1. Yale School of Management Overview of Equity Investing and Value Investing William N. Goetzmann Yale School of Management

2. Equity Investing Motivation and Benefits Long-Term Performance Portfolio Approach to Performance

3. Yale School of Management Why Equity Investing? History Growth Liquidity Diversification Legal rights Aligned interests

4. Yale School of Management Three Centuries of Equities

5. Yale School of Management U.S Financial Markets

6. Yale School of Management Capital Market History 1926 - 1996

7. Yale School of Management The Equity Premium: 1970-1996

8. Yale School of Management Active vs. Passive Investing Value added through information Uncertainty of information Market efficiency Does relative skill exist?

9. Yale School of Management Do Winners Repeat? Goetzmann and Ibbotson 1994 study Used 1976 - 1992 data Found good & bad performance persists Found that active managers beat the Vanguard S&P 500 Index over the period

10. Yale School of Management Evidence on Active Investing

11. Yale School of Management Basics of Active Management Market timing Security selection Diversification Taxes

12. 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

13. 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

14. Yale School of Management The Dow Theory 1903 to 1929

15. Yale School of Management Bull vs. Bear Calls

16. 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

17. Yale School of Management Value Investing Value vs. growth Quantitative approach to valuation models Performance of value stocks Performance of value portfolios

18. 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

19. Yale School of Management The Law of Value Investing C = Cash Flow V = Firm Value R = Discount Rate C = V*R V = C/R R = C/V

20. Yale School of Management No growth in cash flow No changing cash flow No changing discount rate Assumptions

21. 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”

22. 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-estimated R is mis-estimated

23. Yale School of Management Evidence on Value Investing Long-term tests of DCF model Robert Shiller (Yale)  takes known future C/R and compare it to P  finds P is more variable than C/R  Market over-reacts

24. Yale School of Management Under and Over-Valued Markets

25. Yale School of Management Does P/E Forecast for R?

26. 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

27. Yale School of Management Growth and Value G = R - C/V Suppose you had a growth forecast: G * Incremental return = G * - G

28. Yale School of Management Estimating Growth Ibbotson and Riepe, 1997 How well do you do by perfectly forecasting growth? Is growth sufficient? How right do you have to be?

29. Yale School of Management Perfect Foresight Growth

30. Yale School of Management Value vs. Growth Stocks

31. Yale School of Management Value vs. Growth Managers Mutual fund style analysis (Brown and Goetzmann, 1997) Identified equity mutual fund styles Value, Growth & Glamour managers

32. 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

33. 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

34. Yale School of Management How About the Discount Rate? R = G + C/V How is it estimated? Asset pricing models

35. Yale School of Management Summary of Equity Investing Old evidence on timing New evidence on selection Quantitative model of value Value vs. growth stocks Value vs. growth managers Discount rate