What is growth investing?
The Classic Definition: Investing in companies with high PE ratios.
The Correct Definition: Investing in companies where the price paid for growth
< Value of that growth.
The Overall Evidence
The overall evidence is that growth stocks lag
value stocks over long periods, if PE ratios or PBV ratios are used
as proxies for growth and value (High PE stocks, High PBV ratios:
High Growth: Low PE stocks, Low PBV stocks: Value Stocks)
However, there have been extended time periods
where growth investing has outperformed value investing. For
Growth investing seems to do much better when
the overall growth rate of the market is good.
Growth investing also seems to do much better when
the the term structure is much more upward sloping.
And active growth investors seem to beat growth
indices more often than value investors beat value indices.
Small Cap Investing
Studies have consistently found that
(in terms of market value of equity) earn
higher returns than larger firms of
equivalent risk, where risk is defined in terms of the market beta.
Figure 9.9 summarizes returns for stocks in ten market value classes,
for the period from 1927 to 1983.
Figure 2: Small Stock Premiums from
1926 to 1990
- The size of the small firm premium,
while it has varied across time, has been generally positive, as
measured in Figure 9.10, which summarizes small stock premiums
from 1926 to 1990.
- There have been cycles in the
small-stock premium ñ
- There was a bear market in small firm
stocks between 1983 and 1990 ñ
- Small Firms seem to earn a substantial
amount of their premium in January.
- The transactions
costs of investing in small stocks is
significantly higher than the transactions cots of investing in
larger stocks, and the premiums are estimated prior to these
costs. While this is generally true, the differential transactions
costs are unlikely to explain the magnitude of the premium across
time, and are likely to become even less critical for longer
- The difficulties of
replicating the small firm premiums
that are observed in the studies in real time are illustrated in
Figure 9.11, which compares the returns on a hypothetical small
firm portfolio (CRSP Small Stocks) with the actual returns on a
small firm mutual fund (DFA Small Stock Fund), which passively
invests in small stocks.
- The capital asset pricing model may not be
the right model for risk, and betas
under estimate the true risk of small stocks. Thus, the small firm
premium is really a measure of the failure of beta to capture
risk. The additional risk associated with small stocks may come
from several sources.
- First, the estimation risk associated
with estimates of beta for small firms is much greater than the
estimation risk associated with beta estimates for larger
firms. The small firm premium may be a reward for this
additional estimation risk.
- Second, there may be additional risk in
investing in small stocks because far
less information is available on
these stocks. In fact, studies indicate that stocks that are
neglected by analysts and institutional investors earn an
excess return that parallels the small firm premium.
- Fewer small companies are followed by
- More analysts follow large
- There is some counter-evidence on the
riskiness of small stocks
- You also need a long time horizon for
small cap investing to pay off.
Evidence from outside of the United
- There is evidence of a small firm premium in markets outside the United
States as well. Dimson and Marsh
examined stocks in the United Kingdom from 1955 to 1984 and found
that the annual returns on small stocks exceeded that on large
stocks by 7% annually over the period.
- Bergstrom, Frashure and Chisholm report a
large size effect for French
stocks (Small stocks made
year between 1975 to 1989, while large stocks made 23.5% a year), and a much
smaller size effect in Germany.
- Hamao reports a small firm premium of 5.1% for Japanese
stocks between 1971 and 1988.