Investment Strategies by DE Shaw

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Investment Strategies by DE Shaw Powered By Docstoc
					         Company Analysis
•   Industry competitive environment
•   SWOT analysis
•   Present value of cash flows
•   Relative valuation ratio techniques
• Company analysis is the final step in the top-
  down approach to investing
• Macroeconomic analysis identifies industries
  expected to offer attractive returns in the
  expected future environment
• Analysis of firms in selected industries
  concentrates on a stock’s intrinsic value
  based on growth and risk
Porter’s Competitive Strategies
•   Current rivalry
•   Threat of new entrants
•   Potential substitutes
•   Bargaining power of suppliers
•   Bargaining power of buyers
         Identifying and
Selecting Competitive Strategies
• Five conditions affecting the competitive
  structure and profits of an industry
  1. Current rivalry
  2. Threat of new entrants
  3. Potential substitutes
  4. Bargaining power of suppliers
  5. Bargaining power of buyers
    Firm Competitive Strategies
• Defensive strategy involves positioning firm so
  that it its capabilities provide the best means to
  deflect the effect of competitive forces in the
• Offensive strategy involves using the
  company’s strength to affect the competitive
  industry forces, thus improving the firm’s
  relative industry position
• Porter suggests two major strategies: low-cost
  leadership and differentiation
   Porter's Competitive Strategies
• Low-Cost Strategy
  – The firm seeks to be the low-cost
    producer, and hence the cost leader in its
• Differentiation Strategy
  – firm positions itself as unique in the
        Focusing a Strategy
• Select segments in the industry
• Tailor strategy to serve those specific
• Determine which strategy a firm is
  pursuing and its success
• Evaluate the firm’s competitive
  strategy over time
          Focusing a Strategy
• Select one or several segments in the
  industry to which it tailors its strategy.
• Firm’s Questions?
 » Do unique cost or need opportunities exists?
 » Are they are being served by another firm?
 » Can they be priced to generate abnormal returns
   to the firm?
         Focusing a Strategy
• Analyst’s Questions?
 » Which strategy is being pursued?
 » Is the firm successful?
 » Are strategies are being sustained?
 » Does strategy need to be changed?
          SWOT Analysis
• Examination of a firm’s:
  – Strengths
  – Weaknesses
  – Opportunities
  – Threats
          SWOT Analysis
• Examination of a firm’s:
  – Strengths        INTERNAL ANALYSIS
  – Weaknesses
  – Opportunities
  – Threats
          SWOT Analysis
• Examination of a firm’s:
  – Strengths
  – Weaknesses
  – Opportunities
                      EXTERNAL ANALYSIS
  – Threats
    Measures of Value-Added
• Consider economic profit
 – NPV in capital budgeting
• Uses
 – Measure management performance
 – Indicators of future returns
• Economic Value-Added (EVA)
• Market Value-Added (MVA)
 Some Lessons from Peter Lynch
Favorable Attributes of Firms
1. Firm’s product should not be faddish
2. Firm should have some long-run comparative
   advantage over its rivals
3. Firm’s industry or product has market stability
4. Firm can benefit from cost reductions
5. Firms that buy back shares show there are putting
   money into the firm
   Categorizing Companies-
1. Slow growers
2. Stalwart
3. Fast growers
4. Cyclicals
5. Turnarounds
6. Asset plays
     Peter Lynch’s Stock Types
1. Slow grower grows with GDP- Dividend yield,
   not PE
2. Stalwarts- they grow faster (10-12%) than a slow
   grower, but not fast- PE ratio important
3. Fast grower, 20-25% growth --Lynch
   ratio=g/PE>1.0 Must understand the product.
4. Turnaround-battered, depressed, HIGH RISK
5. Asset Plays-value that Wall Street does not
6. Cyclical-”timing is everything” two decision
   stock, buy high PE and sell low PE
       Tenets of Warren Buffet
•   Business Tenets
•   Management Tenets
•   Financial Tenets
•   Market Tenets
           Business Tenets
• Is the business simple and understandable?
• Does the business have a consistent
  operating history?
• Does the business have favorable long-term
        Management Tenets
• Is management rational in allocation
• Is management candid with with its
• Does management resist the institutional
  imperative? Does management just do what
  others are doing or do they think and act
            Financial Tenets
• Focus on return on equity, not earnings per
• Calculate “owner earnings” including the
  effects on cash flow of capital expenditures
• Look for companies with high profit
• For every dollar retained, make sure the
  company has created at least one dollar of
  market value
             Market Tenets
• INTRINSIC VALUE---What is the value of
  the business?
• MARGIN OF SAFETY---Can the business
  be purchased at a significant discount to its
  fundamental intrinsic value?
     Growth Rate Estimates
• Compound Average Historical Dividend
  Growth Rate (or use PV and FV and I/Y)
              n      1

• Sustainable Growth Rate = RR X ROE
An Alternate Measure of Growth
g = (RR)(ROIC)
  – RR = the average retention rate
  – ROIC = EBIT (1-Tax Rate)/Total Capital
Analysis of Growth Companies
• Generating rates of return greater than the
  firm’s cost of capital is considered to be
• Earnings higher the required rate of return
  are pure profits
• How long can they earn these excess
• Is the stock properly valued?
        Measures of Value-Added
• The Franchise Factor
  – Breaks P/E into two components
     • P/E based on ongoing business (base P/E)
     • Franchise P/E the market assigns to the expected value of
       new and profitable business opportunities
     Franchise P/E = Observed P/E - Base P/E
   Incremental Franchise P/E = Franchise Factor X Growth Factor
    =((IRR – k) / (ROE x k)) x (PV new growth projects/PV firm)

                  R  k
                                          G
          Growth Duration
• Evaluate the high P/E ratio by relating P/E
  ratio to the firm’s rate and duration of
  growth – T model (see p 594)
• P/E is function of
  – expected rate of growth of earnings per share
  – stock’s required rate of return
  – firm’s dividend-payout ratio
        Intra-Industry Analysis
• Directly compare two firms in the same industry
• An alternative use of T to determine a reasonable
  P/E ratio
• Factors to consider
   – A major difference in the risk involved
   – Inaccurate growth estimates
   – Stock with a low P/E relative to its growth rate
     is undervalued
   – Stock with high P/E and a low growth rate is
Intrinsic Value and Market Price
 • Intrinsic Value
    – Self assigned Value
    – Variety of models are used for estimation
 • Market Price
    – Consensus value of all potential traders
 • Trading Signal
    – IV > MP Buy
    – IV < MP Sell or Short Sell
    – IV = MP Hold or Fairly Priced
Bloomberg DDM w/o mod.
Modify years and Bond rate
        Site Visits and the
        Art of the Interview
• Focus on management’s plans, strategies, and
• Restrictions on nonpublic information
• “What if” questions can help gauge sensitivity
  of revenues, costs, and earnings
• Management may indicate appropriateness of
  earnings estimates
• Discuss the industry’s major issues
• Review the planning process
• Talk to more than just the top managers
     Influences on Analysts
• Investment bankers may push for favorable
• Corporate officers may try to convince
• Analyst must maintain independence and
  have confidence in his or her analysis
                 When to Sell
• Holding a stock too long may lead to lower returns
  than expected
• If stocks decline right after purchase, is that a
  further buying opportunity or an indication of
  incorrect analysis?
• Continuously monitor key assumptions
• Evaluate closely when market value approaches
  estimated intrinsic value
• Know why you bought it and watch for that to
           Efficient Markets
• Opportunities are mostly among less well-known
• To outperform the market you must find
  disparities between stock values and market
  prices - and you must be correct
• Concentrate on identifying what is wrong with
  the market consensus and what earning surprises
  may exist