aswath_damodaran-investment_philosophies_2012

accompanied by a price increase (and cessation by a decrease). However, there is some evidence that dividend initiations are viewed as bad news in some companies; the stock price drops at about 40 percent of companies that initiate dividends. That should come as no surprise, since growth firms that start paying dividends are sending a signal that their best growth is behind them and that they no longer have the investment opportunities they used to have.68

Finally, what about cash returned by companies to stockholders on an irregular basis? This may have taken the form of special dividends until a few decades ago, but it has generally been replaced with stock buybacks at U.S. companies. The initial price reaction to a buyback announcement is positive, with the magnitude of the reaction increasing with the magnitude of the stock buyback.69 While early studies suggested that this positive price effect carries over into subsequent periods,70 more recent studies contest that finding,71 noting that companies that buy back stock do not outperform the market or their peer group in the periods following the buyback.

Can investors use the information in dividend changes and buybacks to make higher returns? While the price change on the dividend announcement itself might not offer opportunities for investors (unless they have access to inside information), a study that looked at the price drift after dividend changes are announced noted that stock prices continue to drift up after dividend increases and drift down after dividend decreases for long periods and especially so after dividend omissions. Investors may be able to take advantage of this drift and augment returns on their portfolios. With buybacks, as with acquisitions, the bigger payoff to investors comes from identifying companies that are likely to buy back stock before the companies announce these buybacks: companies that generate low returns on equity or capital (relative to their cost of equity and capital), have high cash balances, trade at low valuation multiples, and have low financial leverage. Since these

68R. Michaely, R. H. Thaler, and K. L. Womack, “Price Reactions to Dividend Initiations and Omissions: Overreaction or Drift?” Journal of Finance 50 (1995): 573–608.

69An interesting exception was the first quarter of 2009. Companies that bought back stock in this quarter, shortly after the banking crisis of 2008, were punished rather than rewarded, with stock prices dropping about 1.6 percent on average.

70D. Ikenberry, J. Lakonishok, and T. Vermaelen, “Market Underreaction to Open Market Share Repurchases,” Journal of Financial Economics 39 (1995): 181–208. They find a strong positive excess return over a five-year period from holding shares in companies that buy back their own stock.

71A. C. Eberhart and A. R. Siddique, “Why Are Stock Buyback Announcements Good News?” (SSRN Working Paper 647843, 2004).

were characteristics that we suggested should be used by value investors in picking companies, buybacks may be one way in which a value investing strategy can deliver higher returns.

I M P L E M E N T I N G A N I N F O R M A T I O N - B A S E D

I N V E S T M E N T S T R A T E G Y

If you decide to center your investment strategy around information releases—earnings reports, acquisition announcements, or other news—you have to recognize that it is much more difficult to deliver the returns on an actual portfolio than it is in a hypothetical portfolio. To succeed at this strategy, you have to:

Identify the information around which your strategy will be built. Since you have to trade on the announcement, it is critical that you determine in advance the information that will trigger a trade. To provide an example, you may conclude that your best potential for returns comes from buying shares in small companies that report earnings that are much higher than expected. However, you have to go further and specify what constitutes a small company (market cap less than $1 billion? $5 billion?) and by how much the actual earnings need to beat expectations (10 percent higher than expectations? 20 percent higher than expectations?). This is necessary because you will not have to the time for analysis after the report comes out.

Invest in an information system that will deliver the information to you instantaneously. Many individual investors receive information with a time lag—15 to 20 minutes after it reaches the trading floor and institutional investors. While this may not seem like a lot of time, the biggest price changes after information announcements occur during these periods.

Execute quickly. Getting an earnings report or an acquisition announcement in real time is of little use if it takes you 20 minutes to trade. Immediate execution of trades is essential to succeeding with this strategy.

Keep a tight lid on transaction costs. Speedy execution of trades usually goes with higher transaction costs, but these transaction costs can very easily wipe out any potential you may see for excess returns, especially because you will be trading a lot (as with any short-term strategy).

Know when to sell. Almost as critical as knowing when to buy is knowing when to sell, since the price effects of news releases may begin to fade or even reverse after a while. Thus, if you buy stock of firms after positive earnings announcements, you have to determine at the time you

buy the stock when you will sell it. While this may seem to take away your flexibility, the alternative of holding on to stocks too long, hoping that they will go up, can be even more damaging.

If you consider the requirements for success—immediate access to information, and instantaneous and cheap execution—it is not surprising that information-based investing was for a long time profitable only for institutional investors. In recent years, however, online access to information and trading has made it feasible for individual investors to join the party. This is a mixed blessing, though, since the more investors trade on information, the less returns there are from these strategies.

C O N C L U S I O N

As investors, we all dream of receiving that important news release ahead of the market and making lucrative profits on it. Information is the key to investment success, and this chapter explores the possibility of acquiring and using information to augment portfolio returns. We began by looking at how market prices move in response to information, and noted that in an efficient market, the price reaction to new information is instantaneous. In such a market, investing in an asset after the information has been released is a neutral strategy. In an inefficient market, you can make money after the information is released, buying after good news if it is a slow learning market, or selling after good news if it is an overreacting market.

To examine whether it is possible to use information profitably, we first looked at the two groups of individuals most likely to have access to privileged or private information. Insiders in firms, especially top managers, clearly know more about their firms than do investors in markets. Insider trading does seem to provide a signal of future price movements—insider buying seems to precede stock price increases and selling seems to occur ahead of price drops—but the signal is noisy and the returns are small. This may, however, reflect the fact that the really profitable insider trades—the illegal ones—are never filed with the SEC. Equity research analysts also have access to information that most other investors do not have, and reflect this information in earnings forecasts and recommendations. Here again, while upward revisions in earnings and buy recommendations generally lead to stock price increases, and downward revisions and sell recommendations are followed by poor stock price performance, the returns are surprisingly small. The difficulty that both insiders and analysts have in converting information to returns should be a cautionary note to any investor considering an information-based investment strategy.

In the second part of the chapter, we looked at earnings reports, acquisition announcements, and other firm-specific announcements. These announcements affect prices significantly: positive (or negative) earnings reports are associated with price increases (or decreases), target company stock prices jump on acquisition announcements, and stock prices generally increase when there are stock splits or dividend increases. Unless you can anticipate these news releases, though, this price increase cannot be translated into a large profit. There does seem to be some evidence of a price drift after earnings announcements, and there are investors who try to take advantage of this drift by buying after positive earnings reports and selling after negative reports. To succeed with information-based trading, you have to be selective and disciplined in your investment choices and efficient in your execution.

E X E R C I S E S

1.Do you think markets respond appropriately to new information? If yes, what makes them responsive? If no, what types of mistakes do you think they make and why?

2.Do you believe that insiders in companies know more than you do about the value of the company? If yes, what is the source of their advantage?

a.Assuming that insiders do know more than you do and trade on that information, do you think that you can make money by following their trading?

b.Given the information on insider trading in this chapter, how would you refine this strategy to generate higher returns for yourself?

3.Do you believe that analysts following companies know more than you do about the value of the company? If yes, what is the source of their advantage?

a.Assuming that analysts do know more than you do and trade on that information, do you think that you can make money by following their earnings forecasts and recommendations?

b.Given the information on analyst reports in this chapter, how would you refine this strategy to generate higher returns for yourself?

4.Stock prices clearly move on earnings announcements, with the movement beginning before the announcement, accelerating on the announcement, and continuing afterward.

a.If you believe that you can make money off this price movement, what portion of the price movement (before, contemporaneous, after) do you think you can best exploit?

b.How would you go about doing it?

c.What would your concerns be with this strategy, and how would you go about meeting them?

Lessons for Investors

To be a successful trader on information, you need to:

Find a reliable source of information: It goes without saying that good information is the key to success with any information-based trading strategy. (To stay on the right side of the law, make sure that your reliable source is not an insider.)

Have a clearly defined strategy for trading on information: Since you will have to trade quickly, you will not have the time after information comes out to assess and analyze it. You will need to make a prejudgment on when you will be trading.

Be disciplined: Don’t deviate from your trading strategy, and do stick to the time horizon that you have chosen for yourself. Holding on to a stock for a few days more hoping to recoup your losses can make a bad situation worse.

Control your trading costs: Since you will be trading frequently and immediate execution is key, your trading costs can be large. As the funds at your disposal increase, the price impact you have as you trade can be substantial.

are an equity investor. Second, assuming two identical assets exist, you have to wonder why pricing differences would persist in markets where investors can see those differences. If, in addition, we add the constraint that there is a point in time when the market prices have to converge, it is not surprising that pure arbitrage is most likely to occur with derivative assets—options and futures—and in fixed income markets, especially with default-free government bonds.

F u t u r e s A r b i t r a g e

A futures contract is a contract to buy (and sell) a specified asset at a fixed price in a future time period. There are two parties to every futures contract: the seller of the contract, who agrees to deliver the asset at the specified time in the future, and the buyer of the contract, who agrees to pay a fixed price and take delivery of the asset. If the asset that underlies the futures contract is traded and is not perishable, you can construct a pure arbitrage if the futures contract is mispriced. In this section, we consider the potential for arbitrage first with storable commodities and then with financial assets, and then look at whether such arbitrage is possible and profitable.

T h e A r b i t r a g e R e l a t i o n s h i p s The basic arbitrage relationship can be derived fairly easily for futures contracts on any asset by estimating the cash flows on two strategies that deliver the same end result—the ownership of the asset at a fixed price in the future. In the first strategy, you buy the futures contract, wait until the end of the contract period, and buy the underlying asset at the futures price. In the second strategy, you borrow the money and buy the underlying asset today, and then store it for the period of the futures contract. In both strategies, you end up with the asset at the end of the period and are exposed to no price risk during the period—in the first because you have locked in the futures price and in the second because you bought the asset at the start of the period. Consequently, you should expect the cost of setting up the two strategies to be exactly the same. Across different types of futures contracts, there are individual details that cause the final pricing relationship to vary: commodities have to be stored and create storage costs, whereas stocks may pay a dividend while you are holding them.

Storable Commodities The distinction between storable and perishable goods is that storable goods can be acquired today at the spot price and stored until the expiration of the futures contract, which is the practical equivalent of buying a futures contract and taking delivery at expiration. Since the two approaches provide the same result in terms of having possession of the commodity at expiration, the futures contract, if priced right,

should cost the same as a strategy of buying and storing the commodity. The two additional costs of the latter strategy are as follows:

1.Since the commodity has to be acquired now, rather than at expiration, there is an added financing cost associated with borrowing the funds needed for the acquisition now.

Added interest cost = (Spot price) (1 + Interest rate)Life of futures contract − 1

2.If there is a storage cost associated with storing the commodity until the expiration of the futures contract, this cost has to be reflected in the strategy as well. In addition, there may be a benefit to having physical ownership of the commodity. This benefit is called the convenience yield and will reduce the futures price. The net storage cost is defined as the difference between the total storage cost and the convenience yield.

If F is the futures contract price, S is the spot price, r is the annualized interest rate, t is the life of the futures contract, and k is the net annual storage costs (as a percentage of the spot price) for the commodity, the two equivalent strategies and their costs can be written as follows.

Strategy 1: Buy the futures contract. Take delivery at expiration. Pay $F.

Strategy 2: Borrow the spot price (S) of the commodity and buy the commodity. Pay the additional costs.

Interest cost = S[(1 + r)t − 1]

Cost of storage, net of convenience yield = Skt

If the two strategies have the same costs,

F = S (1 + r)t − 1 + Skt = S (1 + r)t + kt

This is the basic arbitrage relationship between futures and spot prices. Note that the futures price does not depend on your expectations of what will happen to the spot price over time but on the spot price today. Any deviation from this arbitrage relationship should provide an opportunity for arbitrage (i.e., a strategy with no risk and no initial investment) and for positive profits. These arbitrage opportunities are described in Figure 11.1.

This arbitrage is based on several assumptions. First, investors are assumed to borrow and lend at the same rate, which is the riskless rate. Second,

when the futures contract is overpriced, it is assumed that the seller of the futures contract (the arbitrageur) can sell short on the commodity and can recover from the owner of the commodity the storage costs that are saved as a consequence. To the extent that these assumptions are unrealistic, the bounds on prices within which arbitrage is not feasible expand. Assume, for instance, that the rate of borrowing is rb and the rate of lending is ra, and that the short seller cannot recover any of the saved storage costs and has to pay a transaction cost of ts. The futures price will then fall within a bound.

(S − ts ) (1 + ra )t F S (1 + rb)t + kt

If the futures price falls outside this bound, there is a possibility of arbitrage, and this is illustrated in Figure 11.2.

Stock Index Futures Futures on stock indexes have become an important and growing part of most financial markets. Today, you can buy or sell futures on most equity indices in the United States, as well as many indices in other countries. An index futures contract entitles the buyer to any appreciation in the index over and above the index futures price and the seller to any depreciation in the index from the same benchmark. To evaluate the arbitrage pricing of an index futures contract, consider the following strategies.

Strategy 1: Sell short on the stocks in the index for the duration of the index futures contract. Invest the proceeds at the riskless rate. This strategy requires that the owners of the stocks that are sold short be compensated for the dividends they would have received on the stocks.

Strategy 2: Sell the index futures contract.

Both strategies require the same initial investment, have the same risk, and should provide the same proceeds. Again, if S is the spot price of the index, F is the futures price, y is the annualized dividend yield on the stock, and r is the riskless rate, the arbitrage relationship for a futures contract that pays off in time period t can be written as follows:

F = S(1 + r − y)t

If the futures price deviates from this arbitrage price, there should be an opportunity for arbitrage. This is illustrated in Figure 11.3.

This arbitrage is also conditioned on several assumptions. First, we assume that investors can lend and borrow at the riskless rate. Second, we