Question

why had overweighting value and/or small capitalization stocks usually returned more than the overall stock market portfolio? should everybody follow those investment styles? discuss in detail. (10p)

Answer 1

Solution:-

Overweighting value stocks usually returned more than the overall market due to the following reasons:

• Value investing focuses on buying stocks at a cheap value, which is generally possible only during bearish times when the markets are down. This results in lower purchase cost as compared to other strategies such as growth investing.
• Value investors believe in keeping margin of safety when forecasting future business performance. They take conservative views of the future EPS growth and thus never overpay for stocks.
• The whole value approach is based on being conservative and buying stocks only when they are available very cheap while staying away from markets at the other times. This has both pros and cons. The disadvantages of such an approach is that value investors rarely find good times to enter the market and often miss opportunities when stocks don't reach very cheap valuations. On the other hand, the advantage is whenever value investors do find value stocks during bearish times, they generally generate great long-term returns due to cheap purchase costs of their portfolio

Overweighting small cap stocks usually returned more than the overall market due to the following reasons:

• Small cap stocks are businesses that are small in size and thus have potential for high EPS growth in the future. Large companies can't produce the high % EPS growth than smaller companies can.
• As they say in finance, higher the risk higher the return. This concept applies perfectly in small cap companies. These small businesses have higher operating risks as compared to larger companies, and investors require higher returns in lieu of taking those higher risks.
• The investors must understand that these opportunities for higher returns come at a cost of higher risk and therefore, it must be made sure that investments made in small cap companies should be done only for a long-term horizon and are properly diversified into multiples industries and companies

Should everybody follow these investment styles?

As discussed above, both the approaches have advantages and disadvantages. No strategy suits all investors. Value based strategy offers great opportunities but value stocks are rare to find and investors can miss various great opportunities by following value strategy particularly in bull markets. Similarly, small cap stocks do offer opportunities for higher returns but it comes at the expense of higher risks.

Thus every investor must look at his individual desired return and risk appetite and choose the strategy accordingly. Value and small cap investing is not suitable for all investors.