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Damodaran's pearls of wisdom: Part I - Views on News from Equitymaster
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Damodaran's pearls of wisdom: Part I
Jul 4, 2013

In a recent investor event held in India, Professor Aswath Damodaran of The Stern Business School has shared some words, which we believe are invaluable to the investor community. His views on the two most commonly used terms are something that has caught our attention. In the investment world the terms 'investment philosophy' and 'investment strategy' are usually used interchangeably on most occasions. But, Prof. Damodaran, a legend in his own right, believes that the terms have different connotations and therefore have different implications for investors. During the event, he has spoken about the difference between these two concepts and has also talked at length about the two distinct investment philosophies.

We would be presenting a synopsis of Professor Damodaran's views through a two part series. In this article we aim to explain the concept of 'investment philosophy' with a particular emphasis on 'intrinsic value investment philosophy'. The second part would explain Damodaran's views on 'technical analysis and arbitrage'.

So, what is an investment philosophy?

According to Damodaran, an 'investment philosophy' is a core set of beliefs about the markets. It is a behavioural set of assumptions about how markets work, how they fail to work, and how to take advantage of common mistakes made by investors in the markets. Because of the behavioural aspect involved, Damodaran argues that there is no one investment philosophy that should fit all. Thus one needs to understand one's temperament first before deciding on an appropriate investment philosophy that would suit him. A common investment philosophy for all is also impractical because risk aversion, time horizon and tax considerations vary among investors.

Investment strategy on the other hand, is the philosophy in practice.

The importance of an investment philosophy lies in the fact that without a particular investment philosophy, a portfolio will have the tendency to swing from one strategy to another. It would be based on what has worked best recently and this would lead to a huge turnover ratio, large transaction costs and poor returns.

Therefore, it is of utmost importance for investors to decide on an investment philosophy and then keeping that in mind work out a strategy. For example if your investment philosophy is value investing, then the strategy could be to pick the lowest PE multiple stocks. Or, to pick stocks based on a contrarian view. So on and so forth.

Intrinsic Value Investment philosophy

Damodaran believes the intrinsic value investment philosophy can be practiced by both growth investors as well as by value investors.

He classifies value investors as those who have an inherent suspicion about growth and have a knack of buying a company for less than the value of assets in place. Growth investors, on the other hand, are those who are on the lookout for companies, where the market's estimate of the company's growth is less than what the growth investors' perceive.

The basic tenet of 'intrinsic value investment' rests on the fact that there is a difference between the market price and the intrinsic value of a security. While all of us know that at a point in time, market price is a constant, the intrinsic value is an estimate based on several factors. These factors include cash flows generated from existing investments, growth expected to be generated from those cash flows and the inherent risks involved in the growth of those cash flows.

Value Investors believe that the gap between current price and intrinsic value will be closed when the current price will move towards the intrinsic value because of the fundamental strength of the company. However, the price of any tradable thing on this planet is determined by the omnipresent economic forces: demand and supply. Demand and supply are in turn driven by momentum, available liquidity and behavioural factors.

Intrinsic value investors as such are not inclined to study these aspects. These concepts are of more interest to different breeds of investors, commonly known as technical analysts and arbitrageurs. We will discuss Damodaran's views on them in the second series of this article.

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