Post on 08-Apr-2018
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aran
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V
alueInvesting
AswathDamod
aran
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aran
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W
hoisavalue
investor?
TheConventionalDefinition:Avalueinvestorisonewhoinvestsin
lowprice-bookvalueorlowprice-earningsratiosstocks.
TheGenericDefinition:Avaluein
vestorisonewhop
aysaprice
whichislessth
anthevalueofthe
assetsinplaceofa
firm.
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TheDifferen
tFacesofVa
lueInvesting
Today
PassiveScreene
rs:FollowingintheBenGrahamtradition,youscreen
forstocksthath
avecharacteristics
thatyoubelieveidentifyunder
valuedstocks.E
xampleswouldinc
ludelowPEratios
andlowpriceto
bookratios.
ContrarianInve
stors:Theseareinvestorswhoinvestincompanies
thatothershave
givenupon,eitherbecausetheyhave
donebadlyin
thepastorbecausetheirfutureprospectslookbleak.
ActivistValueInvestors:Theseare
investorswhoinve
stinpoorly
managedandpo
orlyrunfirmsbutthentrytochangethewaythe
companiesarerun.
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I.ThePassive
Screener
Thisapproachtovalueinvestingcanbetracedbackto
BenGraham
andhisscreenstofindundervalued
stocks.
Inrecentyears,thesescreenshave
beenrefinedandextended.The
followingsectio
nsummarizesthee
mpiricalevidencethatbacksup
eachofthesescreens.
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Howwell
doGrahams
screensperfo
rm?
AstudybyOpp
enheimerconcludedthatstocksthatpassedthe
Grahamscreens
wouldhaveearned
areturnwellinex
cessofthe
market.
MarkHulbertw
hoevaluatesinvestmentnewslettersconcludedthat
newslettersthat
usedscreenssimilartoGrahamsdidmuchbetterthan
othernewsletter
s.
However,anatt
emptbyJamesRea
torunanactualmutualfundusing
theGrahamscreensfailedtodelive
rthepromisedretu
rns.
Grahamsbestc
laimtofamecomesfromthesuccessofthestudents
whotookhisclassesatColumbiaU
niversity.Amongthemwere
CharlieMunger
andWarrenBuffett.
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TheBuffettM
ystique
Figure8.1:Berkshire
Hathaway
$0.00
$200.00
$400.00
$600.00
$800.00
$1,000.00
$1,200.00
$1,400.00
$1,600.00
$1,800.00
19881989
199019911992199319941995199619971998199920002001
Year
Value of $ 100 invested 12/88
Be
rkshireHathaway
S&
P500
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BuffettsTenets
BusinessTenets:
Thebusinessth
ecompanyisinshouldbesimpleandunderstan
dable.
Thefirm
shou
ldhaveaconsistentoperatinghistory,manifestedinoperating
earningsthatar
estableandpredictable.
Thefirmshouldbeinabusinesswithfavorablelongtermprospects.
ManagementTenets:
Themanagers
ofthecompanyshouldbecandid.Asevidencedbythewayhe
treatedhisown
stockholders,Buffettputapremiumonmanagershetrusted.
Themanagerso
fthecompanyshouldb
eleadersandnotfollow
ers.
FinancialTenets:
Thecompanys
houldhaveahighreturnonequity.Buffettusedamodifiedversion
ofwhathecalle
downerearnings
OwnerEarn
ings=Netincome+Depre
ciation&AmortizationC
apitalExpenditures
Thecompanyshouldhavehighandstableprofitmargins.
MarketTenets:
Useconservativ
eestimatesofearnings
andtherisklessrateasthediscountrate.
Inkeepingwith
hisviewofMr.Marketascapriciousandmoody,evenvaluable
companiescanbeboughtatattractivep
riceswheninvestorsturnawayfromthem.
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BelikeBuffett?
MarketshavechangedsinceBuf
fettstartedhisfirst
partnership.Even
WarrenBuffettwouldhavediffic
ultyreplicatinghissuccessintodays
market,whereinformationoncom
paniesiswidelyavailableanddozens
ofmoneymanagersclaimtobeloo
kingforbargainsinvaluestocks.
Inrecentyears,Buffetthasadoptedamoreactivistinvestmentstyleand
hassucceededwithit.Tosucceedwiththisstyleasaninvestor,though,
youwouldne
edsubstantialresourcesandhavethecredibilitythatcomes
withinvestmentsuccess.Thereare
fewinvestors,evenamongsuccessful
moneymanag
ers,whocanclaimthiscombination.
ThethirdingredientofBuffettssu
ccesshasbeenpatien
ce.Ashehas
pointedout,h
edoesnotbuystocksfortheshorttermbu
tbusinessesfor
thelongterm.Hehasoftenbeenw
illingtoholdstocksthathebelievesto
beundervalu
edthroughdisappointingyears.Inthosesameyears,hehas
facednopressurefromimpatientinvestors,sincestockh
oldersin
BerkshireHathawayhavesuchhig
hregardforhim.
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ValueScreens
PricetoBookra
tios:Buystockswhereequitytradesa
tlessthanorat
leastalowmult
ipleofthebookvalueofequity.
Priceearningsratios:Buystocksw
hereequitytradesatalowmultiple
ofequityearnings.
Pricetosalesratio:Buystockswhereequitytradesatalowmultipleof
revenues.
DividendYields:Buystockswithhighdividendyields.
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1.Price/BookValueScreens
Alowpriceboo
kvalueratiohasbeenconsideredareliableindicator
ofundervaluatio
ninfirms.
Theempiricalevidencesuggeststh
atoverlongtimeperiods,low
price-bookvaluesstockshaveoutp
erformedhighprice-bookvalue
stocksandtheo
verallmarket.
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LowPrice
/BVRatiosandExcessReturns
Lowest
2
3
4
5
6
7
8
9
Highest
192
7-1960
1
961-1990
1991-2001
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
PBVClass
F
igure
8.2:PBVClasses
and
Returns
-1927-2001
1927-1960
1961-1990
1991-2001
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Evidence
fromIntern
ationalMark
ets
Chan,HamaoandLakonishok(1991)findthatthebook-to-market
ratiohasastron
groleinexplaining
thecross-sectiono
faverage
returnsonJapan
esestocks.
Capaul,Rowley
andSharpe(1993)extendtheanalysisofprice-book
valueratiosacrossotherinternationalmarkets,andconcludethatvalue
stocks,i.e.,stockswithlowprice-b
ookvalueratios,e
arnedexcess
returnsinevery
marketthattheyan
alyzed,between1981and1992.
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LowPBV
EffectinInte
rnationalMar
kets
Theirannualizedestimatesofthereturndifferentialea
rnedbystocks
withlowprice-bookvalueratios,overthemarketinde
x,wereas
follows:C
ountry
Added
ReturntolowP/BVportfolio
France
3.26%
German
y
1.39%
Switzerland
1.17%
U.K
1.09%
Japan
3.43%
U.S.
1.06%
Europe
1.30%
Global
1.88%
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2.Price/EarningsRatioScreens
Investorshavelongarguedthatstockswithlowpriceearningsratios
aremorelikelytobeundervalueda
ndearnexcessretu
rns.For
instance,thisis
oneofBenGraham
sprimaryscreens.
Studieswhichh
avelookedattherelationshipbetween
PEratiosand
excessreturnsconfirmthesepriors.
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TheInternationalPEEffect
Country
AnnualPremiumearnedbyl
owestP/EStocks(botto
mquintile)
A
ustralia
3.03%
F
rance
6.40%
G
ermany
1.06%
H
ongKong
6.60%
I
taly
1
4.16%
J
apan
7.30%
S
witzerland
9.02%
U
.K.
2.40%
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C
ompositeScreens:Stockswithlowprice
tosales
ratiosandhigh
margins
Year
UndervaluedPortfolio
OvervaluedPortfolio
S&P500
1982
50.34%
17.72%
40.35%
1983
31.04%
6.18%
0.68%
1984
12.33%
-25.81%
15.43%
1985
53.75%
28.21%
30.97%
1986
27.54%
3.48%
24.44%
1987
-2.28%
8.63%
-2.69%
1988
24.96%
16.24%
9.67%
1989
16.64%
17.00%
18.11%
1990
-30.35%
-17.46%
6.18%
1991
91.20%
55.13%
31.74%
1982-91
23.76%
15.48%
17.49%
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4.DividendYields
Highest
2
3
4
5
6
7
8
9
Lowest
1952-71
1971-90
1991-2001
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
16.00%
18.00%
20.00%
Average Annual Return
PERatioClass
Figure8.4:ReturnsonDividendYieldClasses-1952-2001
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DeterminantsofSuccessatPassiveScr
eening
1.Havealongtim
ehorizon.Allthestudiesquotedabov
elookatreturns
overtimehorizonsoffiveyearsor
greater.Infact,low
price-book
valuestockshaveunderperformedhighprice-bookvaluestocksover
shortertimeperiods.
2.Chooseyourscreenswisely:Toom
anyscreenscanundercutthe
searchforexces
sreturnssincethescreensmayendup
eliminatingjust
thosestocksthatcreatethepositive
excessreturns.
3.Bediversified:T
heexcessreturnsf
romthesestrategiesoftencome
fromafewhold
ingsinlargeportfo
lio.Holdingasmallportfoliomay
exposeyoutoextraordinaryriskan
dnotdeliverthesa
meexcess
returns.
4.Watchoutfortaxesandtransactionscosts:Someof
thescreensmay
endupcreating
aportfoliooflow-pricedstocks,which,inturn,create
largertransactio
nscosts.
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II.Contrarian
ValueInvesting:BuyingtheLosers
Incontrarianvalueinvesting,youb
eginwiththepropositionthat
marketsoverreacttogoodandbad
news.Consequently,stocksthat
havehadbadne
wscomeoutabout
them(earningsdeclines,dealsthat
havegonebad)
arelikelytobeund
ervalued.
EvidencethatM
arketsOverreactto
NewsAnnouncem
ents
Studiesthatlookatreturnsonmarketsoverlongtimeperiodschronicle
thatthereissignificantnegativeserialcorrelationinretu
rns,I.e,good
yearsaremor
elikelytobefollowe
dbybadyearsandviceversal.
Studiesthatfocusonindividualsto
cksfindthesameeff
ect,withstocks
thathavedonewellmorelikelyto
dobadlyoverthenex
tperiod,andvice
versa.
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1.WinnerandLoserportfolios
Sincethereisev
idencethatpricesreversethemselvesinthelongterm
forentiremarke
ts,itmightbewort
hexaminingwheth
ersuchprice
reversalsoccuronclassesofstockwithinamarket.
Forinstance,arestockswhichhavegoneupthemostoverthelast
periodmorelikelytogodownoverthenextperiodandviceversa?
Toisolatetheeffectofsuchpricereversalsontheextr
emeportfolios,
DeBondtandThalerconstructedawinnerportfolioof
35stocks,
whichhadgone
upthemostovertheprioryear,anda
loserportfolio
of35stocks,wh
ichhadgonedown
themostovertheprioryear,each
yearfrom1933
to1978,
Theyexamined
returnsonthesepo
rtfoliosforthesixtymonths
followingthecr
eationoftheportfo
lio.
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ExcessReturnsforWinner
andLoserPo
rtfolios
Figure8.5:CumulativeAbnormalRetu
rns-WinnersversusLosers
-15.00%
-10.00%
-5.00%
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
30.00%
35.00%
1
4
7
10
13
16
19
22
25
28
31
34
37
40
43
46
49
52
55
58
Monthafterportfolioformation
Cumulative Abnormal Return
Winners
Losers
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Moreon
WinnerandLoserPortfoli
os
Thisanalysissugg
eststhatloserportfolioclearlyoutperform
winnerportfolios
inthesixtymonth
sfollowingcreation.
Thisevidenceisconsistentwithmarket
overreactionandcorrectioninlongretu
rnintervals.
Therearemany,a
cademicsaswellasp
ractitioners,whosug
gestthatthese
findingsmaybeinterestingbutthatthe
yoverstatepotentialreturnson'loser'
portfolios.
Thereisevidence
thatloserportfoliosaremorelikelytocon
tainlowpriced
stocks(sellingfor
lessthan$5),which
generatehighertransactionscostsand
arealsomorelikelytoofferheavilyskewedreturns,i.e.,the
excessreturns
comefromafewstocksmakingphenomenalreturnsratherthanfrom
consistentperform
ance.
Studiesalsoseem
tofindloserportfolioscreatedeveryDece
mberearn
significantlyhigherreturnsthanportfolioscreatedeveryJun
e.
Finally,youneed
alongtimehorizonfortheloserportfoliotowinout.
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LoserPortfoliosand
TimeHorizon
Figure8.6:DifferentialReturns-Win
nerversusLoserPortfolios
-2.00%
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
1
2
3
4
5
6
7
8
9101112131415161718
19202122232425262728293031
3233343536
Monthafterpo
rtfolioformation
Cumulative abnormal return (Winner - Loser)
1941-64
1965-89
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GoodCompaniesareno
tnecessarilyGood
Investme
nts
Anyinvestment
strategythatisbas
eduponbuyingwe
ll-run,good
companiesandexpectingthegrowthinearningsinthe
secompaniesto
carrypriceshigherisdangerous,sinceitignoresthere
alitythatthe
currentpriceof
thecompanymay
reflectthequalityo
fthe
managementandthefirm.
Ifthecurrentpriceisright(andthe
marketispayinga
premiumfor
quality),thebig
gestdangeristhatthefirmlosesitslustreovertime,
andthatthepremiumpaidwilldiss
ipate.
Ifthemarketisexaggeratingtheva
lueofthefirm,thisstrategycan
leadtopoorretu
rnsevenifthefirm
deliversitsexpectedgrowth.
Itisonlywhenmarketsunderestim
atethevalueoffirmqualitythat
thisstrategystandsachanceofmakingexcessreturns.
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1.Excellen
tversusUnexcellentCompanies
Thereisevidencethatwellmanage
dcompaniesdono
talwaysmake
greatinvestmen
ts.Forinstance,the
reisevidencethatexcellent
companies(usin
gtheTomPetersstandard)earnpoore
rreturnsthan
unexcellentcompanies.
Figure8.7:ExcellentversusUnexcellentCompanies
050
100
150
200
250
300
350
1
3
5
7
9
11
13
15
17
19
21
23
25
27
29
31
33
35
37
39
41
43
45
47
49
51
53
55
57
59
Monthsafterportfo
lioformation
Value of $ 100 invested in January 1981
ExcellentCompanies
UnexcellentCompanies
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2.Risk/R
eturnbyS&P
QualityIndic
es
Conventionalra
tingsofcompanyq
ualityandstockreturnsseemtobe
negativelycorre
lated.
S&PRatingsandStockReturns
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
16.00%
18.00%
20.00%
A+
A
A-
B+
B
B-
C/D
S&PCommonStockRating
Average Annual Return (1986-94)
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Determinantso
fSuccessat
ContrarianInvesting
1.SelfConfidence:Investingincompaniesthateverybodyelse
viewsaslosers
requiresaselfcon
fidencethatcomeseitherfrompastsucces
s,ahugeegoor
both.
2.Clients/Investorswhobelieveinyou:Y
oueitherneedclientswhothinklike
youdoandagreewithyou,orclientsth
athavemadeenough
moneyofyouin
thepastthattheir
greedoverwhelmsan
ytrepidiationyoumi
ghthaveinyour
portfolio.
3.Patience:Thesestrategiesrequiretimetoworkout.Foreverythreesteps
forward,youwill
oftentaketwostepsback.
4.StomachforShort-termVolatility:Th
enatureofyourinvestmentimpliesthat
therewillbehigh
shorttermvolatilityandhighprofilefailures.
5.Watchoutfortransactionscosts:Thes
estrategiesoftenleadtoportfoliosof
lowpricedstocks
heldbyfewinstitutio
nalinvestors.Thetra
nsactionscosts
canwipeoutanyperceivedexcessreturnsquickly.
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III.
ActivistValu
eInvesting
Anactivistvalueinvestorhavingacquiredastakeinanund
ervalued
companywhichm
ightalsobebadlymanagedthenpushes
themanagement
toadoptthosecha
ngeswhichwillunlockthisvalue.Forinstance,
Ifthevalueofthe
firmislessthanitscomponentparts:
pushforbreakupofthefirm,spinoffs,splitoffsetc.
Ifthefirmisbeingtooconservativeinitsuseofdebt:
pushforhigher
leverageandrecapitaliz
ation
Ifthefirmisaccumulatingtoomuchca
sh:
pushforhigher
dividends,stockrepurchases..
Ifthefirmisbeingbadlymanaged:
pushforachangeinmanagementorto
beacquired
Iftherearegainsfromamergeroracquisition
pushfortheme
rgeroracquisition,evenifitishostile
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a.Breakingupishardtodo
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a.Breakingup
ishardtodo
EffectsofS
pinoffs,
Splitoffs,Divestitu
resonValue
Theoverallemp
iricalevidenceisthatspinoffs,splito
ffsand
divestituresallhaveapositiveeffectonvalue.
LinnandRozeff(1984)examinedthepricereactionto
announcements
ofdivestituresb
yfirmsandreporte
danaverageexcessreturnof
1.45%for77divestituresbetween1977and1982.
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MoreonSpinOffs,SplitOffsetc..
Marketsviewfirm
sthatareevasiveaboutreasonsforandproceedsfrom
divestitureswiths
kepticism.
MarketReactiontoDivestitureAnnoun
cements
PriceAnnounced
M
otiveAnnounced
Yes
N
o
Yes
3.92%
2
.30%
No
0.70%
0
.37%
SchipperandSmith(1983)examined9
3firmsthatannouncedspinoffs
between1963and
1981andreportedanaverageexcessreturnof2.84%inthe
twodayssurround
ingtheannouncement.Further,thereisev
idencethatexcess
returnsincreasew
iththemagnitudeo
fthespunoffentity
.
Finally,Schipper
andSmithfindevidencethattheexcessre
turnsaregreater
forfirmsinwhich
thespinoffismotivatedbytaxandregu
latoryconcerns.
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b.Somefirm
shavetoolittledebtEffectsof
LeverageIncreasingandDe
creasingTran
sactions
Theoverallemp
iricalevidencesug
gestthatleverageincreasing
transactionsincreasevaluewhereasleveragereducing
transactions
decreasevalue.
Typeoftransaction
SecurityIssued
SecurityRetired
SampleSize
2-DayReturn
Leverage-IncreasingTr
ansactions
StockRepurchase
Debt
Comm
on
45
21.9%
ExchangeOffer
Debt
Comm
on
52
14.0%
ExchangeOffer
Preferred
Comm
on
9
8.3%
ExchangeOffer
Debt
Preferr
ed
24
2.2%
ExchangeOffer
Bonds
Preferr
ed
24
2.2%
Transactionswithnoch
angeinleverage
ExchangeOffer
Debt
Debt
36
0.6%
SecuritySale
Debt
Debt
83
0.2%
Leverage-ReducingTra
nsactions
Conversion-forcingcallCommon
Convertible
57
-0.4%
Conversion-forcingcallCommon
Preferr
ed
113
-2.1%
SecuritySale
Conv.Debt
Conv.Debt
15
-2.4%
ExchangeOffer
Common
Debt
30
-2.6%
ExchangeOffer
Preferred
Preferr
ed
9
-7.7%
SecuritySale
Common
Debt
12
-4.2%
ExchangeOffer
Common
Debt
20
-9.9%
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d
.TheEffectsofHostileAcquistionsontheTarget
Firm
Badlymanaged
firmsaremuchmo
relikelytobetarge
tsofacquistions
thanwellmanagedfirms
TargetCharacteristics-Hostilevs.FriendlyTakeovers
-5.00%
0.00%
5.00%
10.00%
15.00%
20.00%
Target
ROE-
Industry
ROE
Target5-
yrStock
Returns-
Market
%of
Stock
Heldby
Insiders
HostileTakeovers
FriendlyTakeovers
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Andacquisitionsareclearlygoodforthetarget
firmsstockh
olders
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DeterminantsofSuccessatActivistInvesting
1.Havelotsofcap
ital:Sincethisstrategyrequiresthaty
oubeabletoput
pressureonincu
mbentmanagemen
t,youhavetobeabletotake
significantstake
sinthecompanies.
2.Knowyourcom
panywell:Sincethisstrategyisgoing
toleada
smallerportfolio,youneedtoknow
muchmoreabout
yourcompanies
thanyouwould
needtoinascreeningmodel.
3.Understandcor
poratefinance:Yo
uhavetoknowenoughcorporate
financetounderstandnotonlythat
thecompanyisdoingbadly(which
willbereflected
inthestockprice)
butwhatitisdoing
badly.
4.Bepersistent:In
cumbentmanagers
areunlikelytorolloverandplay
deadjustbecauseyousayso.They
willfight(andfigh
tdirty)towin.
Youhavetobepreparedtocounter.
5.Doyourhomew
ork:Youhavetoformcoalitionswith
otherinvestors
andtoorganize
tocreatethechangeyouarepushingfor.
8/7/2019 Value Investing by a. Damodaran
43/43
AswathDamod
aran
Conclusion
Valueinvesting
comesinmanystripes.
Therearescreenssuchasprice-bookvalue,priceearnin
gsandprices
ratiosthatsee
mtoyieldexcessreturnsoverlongperiods.Itisnotcle
whetherthese
excessreturnsaretrulyabnormalreturns,
rewardsfor
havingalong
timehorizonorjusttheappropriaterewardsforrisktha
havenotadeq
uatelymeasured.
Therearealsocontrarianvalueinvestors,whotakepo
sitionsin
companiesthathavedonebadlyin
termsofstockprices
and/orhave
acquiredrepu
tationsasbadcompanies.
Thereareactivistinvestorswhotakepositionsinunderv
aluedand/or
badlymanage
dcompaniesandbyvirtueoftheirholding
sareableto
changesthatunlockthisvalue.