Aswath Damodaran: Where Is The “Value” In Value Investing? by DD D via Slide Share
Who is a value investor?
Three faces of value investing…
- Passive Screeners: Following in the Ben Graham tradition, you screen for stocks that have characteristics that you believe identify under valued stocks.
- Contrarian Investors: These are investors who invest in companies that others have given up on, either because they have done badly in the past or because their future prospects look bleak.
- Activist Value Investors: These are investors who invest in poorly managed and poorly run ?rms but then try to change the way the companies are run.
The three biggest Rs of value investing
- Rigid: The strategies that have come to characterize a great deal of value investing reveal an astonishing faith in accounting numbers and an equally stunning lack of faith in markets getting anything right. Value investors may be the last believers in book value. The rigidity extends to the types of companies that you buy (avoiding entire sectors…)
- Righteous: Value investors have convinced themselves that they are better people than other investors. Index fund investors are viewed as “academic stooges”, growth investors are considered to be “dilettantes” and momentum investors are “lemmings”. Value investors consider themselves to be the grown ups in the investing game.
- Ritualistic: Modern day value investing has a whole menu of rituals that investors have to perform to meet be “value investors”. The rituals range from the benign (claim to have read “Security Analysis” by Ben Graham and every Berkshire Hathaway annual report) to the not-so-benign…
Myth 1: DCF valuation is an academic exercise…
The value of an asset is the present value of the expected cash ?ows on that asset, over its expected life:
Proposition 1: If “it” does not affect the cash ?ows or alter risk (thus changing discount rates), “it” cannot affect value.
Proposition 2: For an asset to have value, the expected cash ?ows have to be positive some time over the life of the asset.
Proposition 3: Assets that generate cash ?ows early in their life will be worth more than assets that generate cash ?ows later; the latter may however have greater growth and higher cash ?ows to compensate.
Here is what the value of a business rests on… in DCF valuation
Myth 2: Beta is greek from geeks…and essential to DCF valuation
- Dispensing with all of the noise, here are the underpinnings for using beta as a measure of risk:
- Risk is measured in volatility in asset prices
- The risk in an individual investment is the risk that it adds to the investor’s portfolio
- That risk can be measured with a beta (CAPM) or with multiple betas (in the APM or Multi-factor models)
- Beta is a measure of relative risk: Beta is a way of scaled risk, with the scaling around one. Thus, a beta of 1.50 is an indication that a stock is 1.50 times as risky as the average stock, with risk measured as risk added to a portfolio.
- Beta measures exposure to macroeconomic risk: Risk that is specific to individual companies will get averaged out (some companies do better than expected and others do worse). The only risk that you cannot diversify away is exposure to macroeconomic risk, which cuts across most or all investments.
If you don’t like betas, here are your alternatives
- Market price based alternatives
- Relative volatility: The ratio of a company’s standard deviation to standard deviation of average company in market
- Implied costs of equity and capital: Backed out of current stock prices…
- If you don’t like betas because they are based on stock prices, you won’t like these alternatives either.
- Accounting information based alternatives
- Accounting earnings volatility: The ratio of the stability in earnings in your company, relative to other companies.
- Accounting ratios: Ratios that capture ?nancial leverage (debt ratios) and liquidity of assets (current ratios).
- Accountants are better at measuring default risk than equity risk.
- Proxies for risk
- Dividend Yield: Higher dividend yields -> Less risk
- Sector: Technology is risky, consumer product companies are not…
- Company size: Small companies are risky, big companies are not…
And doing your homework is not going to make the big risks go away…
- There is a widely held view among value investors that they are not as exposed to risk as the rest of the market, because they do their homework, poring over ?nancial statements or using ratios to screen for risky stocks. Put simply, they are assuming that the more they know about an investment, the less risky it becomes.
- That may be true from some peripheral risks and a few ?rm specific risks, but it definitely is not for the macro risks (which is all that you bring into the discount rate in a conventional risk and return model). You cannot make a cyclical company less cyclical by studying it more or take the nationalization risk out of Venezuelan company by doing more research.
Implication 1: The need for diversification does not decrease just because you are a value investor who picks stocks with much research and care.
Implication 2: You can be a good value investor and your picks can still lose money.
Myth 3: The “Margin of Safety” is an alternative to beta and works better
- The margin of safety is a buffer that you build into your investment decisions to protect yourself from investment mistakes. Thus, if your margin of safety is 30%, you will buy a stock only if the price is more than 30% below its “intrinsic” value. There is nothing wrong with using the margin of safety as an additional risk measure, as long as the following are kept in mind:
- Proposition 1: MOS comes into play at the end of the investment process, not at the beginning.
- Proposition 2: MOS does not substitute for risk assessment and intrinsic valuation, but augments them.
- Proposition 3: The MOS cannot and should not be a ?xed number, but should be re?ective of the uncertainty in the assessment of intrinsic value.
- Proposition 4: Being too conservative can be damaging to your long term investment prospects. Too high a MOS can hurt you as an investor.
See full slides below.