success has been patience. As he has pointed out, he does not buy stocks for the short term but businesses for the long term. He has often been willing to hold stocks that he believes to be under valued through disappointing years. In those same years, he has faced no pressure from impatient investors, since stockholders in Berkshire Hathaway have such high regard for him.
Value Screens • Price to Book ratios: Buy stocks where equity trades at less than book value or at least a low multiple of the book value of equity. • Price earnings ratios: Buy stocks where equity trades at a low multiple of equity earnings. • Dividend Yields: Buy stocks with high dividend yields.
Caveat Emptor on P/BV ratios • A risky proxy? Fama and French point out that low price-book value ratios may operate as a measure of risk, since firms with prices well below book value are more likely to be in trouble and go out of business. Investors therefore have to evaluate for themselves whether the additional returns made by such firms justifies the additional risk taken on by investing in them. • Low quality returns/growth: The price to book ratio for a stable growth firm can be written as a function of its ROE, growth rate and cost of equity: Companies that are expected to earn low returns on equity will trade at low price to book ratios. In fact, if you expect the ROE < Cost of equity, the stock should trade at below book value of equity.
What can go wrong? • Companies with high-risk earnings: The excess returns earned by low price earnings ratio stocks can be explained using a variation of the argument used for small stocks, i.e., that the risk of low PE ratios stocks is understated in the CAPM. A related explanation, especially in the aftermath of the accounting scandals of recent years, is that accounting earnings is susceptible to manipulation. • Tax Costs: A second possible explanation that can be given for this phenomenon, which is consistent with an efficient market, is that low PE ratio stocks generally have large dividend yields, which would have created a larger tax burden for investors since dividends were taxed at higher rates during much of this period. • Low Growth: A third possibility is that the price earnings ratio is low because the market expects future growth in earnings to be low or even negative. Many low PE ratio companies are in mature businesses where the potential for growth is minimal.
Determinants of Success at Passive Screening 1. Have a long time horizon: All the studies quoted above look at returns over time horizons of five years or greater. In fact, low price-book value stocks have underperformed high price-book value stocks over shorter time periods. 2. Choose your screens wisely: Too many screens can undercut the search for excess returns since the screens may end up eliminating just those stocks that create the positive excess returns. 3. Be diversified: The excess returns from these strategies often come from a few holdings in large portfolio. Holding a small portfolio may expose you to extraordinary risk and not deliver the same excess returns. 4. Watch out for taxes and transactions costs: Some of the screens may end up creating a portfolio of low-priced stocks, which, in turn, create larger transactions costs.
The Value Investors’ Protective Armor • Accounting checks: Rather than trust the current earnings, value investors often focus on three variants: • Normalized earnings, i.e., average earnings over a period of time. • Adjusted earnings, where investors devise their corrections to earnings for what they see as shortcomings in conventional accounting earnings. • Owner’s earnings, where depreciation, amortization and other non-cash charges are added back and capital expenditures to maintain existing assets is subtracted out. • The Moat: The “moat” is a measure of a company’s competitive advantages; the stronger and more sustainable a company’s competitive advantages, the more difficult it becomes for others to breach the moat and the safer becomes the earnings stream.
II. Contrarian Value Investing: Buying the Losers • In contrarian value investing, you begin with the proposition that markets over react to good and bad news. Consequently, stocks that have had bad news come out about them (earnings declines, deals that have gone bad) are likely to be under valued. • Evidence that Markets Overreact to News Announcements • Studies that look at returns on markets over long time periods chronicle that there is significant negative serial correlation in returns, I.e, good years are more likely to be followed by bad years and vice versal. • Studies that focus on individual stocks find the same effect, with stocks that have done well more likely to do badly over the next period, and vice versa.
Determinants of Success at “Contrarian Investing” 1. Self Confidence: Investing in companies that everybody else views as losers requires a self confidence that comes either from past success, a huge ego or both. 2. Clients/Investors who believe in you: You either need clients who think like you do and agree with you, or clients that have made enough money of you in the past that their greed overwhelms any trepidiation you might have in your portfolio. 3. Patience: These strategies require time to work out. For every three steps forward, you will often take two steps back. 4. Stomach for Short-term Volatility: The nature of your investment implies that there will be high short term volatility and high profile failures. 5. Watch out for transactions costs: These strategies often lead to portfolios of low priced stocks held by few institutional investors. The transactions costs can wipe out any perceived excess returns quickly.
III. Activist Value Investing Activist investors buy companies with a value and/or pricing gap and provide the catalysts for closing the gaps. Passive investors buy companies with a pricing gap and hope (and pray) that the pricing gap closes.
1. Asset Deployment: Why assets may be deployed in sub-optimal uses… • Ego, overconfidence and bias: The original investment may have been colored by any or all of these factors. • Failure to adjust for risk: The original risk assessment may have been appropriate but the company failed to factor in changes in the project’s risk profile over time. • Diffuse businesses: By spreading themselves thinly across multiple bsuinesses, it is possible that some of these businesses may be run less efficiently than if they were stand alone businesses, partly because accountability is weak and partly because of cross subsidies. • Changes in business: Even firms that make unbiased and well reasoned judgments about their investments, at the time that they make them, can find that unanticipated changes in the business or sector can make good investments into bad ones. • Macroeconomic changes: Value creating investments made in assets when the economy is doing well can reverse course quickly, if the economy slows down or goes into a recession.
