Inves&ng  on  Hope?  Growth  Inves&ng  &  Small  Cap  Inves&ng  

Aswath  Damodaran  

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.  

My  defini&on…  

Assets Liabilities

Assets in Place Debt

Equity

Fixed Claim on cash flowsLittle or No role in managementFixed MaturityTax Deductible

Residual Claim on cash flowsSignificant Role in managementPerpetual Lives

Growth Assets

Existing InvestmentsGenerate cashflows todayIncludes long lived (fixed) and

short-lived(working capital) assets

Expected Value that will be created by future investments

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.

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.  

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.  

The  Small  Firm  Effect  

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Small  Firm  Effect  Over  Time  

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Cycles  in  Small  Firm  Premium  

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Has  the  small  firm  premium  disappeared?  

•  The  small  stock  has  become  much  more  vola&le  since  1981.  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?  

The  Size  and  January  Effects  

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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.  

Difficul&es  in  Replica&ng  Small  Firm  Effect  

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Figure 9.5: Returns on CRSP Small Stocks versus DFA Small Stock Fund

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.  

There  is  less  analyst  coverage  of  small  firms  

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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.  

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.  

The  importance  of  a  long  &me  horizon..  

Figure 9.7: Time Horizon and the Small Firm Premium

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