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Small Cap Growth Investing 小型成长股

Investment Philosophy

Small Cap Growth investors believe that there are huge information gaps (between stock price and its intrinsic value) in the small rapidly growing companies’ universe and these gaps tend to occur highly frequently, which creates potentials for dramatic stock price appreciation, and investors will eventually benefit as these companies gain broad attention. Growth investing does best in periods of slow earnings growth, when it has scarcity value, and when the yield curve is flat or downward sloping.

Research & Screening Process

I have met a US Small Cap Growth manager the day before yesterday, who employs fundamental-based, bottom-up stock selection process. The Team typically breaks out the Small Cap Growth investment universe into “Discovery” phase and “Rediscovery” phase:

  1. Discovery Phase: This phase is to discover companies in the early stages of their investment cycle, and can be evidenced with sustainable superior growth prospects (3-5 year EPS growth greater than 20%), as only with impressively high growth will a small company gain investors’ attention and further establish a track record that makes larger investors bid up the stock price to accumulate shares.
  2. Rediscovery Phase: This phase is to seek misunderstood companies and capture “catalysts.” Most commonly, the catalysts involve new management turning the company around, asset redeployment, corporate restructuring, undervalued assets that make a company ripe for a takeover, earnings acceleration due to new product introductions, and powerful cyclical force.

The Team rarely invests in any company until it had met the company’s management. In addition, the Small Cap Growth Portfolio has conducted consistent investment process and buy/sell disciplines.

Portfolio Construction

The Manager’s Small Cap Growth Portfolio is not benchmark-aware; however, guidelines in terms of allocations and positions are in place:

  • Sectors +/- 10% of R2000 Growth Index
  • Discovery/Rediscovery limit of 70%. Typically, the proportions of the discovery companies and rediscovery companies are approximately 60/40; as of January 2013, the “discovery” is 56% and the remaining 44% “rediscovery”
  • The Portfolio aims at a fully-invested level, with a cash position of less than 5%
  • Portfolio holdings range 90 – 125; 121 names as of 12/31/2012
  • Historically, the Portfolio has under-weighted Consumer Staples, Consumer Discretionary, and Health Care sectors; the Team believes that due to restrict regulations and high healthcare costs shifted from employer to employees, healthcare sector has limited potential for stock price appreciation
  • The Portfolio has over-weighed in Financials; in the Manager’s opinion, there has been huge information gaps in this sector and there are more investment opportunities to discover especially after the Depression

Risks and the Size Effect

Risk is not just volatility of returns so it cannot be measured by standard deviation alone. Factors like leverage can make a huge difference in the level of risk for some small companies, e.g. semiconductors, but not for some others, e.g. utilities. Total risk also considers business risk, financial risk, management quality, macro risks, etc.

There are issues with purely systematic or model-approach investing in small caps. To give an example, CAPM is not the right model for small stock risk, as betas underestimate the true risk of small stocks. To point a few:

  • Estimation risk is associated with valuing small company stocks
  • Limited information on small companies
  • Uncertainty about the future of small companies
  • Less analyst coverage

Some Differences in Small Cap Growth Investing

  • In this style, the importance of discipline and diversification becomes even greater, as small-cap stocks tend to be concentrated in a few sectors, therefore a much larger portfolio is needed to be diversified with small cap stocks.
  • Since analyst coverage is significantly less in this space, due diligence becomes more important, which means investors have to go beyond the typical resources and research process.
  • Most small cap growth companies are in the early stage of the investment cycle, thus an even longer time horizon is required for assessment.
  • Techniques of valuing IPOs are required, as a shift in market mood can leave investors with a large allotment of overpriced shares.
  • Superior judgments on growth prospects are required.

Empirical Evidence

Jeremy Siegel notes in the book “Small Cap and Growth Investing”, that the long-term performance of stocks and the small stock premiums can be almost entirely attributed to the performance of small stocks in the 1970s. Since that was a decade with high inflation.

Reference:

Small Cap and Growth Investing by Jeremy Siegel, NYU Stern School of Business

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