Investment Philosophies: Successful Strategies and the Investors Who Made Them Work, + Website

Investment Philosophies: Successful Strategies and the Investors Who Made Them Work, + Website

by Aswath Damodaran

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Choosing the right investment philosophy is the heart of successful investing. To make the choice, though, you need to look within before you look outside. In the Second Edition of Investment Philosophies, New York University Stern Business School Professor Aswath Damodaran will help you do this by going beyond the simple explanations of traditional

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Choosing the right investment philosophy is the heart of successful investing. To make the choice, though, you need to look within before you look outside. In the Second Edition of Investment Philosophies, New York University Stern Business School Professor Aswath Damodaran will help you do this by going beyond the simple explanations of traditional and alternative investment strategies to discuss the individual underlying philosophies that support these techniques.

This reliable resource skillfully explores many of the time-tested investment philosophies that have allowed investors to reap financial rewards over the years, including value investing, growth investing, technical analysis, market timing, arbitrage, indexing, and more.

Along the way, it exposes you to a wide array of investment philosophies so as to give you a sense of what drives investors in each one, how they attempt to put these philosophies into practice, and what determines ultimate success. Author Aswath Damodaran also supplies you with the tools—the definition and measurement of risk, the notion of market efficiency and how to test for inefficiencies, and the components and determinants of trading costs—and empirical evidence for you to make your own judgments on the investment philosophy that fits your specific investment goals and views of how markets work.

Filled with valuable insights and useful formulas, this book provides you with the information you need to pick an investment philosophy that is right for you. With the Second Edition of Investment Philosophies as your guide, you can enter the markets with confidence and exit with profits.

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Publication date:
Wiley Finance Series, #665
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6.10(w) x 9.10(h) x 2.00(d)

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Investment Philosophies

Successful Strategies and the Investors Who Made Them Work
By Aswath Damodaran

John Wiley & Sons

ISBN: 0-471-34503-2

Chapter One

Graham's Disciples: Value Investing


Value investors are bargain hunters and many investors describe themselves as such. But who is a value investor? In this chapter, we begin by addressing this question and argue that value investors come in many forms. Some value investors use specific criteria to screen for what they categorize as undervalued stocks and invest in these stocks for the long term. Other value investors believe that bargains are best found in the aftermath of a sell-off and that the best time to buy a stock is when it is down. Still others adopt a more activist approach, where they buy large stakes in companies that they believe are undervalued and push for changes that they believe will unleash this value.

Value investing is backed by empirical evidence from financial theorists and by anecdotal evidence-the success of value investors like Ben Graham and Warren Buffett are part of investment mythology-but it is not for all investors. We will consider what investors need to bring to the table to succeed at value investing.


Morningstar is a widely used source of mutual fund information, and it categorized 38 percent of mutual funds as value funds in 2001. But how did it make this categorization? While it did look at the way these funds described themselves in their prospectus, the ultimate categorization was based on a far simpler measure. Any fund that invested in stocks with low price-to-book value ratios or low price earnings ratios, relative to the market, was categorized as a value fund. This categorization is fairly conventional, but we believe that it is too narrow a definition and misses the essence of value investing.

Another widely used definition of value investors suggests that they are investors interested in buying stocks for less than what they are worth. But that is too broad a definition, because you could potentially categorize most active investors as value investors on this basis. After all, growth investors (who are often viewed as competing with value investors) also want to buy stocks for less than what they are worth. So, what is the essence of value investing? To understand value investing, we have to begin with the proposition that the value of a firm is derived from two sources-investments that the firm has already made (assets in place) and expected future investments (growth opportunities). What sets value investors apart is their desire to buy firms for less than what their assets-in-place are worth. Consequently, value investors tend to be leery of large premiums paid by markets for growth opportunities and try to find their best bargains in more mature companies that are out of favor.

Even with this definition of value investing, there are three distinct strands that we see in value investing. The first and perhaps simplest form of value investing is passive screening, where companies are put through a number of investment screens-for example, low PE ratios, marketability, and low risk-and those that pass the screens are categorized as good investments. In its second form, you have contrarian value investing, where you buy assets that are viewed as untouchable by other investors because of poor past performance or bad news about them. In its third form, you become an activist value investor who buys equity in undervalued or poorly managed companies but then uses the power of your position (which has to be a significant one) to push for change that will unlock this value.


There are many investors who believe that stocks with specific characteristics-good management, low risk, and high quality earnings, for example-outperform other stocks and that the key to investment success is to identify what these characteristics are. While investors have always searched for these characteristics, it was Ben Graham in his classic books on security analysis (with David Dodd) who converted these qualitative factors into quantitative screens that could be used to find promising investments. In recent years, as data has become more easily accessible and computing power has expanded, these screens have been refined and extended, and variations are used by many portfolio managers and investors to pick stocks.

Ben Graham: The Father of Screening

Many value investors claim to trace their antecedents to Ben Graham and to use the book on security analysis that he co-authored with David Dodd in 1934 as their investment bible. But who was Ben Graham, and what were his views on investing? Did he invent screening, and do his screens still work?

Graham's Screens Ben Graham started life as a financial analyst and later was part of an investment partnership on Wall Street. While he was successful on both counts, his reputation was made in the classroom. He taught at Columbia and the New York Institute of Finance for more than three decades and during that period developed a loyal following among his students. In fact, much of Mr. Graham's fame comes from the success enjoyed by his students in the market.

It was in the first edition of Security Analysis that Ben Graham put his mind to converting his views on markets to specific screens that could be used to find undervalued stocks. While the numbers in the screens did change slightly from edition to edition, they preserved their original form and are as follows:

1. Earnings to price ratio that is double the AAA bond yield

2. PE of the stock has to be less than 40 percent of the average PE for all stocks over the past five years

3. Dividend Yield > Two-thirds of the AAA Corporate Bond Yield

4. Price < Two-thirds of Tangible Book Value

5. Price < Two-thirds of Net Current Asset Value (NCAV), where net current asset value is defined as liquid current assets including cash minus current liabilities

6. Debt-Equity Ratio (Book Value) has to be less than one

7. Current Assets > Twice Current Liabilities

8. Debt < Twice Net Current Assets

9. Historical Growth in EPS (over last 10 years) > 7%

10. No more than two years of declining earnings over the previous 10 years

Any stock that passes all 10 screens, Graham argued, would make a worthwhile investment. It is worth noting that while there have been a number of screens that have been developed by practitioners since these first appeared, many of them are derived from or are subsets of these original screens.

The Performance How well do Ben Graham's screens work when it comes to picking stocks? Henry Oppenheimer studied the portfolios obtained from these screens from 1974 to 1981 and concluded that you could have made an annual return well in excess of the market. As we will see later in this section, academics have tested individual screens-low PE ratios and high-dividend yields to name two-in recent years and have found that they indeed yield portfolios that deliver higher returns. Mark Hulbert, who evaluates the performance of investment newsletters, found newsletters that espoused to follow Graham did much better than other newsletters.


Stocks that pass the Graham screens: Take a look at the stocks that currently pass the Graham screens.

* * *

The only jarring note is that an attempt to convert the screens into a mutual fund that would deliver high returns did fail. In the 1970s, an investor named James Rea was convinced enough of the value of these screens that he founded a fund called the Rea-Graham Fund, which would invest in stocks based upon the Graham screens. While it had some initial successes, the fund floundered during the 1980s and early 1990s and was ranked in the bottom quartile for performance.

The best support for Graham's views on value investing do not come from academic studies or the Rea-Graham fund but from the success of many of his students at Columbia. While they chose diverse paths, many of them ended up managing money and posting records of extraordinary success. In the section that follows, we will look at the most famous of his students-Warren Buffett.

Warren Buffett: Sage from Omaha

No investor is more lionized or more relentlessly followed than Warren Buffet. The reason for the fascination is not difficult to fathom. He has risen to become one of the wealthiest men in the world with his investment acumen, and the pithy comments on the markets that he makes at stockholder meetings and in annual reports for his companies are widely read. In this section, we will consider briefly Buffett's rise to the top of the investment world.

Buffett's History How does one become an investment legend? Warren Buffett started a partnership with seven limited partners in 1956, when he was 25, with $105,000 in funds. He generated a 29 percent return over the next 13 years, developing his own brand of value investing during the period. One of his most successful investments during the period was an investment in American Express after the company's stock price tumbled in the early 1960s. Buffett justified the investment by pointing out that the stock was trading at far less than what the American Express card generated in cash flows for the company for a couple of years. By 1965, the partnership was at $26 million and was widely viewed as successful.

The moment that made Buffett's reputation was his disbanding of the partnership in 1969 because he could not find any stocks to buy with his value investing approach. At the time of the disbanding, he said, "On one point, I am clear. I will not abandon a previous approach whose logic I understand, although I might find it difficult to apply, even though it may mean foregoing large and apparently easy profits to embrace an approach which I don't fully understand, have not practiced successfully and which possibly could lead to substantial permanent loss of capital." The fact that a money manager would actually put his investment philosophy above short-term profits, and the drop in stock prices in the years following this action, played a large role in creating the Buffett legend.

Buffett then put his share of the partnership (about $25 million) into Berkshire Hathaway, a textile company whose best days seemed to be in the past. He used Berkshire Hathaway as a vehicle to acquire companies (GEICO in the insurance business and non-insurance companies such as See's Candy, Blue Chip Stamps, and Buffalo News) and to make investments in other companies (Am Ex, The Washington Post, Coca-Cola, and Disney). His golden touch seemed to carry over, and Berkshire Hathaway's stock price reflected his success (see Figure 8.1).

An investment of $100 in Berkshire Hathaway in December 1988 would have outstripped the S&P 500 four-fold over the next 13 years.

As CEO of the company, Buffett broke with the established practices of other firms in many ways. He refused to fund the purchase of expensive corporate jets and chose to keep the company in spartan offices in Omaha, Nebraska. He also refused to split the stock as the price went ever higher to the point that relatively few individual investors could afford to buy a round lot in the company. On December 31, 2001, a share of Berkshire Hathaway stock was trading at $75,600, making it by far the highest-priced listed stock in the United States. He insisted on releasing annual reports that were transparent and included his views on investing and the market, stated in terms that could be understood by all investors.

Assessing Buffett It might be presumptuous of us to assess an investor who has acquired mythic status, but is Warren Buffett worthy of his reputation? If so, what accounts for his success, and can it be replicated? We believe that his reputation is well deserved and that his extended run of success cannot be attributed to luck. While he has had his bad years, he has always bounced back in subsequent years. The secret to his success seems to rest on the long view he brings to companies and his discipline-the unwillingness to change investment philosophies even in the midst of short-term failure.

Much has been made of the fact that Buffett was a student of Graham at Columbia University and their adherence to value investing. Warren Buffett's investment strategy is more complex than Graham's original passive screening approach. Unlike Graham, whose investment strategy was inherently conservative, Buffett's strategy seems to extend across a far more diverse range of companies, from high-growth firms like Coca-Cola to staid firms such as Blue Chip Stamps. While Graham and Buffett both might use screens to find stocks, the key difference as we see it between the two men is that Graham strictly adhered to quantitative screens whereas Buffett has been more willing to consider qualitative screens. For instance, Buffett has always put a significant weight on both the credibility and the competence of top managers when investing in a company.

In more recent years, he has had to struggle with two byproducts of his success. Buffett's record of picking winners has attracted a crowd of imitators who follow his every move and buy everything be buys, making it difficult for him to accumulate large positions at attractive prices. At the same time, the larger funds at his disposal imply that he is investing far more than he did two or three decades ago in each of the companies that he takes a position in, which makes it more difficult for him to be a passive investor. It should come as no surprise, therefore, that he is a much more activist investor than he used to be, serving on boards of The Washington Post and other companies and even operating as interim chairman of Salomon Brothers during the early 1990s.

Be Like Buffett? Warren Buffett's approach to investing has been examined in detail, and it is not a complicated one. Given his track record, you would expect a large number of imitators. Why, then, do we not see other investors using his approach to replicate his success? There are three reasons:

* Markets have changed since Buffett started his first partnership. His greatest successes occurred in the 1960s and the 1970s, when relatively few investors had access to information about the market and institutional money management was not dominant. Even Warren Buffett would have difficulty replicating his success in today's market, where information on companies is widely available and dozens of money managers claim to be looking for bargains in value stocks. * In recent years, Buffett has adopted a more activist investment style and has succeeded with it. To succeed with this style as an investor, though, you would need substantial resources and have the credibility that comes with investment success.


Excerpted from Investment Philosophies by Aswath Damodaran Excerpted by permission.
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