Security Analysis Introduction to Finance 450 Spring Semester, 2003 (Notes adapted from The Inefficient Stock Market and The New Finance, both by Robert A. Haugen)

Background:  The evolution of academic finance.

The Evolution of Academic Finance 1930’s40’s50’s60’s70’s80’s90’sbeyond The Old Finance Theme: Analysis of Financial Statements and the Nature of Financial Claims Paradigms:Security Analysis Uses and Rights of Financial Claims (Graham & Dodd) (Dewing) Foundation:Accounting and Law The Old Finance

What Warren Buffett was taught The tradition in which he follows Focus on security analysis and value investing What I expected to learn more about in the MBA program

The Evolution of Academic Finance 1930’s40’s50’s60’s70’s80’s90’sbeyond The Old Finance Modern Finance Bob goes to college Modern Finance Theme:Valuation Based on Rational Economic Behavior Paradigms: Optimization Irrelevance CAPM EMH (Markowitz) ( Modigliani & Miller) (Sharpe, Lintner & Mossen) (Fama) Foundation:Financial Economics

Modern Finance What I was taught in my MBA program (and throughout most of my Ph.D. program) My MBA program’s equivalent of the Portfolio and Security Analysis class taught: –Warren Buffett (one of my inspirations for studying investments in the first place) viewed as an anomaly –Focus of course = theory behind why you should just invest in index funds –No room for trying to achieve market-beating performance (except as a reward for taking on more risk)

The Three Foundations of Modern Finance Portfolio Theory (Ch. 8) Portfolio Theory (Ch. 8)  The Tool  Invented in 1952 by Markowitz.

Lowest Risk Portfolio With a 10% Return Expected Return Risk 10% individual stocks

The Bullet Expected Return Risk The Efficient Set (Bullet) (Bullet)

The Three Foundations of Modern Finance Portfolio Theory (Ch. 8) Portfolio Theory (Ch. 8)  The Tool  Invented in 1952 by Markowitz. CAPM (Ch. 9 & 10) CAPM (Ch. 9 & 10)  The Theory  Invented in early ‘60s by Sharpe, Lintner, & Mossin.

Us on the Skin of The Bullet ExpectedReturn10% Risk Us

Expected Return Return Risk We all Make the Market Index Market Index Index

The Three Foundations of Modern Finance Portfolio Theory (Ch. 8) Portfolio Theory (Ch. 8)  The Tool  Invented in 1952 by Markowitz. CAPM (Ch. 9 & 10) CAPM (Ch. 9 & 10)  The Theory  Invented in early ‘60s by Sharpe, Lintner, & Mossin. The Efficient Market Hypothesis (Ch. 7) The Efficient Market Hypothesis (Ch. 7)  The Fantasy(? – Haugen’s view)  Invented by Fama, also in the early ‘60s.

THE FAMA & FRENCH STUDY* Accepted theories of Modern Finance predict that differences in expected stock returns should be related only to differences in risk. Accepted theories of Modern Finance predict that differences in expected stock returns should be related only to differences in risk. Fama & French find beta is unimportant Fama & French find beta is unimportant (At least as the primary determinant of stock returns!) (At least as the primary determinant of stock returns!) Instead, book-to-price appears as the most important. Instead, book-to-price appears as the most important. *(E. Fama and K. French, 1992, “The Cross-section of Expected Stock Returns,” Journal of Finance)

Book to Market as a Predictor of Return Value Growth 0% 5% 10% 15% 20% 25 % Annualized Rate of Return High Book/Market Low Book/Market

Diamond Head & Diamond Bar The difference between the returns to value and growth found by Fama & French is incredibly large. The difference between the returns to value and growth found by Fama & French is incredibly large.

The Roads to Diamond Bar and Diamond Head 2.47% Real Return 15.18% Real Return $0 $500,000 $1,000,000 $1,500,000 $2,000,000 Cumulative Wealth

Moreover, Fama & French also find that value stocks actually have lower betas. Moreover, Fama & French also find that value stocks actually have lower betas.

Book to Market Equity of Portfolios Ranked by Beta Beta Book to Market Equity

The Finance Profession Splits into Three Camps Fama & French results are are an artifact of survival bias.Fama & French results are are an artifact of survival bias. –CAPM and Efficient Markets both still in (Kothari, Shanken & Sloan).

Survival Bias The Compustat data base (used by Fama & French) was greatly expanded to cover 6000 companies in The Compustat data base (used by Fama & French) was greatly expanded to cover 6000 companies in The histories of these companies were back- filled, but no companies were added that failed to survive through The histories of these companies were back- filled, but no companies were added that failed to survive through 1978.

The Finance Profession Splits into Three Camps Fama & French results are are an artifact of survival bias.Fama & French results are are an artifact of survival bias. –CAPM and Efficient Markets both still in (Kothari, Shanken & Sloan). Differences in expected returns are expected risk premiums.Differences in expected returns are expected risk premiums. –CAPM out Efficient Markets still in (Fama & French).

However, Fama & French found that value stocks actually have lower betas, hence they would generally be considered less risky, not more. However, Fama & French found that value stocks actually have lower betas, hence they would generally be considered less risky, not more. Nonetheless, Fama & French argue that, in some undefined way, the value stocks are riskier, and so they include the difference in returns between value and growth stocks as a risk factor in the three- factor model that they develop as an alternative to CAPM.

Book to Market Equity of Portfolios Ranked by Beta Beta Book to Market Equity

The Finance Profession Splits into Three Camps Fama & French results are are an artifact of survival bias.Fama & French results are are an artifact of survival bias. –CAPM and Efficient Markets both still in (Kothari, Shanken & Sloan). Differences in expected returns are expected risk premiums.Differences in expected returns are expected risk premiums. –CAPM out Efficient Markets still in (Fama & French). Differences in expected returns are a surprise to investors.Differences in expected returns are a surprise to investors. –CAPM and Efficient Markets are both out (Haugen).

Was the crash-and-burn of the Nasdaq and the demise of the telecom and dot-com sectors (except for, maybe, Amazon.com), together with the superior performance of, e.g., Berkshire-Hathaway relative to Pets.com and Homegrocer.com, actually anticipated by most investors? Many argued that the telecom and dot-com stocks had become overvalued, but few suggested that, long-term, they would actually underperform the value stocks. Few would argue that investors were not surprised by the rebound of the “old economy” stocks and the dramatic decline of the “new economy” ones. Is Haugen Correct?

A New Paradigm The Efficient Markets Hypothesis (EMH) has been the dominant paradigm in academic finance for the past 30 years If it needs to be replaced, then what comes next? Two alternative viewpoints: –Michael Mauboussin / Robert G. Hagstrom Mauboussin = Security Analysis professor at Columbia Business School; managing director at CSFB Hagstrom = author of The Warren Buffett Portfolio; manager of the Legg Mason Focus Trust –Robert A. Haugen Emeritus Professor of Finance at U.C., Irvine; Founding partner, Haugen Custom Financial Systems

Haugen’s View Author of “The Inefficient Stock Market” – The EMH as a “religion” Markets as Inefficient –“The Wrong 20-Yard Line” (not even close to being efficient) –But still hard to beat the market due to extensive “noise” –Need to make best use of available tools Ad hoc factor model –For determining expected returns and covariances for stocks Markowitz portfolio optimization –For best combining the stocks into portfolios Primacy of portfolio analysis

Haugen’s View Primacy of Portfolio Analysis Quantitative analysis for determining stock expected returns and covariances Portfolio as the primary unit of security analysis Not concerned about characteristics of individual stocks, per se, but with what they contribute to the overall portfolio –Caesar salad analogy No single ingredient tastes like the completed salad, so don’t screen for specific ingredients that do Each unique ingredient contributes to the overall taste –Water analogy Don’t learn about characteristics of H 2 O by studying characteristics of Hydrogen and Oxygen Haugen’s view of the next paradigm in finance:

The Evolution of Academic Finance 1930’s40’s50’s60’s70’s80’s90’sbeyond The Old Finance Modern Finance The New Finance Bob goes to college The New Finance Theme:Inefficient Markets Paradigms:Inductive ad hoc Factor Models Behavioral Models Expected Return Risk (Haugen) (Chen, Roll & Ross) (Kahneman & Tversky) Foundation:Statistics, Econometrics, and Psychology

Mauboussin’s View – “Shift Happens” Similar to view of Robert Hagstrom, author of “The Warren Buffett Portfolio” The EMH as a “stretched” paradigm –Fama quotation – “I think the crash in ’87 was a mistake” Market as Complex Adaptive System –More realistic paradigm –Markets constantly evolve as participants search for new ways to anticipate the future, learning new rules (but forgetting old ones!) –Market’s evolution not “random,” but, for the most part, not predictable either Market as “effectively” efficient

Mauboussin’s View Potential sources for value-added: –Information –Analysis / Valuation –Exploiting psychological biases of investors / making sure to avoid these biases in one’s own investment decisions Primacy of security analysis –Back to basics Cut through Gordian knot of trying to anticipate what all the other investors will anticipate that the market as a whole will anticipate that a stock will do Over time, stock market values tend to track business values, despite short-term trips away from this foundation of value –Warren Buffett approach

Two Different Views Is there any common ground? –Both agree with the need for a new paradigm CAPM & Random Walk Theory are incomplete, at best Complex Adaptive System Theory or “The New Finance”? –Both agree on the importance of taking investor psychology (“behavioral finance”) into account –Interestingly, despite following radically different approaches, both tend the favor a value-oriented approach to investing Ironically, Haugen’s selected companies bear even greater similarity to Buffett’s type of companies than do Mauboussin’s –Chaos and fractal theory could also provide some additional common ground Will come back and talk more about both of these perspectives as we move through the course

Finance 450 vs. 350 Finance 350 –More applied –More institutional overview –Focus on what things there are to look at Finance 450 –More theoretical –More in-depth –More quantitative –Focus on how to look at the things that are there Foundations of Security and Portfolio Analysis –Provided by Reilly & Brown Extensions, Alternatives, & Applications –Provided by Haugen, Mauboussin, and Hagstrom

General Background There are two broad schools of thought regarding the setting of stocks prices: –“Firm Foundation” –“Castle-in-the-Air” Need a model or thought process that can capture or account for both

“Firm Foundation” Intrinsic value as the driver of prices (at least in the long run) –Benjamin Graham –John Burr Williams –Warren Buffett Value based on future earnings / dividend stream

“Castle-in-the-Air” Investor psychology as the driver of prices (esp. in the short run) –John Maynard Keynes –William O’Neill –George Soros Value based on “greater fool theory” “Perception is reality”

Background (Cont.) Role of Investment Analysis: –Flip side of Corporate Finance –The higher is the marginal investor’s required rate of return, ceteris paribus, the higher will be a corporation’s WACC, and the fewer the number of capital budgeting projects that will have a positive NPV –“Two sides of the same coin” –Main factor driving higher required returns is the amount of risk involved in an investment First question to ask when examining a business – is it creating or destroying value??

Types of Business Projects ROI > WACC ROI = WACC ROI < WACC Value created Value neutral Value negative

Valuing a Business Course will focus on equities, but valuation techniques used are similar for other types of corporate issues Some basic concepts: –Value of assets = f(cash generated) balance sheet  value –Value – liabilities = equity concept of residual claim for equities Equities can be viewed as a “derivative” market –Value largely independent of capital structure (M&M Irrelevance) –Q: How are returns best measured?

Valuing a Business Example: Lemonade Stand at the Beach $100 needed to start Bank loan – 10% = WACC Outcomes  $115 – value created – economic profit = $5  $110 – value neutral – economic profit = $0  $105 – value destroyed – economic profit = -$5  Note: assumes no opportunity cost for time spent hanging around at the beach!  Cash-in vs. cash-out  No question of short-term vs. long-term  Understand how value is created

Analyzing a Business vs. Analyzing an Investment Key aspects of valuing a business –Competitive dynamics –Competitive advantage –Strategy –Financial performance –Management Incentives –Limited information Additional aspects of valuing an investment: –Expectations (a good business isn’t always a good stock) –Vast information Macro drivers (interest rates, currencies) Financials and psychological factors Both sets of aspects are important in determining whether a stock is a good investment!

Background (Cont.) What’s the trade-off between risk and return? Studied by Ibbotson and Sinquefield for the period 1926 – 1988

Historical Risk & Returns of Stocks, Bonds, and T-Bills Ibbotson and Sinquefield (I&S) examined nominal and real rates of return for seven major classes of assets in the United States –1. Large-company common stocks –2. Small-capitalization common stocks –3. Long-term U.S. government bonds –4. Long-term corporate bonds –5. Intermediate-term U.S. Treasury bills –6. U.S. Treasury bills –7. Consumer goods (inflation)

Basic Series: Historical Highlights ( ) Table 3.6

Derived Series: Historical Highlights ( ) I & S computed geometric and arithmetic mean rates of return They derived four return premiums –1. Risk premium –2. Small-stock premium –3. Horizon premium –4. Default premium

Historical Risk/Returns on Alternative Investments Table 3.6 Continued

Derived Series: Historical Highlights ( ) I & S adjusted returns of the series for inflation

Historical Risk/Returns on Alternative Investments Table 3.6 Continued

Returns of Stocks, Bonds, and T-Bills Returns and risk increase together Rates of return are generally consistent with the uncertainty of returns

The empirical research provides clear evidence of a direct relationship between systematic risk and expected return. Historical Return Risk Small Company Stocks Large Company Stocks Long-term Government BondsT-bills Inflation Long-term Corporate Bonds Returns of Stocks, Bonds, and T-Bills

Closing Words: Mauboussin’s advice to starting investors: 1.Understand the economic models, including not only the accounting numbers and financial statements, but how businesses work and interact as competitors. 2.Understand the role and limitations of human beings in the investment world. 3.Work hard, but not too hard.