yale school of management overview of equity investing and value investing william n. goetzmann yale...
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Yale School of Management
Overview of Equity Investing and Value Investing
William N. Goetzmann
Yale School of Management
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Yale School of Management
Equity Investing
Motivation and BenefitsLong-Term PerformancePortfolio Approach to Performance
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Yale School of Management
Why Equity Investing?
HistoryGrowthLiquidityDiversificationLegal rightsAligned interests
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Yale School of Management
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
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Yale School of Management
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
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Yale School of Management
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
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Yale School of Management
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
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Yale School of Management
Active vs. Passive Investing
Value added through informationUncertainty of informationMarket efficiencyDoes relative skill exist?
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Yale School of Management
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
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Yale School of Management
Evidence on Active Investing
Period 2Winners
Period 2Losers
Period 1Winners 62% 38%
Period 2Losers 37% 63%
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Yale School of Management
Basics of Active Management
Market timingSecurity selectionDiversificationTaxes
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Yale School of Management
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
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Yale School of Management
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
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Yale School of Management
The Dow Theory 1903 to 1929
BullMarket
BearMarket
BullForecast 74 56
BearForecast 18 36
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Yale School of Management
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
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Yale School of Management
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
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Yale School of Management
Value Investing
Value vs. growth Quantitative approach to valuation modelsPerformance of value stocks Performance of value portfolios
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Yale School of Management
Valuation of Perpetuity
V = C/(1+R) + C/(1+R)2 + … + C/(1+R)T
When T approaches infinity:
V = C/R
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Yale School of Management
The Law of Value Investing
C
V R
C = Cash FlowV = Firm ValueR = Discount Rate
C = V*RV = C/RR = C/V
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Yale School of Management
No growth in cash flowNo changing cash flowNo changing discount rate
Assumptions
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Yale School of Management
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”
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Yale School of Management
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
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Yale School of Management
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
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Yale School of Management
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"
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Yale School of Management
Does P/E Forecast for R?
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Yale School of Management
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
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Yale School of Management
Growth and Value
G = R - C/VSuppose you had a growth forecast: G*
Incremental return = G* - G
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Yale School of Management
Estimating Growth
Ibbotson and Riepe, 1997How well do you do by perfectly
forecasting growth? Is growth sufficient?How right do you have to be?
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Yale School of Management
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
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Yale School of Management
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
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Yale School of Management
Value vs. Growth Managers
Mutual fund style analysis (Brown and Goetzmann, 1997)
Identified equity mutual fund stylesValue, Growth & Glamour managers
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Yale School of Management
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
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Yale School of Management
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
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Yale School of Management
How About the Discount Rate?
R = G + C/V How is it estimated?Asset pricing models
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Yale School of Management
Summary of Equity Investing
Old evidence on timingNew evidence on selectionQuantitative model of value Value vs. growth stocksValue vs. growth managersDiscount rate