Inves&ng on Hope? Growth Inves&ng & Small Cap Inves&ng. Aswath Damodaran

Transcription

1 Inves&ng on Hope? Growth Inves&ng & Small Cap Inves&ng Aswath Damodaran

2 Who is a growth investor? The Conven&onal defini&on: An investor who buys high price earnings ra&o stocks or high price to book ra&o stocks. The Generic defini&on: An investor who buys growth companies where the value of growth poten&al is being under es&mated. In other words, both value and growth investors want to buy under valued stocks. The difference lies mostly in where they think they can find these bargains and what they view as their strengths.

3 My defini&on Assets Liabilities Existing Investments Generate cashflows today Includes long lived (fixed) and short-lived(working capital) assets Assets in Place Debt Fixed Claim on cash flows Little or No role in management Fixed Maturity Tax Deductible Expected Value that will be created by future investments Growth Assets Equity Residual Claim on cash flows Significant Role in management Perpetual Lives If you are a growth investor, you believe that your competitive edge lies in estimating the value of growth assets, better than others in the market.

4 The many faces of growth inves&ng 1. The Small Cap investor: The simplest form of growth inves&ng is to buy smaller companies in terms of market cap, expec&ng these companies to be both high growth companies and also expec&ng the market to under es&mate the value of growth in these companies. 2. The IPO investor: Presumably, stocks that make ini&al public offerings tend to be smaller, higher growth companies. 3. The Passive Screener: Like the passive value screener, a growth screener can use screens - low PE ra&os rela&ve to expected growth, earnings momentum - to pick stocks. 4. The Ac&vist Growth investor: These investors take posi&ons in young growth companies (even before they go public) and play an ac&ve role not only in how these companies are managed but in how and when to take them public.

5 I. Small Cap Inves&ng One of the most widely used passive growth strategies is the strategy of inves&ng in small- cap companies. There is substan&al empirical evidence backing this strategy, though it is debatable whether the addi&onal returns earned by this strategy are really excess returns.

6 The Small Firm Effect

7 Small Firm Effect Over Time

8 Cycles in Small Firm Premium

9 Has the small firm premium disappeared? The small stock has become much more vola&le since Whether this is a long term shiz in the small stock premium or just a temporary dip is s&ll being debated. Jeremy Siegel notes in his book on the long term performance of stocks that the small stock premium can be almost en&rely a]ributed to the performance of small stocks in the 1970s. Since this was a decade with high infla&on, could the small stock premium have something to do with infla&on?

10 The Size and January Effects

11 Possible Explana&ons The transac&ons costs of inves&ng in small stocks is significantly higher than the transac&ons cots of inves&ng in larger stocks, and the premiums are es&mated prior to these costs. While this is generally true, the differen&al transac&ons costs are unlikely to explain the magnitude of the premium across &me, and are likely to become even less cri&cal for longer investment horizons. The difficul&es of replica&ng the small firm premiums that are observed in the studies in real &me are illustrated in Figure 9.11, which compares the returns on a hypothe&cal small firm porcolio (CRSP Small Stocks) with the actual returns on a small firm mutual fund (DFA Small Stock Fund), which passively invests in small stocks.

12 Difficul&es in Replica&ng Small Firm Effect Figure 9.5: Returns on CRSP Small Stocks versus DFA Small Stock Fund 15.00% 10.00% 5.00% 0.00% -5.00% % DFA Small Firm Fund CRSP Small

13 Risk Models and the Size Effect The capital asset pricing model may not be the right model for risk, and betas under es&mate the true risk of small stocks. Thus, the small firm premium is really a measure of the failure of beta to capture risk. The addi&onal risk associated with small stocks may come from several sources. First, the es&ma&on risk associated with es&mates of beta for small firms is much greater than the es&ma&on risk associated with beta es&mates for larger firms. The small firm premium may be a reward for this addi&onal es&ma&on risk. Second, there may be addi&onal risk in inves&ng in small stocks because far less informa&on is available on these stocks. In fact, studies indicate that stocks that are neglected by analysts and ins&tu&onal investors earn an excess return that parallels the small firm premium.

14 There is less analyst coverage of small firms Analyst Coverage 120% % 20 80% 15 60% % covered by analysts Average number of analysts 10 40% 20% 5 0% Large Cap Mid Cap Small Micro-cap 0

15 But not necessarily in a porcolio of small stocks While it is undeniable that the stock returns for individual small cap stocks are much more vola&le than large market cap stocks, a porcolio of small cap stocks has a distribu&on that is similar to the distribu&on for a large cap porcolio.

16 Determinants of Success at Small Cap Inves&ng The importance of discipline and diversifica&on become even greater, if you are a small cap investor. Since small cap stocks tend to be concentrated in a few sectors, you will need a much larger porcolio to be diversified with small cap stocks. In addi&on, diversifica&on should also reduce the impact of es&ma&on risk and some informa&on risk. When inves&ng in small cap stocks, the responsibility for due diligence will ozen fall on your shoulders as an investor, since there are ozen no analysts following the company. You may have to go beyond the financial statements and scour other sources (local newspapers, the firm s customers and compe&tors) to find relevant informa&on about the company. Have a long &me horizon. The small cap premium seems to hold over long &me periods, but disappears for sub- periods that can be as long as five years.

17 The importance of a long &me horizon.. Figure 9.7: Time Horizon and the Small Firm Premium 16.00% % Average Annual Return over Holding Period 14.00% 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% % 80.00% 60.00% 40.00% 20.00% % of time Small Cap Portfolio does better Large Cap Small Cap % of time small caps win 0.00% Time Horizon 0.00%