BEYOND BEHAVIORAL BIASES: VALUE INVESTING

The results of financial models like modern portfolio theory and the capital asset pricing model are often used as a framework to guide investments decisions. These models are built on a set of assumptions about investors’ rationality, preferences and capacity to process information. These assumptions imply that investors make decisions under risk applying expected utility theory sharing homogeneous preferences and being able to access and process all available information so that financial markets are efficient. Empirical anomalies like “lagged reactions to earnings announcements” and the “small firm effect” question the validity of the efficient market hypothesis and consequently the results of modern portfolio theory and of the capital assets pricing model. If this is true, it is possible for an investor to earn higher than average returns buying individual stocks applying different analysis tools. One of them is value investing first theorized by Benjamin Graham in “Security Analysis” and in “The Intelligent Investor”. In this framework it is possible to overperform the market buying undervalued securities that guarantee to the investor a high enough margin of safety. These securities are identified analyzing the company’s financial statements to determine the intrinsic value that is then compared with the stock price. In this thesis I am going to apply Graham’s industry analysis to four sectors of choice: oil, semiconductors, drug manufacturers and auto manufacturers. Doing so I will build a scoring system to quantify each company’s performance and rank them to determine the best in each industry. It is important to note that this is not enough to understand if these four stocks are a good investment or not. To understand it I need to determine the intrinsic value of each company: this will be done building a discounted cash flow model. At the end I will compare the intrinsic value with the stock price to determine if the stock is undervalued or not and, if it is, which is the margin of safety.