The Hindu Business Line : A dose of philosophy for the money-minded

CHOOSING the right investment philosophy could be as tough as finding the right match in the Sunday classifieds. Just as grooms and brides come in all shapes and sizes, the esoteric formulas that investment experts advise to guarantee success could range from cash flow-fixation with an eye on liquid assets, to growth-gyration as in the case of new technology companies. There are also the index-inclined and the active-achievers. "To successfully implement any investment strategy, you must first adopt an investment philosophy that is consistent at its core and which matches not only the markets you choose to invest in, but your personal preferences such as risk tolerance, time horizons and so on," writes Aswath Damodaran in Investment Philosophies — a book on `successful strategies and the investors who made them work'. A few nuggets of philosophy:

Most investors assume that trading costs become smaller as portfolios become larger. While this statement is true for brokerage commissions, it is not always the case for the other components of trading costs. There is one component where larger investors bear a more substantial cost than do smaller investors, and that is in the impact that their trading has on prices. If the basic idea behind successful investing is to buy low and sell high, pushing the price up as you buy and then down as you sell reduces the profits from investing.

When we value businesses and firms, as opposed to individual assets, we are often looking at entities that have no finite life. If they reinvest sufficient amounts in new assets each period, firms could keep generating cash flows forever.

If today is a big up day for a stock, what does this tell us about tomorrow? There are three different points of view. The first is that the momentum from today will carry into tomorrow and that tomorrow is more likely to be an up day than a down day. The second is that there will be the proverbial profit taking as investors cash in their profits and that the resulting correction will make it more likely that tomorrow will be a down day. The third is that each day we begin anew, with new information and new worries, and that what happened today has no implications for what will happen tomorrow.

The ratio of the PE ratio to expected growth (PEG) is defined as PE divided by expected growth rate in earnings per share. How do analysts use PEG ratios? A stock with a low PEG is considered cheap, because you are paying less for the growth. But there are two potential problems with PEG that might lead us to misidentify riskier stocks with higher growth rates as undervalued.

Your potential for large returns is greatest if you can forecast which firms are most likely to report large positive earnings surprises and invest in those firms prior to their earnings announcements. Impossible without insider information, you say. Not quite. You might be able to use a combination of quantitative techniques and trading volume to try to detect these firms. Even if you are right only 55 per cent of the time, you should be able to post high excess returns.

A book worth investing in if your philosophy has place for a god for money in the markets.

(Book courtesy: Wiley www.wiley.com)

BookValue@TheHindu.co.in

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