Question

Explain what is a growth investment strategy? Please explain why both large capitalised equities and small capitalised equities may be selected in a growth investment fund? When does this strategy outperform a Value strategy?

1. Explain the general process of active investments – identifying undervalued securities.

2. Explain how Value and Growth Funds identify undervalued securities.

3. Explain why it is likely that each type investments mostly identify a particular capitalisation of equities and the market conditions they typically do well.

4. Explain why the investments and market conditions may not be limited to that identified in point 3 above.

Answer 1

(1) Growth investing strategy is investing on schemes that lead to capital appreciation or growth in investor's wealth. There are a number of investment avenues that lead to gain of interest like bond or CDs but growth investment strategies lead to short or long term capital appreciation. Growth investors put their bet on companies that have shown above average or strong growth trajectory and are expected to continue to grow tremendously. Thus growth investors put their corpus on such stocks to achieve capital appreciation and not dividends or interest income.

(2) Growth investment fund means wealth accumulation through capital appreciation. We know that EQUITIES are the main driver for such growth. But a large capitalised stock or a small capitalised stock, any such company based on its future projects can deliver tremendous performance. Thus it is a myth that only large capitalised fund should be constitute the growth investment fund. There are small capitalised firms or start ups which have a tremendous potential yet to be unvield and offer huge trajectory of success. Market Capitalisation of a company should not be the criteria for determining its growth.

(3) Value strategy also gives income to investors but growth strategy give capital appreciation. Growth stocks are those which have earnings that are expected to grow at a rate faster than the rest of the stock market as a whole. They are commonly found in exciting or new industries. Value stocks are stocks which, at least temporarily, trade at a stock market price that is lower than they should be fundamentally trading. Value stocks are undervalued and thus they generate income to investors by attaining their true market value.

So in a growing environment when the economy is booming companies are outperforming based on their technology or product or service, companies are expected to have good revenue and thus growth stock will outperform their value peers.

(4) Identifying undervalued stocks:-

1. Quality rating: Looking at stocks with a quality rating that is average or better than industry benchmark is one method of identifying undervalued stocks. Veterans state that it’s best to choose stocks with quality ratings of at least B+ and above.

2. Debt to current asset ratio: Companies with a low debt i.e less leverage. You should select companies with a total debt to current asset ratio of 1.10 or less.

3. Current ratio: The current ratio provides a good indication of how much cash and current assets a company has—something that demonstrates they can weather unanticipated declines in the economy. You should buy stocks from companies with a current ratio of 1.50 or higher.

4. Positive earnings per share growth: To avoid unnecessary risk look for companies with positive earnings per share growth. Specifically, you should examine this metric over the past 5 years, and prioritize companies where earnings increase over that time period. Above all, avoid companies which posted deficits in any of the last 5 years.

5. Price to earnings per share (P/E) ratio: You should select stocks with low P/E ratios, preferably 9.0 or less. These are companies that are selling at bargain. This criterion eliminates high growth companies, which, according to Ward, should be assessed using growth investing techniques.

6. Price to book value (P/BV): P/E values are helpful, but they should be viewed contextually gives you a strong indication of the underlying value of a company. As a value investor, you want to invest in stocks which are selling below their book value. The P/BV ratio is calculated by dividing the current price by the book value per share.

7. Dividends: You should look at companies which are paying steady dividends. Undervalued stocks eventually tick higher as other investors figure out they’re worth more than what their price suggests, but that process can take time. If the company is paying dividends, you can afford to be patient as the stock moves from undervalued to overvalued.