Curated Portfolio | XC Quant: Growth
By Shantnu Sood (shantnu.sood@xumitcapital.com)
One can invest in a variety of ways, particularly in the stock market. A specific proportion of stock marketers purchase shares and keep them for a long time, whereas a small minority sell them within a short time frame. Day traders are those who purchase and sell equities on the same day. Apart from such investors, there are growth investors.
Growth investors prioritise making investments in businesses that are expected to outperform their respective industries in the years to come.
Investors who are looking for extraordinary returns are lured to growth companies because they are intriguing. If an investor is successful in selecting the best growth stocks, the rewards might be enormous.
Growth investors, however, deal with two major issues. They must first select growing firms that are still in the early to middle phases of their growth cycles — those businesses with a significant amount of growth yet to achieve. The second step is to identify businesses that still possess a competitive edge that allows them to stay well ahead of the competition. Rapidly expanding businesses with outstanding CEOs in developing industries can have bright prospects, but their stock prices frequently may not completely represent this growth potential. However, only a small number of businesses are able to sustain rapid rates of revenue and profit development over time.
A business that is anticipated to see rapid profits growth in the future ought to typically be valued more than one that does not. Value grows with rising growth, all else being equal. But all else cannot be kept the same. The necessity to reinvest more into the firm in order to expand more quickly distinguishes one company from another.
Factors along with growth that investors should consider
A company with significant growth should be valued more than a company without growth if all other factors remain the same, as was explained above. However, because everything else cannot be kept constant, it is critical to identify the businesses that will be able to boost their growth rates and hence their stock prices. For instance, if a business is expanding but its return on equity is equal to its cost of equity, the benefits of that expansion (in the form of future earnings that are higher) will be exactly offset by the cost of that expansion (in terms of reinvestment needed to sustain that growth). The caliber of a firm’s investments is a critical factor in determining whether growth enhances or diminishes value. Therefore, an investor can consider factors such as growth, profitability and cash flows. Implementing a multi factor approach to investing ensures that the investment strategy is robust and better to withstand market volatility. A strategy that combines growth, profitability, and cash flow ensures that the firms chosen can develop while being profitable. Now the reason for combining cash flow with growth and profitability is that it is much more difficult to manipulate cash flows in comparison to accounting earnings and therefore, provides the true picture about the company. Companies that have strong cash flows will always ensure that in bad times their businesses won’t suffer and that they will have enough resources at their disposal.
Additionally, it is important to compare the Nifty Growth Sector 15 Index’s performance to that of NSE 500 Index. High growth company exposure is intended by the Nifty Growth Sectors 15 Index. Though for the most part Nifty Growth Sectors 15 Index has performed better than the NSE 500 Index which can be seen in the chart below its CAGR over the past ten years was 11.7 percent compared to the NSE 500 Index’s 13.18 percent, and its Sharpe ratio was 0.75 versus 0.84 for the NSE 500. This shows that the risk to reward ratio of NSE 500 is much better than that of Nifty Growth Sector 15 Index. Therefore, a strategy of combining multiple factors becomes important.
A strategy of combining growth, cash flow and profitability has generated strong average excess returns in the Indian Market. We call this strategy ‘XC Quant: Growth’. This strategy was backtested for a period of 10 years from 2012 to 2022 over a universe of more than 500 stocks. This strategy would have generated a CAGR of 31.61 percent outperforming the NSE 500 by a handsome margin which generated only around 13.61 percent CAGR over the same period. This shows that combining other factors with growth ensures that the company is not only growing but is also able to generate profits along the way. This clear outperformance can also be seen from the chart below.
Moreover the chart above shows us that XC Quant: Growth portfolio has comprehensively outperformed both the NSE 500 and Nifty Growth Sectors 15 Index. The XC Quant: Growth has outperformed NSE 500 in 72.73 percent of the one year periods showing its strong outperformance.
In the table and the chart above we can see that when we divide the stocks into quintiles based on the growth, profitability and cash flow metrics the top two quintiles perform the best and the performance of the portfolios progressively gets worse, indicating that top quintiles contain stocks that are displaying high growth as well as increase in profitability.
Similarly, the Sharpe of the top two quintiles is best and then progressively starts decreasing.
This indicates that the return per unit of risk is highest in the top two quintiles. The benchmark (NSE 500) has been only able to outperform the bottom quintile with all the other quintiles outperforming it.
Combining factors such as growth, profitability and cash flows provides a much more robust strategy for an investor in comparison to selecting stocks on a single criteria as factors have cyclical performance. Therefore, combining factors which have a negative correlation with one another provide much better results. Such a strategy which also ensures that an investor is not just investing in growth stocks that are fueling their growth on the expense profitability.
Subscribe to the portfolio on different platforms:
smallcase: https://xumitcapital.smallcase.com/smallcase/XUMMO_0012
WealthDesk: https://xumitcapital.wealthdesk.in/wealthbaskets/XCQuantGrowth
References:
Damodaran, A. (2006). High Dividend Stocks: Bonds with Price Appreciation? In Investment fables: Exposing the myths of “Can’t miss” investment strategies (pp. 17–56). essay, Pearson Education.
Tortoriello, R. (2009). Growth. In Quantitative strategies for achieving alpha (pp. 181–211). essay, McGraw Hill.
Tortoriello, R. (2009). Valuation. In Quantitative strategies for achieving alpha (pp. 103–149). essay, McGraw Hill.
Tortoriello, R. (2009). Cash Flow. In Quantitative strategies for achieving alpha (pp. 151–179). essay, McGraw Hill.
