Investment Philosophies:
An Overview
Aswath Damodaran
Aswath Damodaran
1
The Investment Process
The Client
Risk Tolerance/
Aversion
Utility
Functions
Investment Horizon
Tax Status
Tax Code
The Portfolio Manager’s Job
Asset Allocation
Asset Classes:
Countries:
Views on
markets
Valuation
based on
- Cash flows
- Comparables
- Technicals
Stocks
Domestic
Bonds
Real Assets
Non-Domestic
Security Selection
- Which stocks? Which bonds? Which real assets?
Trading
Costs
- Commissions
- Bid Ask Spread
- Price Impact
Execution
- How often do you trade?
- How large are your trades?
- Do you use derivatives to manage or enhance risk?
Views on
- inflation
- rates
- growth
Private
Information
Market Efficiency
- Can you beat
the market?
Trading
Speed
Trading Systems
- How does trading
affect prices?
Performance Evaluation
Market
Timing
Aswath Damodaran
1. How much risk did the portfolio manager take?
2. What return did the portfolio manager make?
3. Did the portfolio manager underperform or outperform?
Risk and Return
- Measuring risk
- Effects of
diversification
Stock
Selection
Risk Models
- The CAPM
- The APM
2
Understanding the Client
Q
There is no “one” perfect portfolio for every client. To create a
portfolio that is right for an investor, we need to know:
• The investor’s risk preferences
• The investor’s time horizon
• The investor’s tax status
Aswath Damodaran
3
I. Investor Risk Preferences
Q
The trade off between Risk and Return
•
•
•
Q
- Ways of evaluating risk
•
•
Q
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
Whether we measure risk in quantitative or qualitative terms, investors are
risk averse.
•
Q
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.
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).
Aswath Damodaran
4
II. Investor Time Horizon
Q
An investor’s time horizon reflects
• personal characteristics: Some investors have the patience needed to
hold investments for long time periods and others do not.
• need for cash. Investors with significant cash needs in the near term have
shorter time horizons than those without such needs.
• Job security and income: Other things remaining equal, the more secure
you are about your income, the longer your time horizon will be.
Q
An investor’s time horizon can have an influence on both the kinds of
assets that investor will hold in his or her portfolio and the weights of
those assets.
Aswath Damodaran
5
III. Tax Status and Portfolio Composition
Q
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)
Q
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 nonpension)
• Changing tax rates across time
Aswath Damodaran
6
Turnover and Tax Drag
Figure 5.11: Tax Effect and Turnover Ratio: U.S. Mutual funds- 1999-2001
35.00%
8.00%
7.00%
Annual Return- 1999- 2001
25.00%
5.00%
20.00%
4.00%
15.00%
3.00%
10.00%
2.00%
Tax Effect: Percent of pre-tax lost to taxes
30.00%
6.00%
Pre-tax Return
After-tax return
Tax Effect
5.00%
1.00%
0.00%
0.00%
> 200%
140-200%
100-140%
50-100%
20-50%
<20%
Turnover Ratio Class
Aswath Damodaran
7
The Investment Process
The Client
Risk Tolerance/
Aversion
Utility
Functions
Investment Horizon
Tax Status
Tax Code
The Portfolio Manager’s Job
Asset Allocation
Views on
markets
Asset Classes:
Countries:
Valuation
based on
- Cash flows
- Comparables
- Technicals
Stocks
Domestic
Bonds
Real Assets
Non-Domestic
Security Selection
- Which stocks? Which bonds? Which real assets?
Trading
Costs
- Commissions
- Bid Ask Spread
- Price Impact
Execution
- How often do you trade?
- How large are your trades?
- Do you use derivatives to manage or enhance risk?
Views on
- inflation
- rates
- growth
Private
Information
Market Efficiency
- Can you beat
the market?
Trading
Speed
Trading Systems
- How does trading
affect prices?
Performance Evaluation
Market
Timing
Aswath Damodaran
1. How much risk did the portfolio manager take?
2. What return did the portfolio manager make?
3. Did the portfolio manager underperform or outperform?
Risk and Return
- Measuring risk
- Effects of
diversification
Stock
Selection
Risk Models
- The CAPM
- The APM
8
Asset Allocation
z
z
z
The first step in all portfolio management is the asset allocation
decision.
The asset allocation decision determines what proportions of the
portfolio will be invested in different asset classes.
Studies indicate that good asset allocation trumps good security
selection when it comes to creating excess returns. One study indicates
that 93% of the excess returns earned by portfolios can be attributed to
asset allocation decisions and 7% to security selection.
Aswath Damodaran
9
Approaches to Asset Allocation
z
Asset allocation can be passive,
Î It can be based upon the mean-variance framework
Î It can be based upon simpler rules of diversification or market value based
z
When asset allocation is determined by market views, it is active asset
allocation.
Aswath Damodaran
10
Passive Asset Allocation
Q
In passive asset allocation, the proportions of the various asset classes
held in an investor’s portfolio will be determined by the risk
preferences of that particular investor. These proportions can be
determined in one of two ways:
• Statistical techniques can be employed to find that combination of assets
that yields the highest return, given a certain risk level
• The proportions can mirror the market values of the asset classes. Any
deviation from these proportions will lead to a portfolio that is over or
under weighted in some asset classes and thus not fully diversified.
Aswath Damodaran
11
I. Efficient Portfolios
Return Maximization
Maximize Expected Return
Risk Minimization
Minimize return variance
i=n
E(R p ) = ∑ w i E(R i )
i =1
i=n j =n
σ 2p = ∑ ∑ wi w jσ ij
i =1 j =1
j= n
i=n
subject to σ 2 = i = n w w σ ≤ σ̂ 2
∑
∑
E(R p ) = ∑ w i E(R i ) = E( R̂)
p
i j ij
i =1 j=1
where,
i =1
2
σ = Investor's desired level of variance
E(R) = Investor's desired expected returns
Aswath Damodaran
12
Limitations of this Approach
Q
This approach is heavily dependent upon two assumptions:
• That investors can provide their risk preferences in terms of variance
• That the variance-covariance matrix between asset classes remains stable
over time.
Q
If correlations across asset clases and covariances are unstable, the
output from the Markowitz portfolio approach is useless.
Aswath Damodaran
13
II. Just Diversify
Aswath Damodaran
14
The Optimally Diversified Portfolio
Aswath Damodaran
15
Active Asset Allocation: The Market Timers
Q
Q
In contrast to passive asset allocation, where the portfolio’s
compositition is determined primarily by the risk characteristics of the
investor, the portfolio composition in active asset allocation
approaches will deviate from the “passive” composition, based upon
market views.
In particular, those markets viewed as under valued will be over
weighted and those markets viewed as over valued will be under
weighted. At the limit, no assets might be allocated at all to those asset
classes that are the most over valued.
• Assumption: You can forecast market movements
• Advantage: If you can forecast market movements, the rewards are
immense.
• Disadvantage: If you err, the costs can be significant.
Aswath Damodaran
16
Why Market Timing is so alluring and so
difficult…
Q
Q
Over time, asset allocation decisions dominate security selection in
explaining portfolio returns. A study by Brinson, Hood and Beebower
found that 93% of differences in returns across portfolios could be
explained by asset allocation.
On the other hand, you have to be right about 7 times out of 10 for
market timing to pay off..
Aswath Damodaran
17
Market Timing Approaches
Q
Non-financial indicators
• Spurious Indicators: Example: If Super Bowl winner is from the old NFC,
stock market rises (22 out of 25 times between 1967 and 2001)
• Feel Good Indicators: The Hemline Index
• Hype Indicators: Cocktail party chatter (Time elapsed at party before talk
turns to stocks, average age of chatterers, fad component)
Q
Technical Indicators
• Price Indicators: Charting patterns and indicators
• Volume Indicators
• Volatility Indicators
Q
Q
Reversion to the mean (Normal ranges)
Fundamentals
Aswath Damodaran
18
A Normal Range for PE ratios
Figure 12.2: PE Ratio for S&P 500: 1960-2001
35.00
30.00
25.00
20.00
Normal Range
15.00
10.00
5.00
00
98
20
96
19
94
19
92
19
90
19
88
19
86
19
84
19
82
19
80
19
78
19
76
19
74
19
72
19
70
19
68
19
66
19
64
19
62
19
19
19
60
0.00
Aswath Damodaran
19
Or Interest rates..
1-year Corporate Bond Rate
1900-70
Above 4.40%
3.25% - 4.40%
Below 3.25%
1971-2000 Above 8.00%
Below 8.00%
Aswath Damodaran
Positive
0
10
26
4
15
Slope of Yield Curve
Flat
Negative
0
20
10
5
0
0
1
6
3
1
20
Fundamentals
Q
Fundamental Indicators
• If short term rates are low, buy stocks…
• If long term rates are low, buy stocks
• If economic growth is high, buy stocks…
Q
Intrinsic value models
• Value the market using a discounted cash flow model and compare to
actual level.,
Q
Relative value models
• Look at how market is priced, given fundamentals and given history.
Aswath Damodaran
21
The Relative Value Judgment…
Figure 12.5: S&P 500- Earnings Yield, T.Bond rate and Yield spread
16.00%
14.00%
12.00%
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
1978
1976
1974
1972
1970
1968
1966
1964
1962
1960
-2.00%
Year
T.Bond Rate
Aswath Damodaran
T.Bond-T.Bill
E/P Ratios
22
How well does market timing work?
1. Mutual Funds
Figure 12.6: Mutual Fund Cash Holdings and Stock Returns
40.00%
12.00%
30.00%
10.00%
20.00%
8.00%
10.00%
6.00%
0.00%
Annual Stock Return
Cash as % of Mutual Fund Assets at start of year
14.00%
4.00%
-10.00%
2.00%
0.00%
-20.00%
198119821983198419851986198719881989 19901991199219931994199519961997199819992000 2001
Year
Cash as % of assets at start of year
Stock Returns
Aswath Damodaran
23
2. Tactical Asset Allocation Funds
Performance of Unsophisticated Strategies versus Asset
Allocation Funds
18.00%
16.00%
Average Annual Returns
14.00%
12.00%
Last 10 years
Last 15 years
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%
S & P 500
Couch Potato 50/50
Couch Potato 75/25
Asset Allocation
Type of Fund
Aswath Damodaran
24
3. Market Strategists..
Annual Return from Market Strategists' Mixes: 1992-2001
16.00%
14.00%
Annual Return - 1992-2001
12.00%
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%
Best Market Strategist
Average Market
Strategists
Worst Market Strategist
Robot Blend
Aswath Damodaran
100% Equity
25
Summing Up on Market Timing
Q
Q
Q
A successful market timer will earn far higher returns than a successful
security selector.
Everyone wants to be a good market timer.
Consequently, becoming a good market timer is not only difficult to
do, it is even more difficult to sustain.
Aswath Damodaran
26
The Investment Process
The Client
Risk Tolerance/
Aversion
Utility
Functions
Investment Horizon
Tax Status
Tax Code
The Portfolio Manager’s Job
Asset Allocation
Views on
markets
Asset Classes:
Countries:
Valuation
based on
- Cash flows
- Comparables
- Technicals
Stocks
Domestic
Bonds
Real Assets
Non-Domestic
Security Selection
- Which stocks? Which bonds? Which real assets?
Trading
Costs
- Commissions
- Bid Ask Spread
- Price Impact
Execution
- How often do you trade?
- How large are your trades?
- Do you use derivatives to manage or enhance risk?
Views on
- inflation
- rates
- growth
Private
Information
Market Efficiency
- Can you beat
the market?
Trading
Speed
Trading Systems
- How does trading
affect prices?
Performance Evaluation
Market
Timing
1. How much risk did the portfolio manager take?
2. What return did the portfolio manager make?
3. Did the portfolio manager underperform or outperform?
Risk and Return
- Measuring risk
- Effects of
diversification
Stock
Selection
Risk Models
- The CAPM
- The APM
Aswath Damodaran
27
Security Selection
Q
Q
Security selection refers to the process by which assets are picked
within each asset class, once the proportions for each asset class have
been defined.
Broadly speaking, there are three different approaches to security
selection.
•
The first to focus on fundamentals and decide whether a stock is under or
overvalued relative to these fundamentals.
• The second is to focus on charts and technical indicators to decide
whether a stock is on the verge o changing direction.
• The third is to trade ahead of or on information releases that will affect the
value of the firm.
Aswath Damodaran
28
Active Security Selection
Q
The objective is to use the skills of your security analysts to select
stocks that outperform the market, and create a portfolio.
(1) Technical Analysis, where charts reveal direction of future movements
(2) Fundamental Analysis, where public information is used to pick
undervalued stocks
(3) Private information, which enables the analyst to pinpoint mis-valued
securities.
Assumption: Your stock selection skills help you make choices which, on
average, beat the market.
Inputs: The model will vary with the security selection model used.
Advantage: If there are systematic errors in market valuation, & you can
spot these errors, the portfolio will outperform the market.
Disadvantage: If it does not pay off, you have expended time and
resources to earn what you could have made with random selection.
Aswath Damodaran
29
Active investors come in all forms...
O
Technical investors can be
momentum investors, who buy on strength and sell on weakness
reversal investors, who do the exact opposite
O
Fundamental investors can be
value investors, who buy low PE or low PBV stocks which trade at less than
the value of assets in place
growth investors, who buy high PE and high PBV stocks which trade at less
than the value of future growth
O
Information traders can believe
that markets learn slowly and buy on good news and sell on bad news
that markets overreact and do the exact opposite
Q
They cannot all be right in the same period and no one approach can
be right in all periods.
Aswath Damodaran
30
Value Investing
Q
Q
The Conventional Definition: A value investor is one who invests in
low price-book value or low price-earnings ratios stocks.
The Generic Definition: A value investor is one who pays a price
which is less than the value of the assets in place of a firm.
Aswath Damodaran
31
I. The Passive Screener
Q
Q
This approach to value investing can be traced back to Ben Graham
and his screens to find undervalued stocks.
In recent years, these screens have been refined and extended. The
following section summarizes the empirical evidence that backs up
each of these screens.
Aswath Damodaran
32
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.
Aswath Damodaran
33
Low Price/BV Ratios and Excess Returns
Figure 8.2: PBV Classes and Returns - 1927-2001
25.00%
20.00%
15.00%
10.00%
5.00%
0.00%
Lowest
2
1991-2001
3
4
5
1961-1990
6
PBV Class
1927-1960
Aswath Damodaran
1961-1990
7
8
1927-1960
9
Highest
1991-2001
34
The Low PE Effect
Figure 8.3: Returns on PE Ratio Classes - 1952 - 2001
30.00%
Average Annual Return
25.00%
20.00%
15.00%
10.00%
5.00%
0.00%
Highest
2
3
4
5
PE Ratio Class
6
7
1991-2001
1971-90
1952-71
8
9
Lowest
Aswath Damodaran
35
II. Contrarian Value Investing: Buying the
Losers
Q
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.
Aswath Damodaran
36
Excess Returns for Winner and Loser Portfolios
Figure 8.5: Cumulative Abnormal Returns - Winners versus Losers
35.00%
30.00%
20.00%
15.00%
Winners
Losers
10.00%
5.00%
58
55
52
49
46
43
40
37
34
31
28
25
22
19
16
13
7
10
4
0.00%
1
Cumulative Abnormal Return
25.00%
-5.00%
-10.00%
-15.00%
Month after portfolio formation
Aswath Damodaran
37
Good Companies are not necessarily Good
Investments
Figure 8.7: Excellent versus Unexcellent Companies
350
Value of $ 100 invested in January 1981
300
250
200
150
100
50
59
57
55
53
51
49
47
45
43
41
39
37
35
33
31
29
27
25
23
21
19
17
15
13
9
11
7
5
3
1
0
Months after portfolio formation
Excellent Companies
Aswath Damodaran
Unexcellent Companies
38
III. Activist Value Investing
Q
An activist value investor having acquired a stake in an “undervalued”
company which might also be “badly” managed then pushes the management
to adopt those changes which will unlock this value. For instance,
If the value of the firm is less than its component parts:
Q
If the firm is being too conservative in its use of debt:
Q
If the firm is accumulating too much cash:
Q
If the firm is being badly managed:
Q
If there are gains from a merger or acquisition
Q
•
•
•
•
•
push for break up of the firm, spin offs, split offs etc.
push for higher leverage and recapitalization
push for higher dividends, stock repurchases ..
push for a change in management or to be acquired
push for the merger or acquisition, even if it is hostile
Aswath Damodaran
39
Determinants of Success at Activist Investing
1. Have lots of capital: Since this strategy requires that you be able to put
pressure on incumbent management, you have to be able to take
significant stakes in the companies.
2. Know your company well: Since this strategy is going to lead a
smaller portfolio, you need to know much more about your companies
than you would need to in a screening model.
3. Understand corporate finance: You have to know enough corporate
finance to understand not only that the company is doing badly (which
will be reflected in the stock price) but what it is doing badly.
4. Be persistent: Incumbent managers are unlikely to roll over and play
dead just because you say so. They will fight (and fight dirty) to win.
You have to be prepared to counter.
5. Do your homework: You have to form coalitions with other investors
and to organize to create the change you are pushing for.
Aswath Damodaran
40
Growth Investing
Q
Q
The Classic Definition: Investing in companies with high PE ratios.
The Correct Definition: Investing in companies where the price paid
for growth < Value of that growth.
Aswath Damodaran
41
Is growth investing doomed?
Figure 9.14: PE Ratios and Stock Returns - 1952 -2001
25.00%
Annual Return
20.00%
15.00%
10.00%
5.00%
0.00%
Highest
2
3
4
5
PE Ratio Class
Aswath Damodaran
6
7
Equally Weighted
Value Weighted
8
9
Lowest
42
But ..
Figure 9.15: Relative Performance of Growth and Value versus Earnings Growth
60.00%
40.00%
20.00%
01
99
20
97
19
95
19
93
19
91
19
89
19
87
19
85
19
83
19
81
19
79
19
77
19
75
19
73
19
71
19
69
19
67
19
65
19
63
19
19
19
61
0.00%
-20.00%
-40.00%
-60.00%
-80.00%
Year
Growth - Value
Earnings Growth
Aswath Damodaran
43
And …
Figure 9.16: Relative Performance of Growth Stocks versus Yield Curve
4.00%
60.00%
3.50%
40.00%
2.00%
89
19
91
19
93
19
95
19
97
19
99
20
01
19
87
19
85
19
83
81
19
19
79
77
19
75
19
19
73
19
71
19
69
19
67
19
65
63
19
61
19
-20.00%
1.50%
1.00%
T.Bond rate - T.Bill Rate
2.50%
0.00%
19
Growth versus Value Portfolios
3.00%
20.00%
0.50%
-40.00%
0.00%
-60.00%
-0.50%
-80.00%
-1.00%
Year
Growth - Value
Aswath Damodaran
T. Bond rate - T.Bill rate
44
Furthermore..
Q
And active growth investors seem to beat growth indices more often
than value investors beat value indices.
Active Investing: Value versus Growth
60%
0.20%
0.00%
-0.20%
Percent Beating the Index
40%
-0.40%
30%
-0.60%
20%
-0.80%
Differential Return (Active Average - Index)
50%
% Beating Market
Differential Return
10%
-1.00%
0%
-1.20%
Value Investors
Growth Investors
Aswath Damodaran
45
Growth Investing Strategies
Q
Passive Growth Investing Strategies focus on investing in stocks that
pass a specific screen. Classic passive growth screens include:
• PE < Expected Growth Rate
• Low PEG ratio stocks (PEG ratio = PE/Expected Growth)
• Earnings Momentum Investing (Earnings Momentum: Increasing earnings
growth)
• Earnings Revisions Investing (Earnings Revision: Earnings estimates
revised upwards by analysts)
• Small Cap Investing
Q
Active growth investing strategies involve taking larger positions and
playing more of a role in your investments. Examples of such
strategies would include:
• Venture capital investing
• Private Equity Investing
Aswath Damodaran
46
I. Passive Growth Strategies
Figure 9.17: PEG Ratios and Annual Returns
30.00%
Average Annual Return
25.00%
20.00%
15.00%
10.00%
5.00%
0.00%
1997-2001
Lowest
2
1991-1996
3
PEG Ratio Class
4
Highest
Aswath Damodaran
47
II. Small Cap Investing
Q
Q
One of the most widely used passive growth strategies is the strategy
of investing in small-cap companies. There is substantial empirical
evidence backing this strategy, though it is debatable whether the
additional returns earned by this strategy are really excess returns.
Studies have consistently found that smaller firms (in terms of market
value of equity) earn higher returns than larger firms of equivalent
risk, where risk is defined in terms of the market beta. In one of the
earlier studies, returns for stocks in ten market value classes, for the
period from 1927 to 1983, were presented.
Aswath Damodaran
48
The Small Firm Effect
Figure 9.1: Annual Returns by Market Value Class - 1927 - 2001
30.00%
Average Annual Return
25.00%
20.00%
15.00%
10.00%
5.00%
0.00%
Smallest
2
3
4
5
6
7
Market Value Class
Value Weighted
Equally Weighted
Value Weighted
8
9
Largest
Equally Weighted
Aswath Damodaran
49
A Note of caution…
Figure 9.7: Time Horizon and the Small Firm Premium
120.00%
16.00%
100.00%
12.00%
80.00%
10.00%
8.00%
60.00%
6.00%
40.00%
4.00%
% of time Small Cap Portfolio does better
Average Annual Return over Holding Period
14.00%
Large Cap
Small Cap
% of time small caps win
20.00%
2.00%
0.00%
0.00%
1
5
10
15
20
25
30
35
40
Time Horizon
Aswath Damodaran
50
III. Activist Growth Investing..
Fund Type
Early/Seed Venture Capital
Balanced Venture Capital
Later Stage Venture Capital
All Venture Capital
All Buyouts
Mezzanine
All Private Equity
1 Yr
-36.3
-30.9
-25.9
-32.4
-16.1
3.9
-21.4
3 Yr
81
45.9
27.8
53.9
2.9
10
16.5
5 Yr 10 Yr 20 Yr
53.9 33
21.5
33.2 24
16.2
22.2 24.5
17
37.9 27.4 18.2
8.1 12.7 15.6
10.1 11.8 11.3
17.9 18.8 16.9
Aswath Damodaran
51
Are there great stock pickers?
Firm
Credit Suisse F.B.
Prudential Sec.
U.S. Bancorp Piper J.
Merrill Lynch
Goldman Sachs
Lehman Bros.
J.P. Morgan Sec.
Bear Stearns
A.G. Edwards
Morgan Stanley D.W.
Raymond James
Edward Jones
First Union Sec.
PaineWebber
Salomon S.B.
S&P 500 Index
Aswath Damodaran
Latest qtr.
-3.60%
-12.3
-1.4
-1.9
0
-11.7
2.9
-6.4
-1.7
-2.8
-0.4
-0.5
-12.3
-13.2
-1.8
-2.70%
One- year
36.90%
36.2
28.5
28.1
27.4
18.3
11.6
11.4
9.8
9.5
6.9
4.8
1.8
-3.2
-17
7.20%
Five- year
253.10%
216.1
208.8
162.2
220.3
262.4
N.A.
184.9
194.8
148.8
164.4
204.3
N.A.
153.6
101.7
190.80%
52
The Investment Process
The Client
Risk Tolerance/
Aversion
Utility
Functions
Investment Horizon
Tax Status
Tax Code
The Portfolio Manager’s Job
Asset Allocation
Asset Classes:
Countries:
Views on
markets
Valuation
based on
- Cash flows
- Comparables
- Technicals
Stocks
Domestic
Bonds
Real Assets
Non-Domestic
Security Selection
- Which stocks? Which bonds? Which real assets?
Trading
Costs
- Commissions
- Bid Ask Spread
- Price Impact
Execution
- How often do you trade?
- How large are your trades?
- Do you use derivatives to manage or enhance risk?
Views on
- inflation
- rates
- growth
Private
Information
Market Efficiency
- Can you beat
the market?
Trading
Speed
Trading Systems
- How does trading
affect prices?
Performance Evaluation
Market
Timing
1. How much risk did the portfolio manager take?
2. What return did the portfolio manager make?
3. Did the portfolio manager underperform or outperform?
Risk and Return
- Measuring risk
- Effects of
diversification
Stock
Selection
Risk Models
- The CAPM
- The APM
Aswath Damodaran
53
Trading and Execution Costs
O
The cost of trading includes three components:
the brokerage cost, which tends to decrease as the size of the trade increases
the bid-ask spread, which generally does not vary with the size of the trade
but is higher for less liquid stocks
the price impact, which generally increases as the size of the trade increases
and as the stock becomes less liquid.
Aswath Damodaran
54
Many a slip…
Figure 5.1: Value Line - Paper Portfolio versus Real Fund
$2,500.00
Value of $100 invested in 1978
$2,000.00
$1,500.00
Paper Portfolio
Real Fund
$1,000.00
$500.00
$0.00
1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991
Year
Aswath Damodaran
55
Trading Costs and Performance...
Figure 13.16: Trading Costs and Returns: Mutual Funds
16.00%
14.00%
12.00%
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%
-2.00%
-4.00%
-6.00%
1 (Lowest)
2
3
Total Cost Category
Total Return
Aswath Damodaran
4
5 (Highest)
Excess Return
56
The Trade Off on Trading
O
O
O
There are two components to trading and execution - the cost of
execution (trading) and the speed of execution.
Generally speaking, the tradeoff is between faster execution and lower
costs.
For some active strategies (especially those based on information)
speed is of the essence.
Maximize:
Subject to:
O
For other active strategies (such as those based on long term investing)
the cost might be of the essence.
Minimize:
Subject to:
O
Speed of Execution
Cost of execution < Excess returns from strategy
Cost of Execution
Speed of execution < Specified time period.
The larger the fund, the more significant this trading cost/speed
tradeoff becomes.
Aswath Damodaran
57
Trading-based Investment Strategies
Q
Q
Q
Q
Q
An arbitrage-based investment strategy is based upon buying an asset
(at a market price) and selling an equivalent or the same asset at a
higher price.
A true arbitrage-based strategy is riskfree and hence can be financed
entirely with debt. Thus, it is a strategy where an investor can invest
no money, take no risk and end up with a pure profit.
Most real-world arbitrage strategies (such as those adopted by hedge
funds) have some residual risk and require some investment.
Assumption: Market prices are sometimes wrong, reflecting market
frictions.
Basis for strategy: An investor who has the capacity to spot this mispricing (through models, for instance) and has the resources to take
advantage of this mispricing can earn excess returns.
Aswath Damodaran
58
Are hedge funds that much better?
Figure 11.10: Hedge Funds: Average Returns and Standard Deviations - 1989-1995
18.00%
16.00%
14.00%
12.00%
10.00%
Mean Return
Standard deviation of returns
8.00%
6.00%
4.00%
2.00%
0.00%
Opportunistic
Funds
Short Sales Funds
Market Neutral
Funds
Global Macro
Funds
Global Funds
Fund of Funds
Event-driven funds
Aswath Damodaran
59
The Investment Process
The Client
Risk Tolerance/
Aversion
Utility
Functions
Investment Horizon
Tax Status
Tax Code
The Portfolio Manager’s Job
Asset Allocation
Asset Classes:
Countries:
Views on
markets
Valuation
based on
- Cash flows
- Comparables
- Technicals
Stocks
Domestic
Bonds
Real Assets
Non-Domestic
Security Selection
- Which stocks? Which bonds? Which real assets?
Trading
Costs
- Commissions
- Bid Ask Spread
- Price Impact
Execution
- How often do you trade?
- How large are your trades?
- Do you use derivatives to manage or enhance risk?
Views on
- inflation
- rates
- growth
Private
Information
Market Efficiency
- Can you beat
the market?
Trading
Speed
Trading Systems
- How does trading
affect prices?
Performance Evaluation
Market
Timing
Aswath Damodaran
1. How much risk did the portfolio manager take?
2. What return did the portfolio manager make?
3. Did the portfolio manager underperform or outperform?
Risk and Return
- Measuring risk
- Effects of
diversification
Stock
Selection
Risk Models
- The CAPM
- The APM
60
Performance Evaluation: Time to pay the piper!
Who should measure performance?
• Performance measurement has to be done either by the client or by an
objective third party on the basis of agreed upon criteria. It should not be
done by the portfolio manager.
How often should performance be measured?
• The frequency of portfolio evaluation should be a function of both the
time horizon of the client and the investment philosophy of the portfolio
manager. However, portfolio measurement and reporting of value to
clients should be done on a frequent basis.
How should performance be measured?
Against a market index (with no risk adjustment)
Against other portfolio managers, with similar objective functions
Against a risk-adjusted return, which reflects both the risk of the portfolio
and market performance.
Based upon Tracking Error against a benchmark index
Aswath Damodaran
61
I. Against a Market Index
Figure 13.5: Percent of Money Managers who beat the S&P 500
80%
70%
60%
50%
40%
30%
20%
10%
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
1979
1978
1977
1976
1975
1974
1973
1972
1971
0%
Year
Aswath Damodaran
62
II. Against Other Portfolio Managers
Q
Q
In some cases, portfolio managers are measured against other portfolio
managers who have similar objective functions. Thus, a growth fund
manager may be measured against all growth fund managers.
The implicit assumption in this approach is that portfolio managers
with the same objective function have the same exposure to risk.
Aswath Damodaran
63
Value and Growth Funds…
Figure 13.7: Returns on Growth and Value Funds
60.00%
50.00%
40.00%
30.00%
20.00%
10.00%
0.00%
1987
1988
1989
1990
1991
1992
1993
1987 - 1993
-10.00%
-20.00%
-30.00%
Year
Growth Funds
Aswath Damodaran
Growth index
Value funds
Value Index
64
III. Risk-Adjusted Returns
Q
Q
The fairest way of measuring performance is to compare the actual
returns earned by a portfolio against an expected return, based upon
the risk of the portfolio and the performance of the market during the
period.
All risk and return models in finance take the following form:
Expected return = Riskfree Rate + Risk Premium
Risk Premium: Increasing function of the risk of the portfolio
Q
Q
The actual returns are compared to the expected returns to arrive at a
measure of risk-adjusted performance:
Excess Return = Actual Return - Expected Returns
The limitation of this approach is that there are no perfect (or even
good risk and return models). Thus, the excess return on a portfolio
may be a real excess return or just the result of a poorly specified
model.
Aswath Damodaran
65
The Performance of Mutual Funds..
Figure 13.3: Mutual Fund Performance: 1955-64 - The Jensen Study
-0.08
-0.07
-0.06
-0.05
-0.04
-0.03
-0.02
-0.01
0
0.01
0.02
0.03
0.04
0.05
0.06
Intercept (Actual Return - E(R))
Aswath Damodaran
66
IV. Tracking Error as a Measure of Risk
O
O
O
Tracking error measures the difference between a portfolio’s return
and its benchmark index. Thus portfolios that deliver higher returns
than the benchmark but have higher tracking error are considered
riskier.
Tracking error is a way of ensuring that a portfolio stays within the
same risk level as the benchmark index.
It is also a way in which the “active” in active money management can
be constrained.
Aswath Damodaran
67
Enhanced Index Funds… Oxymoron?
Figure 13.21: Enhanced Index funds: Standard deviation vs. S&P 500
18.00%
16.00%
14.00%
12.00%
10.00%
8.00%
Standard deviation of fund
Standard deviation of S&P 500
6.00%
4.00%
2.00%
0.00%
Fund 10: 1/87-97
Fund 9: 7/92-97
Fund 8: 6/92-97
Fund 7: 7/93-97
Fund 6: 6/93-97
Fund 5: 3/91-97
Fund 4: 1/89-97
Fund 3:12/ 87-97
Fund 2: 1/91-97
Fund 1: 6/91-97
Aswath Damodaran
68
Finding an Investment Philosophy
Short term (days to
a few weeks)
Medium term (few
months to a couple
of years)
Long Term (several
years)
Momentum
Contrarian
• Technical contrarian
• Technical momentum
indicators – Buy stocks based
indicators – mutual fund
upon trend lines and high
holdings, short interest.
trading volume.
These can be for
• Information trading: Buying
individual stocks or for
overall market.
after positive news (earnings
and dividend announcements,
acquisition announcements)
• Market timing, based
• Relative strength: Buy stocks
that have gone up in the last
upon normal PE or
few months.
normal range of interest
• Information trading: Buy small
rates.
• Information trading:
cap stocks with substantial
insider buying.
Buying after bad news
(buying a week after
bad earnings reports
and holding for a few
months)
• Passive value investing:
• Passive growth investing:
Buying stocks where growth
Buy stocks with low
trades at a reasonable price
PE, PBV or PS ratios.
• Contrarian value
(PEG ratios).
investing: Buying losers
or stocks with lots of
bad news.
Opportunisitic
• Pure arbitrage in
derivatives and fixed
income markets.
• Tehnical demand
indicators – Patterns in
prices such as head and
shoulders.
• Near arbitrage
opportunities: Buying
discounted closed end
funds
• Speculative arbitrage
opportunities: Buying
paired stocks and
merger arbitrage.
• Active growth
investing: Take stakes
in small, growth
companies (private
equity and venture
capital investing)
• Activist value investing:
Buy stocks in poorly
managed companies
and push for change.
Aswath Damodaran
69
The Right Investment Philosophy
Q
Q
Single Best Strategy: You can choose the one strategy that best suits
you. Thus, if you are a long-term investor who believes that markets
overreact, you may adopt a passive value investing strategy.
Combination of strategies: You can adopt a combination of strategies
to maximize your returns. In creating this combined strategy, you
should keep in mind the following caveats:
• You should not mix strategies that make contradictory assumptions about
market behavior over the same periods. Thus, a strategy of buying on
relative strength would not be compatible with a strategy of buying stocks
after very negative earnings announcements. The first strategy is based
upon the assumption that markets learn slowly whereas the latter is
conditioned on market overreaction.
• When you mix strategies, you should separate the dominant strategy from
the secondary strategies. Thus, if you have to make choices in terms of
investments, you know which strategy will dominate.
Aswath Damodaran
70
In closing…
Q
Q
Choosing an investment philosophy is at the heart of successful
investing. To make the choice, though, you need to look within before
you look outside. The best strategy for you is one that matches both
your personality and your needs.
Your choice of philosophy will also be affected by what you believe
about markets and investors and how they work (or do not). Since your
beliefs are likely to be affected by your experiences, they will evolve
over time and your investment strategies have to follow suit.
Aswath Damodaran
71