Systematic Relative Strength

Aswath Damodaran wrote the book on valuation, literally. He is a valuation guru, or as close to it as you are going to find. He readily admits that valuation is a biased process. From Business Insider:

Something that Aswath Damodaran reiterated frequently during his lecture is that valuation is not some sort of magical, objective science that will let you know what others don’t. It provides an anchor for your thinking and investment behavior.

Here are the three biggest myths of valuation from Professor Damodaran’s presentation:

• A valuation is an objective search for true value
• A good valuation provides a precise estimate of value
• The more quantitative a model, the better the valuation

Here’s the anecdote Professor Damodaran told to illustrate the first point:

“I have valued Microsoft every year since 1986, the year of their IPO. 26 years in a row. Every year through 2011 when I valued Microsoft I found it to be overvalued. You name the price, I found it overvalued. $2, $4, $8, “don’t buy, don’t buy, don’t buy.” Strange right? One of the great success stories of US equity markets over the last 50 years, and I wouldn’t have touched it one step of the way. Now I can give you access to every one of those models… You can dig through these models looking for clues as to why I found Microsoft to be overvalued, but you’d be looking in the wrong place. If you really want to know why I found Microsoft to be overvalued all of these years, all you need to do is walk up my office and look around. What you’re going to see is a bunch of computers with fruits on the back.”

Although there are multiple ways in which relative strength can be calculated, all investors using the same method are going to get the same result. There is no subjectivity in terms of assumptions and inputs. That kind of objectivity can really help eliminate emotions and biases from the investment process. To take Damodaran’s example, if Microsoft qualifies as one of the great success stories of the past 50 years, it would have had high relative strength somewhere along the line, by definition. End of story.

This entry was posted on Tuesday, June 19th, 2012 at 9:19 am and is filed under Investor Behavior, Markets, Thought Process. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.