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 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 instance,

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.

Studies have consistently found that smaller firms (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.

• 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.

Possible Explanations

• 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 investment horizons.
• 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 analysts

• More analysts follow large companies

• 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 States

• 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 32.3% per 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.