aswath_damodaran-investment_philosophies_2012

Source: Cambridge Associates.

earns extraordinary returns. During the 1990s, for instance, venture capital funds earned an average return of 29.5 percent, compared to the S&P 500’s annual return of 15.1 percent, but there are three potential problems with this comparison. The first is that the appropriate comparison would really be to the NASDAQ, which boomed during the 1990s and contained companies much like those in a venture capital portfolio—young technology firms. The second and related point is that these returns (both on the venture capital funds and on the NASDAQ) are before we adjust for the substantial risk associated with the types of companies in their portfolios. The third is that the returns on the venture capital funds are suspect because they are often based on assessments of value (often made by the venture capitalists) of nontraded investments. In fact, many of these venture capital funds were forced to confront both the risk and self-assessment issues in 2000 and 2001 as many of their investments, especially in new technology businesses, were written down to true value. From September 2000 to September 2001, for instance, venture capital funds lost 32 percent of their value, private equity funds lost 21 percent, and buyout funds lost 16 percent of their value.

When we look at the longer period returns on private equity and venture capital investing over the past two decades, what emerges is the sobering evidence that the strategy has a mixed record. Cambridge Associates, a data service that tracks the returns on venture capital investments, reported shortterm and long-term returns on private equity investments as of June 2011, presented in Table 9.1.

Over the past 20 years, venture capital funds have outperformed public equity indexes, but all of the outperformance can be traced to the 1991– 2000 period. In the past decade, every category of venture capital has

underperformed the equity indexes, sometimes by large amounts. Ljundquist and Richardson examined private equity funds and conclude that they did make modest excess returns between 1981 and 2001, but attribute the higher returns to compensation for illiquidity.24 In a more recent study, Phalippou and Gottschalg document that average reported returns for private equity funds tend to be biased upward, because of the failure to incorporate the effects of funds that closed down and for accounting overstatement. Making these adjustments, they show that the typical fund underperforms the S&P 500 by about 3 percent.25

There is one final point worth making about private equity and venture capital investments. The average returns just reported are pushed up by the presence of a few investments that make very high returns. In general, the highest-return venture capital investments tend to be in (relatively few) companies that eventually go public. Most private equity and venture capital investments generate low or negative returns, and the median (rather than the average) return indicates this propensity. Consider, for instance, the glory years of 1997 through 1999. The conventional wisdom is that private equity investments did well in those years. In 1999, the weighted-average internal rate of return on private equity investments was 119 percent, but the median return in that year was 2.9 percent. The median venture capital investor trailed the average investor badly in most other years as well, indicating the chasm between the best venture capital/private equity investors and the rest of the segment.

D e t e r m i n a n t s o f S u c c e s s i n A c t i v i s t

G r o w t h I n v e s t i n g

While venture capital and private equity investing, in general, is not a recipe for guaranteed high returns, there are some venture capital and private equity investors who succeed and earn extraordinary returns. What set them apart, and how can you partake in their success? The keys seem to be the following:

Pick your companies (and managers) well. Many small private businesses do not survive, either because the products or services they offer do not find a ready audience or because of poor management. Good

24A. Ljundquist and M. Richardson, “The Cash Flow, Return and Risk Characteristics of Private Equity” (SSRN Working Paper, 2003).

25L. Phalippou and O. Gottschalg, “The Performance of Private Equity Funds,”

Review of Financial Studies 22 (2009): 1747–1776.

venture capitalists seem to have the capacity to find the combination of ideas and management that makes success more likely.

Diversify. The rate of failure is high among private equity investments, making it critical that you spread your bets. The earlier the stage of financing—seed money, for example—the more important it is that you diversify.

Support and supplement management. Venture capitalists are also management consultants and strategic advisers to the firms that they invest in. If they do this job well, they can help the managers of these firms convert ideas into commercial success.

Protect your investment as the firm grows. As the firm grows and attracts new investment, you as the venture capitalist will have to protect your share of the business from the demands of those who bring in fresh capital.

Know when to get out. Having a good exit strategy seems to be as critical as having a good entrance strategy. Know how and when to get out of an investment is critical to protecting your returns.

As a successful venture capitalist, you will still find yourself holding not only a risky portfolio but a relatively undiversified one, with large stakes in a number of small and volatile businesses. In short, activist growth investing is best suited for investors who possess substantial capital, have long time horizons, and are willing to take risks.

C O N C L U S I O N

If value investors bet on the market getting it wrong when pricing assets in place, growth investors place their bets on misassessments of the value of growth. While some categorize growth investors based on their willingness to buy high P/E ratio stocks, that characterization does not capture the diversity of growth investors. In this chapter, we began by looking at investing in small-cap stocks and initial public offerings as growth investing strategies. We then considered a variety of growth screens used by investors to find undervalued growth, ranging from high P/E ratios to low PEG ratios. While the empirical evidence is not as supportive of growth screens as it is for value screens, investors who are disciplined, have long time horizons, and are good at gauging market cycles can earn significant excess returns.

In the last part of the chapter, we examined venture capital and private equity investing and categorized them as activist growth investing strategies, since they require taking large positions in young growth businesses and then taking an active role in their operations. While there are some venture capital

and private equity investors who earn huge returns, the overall returns to private equity investing reflect only a modest premium over investing in publicly traded stocks. A large appetite for risk and a long time horizon are prerequisites for success.

E X E R C I S E S

1.Do you think that a growth stock can be cheap? If yes, how or why would that happen? If not, why not?

2.Assume that you are intrigued by the small-cap stock strategy.

a.What do you see as the biggest benefit of the strategy? What do you see as the biggest dangers from investing in small-cap companies?

b.Given the evidence and caveats presented in this chapter on small cap investing, how would you adapt your stock picking to maximize your returns?

3.Assume that you are interested in making money off initial public offerings.

a.What do you see as the biggest benefit of the strategy? What do you see as the biggest dangers from investing in IPOs?

b.Given the evidence and caveats presented in this chapter on IPO investing, how would you adapt your stock picking to maximize your returns?

4.Assuming that you are interested in buying growth at a reasonable price (GARP), come up with two screens that you would use to find cheap GARP stocks.

a.Use those screens to find cheap stocks.

b.Take a look at your list of cheap stocks. Do you see any potential problems with a portfolio composed of these stocks?

c.Add a screen or screens that would help you avoid the problem stocks.

Lessons for Investors

To be a growth investor, you need to:

Make better estimates of growth, and price it well: The success of growth investing ultimately rests on your capacity to forecast growth and to price it right. If you are better at these roles than the market, you improve your odds of success.

Catch growth cycles when they occur: Growth investing has historically done best when earnings growth in the market is low and investors are pessimistic about the future.

To be an activist growth investor, you need to:

Accept skewed returns: Private equity and venture capital investing may offer a few investors spectacular returns, but the average returns to all investors in these categories are low (relative to investing in publicly traded stocks).

Invest in the right businesses: To succeed at private equity investing, you have to pick the right businesses to make the investments in, diversify your bets, and have a well-devised exit strategy.

is a possibility of profiting on information by trading after the announcement. In the final part of the chapter, we consider the essential ingredients of a successful information-based trading strategy.

I N F O R M A T I O N A N D P R I C E S

The market price of an asset is an estimate of its value. Investors in the market make assessments of value based on their expectations for the future; they form these expectations using the information that is available to them, and this information can arrive in different forms. It can be public information available in financial statements or filings with the Securities and Exchange Commission (SEC), or information available to one or a few investors. In this section, we will begin by drawing a distinction between private and public information, and then considering how an efficient market should react to information.

P r i v a t e a n d P u b l i c I n f o r m a t i o n

While the steps in the pricing process—receive information, process the information to form expectations, and trade on the asset—may be the same for all investors, there can be wide variations across investors in when they receive information, how much information they are provided and how they process the information. Some investors have access to more information than others. For instance, an equity research analyst whose job it is to evaluate a stock as an investment may have access to more information about the firm than a small investor making the same decision, or at least get the information in a more timely fashion. These differences in information are compounded by the different ways in which investors use the information to form expectations. Some investors build complex quantitative models, converting the information into expected earnings and cash flows, and then value the investments. Other investors use the same information to make comparisons across traded investments. The net effect is that, at any point in time, investors will disagree on how much an asset is worth. Those who think that it is worth more will be the buyers of the asset, and those who think it is worth less will sell the asset. The market price represents the price at which the market clears—that is, where demand (buying) is equal to supply (selling).

Let us now consider the relationship between price and value. In Chapter 4, we argued that the value of an asset is the present value of the expected cash flows over its lifetime. The price of that asset represents the product of a process in which investors use the information available on the asset to