aswath_damodaran-investment_philosophies_2012

20	INVESTMENT PHILOSOPHIES

but are restricted to that sector; we call this sector risk. For instance, a cut in the defense budget in the United States will adversely affect all firms in the defense business, including Boeing, but there should be no significant impact on other sectors, such as food and apparel. What is common across the three risks described—project, competitive, and sector risk—is that they affect only a small subset of firms.

There is other risk that is much more pervasive and affects many, if not all, investments. For instance, when interest rates increase, all investments, not just Boeing, are negatively affected, albeit to different degrees. Similarly, when the economy weakens, all firms feel the effects, though cyclical firms (such as automobiles, steel, and housing) may feel it more. We term this risk market risk.

Finally, there are risks that fall in a gray area, depending on how many assets they affect. For instance, when the dollar strengthens against other currencies, it has a significant impact on the earnings and values of firms with international operations. If most firms in the market have significant international operations, as is the case now, it could well be categorized as market risk. If only a few do, it would be closer to firm-specific risk. Figure 2.3 summarizes the breakdown or spectrum of firm-specific and market risks.

W h y D i v e r s i f i c a t i o n R e d u c e s o r E l i m i n a t e s F i r m - S p e c i f i c R i s k : A n I n t u i t i v e E x p l a n a t i o n As an investor, you could invest your entire wealth in one stock, say Boeing. If you do so, you are exposed to both firm-specific and market risk. If, however, you expand your portfolio to include other assets or

Competition

may be stronger

or weaker than

Exchange rate

anticipated.

and political

risk

Projects may

do better or

Interest rate,

Entire sector

worse than

inflation, &

may be affected

expected.

news about

by action.

economy

Firm-specific

Market

Actions/risks that

Actions/risks that

affect only one

affect all

Affects few

Affects many

firm

investments

firms

firms

F I G U R E 2 . 3 A Breakdown of Risk

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stocks, you are diversifying, and by doing so, you can reduce your exposure to firm-specific risk. There are two reasons why diversification reduces or, at the limit, eliminates firm-specific risk. The first is that each investment in a diversified portfolio is a much smaller percentage of that portfolio than would be the case if you were not diversified. Thus, any action that increases or decreases the value of only that investment or small group of investments will have only a small impact on your overall portfolio, whereas undiversified investors are much more exposed to changes in the values of the investments in their portfolios. The second and stronger reason is that the effects of firm-specific actions on the prices of individual assets in a portfolio can be either positive or negative for each asset in any period. Thus, in very large portfolios, this risk will average out to zero and will not affect the overall value of the portfolio.2

N U M B E R W A T C H

Risk breakdown by sector: Take a look at variations in the proportion of risk explained by the market, broken down by sector for U.S. stocks.

In contrast, the effects of market-wide movements are likely to be in the same direction for most or all investments in a portfolio, though some assets may be affected more than others. For instance, other things being equal, an increase in interest rates will lower the values of most assets in a portfolio. Being more diversified does not eliminate this risk.

One of the simplest ways of measuring how much risk in an investment (either an individual firm or even a portfolio) is firm-specific is to look at the proportion of the price movements that are explained by the market. This is called the R-squared and it should range between zero and 1, and can be stated as a percentage; it measures the proportion of the investment’s stock price variation that comes from the market. An investment with an R-squared of zero has all firm-specific risk, whereas a firm with an R-squared of 1 (100 percent) has no firm-specific risk.

2This is the insight that Harry Markowitz had that gave rise to modern portfolio theory. Harry M. Markowitz, “Foundations of Portfolio Theory,” Journal of Finance 46, no. 2 (1991): 469–478.

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W H Y I S T H E M A R G I N A L I N V E S T O R A S S U M E D

T O B E D I V E R S I F I E D ?

The argument that diversification reduces an investor’s exposure to risk is clear both intuitively and statistically, but risk and return models in finance go further. The models look at risk in an investment through the eyes of the investor most likely to be trading on that investment at any point in time (i.e., the marginal investor). They argue that this investor, who sets prices for investments at the margin, is well diversified; thus, the only risk that he or she cares about is the risk added to a diversified portfolio (market risk). This argument can be justified simply. The risk in an investment will always be perceived to be higher for an undiversified investor than for a diversified one, since the latter does not shoulder any firm-specific risk and the former does. If both investors have the same expectations about future earnings and cash flows on an asset, the diversified investor will be willing to pay a higher price for that asset because of his or her perception of lower risk. Consequently, the asset, over time, will end up being held by diversified investors.

This argument is powerful, especially in markets where assets can be traded easily and at low cost. Thus, it works well for a large market cap stock traded in the United States, since investors can become diversified at fairly low cost. In addition, a significant proportion of the trading in U.S. stocks is done by institutional investors, who tend to be well diversified. It becomes a more difficult argument to sustain when assets cannot be easily traded or the costs of trading are high. In these markets, the marginal investor may well be undiversified, and firm-specific risk may therefore continue to matter when looking at individual investments. For instance, real estate in most countries is still held by investors who are undiversified and have the bulk of their wealth tied up in these investments.

M o d e l s M e a s u r i n g M a r k e t R i s k

While most risk and return models in use in finance agree on the first two steps of the risk analysis process (i.e., that risk comes from the distribution of actual returns around the expected return and that risk should be measured from the perspective of a marginal investor who is well diversified),

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they part ways when it comes to measuring nondiversifiable or market risk. In this section, we discuss the different models that exist in finance for measuring market risk and why they differ. We will begin with the capital asset pricing model (CAPM), the most widely used model for measuring market risk in finance—at least among practitioners, though academics usually get blamed for its use. We will then discuss the alternatives to this model that have developed over the past two decades. Though we will emphasize the differences, we will also look at what all of these models have in common.

T h e C a p i t a l A s s e t P r i c i n g M o d e l The risk and return model that has been in use the longest and is still the standard in most real-world analyses is the capital asset pricing model (CAPM). In this section, we will examine the assumptions made by the model and the measures of market risk that emerge from these assumptions.

Assumptions While diversification reduces the exposure of investors to firm-specific risk, most investors limit their diversification to holding only a few assets. Even large mutual funds rarely hold more than a few hundred stocks, and some of them hold as few as 10 to 20. There are two reasons why investors stop diversifying. One is that an investor or mutual fund manager can obtain most of the benefits of diversification from a relatively small portfolio, because the marginal benefits of diversification become smaller as the portfolio gets more diversified. Consequently, these benefits may not cover the marginal costs of diversification, which include transaction and monitoring costs. Another reason for limiting diversification is that many investors (and funds) believe they can find undervalued assets and thus choose not to hold only those assets that they believe are most undervalued.

The capital asset pricing model assumes that there are no transaction costs and that everyone has access to the same information, that this information is already reflected in asset prices and that investors therefore cannot find underor overvalued assets in the marketplace. Making these assumptions allows investors to keep diversifying without additional cost. At the limit, each investor’s portfolio will include every traded asset in the market held in proportion to its market value. The fact that this diversified portfolio includes all traded assets in the market is the reason it is called the market portfolio, which should not be a surprising result, given the benefits of diversification and the absence of transaction costs in the capital asset pricing model. If diversification reduces exposure to firm-specific risk and there are no costs associated with adding more assets to the portfolio, the logical limit to diversification is to hold every traded asset in the market, in proportion to its market value. If this seems abstract, consider the market

24	INVESTMENT PHILOSOPHIES

portfolio to be an extremely well-diversified mutual fund (a supreme index fund) that holds all traded financial and real assets, along with a default-free investment (a treasury bill, for instance) as the riskless asset. In the CAPM, all investors will hold combinations of the riskless asset and the market index fund.3

Investor Portfolios in the CAPM If every investor in the market holds the identical market portfolio, how exactly do investors reflect their risk aversion in their investments? In the capital asset pricing model, investors adjust for their risk preferences in their allocation decision, where they decide how much to invest in a riskless asset and how much in the market portfolio. Investors who are risk averse might choose to put much or even all of their wealth in the riskless asset. Investors who want to take more risk will invest the bulk or even all of their wealth in the market portfolio. Investors who invest all their wealth in the market portfolio and are still desirous of taking on more risk would do so by borrowing at the riskless rate and investing more in the same market portfolio as everyone else.

These results are predicated on two additional assumptions. First, there exists a riskless asset whose returns are known with certainty. Second, investors can lend and borrow at the same riskless rate to arrive at their optimal allocations. Lending at the riskless rate can be accomplished fairly simply by buying Treasury bills or bonds, but borrowing at the riskless rate might be more difficult to do for individuals. There are variations of the CAPM that allow these assumptions to be relaxed and still arrive at the conclusions that are consistent with the model.

N U M B E R W A T C H

Highest and lowest beta sectors: Take a look at the average beta, by sector, for U.S. stocks. The betas are estimated before and after considering leverage.

3The significance of introducing the riskless asset into the choice mix and the implications for portfolio choice were first noted in Sharpe (1964) and Lintner (1965). Hence, the model is sometimes called the Sharpe-Lintner model. J. Lintner, “The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets,” Review of Economics and Statistics 47 (1965): 13–37; W. F. Sharpe, “Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk,” Journal of Finance 19 (1964): 425–442.

Upside, Downside: Understanding Risk	25
Measuring the Market Risk of an Individual Asset	The risk of any asset to

an investor is the risk added by that asset to the investor’s overall portfolio. In the CAPM world, where all investors hold the market portfolio, the risk to an investor of an individual asset will be the risk that this asset adds to that portfolio. Intuitively, if an asset moves independently of the market portfolio, it will not add much risk to the market portfolio. In other words, most of the risk in this asset is firm-specific and can be diversified away. In contrast, if an asset tends to move up when the market portfolio moves up and down when it moves down, it will add risk to the market portfolio. This asset has more market risk and less firm-specific risk. Statistically, the risk added to the market portfolio is measured by the covariance of the asset with the market portfolio.

The covariance is a percentage value, and it is difficult to pass judgment on the relative risk of an investment by looking at this value. In other words, knowing that the covariance of Boeing with the market portfolio is 55 percent does not provide us a clue as to whether Boeing is riskier or safer than the average asset. We therefore standardize the risk measure by dividing the covariance of each asset with the market portfolio by the variance of the market portfolio. This yields a risk measure called the beta of the asset:

Beta of an asset = Covariance of asset with market portfolio Variance of the market portfolio

The beta of the market portfolio, and by extension the average asset in it, is 1. Assets that are riskier than average (using this measure of risk) will have betas that are greater than 1, and assets that are less risky than average will have betas that are less than 1. The riskless asset will have a beta of zero.

Getting Expected Returns Once you accept the assumptions that lead to all investors holding the market portfolio and you measure the risk of an asset with beta, the return you can expect to make can be written as a function of the risk-free rate and the beta of that asset.

Expected return on an investment = Risk-free rate + Beta Risk premium for buying the average-risk investment

Consider the three components that go into the expected return.

1.Riskless rate. The return that you can make on a risk-free investment becomes the base from which you build expected returns. Essentially, you are assuming that if you can make 5 percent investing in a riskfree asset, you would not settle for less than this as an expected return

26	INVESTMENT PHILOSOPHIES

for investing in a riskier asset. Generally speaking, we use the interest rate on government securities as the risk-free rate, assuming that such securities have no default risk. This used to be a safe assumption in the United States and other developed markets, but sovereign ratings downgrades and economic woes have raised questions about whether this is still a reasonable premise. If there is default risk in a government, the government bond rate will include a premium for default risk and this premium will have to be removed to arrive at a risk-free rate.4

2.The beta of the investment. The beta is the only component in this model that varies from investment to investment, with investments that add more risk to the market portfolio having higher betas. But where do betas come from? Since the beta measures the risk added to a market portfolio by an individual stock, it is usually estimated by running a regression of past returns on the stock against returns on a market index. Consider, for instance, Figure 2.4, where we report the regression of returns on Netflix against the S&P 500, using weekly returns from 2009 to 2011.

The slope of the regression captures how sensitive a stock is to market movements and is the beta of the stock. In the regression in Figure 2.4, for instance, the beta of Netflix would be 0.74.5 Why is it so low? The beta reflects the market risk (or nondiversifiable risk) in Netflix, and this risk is only 5.4 percent (the R-squared) of the overall risk. If the regression numbers hold up, the remaining 94.6 percent of the variation in Netflix stock can be diversified away in a portfolio. Even if you buy into this rationale, there are two problems with regression betas. One is that the beta comes with estimation error—the standard error in the estimate is 0.31. Thus, the true beta for Netflix could be anywhere from 0.12 to 1.36; this range is estimated by adding and subtracting two standard errors to/from the beta estimate. The other is that firms change over time and we are looking backward rather than looking forward. A better way to estimate betas is to look at the average beta for publicly traded firms in the business or businesses Netflix operates in. Though

4Consider, for example, a government bond issued by the Indian government. Denominated in Indian rupees, this bond has an interest rate of 8 percent. The Indian government is viewed as having default risk on this bond and it’s local currency bon is rated Baa3 by Moody’s. If we subtract the typical default spread earned by Baa3rated country bonds (about 2 percent) from 8 percent, we end up with a riskless rate in Indian rupees of 6 percent.

5Like most beta estimation services, Bloomberg estimates what it calls an adjusted beta. This number is just the raw (regression) beta moved toward 1 (the average for the market).

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NFLX U.S. Equity			Relative Index		SPX Index
Data		Last Price		Range	11/06/09	- 10/28/11		Period	Weekly
Linear		Beta + / –		Non-Parametric		Lag	0 +–
	30							Y = NETFLIX INC
Y=0.736X+0.567								X = S&P 500 INDEX
	20								Item
Equity								Raw BETA
	10							Adj BETA
U.S.								ALPHA(Intercept)
	0							R^2(Correlation^2)
NFLX								R(Correlation)
								Std Error Of ALPHA
	–10							Std Dev Of Error
-								Std Error Of BETA
Y	–20
								t-Test
	–30							Significance
								Last T-Value
								Last P-Value
								Number Of Points

Historical Beta

Local CCY

Value 0.736 0.824 0.567 0.054 0.232 7.782 0.770 0.307 2.401 0.018

–3.984

0.000

103

–8 –6 –4 –2										0			2			4				6			8 Last Observation

X = SPX Index

F I G U R E 2 . 4 Beta Regression—Netflix versus S&P 500

these betas come from regressions as well, the average beta is always more precise than any one firm’s beta estimate. Thus, you could use the average beta of 1.38 for the entertainment business in the United States in 2011 and adjust for Netflix’s low debt-to-equity (D/E) ratio of 2.5% to estimate a beta of 1.40 for Netflix.6

N U M B E R W A T C H

Risk premium for the United States: Take a look at the equity risk premium implied in the U.S. stock market from 1960 through the most recent year.

3.The risk premium for buying the average-risk investment. You can view this as the premium you would demand for investing in equities as

6The beta can be adjusted for financial leverage using the following equation: Levered beta = Unlevered beta (1 + (1 − tax rate) (D/E))

Assuming a 40% tax rate for Netflix and using its debt to equity ratio of 2.5% Levered beta for Netflix = 1.38 (1 + (1 − .40) (.025)) = 1.40

28	INVESTMENT PHILOSOPHIES

a class as opposed to the riskless investment. Thus, if you require a return of 9 percent for investing in stocks and the Treasury bond rate is 5 percent, your equity risk premium is 4 percent. There are again two ways in which you can estimate this risk premium. One is to look at the past and calculate the typical premium you would have earned investing in stocks as opposed to a riskless investment. This number is called a historical premium and yields about 4.10 percent for the United States, looking at stock returns relative to returns on Treasury bonds from 1928 to 2011. The other is to look at how stocks are priced today and to estimate the premium that investors must be demanding. This is called an implied premium and yields a value of about 6 percent for U.S. stocks in January 2012.7

Bringing it all together, you could use the capital asset pricing model to estimate the expected return on a stock for Netflix, for the future, in January 2012 (using a Treasury bond rate of 2 percent, the sector based beta of 1.40, and a risk premium of 6 percent):

Expected return on Netflix = T-bond rate + Beta Risk premium

= 2% + 1.40 6% = 10.40%

What does this number imply? It does not mean that you will earn 10.4 percent every year, but it does provide a benchmark that you will have to meet and beat if you are considering Netflix as an investment. For Netflix to be a good investment, you would have to expect it to make more than 10.4 percent as an annual return in the future.

In summary, in the capital asset pricing model, all the market risk is captured in the beta, measured relative to a market portfolio, which at least in theory should include all traded assets in the marketplace held in proportion to their market value.

B e t a s : M y t h a n d F a c t There is perhaps no measure in finance that is more used, misused, and abused than beta. To skeptical investors and practitioners, beta has become the cudgel used not only to beat up theorists but also to discredit any approach that uses beta as an input, including most discounted

7The implied premium for U.S. equities (and equities of other developed markets) was stable and varied between 4 and 5 percent between 2002 and 2008. It spiked sharply to hit 6.5 percent during the banking crisis of 2008, and has been much more volatile since. In 2011, for instance, the premium started the year at about 5 percent and rose to 6 percent by January 2012.

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cash flow (DCF) models. There are plenty of legitimate critiques of betas, and we will consider several in the next few pages. Here are five clarifications on what beta tells you and what it does not:

1.Beta is not a measure of overall risk. Beta is a measure of a company’s exposure to macroeconomic risk and not a measure of overall risk. Thus, it is entirely possible that a very risky company can have a low beta if most of the risk in that company is specific to the company (a biotechnology company, for instance) and is not macroeconomic risk.

2.Beta is not a statistical measure. The use of a market regression to get a beta leaves an unfortunate impression with many that it is a statistical measure. We may estimate a beta from a regression, but the beta for a company ultimately comes from its fundamentals and how these fundamentals affect macroeconomic risk exposure. Thus, a company that produces luxury products should have a higher beta than one that produces necessities, since the fate of the former will be much more closely tied to how well the economy and the overall market are doing. By the same token, a company with high fixed costs (operating leverage) and/or high debt (financial leverage) will have higher betas for its equity, since both increase the sensitivity of equity earnings to changes in the top line (revenues). In fact, that is why it is preferable to estimate a beta from sector averages and adjust for operating and financial leverage differences rather than from a single regression.

3.Beta is a relative (market) risk measure. Shorn of its theoretical roots, beta is a measure of relative risk, with risk being defined as market risk. Thus, a stock with a beta of 1.20 is 1.20 times more exposed to market risk than the average stock in the market. Thus, the betas for all companies cannot go up or down at the same time; if one sector sees an increase in beta, there has to be another sector where there is a decrease.

4.Beta is not a fact but an estimate. This should go without saying, but analysts who obtain their beta estimates from services (and most do) often are provided with a beta for the company that comes from either a regression or a sector average, and both are estimates with error associated with them. That, of course, will be true for any risk measure that you use but it explains why different services may report different estimates of beta for the same company at the same point in time.

5.Beta is a measure of investment risk, not of investment quality. The beta of a company is useful insofar as it allows you to estimate the rate of return you need to make when investing in that company; think of it as a hurdle rate. You still have to look at its market size, growth,