value investing: the passive...

VALUEINVESTING:THEPASSIVEVERSION

AswathDamodaran

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TheScreeners

• Inpassivevalueinvesting,youscreencompaniesbaseduponeitherqualitativeorquantitativefactorstofind“cheap”companies.

• Qualitativescreening:Investorslookfor“good”companies,preferablywithlittleornorisk,andbuyandholdthesecompanies.

• Quantitativescreening:TracingtheirlineagebacktoBenGraham,thescreenerstrytofindcheapstocksbyscreeningstocks,usingpricingmultiplesinconjunctionwithotherscreens

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A.Justfindgoodcompanies

¨ Thereisabranchofvalueinvestingthatarguesthatthekeytosuccessininvestingistojustbuy“good”companiesandholdthemforthelongterm.

¨ Therearetwodetailsonwhichinvestorsevenwithinthisschooldisagree:¤ Whatisa”good”company?Somedefinegoodtomeanthecapacitytogeneratehighcashflows,someintermsofstabilityinthesecashflowsandsomeintermsofmoats(competitiveadvantages).Mostuseacombination.

¤ Howlongtermislongterm?Theconsensusseemstobethatthishastobemanyyears,notmonths.

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GoodandBadCompanies

Excellentcompaniesarenotalwaysexcellentinvestments..

¨ Thereisevidencethatwellmanagedcompaniesdonotalwaysmakegreatinvestments.

¨ Forinstance,excellentcompanies(usingtheTomPetersstandard)earnpoorerreturnsthan“unexcellentcompanies”.

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ANewerStudytobackthatup..

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B.QuantitativeScreens

¨ Inthisapproach,investorsusepricingscreensforcheapnesstofindtheirstocks.Whiletherearemanyscreens,theycanbebroadlyclassifiedintothreegroups:• Bookvaluescreens:Buystockswherethecompanytradesatlessthanbookvalueoratleastalowmultipleofthebookvalue.

• EarningsMultiplescreens:Buyassetswheretheassettradesatalowmultipleofearnings.

• CashYieldscreens:Buystockswithhighyields.Initsstrictestform,thecashflowisjustdividends.Inmoregeneralform,itcanbebaseduponaugmenteddividends(withbuybacks)orevenpotentialdividends.

• Insomecases,investorsaddotherscreensforfundamentals(growth,risk,cashflow)toensurethatthereisnogoodreasonforthecheapness.

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1.Price/BookValueScreens:LowP/BVstocksarewinners..

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Patternsintime:USstocks

PBVRatio 1952-2018 1969-2018 1999-2018

LowestPBV 16.46% 15.38% 9.34%2 16.48% 14.91% 10.57%3 15.25% 13.03% 8.44%4 12.52% 11.97% 7.36%5 13.36% 12.67% 9.57%6 12.78% 11.81% 9.98%7 11.63% 11.75% 8.86%8 11.85% 12.60% 10.46%9 12.10% 11.90% 8.12%

HighestPBV 11.04% 10.43% 7.92%

LowestvsHighest 5.42% 4.96% 1.42%

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EvidencefromInternationalMarkets

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CaveatEmptoronP/BVratios

¨ Ariskproxy:FamaandFrenchpointoutthatlowprice-bookvalueratiosmayoperateasameasureofrisk,sincefirmswithpriceswellbelowbookvaluearemorelikelytobeintroubleandgooutofbusiness.Investorsthereforehavetoevaluateforthemselveswhethertheadditionalreturnsmadebysuchfirmsjustifiestheadditionalrisktakenonbyinvestinginthem.

¨ Lowqualityreturns/growth:ThepricetobookratioforastablegrowthfirmcanbewrittenasafunctionofitsROE,growthrateandcostofequity:

¤ Companiesthatareexpectedtoearnlowreturnsonequitywilltradeatlowpricetobookratios.Infact,ifyouexpecttheROE<Costofequity,thestockshouldtradeatbelowbookvalueofequity.

(Return on Equity - Expected Growth Rate)(Return on Equity - Cost of Equity)

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Andachangingworldhasmadebookvalueslessrelevant

¨ Thebasisforbookvaluebasedinvestingisthatbookvaluemeasurescapitalinvestedinacompany,albeitfromanaccountingstandpoint.

¨ Thatmaybeadefensibleargumentwithmanufacturingortangibleassetbasedcompanies,butitisgettingincreasinglydifficulttosustainastheeconomytiltstowardsservicebasedortechnologycompanies.

¨ Inconsistenciesinaccountingcancauseinvestmentsmadebythesecompaniestobeeithermismeasured ormissedentirely,leadingtobookvaluesthatdon’ttrulymeasurecapitalinvestedinabusinessoritsassets.

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PricetoBookovertime:S&P500

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2.Price/EarningsRatioScreens:TheLowPEstoryhaslegs…

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Butisitfading?

PERatio 1952-2018 1969-2018 1999-2018LowestPE 17.96% 15.08% 11.66%

2 17.21% 14.30% 10.91%3 16.05% 13.90% 10.36%4 14.73% 13.85% 8.98%5 13.99% 12.25% 7.82%6 12.27% 11.57% 8.34%7 11.70% 11.34% 7.35%8 12.03% 12.04% 9.02%9 10.23% 10.21% 7.44%

HighestPE 11.82% 10.98% 9.98%

LowestvsHighest 6.14% 4.10% 1.68%

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Whatcangowrong?

¨ Companieswithhigh-riskearnings:Theexcessreturnsearnedbylowpriceearningsratiostockscanbeexplainedusingavariationoftheargumentusedforsmallstocks,i.e.,thattheriskoflowPEratiosstocksisunderstatedintheCAPM.Arelatedexplanation,especiallyintheaftermathoftheaccountingscandalsofrecentyears,isthataccountingearningsissusceptibletomanipulation.

¨ TaxCosts:Asecondpossibleexplanationthatcanbegivenforthisphenomenon,whichisconsistentwithanefficientmarket,isthatlowPEratiostocksgenerallyhavelargedividendyields,whichwouldhavecreatedalargertaxburdenforinvestorssincedividendsweretaxedathigherratesduringmuchofthisperiod.

¨ LowGrowth:Athirdpossibilityisthatthepriceearningsratioislowbecausethemarketexpectsfuturegrowthinearningstobeloworevennegative.ManylowPEratiocompaniesareinmaturebusinesseswherethepotentialforgrowthisminimal.

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Avariantonearningsmultiples:EV/EBITDA

EV/EBITDA=(Marketvalueofequity+Debt– Cash)/EBITDA

¨TheproponentsofthismultiplearguethatitisbetterthanPE,becauseitislessimpactedbyfinancialleverageandfocusedonacashflowmeasure,ratherthanearnings.¨Therearetwocounterarguments:

¤ EBITDAisnotafreecashflow,becauseyouhavetopaytaxesandcoverreinvestmentneeds.

¤ AswithPEratios,youhavetobecarefulaboutcheckingforriskinEBITDAandlowgrowthorlowqualitygrowth(lowreturnoncapital)

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Andacaveataboutchangingtimes..

¨ Justasbookvaluemeasurementshavebeenskewedbytheshiftineconomiestowardsserviceandtechnologycompanies,earningshavealsobeenaffected.

¨ Ifthelargestcapitalexpendituresofcompaniesaretreatedasoperatingexpenses(asisthecasewithR&Dattechnologycompanies),youwillunderstateearningsatthesecompaniesandoverstatePEratios.

¨ ApurePEapproachmaythenfindthesecompaniestobeexpensive,evenwhentheyarenot.

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3.DividendYields

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Andhowithasheldupovertime..

DividendYield 1952-2018 1969-2018 1999-2018HighestYield 13.09% 12.49% 9.64%

2 13.31% 12.50% 7.98%3 13.60% 13.32% 8.52%4 13.35% 12.47% 8.89%5 12.33% 12.51% 8.97%6 10.89% 10.94% 7.97%7 12.36% 12.10% 9.00%8 11.06% 12.07% 8.01%9 11.55% 10.45% 7.12%

LowestYield 10.90% 10.50% 4.80%

LowestvsHighest 2.19% 1.99% 4.84%

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DividendScreens:Specializedversions

¨ DogsoftheDow:Inthisversion,investorsfocusonthelargestdividendpayersintheDow30,investinthattightlyconcentratedgroup.

¨ DividendAristocrats:Companiesthatnotonlypaylargedividendsbuthaveahistoryofdoingso.

¨ Inallofthesemodels,investorsareputtingtheirfaithindividends,arguingthat¤ Dividendsaretheonlytangiblereturnsthatyougetfrominvestinginstocks,sincepriceappreciationiseitherjustonpaperorreliantonotherinvestorspaying.

¤ Dividendsaremorepredictablethanpriceappreciation,becausecompaniesarereluctanttocutthem.

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Howstickyaredividends?

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Figure10.6:DividendChangesatUScompanies

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Whattowatchoutfor..

¨ Unsustainabledividends:Whenyoubuyastockwithahighdividendyield,youarehopingthatthedividendswillnotbecutorcomeunderthreat.Whilethismaybeareasonableassumptionacrosstheentiremarket,itisalsotruethatcompaniesthatarepayingtoomuchindividendswillbeunabletosustainthosedividends.

¨ Lowgrowth:Oneofthecostsofreturningmoreindividendsisthatthereislesstoreinvest,leadingtolowgrowth.

¨ Taxes:Investorswhoreceivedividendshavenochoiceontaxtimingandmayhavetopayhighertaxesondividends.

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Andabrutalnewreality…Companiesareshiftingawayfromdividends..

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DividendsandBuybacks- USCompanies

StockBuybacks Dividends ProportionfromBuybacks

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TheScreener’sweakestlink:ValueTraps

¨ Avaluetrapisacompanythatlookscheapbutratherthanbouncebacktowhatyouperceiveasafairpriceeithercontinuestoremaincheaporbecomesevencheaper.

¨ Acompanybecomesavaluetrapwhenforceswithinorwithoutthefirmcausethefundamentalstoshiftpermanently,makingassumptionsthatthingswillrevertbacktoanorm(intermsofprofitsandpricing)intoapipedream.

¨ Inaworldwheredisruptionisthenorm,ratherthantheexception,establishedcompaniesinindustriesthatarebeingdisruptedrapidlycanlookcheap,buttheywillbecomecheaperovertime.

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TheValueInvestors’ProtectiveArmour

¨ Accountingchecks:Ratherthantrustthecurrentearnings,valueinvestorsoftenfocusonthreevariants:

1. Normalizedearnings,i.e.,averageearningsoveraperiodoftime.2. Adjustedearnings,whereinvestorsdevisetheirownmeasuresofearningsthatcorrectfor

whattheyseeasshortcomingsinconventionalaccountingearnings.3. Owner’searnings,wheredepreciation,amortizationandothernon-cashchargesare

addedbackandcapitalexpenditurestomaintainexistingassetsissubtractedout.¨ TheMoat:The“moat”isameasureofacompany’scompetitiveadvantages;the

strongerandmoresustainableacompany’scompetitiveadvantages,themoredifficultitbecomesforotherstobreachthemoatandthesaferbecomestheearningsstream.

¨ Marginofsafety:Themarginofsafety(MOS)isthebufferthatvalueinvestorsbuildintotheirinvestmentdecisiontoprotectthemselvesagainstrisk.Thus,aMOSof20%wouldimplythataninvestorwouldbuyastockonlyifitspriceismorethan20%belowtheestimatedvalue(estimatedusingamultipleoradiscountedcashflowmodel).

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AScreeningtemplate

1. Screenforcheapness:Youuseapricingmultiple(PE,PBV,EV/EBITDA)tofindcheapstocks.

2. Screenforlowrisk:Youtrytoremovethosestocksthatlookcheapbutarerisky,usingyourpreferredproxyforrisk.Thisproxycanbeaprice-basedone(standarddeviation,beta),anaccountingmeasure(debtratio)orasectorscreen(notechstocks…)

3. Screenforhighgrowth:Youalsowanttogetcompaniesthathave,innothighgrowth,somegrowthinthem.So,youmayputinaminimumgrowthrequirement.

4. Screenforhighqualitygrowth:Finally,youalsowanttoremovecompaniesthatreinvestbadly(earninglowreturnsoninvestments).

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DeterminantsofSuccessatPassiveScreening

1. Havealongtimehorizon:Allthestudiesquotedabovelookatreturnsoverlongtimehorizons.Infact,lowprice-bookvaluestockshaveunderperformedhighprice-bookvaluestocksovershortertimeperiods.

2. Chooseyourscreenswisely:Toomanyscreenscanundercutthesearchforexcessreturnssincethescreensmayendupeliminatingjustthosestocksthatcreatethepositiveexcessreturns.

3. Trustmeanreversion:Hopethatthemarket/companieshavenotchangedfundamentally.

4. Bediversified:Theexcessreturnsfromthesestrategiesoftencomefromafewholdingsinlargeportfolio.Holdingasmallportfoliomayexposeyoutoextraordinaryriskandnotdeliverthesameexcessreturns.

5. Watchoutfortaxesandtransactionscosts:Someofthescreensmayendupcreatingaportfoliooflow-pricedstocks,which,inturn,createlargertransactionscosts.