Value Investing - Investment Management - Lecture Slides, Slides of Investment Management and Portfolio Theory

Download Value Investing - Investment Management - Lecture Slides and more Slides Investment Management and Portfolio Theory in PDF only on Docsity! Aswath Damodaran! 1! Investing for grown ups? Value Investing Aswath Damodaran Aswath Damodaran! 2! Who is a value investor?   The simplistic definition: The lazy definition (used by services to classify investors into growth and value investors) is that anyone who invests in low PE stocks is a value investor.   The too broad definition: Another widely used definition of value investors suggests that they are investors interested in buying stocks for less that what they are worth. But that is too broad a definition since you could potentially categorize most active investors as value investors on this basis. After all, growth investors also want to buy stocks for less than what they are worth. Aswath Damodaran! 5! 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). Aswath Damodaran! 6! 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! 7! 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. Updating Buffett’s record ath Damodaran 160000 140000 120000 100000 Figure 2: Berkshire Hathaway: Price to Book from 1998 to 2010 25 —Ppv EBV share MVishare 10 Aswath Damodaran! 11! 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). Aswath Damodaran! 12! 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. Aswath Damodaran! 15! Low Price/BV Ratios and Excess Returns ! Evidence from International Markets 15% 10% 5% 15% -20% Premium earned by low price to book stocks over high price to book stocks 1975-2011 o> . ° 2000-2011 FP SS fe. SP eS a ath Damodaran 16 Aswath Damodaran! 17! 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. (Return on Equity - Expected Growth Rate) (Return on Equity - Cost of Equity) Aswath Damodaran! 20! More On the PE Ratio Effect   Firms in the lowest PE ratio class earned an average return substantially higher than firms in the highest PE ratio class in every sub-period.   The excess returns earned by low PE ratio stocks also persist in other international markets. Aswath Damodaran! 21! What can go wrong? 1.  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. 2.  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. 3.  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. Aswath Damodaran! 22! 3. Revenue Multiples   Senchack and Martin (1987) compared the performance of low price-sales ratio portfolios with low price-earnings ratio portfolios, and concluded that the low price-sales ratio portfolio outperformed the market but not the low price- earnings ratio portfolio.   Jacobs and Levy (1988a) concluded that low price-sales ratios, by themselves, yielded an excess return of 0.17% a month between 1978 and 1986, which was statistically significant. Even when other factors were thrown into the analysis, the price-sales ratios remained a significant factor in explaining excess returns (together with price-earnings ratio and size) Aswath Damodaran! 25! 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. Aswath Damodaran! 26! The Value Investors’ Protective Armour   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 own measures of earnings that correct 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.   Margin of safety: The margin of safety (MOS) is the buffer that value investors build into their investment decision to protect themselves against risk. Thus, a MOS of 20% would imply that an investor would buy a stock only if its price is more than 20% below the estimated value (estimated using a multiple or a discounted cash flow model). Aswath Damodaran! 27! 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. Aswath Damodaran! 30! More on Winner and Loser Portfolios   This analysis suggests that loser portfolio clearly outperform winner portfolios in the sixty months following creation. This evidence is consistent with market overreaction and correction in long return intervals.   There are many, academics as well as practitioners, who suggest that these findings may be interesting but that they overstate potential returns on 'loser' portfolios. •  There is evidence that loser portfolios are more likely to contain low priced stocks (selling for less than $5), which generate higher transactions costs and are also more likely to offer heavily skewed returns, i.e., the excess returns come from a few stocks making phenomenal returns rather than from consistent performance. •  Studies also seem to find loser portfolios created every December earn significantly higher returns than portfolios created every June. •  Finally, you need a long time horizon for the loser portfolio to win out. Loser Portfolios and Time Horizon ath Damodaran Cumulative abnormal return (Winner - Loser) 12.00% 10.00% 8.00% 6.00% 4.00% 0.00% Figure 7: Differential Returns - Winner versus Loser Portfolios o—~™ / L/S i \ £ — 12 3.4 5 6 7 8 9 1011 12 13 14.15 16 17 18 19 20 21 22 23 24 25 26 27 28 31 32 33 34 35 36 Month after portfolio formation TT 1941-64 1965-89 31 Aswath Damodaran! 32! 2. Buy “bad” companies   Any investment strategy that is based upon buying well-run, good companies and expecting the growth in earnings in these companies to carry prices higher is dangerous, since it ignores the reality that the current price of the company may reflect the quality of the management and the firm.   If the current price is right (and the market is paying a premium for quality), the biggest danger is that the firm loses its lustre over time, and that the premium paid will dissipate.   If the market is exaggerating the value of the firm, this strategy can lead to poor returns even if the firm delivers its expected growth.   It is only when markets under estimate the value of firm quality that this strategy stands a chance of making excess returns. Aswath Damodaran! 35! 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. Aswath Damodaran! 36! III. Activist Value Investing Passive investors buy companies with a pricing gap and hope (and pray) that the pricing gap closes. Activist investors buy companies with a value and/or pricing gap and provide the catalysts for closing the gaps. (2) Are you investing optimally fo future growth? a. If ROC < WACC, invest less b. If ROC > WACC, invest more Growth from new investments Growth created by making new investments; function of amount and quality of investments (1) How well do you manage your existing investments/assets? a. Cost cutting b. Asset divestitures c. Tax management d. Working capital management (3) Is there scope for more efficient utilization of exsting assets? Efficiency Growth Growth generated by using existing assets better Cashflows from existing assets Cashflows before debt payments, but after taxes and reinvestment to Expected Growth during high growth period maintain exising assets (4) Are you building on your competitive advantages? a. Augment existing advantages b. Find new barriers to entry (5) Are you using the right amount and kind of debt for your firm? a. Change mix of debt and equity b. Match debt to assets c. Make your products less discrtionary d. Reduce fixed costs Stable growth firm, with no or very limited excess returns Length of the high growth period Since value creating growth requires excess returns| this is a function of - Magnitude of competitive advantages - Sustainability of competitive advantages Cost of capital to apply to discounting cashflows Determined by - Operating risk of the company - Default risk of the company - Mix of debt and equity used in financing With young growth firms, start of the life cycle: Focus on (2) With established growth firms, later in life cycle: Focus on (2, (4) and (5) With mature firms, middle of life cycle: Focus on (1), (3) and (5) With declining firms, end of life cycle: Focus on (1) and (5) Aswath Damodaran 37 Aswath Damodaran! 40! Redeploying assets: spin offs, split offs and split ups   In a spin off, a firm separates out assets or a division and creates new shares with claims on this portion of the business. Existing stockholders in the firm receive these shares in proportion to their original holdings. They can choose to retain these shares or sell them in the market.   In a split up, which can be considered an expanded version of a spin off, the firm splits into different business lines, distributes shares in these business lines to the original stockholders in proportion to their original ownership in the firm, and then ceases to exist.   A split off is similar to a spin off, insofar as it creates new shares in the undervalued business line. In this case, however, the existing stockholders are given the option to exchange their parent company stock for these new shares, which changes the proportional ownership in the new structure. Aswath Damodaran! 41! Choosing between spin offs and split offs   Whose fault? A spin off can be an effective way of creating value when subsidiaries or divisions are less efficient than they could be and the fault lies with the parent company, rather than the subsidiaries.   Taxes: The second advantage of a spin off or split off, relative to a divestiture, is that it might allow the stockholders in the parent firm to save on taxes. If spin offs and split offs are structured correctly, they can save stockholders significant amounts in capital gains taxes.   Contamination: The third reason for a spin off or split off occurs when problems faced by one portion of the business affect the earnings and valuation of other parts of the business.   Regulatory factors: Finally, spin offs and split offs can also create value when a parent company is unable to invest or manage its subsidiary businesses optimally because of regulatory constraints. Aswath Damodaran! 42! And markets generally react positively to spin offs… ! Aswath Damodaran! 45! Ways of adjusting financing mix   Marginal recapitalization: A firm that is under (over) levered can use a disproportionately high (low) debt ratio to fund new investments.   Total recapitalization: In a recapitalization, a firm changes its financial mix of debt and equity, without substantially altering its investments or asset holdings. If under levered, the firm can borrow money and buy back stock or do a debt for equity swap. If over levered, it can issue new equity to retire debt or offer its debt holders equity positions in the company.   Leveraged acquisition: If a firm is under levered and the existing management is too conservative and stubborn to change, there is an extreme alternative. An acquirer can borrow money, implicitly using the target firm’s debt capacity, and buy out the firm. ath Damodaran 3. Dividend policy Market Value of $ 1 in cash: Estimates obtained by regressing Enterprise Value against Cash Balances 0 Mature firms, Negative excess returns All firms High Growth firms, High Excess Returns 46 If you have too much cash... ath Damodaran $ Dividends & Buybacks $600,000.00 $500,000.00 $400,000.00 $300,000.00 $200,000.00 $100,000.00 Figure 12:: Stock Buybacks and Dividends: Aggregate for US Firms - 1989-2010 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Year Stock Buybacks ™ Dividends 47 Aswath Damodaran! 50! b. Change top management   The overall empirical evidence suggests that changes in management are generally are viewed as good news. Returns Around Management Changes -25.00% -20.00% -15.00% -10.00% -5.00% 0.00% 5.00% Forced Resignations Normal Retirements All Changes Type of Management Change A bn or m al R et ur ns Pre-Announcement Returns Returns on Announcement of change Aswath Damodaran! 51! c. The Effects of Hostile Acquisitions on the Target Firm   Badly managed firms are much more likely to be targets of acquistions than well managed firms  ! Aswath Damodaran! 52! And acquisitions are clearly good for the target firm’s stockholders Aswath Damodaran! 55! What do they do?   Institutional activists primarily push for changes in corporate governance – more independent boards and improved voting rights.   Individual activists agitate for asset redeployment (divestitures of non-core assets) and higher dividends/buybacks.   A study of 1164 hedge fund activist investing campaigns between 2000 and 2007 documents some interesting facts about hedge fund activism: •  Two-thirds of activist investors quit before making formal demands of the target. The failure rate in activist investing is very high. •  Among those activist investors who persist, less than 20% request a board seat, about 10% threaten a proxy fight and only 7% carry through on that threat. •  Activists who push through and make demands of managers are most successful (success rate in percent next to each action) when they demand the taking private of a target (41%), the sale of a target (32%), restructuring of inefficient operations (35%) or additional disclosure (36%). They are least successful when they ask for higher dividends/buybacks (17%), removal of the CEO (19%) or executive compensation changes (15%). Overall, activists succeed about 29% of the time in their demands of management. How do markets react? Abnormal Buy-and-Hold Retum Note: The solid line (left axis) plots the average buy-and-hold return around the Schedule 13D filing, in excess of the buy-and-hold return of the value-weight market, from 20 days prior the 13D file date to 20 days afterwards. The bars (right axis) plot the increase (in ‘percentage points) in the share trading turnover during the same time window compared to the average turnover rate during the preceding (100, -40) event window. ath Damodaran 56 Aswath Damodaran! 57! What returns do activist investors make for themselves?   Overall returns: Activist mutual funds seem to have had the lowest payoff to their activism, with little change accruing to the corporate governance, performance or stock prices of targeted firms. Activist hedge funds, on the other hand, seem to earn substantial excess returns, ranging from 7-8% on an annualized basis at the low end to 20% or more at the high end. Individual activists seem to fall somewhere in the middle, earning higher returns than institutions but lower returns than hedge funds.   Volatility in returns: While the average excess returns earned by hedge funds and individual activists is positive, there is substantial volatility in these returns and the magnitude of the excess return is sensitive to the benchmark used and the risk adjustment process.   Skewed distributions: The average returns across activist investors obscures a key component, which is that the distribution is skewed with the most positive returns being delivered by the activist investors in the top quartile; the median activist investor may very well just break even, especially after accounting for the cost of activism. Aswath Damodaran! 60! Where’s the beef? Overall assessment of value investing Evidence from active value funds ! Aswath Damodaran! 61! What about individual value investors?   In a study of the brokerage records of a large discount brokerage service between 1991 and 1996, Barber and Odean concluded that while the average individual investor under performed the S&P 500 by about 1% and that the degree of under performance increased with trading activity, the top- performing quartile outperformed the market by about 6%. Another study of 16,668 individual trader accounts at a large discount brokerage house finds that the top 10 percent of traders in this group outperform the bottom 10 percent by about 8 percent per year over a long period.   Studies of individual investors find that they generate relatively high returns when they invest in companies close to their homes compared to the stocks of distant companies, and that investors with more concentrated portfolios outperform those with more diversified portfolios.   While none of these studies of individual investors classify the superior investors by investment philosophy, the collective finding that these investors tend not to trade much and have concentrated portfolios can be viewed as evidence (albeit weak) that they are more likely to be value investors. Aswath Damodaran! 62! The fallback position…   To the extent that the evidence on both institutional and individual value investors’ capacity to beat the market consistently is not convincing, some value investors will fall back on that old standby, which is that we should draw our cues from the most successful of the value investors, not the average.   Arguing that value investing works because Warren Buffett and Seth Klarman have beaten the market is a sign of weaknesss, not strength. After all, every investment philosophy (including technical analysis) has its winners and its losers.   A more telling test would be to take the subset of value investors, who come closest to purity, at least as defined by the oracles in value investing, and see if they collectively beat the market. Have those investors who have read Graham and Dodd generated higher returns, relative to the market, than those who just listen to CNBC? Do the true believers who trek to Omaha for the Berkshire Hathaway annual meeting every year have superior track records to those who buy index funds?