Investments Phil

8/10/2019 Investments Phil

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INVESTMENT PHILOSOPHY:THE SECRET INGREDIENT IN

INVESTMENT SUCCESS


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INGREDIENTS OF AN INVESTMENTPHILOSOPHY

Ste p 1: All investment philosophies begin with a viewabout how human beings learn (or fail to learn).Underlying every philosophy, therefore is a view ofhuman frailty - that they learn too slowly, learn too fast,

tend to crowd behavior etc.

Ste p 2: From step 1, you generate a view about marketsbehave and perhaps where they fail. Your views onmarket efficiency or inefficiency are the foundations for

your investment philosophy.Ste p 3: This step is tactical. You take your views about how

investors behave and markets work (or fail to work) andtry to devise strategies that reflect your beliefs.


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WHY DO YOU NEED AN INVESTMENTPHILOSOPHY?

If you do not have an investment philosophy, you will findyourself doing the following:

1. Lacking a rudderora core set of beliefs, you will be easyprey for charlatans and pretenders, with each oneclaiming to have found the magic strategy that beatsthe market.

2. Switching from strategy to strategy, you will have tochange your portfolio, resulting in high transactions costsand paying more in taxes.

3. Using a strategy that may not be appropriate for you,

given your objectives, risk aversion and personalcharacteristics. In addition to having a portfolio thatunder performs the market, you are likely to find yourselfwith an ulcer or worse.


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The Investment Process

The Client

Risk Tolerance/Avers ion

Tax StatusInvestment Horizon

The Portfolio Managers Job

Asset Allocation Risk and Return- Measuring risk- Effects ofdiversification

Security Selection

- Which s tocks? Which bonds? Which real assets?

Valuationbased on- Cash flows- Comparables- Technicals

PrivateInformation

Execution

- How often do you trade?- How large are your trades?- Do you use derivatives to manage or enhance risk?

Ass et Classes: Stocks Bonds Real Assets

Countries: Domestic Non-Domestic

TradingCosts

- Commissions- Bid Ask Spread- Price Impact

Trading

Speed

Market Efficiency- Can you beatthe market?

Views onmarkets

Performance Evaluation

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?

MarketTiming

StockSelection

UtilityFunctions

Tax Code

Views on- inflation- rates- growth

Trading Systems

- How does tradingaffect prices?

Risk Models- The CAPM- The APM


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UNDERSTANDING THE CLIENT(INVESTOR)

There is no one perfect portfolio for every client.To create a portfolio that is right for an investor, weneed to know:

The investors risk preferences The investors time horizon

The investors tax status

If you are your own client (i.e, you are investing yourown money), know yourself.


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I. MEASURING RISK

Risk is not a bad thing to be avoided, nor is it agood thing to be sought out. The best definition ofrisk is the following:

Ways of evaluating risk 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 interms of volatility or standard deviation


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WHAT WE KNOW ABOUT INVESTORRISK PREFERENCES..

Whether we measure risk in quantitative orqualitative terms, investors are risk averse. The degree of risk aversion will vary across investors at any

point in time, and for the same investor across time (as afunction of his or her age, wealth, income and health)

There is a trade off between risk and return To get investors to take more risk, you have to offer a

higher expected returns Conversely, if investors want higher expected returns, they

have to be willing to take more risk.

Proposition 1: The more risk averse an investor, theless of his or her portfolio should be in risky assets(such as equities).


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RISK AND RETURN MODELS INFINANCE

The risk in an investment can be measured by the v ariance in actual returns around anexpected return

E(R)

Riskless Investment Low Risk Investment High Risk Investment

E(R) E(R)

Risk that is specific to investment (Firm Specific) Risk that affects all investments (Market Risk)Can be diversified away in a diversified portfolio Cannot be diversified away since most assets1. each investment is a small proportion of portfolio are affected by it.2. risk averages out across investments in portfolioThe marginal investor is assumed to hold a diversified portfolio. Thus, only market risk wil lbe rewarded and priced.

The CAPM The APM Multi-Factor Models Proxy Models

If there is1. no private information2. no transactions costthe optimal diversifiedportfolio includes everytraded asset. Everyonewill hold this market portfolioMarket Risk = Riskadded by any investmentto the market portfolio:

If there are noarbitrage opportunitiesthen the market risk ofany asset must becaptured by betas

relative to factors thataffect all investments.Market Risk = Riskexposures of anyasset to marketfactors

Beta of asset relative toMarket portfolio (froma regression)

Betas of asset relativeto unspecified marketfactors (from a factoranalysis)

Since market risk affectsmost or all investments,it must come frommacro economic factors.Market Risk = Riskexposures o f anyasset to macroeconomic factors.

Betas of assets relativeto specified macroeconomic factors (froma regression)

In an efficient market,differences in returnsacross long periods mustbe due to market riskdifferences. Looking forvariables correlated withreturns should then giveus proxies for this risk.Market Risk =Captured by theProxy Variable(s)

Equation relatingreturns to proxyvariables (from aregression)

Step 1: Defining Risk

Step 2: Differentiating betwee n Rewarded and Unrewarded Risk

Step 3: Measurin g Market Risk


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SOME QUIRKS IN RISK AVERSION

Individuals are far more affected by losses than equivalent gains (lossaversion), and this behavior is made worse by frequent monitoring(myopia).

The choices that people make (and the risk aversion they manifest) whenpresented with risky choices or gambles can depend upon how thechoice is presented (framing).

Individuals tend to be much more willing to take riskswith what theyconsider found money than with money that they have earned (housemoney effect).

There are two scenarios where risk aversion seems to decrease and evenbe replaced by risk seeking. One is when individuals are offered thechance of making an extremely large sum with a very small probability ofsuccess (long shot bias). The other is when individuals who have lost

money are presented with choices that allow them to make their moneyback (break even effect). When faced with risky choices, whether in experiments or game shows,

individuals often make mistakes in assessing the probabilities ofoutcomes, over estimating the likelihood of success,, and this problemgets worse as the choices become more complex.


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INVESTOR TIME HORIZON

An investors time horizon reflects personal characteristics: Some investors have the patience

needed to hold investments for long time periods and othersdo 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 timehorizon will be.

An investors time horizon can have an influence onboth the kinds of assets that investor will hold in his or her

portfolio and the weights of those assets. Proposition 2: Most investors actual time horizons are

shorter than than their stated time horizons. (We are allless patient than we think we are)


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The Client





Security Selection



PrivateInformation

Execution

- How often do you trade?- How large are your trades?- Do you use derivatives to manage or enhance risk?

Asset Classes: Stocks Bonds Real Assets


TradingCosts- Commissions

- Bid Ask Spread- Price Impact

TradingSpeed


Views onmarkets


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?

MarketTiming

StockSelection

UtilityFunctions

Tax Code


Trading Systems- How does trading

affect prices?



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ASSET ALLOCATION

The first step in portfolio management is the assetallocation decision.

The asset allocation decision determines whatproportions of the portfolio will be invested in differentasset classes - stocks, bonds and real assets.

Asset allocation can be passive,

It can be based upon the mean-variance framework: tradingoff higher expected return for higher standard deviation.

It can be based upon simpler rules of diversification or marketvalue based

When asset allocation is determined by market views, itis active asset allocation.


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I. PASSIVE ASSET ALLOCATION

In passive asset allocation, the proportions of thevarious asset classes held in an investors portfoliowill be determined by the risk preferences of thatparticular 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 acertain risk level

The proportions of risky assets can mirror the market values

of the asset classes. Any deviation from these proportionswill lead to a portfolio that is over or under weighted insome asset classes and thus not fully diversified. The riskaversion of an investor will show up only in the riskless assetholdings.


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A. EFFICIENT (MARKOWITZ)PORTFOLIOS

Return Maximization Risk Minimization

Maximize Expected Return Minimize returnvariance

subject to

where,

2 = Investor's desired level of variance

E(R) = Investor's desired expected returns

p2= wiwj ij

j=1

j=n

i=1

i= n

2

E(Rp )= wii=

1

i= n

E(Ri )p

2= wiwj

ijj=1

j=n

i=1

i=n

E(Rp )= wii=1

i= n

E(Ri ) = E(R )


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LIMITATIONS OF THIS APPROACH

This approach is heavily dependent upon threeassumptions:

That investors can provide their risk preferences in terms ofvariance

They do not care about anything but mean and variance.

That the variance-covariance matrix between asset classesremains stable over time.

If correlations across asset classes and covariances

are unstable, the output from the Markowitzportfolio approach is useless.


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THE OPTIMALLY DIVERSIFIEDPORTFOLIO

Global Investable Capital: 1998

Venture

CapitalEmerging Markets

3%US Real Estate

4%

Cash Equivalents

5%

International Bonds

26%

US Bonds

19%

International Equity

20%

US Equity

22%


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II. ACTIVE ASSET ALLOCATION(MARKET TIMING)

The payoff to perfect timing: In a 1986 article, a group of researchersraised the shackles of many an active portfolio manager byestimating that as much as 93.6% of the variation in quarterlyperformance at professionally managed portfolios could beexplained by the mix of stocks, bondsand cash at these portfolios.

Avoiding the bad markets: In a different study in 1992, Shilling

examined the effect on your annual returns of being able to stay outof the market during bad months. He concluded that an investorwho would have missed the 50 weakest months of the marketbetween 1946 and 1991 would have seen his annual returns almostdouble from 11.2%to 19%.

Across funds: Ibbotson examined the relative importance of assetallocation and security selection of 94 balanced mutual fundsand 58

pension funds, all of which had to make both asset allocation andsecurity selection decisions. Using ten years of data through 1998,Ibbotson finds that about 40% of the differences in returns acrossfunds can be explained by their asset allocation decisions and 60%by security selection.


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MARKET TIMING STRATEGIES

Asset Allocation: Adjust your mix of assets, allocatingmore than you normally would (given your time horizonand risk preferences) to markets that you believe areunder valued and less than you normally would to

markets that are overvalued. Style Switching: Switch investment styles and strategiesto

reflect expected market performance.

Sector Rotation: Shift your funds within the equity marketfrom sector to sector, depending upon your

expectations of future economic and market growth. Market Speculation: Speculate on market direction,

using either financial leverage (debt) or derivatives tomagnify profits.


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MARKET TIMING APPROACHES

Non-financial indicators Spurious Indicators: Over time, researchers have found a number of real

world phenomena to be correlated with market movements. (The winnerof the Super Bowl, Sun Spots)

Feel Good Indicators: When people are feeling good, markets will do well. Hype Indicators: When stocks become the topic of casual conversation, it

is time to get out. The Cocktail party chatter measure (Time elapsed atparty before talk turns to stocks, average age of chatterers, fadcomponent)

Technical Indicators Price Indicators: Charting patterns and indicators give advance notice. Volume Indicators: Trading volume may give clues to market future Volatility Indicators: Higher volatility often a predictor or higher stock returns

in the future Reversion to the mean: Every asset has a normal range of value and

things revert back to normal. Fundamentals:There is an intrinsic value for the market.


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NON-FINANCIAL INDICATORS..

Spurious indicators that may seem to be correlatedwith the market but have no rational basis. Almostall spurious indicators can be explained by chance.

Feel good indicators that measure how happy arefeeling - presumably, happier individuals will bid uphigher stock prices. These indicators tend to becontemporaneous rather than leading indicators.

Hype indicators that measure whether there is astock price bubble. Detecting what is abnormalcan be tricky and hype can sometimes feed onitself before markets correct.


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THE JANUARY EFFECT, THE WEEKENDEFFECT ETC.

As J anuary goes, so goes the year if stocks are up,the market will be up for the year, but a badbeginning usually precedes a poor year.

According to the venerable Stock TradersAlmanac that is compiled every year by Yale Hirsch,this indicator has worked 88% of the time.


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TRADING VOLUME

Price increases that occur without much trading volume are viewedas less likely to carry over into the next trading period than those thatare accompanied by heavy volume.

At the same time, very heavy volume can also indicate turning pointsin markets. For instance, a drop in the index with very heavy trading

volume is called a selling c limax and may be viewed as a sign thatthe market has hit bottom. This supposedly removes most of thebearish investors from the mix, opening the market up presumably tomore optimistic investors. On the other hand, an increase in the indexaccompanied by heavy trading volume may be viewed as a signthat market has topped out.

Another widely used indicator looks at the trading volume on puts asa ratio of the trading volume on calls. This ratio, which is called theput-call ratio is often used as a contrarian indicator. When investorsbecome more bearish, they sell more puts and this (as the contrarianargument goes) is a good sign for the future of the market.


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INTEREST RATES

The same argument of mean reversion has beenmade about interest rates. For instance, there aremany economists who viewed the low interest ratesin the United States in early 2000 to be anaberration and argued that interest rates wouldrevert back to normal levels (about 6%, which wasthe average treasury bond rate from 1980-2000).

The evidence on mean reversion on interest rates ismixed. While there is some evidence that interestrates revert back to historical norms, the normsthemselves change from period to period.


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FUNDAMENTALS

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

Intrinsic value models

Value the market using a discounted cash flow model andcompare to actual level.,

Relative value models

Look at how market is priced, given fundamentals andgiven history.


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THE PROBLEM WITH FUNDAMENTALINDICATORS..

There are many indicators that market timers use inforecasting market movements. They can begenerally categorized into:

Macro economic Indicators: Market timers have at varioustimes claimed that the best time to invest in stocks is wheneconomic growth is picking up

Interest rate Indicators: Both the level of rates and the slopeof the yield curve have been used as predictors of futuremarket movements.

It is easy to show that markets are correlated withfundamental indicators but it is much more difficultto find leading indicators of market movements.


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IV. TIMING OTHER MARKETS

It is not just the equity and bond markets that investors try to time. Infact, it can be argued that there are more market timers in thecurrency and commodity markets.

The keys to understanding the currency and commodity markets are

These markets have far fewer investors and they tend to be bigger.

Currency and commodity markets are not as deep as equity markets

As a consequence,

Price changes in these markets tend to be correlated over time andmomentum can have a bigger impact

When corrections hit, they tend to be large

Resulting in Timing strategies that look successful and low risk for extended periods

But collapse in a crisis


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SUMMING UP ON MARKET TIMING

A successful market timer will earn far higher returnsthan a successful security selector.

Everyone wants to be a good market timer.

Consequently, becoming a good market timer isnot only difficult to do, it is even more difficult tosustain.


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TO BE A SUCCESSFUL MARKET TIMER

Understand the determinantsof markets

Be aware of shifts in fundamentals

Since you are basing your analysis by looking at the past,

you are assuming that there has not been a significant shiftin the underlying relationship. As Wall Street would put it,paradigm shiftswreak havoc on these models.

Even if you assume that the past is prologue and that therewill be reversion back to historic norms, you do not controlthis part of the process..

And respect the market

You can believe the market is wrong but you ignore it atyourown peril.


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The Client





Security Selection



PrivateInformation

Execution

- How often do you trade?

- How large are your trades?- Do you use derivatives to manage or enhance risk?



TradingCosts


TradingSpeed


Views onmarkets


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?

MarketTiming

StockSelection

UtilityFunctions

Tax Code


Trading Systems- How does tradingaffect prices?



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SECURITY SELECTION

Security selection refers to the process by whichassets are picked within each asset class, once theproportions for each asset class have been defined.

Broadly speaking, there are three differentapproaches to security selection.

The first to focus on fundamentalsand decide whether astock 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 changingdirection.

The third is to trade ahead of or on information releases thatwill affect the value of the firm.


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ACTIVE INVESTORS COME IN ALLFORMS...

Fundamental investors can bevalue investors, who buy low PE or low PBV stocks which trade at

less than the value of assets in placegrowth investors, who buy high PE and high PBV stocks which

trade at less than the value of future growth

Technical investors can bemomentum investors, who buy on strength and sell on weaknessreversal investors, who do the exact opposite

Information traders can believethat markets learn slowly and buy on good news and sell on bad

newsthat markets overreactand do the exact opposite

They cannot all be right in the same period and no oneapproach can be right in all periods.


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THE MANY FACES OF VALUEINVESTING

In trinsic Va lue Inve sto rs:These investors try to estimatethe intrinsic value of companies (using discounted cashflow models) and act on their findings.

Re la tive Va lue Inve sto rs: Following in the Ben Grahamtradition, these investors use multiples and fundamentals

to identify companies that look cheap on a relativevalue basis.

Contra ria n Inve sto rs: These are investors who invest incompanies that others have given up on, eitherbecause they have done badly in the past or becausetheir future prospects look bleak.

Ac tivist Va lue Inve sto rs: These are investors who invest inpoorly managed and poorly run firms but then try tochange the way the companies are run.


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I. INTRINSIC VALUE INVESTORS: THEDETERMINANTS OF INTRINSIC VALUE

Cash flowsFirm: Pre-debt cashflow

Equity: After debtcash flows

Expected Grow thFirm: Growth inOperating EarningsEquity: Growth in

Net Income/EPS

CF1 CF2 CF3 CF4 CF5

Forever

Firm is in stable growth:Grows at constant rateforever

Terminal Value

CFn.........

Discount RateFirm:Cost of Capital

Equity: Cost of Equity

ValueFirm: Value of Firm

Equity: Value of Equity

DISCOUNTED CASHFLOW VALUATION

Length of Period of High Grow th


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Cashf low to FirmEBIT (1-t)- (Cap Ex - Depr)- Change in WC= FCFF

Expec ted Grow thReinvestment Rate* Return on Capital

FCFF1 FCFF2 FCFF3 FCFF4 FCFF5

Forever

Firm is in stable growth:

Grows at cons tant rateforever

Terminal Value= FCFFn+1/(r-gn)

FCFFn.........

Cost of Equity Cost of Debt(Riskfree Rate+ Default Spread) (1-t)

WeightsBased on Market Value

Discount at WACC= Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity))

Value of Operating Assets+ Cash & Non-op Assets= Value of Firm

- Value of Debt= Value of Equity

Risk free Rate :- No default risk- No reinvestment risk- In same currency andin same terms (real ornominal as cash flows

+Beta- Measures market risk X

Risk Premium- Premium for averagerisk investment

Type ofBusiness

OperatingLeverage

FinancialLeverage

Base EquityPremium

Country RiskPremium

DISCOUNTED CASHFLOW VALUATION

Embraer: Status Quo ( ) R t C it lAvg Reinvestment


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Current Cashf low to FirmEBIT(1-t) : $ 404- Nt CpX 23- Chg WC 9= FCFF $ 372Reinvestment Rate = 32/404= 7.9%

Expected Grow thin EBIT (1-t).2185*.2508=.05485.48%

Stable Growthg = 4.17%; Beta = 1.00;Country Premium= 5%Cost of capital = 8.76%ROC= 8.76%; Tax rate=34%Reinvestment Rate=g/ROC

=4.17/8.76= 47.62%

Terminal Value5= 288/(.0876-.0417) = 6272

Cost of Equity10.52%

Cost of Debt(4.17%+1%+4%)(1-.34)= 6.05%

WeightsE = 84% D = 16%

Discount at$ Cos t of Capital (WACC) = 10.52% (.84) + 6.05% (0.16) = 9.81%

Op. Assets $ 5,272+ Cash: 795- Debt 717- Minor. Int. 12=Equity 5,349-Options 28Value/Share $7.47

R$ 21.75

Riskfree Rate :$ Riskfree Rate= 4.17%

+Beta1.07 X

Mature marketpremium4 %

Unlevered Beta forSectors: 0.95

Firms D/ERatio: 19%

Embraer: Status Quo ( )Reinvestment Rate25.08%

Return on Capital21.85%

Term Yr 549- 261= 288

grate = 25.08%

Year 1 2 3 4 5EBIT(1-t) 426 449 474 500 527- Reinvestment 107 113 119 126 132= FCFF 319 336 355 374 395

+ Lambda0.27

XCountry Equity RiskPremium7.67%

Country DefaultSpread6.01%

X

Rel EquityMkt Vol

1.28

On October 6, 2003Embraer Price = R$15.51

$ Cashflows


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TO DO INTRINSIC VALUATION RIGHT

Check for consistency:

Are your cash flows and discount rates in the same currency?

Are you computing cash flows to equity or the firm and areyour discount rates computed consistently?

Are your growth rate and reinvestment assumptions consistent?

Focus on excess returns and competitive advantages;success breeds competition.

Recognize that as firms get larger, growth will get more

difficult to pull off. Remember that you dont run the firm, if you are a

passive investor. So, do not move to target debt ratios,higher margin businesses and better dividend policy.


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TO MAKE MONEY ON INTRINSICVALUATION

You have to be able to value a company, given itsfundamental risk, cash flow and growth characteristics,without being swayed too much by what the marketmood may be about the company and the sector.

The market has to be making a mistake in pricing one ormore of these fundamentals.

The market has to correct its mistake sooner or later foryou to make money.

Proposition 1: For intrinsic valuation to work, you have tobe willing to expend time and resources to understandthe company you are valuing and to relate its value toits fundamentals.

Proposition 2: You need a long time horizon for intrinsicvaluation to pay off.

Proposition 3: Your universe of investments has to belimited.


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II. THE RELATIVE VALUE INVESTOR

In relative value investing, you compare how stocksare priced to their fundamentals (using multiples) tofind under and over valued stocks.

This approach to value investing can be tracedback to Ben Graham and his screens to findundervalued stocks.

In recent years, these screens have been refinedand extended and the availability of data andmore powerful screening techniques has allowed usto expand these screens and back-test them.


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BUFFETTS TENETS

Busine ss Te ne ts: The businessthe company is in should be simple and understandable.

The firm should have a consistent operating history, manifested in operatingearningsthat are stable and predictable.

The firm should be in a business with favorable long term prospects.

Ma nag em en t Tene t s:

The managers of the company should be candid. As evidenced by the way hetreated his own stockholders, Buffett put a premium on managers he trusted.The managers of the company should be leadersand not followers.

Fina nc ia l Te ne ts:

The company should have a high return on equity. Buffett used a modifiedversion of what he called owner earnings

Owner Earnings = Net income + Deprec iation & Amortization Capital Expenditures

The company should have high and stable profit margins.

Ma rket Ten ets: Use conservative estimatesof earningsand the risklessrate as the discount rate.

In keeping with his view of Mr. Market as moody, even valuable companies canbe bought at attractive prices when investors turn away from them.


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BE LIKE BUFFETT?

Marketshave changed since Buffett started his first partnership.Even Warren Buffett would have difficulty replicating hissuccess in todays market, where information on companies iswidely available and dozens of money managers claim to belooking for bargainsin value stocks.

In recent years, Buffett has adopted a more activist investmentstyle and has succeeded with it. To succeed with this style asan investor, though, you would need substantial resources andhave the credibility that comes with investment success. Thereare few investors, even among successful money managers,who can claim this combination.

The third ingredient of Buffetts success has been patience. Ashe has pointed out, he does not buy stocks for the short termbut businesses for the long term. He has often been willing to

hold stocks that he believes to be under valued throughdisappointing years. In those same years, he has faced nopressure from impatient investors, since stockholders in BerkshireHathaway have such high regard for him.


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III. CONTRARIAN VALUE INVESTING:BUYING THE LOSERS

The fundamental premise of contrarian value investing isthat markets often over react to bad news and pushprices down far lower than they should be.

A follow-up premise is that they markets eventually

recognize their mistakes and correct for them. There is some evidence to back this notion:

Studies that look at returns on markets over long time periodschronicle that there is significant negative serial correlation inreturns, I.e, good years are more likely to be followed by badyears and vice versa

Studies that focus on individual stocks find the same effect,with stocks that have done well more likely to do badly overthe next period, and vice versa.


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A VARIATION ON CONTRARIAN VALUEINVESTING

If you accept the premise that markets becomeover-enamored with companies that are viewed asgood and well managed companies and over-soldon companies that are viewed as poorly run withbad prospects, the former should be priced toohigh and the latter too low.

A particularly perverse value investing strategy is topick badly managed, badly run companies as your

investments and wait for the recovery.


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IV. ACTIVIST VALUE INVESTING

An activist value investor having acquired a stake in anundervalued company which might also be badlymanaged then pushes the management to adopt thosechanges which will unlock this value.

If the value of the firm is less than its component parts: push for break up of the firm, spin offs, split offs etc.

If the firm is being too conservative in its use of debt: push for higher leverage and recapitalization

If the firm is accumulating too much cash: push for higher dividends, stock repurchases ..

If the firm is being badly managed: push for a change in management or to be acquired

If there are gains from a merger or acquisition push for the merger or acquisition, even if it is hostile

Increase Cash Flows


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Revenues

* Operating Margin

= EBIT

- Tax Rate * EBIT

= EBIT (1-t)

+ Depreciation- Capital Expenditures- Chg in Working Capital= FCFF

Divest assets thathave negative EBIT

More efficientoperations andcost cuttting:Higher Margins

Reduce tax rate- moving income to lower tax locales

Better inventorymanagement andtighter credit policies

Increase Cash Flows

Reinvestment Rate

* Return on Capital

= Expected Growth Rate

Reinvest more inprojects

Do acquisitions

Increase operatingmargins

Increase capital turnover ratio

Increase Expected Growth

Firm Value

Increase length of growth period

Build on existingcompetitiveadvantages

Create newcompetitiveadvantages

Reduce the cost of capital

Cost of Equity * (Equity/Capital) +Pre-tax Cost of Debt (1- tax rate) *(Debt/Capital)

Make yourproduct/service lessdiscretionary

ReduceOperatingleverage

Match your financingto your assets:Reduce your default

risk and cost of debt

Reduce beta

Interest advantage

Change financingmix to reducecost of capital


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DETERMINANTS OF SUCCESS ATACTIVIST INVESTING

1. Have lots of capital: Since this strategy requires that you beable to put pressure on incumbent management, you have tobe able to take significant stakes in the companies.

2. Know your company well: Since this strategy is going to lead asmaller 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 enoughcorporate finance to understand not only that the company isdoing badly (which will be reflected in the stock price) butwhat it is doing badly.

4. Be persistent: Incumbent managers are unlikely to roll overand play dead just because you say so. They will fight (andfight dirty) to win. You have to be prepared to counter.

5. Do your homework: You have to form coalitions with otherinvestors and to organize to create the change you arepushing for.


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GROWTH INVESTING

Assets Liabilities

Assets in Place Debt

Equity

Fixed Claim on cash flowsLittle or No role in managementFixed MaturityTax Deductible

Residual Claim on cash flowsSignificant Role in managementPerpetual Lives

Growth Assets

Existing InvestmentsGenerate cashflows todayIncludes long lived (fixed) and

short-lived(workingcapital) assets

Expected Value that will becreated by future investments

Growth investors bet on growth assets: They believe

that they can assess their value better than markets

Value investors focus

assets in place


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GROWTH INVESTING STRATEGIES

Passive Growth Investing Strategies focus oninvesting in stocks that pass a specific screen.Classic passive growth screens include: Earnings Momentum Investing (Earnings Momentum:

Increasing earnings growth)

Earnings Revisions Investing (Earnings Revision: Earningsestimates revised upwards by analysts)

Small Cap Investing

Active growth investing strategies involve takinglarger positions and playing more of a role in your

investments. Examples of such strategies wouldinclude: Venture capital investing Private Equity Investing


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II. SMALL CAP INVESTING

One of the most widely used passive growth strategies isthe strategy of investing in small-cap companies. There issubstantial 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 thanlarger firms of equivalent risk, where risk is defined interms of the market beta. In one of the earlier studies,returns for stocks in ten market value classes, for theperiod from 1927 to 1983, were presented.


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INFORMATION TRADING

Information traders dont bet on whether a stock isunder or over valued. They make judgments onwhether the price changes in response toinformation are appropriate.

There are two classes of information traders

Those that believe that markets learn slowly

Those that believe that markets over react


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INFORMATION AND PRICES IN ANEFFICIENT MARKET

TimeNew information is revealed

Asset price

Figure 10.1: Price Adjustment in an Efficient Market

Notice that the price

adjusts instantaneouslyto the information


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A SLOW LEARNING MARKET


Asset price

Figure 10.2 A Slow Learning Market

The price drifts upwards after thegood news comes out.


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AN OVERREACTING MARKET


Asset price

Figure 10.3: An Overreacting Market

The price increases too much on thegood news announcement, and thendecreases in the period after.


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TO BE A SUCCESSFUL INFORMATIONTRADER

Id e nt ify the in fo rm a t io n a ro und w h ic h yo ur stra te g y w ill b e b u ilt : Since youhave to trade on the announcement, it is critical that you determine inadvance the information that will trigger a trade.

Inve st in a n in fo rm a tio n system tha t w ill d e live r the in fo rm a t io n to yo u

instantaneous: Many individual investors receive information with a time lag 15 to 20 minutes after it reaches the trading floor and institutional investors.

While this may not seem like a lot of time, the biggest price changes afterinformation announcementsoccurduring these periods.

Exe c ute q uic kly: Getting an earnings report or an acquisition announcementin real time is of little use if it takes you 20 minutes to trade. Immediateexecution of trades is essential to succeeding with this strategy.

Kee p a t ig ht lid o n tra nsa c t io ns c o sts: Speedy execution of trades usuallygoes with higher transactions costs, but these transactions costs can very

easily wipe out any potential you may see for excess returns). Know w he n to se ll: Almost as critical as knowing when to buy is knowing when

to sell, since the price effects of news releases may begin to fade or evenreverse after a while.



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The Client





Security Selection



PrivateInformation

Execution





TradingCosts


TradingSpeed


Views onmarkets



MarketTiming

StockSelection

UtilityFunctions

Tax Code



affect prices?



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TRADING AND EXECUTION COSTS

The cost of trading includes four components:

the brokerage cost, which tends to decrease as the size ofthe trade increases

the bid-ask spread, which generally does not vary with the

size of the trade but is higher for less liquid stocksthe price impact, which generally increases as the size of thetrade increases and as the stock becomes less liquid.

the cost of waiting, which is difficult to measure since it showsup as trades not made.


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ARBITRAGE INVESTMENT STRATEGIES

An arbitrage-based investment strategy is basedupon buying an asset (at a market price) andselling an equivalent or the same asset at a higherprice.

A true arbitrage-based strategy is riskfree andhence can be financed entirely with debt. Thus, it isa 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 thoseadopted by hedge funds) have some residual riskand require some investment.


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A. PURE ARBITRAGE STRATEGIES

Mispriced Options when the underlying stock is traded Since you can replicate a call or a put option using the

underlying asset and borrowing/ lending, you can createriskfree positions where you buy (sell) the option and sell (buy)the replicating portfolio.

This position should be riskless and costless and create

guaranteed profits. Mis-priced Futures Contracts Riskless positions can be created using the underlying asset

and borrowing and lending (as long as the asset can bestored)

Futures on currenc ies and storable commodities have to obeythis arbitrage relationship.

Mispriced Default-free Bonds The cash flows on a default free bond are known with

certainty. When default-free bonds are priced inconsistently, we should

be able to combined them to create riskfree arbitrage.


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B. CLOSE TO ARBITRAGE

Corporate Bonds Corporate bonds of similar default risk should be priced

consistently. Similar default risk may not be the same as identical default

risk, and this can create a residue of risk. This risk will increase as default risk increases

Securities issued by same firm Debt and equity issued by the same firm should be priced

consistently. If they are mispriced relative to each other, you can buy the

cheaper one and sell the more expensive one. The valuation is subjective and can be wrong, giving rise to risk.

Options issued by firm If a company has convertible bonds, warrants and listedoptions outstanding, they have to be priced consistently witheach other and with the underlying securities.


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C. PSEUDO ARBITRAGE

Quasi arbitrage is not really arbitrage since it is not evenclose to riskless. You try to take advantage of what yousee as mispricing between two securities that youbelieve should maintain a consistent pricing relationship.

Examples include Locally listed stock and an ADR, where there are constraints on

buying the local listing and converting the ADR into localshares.

Paired stocks (example GM and Ford) that have been around

a long time and have an established historical relationship. Listings of the same stock in multiple markets, though there are

differences between the listings and restrictions onconversion/trading.


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HEDGE FUNDS: WHAT DO THEY BRINGTO THE MARKET?

At the heart of all arbitrage based strategies is thecapacity to go long and short and the use of leverage.

If there is a common component to hedge funds, it istheir capacity to do both of these whereas conventionalmutual funds are restricted on both counts.

Proposition 1: In down or flat markets, hedge funds willalways look good relative to conventional mutual fundsbecause of their capacity to short stocks and otherassets.

Proposition 2: The use of leverage will exaggerate thestrengths and weaknesses of investors. A good hedgefund will look better than a good mutual fund and a bad

hedge fund will look worse. Proposition 3: If the average hedge fund manager is not

smarter or dumber than an average mutual fundmanager, history suggests that the freedom they havebeen granted will hurt more than help.


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LOOKING A LITTLE CLOSER AT THENUMBERS

The average hedge fund earned a lower return(13.26%) over the period than the S&P 500 (16.47%),but it also had a lower standard deviation in returns(9.07%) than the S & P 500 (16.32%). Thus, it seems to

offer a better payoff to risk, if you divide theaverage return by the standard deviation this isthe commonly used Sharpe ratio for evaluatingmoney managers.

These funds are much more expensive than

traditional mutual funds, with much higher annualfess and annual incentive fees that take away oneout of every five dollars of excess returns.



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The Client





Security Selection



PrivateInformation

Execution





TradingCosts- Commissions- Bid Ask Spread- Price Impact

TradingSpeed


Views onmarkets



MarketTiming

StockSelection

UtilityFunctions

Tax Code



affect prices?


PERFORMANCE EVALUATION TIME TO


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PERFORMANCE EVALUATION: TIME TOPAY THE PIPER!

Who should m ea sure p er forma nc e?

Performance measurement has to be done either by the client or by anobjective third party on the basis of agreed upon criteria. It should not bedone by the portfolio manager.

How often shou ld p erfo rm anc e be m ea sured ?

The frequency of portfolio evaluation should be a function of both the timehorizon of the c lient and the investment philosophy of the portfoliomanager. However, portfolio measurement and reporting of value toclients should be done on a frequent basis.

How shou ld p erfo rm anc e b e m ea sured ?

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 andmarket performance.

Based upon Tracking Error against a benchmark index


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I. AGAINST A MARKET INDEX

0%

10%

20%

30%

40%

50%

60%

70%

80%

1971

II AGAINST OTHER PORTFOLIO


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II. AGAINST OTHER PORTFOLIOMANAGERS

In some cases, portfolio managers are measuredagainst other portfolio managers who have similarobjective functions. Thus, a growth fund managermay be measured against all growth fund

managers.

The implicit assumption in this approach is thatportfolio managers with the same objectivefunction have the same exposure to risk.


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IV TRACKING ERROR AS A MEASURE


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IV. TRACKING ERROR AS A MEASUREOF RISK

Tracking error measures the difference between aportfolios return and its benchmark index. Thusportfolios that deliver higher returns than thebenchmark but have higher tracking error are

considered riskier.

Tracking error is a way of ensuring that a portfoliostays within the same risk level as the benchmarkindex.

It is also a way in which the active in activemoney management can be constrained.

SO WHY IS IT SO DIFFICULT TO WIN AT


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SO, WHY IS IT SO DIFFICULT TO WIN ATTHIS GAME?

Is it a losers game? To win at a game, you need a ready supply of losers

Unfortunately, losers leave the game early and you end upplaying with other winners.

As markets develop and become deeper, this tendency isexaggerated.

What is your investing edge? Getting an edge in investing is tough to do and even tougher

to sustain.

Success at investing breeds imitation which makes future

success more difficult. Proposition 1: If you dont bring anything to the table,

dont expect to take anything away in the long term.


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WHAT MAKES YOU SPECIAL?

Institutional claims

We are bigger : Size is relative. You may be big but someone isalways bigger. Even if you are the biggest investor, it is difficult to seewhat that gets you unless you are big enough to move the market.

Our computers are more powerful: Really?

Our analysts are smarter: If they are, they will move elsewhere andclaim the rents.

We have better traders: See Our analysts are smarter and double it.

Our information is better: What do you plan to do in jail?

Individual claims

We can wait longer: Patience is rare and there is a payoff.

Our tax structure is different: Tax avoidance versus tax evasion?

We dont bow to peer pressure: Contrarian to the core?

FINDING AN INVESTMENT


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FINDING AN INVESTMENTPHILOSOPHY

Momentum Contrarian Opportunisitic

Short term (days toa few weeks)

Technical momentumindicators Buy stocks basedupon trend lines and hightrading volume.

Information trading: Buyingafter positive news (earningsand dividend announcements,acquisition announcements)

Technical contrarianindicators These canbe for individual stocksor for overall market.

Pure arbitrage inderivatives and fixedincome markets.

Tehnical demandindicators Patterns in

prices such as head andshoulders.

Medium term (fewmonths to a couple

of years)

Relative strength: Buy stocksthat have gone up in the last

few months. Information trading: Buy

small cap stocks withsubstantial insider buying.

Market timing, basedupon normal range of

indicators. Information trading:

Buying after bad news(buying a week after

bad earnings reportsand holding for a fewmonths)

Near arbitrageopportunities: Buying

discounted closed endfunds

Speculative arbitrageopportunities: Buying

paired stocks andmerger arbitrage.

Long Term (severalyears)

Passive growth investing:Buying stocks where growthtrades at a reasonable price

(PEG ratios).

Passive value investing:Buy stocks with lowPE, PBV or PS ratios.

Contrarian valueinvesting: Buyinglosers or stocks withlots of bad news.

Active growthinvesting: Take stakesin small, growth

companies (privateequity and venture

capital investing)

Activist value investing:Buy stocks in poorly


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THE RIGHT INVESTMENT PHILOSOPHY

Single Best Strategy: You can choose the one strategy thatbest suits you. Thus, if you are a long-term investor whobelieves that markets overreact, you may adopt a passivevalue investing strategy.

Combination of strategies: You can adopt a combination ofstrategies to maximize your returns. In creating this combinedstrategy, 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 ofbuying on relative strength would not be compatible with a strategy ofbuying stocks after very negative earnings announcements. The firststrategy is based upon the assumption that markets learn slowlywhereas the latter isconditioned on market overreac tion.

When you mix strategies, you should separate the dominant strategyfrom the secondary strategies. Thus, if you have to make choices interms of investments, you know which strategy will dominate.


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IN CLOSING

Choosing an investment philosophy is at the heartof successful investing. To make the choice, though,you need to look within before you look outside. Thebest strategy for you is one that matches both your

personality and your needs.

Your choice of philosophy will also be affected bywhat you believe about markets and investors andhow they work (or do not). Since your beliefs are

likely to be affected by your experiences, they willevolve over time and your investment strategieshave to follow suit.

IF YOU WALK LIKE A LEMMING, RUN


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LIKE A LEMMING YOU ARE ALEMMING

Investments Phil

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