INVESTMENT PHILOSOPHY:

THE SECRET INGREDIENT IN

INVESTMENT SUCCESS

WHAT IS AN INVESTMENT
PHILOSOPHY?
An investment philosophy is a coherent way of
thinking about markets, how they work (and
sometimes do not) and the types of mistakes that
you believe consistently underlie investor behavior.
An investment strategy is much narrower. It is a way
of putting into practice an investment philosophy.
For lack of a better term, an investment philosophy
is a set of core beliefs that you can go back to in
order to generate new strategies when old ones do
not work.

INGREDIENTS OF AN INVESTMENT
PHILOSOPHY
Step 1: All investment philosophies begin with a view
about how human beings learn (or fail to learn).
Underlying every philosophy, therefore is a view of
human frailty - that they learn too slowly, learn too fast,
tend to crowd behavior etc.
Step 2: From step 1, you generate a view about markets
behave and perhaps where they fail. Your views on
market efficiency or inefficiency are the foundations for
your investment philosophy.
Step 3: This step is tactical. You take your views about how
investors behave and markets work (or fail to work) and
try to devise strategies that reflect your beliefs.

AN EXAMPLE..
Market Belief: Investors over react to news
Investment Philosophy: Stocks that have had bad
news announcements will be under priced relative
to stocks that have good news announcements.
Investment Strategies:
Buy (Sell short) stocks after bad (good) earnings
announcements
Buy (Sell short) stocks after big stock price declines
(increases)

WHY DO YOU NEED AN INVESTMENT

PHILOSOPHY?
If you do not have an investment philosophy, you will find
yourself doing the following:
1. Lacking a rudder or a core set of beliefs, you will be easy
prey for charlatans and pretenders, with each one
claiming to have found the magic strategy that beats
the market.
2. Switching from strategy to strategy, you will have to
change your portfolio, resulting in high transactions costs
and paying more in taxes.
3. Using a strategy that may not be appropriate for you,
given your objectives, risk aversion and personal
characteristics. In addition to having a portfolio that
under performs the market, you are likely to find yourself
with an ulcer or worse.

The Investment Process

Utility
Functions

The Client
Investment Horizon

Risk Tolerance/
Aversion

Tax Status

Tax Code

The Portfolio Managers Job

Views on
markets

Asset Classes:
Countries:

Valuation
based on
- Cash flows
- Comparables
- Technicals
Trading
Costs
- Commissions
- Bid Ask Spread
- Price Impact

Market
Timing

Asset Allocation
Stocks
Bonds
Real Assets
Domestic
Non-Domestic

Security Selection
- Which stocks? Which bonds? Which real assets?

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

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?

Views on
- inflation
- rates
- growth

Risk and Return

- Measuring risk
- Effects of
diversification

Private
Information

Market Efficiency
- Can you beat
the market?

Trading
Speed

Trading Systems
- How does trading
affect prices?

Stock
Selection

Risk Models
- The CAPM
- The APM

UNDERSTANDING THE CLIENT

(INVESTOR)
There is no one perfect portfolio for every client.
To create a portfolio that is right for an investor, we
need 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 your
own money), know yourself.

I. MEASURING RISK
Risk is not a bad thing to be avoided, nor is it a
good thing to be sought out. The best definition of
risk 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 in
terms of volatility or standard deviation

WHAT WE KNOW ABOUT INVESTOR

RISK PREFERENCES..
Whether we measure risk in quantitative or
qualitative 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 a
function 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, the

less of his or her portfolio should be in risky assets
(such as equities).

RISK AND RETURN MODELS IN

FINANCE
Step 1: Defining Risk
The risk in an investment can be measured by the variance in actual returns around an
expected return
Riskless Investment
Low Risk Investment
High Risk Investment

E(R)
E(R)
E(R)
Step 2: Differentiating between Rewarded and Unrewarded Risk
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 assets
1. each investment is a small proportion of portfolio
are affected by it.
2. risk averages out across investments in portfolio
The marginal investor is assumed to hold a diversified portfolio. Thus, only market risk will
be rewarded and priced.
Step 3: Measuring Market Risk
The CAPM
If there is
1. no private information
2. no transactions cost
the optimal diversified
portfolio includes every
traded asset. Everyone
will hold this market portfolio
Market Risk = Risk
added by any investment
to the market portfolio:

The APM
If there are no
arbitrage opportunities
then the market risk of
any asset must be
captured by betas
relative to factors that
affect all investments.
Market Risk = Risk
exposures of any
asset to market
factors

Multi-Factor Models
Since market risk affects
most or all investments,
it must come from
macro economic factors.
Market Risk = Risk
exposures of any
asset to macro
economic factors.

Beta of asset relative to

Market portfolio (from
a regression)

Betas of asset relative

to unspecified market
factors (from a factor
analysis)

Betas of assets relative

to specified macro
economic factors (from
a regression)

Proxy Models
In an efficient market,
differences in returns
across long periods must
be due to market risk
differences. Looking for
variables correlated with
returns should then give
us proxies for this risk.
Market Risk =
Captured by the
Proxy Variable(s)
Equation relating
returns to proxy
variables (from a
regression)

SOME QUIRKS IN RISK AVERSION

Individuals are far more affected by losses than equivalent gains (loss
aversion), and this behavior is made worse by frequent monitoring
(myopia).
The choices that people make (and the risk aversion they manifest) when
presented with risky choices or gambles can depend upon how the
choice is presented (framing).
Individuals tend to be much more willing to take risks with what they
consider found money than with money that they have earned (house
money effect).
There are two scenarios where risk aversion seems to decrease and even
be replaced by risk seeking. One is when individuals are offered the
chance of making an extremely large sum with a very small probability of
success (long shot bias). The other is when individuals who have lost
money are presented with choices that allow them to make their money
back (break even effect).
When faced with risky choices, whether in experiments or game shows,
individuals often make mistakes in assessing the probabilities of
outcomes, over estimating the likelihood of success,, and this problem
gets worse as the choices become more complex.

INVESTOR TIME HORIZON

An investors time horizon reflects

personal characteristics: Some investors have the patience

needed to hold investments for long time periods and others
do 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 time
horizon will be.

An investors time horizon can have an influence on

both 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 all
less patient than we think we are)

The Investment Process

Utility
Functions

The Client
Investment Horizon

Risk Tolerance/
Aversion

Tax Status

Tax Code

The Portfolio Managers Job

Views on
markets

Asset Classes:
Countries:

Valuation
based on
- Cash flows
- Comparables
- Technicals
Trading
Costs
- Commissions
- Bid Ask Spread
- Price Impact

Market
Timing

Asset Allocation
Stocks
Bonds
Real Assets
Domestic
Non-Domestic

Security Selection
- Which stocks? Which bonds? Which real assets?

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

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?

Views on
- inflation
- rates
- growth

Risk and Return

- Measuring risk
- Effects of
diversification

Private
Information

Market Efficiency
- Can you beat
the market?

Trading
Speed

Trading Systems
- How does trading
affect prices?

Stock
Selection

Risk Models
- The CAPM
- The APM

ASSET ALLOCATION
The first step in portfolio management is the asset
allocation decision.
The asset allocation decision determines what
proportions of the portfolio will be invested in different
asset classes - stocks, bonds and real assets.
Asset allocation can be passive,
It can be based upon the mean-variance framework: trading
off higher expected return for higher standard deviation.
It can be based upon simpler rules of diversification or market
value based

When asset allocation is determined by market views, it

is active asset allocation.

I. PASSIVE ASSET ALLOCATION

In passive asset allocation, the proportions of the
various asset classes held in an investors portfolio
will be determined by the risk preferences of that
particular 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 a
certain risk level
The proportions of risky assets can mirror the market values
of the asset classes. Any deviation from these proportions
will lead to a portfolio that is over or under weighted in
some asset classes and thus not fully diversified. The risk
aversion of an investor will show up only in the riskless asset
holdings.

A. EFFICIENT (MARKOWITZ)
PORTFOLIOS
Return Maximization
Risk Minimization
Maximize Expected Return Minimize return
variance i= n
i =n j =n
E(R p ) = wi E(R i )

2p = wi w j ij

i =1

subject to
where,

i=1 j =1

i = n j =n

2
p

= wi wj ij
i =1 j=1

i= n

)
E(R p ) = wi E(R i ) = E(R
i =1

2 = Investor's desired level of variance

E(R) = Investor's desired expected returns

LIMITATIONS OF THIS APPROACH

This approach is heavily dependent upon three
assumptions:
That investors can provide their risk preferences in terms of
variance
They do not care about anything but mean and variance.
That the variance-covariance matrix between asset classes
remains stable over time.

If correlations across asset classes and covariances

are unstable, the output from the Markowitz
portfolio approach is useless.

THE OPTIMALLY DIVERSIFIED

PORTFOLIO
Global Investable Capital: 1998

Venture
Capital
Emerging Markets
US Real Estate
3%
4%
US Equity
22%

Cash Equivalents
5%

International Bonds
26%
International Equity
20%

US Bonds
19%

II. ACTIVE ASSET ALLOCATION

(MARKET TIMING)
The payoff to perfect timing: In a 1986 article, a group of researchers
raised the shackles of many an active portfolio manager by
estimating that as much as 93.6% of the variation in quarterly
performance at professionally managed portfolios could be
explained by the mix of stocks, bonds and 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 out
of the market during bad months. He concluded that an investor
who would have missed the 50 weakest months of the market
between 1946 and 1991 would have seen his annual returns almost
double from 11.2% to 19%.
Across funds: Ibbotson examined the relative importance of asset
allocation and security selection of 94 balanced mutual funds and 58
pension funds, all of which had to make both asset allocation and
security selection decisions. Using ten years of data through 1998,
Ibbotson finds that about 40% of the differences in returns across
funds can be explained by their asset allocation decisions and 60%
by security selection.

MARKET TIMING STRATEGIES

Asset Allocation: Adjust your mix of assets, allocating
more than you normally would (given your time horizon
and risk preferences) to markets that you believe are
under valued and less than you normally would to
markets that are overvalued.
Style Switching: Switch investment styles and strategies to
reflect expected market performance.
Sector Rotation: Shift your funds within the equity market
from 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 to
magnify profits.

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 winner
of 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 at
party before talk turns to stocks, average age of chatterers, fad
component)

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.

NON-FINANCIAL INDICATORS..
Spurious indicators that may seem to be correlated
with the market but have no rational basis. Almost
all spurious indicators can be explained by chance.
Feel good indicators that measure how happy are
feeling - presumably, happier individuals will bid up
higher stock prices. These indicators tend to be
contemporaneous rather than leading indicators.
Hype indicators that measure whether there is a
stock price bubble. Detecting what is abnormal
can be tricky and hype can sometimes feed on
itself before markets correct.

THE JANUARY EFFECT, THE WEEKEND

EFFECT ETC.
As January goes, so goes the year if stocks are up,
the market will be up for the year, but a bad
beginning usually precedes a poor year.
According to the venerable Stock Traders
Almanac that is compiled every year by Yale Hirsch,
this indicator has worked 88% of the time.

TRADING VOLUME
Price increases that occur without much trading volume are viewed
as less likely to carry over into the next trading period than those that
are accompanied by heavy volume.
At the same time, very heavy volume can also indicate turning points
in markets. For instance, a drop in the index with very heavy trading
volume is called a selling climax and may be viewed as a sign that
the market has hit bottom. This supposedly removes most of the
bearish investors from the mix, opening the market up presumably to
more optimistic investors. On the other hand, an increase in the index
accompanied by heavy trading volume may be viewed as a sign
that market has topped out.
Another widely used indicator looks at the trading volume on puts as
a ratio of the trading volume on calls. This ratio, which is called the
put-call ratio is often used as a contrarian indicator. When investors
become more bearish, they sell more puts and this (as the contrarian
argument goes) is a good sign for the future of the market.

INTEREST RATES
The same argument of mean reversion has been
made about interest rates. For instance, there are
many economists who viewed the low interest rates
in the United States in early 2000 to be an
aberration and argued that interest rates would
revert back to normal levels (about 6%, which was
the average treasury bond rate from 1980-2000).
The evidence on mean reversion on interest rates is
mixed. While there is some evidence that interest
rates revert back to historical norms, the norms
themselves change from period to period.

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 and
compare to actual level.,

Relative value models

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

THE PROBLEM WITH FUNDAMENTAL

INDICATORS..
There are many indicators that market timers use in
forecasting market movements. They can be
generally categorized into:
Macro economic Indicators: Market timers have at various
times claimed that the best time to invest in stocks is when
economic growth is picking up
Interest rate Indicators: Both the level of rates and the slope
of the yield curve have been used as predictors of future
market movements.

It is easy to show that markets are correlated with

fundamental indicators but it is much more difficult
to find leading indicators of market movements.

IV. TIMING OTHER MARKETS

It is not just the equity and bond markets that investors try to time. In
fact, it can be argued that there are more market timers in the
currency 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 and
momentum 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

SUMMING UP ON MARKET TIMING

A successful market timer will earn far higher returns
than a successful security selector.
Everyone wants to be a good market timer.
Consequently, becoming a good market timer is
not only difficult to do, it is even more difficult to
sustain.

TO BE A SUCCESSFUL MARKET TIMER

Understand the determinants of 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 shift
in the underlying relationship. As Wall Street would put it,
paradigm shifts wreak havoc on these models.
Even if you assume that the past is prologue and that there
will be reversion back to historic norms, you do not control
this part of the process..

And respect the market

You can believe the market is wrong but you ignore it at
your own peril.

The Investment Process

Utility
Functions

The Client
Investment Horizon

Risk Tolerance/
Aversion

Tax Status

Tax Code

The Portfolio Managers Job

Views on
markets

Asset Classes:
Countries:

Valuation
based on
- Cash flows
- Comparables
- Technicals
Trading
Costs
- Commissions
- Bid Ask Spread
- Price Impact

Market
Timing

Asset Allocation
Stocks
Bonds
Real Assets
Domestic
Non-Domestic

Security Selection
- Which stocks? Which bonds? Which real assets?

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

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?

Views on
- inflation
- rates
- growth

Risk and Return

- Measuring risk
- Effects of
diversification

Private
Information

Market Efficiency
- Can you beat
the market?

Trading
Speed

Trading Systems
- How does trading
affect prices?

Stock
Selection

Risk Models
- The CAPM
- The APM

SECURITY SELECTION
Security selection refers to the process by which
assets are picked within each asset class, once the
proportions for each asset class have been defined.
Broadly speaking, there are three different
approaches to security selection.
The first to focus on fundamentals and decide whether a
stock 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 changing
direction.
The third is to trade ahead of or on information releases that
will affect the value of the firm.

ACTIVE INVESTORS COME IN ALL

FORMS...
Fundamental investors can be

value investors, who buy low PE or low PBV stocks which trade at
less than the value of assets in place
growth investors, who buy high PE and high PBV stocks which
trade at less than the value of future growth

Technical investors can be

momentum investors, who buy on strength and sell on weakness

reversal investors, who do the exact opposite

Information traders can believe

that markets learn slowly and buy on good news and sell on bad
news
that markets overreact and do the exact opposite

They cannot all be right in the same period and no one

approach can be right in all periods.

THE MANY FACES OF VALUE

INVESTING
Intrinsic Value Investors: These investors try to estimate
the intrinsic value of companies (using discounted cash
flow models) and act on their findings.
Relative Value Investors: Following in the Ben Graham
tradition, these investors use multiples and fundamentals
to identify companies that look cheap on a relative
value basis.
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 firms but then try to
change the way the companies are run.

I. INTRINSIC VALUE INVESTORS: THE

DETERMINANTS OF INTRINSIC VALUE
DISCOUNTED CASHFLOW VALUATION

Expected Growth
Firm: Growth in
Operating Earnings
Equity: Growth in
Net Income/EPS

Cash flows
Firm: Pre-debt cash
flow
Equity: After debt
cash flows

Firm is in stable growth:

Grows at constant rate
forever

Terminal Value
Value
Firm: Value of Firm

CF1

CF2

CF3

CF4

CF5

CFn
.........
Forever

Equity: Value of Equity

Length of Period of High Growth

Discount Rate
Firm:Cost of Capital
Equity: Cost of Equity

DISCOUNTED CASHFLOW VALUATION

Cashflow to Firm
EBIT (1-t)
- (Cap Ex - Depr)
- Change in WC
= FCFF

Value of Operating Assets

+ Cash & Non-op Assets
= Value of Firm
- Value of Debt
= Value of Equity

Firm is in stable growth:

Grows at constant rate
forever

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

FCFF1
FCFF2
FCFF3
FCFF4
FCFF5
FCFFn
.........
Forever
Discount at WACC= Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity))

Cost of Equity

Riskfree Rate :
- No default risk
- No reinvestment risk
- In same currency and
in same terms (real or
nominal as cash flows

Expected Growth
Reinvestment Rate
* Return on Capital

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

Beta
- Measures market risk X

Type of
Operating
Business Leverage

Weights
Based on Market Value

Risk Premium
- Premium for average
risk investment

Financial
Leverage

Base Equity
Premium

Country Risk
Premium

Avg Reinvestment
rate = 25.08%

Embraer: Status Quo ($)

Current Cashflow to Firm

EBIT(1-t) :
$ 404
- Nt CpX
23
- Chg WC
9
= FCFF
$ 372
Reinvestment Rate = 32/404= 7.9%

Reinvestment Rate
25.08%

Return on Capital
21.85%
Stable Growth
g = 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%

Expected Growth
in EBIT (1-t)
.2185*.2508=.0548
5.48 %

Terminal Value
5= 288/(.0876-.0417) = 6272

$ Cashflows
Op. Assets $ 5,272
+ Cash:
795
- Debt
717
- Minor. Int.
12
=Equity
5,349
-Options
28
Value/Share $7.47
R$ 21.75

Year
EBIT(1-t)
- Reinvestment
= FCFF

1
426
107
319

2
449
113
336

3
474
119
355

4
500
126
374

Term Yr
549
- 261
= 288

5
527
132
395

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

Cost of Equity
10.52 %

Riskfree Rate :
$ Riskfree Rate= 4.17%

On October 6, 2003
Embraer Price = R$15.51

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

Beta
1.07

Unlevered Beta for

Sectors: 0.95

Weights
E = 84% D = 16%

Mature market
premium
4%
Firms D/E
Ratio: 19%

Lambda
0.27

Country Equity Risk

Premium
7.67%

Country Default
Spread
6.01%

Rel Equity
Mkt Vol
1.28

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 are
your 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.

TO MAKE MONEY ON INTRINSIC

VALUATION
You have to be able to value a company, given its
fundamental risk, cash flow and growth characteristics,
without being swayed too much by what the market
mood may be about the company and the sector.
The market has to be making a mistake in pricing one or
more of these fundamentals.
The market has to correct its mistake sooner or later for
you to make money.
Proposition 1: For intrinsic valuation to work, you have to
be willing to expend time and resources to understand
the company you are valuing and to relate its value to
its fundamentals.
Proposition 2: You need a long time horizon for intrinsic
valuation to pay off.
Proposition 3: Your universe of investments has to be
limited.

II. THE RELATIVE VALUE INVESTOR

In relative value investing, you compare how stocks
are priced to their fundamentals (using multiples) to
find under and over valued stocks.
This approach to value investing can be traced
back to Ben Graham and his screens to find
undervalued stocks.
In recent years, these screens have been refined
and extended and the availability of data and
more powerful screening techniques has allowed us
to expand these screens and back-test them.

BUFFETTS TENETS
Business Tenets:

The business the company is in should be simple and understandable.

The firm should have a consistent operating history, manifested in operating
earnings that are stable and predictable.
The firm should be in a business with favorable long term prospects.

Management Tenets:

The managers of the company should be candid. As evidenced by the way he

treated his own stockholders, Buffett put a premium on managers he trusted.
The managers of the company should be leaders and not followers.

Financial Tenets:

The company should have a high return on equity. Buffett used a modified
version of what he called owner earnings
Owner Earnings = Net income + Depreciation & Amortization Capital Expenditures

The company should have high and stable profit margins.

Market Tenets:

Use conservative estimates of earnings and the riskless rate as the discount rate.
In keeping with his view of Mr. Market as moody, even valuable companies can
be bought at attractive prices when investors turn away from them.

BE LIKE BUFFETT?
Markets have changed since Buffett started his first partnership.
Even Warren Buffett would have difficulty replicating his
success in todays market, where information on companies is
widely available and dozens of money managers claim to be
looking for bargains in value stocks.
In recent years, Buffett has adopted a more activist investment
style and has succeeded with it. To succeed with this style as
an investor, though, you would need substantial resources and
have the credibility that comes with investment success. There
are few investors, even among successful money managers,
who can claim this combination.
The third ingredient of Buffetts success has been patience. As
he has pointed out, he does not buy stocks for the short term
but businesses for the long term. He has often been willing to
hold stocks that he believes to be under valued through
disappointing years. In those same years, he has faced no
pressure from impatient investors, since stockholders in Berkshire
Hathaway have such high regard for him.

III. CONTRARIAN VALUE INVESTING:

BUYING THE LOSERS
The fundamental premise of contrarian value investing is
that markets often over react to bad news and push
prices 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 periods
chronicle that there is significant negative serial correlation in
returns, I.e, good years are more likely to be followed by bad
years and vice versa
Studies that focus on individual stocks find the same effect,
with stocks that have done well more likely to do badly over
the next period, and vice versa.

A VARIATION ON CONTRARIAN VALUE

INVESTING
If you accept the premise that markets become
over-enamored with companies that are viewed as
good and well managed companies and over-sold
on companies that are viewed as poorly run with
bad prospects, the former should be priced too
high and the latter too low.
A particularly perverse value investing strategy is to
pick badly managed, badly run companies as your
investments and wait for the recovery.

IV. ACTIVIST VALUE INVESTING

An activist value investor having acquired a stake in an
undervalued company which might also be badly
managed then pushes the management to adopt those
changes 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

More efficient
operations and
cost cuttting:
Higher Margins

Reduce the cost of capital

Make your
product/service less
discretionary

Revenues
* Operating Margin

Reduce beta

= EBIT
Divest assets that
have negative EBIT

- Tax Rate * EBIT

Cost of Equity * (Equity/Capital) +

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

= EBIT (1-t)
Reduce tax rate
- moving income to lower tax locales

Reduce
Operating
leverage

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

Match your financing

Interest advantage
to your assets:
Reduce your default
risk and cost of debt
Change financing
mix to reduce
cost of capital

Better inventory
management and
tighter credit policies

Firm Value

Increase Expected Growth

Reinvest more in
projects
Increase operating
margins

Increase length of growth period

Do acquisitions

Reinvestment Rate
* Return on Capital
= Expected Growth Rate

Increase capital turnover ratio

Build on existing
competitive
advantages

Create new
competitive
advantages

DETERMINANTS OF SUCCESS AT
ACTIVIST INVESTING
1. Have lots of capital: Since this strategy requires that you be
able to put pressure on incumbent management, you have to
be able to take significant stakes in the companies.
2. Know your company well: Since this strategy is going to lead a
smaller 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 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.
4. Be persistent: Incumbent managers are unlikely to roll over
and play dead just because you say so. They will fight (and
fight dirty) to win. You have to be prepared to counter.
5. Do your homework: You have to form coalitions with other
investors and to organize to create the change you are
pushing for.

GROWTH INVESTING
Value investors focus
assets in place

Assets
Existing Investments
Generate cashflows today
Includes long lived (fixed) and
short-lived(working
capital) assets
Expected Value that will be
created by future investments

Liabilities

Assets in Place

Debt

Growth Assets

Equity

Growth investors bet on growth assets: They believe

that they can assess their value better than markets

Fixed Claim on cash flows

Little or No role in management
Fixed Maturity
Tax Deductible

Residual Claim on cash flows

Significant Role in management
Perpetual Lives

GROWTH INVESTING STRATEGIES

Passive Growth Investing Strategies focus on
investing 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: Earnings
estimates revised upwards by analysts)
Small Cap Investing

Active growth investing strategies involve taking

larger positions and playing more of a role in your
investments. Examples of such strategies would
include:
Venture capital investing
Private Equity Investing

II. SMALL CAP INVESTING

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

INFORMATION TRADING
Information traders dont bet on whether a stock is
under or over valued. They make judgments on
whether the price changes in response to
information are appropriate.
There are two classes of information traders
Those that believe that markets learn slowly
Those that believe that markets over react

INFORMATION AND PRICES IN AN

EFFICIENT MARKET
Figure 10.1: Price Adjustment in an Efficient Market

Notice that the price

adjusts instantaneously
to the information

New information is revealed

Asset price

Time

A SLOW LEARNING MARKET

Figure 10.2 A Slow Learning Market

Asset price
The price drifts upwards after the
good news comes out.

New information is revealed

Time

AN OVERREACTING MARKET
Figure 10.3: An Overreacting Market

The price increases too much on the

good news announcement, and then
decreases in the period after.

New information is revealed

Asset price

Time

TO BE A SUCCESSFUL INFORMATION
TRADER
Identify the information around which your strategy will be built: Since you
have to trade on the announcement, it is critical that you determine in
advance the information that will trigger a trade.
Invest in an information system that will deliver the information to you
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 after
information announcements occur during these periods.
Execute quickly: Getting an earnings report or an acquisition announcement
in real time is of little use if it takes you 20 minutes to trade. Immediate
execution of trades is essential to succeeding with this strategy.
Keep a tight lid on transactions costs: Speedy execution of trades usually
goes with higher transactions costs, but these transactions costs can very
easily wipe out any potential you may see for excess returns).
Know when to sell: 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 even
reverse after a while.

The Investment Process

Utility
Functions

The Client
Investment Horizon

Risk Tolerance/
Aversion

Tax Status

Tax Code

The Portfolio Managers Job

Views on
markets

Asset Classes:
Countries:

Valuation
based on
- Cash flows
- Comparables
- Technicals
Trading
Costs
- Commissions
- Bid Ask Spread
- Price Impact

Market
Timing

Asset Allocation
Stocks
Bonds
Real Assets
Domestic
Non-Domestic

Security Selection
- Which stocks? Which bonds? Which real assets?

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

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?

Views on
- inflation
- rates
- growth

Risk and Return

- Measuring risk
- Effects of
diversification

Private
Information

Market Efficiency
- Can you beat
the market?

Trading
Speed

Trading Systems
- How does trading
affect prices?

Stock
Selection

Risk Models
- The CAPM
- The APM

TRADING AND EXECUTION COSTS

The cost of trading includes four components:
the brokerage cost, which tends to decrease as the size of
the trade increases
the bid-ask spread, which generally does not vary with the
size of the trade but is higher for less liquid stocks
the price impact, which generally increases as the size of the
trade increases and as the stock becomes less liquid.
the cost of waiting, which is difficult to measure since it shows
up as trades not made.

THE TRADE OFF ON TRADING

There are two components to trading and execution - the cost of
execution (trading) and the speed of execution.
Generally speaking, the tradeoff is between faster execution and
lower costs.
For some active strategies (especially those based on information)
speed is of the essence.
Maximize:
Subject to:

Speed of Execution
Cost of execution < Excess returns from strategy

For other active strategies (such as those based on long term

investing) the cost might be of the essence.
Minimize:
Subject to:

Cost of Execution
Speed of execution < Specified time period.

The larger the fund, the more significant this trading cost/speed
tradeoff becomes.

ARBITRAGE INVESTMENT STRATEGIES

An arbitrage-based investment strategy is based
upon buying an asset (at a market price) and
selling an equivalent or the same asset at a higher
price.
A true arbitrage-based strategy is riskfree and
hence can be financed entirely with debt. Thus, it is
a 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 those
adopted by hedge funds) have some residual risk
and require some investment.

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 create
riskfree 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 be
stored)
Futures on currencies and storable commodities have to obey
this 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.

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 listed

options outstanding, they have to be priced consistently with
each other and with the underlying securities.

C. PSEUDO ARBITRAGE
Quasi arbitrage is not really arbitrage since it is not even
close to riskless. You try to take advantage of what you
see as mispricing between two securities that you
believe 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 local
shares.
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 on
conversion/trading.

HEDGE FUNDS: WHAT DO THEY BRING

TO THE MARKET?
At the heart of all arbitrage based strategies is the
capacity to go long and short and the use of leverage.
If there is a common component to hedge funds, it is
their capacity to do both of these whereas conventional
mutual funds are restricted on both counts.
Proposition 1: In down or flat markets, hedge funds will
always look good relative to conventional mutual funds
because of their capacity to short stocks and other
assets.
Proposition 2: The use of leverage will exaggerate the
strengths and weaknesses of investors. A good hedge
fund 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 fund
manager, history suggests that the freedom they have
been granted will hurt more than help.

LOOKING A LITTLE CLOSER AT THE

NUMBERS
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 the
average return by the standard deviation this is
the commonly used Sharpe ratio for evaluating
money managers.
These funds are much more expensive than
traditional mutual funds, with much higher annual
fess and annual incentive fees that take away one
out of every five dollars of excess returns.

The Investment Process

Utility
Functions

The Client
Investment Horizon

Risk Tolerance/
Aversion

Tax Status

Tax Code

The Portfolio Managers Job

Views on
markets

Asset Classes:
Countries:

Valuation
based on
- Cash flows
- Comparables
- Technicals
Trading
Costs
- Commissions
- Bid Ask Spread
- Price Impact

Market
Timing

Asset Allocation
Stocks
Bonds
Real Assets
Domestic
Non-Domestic

Security Selection
- Which stocks? Which bonds? Which real assets?

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

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?

Views on
- inflation
- rates
- growth

Risk and Return

- Measuring risk
- Effects of
diversification

Private
Information

Market Efficiency
- Can you beat
the market?

Trading
Speed

Trading Systems
- How does trading
affect prices?

Stock
Selection

Risk Models
- The CAPM
- The APM

PERFORMANCE EVALUATION: TIME TO

PAY THE PIPER!
Who should measure performance?

Performance measurement has to be done either by the client or by an

objective third party on the basis of agreed upon criteria. It should not be
done by the portfolio manager.

How often should performance be measured?

The frequency of portfolio evaluation should be a function of both the time

horizon of the client and the investment philosophy of the portfolio
manager. However, portfolio measurement and reporting of value to
clients should be done on a frequent basis.

How should performance be measured?

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 and
market performance.
Based upon Tracking Error against a benchmark index

I. AGAINST A MARKET INDEX

80%

70%

60%

50%

40%

30%

20%

10%

1971

0%

II. AGAINST OTHER PORTFOLIO

MANAGERS
In some cases, portfolio managers are measured
against other portfolio managers who have similar
objective functions. Thus, a growth fund manager
may be measured against all growth fund
managers.
The implicit assumption in this approach is that
portfolio managers with the same objective
function have the same exposure to risk.

III. RISK-ADJUSTED RETURNS

The fairest way of measuring performance is to compare the actual
returns earned by a portfolio against an expected return, based
upon the risk of the portfolio and the performance of the market
during the period.
All risk and return models in finance take the following form:
Expected return = Riskfree Rate + Risk Premium
Risk Premium: Increasing function of the risk of the portfolio

The actual returns are compared to the expected returns to arrive at

a measure of risk-adjusted performance:
Excess Return = Actual Return - Expected Returns
The limitation of this approach is that there are no perfect (or even
good risk and return models). Thus, the excess return on a portfolio
may be a real excess return or just the result of a poorly specified
model.

IV. TRACKING ERROR AS A MEASURE

OF RISK
Tracking error measures the difference between a
portfolios return and its benchmark index. Thus
portfolios that deliver higher returns than the
benchmark but have higher tracking error are
considered riskier.
Tracking error is a way of ensuring that a portfolio
stays within the same risk level as the benchmark
index.
It is also a way in which the active in active
money management can be constrained.

SO, WHY IS IT SO DIFFICULT TO WIN AT

THIS 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 up
playing with other winners.
As markets develop and become deeper, this tendency is
exaggerated.

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.

WHAT MAKES YOU SPECIAL?

Institutional claims
We are bigger : Size is relative. You may be big but someone is
always bigger. Even if you are the biggest investor, it is difficult to see
what 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 and
claim 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
PHILOSOPHY
Short term (days to
a few weeks)

Medium term (few

months to a couple
of years)

Long Term (several

years)

Momentum
Technical momentum
indicators Buy stocks based
upon trend lines and high
trading volume.
Information trading: Buying
after positive news (earnings
and dividend announcements,
acquisition announcements)
Relative strength: Buy stocks
that have gone up in the last
few months.
Information trading: Buy
small cap stocks with
substantial insider buying.

Passive growth investing:

Buying stocks where growth
trades at a reasonable price
(PEG ratios).

Contrarian
Opportunisitic
Technical contrarian
Pure arbitrage in
indicators These can
derivatives and fixed
be for individual stocks
income markets.
or for overall market.
Tehnical demand
indicators Patterns in
prices such as head and
shoulders.
Market timing, based
upon normal range of
indicators.
Information trading:
Buying after bad news
(buying a week after
bad earnings reports
and holding for a few
months)
Passive value investing:
Buy stocks with low
PE, PBV or PS ratios.
Contrarian value
investing: Buying
losers or stocks with
lots of bad news.

Near arbitrage
opportunities: Buying
discounted closed end
funds
Speculative arbitrage
opportunities: Buying
paired stocks and
merger arbitrage.
Active growth
investing: Take stakes
in small, growth
companies (private
equity and venture
capital investing)
Activist value investing:
Buy stocks in poorly

THE RIGHT INVESTMENT PHILOSOPHY

Single Best Strategy: You can choose the one strategy that
best suits you. Thus, if you are a long-term investor who
believes that markets overreact, you may adopt a passive
value investing strategy.
Combination of strategies: You can adopt a combination of
strategies to maximize your returns. In creating this combined
strategy, 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 of
buying on relative strength would not be compatible with a strategy of
buying stocks after very negative earnings announcements. The first
strategy is based upon the assumption that markets learn slowly
whereas the latter is conditioned on market overreaction.
When you mix strategies, you should separate the dominant strategy
from the secondary strategies. Thus, if you have to make choices in
terms of investments, you know which strategy will dominate.

IN CLOSING
Choosing an investment philosophy is at the heart
of successful investing. To make the choice, though,
you need to look within before you look outside. The
best strategy for you is one that matches both your
personality and your needs.
Your choice of philosophy will also be affected by
what you believe about markets and investors and
how they work (or do not). Since your beliefs are
likely to be affected by your experiences, they will
evolve over time and your investment strategies
have to follow suit.

IF YOU WALK LIKE A LEMMING, RUN

LIKE A LEMMING YOU ARE A
LEMMING