Aswath Damodaran – Investment Philosophies NYU Classes [Part III]VW Staff
Aswath Damodaran just started uploading his NYU class lectures – we have posted the first batch below, which we hope readers will enjoy. Check back since there is a lot more coming or better yet, sign up for our free daily newsletter to ensure you never miss a post.
Also see The Little Book of Valuation: How to Value a Company, Pick a Stock and Profit, Investment Valuation: Tools and Techniques for Determining the Value of Any Asset,Damodaran on Valuation: Security Analysis for Investment and Corporate Finance and Applied Corporate Finance
Aswath Damodaran, in part three of these investment philosophies videos, talks about activist growth investing, information trading, pure and near arbitrage and much more.
Investment Philosophies: Activist Growth Investing – Be your own change agent
In this session, we look at growth investing strategies where you not only invest in growth companies but also play a role in their growth. In particular, we focus on venture capital investing, by looking at the process by which a young, start-up negotiates with a venture capitalist and how the latter tries to profit from the investment. We also evaluate the failure risk that venture capitalists face, while investing in young companies, and the overall returns generated by venture capital investing over long time periods.
Investment Philosophies: Growth Investing – Against the tide of history?
In this session, we wrap up our discussion of growth investing by looking at why some investors may choose to be growth investors, even though it has historically not delivered the types of return that value investing has. In particular, we note that investors who are good at timing macro or market-wide shifts in interest rates and earnings can also generate high returns from growth investing. We also present evidence that activity (collecting and processing information, doing research) has a much bigger payoff with growth stocks than with value stocks, perhaps because markets make bigger mistakes with growth stocks and investors are far more likely to give up on intrinsic valuation.
Investment Philosophies: Information Trading – Trading on the news
In this session, we introduce information trading (as a philosophy) by first delineating how efficient markets should respond to new information, as opposed to slow learning or over reacting markets. We then lay out different ways in which investors can play the information game: by getting a whiff of forthcoming information announcements (from private sources, rumors or research) and trading on that basis, by trading on the information announcement itself on the assumption that the immediate market reaction is likely to be skewed or investing after the announcement on the presumption that markets learn slowly or over react.
Investment Philosophies: Information Trading – Following the insiders
In this session, we look at a strategy of following the insiders in a company, buying when they are buying and selling when they are, on the assumption that insiders know more about a company’s value than market participants. To evaluate whether this strategy works, we first look at whether insider trading is a good predictor of stock returns in subsequent time periods. While we do find that insider buying (selling) is followed by positive (negative) market returns, we also find that the signal is often wrong and that timely access to the insider trading information is critical. We also find insider trading is more predictive, if top executives are involved and at smaller companies. Finally, we conclude that we would generate far more lucrative payoffs if we had access to illegal insider trading information.
Investment Philosophies: Information Trading – Following the analysts
In this session, we look at equity research analysts and consider whether following their advice is a market-beating strategy. We begin by looking at earnings estimates from analysts and note that while they are better predictors of actual earnings than time series models (which use only past earnings), the improvement in accuracy is modest and primarily in short term forecasts. We also note that revisions made by analysts to earnings estimates often generate short-term price momentum in stocks, perhaps because analysts can get clients to trade on those revisions. Finally, we look at analyst recommendations, by first reporting on the bias in the process (with positive recommendations vastly outnumbering negative recommendations) and then looking at the price impact of these recommendations. We note that sell recommendations have larger, long-term price impact than buy recommendations and that some analysts have more impact than others, either because their recommendations are built around stronger narratives or because they have more institutional following. A strategy of investing based upon analyst recommendations is unlikely to yield high returns unless it is focused on smaller, less followed companies and more influential, unbiased analysts.
Investment Philosophies: Information Trading – Public Information – Earnings Reports
In this session, we begin our discussion of trading based upon public information by looking at earnings reports. Since markets react to the news in earnings reports, we begin by categorizing that news into good, neutral and bad, by comparing the actual earnings to the predicted earnings. Not only do we see a price change that is consistent with the nature and magnitude of the surprise (positive price changes on positive surprises) but we also see two other phenomena. The first is that prices start to drift in the direction of the surprise even before the earnings report is made public (suggesting that someone is trading illegally ahead of the report) and that they continue to drift in the same direction after the report comes out (suggesting a slow learning market). We also look at earnings reports that are delayed and find that they are more likely to contain bad news. Finally, we look at the speed of price reaction on the day of the report and find that prices adjust quickly to earnings surprises, suggesting that any investment strategy built around earnings surprises has to be built around speedy trading/execution.
Investment Philosophies: Information Trading – Public information, other than earnings
In this session, we turn our attention to public announcements other than earnings. We begin by looking at acquisition announcements, establishing that the winners in acquisitions are clearly target company stockholders and that many acquisitions don’t work in delivering value to acquiring company stockholders either at the time of the announcement or in the years after. We look at investment strategies built around acquisitions, with the most lucrative one being the identification of potential target companies ahead of the acquisition announcements. We also look at stock splits, where the evidence of a price reaction is mixed, and dividend announcements, where increases (decreases) in dividends are accompanied by stock price increases (decreases), though the price effect has decreased over time.
Investment Philosophies: Too Good to be true? Pure Arbitrage
In this session, we lay down the requirements for pure arbitrage: assets that have identical cash flows that trade at different prices at the same point in time in different markets, with a guarantee that that the price difference will close. We note that pure arbitrage is most likely to occur in the derivatives markets and establish the arbitrage relationships that should govern the pricing of futures and options. With futures on storable commodities and financial assets, we create positions that have the same cash flows and risk using the futures and the underlying assets, and argue that if these positions have different costs, arbitrage is possible. With options, we introduce the notion of a replicating portfolio, where combining the underlying asset with borrowing/lending can create the same cash flows as an option, and argue that arbitrage is possible if the option and the replicating portfolio trade at different prices. We also look at arbitrage across options (calls and puts, options with different strike prices). With both futures and options, we conclude that arbitrage opportunities seem to exist in the early years after a new derivative is listed but fade as investors learn how to price the derivative.
Investment Philosophies: Close Enough? Near Arbitrage
In this session, we look at near arbitrage, where you have two very similar (but not identical) assets trading at different prices at the same point in time or two identical assets that are mispriced with no guarantee that the price difference will close. In both cases, we argue that while you can create low-risk positions, it is impossible to create the riskless, guaranteed profit positions that characterize pure arbitrage. We look at three examples of near arbitrage: a stock that is listed and traded on different markets (either as a multiple listing or depository receipt), a closed end fund (with the possibility of liquidation or open ending) and convertible mispricing (where the stocks, bonds, convertible bonds and options on the same company are mispriced, relative to each other). With each of these, we argue that investors with sufficient capital and the power to force convergence can make excess returns.
Investment Philosophies: Close Enough? Near Arbitrage
In this session, we focus on strategies that are often labeled as “arbitrage” but are really speculative, risky strategies that may or may not generate excess returns. First, we look at paired arbitrage, a practice of finding two companies that have historically moved together, where the current price relationship is not consistent with historic norms. While the strategy has made money for investors over time, the evidence suggests that the returns have come with risk and that the excess returns have faded over time. Second, we examine “merger arbitrage”, the practice of buying target company shares after a merger/acquisition is announced, hoping to make money from the price being higher when the deal is consummated. Again, while the returns are generally positive, it is exposed to the risk that the acquisition may fail, causing the stock price to drop back to pre-announcement levels. With speculative arbitrage strategies, we note the importance of adjusting borrowing (financial leverage) to reflect the risk in the strategy. We close the session by looking at hedge funds, noting three findings: that they have historically generated higher returns, given their risk exposures, than the rest of the market, that these higher returns come from a few big hedge fund winners (rather than from overall consistency) and that the worst hedge funds usually go out of business.