Investment Philosophies
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Investment Philosophies Successful Strategies and the Investors Who Made Them Work Second Edition ASWATH DAMODARAN www.damodaran.com John Wiley & Sons, Inc.
Copyright C 2012 by Aswath Damodaran. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. First Edition Copyright C 2003 by John Wiley & Sons, Inc. All rights reserved. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com. Library of Congress Cataloging-in-Publication Data: Damodaran, Aswath. Investment philosophies : successful strategies and the investors who made them work / Aswath Damodaran. 2nd ed. p. cm. (Wiley finance series) Includes index. ISBN 978-1-118-01151-5 (cloth); ISBN 978-1-118-22192-1 (ebk); ISBN 978-1-118-23561-4 (ebk); ISBN 978-1-118-26049-4 (ebk) 1. Investment analysis. I. Title. HG4529.D36 2012 332.6 dc23 2012005823 Printed in the United States of America. 10 9 8 7 6 5 4 3 2 1
Contents CHAPTER 1 Introduction 1 What Is an Investment Philosophy? 2 Why Do You Need an Investment Philosophy? 3 The Big Picture of Investing 4 Categorizing Investment Philosophies 7 Developing an Investment Philosophy 10 Conclusion 12 Exercises 13 CHAPTER 2 Upside, Downside: Understanding Risk 15 What Is Risk? 16 Equity Risk: Theory-Based Models 16 Assessing Conventional Risk and Return Models 32 Equity Risk: Alternative Measures 34 Equity Risk: Assessing the Field 45 Default Risk 46 Conclusion 50 Exercises 51 CHAPTER 3 Numbers Don t Lie Or Do They? 53 The Basic Accounting Statements 53 Asset Measurement and Valuation 55 Measuring Financing Mix 62 Measuring Earnings and Profitability 69 Measuring Risk 75 Differences in Accounting Standards and Practices 82 Conclusion 82 Exercises 85 v
vi CONTENTS CHAPTER 4 Show Me the Money: The Basics of Valuation 87 Intrinsic Value 87 Relative Valuation 110 Valuing an Asset with Contingent Cash Flows (Options) 119 Conclusion 121 Exercises 122 CHAPTER 5 Many a Slip: Trading, Execution, and Taxes 125 The Trading Cost Drag 125 The Components of Trading Costs: Traded Financial Assets 127 Trading Costs with Nontraded Assets 146 Management of Trading Costs 148 Taxes 150 Conclusion 159 Exercises 160 CHAPTER 6 Too Good to Be True? Testing Investment Strategies 163 Why Does Market Efficiency Matter? 163 Efficient Markets: Definition and Implications 164 Behavioral Finance: The Challenge to Efficient Markets 170 A Skeptic s Guide to Investment Strategies 204 Conclusion 206 Exercises 207 CHAPTER 7 Smoke and Mirrors? Price Patterns, Volume Charts, and Technical Analysis 209 Random Walks and Price Patterns 209 Empirical Evidence 211 The Foundations of Technical Analysis 239 Technical Indicators and Charting Patterns 240 Conclusion 255 Exercises 256 CHAPTER 8 Graham s Disciples: Value Investing 259 Who Is a Value Investor? 259 The Passive Screener 260
Contents vii The Contrarian Value Investor 284 Activist Value Investing 293 Conclusion 326 Exercises 326 CHAPTER 9 The Allure of Growth: Small Cap and Growth Investing 329 Who Is a Growth Investor? 329 Passive Growth Investing 330 Activist Growth Investing 365 Conclusion 372 Exercises 373 CHAPTER 10 Information Pays: Trading on News 375 Information and Prices 376 Trading on Private Information 378 Trading on Public Information 398 Implementing an Information-Based Investment Strategy 421 Conclusion 422 Exercises 423 CHAPTER 11 A Sure Profit: The Essence of Arbitrage 425 Pure Arbitrage 425 Near Arbitrage 450 Speculative Arbitrage 460 Long/Short Strategies Hedge Funds 465 Conclusion 469 Exercises 470 CHAPTER 12 The Impossible Dream? Timing the Market 473 Market Timing: Payoffs and Costs 473 Market Timing Approaches 477 The Evidence on Market Timing 506 Market Timing Strategies 514 Market Timing Instruments 518 Connecting Market Timing to Security Selection 521 Conclusion 521 Exercises 522
viii CONTENTS CHAPTER 13 Ready to Give Up? The Allure of Indexing 525 The Mechanics of Indexing 525 A History of Indexing 527 The Case for Indexing 530 Why Do Active Investors Not Perform Better? 554 Alternative Paths to Indexing 562 Conclusion 571 Exercises 572 CHAPTER 14 A Road Map to Choosing an Investment Philosophy 575 A Self-Assessment 575 Finding an Investment Philosophy 579 The Right Investment Philosophy 581 Conclusion 583 Exercises 584 Index 585
Investment Philosophies
CHAPTER 1 Introduction Who wants to be an average investor? We all dream of beating the market and being super investors, and we spend an inordinate amount of time and resources in this endeavor. Consequently, we are easy prey for the magic bullets and the secret formulas offered by salespeople pushing their wares. In spite of our best efforts, though, most of us fail in our attempts to be more than average. Nonetheless, we keep trying, hoping that we can be more like the investing legends another Warren Buffett, George Soros, or Peter Lynch. We read the words written by and about successful investors, hoping to find in them the key to their stock-picking abilities, so that we can replicate them and become like them. In our search, though, we are whipsawed by contradictions and anomalies. On one corner of the investment town square stands an adviser, yelling to us to buy businesses with solid cash flows and liquid assets because that s what worked for Buffett. On another corner, another investment expert cautions us that this approach worked only in the old world, and that in the new world of technology we have to bet on companies with great growth prospects. On yet another corner stands a silver-tongued salesperson with vivid charts who presents you with evidence of the charts capacity to get you in and out of markets at exactly the right times. It is not surprising that facing this cacophony of claims and counterclaims we end up more confused than ever. In this chapter, we present the argument that to be successful with any investment strategy, you have to begin with an investment philosophy that is consistent at its core and matches not only the markets you choose to invest in but your individual characteristics. In other words, the key to success in investing may lie not in knowing what makes others successful but in finding out more about yourself. 1
2 INVESTMENT PHILOSOPHIES WHAT IS AN INVESTMENT PHILOSOPHY? 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. Why do we need to make assumptions about investor mistakes? As we will argue, most investment strategies are designed to take advantage of errors made by some or all investors in pricing stocks. Those mistakes themselves are driven by far more basic assumptions about human behavior. To provide an illustration, the rational or irrational tendency of human beings to join crowds can result in price momentum: stocks that have gone up the most in the recent past are more likely to go up in the near future. Let us consider, therefore, the ingredients of an investment philosophy. Human Frailty Underlying every investment philosophy is a view about human behavior. In fact, one weakness of conventional finance and valuation has been the short shrift given to behavioral quirks. It is not that conventional financial theory assumes that all investors are rational, but that it assumes that irrationalities are random and cancel out. Thus, for every investor who tends to follow the crowd too much (a momentum investor), we assume there is an investor who goes in the opposite direction (a contrarian), and that their push and pull in prices will ultimately result in a rational price. While this may, in fact, be a reasonable assumption for the very long term, it may not be a realistic one for the short term. Academics and practitioners in finance who have long viewed the rational investor assumption with skepticism have developed a branch of finance called behavioral finance that draws on psychology, sociology, and finance to try to explain both why investors behave the way they do and the consequences for investment strategies. As we go through this book, examining different investment philosophies, we will try at the outset of each philosophy to explore the assumptions about human behavior that represent its base. Market Efficiency A closely related second ingredient of an investment philosophy is the view of market efficiency or inefficiency that you need for the philosophy to be a successful one. While all active investment philosophies make the assumption that markets are inefficient, they differ in their views on what parts of the market the inefficiencies are most likely to show up in and how long
Introduction 3 they will last. Some investment philosophies assume that markets are correct most of the time but that they overreact when new and large pieces of information are released about individual firms: they go up too much on good news and down too much on bad news. Other investment strategies are founded on the belief that markets can make mistakes in the aggregate the entire market can be undervalued or overvalued and that some investors (mutual fund managers, for example) are more likely to make these mistakes than others. Still other investment strategies may be based on the assumption that while markets do a good job of pricing stocks where there is a substantial amount of information financial statements, analyst reports, and financial press coverage they systematically misprice stocks on which such information is not available. Tactics and Strategies Once you have an investment philosophy in place, you develop investment strategies that build on the core philosophy. Consider, for instance, the views on market efficiency expounded in the previous section. The first investor, who believes that markets overreact to news, may develop a strategy of buying stocks after large negative earnings surprises (where the announced earnings come in well below expectations) and selling stocks after positive earnings surprises. The second investor, who believes that markets make mistakes in the aggregate, may look at technical indicators (such as cash held by mutual funds or short selling by investors in the stock) to find out whether the market is overbought or oversold and take a contrary position. The third investor, who believes that market mistakes are more likely when information is absent, may look for stocks that are not followed by analysts or owned by institutional investors. It is worth noting that the same investment philosophy can spawn multiple investment strategies. Thus, a belief that investors consistently overestimate the value of growth and underestimate the value of existing assets can manifest itself in a number of different strategies ranging from a passive one of buying low price-earnings (P/E) ratio stocks to a more active one of buying cheap companies and attempting to liquidate them for their assets. In other words, the number of investment strategies will vastly surpass the number of investment philosophies. WHY DO YOU NEED AN INVESTMENT PHILOSOPHY? Most investors have no investment philosophy, and the same can be said about many money managers and professional investment advisers. They