Revisiting the basics with Aswath

In most professional interactions, the terms ‘investment strategy’ and ‘investment philosophy’ are interchangeably used. So, they must mean the same, right? “Wrong,” says Aswath Damodaran and that is why at the last IAIP-CFA Institute annual event, the valuation expert spoke on how the two differ. 

Damodaran, a professor of finance at the Stern School of Business at New York University, is a familiar name for those who invest for a living. However, at the opening of his presentation, he said, “In the 25 years of being around money managers, I have frequently been asking them one question to which I don’t get a good answer and the question is, ‘What is your investment philosophy’?” He adds that many portfolio managers do not have a core philosophy and for an investment philosophy to work, it has to fit your strengths and weaknesses and your perspective as a human being.

But, what exactly is an investment philosophy and how is it different from an investment strategy? According to Damodaran, an investment philosophy “is a core set of beliefs about markets, a behavioural set of assumptions about how markets work, how they fail to work, and how to take advantage of common mistakes made by investors in the markets. This is as opposed to an investment strategy, such as buying low price to earnings stocks or going contrarian.” And why does one need an investment philosophy? Because without it, your portfolio is going to swing from one strategy to another, based on what worked best recently, leading to a huge turnover ratio, large transaction costs and poor returns. 

Obviously, there is no one investment philosophy that fits us all. As Damodaran points out, “You cannot read a book on Warren Buffett or Peter Lynch and invest like them. To be a successful investor you don’t have to understand Buffett or Lynch, you have to understand yourself.” The temperament part aside, a common investment philosophy is impractical because risk aversion, time horizon and tax considerations vary from investor to investor.

The time horizon aspect is the trickiest for professional money managers. When you invest other people’s money, it is not the fund manager’s time horizon but the client’s time horizon that matters. One cannot undertake a contrarian or deep value style of investing if the client’s time horizon is three months. This is why it is critical for them to have investors who understand and appreciate their investment philosophy. 

Now that the terms contrarian and deep value have crept in, let’s take a closer look at different investment philosophies. The first investment philosophy that Damodaran discusses is intrinsic value investing and in this fall two types of investors — value and growth investors.  The primary difference between value and growth investors is that value investors have an inherent suspicion about growth and want to buy a company for less than the value of assets in place. For value investors, growth is the icing on the cake. Growth investors, on the other hand, believe they can find companies where the market is underpricing growth.

Crossing the chasm 

As an intrinsic value investor, you might think you just bought a bargain, but that is where your troubles start. Damodaran reminds all those following the intrinsic value philosophy that, “The price is a given, the value is an estimate.” One of the problems that intrinsic value investors face is the gap that exists between value and price. A company’s value is derived from the cash flows generated from existing investments, the growth expected to be generated from those cash flows and the inherent risks in them. On the other side, market pricing of a security is a far more complex process driven by demand and supply, which in turn, is driven from everything ranging from behavioural factors, momentum and available liquidity. 

Having mentioned momentum and liquidity, Damodaran brings in a couple of other investing philosophies, namely technical analysts and arbitrageurs. 

The followers of these schools of thought are mostly concerned with price and care little about value. Likewise value investors, too, don’t obsess much with respect to the future when they buy as they believe that price will eventually converge with value. However, to make money consistently in the markets one has to understand the price and value equation and the gap between perceived value and market price has to narrow.

Let’s now take a look at price-based investment philosophies in greater detail.  In this camp are chartists who study price movements with the help of technical indicators and use that as a basis for investing. Damodaran is of the view that a growing body of evidence backs up technical analysts’ methods. He says, “Technical analysts are much more honest about what they are doing. They say, ‘We don’t know what the value is, but we have indicators that might tell us which direction the price is going’.” Then you have arbitrageurs who try to find the same asset trading at different prices in different markets and try to lock in on those price differences. 

Another investing philosophy that uses price as a benchmark is what Damodaran calls information traders. This set seeks to take advantage of new information that could result in a change in price. This pursuit comes with its own disadvantages, though. For one, information traders react to whatever the market does and have no anchor such as intrinsic value. Therefore, they tend to be pushed back and forth with price movements. Secondly, the key to their success lies in detecting shifts in the perception of other investors. This is next to impossible, as crowd behaviour is very tough to analyse.

Investigate and invest 

As the session progresses, Damodaran delves on the two investment philosophies that represent the extremes in the investing process — value investors and chartists. A true value investor is someone who buys stocks for less than what they are worth and believes in focusing on assets in place rather than future assets. He further classifies value investors into three categories on the basis of their approach — passive screeners, contrarian investors and activist value investors. 

Passive screeners follow Benjamin Graham’s famous tenets on screening. Graham was well ahead of his time and many of the screens that he devised delivered higher than market returns.  Damodaran then proceeds to examine some of these screens. The first of these is price-to-book. Over a long time period there seems to be no contest: low price-to-book stocks offer higher risk-adjusted returns than high price-to-book stocks. But then comes the caveat, “Some low price-to-book stocks deserve to trade at low price-to-book because they continue to generate terrible return on equity.” 

The second screen is low price-to-earnings (PE) ratio stocks that have historically delivered better returns than high PE stocks. Here, too, Damodaran offers a word of caution. “Earnings can be manipulated, so low PE stocks aren’t necessarily a bargain. Secondly, most low PE stocks also tend to be low growth. Not all growth creates value and earns more than the cost of capital.” The third screen is of high dividend yield stocks. While these, too, have delivered above-average returns over a period of time, the danger here is that not all companies can sustain the rate of dividends going forward. Relying on past dividends is like driving by looking at the rear-view mirror. 

Damodaran then offers the following advice. “Look for low PE, high growth, high return on equity and low price-to-book stocks. To be a successful passive screener, you need to devise better screens and minimise transaction costs. Also double check normalised, adjusted and owners’ earnings of firms as numbers can be made to lie.” 

Anything goes

The next category of value investors are contrarians who bet heavily on the losers. While this may look foolish, a study by the University of Wisconsin backs up contrarian investing. At the end of every year, the researchers took the top 50 and bottom 50 stocks of the S&P Index and compared their returns over a five-year period. The losers at the start of the period actually emerged as winners after five years and it took 18 months for the momentum to shift. 

The caveat here is that while the University of Wisconsin sample size may have worked, it is not as simple as it sounds. The fact remains that just because it has worked in the past does not mean that buying losers should work out in the future. Secondly, there is a risk arising from transaction costs in this style of investing. Of the 50 stocks in the study, half traded at less than a dollar, which meant transaction costs ate into excess returns.

The final category of value investors are activist value investors. They buy companies with a value or pricing gap and attempt to pro-actively bridge the gap. Activist investors buy a large stake in a badly managed company and change the way it is run. They do this by squeezing existing assets more efficiently, deriving more cash flows from them and by lowering the cost of capital for the firm. 

Damodaran classifies this valuation scenario in situations like this into two categories. The first he calls “status quo valuation” where he assumes the existing management will continue to run the company. The second category is where a more able competent management takes over and brings change. This he labels “optimum valuation” and is only possible with good corporate governance.

Tales of human folly 

Damodaran might not use technical analysis himself but he does not dismiss it as useless mumbo-jumbo. Technical analysis assumes that price trends can be used to predict future price movements with the help of charts.  This is because chartists assume that price is determined by the interaction of demand and supply. Technicians also assume that disregarding minor market distortions, stock prices move in trends that persist for some time and any change in trends caused by shift in demand and supply can be detected. Damodaran says a trend persists because price changes themselves may provide information to markets. “Thus, the fact that a stock has gone up continuously may be viewed as good news by investors, making it more likely that the price will go up than down.” 

Two other theories of repute used extensively in charting are the Elliott Wave Theory, which states that the market moves in waves lasting from a few trades to a century on the basis of which it is possible to determine the position of the market at all times. The second is the Dow Theory, which divides market movements into three time periods — the short daily fluctuations, the fluctuations running from a few weeks to a month and the long-term four year movement in trends.    

Depending on the school followed, the indicators used in technical analysis vary. The contrarian school here is of the view that as people overreact to news, extreme movements in stock prices will be followed by more extreme movements in the reverse direction. Indicators used in conjunction with this belief are support and resistance lines, moving averages and volume indicators. Secondly, markets learn slowly and some investors are sharper than the market and thus make excess returns. Indicators used to take advantage of such price drifts include the relative strength index and trend lines. 

Here, too, Damodaran has a few pearls of wisdom for those intending to punt on the basis of the charts.  “The success of these strategies depends upon timely trading. As an investor you need to monitor prices closely and look for triggers. It is also essential to back test the indicator being used to ensure that it delivers the returns expected.” In a sense he says “we are all market timers, and there lies the problem. When everyone tries to do it, it is difficult to win. 

Peek inside

As far as his personal investing is concerned, Damodaran says his portfolio gets revalued every year. He says, “I hold about 45 stocks and value everything every year. Every stock has to justify being held based on what the value is today, not what it has done for me.” Clearly Damodaran is not sentimental about what he holds and applies exacting valuation standards to his portfolio, “If you have a well thought out valuation, every number should have a story behind it. You need to justify why the number is what it is.” 

If he has a grouse, it is more to do with the disproportionate time that is spent talking about buying stocks than being told to sell them. “When you look at the time spent talking about what to buy and when to sell, the time spent is asymmetric. You almost never hear talk about when you should sell.”