yale school of management overview of equity investing and value investing william n. goetzmann yale...

Yale School of Management

Overview of Equity Investing and Value Investing

William N. Goetzmann



Equity Investing

Motivation and BenefitsLong-Term PerformancePortfolio Approach to Performance


Why Equity Investing?

HistoryGrowthLiquidityDiversificationLegal rightsAligned interests


Three Centuries of Equities

0

1

10

100

1000

1700 1750 1800 1850 1900 1950 2000

U.K. Share Prices and Inflation1700 - 1987

333.32Equities

20.24Inflation


U.S Financial Markets

Time

Index ValuesCumulative Wealth

1370.95

4495.99

33.7326.4113.54

49.03

Dec1925

Dec1996

Dec1930

Dec1940

Dec1950

Dec1960

Dec1970

Dec1980

Dec1990

0.1

5000

0.1

1

10

100

1000

S&P 500 TR U.S. Small Stk TRU.S. LT Gvt TR MSCI EAFE TRU.S. 30 Day TBill TR U.S. LT Corp TR


Capital Market History 1926 - 1996

SP Small LTG EAFE TB LTCN Periods 852.00 852.00 852.00 324.00 852.00 852.00Geometric Mean (%)10.71 12.58 5.08 12.89 3.74 5.64Arithmetic Mean (%) 12.82 17.50 5.38 14.49 3.74 5.88Standard Deviation (%)22.13 35.65 8.08 19.30 0.95 7.20Highest Return (%) 42.56 73.46 15.23 17.87 1.35 13.76Lowest Return (%) -29.73 -36.74 -8.41 -14.38 -0.06 -8.90N Positive Periods 528 520 533 197 838 574N Negative Periods 322 331 318 127 13 276


The Equity Premium: 1970-1996

Risk (STD)

Return (AM)Risk vs. Return

0% 26% 3% 6% 9% 12% 15% 18% 21% 6%

17%

8%

10%

12%

14%

16%

S&P 500 TR

U.S. Small Stk TR

U.S. LT Gvt TR

MSCI EAFE TR

U.S. 30 Day TBill TR

U.S. LT Corp TR


Active vs. Passive Investing

Value added through informationUncertainty of informationMarket efficiencyDoes relative skill exist?


Do Winners Repeat?

Goetzmann and Ibbotson 1994 studyUsed 1976 - 1992 dataFound good & bad performance persistsFound that active managers beat the

Vanguard S&P 500 Index over the period


Evidence on Active Investing

Period 2Winners

Period 2Losers

Period 1Winners 62% 38%

Period 2Losers 37% 63%


Basics of Active Management

Market timingSecurity selectionDiversificationTaxes


Market Timing

Little evidence of widespread timing skill survivors appear to have done well market timing letters show no skill

The Dow theory: a momentum play some evidence of timing ability


The Dow Theory

Classic timing strategy of equity investment

Popularized by the Wall Street Journal from 1903 through 1929

A momentum strategy market follows trends Industrial and transportation sectors confirm high volume indicates move


The Dow Theory 1903 to 1929

BullMarket

BearMarket

BullForecast 74 56

BearForecast 18 36


Bull vs. Bear Calls

0.96

0.97

0.98

0.99

1

1.01

1.02

1.03

1.04

1.05

1.06

Pri

ce I

ndex

-40 -35 -30 -25 -20 -15 -10 -5 0 5 10 15 20 25 30 35 40 Days Around Editorialbuys neutrals sells

DJIA Around Editorials

Sells

Neutral

Buys


Security Selection

“Do Security Analyst’s Recommendations Have Value?” by Kent Womack JF (1996)

Studied broker recommendations over a decade Buy recommendations: 2% gain over days Sell recommendations: 9% loss over 6 months


Value Investing

Value vs. growth Quantitative approach to valuation modelsPerformance of value stocks Performance of value portfolios


Valuation of Perpetuity

V = C/(1+R) + C/(1+R)2 + … + C/(1+R)T

When T approaches infinity:

V = C/R


The Law of Value Investing

C

V R

C = Cash FlowV = Firm ValueR = Discount Rate

C = V*RV = C/RR = C/V


No growth in cash flowNo changing cash flowNo changing discount rate

Assumptions


Estimating Cash Flow

Dividends Yield = discount rate logic: Shareholders get dividends High yield firm is a value firm

Earnings E/P = discount rate logic: earnings measure increase is economic value

of the firm High Book to Market is a “Value Firm”


Example: EVA

EVA: Economic value-added net after-tax profit - capital*cost of capital C - V*R>0

means firm is undervalued, or:C is mis-estimatedR is mis-estimated


Evidence on Value Investing

Long-term tests of DCF modelRobert Shiller (Yale)

takes known future C/R and compare it to P finds P is more variable than C/R Market over-reacts


Under and Over-Valued Markets

5

10

15

20

25

30

35

P/E

Ratio

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990

P/E

V/E

V/E R fixed

S&P Price vs. ValueFrom Shiller "Market Volatilty"


Does P/E Forecast for R?


What About Growth?

Another Variable: G C grows at G

Uses analyst’s forecasts of growth

Growth firms are: Low yield Low earnings Low B/M

C

V R - G


Growth and Value

G = R - C/VSuppose you had a growth forecast: G*

Incremental return = G* - G


Estimating Growth

Ibbotson and Riepe, 1997How well do you do by perfectly

forecasting growth? Is growth sufficient?How right do you have to be?


Perfect Foresight Growth

1974-1990 Total High P/E&

Growth

LowP/E &Value

PerfectForesight

Growth21.1 18.1 32.7

S&P/Barra 13.3 15.05 18.18


Value vs. Growth Stocks

1975-1995Performance

GeometricReturn

ArithmeticReturn

StandardDeviation

S&P/BARRA Growth 13.98 15.46 18.51

S&P/BARRAValue

16.87 18.02 16.49

S&P 500 15.57 16.82 17.10


Value vs. Growth Managers

Mutual fund style analysis (Brown and Goetzmann, 1997)

Identified equity mutual fund stylesValue, Growth & Glamour managers


Glamour Managers

High growth and small stocks P/E ratio = 24.00 Market to book= 4.29 Five yr. earnings growth = 23.59 11 year risk-adjusted performance:

Performance = .51 % excess return per year


Value Managers

High value, small stocks P/E ratio = 20.2 Market to book = 3.21 Five yr. earnings growth = 9.92

Performance = 2.25 % excess return per year


How About the Discount Rate?

R = G + C/V How is it estimated?Asset pricing models


Summary of Equity Investing

Old evidence on timingNew evidence on selectionQuantitative model of value Value vs. growth stocksValue vs. growth managersDiscount rate

yale school of management overview of equity investing and value investing william n. goetzmann yale...

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