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

Security AnalysisSecurity 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:Background:

The evolution of academic finance.The evolution of academic finance.

The Evolution of Academic Finance

1930’s 40’s 50’s 60’s 70’s 80’s 90’s beyond

The Old FinanceThe 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

The Old FinanceThe 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


1930’s 40’s 50’s 60’s 70’s 80’s 90’s beyond

The Old Finance

Modern Finance

Bob goes to college

Modern FinanceModern Finance

Theme: Valuation Based on Rational Economic Behavior

Paradigms: Optimization Irrelevance CAPM EMH

(Markowitz) (Modigliani & Miller) (Sharpe, Lintner & Mossen) (Fama)

Foundation: Financial Economics

Modern FinanceModern 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 The Three Foundations of Modern Financeof Modern Finance

• Portfolio TheoryPortfolio Theory (Ch. 8) (Ch. 8) The ToolThe Tool

Invented in 1952 by Markowitz.Invented in 1952 by Markowitz.

Lowest Risk Portfolio With a 10% ReturnLowest Risk Portfolio With a 10% Return

Expected ReturnExpected Return

RiskRisk

10%10%

individual stocks

The BulletThe Bullet

Expected ReturnExpected Return

RiskRisk

The Efficient SetThe Efficient Set (Bullet)(Bullet)




• CAPMCAPM (Ch. 9 & 10) (Ch. 9 & 10) The TheoryThe Theory

Invented in early ‘60s by Sharpe, Lintner, & Invented in early ‘60s by Sharpe, Lintner, & Mossin.Mossin.

Us on the Skin of The BulletUs on the Skin of The Bullet

Expected Expected ReturnReturn

10%10%

RiskRisk

UsUs

ExpectedExpected ReturnReturn

RiskRisk

We all Make the Market We all Make the Market IndexIndex

MarketMarket IndexIndex




• CAPM (Ch. 9 & 10)CAPM (Ch. 9 & 10) The Theory The Theory

Invented in early ‘60s by Sharpe, Lintner, & Invented in early ‘60s by Sharpe, Lintner, & Mossin.Mossin.

• The Efficient Market Hypothesis (Ch. 7)The Efficient Market Hypothesis (Ch. 7) The Fantasy(? – Haugen’s view)The Fantasy(? – Haugen’s view)

Invented by Fama, also in the early ‘60s.Invented by Fama, also in the early ‘60s.

THE FAMA & FRENCH STUDY*THE FAMA & FRENCH STUDY*

• Accepted theories of Modern Finance predict that Accepted theories of Modern Finance predict that differences in expected stock returns should be differences in expected stock returns should be related only to differences in risk . related only to differences in risk .

• Fama & French find beta is Fama & French find beta is unimportantunimportant

• (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 Instead, book-to-price appears as the mostmost important.important.

*(E. Fama and K. French, 1992, “The Cross-section *(E. Fama and K. French, 1992, “The Cross-section of Expected Stock Returns,” of Expected Stock Returns,” Journal of FinanceJournal of Finance))

Book to Market as a Predictor of ReturnBook to Market as a Predictor of Return

ValueValue

GrowthGrowth

0%0%

5%5%

10%10%

15%15%

20%20%

2525%%

Annualiz

ed R

ate

of

Retu

rnA

nnualiz

ed R

ate

of

Retu

rn

1010998877665544332211

High Book/Market Low Book/MarketHigh Book/Market Low Book/Market

Diamond Head & Diamond BarDiamond Head & Diamond Bar

The difference between the returns to value and growth found by Fama & French is The difference between the returns to value and growth found by Fama & French is incrediblyincredibly large. large.

The Roads to Diamond Bar and Diamond HeadThe Roads to Diamond Bar and Diamond Head

2.47% Real Return2.47% Real Return

15.18% Real Return15.18% Real Return

30303232

34343636

38384040

42424444

46464848

5052

545656

58586060

62626464

$0$0

$500,000$500,000

$1,000,000$1,000,000

$1,500,000$1,500,000

$2,000,000$2,000,000

Cumulative WealthCumulative Wealth

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

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

0.60.6 0.80.8 11 1.21.2 1.41.4 1.61.6 1.81.8

BetaBeta

0.50.5

0.60.6

0.70.7

0.80.8

0.90.9

11

Book

to M

ark

et

Equit

yB

ook

to M

ark

et

Equit

y

The Finance Profession The Finance Profession Splits into Three CampsSplits into Three Camps

• Fama & French results are are an artifact of Fama & French results are are an artifact of survival bias. survival bias.

– CAPM and Efficient Markets both still in CAPM and Efficient Markets both still in (Kothari, Shanken & Sloan).(Kothari, Shanken & Sloan).

Survival BiasSurvival Bias

The Compustat data base (used by Fama & The Compustat data base (used by Fama & French) was greatly expanded to cover 6000 French) was greatly expanded to cover 6000 companies in 1978. companies in 1978.

The histories of these companies were back-The histories of these companies were back-filled, but no companies were added that filled, but no companies were added that failed to survive through 1978.failed to survive through 1978.



– CAPM and Efficient Markets both still in CAPM and Efficient Markets both still in (Kothari, Shanken & Sloan).(Kothari, Shanken & Sloan).

• Differences in expected returns are expected Differences in expected returns are expected risk premiums.risk premiums.– CAPM out Efficient Markets still in (Fama & CAPM out Efficient Markets still in (Fama &

French).French).

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

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

0.60.6 0.80.8 11 1.21.2 1.41.4 1.61.6 1.81.8

BetaBeta

0.50.5

0.60.6

0.70.7

0.80.8

0.90.9

11

Book

to M

ark

et

Equit

yB

ook

to M

ark

et

Equit

y



– CAPM and Efficient Markets both still in (Kothari, CAPM and Efficient Markets both still in (Kothari, Shanken & Sloan).Shanken & Sloan).

• Differences in expected returns are expected risk Differences in expected returns are expected risk premiums.premiums.– CAPM out Efficient Markets still in (Fama & French).CAPM out Efficient Markets still in (Fama & French).

• Differences in expected returns are a surprise to Differences in expected returns are a surprise to investors.investors.– CAPM and Efficient Markets are both out (Haugen).CAPM and Efficient Markets are both out (Haugen).

Was the crash-and-burn of the Nasdaq and the demise of the Was the crash-and-burn of the Nasdaq and the demise of the telecom and dot-com sectors (except for, maybe, Amazon.com), telecom and dot-com sectors (except for, maybe, Amazon.com), together with the superior performance of, e.g., Berkshire-together with the superior performance of, e.g., Berkshire-Hathaway relative to Pets.com and Homegrocer.com, actually Hathaway relative to Pets.com and Homegrocer.com, actually anticipated by most investors?anticipated by most investors?Many argued that the telecom and dot-com stocks had become Many argued that the telecom and dot-com stocks had become overvalued, but few suggested that, long-term, they would actually overvalued, but few suggested that, long-term, they would actually underperform the value stocks.underperform the value stocks.Few would argue that investors were Few would argue that investors were notnot surprised by the rebound surprised by the rebound of the “old economy” stocks and the dramatic decline of the “new of the “old economy” stocks and the dramatic decline of the “new economy” ones.economy” ones.

Is Haugen Correct?Is Haugen Correct?

A New ParadigmA 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 ViewHaugen’s View• Author of “The Inefficient Stock Market”

– www.haugensystems.com

• 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 ViewHaugen’s ViewPrimacy 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 H2O by studying characteristics of

Hydrogen and Oxygen

Haugen’s view of the next paradigm in finance:


1930’s 40’s 50’s 60’s 70’s 80’s 90’s beyond

The Old Finance

Modern Finance

The New Finance Bob goes to college

The New FinanceThe 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 ViewMauboussin’s View• www.capatcolumbia.com – “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 ViewMauboussin’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 ViewsTwo Different ViewsIs 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. 350Finance 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 BackgroundGeneral 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”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”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.)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 Types of Business ProjectsBusiness Projects

• ROI > WACC

• ROI = WACC

• ROI < WACC

• Value created

• Value neutral

• Value negative

Valuing a BusinessValuing 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 BusinessValuing 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 a Business vs. Analyzing an InvestmentAnalyzing 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.)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 Historical Risk & Returns of Stocks, Bonds, and T-BillsStocks, 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 Basic Series: Historical Highlights (1926 - 1997)Highlights (1926 - 1997)

Annual Arithmetic Standard

Geometric Mean of Deviation

Mean Rate Annual of Annual

Series of Return Returns Returns

12.7 % 17.7 % 33.9 %Large company stocks 11.0 13.0 20.3

5.7 6.1 8.75.2 5.6 9.2

Intermediate-term government bonds 5.3 5.4 5.73.8 3.8 3.2

Consumer price index 3.1 3.2 4.5Source: © Stocks, Bonds, Bills, and Inflation: 1998 YearbookTM, Ibbotson Associates, Chicago(Annually updates work by Roger G. Ibbotson and Rex A. Sinquefield). Used with permission. All rights reserved.

Small capitalization stocks

Long-term corporate bondsLong-term government bonds

U.S. Treasury bills

Table 3.6

Derived Series: Historical Derived Series: Historical Highlights (1926 - 1997)Highlights (1926 - 1997)

• 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 Historical Risk/Returns on Alternative InvestmentsAlternative Investments




1.5 1.7 8.6Default premium 0.4 0.4 3.0Equity risk premium 6.9 8.9 20.4Small stock premium 1.6 3.1 18.2Source: © Stocks, Bonds, Bills, and Inflation: 1998 YearbookTM, Ibbotson Associates, Chicago(Annually updates work by Roger G. Ibbotson and Rex A. Sinquefield). Used with permission. All rights reserved.

Horizon Premium

Table 3.6

Continued

Derived Series: Historical Derived Series: Historical Highlights (1926 - 1997)Highlights (1926 - 1997)

• I & S adjusted returns of the series for

inflation

Historical Risk/Returns on Historical Risk/Returns on Alternative InvestmentsAlternative Investments

Annual Arithmetic Standard




INFLATION ADJUSTED9.3 14.2 33.3

Large company stocks 7.7 9.7 20.52.6 3.0 10.02.1 2.6 10.5

Intermediate-term government bonds 2.1 2.3 7.00.6 0.7 4.2

Source: © Stocks, Bonds, Bills, and Inflation: 1998 YearbookTM, Ibbotson Associates, Chicago(Annually updates work by Roger G. Ibbotson and Rex A. Sinquefield). Used with permission. All rights reserved.

Long-term corporate bondsLong-term government bonds

Small capitalization stocks

U.S. Treasury bills

Table 3.6

Continued

Returns of Stocks, Bonds, and Returns of Stocks, Bonds, and T-BillsT-Bills

• Returns and risk increase together

• Rates of return are generally consistent

with the uncertainty of returns

The empirical research provides clear evidenceof a direct relationship between systematic riskand expected return.

HistoricalReturn

Risk

SmallCompany Stocks

LargeCompany Stocks

Long-term Government BondsT-bills

Inflation

Long-term Corporate Bonds

Returns of Stocks, Bonds, and Returns of Stocks, Bonds, and T-BillsT-Bills

Closing Words: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.

Documents

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