Investment Philosophy and Strategies

Investment Philosophy and Strategies - Damodaran.

• Your investment philosophy is your set of core beliefs about how investors
behave and the extent to which you consider the market to be efficient.

• Your investment strategy should be designed to take advantage of pricing errors –
e.g. price momentum resulting from the herd mentality; market over-reaction to
news; mis-pricing due to lack of financial coverage. Basing a strategy on market
over-reaction to news is a short-term strategy whereas buying neglected
companies is longer term. Strategies become less successful the more they are
publicised.

• Consideration of your strengths and weaknesses is important e.g. your attitude to
risk. Also your time horizons.

• Firm specific risk can be diversified away. The Capital Asset Pricing Model
(CAPM) measures market risk – this is measured by the Beta of an asset. A
riskless asset has a Beta = 0; a riskier asset > 1.

Use of Financial Ratios:

• Current Ratio – traditional analysis suggests 2 or greater but a very high number
may reflect an inability to reduce inventory.

• Operating Cash Flow = EBITDA.

• Tobin’s Q is a ratio of the value of the firm to replacement cost and some think it
a better measure than Book Value.

Multiples should be used along with their companion variable:
PE with Earnings Growth; PBV with ROE; PSR with Net Margin; EV/Sales with Operating Margin. Each multipleshould be compared with the average for the sector. If the difference cannot be explained by the fundamentals then the firm can be classed as undervalued. Firms in the same sector are presumed to have similar risk, growth, and cash flow profiles. PE/EPS Growth rate =Growth adjusted PE Ratio; PBV/ROE = Value Ratio; PSR/Net Margin = Margin adjusted
PSR. Comparing with firms outside the sector can be done as follows:
PE = Actual + EPS Growth + Payout Ratio (cash flow) + Risk (Beta); PBV = Actual + EPS Growth + Payout Ratio (cash flow) + Risk (Beta) + ROE; PSR = Actual + EPS Growth + Payout
Ratio (cash flow) + Risk (Beta) + Net Margin.

Price Momentum.

• Over a time period of up to 8 months, stocks that have gone up in the last 6
months tend to continue and vice versa. Over a period of years, there is a negative
correlation suggesting that markets reverse themselves over long periods.

• Stocks go up more on Mondays and do better in January esp. small firms; Returns
on Monday are likely to be negative if the previous Friday was negative and vice
versa. Days following trading holidays are usually positive.

• Strong volume helps price momentum. TA could be used to augment returns on a
primary FA strategy e.g. using RS with Rising EPS growth.


Market Psychology:

• Investors over-react to new information so buy when others are selling and vice
versa; market participants are slow learners so there may still be an opportunity to
trade after an announcement; investors change their mind frequently and
irrationally; tendency for investors to be swayed by the crowd; tendency for
investors to hold on to losers too long and sell winners too soon. Keynes
compared playing the stock market to guessing the winner of a beauty contest –
the winner will be the one who best gauges who the judges will pick.

Value:

• A low PBV may be a measure of risk and justified if a low ROE is expected; a
firm expected to earn an ROE less than the Cost of Equity should trade at a
discount to Book Value. Therefore, look for low PBV, a high ROE and low
default risk (Debt ratios). Tobin’s Q provides an alternative to PBV – a low
Tobin’s Q firm is more likely to be taken over.

• Low PE stocks may have high-risk earnings or low growth. You could modify
earnings e.g. a) P/Normalised Earnings b) P/Adjusted Earnings or c) P/Cash
Earnings [=P/Cash Earnings + Depreciation + Amortisation]. Then check for Risk
using Beta or Debt to Equity Ratio. Assess growth and eliminate declining
Earnings or Earnings Growth lower than the sector.

• EBITDA multiples. EV/EBITDA = Market Value of Equity + Market Value of
Debt – Cash & Marketable securities. If using this multiple, screen for low
Investment Needs and high ROC.

• PSR. A low PSR is a useful measure for smaller firms. Look for low Risk, good
Margins and low Debt (or EV/Sales).

• High Yield. Need to check Dividend Cover and Reinvestment needs.

• Overall, Value investing needs a long time horizon and reasonable diversification.

• Contrarian. Markets tend to over-react and stocks doing well/badly tend to
reverse over time. For example, buy stocks that have gone down the most over the
last 5 years. Need to hold for long periods.

• Vulture Investing = betting on a restructuring or a recovery. Avoid sectors in
long-term decline; buy a poorly performing company in a positive sector; bad
managers can be removed. Bad companies will often get worse before they get
better. Companies take long periods to recover. Diversification is crucial with this
strategy. Need to be of independent mind and not easily swayed. Some investors
lack patience and bail out early. Need to be able to cope with short-term volatility.
If the company divests assets the market usually responds positively to the news –
operating performance tends to improve after the divestitures. With a Spin-off the
parent company’s share price tends to increase on the announcement. Debt is
often the problem – some believe no debt is best; Damodaran believes in an
optimal debt ratio e.g. a firm with stable and large cash flows and a high tax rate
can gain value from the use of debt. Evidence suggests changes in management
are generally viewed as good news. Managers tend to be stubborn and resilient.

Small Cap:

• Small Caps tend to do better when the Yield Curve is downward sloping and
inflation is high. Small Caps tend to do well in January.

• To be successful here, you need a long time horizon, good diversification, and
reliance on one’s own research. Small-Cap and Value go well together. See
Pradhuman on Small Cap Investing.

Growth:

• Past Earnings Growth is not a reliable indicator of future growth. Companies
growing fast will see their growth rates decline towards the market average.
Revenue Growth seems to be more predictable than Earnings Growth. Some
investors go for accelerating Earnings Growth.

• Better to look to expected growth and Analysts’ Estimates. However, analysts
have a tendency to overestimate growth. Markets also tend to over-price growth.
Growth investing seems to do better when the Yield Curve is flat or down
sloping. Low PEGs may be high risk. The PEG can be modified to include the
Dividend Yield e.g. PEGY = PE/ (Expected Growth Rate + Dividend Yield).

• Growth investing has done best when Earnings Growth is low and investors are
pessimistic.

Trading on News:

• Best if you can follow the trades of top executives. N.B. Insider trading using
derivatives to hedge increases following price run-ups and prior to poor earnings
announcements. Stock prices tend to go down after insiders take hedging
positions.

• Most announcements are preceded by price run-ups on good news and vice versa,
due to insider information. Increased trading volume in the stock and derivatives
are also indications.

• You can track illegal insider trading by looking at trading volume and bid-ask
spreads.

Analyst Forecasts:

• Information showing the economy grower at a faster rate than forecast will result
in analysts increasing their growth forecasts for cyclical firms. Analysts may also
adjust their estimates based on information revealed by competitors. Analysts are
generally over-optimistic about future growth; they over-estimate growth at the
peak of a recovery and under-estimate growth in the midst of a recession.

• An earnings momentum strategy is to buy stocks when analysts revise forecasts
upwards (short-term strategy with limited returns); the weakness is that the
strategy is depending on weak links – company reports and analyst forecasts.
Some analysts may be too close to the firm. It is best to identify the most
influential analysts rather than following consensus forecasts.

Analyst Recommendations:

• Any downgrade is a Sell signal. Analysts tend to follow the lead of others in
herd-like fashion. Sell recommendations affect prices much more than Buy
recommendations. Prices tend to trend down on sells whereas the price impact
with Buys is immediate (usually 3% on Buys and 4% on Sells in the first three
days, followed in the next 6 months by an additional 5% for Sells and levelling
off for Buys).

Announcements on Earnings:

• The major question is how it fares in relation to expectations; returns on the three
days around the announcements tend to be more positive for Value and Small
Cap stocks. Announcements on Fridays are more likely to contain negative
information – also announcements that are delayed, esp. more than 6 days.

• Markets are more efficient about assessing good news; an investor needs to move
quickly if he is to benefit. Best if you can forecast the likely firms based on
historical earnings and trading volume. ‘Buy on the rumour, Sell on the News’
means that most of the benefit comes in the run-up with only a small advance
after the announcement.

Takeovers:

• Price movements occur around the announcement date and not when
consummated. Target firms are the clear winners. Half the premium is usually
incorporated by the time of the announcement due to leakage – then, a jump on
the date. Cash-based acquisitions are best. If a takeover attempt fails, there is a
price fall but 60% of firms are taken over within 60 days of the first failure.
Bidding firms tend to fall in price because it is felt they usually fail to deliver on
promises of efficiency and synergy plus the fact that they often over-pay. Best if
you can invest before they become targets.

• A typical target firm is i) under performing in its sector and market ii) less
profitable iii) lower stock holding by insiders iv) low Tobin’s Q v) smaller Market
Cap. Therefore, screen for a) low Market Cap b) low insider holdings c) low
PTBV d) low ROE.


Stock Splits:
• Prices tend to go up on the announcement. Companies that expect their stock
prices to go up in the future are more likely to announce stock splits.


Dividends:
• Any increase is seen as a positive signal. There is usually a more pronounced
reaction on a decrease e.g. 5% compared to 1%. Prices tend to drift up/ down for
long periods after dividend changes.

[Information based strategies need instant information and instant execution

Market Timing:

• You need to be right 70%+ of the time to break even. Market timing skills are
vastly over-stated. Various indicators may tell you that the market is over-valued
but it does not tell you when the correction will occur.

• You can always find under-valued stocks in an over-priced market. PEs tend to
revert to 16 but lower interest rates allow for much higher PEs. There is a
positive relationship between GDP growth and stock returns in any single year
but it does not predict returns for the following year.

• Increases in Interest rates leads to higher Cost of Equity and lower PEs. Greater
willingness to take risk leads to a higher Risk Premium for equity and higher
PEs. An increase in expected Earnings Growth leads to a higher Market PE.

• If markets are over-valued, you could switch from Growth to Value. If a market
increase based on real economic growth is expected, then you might switch into
cyclicals. If interest rates go up causing the market to drop, switch out of
financials into consumer products. N.B. The market will bottom out and peak
before the economy e.g. invest in cyclicals when the economy enters a recession,
then shift into industrials and energy as the economy improves. Contrarians may
invest in sectors that delivered the worst performance in previous periods.

• Professional attempts at market timing have generally failed.

Indexing:

• Pick funds with the lowest expenses and the highest R Squared.

• Small Cap funds outperform Large Cap. Younger funds do better than older ones.
Also younger managers.

• The highest rated funds do not do any better – they tend to increase their
management fees. Active funds tend to stay in cash too long. They sometimes
suffer from lack of consistency in investing style. There is a tendency to herd
behaviour. Window dressing takes place in December. Avoid funds with high
turnover ratio.

• EFTs have advantages, being liquid and can be sold short.