Session 17 (of 42): Investing on Hope - Introduction to Growth Investing

0:00 Hi, welcome back. In the last few sessions, we've talked about value investing, its glory in the 20th century and its fading in the 21st century and its allure to investors. In the next few, I want to look at growth investing in its various forms. And in this particular session, I want to focus on one variant of growth investing, which is investing in small cap companies or small companies. So, let's start by defining what a growth investor is.

0:28 Again, we'll start with the conventional and lazy definition. The conventional and lazy definition is a growth investor buys companies that are growing or even more lazily buys companies that trade at high PE ratios or high price to book ratios. Implicit in that definition seems to be the suggestion that growth investors don't care about value. So, I'm going to give you my generic definition of a growth investor, which I think is a lot more charitable to what growth investors try to do. Growth investors try to buy companies where they think the value of growth is being underestimated by the market. Let me repeat that again. Growth investors buy companies where they think the value of growth is being underestimated by the market. Put simply, both value investors and growth investors care about value.

1:13 The question is where they where they think they can find those bargains in the market. using that financial balance sheet I used to illustrate value investing. The simple way to think about growth investing is rather than focus on assets in place, which is what value investors do, growth investors believe that their best shot at finding cheap companies or mispriced companies, is look at companies with the bulk of the value comes from growth assets. That markets for whatever reason make mistakes about valuing those growth assets and you can take advantage of those. With that in place, let's talk about the many phases of growth investing. I'm going to start and spend the bulk of this session talking about investing in small cap companies. It's true. It's true. Small cap companies don't necessarily have to be growth companies, but many people use it as a shortcut to go with growth. We'll talk about the logic of doing it, whether it pays off and whether that payoff is changing over time. We'll then move on to investing in companies that have just gone public or are planning to go public. Investing in IPOs, initial public offerings. Again, we look at the allure, whether it pays off and what the what the limitations might be. We'll then bring in something we saw with value investing screening for cheap growth stocks. Here we will look at the variance, the types of screens people use to find cheap growth stocks. And we'll close off as we did the value investing section by looking at activist investors but activist investors in the growth space. You might not have heard of these but you probably heard of them with a different name. Venture capital is after all investing in growth and being activists. You try to change the companies and modify them after you've invested in them. So let's start with small cap investing. As I said at the start, not all small cap stocks are growth stocks, but many people use small cap investing as their entree into growth investing. So there are three basic questions I would like to examine in this session. First, does investing in small cap stocks generate higher returns especially after adjusting for risk than investing in large cap stocks?

3:25 Then I'm going to follow up and say, are those higher returns compensation for taking risks? You can't see risks that don't get captured by traditional risk measures and can you generate those excess returns you see on paper in practice and if there are excess returns have there been changes over time to those excess returns so let's start by looking at small cap stocks before I get embark on this process I want to emphasize that at least in finance when we talk about small companies we don't talk about small companies in terms of revenues or earnings we talk about small companies companies in terms of market cap, in terms of the market value attached to these companies. So, let me start with a graph that pretty much every finance student sees somewhere during the course of their finance class. In this graph, here's what I've done. I've looked at companies classified by market capitalization from smallest to largest.

4:21 These categorizations are made at the start of the every year. and then you look at the returns you'd have made on each class in the following year. This graph looks at the average annual returns across those classes. Now you're saying why are there two measures? Let's start with the equally weighted portfolios. Here what you do is you find the 300 smallest market cap companies put an equal amount. What's the alternative? You could take the 300 smallest companies and invest in proportion their market cap. We'll talk about why there might be a difference and what the difference tells us. But look at the equally weighted portfolio.

4:58 You can see that there's a massive difference between the smallest and the largest stocks. In fact, the smallest companies on a on an equally weighted basis earn close to 25%. The largest companies earn about 11% on an annual basis. That's a 14% premium. The premium continues even when I use value weightings, but it's smaller. The smallest companies, if you created value weighted portfolios, have returns of about 18%. And the largest companies have returns about 11 to 12%.

5:30 There's a difference, but it's not as big. Now, you say, what does the difference tell us? It tells us that there's a small cap effect. It's actually greatest in the smallest companies in the portfolio rather than in the larger companies, even in the small in the smallest desile. File that away because we're going to come back and talk about it. But let's take a deeper look at this small cap phenomenon. This has been something that finance documented starting in the 1970s. It's called the small cap premium and it's driven a lot of practice in valuation. For instance, people often attach a small cap premium in estimating a discount rate for small companies.

6:10 If you take that small cap premium and you take the smallest and the largest cells and you take the difference and you graph it over time, this is the small cap premium on an annual basis. Here's the first thing that jumps out at you. It's volatile. Small caps don't beat large cap stocks every single year. In fact, there are periods of history where small cap stocks lag large cap stocks, but over the entire time period, small cap stocks deliver higher returns.

6:38 So here I've looked at both the premium for small the smallest decile over the market that's a red line and the premium over the largest cap stocks and you see the same phenomenon kick in. So it's volatile over time. Here's the second aspect of the small cap premium. We talked about this earlier when we talked about temporal price patterns. Almost the entire small cap premium over thatund almost 100year period has come in one month of the year January. In fact, if you take January's, you can see that small cap stocks significantly outperform large cap stocks. But you look at the rest of the year, they look very similar. Whatever it is that causes the small cap premium seems to be isolated to January.

7:23 There's also the underlying question, which is, is this really an excess return or is this a payment for risk that you're taking on when you invest in small companies? You're saying what if I risk adjust the returns using betas? Even then the small cap premium persists. But the question is do bas capture the risk of small cap stocks? Because there are at least two issues that people face with small cap stocks that lead them to believe that they should earn a higher return. The first is estimation risk. What does that mean?

7:54 When you value a company, you face the risk that you could be wrong on your estimates. That risk is greater with small cap companies because you have less of a supporting cast. What I mean by that is when you invest a large cap company, there might be dozens of analysts tracking the company and you can look at what they're forecasting and it helps you make your forecast. You might not have that available with large cap with small cap companies. In fact, as an extended point, the fact that you have fewer people looking at these companies might mean that there's less information in general available about small companies and you're saying, "Hey, that explains it. That's why I need to earn a higher return." Now, I'm going to push back a little on that phenomenon.

8:36 It is true that if you take an individual small company and an individual large company, that individual small company, you face more estimation risk, less information. But remember, as an investor, you're not forced to own one company. You can own a portfolio. You're saying, "So what?" If I take a 100 small companies and 100 large companies, it turns out that the standard deviation of those portfolios are not that different. You're saying, "How can that be? If the small companies are riskier, how come a portfolio of small companies is not riskier as well?"

9:09 Because the risk is estimation risk or information not being available. It averages out across a portfolio. So the first push back might be while individual small cap stocks might be riskier on a portfolio basis small cap stocks are not that much more risky than large cap stocks. It is true that there are fewer analysts fewer people tracking small cap stocks. In this graph I look at the average number of analysts based on large cap midcap small cap and micro cap companies and especially in the really small companies only about 20% get tracked by analysts. Many of these companies when you try to invest in them, you will find no support with an equity research report or analyst projections, you might not think you're losing much, but it it's still scarier as an investor when there's nobody else tracking the company.

10:00 So, the small cap cost companies historically have earned a high return. Much of that has come in January. And it m you know while the return some people can argue is is compensation for higher risk. It turns out that portfolios of small cap companies are not that much more risky than portfolios of large companies. There's also a problem of execution. Much of the research on small cap premiums comes from research on paper where researchers look at data and they assume you can buy at the prices in the computer database and sell at those prices and generate those returns. It turns out that replicating the small cap premium is tough to do even if you're an index fund investing these companies.

10:46 But simply, let's suppose you create an index fund to do exactly what those graphs you saw a few pages ago did, which is to invest in the smallest companies. All you do is you don't do any research. You pick the 300 smallest companies, you put your put your money on them. There there was a fund called the DFA small cap fund, you know, which essentially tried to do this, and it was a pretty successful fund, but it found that its returns were lower than the returns you saw on paper. There's an execution and a trading cost which we might not be capturing with those paper portfolios and that shouldn't surprise you. It is true that the transactions cost for investing in smaller companies is higher higher bid assets many are lower priced and maybe a bigger price impact if you're a larger portfolio. So you could argue that while small cap stocks good look good on paper, the actual returns you're going to earn are going to be lower. They still might be good enough for you to invest in them, but you got to factor that into your decision process.

11:47 So, small cap stocks historically have earned a higher return. But as you saw on a year-to-year basis that small cap pre premium was volatile. So, here's an add-on. If you truly believe there's a small cap premise, the data suggests that you can it's large enough to cover your risk and your execution costs. There's one more caveat I would like to add to the process. To earn that premium, you need a longer time horizon. In fact, in this graph, here's what I've looked at. I've looked at small cap versus large cap stocks and the percentage of the time small cap that small cap portfolio wins as a function of your time horizon. If your time horizon is one year, your chance of winning is barely above 50%. If it's 2 years, it improves a tiny bit. 3 years, it starts to jump. By the time you get to 10, 15, 20 years, you see a small cap premium dominate. So even if you believe there's a small cap premium, it turns out that you will need to have a long time horizon to be able to generate the returns you thought you could make. So that's a that that that brings home the importance of longtime horizon. So let's summarize. Even if you believe there's a small cap premium based on the data, if you're a small cap investor, it becomes far more critical to be disciplined and diversified than if you're a large cap investor. So if you're large cap investor, you might get away owning 10 large cap stocks. With small cap stocks, you might need 20 or 25 stocks. You need more diversification and you need more discipline because you might need to hold the stock through some bad time periods to be able to generate those returns.

13:32 Second, if you're a small cap investor, a great deal of the responsibility for collecting information and doing your due diligence rests on you. You can't fall, you know, ride on the backs of equity research analysts to do this due diligence for you. And third, you need a long time horizon. So, if those things hold at least for much of the last century as a small cap investor, you'd have run ahead of large cap investors. But if you track the small cap premium over time, something significant seems to be happening. So to do this, here's what I did. I took that data from 1927 through 2024 and I looked to see what would happen to the small cap premium if I started the data in 1927, 28, 29, 30.

14:19 In other words, I kept moving the starting date to see what happened to the small cap premium. And as I kept moving the starting date, the small cap premium started shrinking. So if I started in 1945 instead of 1927, you can see and I've reported both the equally weighted and the value weighted. The small cap premium persists, but it's much smaller than it was if I started in 1927. The small cap premium is drifting down over time. And in fact, there seems to be a tipping point in the 1970s.

14:51 If I start estimating the small cap premium in 1977,778,79 80, it turns out that the small cap premium pretty much disappears. Think about that. There is a small cap premium go back all the way to 1927, but there hasn't been one for almost 50 years, for the last 47 years. Sometimes in investing, we do things because it's always been done. In this case with the small cap premium there is a strong argument to be made that it's not just become more volatile recently but that much of it has dissipated.

15:29 Jeremy Seagull in his in his book on stocks went in the long term argues that a lot of the small cap premium can be attributed in 1970s that I inflation period and it is entirely possible that the small cap premium has dissipated. Now, if you're wondering why that might be happening, part of it might be a shifting in the market micro structure. In 1965 or 1970, actually trading a small cap stocks was much more expensive than it is today. Maybe collecting information in 1970 in small cap stocks.

16:03 I I'm not even sure how you'd have done it. Would you have written to the company for an annual report? Now you can get the data on small cap stocks, the smallest cap stocks if you have access to a large database. The question of whether it's an excess return or a risk mismeasurement has persisted. Maybe small cap stocks are riskier than we think they are. And clearly it's weakened over time. Now in addition to having index funds, you have ETFs of small cap stocks. If you truly believe that there is still a small cap premium, there are easier ways for you to exploit it than it used to be. And maybe by making it easier to exploit, we're driving it out. So let's summarize. If you look at the 20th century, clearly small cap stocks earned higher returns than large cap stocks after adjusting risk using traditional risk measures. And even after you broaden the additional trading cost, you could argue that it have earned a premium, a higher return from adding small cap stocks. That small cap premium seems to have faded over the last four or five decades. Maybe because of changes in the marketplace. But if you still believe there's a small cap premium, it's far easier to try to exploit it now because you have more choices on exploiting it. I hope you found this session useful and I thank you very much for listening.