value investing: the passive...
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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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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.