Strategy Value and Investors' Sentiment
Valuation Lecture 16
Some materials from Lee (2003), Lee (2001), Lee et al (2005). See reference list
Midterm
Case Case is due on 3/31. Homework is still due on 3/26.
Review: Pro Forma Statements
What are Pro-forma statements? Why do we prepare Pro-forma Statements?
How to prepare Pro-forma Statements?
Outline
The limit of Valuation in Stock Investing The use of valuation in investing
Contrarian
investing, value investing
The limit of valuation
Briefly
investors' sentiments
EMH: The Traditional View
If we define the intrinsic value of a firm as the present value of its expected future payoffs, conditional on information set ( ):
V E = t
i= 1
t
(1+ ) r
( Dt + | ) i
i
Then, operationally, the EMH is often interpreted to mean price reflects a stock's intrinsic value
(P
=
t
V
t
,
) t
The Noise Trader Model: Shiller (1984):
In equilibrium, price is:
Fundamental value Noise trader demand
t t+k t t+k
E ( D ) + E (Y P = (1+ + )
t k =0 k +1
)
Arbitrage costs
As zero, we have the EMH as a special case As infinity, noise traders determine the price
Example of noise traders... The extended Dong's family
My father in law & mother in law My brother in law My wife
Implications of the Model
Fundamental value Investor Sentiment
P
t
= Et
k =0
( Dt + k ) + E t (Y t + k )
(1+ + )
k +1
Price is a weighted average of a stock's fundamental value and noise trader demand (as long as arbitrage involves cost, price will not typically equal value) Fundamental analysis (I.e., valuation and cash flow projection) is only one component of investing in stocks Rational investors (smart traders) need to consider "fads" and "fashions", as well as "fundamentals". This harkens back to the Keynesian idea of the stock market as a beauty contest. The timeseries behavior of Yt matters. Is it meanreverting? If so, how quickly?
How might we measure investor sentiment?
Fundamental value Investor Sentiment
t t +k t t+k
E ( D ) + E (Y P = (1+ + )
t k =0 k +1
)
A. Focus on fundamental value
Estimate
the present value of future cash flows for a firm (V), and compare it to price. The difference is a measure of investor sentiment. for sentiment indicators that help to predict the direction of noise trader demand (Yt )
B. Focus on noise trader demand
Look
Some Valuation Studies
Frankel and Lee (JAE, 1998)
Use
the residual-income model (RIM) to develop a V/P ratio, and predict cross-sectional returns the RIM to price the Dow 30
Lee, Myers and Swaminathan (JF, 1999)
Use
Gebhardt, Lee, and Swaminathan (JAR, 2001) and Lee, Ng and Swaminathan (WP)
Compute
implied costs-of-capital
Bhojraj and Lee (JAR, 2002) & Bhojraj, Lee and Ng (WP)
Who
is my peer? A valuation-based technique for selecting comparable firms.
Frankel and Lee (1998) Compute a "V" estimate and trade on the V/P ratio
Do better valuation models lead to better returns forecasts? Yes
Buy-and hold returns on hedge portfolio over next 36 months
But, value plays require patience
Frankel and Lee (1999) - Price convergence to value is a long-term phenomenon (most of the improvement comes after the first year):
Value plays can also be quite risky
Piotroski (2001): Examines top quintile B/M firms While the mean market-adjusted return is positive, the median value firm actually underperforms
In short, value investing has its limits:
A. Value plays require patience (FL (1998))
Abnormal returns are realized over 2 to 4 years The median "value" stock underperforms the market Buying them can be like catching a falling knife
B. Value plays can be risky (Piotroski (2001))
C. Value stocks tend to be negative momentum stocks
D. Often improvements in the valuation technique are helpful but not crucial
when a stock is really over- or under-valued, a reasonable valuation model will spot it; when a stock is only marginally over-valued or under-valued, it's typically not in a hurry to correct
An example: EWT
What is the problem?
Prices in equity markets are much noisier than many people expected Black (1986):
"All estimates of value are noisy, so we can never know how far away price is from value. However, we might define an efficient market as one in which price is within a factor of 2 of value, i.e., the price is more than half of value and less than twice value... By this definition, I think almost all markets are efficient almost all the time. "Almost all" means at least 90%."
How bad is the problem?
Evidence from Closed-end Funds:
A closed-end fund is a publicly traded stock whose only asset consists of a portfolio of other publicly traded securities. The closed-end fund puzzle is the empirical phenomenon that the stock price (SP) of these funds is rarely equal to the net asset value (NAV) of these securities. Typically, these funds trade at a discount to their NAV. Occasionally, they also trade at a premium. For U.S. funds DISC rountinely fluctuate between an upper bound of around +5 to 10%, and a lower bound of 30% to 40%. (LST (1991))
Gemmill & Thomas (JF, Dec. 2002):
Sample of UK Closed-end level Funds:
The of the discount is a function of arbitrage costs:
Funds that are more difficult to arbitrage have larger discounts, on average The discounts are censored by arbitrage bounds
The changes (weekly fluctuations) in the discount are a function of noise-trader sentiment, as proxied by retail-investor flows into openend funds in the same sectors.
When net retail flows are positive (negative), discounts narrow (widen), across funds in the same sector
Prices are indeed set by the interplay between noise traders and rational arbitrageurs.
How might we measure investor sentiment?
Fundamental value Investor Sentiment
t t +k t t+k
E ( D ) + E (Y P = (1+ + )
t k =0 k +1
)
A. Focus on fundamental value
Estimate
the present value of future cash flows for a firm (V), and compare it to price. The difference is a measure of investor sentiment. for sentiment indicators that help to predict the direction of noise trader demand (Yt )
B. Focus on noise trader demand
Look
What gives rise to investor sentiment?
Sentiment involves systematic deviations of price from intrinsic value
The
mistakes must be correlated across noise traders More like mass psychology than animal spirits
What gives rise to a common sentiment? (what affects Y ?)
t
"pseudo-signals"
signals that contain no real information, yet are persuasive Under-reaction to value-relevant information
sub-optimal use of actual signals
An Example: Krispy Cream (7/7/01)
"I go to the convenience store by my house to buy the donuts which are delivered at 4 am. The place is Jam packed, and it's surreal how many people are walking around with Krispy bags. People literally run from their cars and practically tackle each other at the Krispy Kreme Doughnut cabinet." - 4CommonSense "I can't understand how ANYTHING can taste that good. If this isn't the stuff classic American brand names are made of, nothing is. These things are addictive and they bring pleasure to the senses." "A well-managed company with nothing but upside for the next 12-18 years...They have NO market penetration to speak of in the United States as a whole...People are just beginning to hear of them and everybody wants one." - EMCauley
On the other hand...
So what is next for KKD?
Best value estimate
Analysts as sentiment generators?
JKKL (2001) - Analyzing the analysts: When do Stock Recommendations add Value? Compared stocks analysts recommend to stocks selected by quantitative investment signals Table 5
In
general, analysts exhibit a strong bias in favor of glamour stocks with growth characteristics Their recommendations run counter to contrarian indicators (7 out of 8 cases, analyst's stock recommendations are directionally opposite to the variable's normative usage in returns predictions)
Sentiment indicators: Volume
Lee and Swaminathan (JF, 2000): Price Momentum and Trading Volume
Recent trading volume (shares traded scaled by shares outstanding) is a good indicator of investor sentiment about a stock High (low) volume stocks exhibit glamour (value) characteristics, and earn lower (higher) subsequent returns Integrating volume into the analysis greatly enhances the predictive power of the overall model
Short term momentum (Lec 2)
Stockprice momentum
Cumulative Abnormal Return
0
-5 -4 +5
-3
-2
-1
0
+1
+2 +3 +4
Time (months)
Long term reversal
Stockprice momentum
Cumulative Abnormal Return
0
-5 -4
-3
-2
-1
0
+1
+2 +3 +4
+5
Time (years)
Implications:
Both
mid-horizon momentum and long-horizon value effects are elements of a single process by which information is incorporated in price Sentiment indicators, such as trading volume, help us to understand the transitional dynamics between long-term reversals and short-term momentum Think in terms of both value and momentum indicators when evaluating stocks For example, how would you classify KKD? Momentum Volume Valuation positive (2) high (10) high (10)
KKD: Revisited
Best value estimate
Cayuga MBA Fund
4Q 2008 Return Cayuga MBA -1.29% Fund HFRX Equtiy -13.7% Hedge SP500 -21.9% Sharpe Ratio 2008 Retrun (TTM) -0.13 -2.02 0.42% -25.45% -37.0% -33.8%
Russell 2000 -26.1% Total Asset Value As of Dec. 31 2008, $14,434,714.11
References
Most papers cited in this talk can be found in the reference list for:
Lee, C., 2001, "Market Efficiency and Accounting Research", Journal of Accounting and Economics. Bhojraj S., and C. Lee, 2001, "Who is my peer? A valuation-based approach to the selection of comparable firms", Journal of Accounting Research. Jegadeesh, Kim, Krische, & Lee, 2002, "Analyzing the analysts: When do recommendations add value?", University of Illinois and Cornell University working paper. Gemmill, and Thomas, 2002, "Noise-Trading, Costly Arbitrage, and Asset Prices: Evidence from Closed-end Funds", Journal of Finance. Bhojraj Sanjeev, Charles Lee, and David Ng 2005, "International Valuation Using Smart Multiples" Lee, Charles, B. Swaminathan and David Ng 2005, "International Asset Pricing: Evidence from Implied Cost of Capital."
Exceptions are: