Value Investing

Question 1

Price to book ratio (P/B)

Answer 1

on a stock’s price-to-book (P/B) ratio. The price-to-book ratio is a stock’s current price divided by the net balance sheet (book) value of the stock. Book value is the recorded accounting “value” of the firm’s assets (which can either be their cost or some estimate of the value at which they could be sold) minus the accounting “value” of the firm’s liabilities. In other words, the P/B ratio measures the market’s perception of the stock versus what the underlying assets are “worth” from an accounting sense. Stocks with P/B ratios in the lowest 30th percentile at the beginning of a given year are considered value stocks (they are selling for a low price relative to their underlying net assets), while stocks with P/B ratios in the highest 30th percentile are considered growth stocks for that year.

Value investors generally prefer firms selling at lower P/E ratios, as they believe there is less chance that they will be disappointed that future growth prospects will not be realized. Just because a stock is selling at a relatively low P/E ratio certainly does not mean that it is undervalued. It may sell at a low P/E ratio because investors are pessimistic regarding future earnings from the stock. P/E ratios vary considerably through time and also across industries. When overall market sentiment is positive, P/E ratios can be very high, as investors place a high premium on future growth prospects. However, P/E ratios can also be very high when overall earnings fall considerably. For the S&P 500 Index, the P/E ratio reached a historic high of 46.5 in the early 2000s, largely due to falling earnings (see Figure 4-6). The average P/E for the past 100 years has been around 15. Firms in growth industries typically sell at much higher P/E ratios than firms in mature industries.

Question 2

Value stock vs growth stock

Answer 2

Value: p/b ratios lower than 30th percentile
Growth: p/b ratios higher than 30th percentile

Question 3

Risk

Answer 3

With investments, risk is often measured as the variability of returns.

we can expect the return in any given year to fall within one standard deviation of the average about two-thirds of the time. For example, the standard deviation for the overall market is 20.3 percent, and the average return is 11.8 percent. Therefore, we would expect the overall stock market to record a return within –8.5 percent and 32.1 percent in any given year about two-thirds of the time. We derive these figures by subtracting the standard deviation from the average return and adding the standard deviation to the average return. This range is quite large because the standard deviation is relatively high, which is an indication of risk and the overall stock market.

The range defined by adding and subtracting one standard deviation from the mean will tend to capture only about two-thirds of the returns.

We can expect returns to fall within two standard deviations of the average about 95 percent of the time. Therefore, we would expect the overall stock market to record a return within –28.8 percent and 52.4 percent in any given year. Because this range is so wide, it is not terribly informative.

Question 4

Sharpe ratio

Answer 4

The Sharpe ratio compares the average excess return on a risky investment with its standard deviation. Excess return is the average return on a risky investment (like the stock market) less what could have been earned on a risk-free investment (like three-month Treasury bills). The ratio of this excess return to the standard deviation is called the Sharpe ratio.

Question 5

Volatility drag

Answer 5

volatility drag, which is determined in large part by the standard deviation. Most of us are familiar with the adage that if you lose 50 percent of your money one year and gain 50 percent the next year, you are not back to even. Rather, you are still down 25 percent despite our “average” return being 0 percent.3 The reason is that volatility puts a drag on capital accumulation. If we had earned 0 percent the first and second years consistently, we would have had the same “average” return, but had a lot more money after two years: $100 versus $75.

This is not some numerical trickery. The higher the standard deviation, the higher the volatility drag. In our example in which the average return is 11.8 percent, we are more likely to double our money rather than triple it if the standard deviation is 20.3 percent. That is, half the time our $1,000 will grow to over $2,000. The other half of the time it will grow to less than $2,000.

Question 6

Kurtosis

Answer 6

When extremely positive or negative returns are more common than the bell curve would suggest, those returns are said to exhibit excess kurtosis. As a result, the returns are more risky than a limited examination of only standard deviation would suggest.

Question 7

Correlation coefficient

Answer 7

correlation coefficient measures how two securities move together. A value of positive one means that the two securities always move in the same direction, even if the magnitude of those movements is different. A value of negative 1 means that the two securities always move in opposite directions. The value of zero means they may or may not move in the same direction and that knowing the direction in which one moves does not help us predict the direction in which the other one moves.

Question 8

Beta

Answer 8

We can also measure risk by incorporating how our security or portfolio moves with the overall market. If a portfolio tends to exacerbate overall market movements, it would be considered relatively more risky. If it increased and decreased in value in a more muted manner than the overall market, it would be considered less risky. The measure we use to capture this phenomenon is called beta.

Question 9

Price reversal

Answer 9

Change in direction, from going up to going down, or vice versa.

Question 10

Arbitrage

Answer 10

Arbitrage involves buying an underpriced security in one market and short selling (Box 3-6) a similar overpriced security in another market in the hope that the two similar securities converge to the same, fair value. An arbitrageur profits when the underpriced security increases to its fundamental value and the overpriced security decreases to its fundamental value.10 Arbitrage is pure, unadulterated value investing.

On December 4, 1998, Creative Computers issued 20 percent of the shares of its online auction subsidiary, uBid, to the public. After the first day of trading, Creative Computer’s stake in uBid was worth $351.2 million according to uBid’s share price. Creative Computer’s total equity market value was only about $275 million, implying the value of all of Creative Computer’s other assets was negative $76 million! An arbitrageur would buy shares of Creative Computer and sell shares of uBid until the implied negative valuation disappeared. Ideally, proceeds from the short sale of uBid can be used to fund the purchase of Creative Computer so that no capital is required. Moreover, because the relative prices of the securities are determined by a mathematical relationship, it is somewhat “riskless.”

Question 11

Short selling

Answer 11

On Wall Street, however, it is not a prerequisite to own something before you sell it. It is nowhere near as nefarious as it sounds and is called short selling. Short sellers are able to sell shares they do not own by borrowing them from somebody who does. Short sellers are said to “cover their short” by buying back shares and returning them to their original owner. The short seller sells shares at the higher price and purchases them back later at a lower price.

Question 12

Price reversal strategy

Answer 12

Price reversal strategies are most successful over six and 10-year periods (e.g., five years of underperformance followed by five years of overperformance according to research by Werner DeBont and Richard Thaler.

Question 13

Top down

Answer 13

there are two basic styles, top-down or bottom-up, as depicted in Figure 4-1. As the titles suggest, a top-down investor first analyzes the economy as a whole, then industries, and finally tries to identify firms within the selected industry expected to outperform rivals relative to expectations. From a value investor’s perspective you must also determine whether these companies are a good value relative to other potential investments.

Question 14

Top down analysis

Answer 14

analysis of the global/domestic economy is first performed to determine what portion of a portfolio will be allocated to international and domestic equities. This is usually followed by an analysis of which sectors (for example, consumer staples) are more attractive within the equity market. Within each sector, attractive industries (an industry in this context is defined as a subdivision of a sector, such as food and beverages) are identified. Finally, an analysis is performed to determine which companies within the industry are most attractive based on the relationship of valuation to expected performance. (A whirling funnel with the economy on top, and square at the most narrow part)

Question 15

Bottom up analysis

Answer 15

In a bottom-up analysis, the process starts at the level of individual companies. An investor begins by looking for companies that are attractive based upon some fundamental characteristics (such as return on equity (ROE), price-to-earnings (P/E) ratios, and total debt). The majority of individual investors can be characterized as bottom-up investors. Bottom-up analysis can begin by a company coming to an investor’s attention for any number of reasons, such as a new product launch, a change of management, or high quality of service. On the other hand, bottom-up analysis can also involve screening on large databases of equities in an attempt to identify those firms that have attractive characteristics. (Bill gates face then drone camera shoots up and we get a shot of the earth)

Question 16

GDP (growth domestic product)

Answer 16

Gross domestic product (GDP) is the total value of all final goods and services produced within a country. Nominal GDP is GDP measured in terms of current dollars. Real GDP is nominal GDP adjusted for changing prices. Table 4-1 presents nominal and real GDP for the United States from 1990 to 2012. Note that in nominal terms U.S. GDP grew by a robust 4.58 percent in 2012 relative to 2011. In real terms, however, economic growth was only 2.78 percent.

GDP is for use in measuring the business cycle and long-term economic trends.

Question 17

Gross national product

Answer 17

similar measure, gross national product (GNP) is the total value of all final goods and services produced by factors of production owned by citizens of a country, regardless of where they are produced.

Question 18

Recession

Answer 18

Recession is a period of contraction following the peak, characterized by falling productive output and employment (rising unemployment). Typically a recession is defined as two quarters of falling output, measured by real GDP.

Question 19

Sectors

Answer 19

Importantly, some sectors and industries perform better in some stages of the economic cycle than in others. Under the Global Industry Classification System (GICSSM) developed by Morgan Stanley Capital International and Standard & Poor’s (S&P), companies are divided into 10 sectors, 24 industry groups, 68 industries and 154 subindustries. The 10 sectors and an example of an industry for each are:

Energy
Materials 
Industrial 
Consumer discretionary (auto mobiles)
Consumer staples (food)
Healthcare
Financials
IT (computers)
Telecommunications (wireless)
Utilities

Question 20

Cyclical vs. non cyclical

Answer 20

1. Cyclical : vacations, things sensitive to the business cycle
2. Non cyclical: not sensitive (food) also called defensive

Question 21

Inflation

Answer 21

An important aspect of the analysis of the economy is an overall assessment of expected inflation. The risk-free rate of interest is an input into the valuation of a company’s future cash flows. The nominal risk-free rate is a function of the inflation rate and the real interest rate required by investors to forgo consumption. The higher the level of expected inflation the higher the required risk-free rate of interest.

Question 22

Producer price indices (PPIs)

Answer 22

measure inflation at the wholesale level.

Question 23

Sentiment index

Answer 23

Sentiment measures are generally considered contrary indicators. When a sentiment index shows heightened fear of a market drop, one can infer that investors are concerned and nervous about the future. Thus, investors may be keeping money out of the market that can be used in the future to buy stocks and increase prices. It may seem counterintuitive, but a sentiment index that is in negative territory signals a potential buying opportunity for the value investor, as that investor is trying to go against the consensus of the market by buying low and selling high.

Question 24

Put option

Answer 24

put option gives the holder the right to sell shares of stock at a specific price. Put options increase in value as share prices fall.

Question 25

Call option

Answer 25

A call option gives the holder the right to buy shares of stock at a specific price. A call option increases in value as share prices rise.

Question 26

Put call ratio

Answer 26

The Chicago Board Options Exchange publishes a daily put-call ratio (PCR), shown in Figure 4-3.3 It is simply the ratio of put option trading volume to call option volume. rising put-call ratio reflects concern by options traders about the potential of falling share prices. Although a value of 1.0 might seem to be a “neutral” reading (an equal number of put options and call options), historically there are more calls than puts bought on what would be considered a normal day. Thus, a PCR of approximately 0.80 is considered normal. Markets are considered strong (and contrarians would contend overbought) when the ratio falls below 0.7 since the optimists clearly outweigh the pessimists. Markets are considered weak (and contrarians would contend oversold) when the ratio rises above 1.1 because the pessimists outweigh the optimists. Since the put-call ratio is a contrary indicator, the high ratio, all else equal, would be viewed as a positive for the near term prospects for Walmart stock.

Question 27

VIX

Answer 27

CBOE Volatility Index (VIX) is a measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. The interpretation of the VIX is the expected volatility in the index over the next 30 days on an annualized basis. This volatility is that implied from the well-known Black-Scholes option-pricing model by the options prices in the marketplace. Introduced in 1993, the VIX has been considered an indicator of investor sentiment as well as market volatility. While the VIX is an indicator of the implied volatility in options prices (and, of course, volatility can be on the upside or downside), many believe that a rising VIX signals growing fear and willingness to pay more for protection against falling stock prices (see Figure 4-4). As a rule of thumb, VIX measures over 30 correspond to a large amount of investor uncertainty and implied volatility, while readings under 20 are found during relatively calm periods in the market. High vix reading as more attractive time to invest for contrarian.

Question 28

Ips (investment policy statement)

Answer 28

The basic IPS can be organized into three main parts: 1. Investment Objectives a. Return Requirements b. Risk Tolerance and Risk Capacity 2. Investment Constraints a. Liquidity Needs b. Time Horizon c. Tax Considerations d. Legal and Regulatory Considerations e. Unique Circumstances 3. Investment Philosophy and Strategies

Question 29

Real vs nominal GDP

Answer 29

Gross domestic product (GDP) is the total value of all final goods and services produced within a country. Nominal GDP is GDP measured in terms of current dollars. Real GDP is nominal GDP adjusted for changing prices. Table 4-1 presents nominal and real GDP for the United States from 1990 to 2012. Note that in nominal terms U.S. GDP grew by a robust 4.58 percent in 2012 relative to 2011. In real terms, however, economic growth was only 2.78 percent.

Question 30

Barrons confidence index

Answer 30

Barron’s Confidence Index The Barron’s Confidence Index attempts to gauge investor confidence in the economy by dividing the average yield on high-grade bonds by the average yield on intermediate-grade bonds. Since yields on intermediate-grade bonds are higher than yields on high-grade bonds, a rising Barron’s Confidence Index would indicate that the consensus of bond investors has increasing confidence in the economy as the premium for bearing higher risk is declining. That is, investors are more willing to invest in higher risk bonds, driving their yields lower relative to lower risk bonds.

Question 31

American association of individual investors sentiment index

Answer 31

AAII) American Association of Individual Investors Sentiment Index The American Association of Individual Investors (AAII) Sentiment Survey measures the percentage of individual investors who are bullish, bearish, and neutral on the stock market over the next six months.

Question 32

Sector rotation

Answer 32

Sector rotation involves an analysis of the current economic environment and a forecast of where the overall economy is heading.

Question 33

Sector / industry analysis

Answer 33

In examining a sector or industry, it is important to note that a strategic value investor is primarily concerned with assessing the ability of companies within the industry to generate cash flow, the potential growth of that cash flow and the risks related to the receipt of those cash flows. An industry that is very profitable (measured, for example, by return on equity) will attract more competitors. As competition increases, the supply of goods and services will increase relative to the demand, and prices may fall. At the very least, the overall industry sales are divided up amongst more industry participants. Conversely, if an industry is not profitable, companies will exit (through bankruptcy or otherwise). As competition declines, the industry may become profitable for the remaining participants.

Question 34

Pioneer stage

Answer 34

The pioneer stage is when the industry is attempting to establish a market for its products. This stage is characterized by venture capital financing and high failure rates. Industries in the pioneer stage are generally not profitable, as they are investing heavily and are, by nature, quite speculative.

Question 35

Growth stage

Answer 35

In the growth stage, firms are often able to enjoy large profit margins, as it takes time for potential competitors to ramp up and participate in a burgeoning industry. Growth stock investors typically look for firms in the growth stage of the industry life cycle.

Question 36

Sustainable economic advantage (unbreachable moat)

Answer 36

Morningstar has adopted the concept of an economic moat and classifies them into five main types: low-cost producer, switching costs, the network effect, efficient scale, and intangible assets.7

Question 37

Switching costs

Answer 37

Switching costs are one-time inconveniences or expenses that a customer must incur in order to change from one product to another. Often, the costs are not monetary Bundling goods and services is an effective way of increasing the switching costs and widening that economic moat.

Question 38

Network effect

Answer 38

network effect occurs when the value of a good or service increases as more people use that particular good or service. FedEx is a prime example of a firm that has a strong network effect. As more and more consumers throughout the world choose FedEx as their preferred shipping firm, FedEx can, in turn, open more and more locations worldwide and provide improved service.

Question 39

ROE

Answer 39

Return on equity ROE = Net Income/Shareholder’s Equity Historically, ROEs in excess of 10 percent are generally considered desirable by investors. A 10 percent ROE means that each year the company is generating $10 of profits for every $100 invested in it cumulative by the owners.

Question 40

Long-Term Debt–to–Total Capital Ratio

Answer 40

Long-term debt–to–total capital (LTD/Cap) is computed by dividing a firm’s long-term debt by the total capital provided to the firm by debt holders, preferred stockholders, and common stockholders: The long-term debt–to–total capital ratio indicates the level of financial leverage employed by a firm.

Question 41

Price to earnings ratio

Answer 41

Price-to-Earnings Ratio The price-to-earnings ratio (or P/E ratio) is simply the current stock price divided by a measure of the net income per share for a firm. P/E = Market price per share/Earnings per share Value investors generally prefer firms selling at lower P/E ratios, as they believe there is less chance that they will be disappointed that future growth prospects will not be realized. Just because a stock is selling at a relatively low P/E ratio certainly does not mean that it is undervalued. It may sell at a low P/E ratio because investors are pessimistic regarding future earnings from the stock. A higher P/E ratio means that investors are paying more for each unit of net income. Another interpretation of P/E ratio is the number of years of current earnings the investor would need in order to get paid back for the purchase price.

Question 42

Screening (important)

Answer 42

Example of a Value Investment Screening Process as of December 22, 2011 Stocks that meet four criteria: 1. Value Line Timeliness ranking of “1” 2. Return on equity > 10% for each of the past 5 years 3. Long-term debt to total capital < 30% 4. Price-to-earnings ratio < 15

Question 43

Assessing profit growth

Answer 43

In order to really assess how the company performed in generating profits, we need to remove “size” as a factor. We can do this in two different ways: We can calculate each income statement item as a percentage of revenue for the same year (analysts call this vertical common size analysis) or we can compute the year-over-year change for each item (analysts call this horizontal common size analysis). So let’s look at the net profit as a percentage of revenue (we call this net profit margin) for this fiscal year versus last fiscal year. Net profit margin was 3.9 percent in the fiscal year ended January 31, 2011. The company generated 3.9 percent of profit relative to revenue or $3.9 of profits for every $100 of revenue. management discussion and analysis (MD&A) The MD&A section is a great place to start your analysis.