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Value: Low P/E Ratio Low MV/BV Ratio Low Price-to-Sales Ratio High Dividend Yield Price is “cheap” by some measure

of comparison

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Passive Screeners• Screen for stocks that have characteristics

that you believe identify undervalued stocks Contrarian Investors

• Invest in companies that others have given up on

Activist Value Investors• Invest in poorly managed firms and then try

to change the way the companies are run

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P/E is less than the inverse of the yield on AAA Corporate Bonds

P/E is less than 40% of average P/E over the last 5 years

Price is less than 2/3 of Book Value Price is less than 2/3 of Net Current

Assets D/E ratio is less than one

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Current Assets are more than twice current liabilities

Debt is less than twice net current assets

Historical Growth in EPS over last ten years is greater than 7%

No more than two years of negative earnings during the last ten years

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Benjamin Graham Warren Buffett (more activist in

recent years)

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Empirical evidence indicates that over long time periods, low MV/BV stocks have outperformed high MV/BV stocks and the overall market both in the U.S. and internationally

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Year Low MV/BV Port.

High MV/BV Port.

S&P 500

1982 37.64% 14.64% 40.35%

1983 34.89% 3.07% 0.68%

1984 20.52% -28.82% 15.43%

1985 46.55% 30.22% 30.97%

1986 33.61% 0.60% 24.44%

1987 -8.80% -0.56% -2.69%

1988 23.52% 7.21% 9.67%

1989 37.50% 16.55% 18.11%

1990 -26.71% -10.98% 6.18%

1991 74.22% 28.76% 31.74%

1982-91 25.60% 10.61% 17.49%

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Contrarians believe that markets overreact to both good and bad news. So stocks that have had bad news are likely to be undervalued

Studies indicate that there is negative serial correlation in returns over long time periods• DeBondt and Thaler looked at 1933 - 1978

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Some feel the findings overstate the potential returns on ‘loser’ portfolios as they are more likely to contain low-priced stocks which generate higher transactions costs and offer the potential for skewed returns

Portfolios created in December work better than those created in June

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Good companies are not necessarily good investments• Current price may already reflect quality of

management and firm• More potential for downside surprises than

upside

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If value of firm is less than its component parts – push for breakup or spinoff

If firm is too conservative in use of debt – push for higher leverage and recapitalization

If firm is hording too much cash – push for higher dividends or stock repurchases

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If firm is being badly managed – push for a change in management or to be acquired

Example of Activist Value Investor• Carl Ichan

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High P/E Ratio (high MV/BV)• Investor feels the value of the growth

potential is being underestimated Low PEG Ratio

• Ratio of P/E to growth rate – PEG close to or below 1.0 is very good

• But low PEG Ratio firms tend to be more risky

Earnings Momentum• Earnings growth over time

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Venture Capital Funds• Help small, private start-up companies with

their first infusion of capital. Usually take position on Board. Goal is usually to eventually do an IPO.

Leveraged Buyout Funds• Use significant debt to take over publicly

traded firms and make them private Private Equity Funds

• Pool the wealth of individual investors to invest in private firms that show promise

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Over the long-run, value has outperformed growth, but growth tends to outperform value when the yield curve is flat or downward sloping.

Active growth investors seem to beat growth indices more often than active value investors beat value indices.

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Approximate Definitions: Big Cap: More than $10 billion

Mid Cap: $2 billion to $10 billion Small Cap: $300 million to $2 billion Micro Cap: $50 million to $300 million

Nano Cap: Under $50 million

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There is substantial empirical evidence that over time, small cap stocks have outperformed large cap stocks. • It may not be an excess risk-adjusted return

though

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The Small Stock Premium• Not very prevalent since 1981• Mostly attributable to performance in 1970s

when inflation was high• Almost entirely due to superior performance

in the month of January

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CAPM may not be the right model for risk of small stocks and thus beta doesn’t capture full measure of risk.

Small stocks tend to be concentrated in just a few sectors

Estimation risk of beta is higher for small firms (assuming beta is correct measure of risk) because there is less information available and fewer analysts cover them.

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Funds are often classified by type:

Lg Cap Value Lg Cap Growth

Mid Cap Value Mid Cap Growth

Sm Cap Value Sm Cap Growth

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The size-style grid can be used as a risk-adjustment model.

Abnormal Return = RP,t – R Benchmark,t

where the “Benchmark” portfolio is an index matched on the Size and Value-Growth Dimensions.

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