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Investment Fables: Exposing the Myths of "Can't Miss" Investment Strategies
- By Aswath Damodaran
- Published Mar 12, 2004 by FT Press.
Book
- This product currently is not for sale.
About
Features
Description
- Copyright 2004
- Dimensions: 6-1/4" x 9-1/8"
- Pages: 576
- Edition: 1st
- Book
- ISBN-10: 0-13-140312-5
- ISBN-13: 978-0-13-140312-3
The truth about 13 of today's most widely touted investment strategies.
- 10 powerful lessons for every investor
- Overcoming the enduring myths about markets
- High dividend stocks: better and safer than bonds--or not?
- Cheap stocks: cheap for a reason?
- Should you invest in quality? Momentum? The next big thing? Or what?
You've heard 'em. (Maybe even from your broker!) They're the "can't lose" investment stories that promise you a no-risk path to profits …
- "Buy companies trading below book value."
- "Follow the momentum."
- "Buy stocks with low P/Es."
- "Stick with quality."
- "Buy after bad news."
- "Buy after good news."
- "Follow the insiders."
- "Do whatever Warren Buffett's doing."
And on, and on, and on …
They sound good. But do they really work? You're about to find out.
In Investment Fables, one of the world's leading investment researchers runs the numbers on 13 of today's most widely touted strategies, objectively answering the questions your broker can't answer. Has it worked over the long term? Over the short term? If it made sense once, does it still make sense? Are the promised benefits a statistical mirage? Could it work, as one part of your investment strategy? What are the downsides–and how can you mitigate them?
If you want to make smarter investment decisions, you'll find this book utterly indispensable. Sample Content
Online Sample Chapter
This Stock Is So Cheap! The Low Price-Earnings Story
Downloadable Sample Chapter
Table of Contents
Investment Fables: Tall Tales about Stocks.
1. Introduction.
The Power of the Story.
Categorizing Investment Stories.
Stories for the Risk Averse.
Stories for the Risk Seeker.
Stories for the Greedy.
Stories for the Hopeful.
Deconstructing an Investment Story.
I. Theoretical Roots: Isolating the Kernel of Truth.
II. Looking at the Evidence: Getting the Full Picture.
III. Crunching the Numbers: Developing a Frame of Reference.
IV. More to the Story: Probing for Weaknesses.
V. Lessons for Investors.
Conclusion.
2. High Dividend Stocks: Bonds with Price Appreciation?
Core of the Story.
Theoretical Roots: Dividends and Value.
Dividends Do Not Matter: The Miller-Modigliani Theorem.
Dividends Are Bad: The Tax Argument.
Dividends Are Good: The Clientele and Signaling Stories.
Looking at the Evidence.
Do Higher Yield Stocks Earn Higher Returns?
The Dividend Dogs.
Dividend Increases.
Crunching the Numbers.
Dividend Yields: Across Companies and Over Time.
Sector Differences in Dividend Policy.
A Portfolio of High Dividend Stocks.
The Rest of the Story.
Unsustainable Dividends.
Low Growth.
Taxes.
Lessons for Investors.
Conclusion.
3. This Stock Is So Cheap! The Low Price Earnings Story.
Core of the Story.
Theoretical Roots: Determinants of PE Ratio.
What Is the PE Ratio?
A Primer on Accounting Earnings.
Determinants of PE Ratios.
Looking at the Evidence.
Ben Graham and Value Screening.
Low PE Stocks versus the Rest of the Market.
Crunching the Numbers.
PE Ratios Across the Market.
PE Ratios Across Sectors.
PE Ratio Across Time.
A Low PE Portfolio.
More to the Story.
Risk and PE Ratios.
Low Growth and PE Ratios.
Earnings Quality and PE Ratios.
Lessons for Investors.
Conclusion.
Endnotes.
4. Less than Book Value: What a Bargain?
The Core of the Story.
Theoretical Roots Theory: Price to Book Ratios and Fundamentals.
Defining the Price-to-Book Ratio.
How Accountants Measure Book Value.
Determinants of PBV Ratios.
Looking at the Evidence.
Evidence from the United States.
Evidence from Outside the United States.
Crunching the Numbers.
Distribution of Price-to-Book Ratios Across the Market.
Price-to-Book Ratios by Sector.
A Low Price-to-Book Portfolio.
More to the Story.
High-Risk Stocks.
Low-Priced Stocks.
Poor Projects: Low Return on Equity.
Lessons for Investors.
Conclusion.
5. Stable Earnings, Better Investment?
Core of the Story.
Measurement of Earnings Stability.
Theoretical Roots: Earnings Stability and Value.
Diversification and Risk.
Stable Earnings, Risk and Value.
Looking at the Evidence.
Stable Businesses with No Competition.
Diversified Business Mix: The Allure of Conglomerates.
Global Diversification.
The Risk Hedgers.
The Earnings Smoothers.
Crunching the Numbers.
Earnings Volatility Across the Market.
A Portfolio of Stable Earnings Companies.
More to the Story.
Stable Earnings, Risky Investment?
Giving Up on Growth Opportunities.
Priced Right?
Earnings Quality.
Lessons for Investors.
Conclusion.
6. In Search of Excellence: Are Good Companies Good Investments?
Core of the Story.
What Is a Good Company?
Financial Performance.
Corporate Governance.
Social Responsibility.
The Theory: Building Quality into Value.
Inputs in a DCF Valuation.
EVA and Excess Return Models.
Looking at the Evidence.
Project Quality and Stock Returns.
The Payoff to Corporate Governance.
The Payoff to Social Responsibility.
Broader Definitions of Good Companies.
Crunching the Numbers.
Across the Market.
A Superior Company List.
More to the Story.
Failing the Expectations Game.
Revering to the "Norm".
Lessons for Investors.
Conclusion.
Endnotes.
7. Grow, Baby, Grow!: The Growth Story.
The Core of the Story.
The Theory: Growth and Value.
Growth in a Discounted Cash Flow Valuation.
The Value of Growth in a Relative Valuation.
Looking at the Evidence.
High PE Strategy.
Growth at a Reasonable Price (GARP) Strategies.
Crunching the Numbers.
Across the Market.
The Value of Growth.
A High Growth Portfolio.
More to the Story.
Identifying Growth Companies.
Screening for Risk.
Poor-Quality Growth.
Lessons for Investors.
Conclusion.
8. The Worst Is Behind You: The Contrarian Story.
The Core of the Story.
Theoretical Roots: The Contrarian Story.
Information and Price.
The Random-Walk World.
The Basis for Contrarian Investing.
Looking at the Evidence.
Serial Correlation.
Loser Stocks.
Crunching the Numbers.
Across the Market.
The Sector Effect.
A Portfolio of Losers.
More to the Story.
Transactions Costs.
Volatility and Default Risk.
Catalysts for Improvement.
Lessons for Investors.
Conclusion.
Endnotes.
9. The Next Big Thing: New Businesses and Young Companies.
Core of the Story.
Theoretical Roots: Risk and Potential Growth.
Additional Risk.
Potential for Excess Return.
Looking at the Evidence.
Small Companies.
Initial Public Offerings.
Private Companies.
Crunching the Numbers.
Market Capitalization.
Initial Public Offerings.
Private Equity Investments.
A Portfolio of Small Cap, Lightly Followed Stocks.
More to the Story.
Small and Lightly Followed Stocks.
Initial Public Offerings.
Private Companies.
Lessons for Investors.
Conclusion.
Endnotes.
Appendix: Small-Cap Companies That Are Lightly Followed: January 2003.
10. Mergers and Returns: The Acquisitive Company.
Core of the Story.
Theoretical Roots: Acquisitions and Value.
Acquisitions and Value Creation.
Acquisitions and Value Division.
Looking at the Evidence.
Acquisition Date.
From Announcement to Action.
After the Acquisition.
Crunching the Numbers.
Acquiring and Acquired Firms.
Creating Portfolios.
More to the Story.
Investing in Acquiring Firms.
Investing in Target Firms.
Lessons for Investors.
Conclusion.
Endnotes.
Appendix: Potential Takeover Targets Among US Companies-March 2003.
11. A Sure Thing: No Risk and Sure Profits.
Core of the Story.
Theoretical Roots of Arbitrage.
Pure Arbitrage.
Near Arbitrage.
Pseudo or Speculative Arbitrage.
Looking at the Evidence.
Pure Arbitrage.
Near Arbitrage.
Pseudo or Speculative Arbitrage.
Crunching the Numbers.
Futures and Options Arbitrage.
Depository Receipts.
Closed-End Funds.
More to the Story.
Pure Arbitrage.
Near Arbitrage.
Speculative Arbitrage.
Lessons for Investors.
Conclusion.
Endnotes.
12. It's All Upside: The Momentum Story.
The Core of the Story.
Theoretical Roots of Momentum Investing.
Measures Used by Momentum Investors.
Models for Momentum.
Looking for the Evidence.
Serial Correlation in Stock Price Drifts.
Information Announcements.
The Confounding Effect of Trading Volume.
Momentum in Mutual Funds.
Crunching the Numbers.
Momentum Measures.
Constructing a Momentum Portfolio.
More to the Story.
Risk.
Momentum Shifts (When Do You Sell?).
Execution Costs.
Lessons for Investors.
Conclusion.
Endnotes.
13. Follow the Experts.
The Core of the Story.
Theoretical Roots: The Value of Expert Opinion.
Looking at the Evidence.
Insiders.
Analysts.
Investment Advisors and Other Experts.
Crunching the Numbers.
Insider Trading.
Analyst Recommendations and Revisions.
Portfolio of "Expert" Stocks.
More to the Story.
Following Insiders: Timing Is Everything.
Earnings Revisions.
Analyst Recommendations.
Lessons for Investors.
Conclusion.
14. In the Long Term... Myths about Markets.
Core of the Story.
Theoretical Roots: Market Timing.
Market Timing Trumps Stock Selection.
Market Timing Works.
Looking at the Evidence.
Do Stocks Always Win in the Long Term?
Market Timing Indicators.
Market Timers.
More to the Story.
Stocks Are Not Riskless in the Long Term.
Market Timing Works Only Infrequently.
Lessons for Investors.
Conclusion.
15. Ten Lessons for Investors.
Lesson 1: The more things change, the more they stay the same.
Lesson 2: If you want guarantees, don't invest in stocks.
Lesson 3: No pain, no gain.
Lesson 4: Remember the fundamentals.
Lesson 5: Most stocks that look cheap are cheap for a reason.
Lesson 6: Everything has a price.
Lesson 7: Numbers can be deceptive.
Lesson 8: Respect the market.
Lesson 9: Know yourself.
Lesson 10: Luck overwhelms skill (at least in the short term).
Conclusion.
Index.
Preface
As investors, you have all been on the receiving end of sales pitches from brokers, friends and investment advisors about stocks that they claim will deliver spectacular returns. These stories not only sound persuasive and reasonable but are also backed up by evidence—anecdotal, in some cases, and statistical, in others—that the strategies work. When you try to implement them for your investments, though, you seldom can match their success on paper. All too often, you end up with buyer's remorse, poorer for the experience and promising yourselves that you will not fall for the allure of these stories again. All too often, you forget the lessons of past mistakes and are easy prey for the next big stock story.
While there are literally hundreds of schemes to beat the market in circulation, they are all variants of about a dozen basic themes that have been around for as long as there have been stocks to buy and sell. These broad themes are modified, given new names and marketed as new and different investment strategies by salespeople to a new generation of investors. There must be something in these stories that appeals to investor instincts and to human weaknesses— greed, fear and hubris, to name but three—to give them the staying power that they do. This book is an exploration of the appeal of these stories, why so many investors fall for them and fail with them, and what it may take to win with each of them.
As you will see, with each story, there is a kernel of truth that makes it believable and a base in financial theory that allows proponents to claim to have a solid rationale. Each chapter begins with an examination of the basis for each investment story and the theory that would justify its adoption. Why bother with the theory? Not only will it give you perspective on what makes each story work, but it will also allow you to identify potential weaknesses with the story.
If you have been on the receiving end of one of these investment stories, you probably have also been told of studies that back them up and you are offered evidence of their potency. It should come as no surprise, given the source, that most of these studies give you only a portion of the truth. As you will see in this book, every investment strategy ever devised has succeeded for some periods and with some stocks, but the complete picture requires an assessment of whether it works over long periods and with a wide cross section of stocks. That is why you will see a review of the existing empirical evidence, drawn from both believers and skeptics, on each strategy and some of the potential problems with each.
With every investment strategy, investors also grapple with the question of what adopting that strategy will mean in terms of investment choices. If you adopt a strategy of buying “low” PE stocks, you have to judge what represents a low PE ratio and what types of stocks have low PE ratios. If you believe that your best investments are in small companies, you have to decide how to measure the size of companies —sales, market capitalization, etc.—and what level would represent a small company. You will be presented with rules of thumb, that a PE of 8 is cheap or that a company with a market capitalization less than $100 million is small, but these rules of thumb can be dangerous as markets themselves change over time. To provide a frame of reference, this book examines the distribution of various measures— PE, price-to-book ratio and market capitalization, to name a few— across the entire market. This should then allow you to get a sense of differences across the market and to develop portfolio standards.
The best test of any strategy is to apply it to the market and to peruse the portfolio that you would have ended up with as a result of following it. This book attempts to do this with each of the broad strategies examined, and you can ask yourself whether you would be comfortable investing in the stocks that make up this portfolio. If you are not, it is a warning sign that this strategy may not be appropriate for you. If you are a careful investor, putting this portfolio under a microscope will allow you to study the strategy for weaknesses and examine what you can do to minimize the damage.
It is worth emphasizing what this book is about and what it does not try to do. It is not about promoting or debunking investment strategies, since there are plenty of analysts and brokers who do the former and lots of cynics, many from academia, who do the latter. But it is about providing a full picture of each investment strategy so that you can make your own judgments about what works and what does not. It is not about answering every investment question that has ever been asked; no one can have the foresight to do this. But it is about providing you with the ammunition to ask the right questions when confronted with promoters of these strategies. It is not a book for pessimists who are convinced that picking stocks is an exercise in futility, but it is a book for optimists who want to figure out how to make active strategies pay off and how to use them prudently. It is not about things you cannot and should not do while investing, but it is about things you can and should do as an investor to improve your odds for success.
As long as there have been financial markets, there have been mountebanks and frauds luring investors into get-rich schemes that ultimately fail. In the aftermath of these failings, you are often tempted to turn to the courts and to governments to protect you from yourself. The best antidote, though, to an unscrupulous sales pitch about “stocks that cannot lose” or to a “get rich quickly” scheme is a skeptical and informed investor. I hope this book helps you become one.
Index