L5 - Equity Strategies: Intro, Discretionary & Short Bias

Question 1

What is Discretionary Equity?

Answer 1

In principle, all rules can be coded into a quant strategy. However, some information can be difficult to read by a computer.

–Discretionary equity investment means that the traders and portfolio managers buy stocks based on their discretionary views.

Advantage: a tailored analysis of each trade and the use of a lot of soft information, e.g. discussions with the firms’ management, intuition, and experience.

Disadvantage: the labour-intensive –only a limited number of securities can be analysed in depth, and the discretion exposes the trader to psychological biases.

Question 2

What Dedicated Short Bias?

Answer 2

-Dedicated short bias hedge funds focus on findings stocks that are about to go down, looking for frauds, over-stated earnings, or poor business plans.

–Dedicated short bias hedge funds rely on a fundamental analysis of companies in a similar way to other discretionary equity investors.

Question 3

What is Quantitative Equity?

Answer 3

Quantitative trading has the advantage of discipline, an ability to apply a trading idea to a wide universe of securities with the benefits of diversification, and efficient portfolio construction

But it must rely only on hard data and the computer program’s limited ability to incorporate real-time judgment.

Question 4

What is the Intrinsic Value?

Answer 4

The value of a stock is often called its intrinsic value (or fundamental value) to distinguish it from the market price.

–Believers in market efficiency: the price and the intrinsic value are the same

–Believers in value investing: look for stocks where the market price is low relative to the intrinsic value.

Question 5

What is the Discounted Dividend Model?

Answer 5

where V_t is the fundamental value or the value you would be willing to pay

Question 6

Why does the discounted dividend model not always work?

Answer 6

*

Question 7

What is the Gordon Growth model of dividends?

Answer 7

• -average dividend level grows at a rate ‘g’
  *

Question 8

What is the problem with considering a constant g under the Gordon’s Growth Model?

Answer 8

• • This is not realistic for firms with temporary high growth
• A high growth rate relative to the discount rate cannot be achieved in a long-run equilibrium
  
  • The PV of the dividend would be infinite

Question 9

How do you calculate the multi-stage model?

Answer 9

Question 10

Why is it hard to estimate dividend for some firms?

Answer 10

• For some firms, estimating dividends is difficult, e.g. young firms tend to retain earnings for a number of years until they finally mature and start paying out dividends.
• More broadly, it is sometimes more natural to focus on a firm’s economic earnings than its dividend payments. The two concepts are closely linked: to pay out dividends, the firm must earn profits, and earnings must ultimately be returned to shareholders to have consumption value.
• We define the earnings as the net income, NI_t, and keep track of the stock’s book value, B_t.
• The book value is increased by the net income and reduced by capital paid out as dividends, in a link which is called the clean surplus accounting relationship

B_t = B_t-1 + NI_t - D_t

Question 11

What are some other valuation methods?

Answer 11

• Relative valuation, multipliers/ratios – For example P/E, P/B, P/S
  
  • – Relative valuation cannot tell you whether the entire stock market is over
  • • or undervalued, but it can be informative about which stocks are expensive or cheap relative to others.
• Implied Expected Return
  
  • – Use the current price and the estimated future cash flows to compute the “implied return”
  • – A value investor might go long on those with high expected returns and short those with low ones

Question 12

What are the main principles of Equity Long-Short?

Answer 12

Most active equity investors trade based on discretionary judgment, and many of the most successful ones follow the principles Benjamin Graham

• Make a tailored analysis of the selected securities, relying on both hard information (data) and soft information (discussion with executives, customers, other traders)
• Consider whether the management has the ability to deliver on this potential and the integrity to pay the profits out to shareholders
• Value the firm in relation to its price, and act on the judgment even if it goes against conventional wisdom

Question 13

What are the strategies applied by Equity Long Short firms?

Answer 13

• Go long and short - more often more long than short
• Security selection: Value, growth; earnings quality; management quality; sector specialists; catalysts; flows in the market
• – Industry rotations
• – Market timing (go long when the entire market is undervalued)
• – Activist - be part of the decision making

Question 14

What are the basics of Value Investing strategies?

Answer 14

• Value investing can be defined simply –
  
  • Buy low (stocks with high intrinsic value relative to market value)
  • Sell high (stocks with low intrinsic value relative to market value)
  • E.g. Buy a company with more cash than the equity value and no debt – if you can find it
• Value investing is harder than it sounds
  
  • – Stocks are often cheap because there is something about them that makes investors uncomfortable, and stocks are often expensive because lots of investors love them
  • – Value investing means going against conventional wisdom, which is never easy

Question 15

How does the implementation of value investing differ in the definition of intrinsic value, typical holding period and portfolio constructions?

Answer 15

• The process of estimating the inputs in the dividend discount model is called fundamental analysis.
  
  • The difficult thing is to find the inputs to the model, not to plug them in.
  • Some focus on the numbers, others on the people, yet others on the industry dynamics.
• Holding period
  
  • Some value investors are patient and seek to hold their positions for the long term. They seek to buy a stock for less than the value of the future dividends that they will collect over time.
  • Other value investors seek to buy a cheap stock and sell it over the medium term as they hope the pricing of the stock corrects itself.
• A simple implementation of value investing is to buy stocks with a high book value relative to the market value. Historically, even this very simple value strategy has been profitable.

Question 16

How do some value investors focus on industry dynamics?

Answer 16

Some value investors focus on the industry dynamics, often specializing in a single or a few industries

• – Who is dominating an industry
  
  • • Is this sustainable? Is this profitable? (A firm needs profits, not just sales)
  • • Are there barriers to entry?
• – Who will rise within an industry
  
  • • Who will benefit from the changes that are going on?
  • • Who is making the key innovations?

Some value investors bet on entire industries, going long on several stocks in the same industry (or an industry index) while shorting stocks in another industry

• – Which industries are about the rise/fall
  
  • • Betting on a whole industry more than specific stocks
  • • How does the macro environment help/hurt certain industries

Question 17

What does the Price of a stock look like to a value investor?

Answer 17

• decide on a fundamental price of a stock
  
  • buy when below
  • at some point, it will appear to high and they will sell the stock
• the margin of safety
  
  • leaving some room between the market value and the best estimate of intrinsic value
  • Value investor should only buy once the price has fallen below this line to account for the uncertainty of price fluctuation

Question 18

What is the Value Trap?

Answer 18

• Is a stock cheap because its cheap or it deserves to be cheap

Does a stock look cheap because

• – It is cheap because other investors somehow fail to recognize?
• Or, because its fundamentals are collapsing?
  
  • E.g. a bank stock may be low because the market recognizes that the bank will have to write down many of its loans.
  • E.g. a stock can look cheap because the market realizes that the firm is subject to a lawsuit that will be very costly.

The risk that a value investor ends up owning fundamentally flawed companies is called the value trap.

• – Investing based on M/B has been profitable on average historically, but many bets have led to losses because of the value trap.

The value trap can be mitigated, at least partially, by focusing on a stock’s quality characteristics.

Question 19

What are some measures of profitability?

Answer 19

• Profitability can be measured in several different ways
  
  • – E.g. gross profits over assets (GPOA), return on equity (ROE), return on assets (ROA), cash flow over assets (CFOA), gross margin (GMAR)
  • can take an average of all of these
• Investors also look at a company’s “earnings quality”
  
  • – more or less aggressive in moving items off the balance sheet
  • – pushing expenses into the future
  • – recognizing revenues early using so-called accruals
• Investors prefer a stock with higher true profits to one with similar apparent profits generated by accounting adjustments.

Question 20

How can you measure growth?

Answer 20

• We can measure growth as the five-year prior growth in profitability, averaged across over measures of profitability.
• Good growth is sustainable growth in profits that leads to growth in free cash flows. Bad growth is growth in other numbers that ultimately hurts profits.
• Example of retail shops
  
  • – Good growth: increase sales in its existing shops, while keeping expenses constant and increasing profit margins.
  • – Bad growth: buying up other retailers at premium prices. CEO who likes “empire building” – increase the scale of the firm to grow his own power and compensation.

Question 21

How can you measure safety and stable profits under quality investing?

Answer 21

• Safety can be measured using stock returns
  
  • – The standard return-based measure is the market beta – relevant for measuring the contribution to risk in a very well-diversified portfolio
  • – Some equity investors also look at a stock’s total volatility (or even its idiosyncratic volatility), which matters when holding the stock in a concentrated portfolio.
• Alternatively, we can use fundamental accounting variables
• – the risk of declining future profits
• – E.g. using the past variation in profitability.

Empirically, we can use define safe firms as those with low beta (BAB), low leverage (LEV), low bankruptcy risk (O-Score and Z-Score) and low ROE volatility (EVOL)

Question 22

How can you measure payout and management quality under quality investing?

Answer 22

• A fourth class of quality measures focuses on how shareholder-friendly the firm is and how well managed it is. Specifically, one can look at whether profits are paid out to shareholders as dividends or share repurchases.
• We can measure payout using equity and debt net issuance (EISS, DISS) and total net payout over profits (NPOP)
• Signs of poor management
  
  • – the board is packed with cronies rather than independent board members
  • – management is entrenched, i.e. it very difficult to take the firm over by outsiders.

Question 23

Why does quality investing work during ‘bad’ times?

Answer 23

There is a flight to quality as people want their wealth to be safer and more secure - rather than uncertainty growth or decline due to a crisis or the fundamentals of a specific firm

Question 24

What is a growth investors?

Answer 24

• Try to buy a high-growth stock with a chance of becoming the next home run
• value investors and growth investors are often thought of as polar opposites, and sometimes they are, but at other times they end up buying the same stocks
  
  • General Investors dont realise that the fundamental value is rising
    
    • While a value investor recognises this and then invest in the stock due to its value currently being above its market price
    • Where as a growth investor would invest as the price and the fundamental value of the firm are growing at at a fast pace

Question 25

What is the Growth At a Reasonable Price (GARP) strategy?

Answer 25

• Historically, stocks that are cheap/ low price-to-book ratio have done well
• But stocks based on measures of actual growth have outperformed low-growth stocks

Give that both growth and value investor works we can combine these strategies –> finding a firm that is cheap relative to its expected growth (GARP):

• Look at firms with:
  
  • Consistent past growth and execellent future growth prospects
  • Perform a valuatin to see if the price reflects this/ stock appears cheap

Question 26

What is the dispoition effect?

Answer 26

• Individual investors often sell winners too quickly and hang onto losers. This behavior (bias) is called the “disposition effect.”

Question 27

What are some different holding/ selling period ideologies of different investors?

Answer 27

• Value investors = buy cheap and hold forever
• Some buy and only hold till the prcie has converged on its fair value –> capital is limited and only want to apply it when reture is the highest
• Some impatient investors only buy a cheap stock if they believe a ‘catalyst; will make the stock price rise within a limit time horizon –> e.g. next earnings annoucement
  
  • Some even try to create the catalyst –> issue a detailed report after building up a position

Question 28

What is Activist Investing?

Answer 28

• creating a catalyst by engaging actively in a discussion with the firm’s board –> buy shares that could be worth more better management and then try to infect decisions
  
  • After buying more than 5% of shares –> must file a 13D and delcar whether they intend to be active, this can already send a message to managmenet
  • Send a letter to management and the board –> get rid of managment, give cash bck to shareholders, cut costs, sell assets that are woth more elsewhere
  • Proxy fight –> Put up a referendum eg. at the annual meeting

Question 29

Who are Dedicated Short biased investors?

Answer 29

• Goes more short than long, but use similar techniques and processes to equity long short
• Focus on short ideas: looks for companies
  
  • With materially over-stated earnings
    
    • Aggresive accounting methods, incoprehensible statements in SEC filings
    • Engaged in outright fraud
  • With flawed business plans
    
    • `No sustainable way to make profit (e.g. many interenet companies), based on tehcnology become obsolete
  • Relying on excessive use of creidt

E.g. Enron, Hotels where all rooms are empty, Parma company with drugs but no doctor to prescribe

Question 30

How does Short-selling work?

Answer 30

How do you accomplish this? You

–Borrow shares of the stock

–Sell the shares

–Later buy the shares back, hopefully cheaper

–Return the shares

Question 31

How is a short- position opened?

Answer 31

Question 32

How does mark to market work with short-selling?

Answer 32

Question 33

How does closing a short position work?

Answer 33

• short interest –> the interest in shorting a current stock/bond etc.

Question 34

What are the difficulties in Short-selling?

Answer 34

• Short-selling requires you to borrow the security
  
  • pay lending fees, Risk than the security is re-called –> drives the prices up (leads to a new round of recall)
  • Short squeeze –> many short sellers are forced to buy back the shares
  • Risk that you lose funding before the trade converges
• Companies sometimes fight short sellers:
  
  • Accusing them of crimes and sueing them
  • Requesting that the authorities investigated their acitvites
  • Take actions to make shorting difficult such as
    
    • Stock splits or distribution specficallly designed to disrupt short selling
    • Try to coordinate with shareholders to withfraw shares from stock lending markets
• Stocks often go up more than down (equity premium) –> 11% return
• Short positions get larger when you are wrong, long ones gets smaller
• Dedicated short biased comprises a very small groud of hedge fund anecdotally consisting a pessimistic managers

Question 35

How does Short-selling friction effect the value of companies?

Answer 35

• means they can be over-valued
• some people have positive informaiton/ opinions and others have negative
• If it is costly/difficult to short sell:
  
  • Negative informaiton may not be relfect in the price –> the price could be too high –> future returns would be too low
• A large speculative premium can arise when people forcase the forecast of others:
  
  • People may anticipate that th efitire price will be driven up by a greater fool plus short-sale friction