strategy, you have to begin with an investment philosophy that is consistent at While all active investment philosophies make the assumption that markets are. Aswath Damodaran If you do not have an investment philosophy, you will find yourself: 1. investing philosophy, you download when the price is lower than the. Aswath Damodaran. 8. Developing an Investment Philosophy. □ Step 1: Understand the fundamentals of risk and valuation. □ Step 2: Develop a point of view.

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Aswath Damodaran. 2. What is an investment philosophy? □ An investment philosophy is a coherent way of thinking about markets, how they work (and. Aswath Damodaran Aswath Damodaran 1. What is an investment philosophy? n An investment philosophy is a coherent way of thinking . Investment. Philosophies. Successful Strategies and the. Investors Who Made Them Work. Second Edition. ASWATH DAMODARAN

To be a successful chartist. An investor who downloads growth companies where the value of growth potential is being under estimated. Who is a growth investor? An investor who downloads high price earnings ratio stocks or high price to book ratio stocks. The difference lies mostly in where they think they can find these bargains and what they view as their strengths.

Like the passive value screener. These investors take positions in young growth companies even before they go public and play an active role not only in how these companies are managed but in how and when to take them public. The many faces of growth investing n The Small Cap investor: The simplest form of growth investing is to download smaller companies in terms of market cap. Since this was a decade with high inflation. Whether this is a long term shift in the small stock premium or just a temporary dip is still being debated.

Has the small firm premium disappeared? In fact. The small firm premium may be a reward for this additional estimation risk.

The additional risk associated with small stocks may come from several sources. Risk Models and the Size Effect n The capital asset pricing model may not be the right model for risk. Since small cap stocks tend to be concentrated in a few sectors.

You may have to go beyond the financial statements and scour other sources local newspapers. Figure 9. Time Horizon and the Small Firm Premium The importance of a long time horizon.

Average Initial Return and Issue Size Initial Public Offerings Figure 9. Table 9. What happens after the IPO? The Passive Screener n In passive screening. But growth outperforms value when earnings growth is low.

And when the yield curve is flat or downward sloping.. On the PEG ratio front. While there is little evidence that downloading stocks with PE ratios less than the expected growth rate earns excess returns. It is intuitive and simple. download stocks that trade at PE ratios that are less than their expected growth rates.

If you can time these cycles. To be a successful passive growth investor. There are extended cycles where the growth screens work exceptionally well and other cycles where they are counter productive. Since growth is the key dimension of value in these companies.. Since many of these cycles are related to how the overall market is doing.

If your underlying strategy is sound. This has allowed investors to invest in private businesses without either giving up diversification or taking an active role in managing these firms. Pension funds and institutional investors. Activist Growth Investing n The first are venture capital funds that trace their lineage back to the s. One of the first was American Research and Development that provided seed money for the founding of Digital Equipment. The rate of failure is high among private equity investments.

If they do this job well. Venture capitalists are also management consultants and strategic advisors to the firms that they invest in. As the firm grows and attracts new investment.

To be a successful activist growth investor… n Pick your companies and managers well: Good venture capitalists seem to have the capacity to find the combination of ideas and management that make success more likely. Know how and when to get out of an investment is critical to protecting your returns.

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Having a good exit strategy seems to be as critical as having a good entrance strategy. The earlier the stage of financing — seed money. Examples would include low PE ratios and low price to book ratios. Following in the Ben Graham tradition. These are investors who invest in companies that others have given up on.

These are investors who invest in poorly managed and poorly run firms but then try to change the way the companies are run. The following section summarizes the empirical evidence that backs up each of these screens.

The Passive Screener n This approach to value investing can be traced back to Ben Graham and his screens to find undervalued stocks. No more than two years of negative earnings over the previous ten years. Debt-Equity Ratio Book Value has to be less than one. Among them were Charlie Munger and Warren Buffett. Buffett put a premium on managers he trusted. As evidenced by the way he treated his own stockholders.

Market as capricious and moody. He has often been willing to hold stocks that he believes to be under valued through disappointing years. As he has pointed out. Be like Buffett?

To succeed with this style as an investor. In those same years. There are few investors. Buffett has adopted a more activist investment style and has succeeded with it.

Value Screens n Price to Book ratios: download stocks where equity trades at less than or at least a low multiple of the book value of equity. download stocks where equity trades at a low multiple of equity earnings.

download stocks with high dividend yields. download stocks where equity trades at a low multiple of revenues. Low Price to Book Ratios Figure 8.

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Even when other factors were thrown into the analysis. Watch out for taxes and transactions costs: Some of the screens may end up creating a portfolio of low-priced stocks. Be diversified: The excess returns from these strategies often come from a few holdings in large portfolio.

Have a long time horizon. To be a successful passive value investor… 1. Holding a small portfolio may expose you to extraordinary risk and not deliver the same excess returns.

All the studies quoted above look at returns over time horizons of five years or greater. Choose your screens wisely: Too many screens can undercut the search for excess returns since the screens may end up eliminating just those stocks that create the positive excess returns.

Contrarian Value Investing: downloading the Losers n In contrarian value investing. Winner and Loser Portfolios Aswath Damodaran This evidence is consistent with market overreaction and correction in long return intervals. More on Winner and Loser Portfolios n This analysis suggests that loser portfolio clearly outperform winner portfolios in the sixty months following creation.

Good Companies are not necessarily Good Investments n Any investment strategy that is based upon downloading well-run. Excellent versus Unexcellent Companies n There is evidence that well managed companies do not always make great investments. These strategies require time to work out. Stomach for Short-term Volatility: The nature of your investment implies that there will be high short term volatility and high profile failures. Self Confidence: Investing in companies that everybody else views as losers requires a self confidence that comes either from past success.

Watch out for transactions costs: These strategies often lead to portfolios of low priced stocks held by few institutional investors. For every three steps forward. To be a successful contrarian value investor… 1. The transactions costs can wipe out any perceived excess returns quickly. You either need clients who think like you do and agree with you. Markets view firms that are evasive about reasons for and proceeds from divestitures with skepticism. Split offs. Breaking up is hard to do… Effects of Spin offs.

Divestitures on Value n Linn and Rozeff examined the price reaction to announcements of divestitures by firms and reported an average excess return of 1. The excess returns are greater for firms in which the spin off is motivated by tax and regulatory concerns Aswath Damodaran Debt 15 Some firms have too little debt…Effects of Leverage Increasing and Decreasing Transactions n The overall empirical evidence suggest that leverage increasing transactions increase value whereas leverage reducing transactions decrease value.

Debt Conv. Effects of Management Changes on Firm Value n The overall empirical evidence suggests that changes in management are generally are viewed as good news. Returns Around Management Changes 5.

Hostile vs. Friendly Takeovers Target Target 5. The Effects of Hostile Acquisitions on the Target Firm n Badly managed firms are much more likely to be targets of acquisitions than well managed firms Target Characteristics. Be persistent: Incumbent managers are unlikely to roll over and play dead just because you say so. Have lots of capital: Since this strategy requires that you be able to put pressure on incumbent management.

You have to be prepared to counter. Do your homework: You have to form coalitions with other investors and to organize to create the change you are pushing for. Know your company well: Since this strategy is going to lead a smaller portfolio. They will fight and fight dirty to win. To be a successful activist value investor… 1. Understand corporate finance: You have to know enough corporate finance to understand not only that the company is doing badly which will be reflected in the stock price but what it is doing badly.

Price Adjustment in an Efficient Market Asset price Notice that the price adjusts instantaneously to the information Time New information is revealed Aswath Damodaran Information and Prices in an Efficient Market Figure A Slow Learning Market… Figure Time New information is revealed Aswath Damodaran An Overreacting Market Figure An Overreacting Market The price increases too much on the Asset price good news announcement.

Trading on Private Information n Insiders are managers. Insider Trading as a Leading Indicator of Stock prices.. Can you follow insiders and make money? Bizjak and Lemmon find that insider trading in derivative securities options specifically to hedge their common stock positions increases immediately following price run-ups and prior to poor earnings announcements. Vickrey and Vickery finds that investors who focus only on large trades made by top executives.

As an outside investor. A study by Bettis. Are some insiders more inside than others? Top managers and members of the board should be privy to much more important information and thus their trades should be more revealing. One study find that insiders sell stock between 3 and 9 quarters before their firms report a break in consecutive earnings increases.

They also find. Illegal Insider Trading: Is it profitable? While this may indicate a very prescient market. Analysts n Analysts have access to public information and to the managers of the firm and thus to private information. Earnings Forecasts n The general consensus from studies that have looked at short-term forecasts one quarter ahead to four quarters ahead of earnings is that analysts provide better forecasts of earnings than models that depend purely upon historical data. It found that the time series models actually outperform analyst forecasts from April until August.

The mean relative absolute error. Analyst Errors seem to be related to macroeconomic conditions… Aswath Damodaran How about long term forecasts? An early study by Cragg and Malkiel compared long-term forecasts by five investment management firms in and with actual growth over the following three years to conclude that analysts were poor long term forecasters. Earnings Revisions… n The evidence suggests that downloading stocks where earnings have been revised upwards by analysts is a profitable strategy.

Day and Lewis report that much of the excess returns is concentrated in the weeks around the revision — 1. For example.

The more influential they are. Potential Pitfalls and possible use… n The limitation of an earnings momentum strategy is its dependence on two of the weakest links in financial markets —earnings reports that come from firms where accounting games skew earnings and analyst forecasts of these earnings which are often biased. While forecast revisions and earnings surprises by themselves are unlikely to generate lucrative portfolios. Analyst Recommendations… Aswath Damodaran Tempered by fears of bias… Aswath Damodaran If this is the only reason for the stock price reaction.

Since these signals are often subtle. You should invest based upon their recommendations. Using Analyst Recommendations… n Even if there were no new information contained in recommendations. Trading on Public Information n There is substantial information that comes out about stocks. Some of the information comes from the firm.

By day of the week. Figure Earnings and Dividend Reports by Day of the Week 0. The Consequence of Delays… Aswath Damodaran The Intraday reaction.

Jegadeesh and Lakonishok examined firms that reported high accruals — i. When they tracked a portfolio composed of these firms. A firm that beats earnings estimates because it has more efficient operating should be viewed more favorably than one that beats estimates because it changed the way it valued inventory.

And earnings quality matters… n As firms play the earnings game. The evidence indicates that across all stocks.

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Evidence on Target Firms Aswath Damodaran Brickley and Netter.. The Effect on Acquirers. They concluded that 28 of the 58 programs failed both tests. After the acquisition… Divestitures n The most damaging piece of evidence on the outcome of acquisitions is the large number of acquisitions that are reversed within fairly short time periods. In a study published in In another study. Mitchell and Lehn note that Takeover based investment strategies n The first and most lucrative.

This is often called risk arbitrage. Preannouncement Trading n Research indicates that the typical target firm in a hostile takeover has the following characteristics: You could. Post-Announcement Trading n In this strategy.

To be a successful information trader… n Identify the information around which your strategy will be built: Since you have to trade on the announcement. Getting an earnings report or an acquisition announcement in real time is of little use if it takes you 20 minutes to trade. Almost as critical as knowing when to download is knowing when to sell. While this may not seem like a lot of time. Immediate execution of trades is essential to succeeding with this strategy.

Many individual investors receive information with a time lag — 15 to 20 minutes after it reaches the trading floor and institutional investors. Speedy execution of trades usually goes with higher transactions costs. Arbitrage Aswath Damodaran Aswath Damodaran The Essence of Arbitrage n In pure arbitrage.

Pure Arbitrage n For pure arbitrage. This is especially so. When options are mispriced relative to the underlying asset or to each other. When the option price is less than the exercise value. Markets where pure arbitrage may be feasible… n Futures Markets: The basic arbitrage relationship can be derived fairly easily for futures contracts on any asset.

Fixed income securities lend themselves to arbitrage more easily than equity because they have finite lives and fixed cash flows. Even when there are pricing errors. When these small and uncommon pricing errors surface.

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Evidence on pure arbitrage opportunities… n They are uncommon: In the futures and the options markets. Note that many of the arbitrage positions require you to be able to borrow at the riskless rate. To succeed at pure arbitrage… n The nature of pure arbitrage — two identical assets that are priced differently — makes it likely that it will be short lived.

To make pure arbitrage feasible. Near Arbitrage n In near arbitrage. Same Stock listed in Multiple Markets n If you can download the same stock at one price in one market and simultaneously sell it at a higher price in another market. Depository receipts create a claim equivalent to the one you would have had if you had bought shares in the local market and should therefore trade at a price consistent with the local shares. What makes them different and potentially riskier than the stocks with dual listings is that ADRs are not always directly comparable to the common shares traded locally — one ADR on Telmex.

Many large companies trade on multiple markets on different continents.

Since there are time periods during the day when there is trading occurring on more than one market on the same stock. Dual Listed Stocks: Evidence of Mispricing? These arbitrage opportunities seem to increase for less liquid stocks. Depository Receipts: Evidence on Pricing n In a study conducted in that looks at the link between ADRs and local shares.

Closed End Funds: June 70 60 50 40 30 20 10 0 Discount Discount: There have been a few cases of closed end funds being liquidated. What is the catch? An Investment Strategy of downloading discounted funds… Aswath Damodaran Convertible Arbitrage n When companies have convertible bonds or convertible preferred stock outstanding in conjunction with common stock.

Determinants of Success at Near Arbitrage n These strategies will not work for small investors or for very large investors. Small investors will be stymied both by transactions costs and execution problems. Very large investors will quickly drive discounts to parity and eliminate excess returns. Pseudo or Speculative Arbitrage n There are a large number of strategies that are characterized as arbitrage. Paired Arbitrage n In paired arbitrage.

Controlling for the bid-ask spread in the strategy reduces the excess returns by about a fifth. When the pairs are constructed by industry group rather than just based upon historical prices. You can normalize the prices around 1 and use these series. Evidence on Paired Trading n Screening first for only stocks that traded every day. Once they had paired all the stocks. As the novelty has worn off. Two Caveats on Paired Arbitrage n The study quoted found that the pairs trading strategy created negative returns in about one out of every six periods.

If the merger succeeds. Merger Arbitrage n The stock price of a target company jumps on the announcement of a takeover. Evidence from merger arbitrage n Mitchell and Pulvino use a sample of mergers and acquisitions to examine this question. They conclude that there are excess returns associated with downloading target companies after acquisition announcements of about 9.

The strategy has payoffs that resemble those you would observe if you sell puts — when the market goes up. The more risky a strategy and the less certain you are about convergence.

Since there is no risk. As you get more funds to invest and your strategy becomes more visible to others. With pure arbitrage. As you move to near and speculative arbitrage. In futures arbitrage.

Determinants of Success at Speculative Arbitrage n The use of financial leverage has to be scaled to reflect the riskiness of the strategy.

How much it has to be reduced will depend upon both the degree of risk in the strategy and the speed with which you think prices will converge. Long Short Strategies: Hedge Funds n While hedge funds come in all varieties. They can go both download and sell short assets.

Looking a little closer at the numbers… n The average hedge fund earned a lower return Returns by sub-category Aswath Damodaran There is substantial survival risk. Of the funds over the period for instance. While his overall conclusions matched those of Brown et al. The Case for Indexing n The case for indexing is best made by active investors who try to beat the market and fail.

Between and Individual Investors n The average individual investor does not beat the market. Barber and Odean examined the performance of randomly selected investment clubs that used the discount brokerage house.

After transactions costs are accounted for. Professional Money Managers n Professional money managers operate as the experts in the field of investments. They are supposed to be better informed. Mutual Fund Performance: E R Aswath Damodaran The Jensen Study An Even Simpler Measure: Relative to the Market Figure The same holds true for bond funds as well… Lehman Bond Index Active Bond funds 83 84 85 86 87 88 89 90 91 92 Aswath Damodaran In the studies that are most favorable for professional money managers.

More Findings on Money Managers n These results have been replicated with mild variations in the conclusions. Categorized by Style Aswath Damodaran Emerging Market and International Funds Figure Emerging Market Funds versus Indices Jensen's Alpha: Load versus No-load Funds 0. Load versus No-load Funds Figure Institutional versus Retail Funds Figure Institutional versus Retail Funds: Annualized Excess Returns 0.

Performance Continuity n Fund managers argue that the average is brought down by poor money managers. They argue that good managers continue to be good managers whereas bad managers drag the average down year after year.

The Value of Rankings Aswath Damodaran High Tax Burdens Figure He has been the recipient of numerous awards for outstanding teaching, including the NYU university-wide Distinguished Teaching Award, and was named one of the nation's top business school teachers by BusinessWeek in In addition, Damodaran teaches training courses in corporate finance and valuation at many leading investment banks.

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His publications include Investment Valuation now in its third edition , Damodaran on Valuation: Request permission to reuse content from this site. Undetected country. NO YES. Selected type: Added to Your Shopping Cart. Evaluation Copy Request an Evaluation Copy. The guide for investors who want a better understanding of investment strategies that have stood the test of time This thoroughly revised and updated edition of Investment Philosophies covers different investment philosophies and reveal the beliefs that underlie each one, the evidence on whether the strategies that arise from the philosophy actually produce results, and what an investor needs to bring to the table to make the philosophy work.

Presents the tools needed to understand portfolio management and the variety of strategies available to achieve investment success Explores the process of creating and managing a portfolio Shows readers how to profit like successful value growth index investors Aswath Damodaran is a well-known academic and practitioner in finance who is an expert on different approaches to valuation and investment This vital resource examines various investing philosophies and provides you with helpful online resources and tools to fully investigate each investment philosophy and assess whether it is a philosophy that is appropriate for you.

Original Price: Permissions Request permission to reuse content from this site. Understanding Risk 15 What Is Risk?Experimental Studies of Rationality n While most experimental studies suggest that traders are rational.

But how good is it? To be a successful contrarian value investor… 1. No more than two years of negative earnings over the previous ten years. In addition, these new chapters also cover significant crises of the last fifteen years.

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