value investing by a. damodaran

8/7/2019 Value Investing by a. Damodaran

1/43

AswathDamod

aran

1

V

alueInvesting

AswathDamod

aran


2/43

AswathDamod

aran

2

W

hoisavalue

investor?

TheConventionalDefinition:Avalueinvestorisonewhoinvestsin

lowprice-bookvalueorlowprice-earningsratiosstocks.

TheGenericDefinition:Avaluein

vestorisonewhop

aysaprice

whichislessth

anthevalueofthe

assetsinplaceofa

firm.


3/43

AswathDamod

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3

TheDifferen

tFacesofVa

lueInvesting

Today

PassiveScreene

rs:FollowingintheBenGrahamtradition,youscreen

forstocksthath

avecharacteristics

thatyoubelieveidentifyunder

valuedstocks.E

xampleswouldinc

ludelowPEratios

andlowpriceto

bookratios.

ContrarianInve

stors:Theseareinvestorswhoinvestincompanies

thatothershave

givenupon,eitherbecausetheyhave

donebadlyin

thepastorbecausetheirfutureprospectslookbleak.

ActivistValueInvestors:Theseare

investorswhoinve

stinpoorly

managedandpo

orlyrunfirmsbutthentrytochangethewaythe

companiesarerun.


4/43

AswathDamod

aran

4

I.ThePassive

Screener

Thisapproachtovalueinvestingcanbetracedbackto

BenGraham

andhisscreenstofindundervalued

stocks.

Inrecentyears,thesescreenshave

beenrefinedandextended.The

followingsectio

nsummarizesthee

mpiricalevidencethatbacksup

eachofthesescreens.


5/43


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AswathDamod

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6

Howwell

doGrahams

screensperfo

rm?

AstudybyOpp

enheimerconcludedthatstocksthatpassedthe

Grahamscreens

wouldhaveearned

areturnwellinex

cessofthe

market.

MarkHulbertw

hoevaluatesinvestmentnewslettersconcludedthat

newslettersthat

usedscreenssimilartoGrahamsdidmuchbetterthan

othernewsletter

s.

However,anatt

emptbyJamesRea

torunanactualmutualfundusing

theGrahamscreensfailedtodelive

rthepromisedretu

rns.

Grahamsbestc

laimtofamecomesfromthesuccessofthestudents

whotookhisclassesatColumbiaU

niversity.Amongthemwere

CharlieMunger

andWarrenBuffett.


7/43

AswathDamod

aran

7

TheBuffettM

ystique

Figure8.1:Berkshire

Hathaway

$0.00

$200.00

$400.00

$600.00

$800.00

$1,000.00

$1,200.00

$1,400.00

$1,600.00

$1,800.00

19881989

199019911992199319941995199619971998199920002001

Year

Value of $ 100 invested 12/88

Be

rkshireHathaway

S&

P500


8/43

AswathDamod

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8

BuffettsTenets

BusinessTenets:

Thebusinessth

ecompanyisinshouldbesimpleandunderstan

dable.

Thefirm

shou

ldhaveaconsistentoperatinghistory,manifestedinoperating

earningsthatar

estableandpredictable.

Thefirmshouldbeinabusinesswithfavorablelongtermprospects.

ManagementTenets:

Themanagers

ofthecompanyshouldbecandid.Asevidencedbythewayhe

treatedhisown

stockholders,Buffettputapremiumonmanagershetrusted.

Themanagerso

fthecompanyshouldb

eleadersandnotfollow

ers.

FinancialTenets:

Thecompanys

houldhaveahighreturnonequity.Buffettusedamodifiedversion

ofwhathecalle

downerearnings

OwnerEarn

ings=Netincome+Depre

ciation&AmortizationC

apitalExpenditures

Thecompanyshouldhavehighandstableprofitmargins.

MarketTenets:

Useconservativ

eestimatesofearnings

andtherisklessrateasthediscountrate.

Inkeepingwith

hisviewofMr.Marketascapriciousandmoody,evenvaluable

companiescanbeboughtatattractivep

riceswheninvestorsturnawayfromthem.


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AswathDamod

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9

BelikeBuffett?

MarketshavechangedsinceBuf

fettstartedhisfirst

partnership.Even

WarrenBuffettwouldhavediffic

ultyreplicatinghissuccessintodays

market,whereinformationoncom

paniesiswidelyavailableanddozens

ofmoneymanagersclaimtobeloo

kingforbargainsinvaluestocks.

Inrecentyears,Buffetthasadoptedamoreactivistinvestmentstyleand

hassucceededwithit.Tosucceedwiththisstyleasaninvestor,though,

youwouldne

edsubstantialresourcesandhavethecredibilitythatcomes

withinvestmentsuccess.Thereare

fewinvestors,evenamongsuccessful

moneymanag

ers,whocanclaimthiscombination.

ThethirdingredientofBuffettssu

ccesshasbeenpatien

ce.Ashehas

pointedout,h

edoesnotbuystocksfortheshorttermbu

tbusinessesfor

thelongterm.Hehasoftenbeenw

illingtoholdstocksthathebelievesto

beundervalu

edthroughdisappointingyears.Inthosesameyears,hehas

facednopressurefromimpatientinvestors,sincestockh

oldersin

BerkshireHathawayhavesuchhig

hregardforhim.


10/43

AswathDamod

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10

ValueScreens

PricetoBookra

tios:Buystockswhereequitytradesa

tlessthanorat

leastalowmult

ipleofthebookvalueofequity.

Priceearningsratios:Buystocksw

hereequitytradesatalowmultiple

ofequityearnings.

Pricetosalesratio:Buystockswhereequitytradesatalowmultipleof

revenues.

DividendYields:Buystockswithhighdividendyields.


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AswathDamod

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11

1.Price/BookValueScreens

Alowpriceboo

kvalueratiohasbeenconsideredareliableindicator

ofundervaluatio

ninfirms.

Theempiricalevidencesuggeststh

atoverlongtimeperiods,low

price-bookvaluesstockshaveoutp

erformedhighprice-bookvalue

stocksandtheo

verallmarket.


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AswathDamod

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12

LowPrice

/BVRatiosandExcessReturns

Lowest

2

3

4

5

6

7

8

9

Highest

192

7-1960

1

961-1990

1991-2001

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

PBVClass

F

igure

8.2:PBVClasses

and

Returns

-1927-2001

1927-1960

1961-1990

1991-2001


13/43

AswathDamod

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13

Evidence

fromIntern

ationalMark

ets

Chan,HamaoandLakonishok(1991)findthatthebook-to-market

ratiohasastron

groleinexplaining

thecross-sectiono

faverage

returnsonJapan

esestocks.

Capaul,Rowley

andSharpe(1993)extendtheanalysisofprice-book

valueratiosacrossotherinternationalmarkets,andconcludethatvalue

stocks,i.e.,stockswithlowprice-b

ookvalueratios,e

arnedexcess

returnsinevery

marketthattheyan

alyzed,between1981and1992.


14/43

AswathDamod

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14

LowPBV

EffectinInte

rnationalMar

kets

Theirannualizedestimatesofthereturndifferentialea

rnedbystocks

withlowprice-bookvalueratios,overthemarketinde

x,wereas

follows:C

ountry

Added

ReturntolowP/BVportfolio

France

3.26%

German

y

1.39%

Switzerland

1.17%

U.K

1.09%

Japan

3.43%

U.S.

1.06%

Europe

1.30%

Global

1.88%


15/43


16/43


17/43

AswathDamod

aran

17

2.Price/EarningsRatioScreens

Investorshavelongarguedthatstockswithlowpriceearningsratios

aremorelikelytobeundervalueda

ndearnexcessretu

rns.For

instance,thisis

oneofBenGraham

sprimaryscreens.

Studieswhichh

avelookedattherelationshipbetween

PEratiosand

excessreturnsconfirmthesepriors.


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AswathDamod

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20

TheInternationalPEEffect

Country

AnnualPremiumearnedbyl

owestP/EStocks(botto

mquintile)

A

ustralia

3.03%

F

rance

6.40%

G

ermany

1.06%

H

ongKong

6.60%

I

taly

1

4.16%

J

apan

7.30%

S

witzerland

9.02%

U

.K.

2.40%


21/43


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AswathDamod

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22

C

ompositeScreens:Stockswithlowprice

tosales

ratiosandhigh

margins

Year

UndervaluedPortfolio

OvervaluedPortfolio

S&P500

1982

50.34%

17.72%

40.35%

1983

31.04%

6.18%

0.68%

1984

12.33%

-25.81%

15.43%

1985

53.75%

28.21%

30.97%

1986

27.54%

3.48%

24.44%

1987

-2.28%

8.63%

-2.69%

1988

24.96%

16.24%

9.67%

1989

16.64%

17.00%

18.11%

1990

-30.35%

-17.46%

6.18%

1991

91.20%

55.13%

31.74%

1982-91

23.76%

15.48%

17.49%


23/43

AswathDamod

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23

4.DividendYields

Highest

2

3

4

5

6

7

8

9

Lowest

1952-71

1971-90

1991-2001

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

18.00%

20.00%

Average Annual Return

PERatioClass

Figure8.4:ReturnsonDividendYieldClasses-1952-2001


24/43

AswathDamod

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24

DeterminantsofSuccessatPassiveScr

eening

1.Havealongtim

ehorizon.Allthestudiesquotedabov

elookatreturns

overtimehorizonsoffiveyearsor

greater.Infact,low

price-book

valuestockshaveunderperformedhighprice-bookvaluestocksover

shortertimeperiods.

2.Chooseyourscreenswisely:Toom

anyscreenscanundercutthe

searchforexces

sreturnssincethescreensmayendup

eliminatingjust

thosestocksthatcreatethepositive

excessreturns.

3.Bediversified:T

heexcessreturnsf

romthesestrategiesoftencome

fromafewhold

ingsinlargeportfo

lio.Holdingasmallportfoliomay

exposeyoutoextraordinaryriskan

dnotdeliverthesa

meexcess

returns.

4.Watchoutfortaxesandtransactionscosts:Someof

thescreensmay

endupcreating

aportfoliooflow-pricedstocks,which,inturn,create

largertransactio

nscosts.


25/43

AswathDamod

aran

25

II.Contrarian

ValueInvesting:BuyingtheLosers

Incontrarianvalueinvesting,youb

eginwiththepropositionthat

marketsoverreacttogoodandbad

news.Consequently,stocksthat

havehadbadne

wscomeoutabout

them(earningsdeclines,dealsthat

havegonebad)

arelikelytobeund

ervalued.

EvidencethatM

arketsOverreactto

NewsAnnouncem

ents

Studiesthatlookatreturnsonmarketsoverlongtimeperiodschronicle

thatthereissignificantnegativeserialcorrelationinretu

rns,I.e,good

yearsaremor

elikelytobefollowe

dbybadyearsandviceversal.

Studiesthatfocusonindividualsto

cksfindthesameeff

ect,withstocks

thathavedonewellmorelikelyto

dobadlyoverthenex

tperiod,andvice

versa.


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AswathDamod

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26

1.WinnerandLoserportfolios

Sincethereisev

idencethatpricesreversethemselvesinthelongterm

forentiremarke

ts,itmightbewort

hexaminingwheth

ersuchprice

reversalsoccuronclassesofstockwithinamarket.

Forinstance,arestockswhichhavegoneupthemostoverthelast

periodmorelikelytogodownoverthenextperiodandviceversa?

Toisolatetheeffectofsuchpricereversalsontheextr

emeportfolios,

DeBondtandThalerconstructedawinnerportfolioof

35stocks,

whichhadgone

upthemostovertheprioryear,anda

loserportfolio

of35stocks,wh

ichhadgonedown

themostovertheprioryear,each

yearfrom1933

to1978,

Theyexamined

returnsonthesepo

rtfoliosforthesixtymonths

followingthecr

eationoftheportfo

lio.


27/43

AswathDamod

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27

ExcessReturnsforWinner

andLoserPo

rtfolios

Figure8.5:CumulativeAbnormalRetu

rns-WinnersversusLosers

-15.00%

-10.00%

-5.00%

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

1

4

7

10

13

16

19

22

25

28

31

34

37

40

43

46

49

52

55

58

Monthafterportfolioformation

Cumulative Abnormal Return

Winners

Losers


28/43

AswathDamod

aran

28

Moreon

WinnerandLoserPortfoli

os

Thisanalysissugg

eststhatloserportfolioclearlyoutperform

winnerportfolios

inthesixtymonth

sfollowingcreation.

Thisevidenceisconsistentwithmarket

overreactionandcorrectioninlongretu

rnintervals.

Therearemany,a

cademicsaswellasp

ractitioners,whosug

gestthatthese

findingsmaybeinterestingbutthatthe

yoverstatepotentialreturnson'loser'

portfolios.

Thereisevidence

thatloserportfoliosaremorelikelytocon

tainlowpriced

stocks(sellingfor

lessthan$5),which

generatehighertransactionscostsand

arealsomorelikelytoofferheavilyskewedreturns,i.e.,the

excessreturns

comefromafewstocksmakingphenomenalreturnsratherthanfrom

consistentperform

ance.

Studiesalsoseem

tofindloserportfolioscreatedeveryDece

mberearn

significantlyhigherreturnsthanportfolioscreatedeveryJun

e.

Finally,youneed

alongtimehorizonfortheloserportfoliotowinout.


29/43

AswathDamod

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29

LoserPortfoliosand

TimeHorizon

Figure8.6:DifferentialReturns-Win

nerversusLoserPortfolios

-2.00%

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

1

2

3

4

5

6

7

8

9101112131415161718

19202122232425262728293031

3233343536

Monthafterpo

rtfolioformation

Cumulative abnormal return (Winner - Loser)

1941-64

1965-89


30/43

AswathDamod

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30

GoodCompaniesareno

tnecessarilyGood

Investme

nts

Anyinvestment

strategythatisbas

eduponbuyingwe

ll-run,good

companiesandexpectingthegrowthinearningsinthe

secompaniesto

carrypriceshigherisdangerous,sinceitignoresthere

alitythatthe

currentpriceof

thecompanymay

reflectthequalityo

fthe

managementandthefirm.

Ifthecurrentpriceisright(andthe

marketispayinga

premiumfor

quality),thebig

gestdangeristhatthefirmlosesitslustreovertime,

andthatthepremiumpaidwilldiss

ipate.

Ifthemarketisexaggeratingtheva

lueofthefirm,thisstrategycan

leadtopoorretu

rnsevenifthefirm

deliversitsexpectedgrowth.

Itisonlywhenmarketsunderestim

atethevalueoffirmqualitythat

thisstrategystandsachanceofmakingexcessreturns.


31/43

AswathDamod

aran

31

1.Excellen

tversusUnexcellentCompanies

Thereisevidencethatwellmanage

dcompaniesdono

talwaysmake

greatinvestmen

ts.Forinstance,the

reisevidencethatexcellent

companies(usin

gtheTomPetersstandard)earnpoore

rreturnsthan

unexcellentcompanies.

Figure8.7:ExcellentversusUnexcellentCompanies

050

100

150

200

250

300

350

1

3

5

7

9

11

13

15

17

19

21

23

25

27

29

31

33

35

37

39

41

43

45

47

49

51

53

55

57

59

Monthsafterportfo

lioformation

Value of $ 100 invested in January 1981

ExcellentCompanies

UnexcellentCompanies


32/43

AswathDamod

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32

2.Risk/R

eturnbyS&P

QualityIndic

es

Conventionalra

tingsofcompanyq

ualityandstockreturnsseemtobe

negativelycorre

lated.

S&PRatingsandStockReturns

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

18.00%

20.00%

A+

A

A-

B+

B

B-

C/D

S&PCommonStockRating

Average Annual Return (1986-94)


33/43

AswathDamod

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33

Determinantso

fSuccessat

ContrarianInvesting

1.SelfConfidence:Investingincompaniesthateverybodyelse

viewsaslosers

requiresaselfcon

fidencethatcomeseitherfrompastsucces

s,ahugeegoor

both.

2.Clients/Investorswhobelieveinyou:Y

oueitherneedclientswhothinklike

youdoandagreewithyou,orclientsth

athavemadeenough

moneyofyouin

thepastthattheir

greedoverwhelmsan

ytrepidiationyoumi

ghthaveinyour

portfolio.

3.Patience:Thesestrategiesrequiretimetoworkout.Foreverythreesteps

forward,youwill

oftentaketwostepsback.

4.StomachforShort-termVolatility:Th

enatureofyourinvestmentimpliesthat

therewillbehigh

shorttermvolatilityandhighprofilefailures.

5.Watchoutfortransactionscosts:Thes

estrategiesoftenleadtoportfoliosof

lowpricedstocks

heldbyfewinstitutio

nalinvestors.Thetra

nsactionscosts

canwipeoutanyperceivedexcessreturnsquickly.


34/43

AswathDamod

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34

III.

ActivistValu

eInvesting

Anactivistvalueinvestorhavingacquiredastakeinanund

ervalued

companywhichm

ightalsobebadlymanagedthenpushes

themanagement

toadoptthosecha

ngeswhichwillunlockthisvalue.Forinstance,

Ifthevalueofthe

firmislessthanitscomponentparts:

pushforbreakupofthefirm,spinoffs,splitoffsetc.

Ifthefirmisbeingtooconservativeinitsuseofdebt:

pushforhigher

leverageandrecapitaliz

ation

Ifthefirmisaccumulatingtoomuchca

sh:

pushforhigher

dividends,stockrepurchases..

Ifthefirmisbeingbadlymanaged:

pushforachangeinmanagementorto

beacquired

Iftherearegainsfromamergeroracquisition

pushfortheme

rgeroracquisition,evenifitishostile


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AswathDamod

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35

a.Breakingupishardtodo


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AswathDamod

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36

a.Breakingup

ishardtodo

EffectsofS

pinoffs,

Splitoffs,Divestitu

resonValue

Theoverallemp

iricalevidenceisthatspinoffs,splito

ffsand

divestituresallhaveapositiveeffectonvalue.

LinnandRozeff(1984)examinedthepricereactionto

announcements

ofdivestituresb

yfirmsandreporte

danaverageexcessreturnof

1.45%for77divestituresbetween1977and1982.


37/43

AswathDamod

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37

MoreonSpinOffs,SplitOffsetc..

Marketsviewfirm

sthatareevasiveaboutreasonsforandproceedsfrom

divestitureswiths

kepticism.

MarketReactiontoDivestitureAnnoun

cements

PriceAnnounced

M

otiveAnnounced

Yes

N

o

Yes

3.92%

2

.30%

No

0.70%

0

.37%

SchipperandSmith(1983)examined9

3firmsthatannouncedspinoffs

between1963and

1981andreportedanaverageexcessreturnof2.84%inthe

twodayssurround

ingtheannouncement.Further,thereisev

idencethatexcess

returnsincreasew

iththemagnitudeo

fthespunoffentity

.

Finally,Schipper

andSmithfindevidencethattheexcessre

turnsaregreater

forfirmsinwhich

thespinoffismotivatedbytaxandregu

latoryconcerns.


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AswathDamod

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38

b.Somefirm

shavetoolittledebtEffectsof

LeverageIncreasingandDe

creasingTran

sactions

Theoverallemp

iricalevidencesug

gestthatleverageincreasing

transactionsincreasevaluewhereasleveragereducing

transactions

decreasevalue.

Typeoftransaction

SecurityIssued

SecurityRetired

SampleSize

2-DayReturn

Leverage-IncreasingTr

ansactions

StockRepurchase

Debt

Comm

on

45

21.9%

ExchangeOffer

Debt

Comm

on

52

14.0%

ExchangeOffer

Preferred

Comm

on

9

8.3%

ExchangeOffer

Debt

Preferr

ed

24

2.2%

ExchangeOffer

Bonds

Preferr

ed

24

2.2%

Transactionswithnoch

angeinleverage

ExchangeOffer

Debt

Debt

36

0.6%

SecuritySale

Debt

Debt

83

0.2%

Leverage-ReducingTra

nsactions

Conversion-forcingcallCommon

Convertible

57

-0.4%

Conversion-forcingcallCommon

Preferr

ed

113

-2.1%

SecuritySale

Conv.Debt

Conv.Debt

15

-2.4%

ExchangeOffer

Common

Debt

30

-2.6%

ExchangeOffer

Preferred

Preferr

ed

9

-7.7%

SecuritySale

Common

Debt

12

-4.2%

ExchangeOffer

Common

Debt

20

-9.9%


39/43


40/43

AswathDamod

aran

40

d

.TheEffectsofHostileAcquistionsontheTarget

Firm

Badlymanaged

firmsaremuchmo

relikelytobetarge

tsofacquistions

thanwellmanagedfirms

TargetCharacteristics-Hostilevs.FriendlyTakeovers

-5.00%

0.00%

5.00%

10.00%

15.00%

20.00%

Target

ROE-

Industry

ROE

Target5-

yrStock

Returns-

Market

%of

Stock

Heldby

Insiders

HostileTakeovers

FriendlyTakeovers


41/43

AswathDamod

aran

41

Andacquisitionsareclearlygoodforthetarget

firmsstockh

olders


42/43

AswathDamod

aran

42

DeterminantsofSuccessatActivistInvesting

1.Havelotsofcap

ital:Sincethisstrategyrequiresthaty

oubeabletoput

pressureonincu

mbentmanagemen

t,youhavetobeabletotake

significantstake

sinthecompanies.

2.Knowyourcom

panywell:Sincethisstrategyisgoing

toleada

smallerportfolio,youneedtoknow

muchmoreabout

yourcompanies

thanyouwould

needtoinascreeningmodel.

3.Understandcor

poratefinance:Yo

uhavetoknowenoughcorporate

financetounderstandnotonlythat

thecompanyisdoingbadly(which

willbereflected

inthestockprice)

butwhatitisdoing

badly.

4.Bepersistent:In

cumbentmanagers

areunlikelytorolloverandplay

deadjustbecauseyousayso.They

willfight(andfigh

tdirty)towin.

Youhavetobepreparedtocounter.

5.Doyourhomew

ork:Youhavetoformcoalitionswith

otherinvestors

andtoorganize

tocreatethechangeyouarepushingfor.


43/43

AswathDamod

aran

Conclusion

Valueinvesting

comesinmanystripes.

Therearescreenssuchasprice-bookvalue,priceearnin

gsandprices

ratiosthatsee

mtoyieldexcessreturnsoverlongperiods.Itisnotcle

whetherthese

excessreturnsaretrulyabnormalreturns,

rewardsfor

havingalong

timehorizonorjusttheappropriaterewardsforrisktha

havenotadeq

uatelymeasured.

Therearealsocontrarianvalueinvestors,whotakepo

sitionsin

companiesthathavedonebadlyin

termsofstockprices

and/orhave

acquiredrepu

tationsasbadcompanies.

Thereareactivistinvestorswhotakepositionsinunderv

aluedand/or

badlymanage

dcompaniesandbyvirtueoftheirholding

sareableto

changesthatunlockthisvalue.

value investing by a. damodaran

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