When the market value of the security is considered too high for its fundamentals, then it is termed an overvalued. The companies used metrics such as Price / Earnings ratio to check whether the securities are overvalued or undervalued.
What are Hedge Funds? A hedge fund is a managed pooled fund for alternative investment method which employs trading into complex products including equities, derivatives, real estate, currencies and many others. The performance of the fund is measured in absolute return units. As the name suggests, hedge fund tries to “hedge” the risk associated with a particular investment choice based on the price relevant information. Hedge fund managers choose from the variety of options from stocks to bonds and commodities to currencies. Sometimes they may invest their own money to a fund to leverage the magnifying effect of the investment. How did it start? Alfred Winslow Jones is regarded as a pioneer in the field of hedge fund management, and he launched the first hedge fund in 1949. Alfred structured the funds by finding the loopholes in the regulations and reaping benefits from them. Alfred formed an investment partnership and committed his own money in the partnership. He fixed his remuneration in the form of performance incentive, which was 20% of profits. Alfred, in his endeavour, combined shorting and leverage, and hedged them against the market movements and reduced the risk exposure. He chose equal short and long positions for his portfolio. The overall impact of the combination of long and short positions, his portfolio became more stable with lower risks. Why opt for Hedge Funds Image source - © Kalkine Group 2020 Many fund managers joined Alfred to gain fame and fortune. Some of them even went to start their own fund houses and an SEC report of 1968 reported 140 hedge funds in the United States of America. During the stock market boom of the late 1960s led to a belief that Hedge Funds underperformed than the overall market. Many hedge fund managers dropped the idea of long term and short term positions and did not feel the need for risk hedging. To take the benefits of the market boom, many fund managers moved out from the Alfred technique of lowering market movement risks. The fund managers moved boldly to the riskier strategies, which led to heavy losses in 1969-70. The bear market of 1973-74 drove a massive plunge in hedge funds and saw closure of many such funds due to heavy losses. During the mid-80s, hedge funds again became centre of attraction for large investors due to the Julian Robertson’s Tiger Fund. The fund was one of the many global macro funds that used leveraged investments in securities and currencies after careful assessments of global macroeconomic and political situations. Tiger Fund, in 1985, correctly forecasted the end of the four-year trend of the US dollar appreciation against currencies of Europe and Japan and speculated in non-US currency call options. A report in the year 1986, reveals that since its inception, Tiger Fund gave an average of 43% return to its investors. During the late 1990s, hedge fund suffered one of the largest losses. Quantum Fund lost US$2 billion in 1998 during the Russian debt crisis. Tiger Fund lost more than US$2 billion in trading of Japanese Yen with respect to the US dollar. The losses and redemption of money by the investors led to the closure of the Tiger Fund in 2000. What are the different types of hedge funds? Hedge funds can differ based on the strategy chosen by the manager after consulting the investors. The strategy is laid out to the investors through a prospectus before going forward with it. This makes a hedge fund more flexible as investors are always aware of about where the funds are going. Thus, hedge funds can be of the following types: Macro: These hedge funds aim to profit through macroeconomic trends. These macro parameters may include global trade, interest rates, forex policies, etc. Equity: These hedge funds involve investments into stocks nationally and internationally, both. This is accompanied by a hedging position against stock market downfalls by shorting overvalued stocks. However, the striking feature of this type of hedge fund is that managers pick up undervalued stocks and split the investment between going long in stocks and shorting others. Relative-Value: This type of hedge fund takes advantage of inefficiencies existing in the spread. A Spread is the difference between bid price and ask price of a security. Event-based: These involve those funds that seek to gain from inefficiencies brought on by corporate events, corporate restructurings, mergers, and takeovers, etc. How is a hedge fund different from a mutual fund? In operation, hedge funds and mutual funds may sound the same as they both involve a pooled sum of funds being invested. However, there are some fundamental differences between both. These include: The need for accredited investors: Hedge funds are only open to certain accredited wealthy investors holding high level of capital. However, mutual funds are open to non-accredited investors as well. Liquidity: Hedge funds do not maintain daily liquidity, whereas mutual funds are much more liquid. Hedge fund investors may only liquidate after the specified subscription period is over. This period may be a quarter long or a month long depending on the type of fund. Investment instruments: Hedge funds investors can invest in various types of investments other than stocks. These include bonds, commodities, exchange rate, etc. However, mutual funds invest in stocks. This makes hedge funds much riskier than mutual funds. Regulations: Hedge funds are subjected to less regulatory checks are compared to mutual funds. Some hedge fund managers may not even be required to register the fund with the Security Exchange Authority. However, mutual funds are subject to greater level of regulations and must provide higher level of disclosure than that required by hedge funds. How is it doing now? The hedge fund industry has evolved substantially, and their numbers are in thousands and managing trillion dollars of investment around the globe. Their Modulus Operandi has also evolved over the year. They ask their investors to put the money in locking period of a minimum of 1 year. Hedge funds are usually open to qualified investors. The fees charged by the fund managers are also generally on the higher side, around 2% of the underline asset value plus the performance fee on gains generated. The basic principle of hedging the investment has now changed, and the key focus is to maximise profits or to give higher returns on the investments. To achieve higher returns, fund managers often put their money on higher risk elements. Fund managers use leverage to increase the spread of profit, but at the same time, leveraging can incur more loss than the actual investment would have made. Speculative investment has the potential of higher risk and huge losses. Being said that, the past financial blunders of hedge fund have also provided expensive learning and experience to the fund managers. Building upon the legacy, hedge funds have given higher returns over the years. The average rate of returns of hedge funds attracts most of the wealthy investors towards them. They invest in anything from bonds to securities to currencies and even real estate. There is no fixed rule of investment or instrument for investment, and no definition could cover the entire system of hedge funds. What are the two sides of investing in Hedge Funds? Image source: ©Kalkine Group
What are Growth Stocks? Although legendary investor like Warren Buffet has reckoned that ‘Growth and Value Investing are joined at the hip’, the market obsession with the divergences in the market multiples across businesses continues to ignite Growth and Value debate. Thomas Rowe Price Jr is called the father of Growth Investing. Initially a chemist at DuPont, he later opted to work at a brokerage. He set up T. Rowe Price Associates, an investment advisory firm in 1937 and T. Rowe Price Growth Stock Fund was incorporated in 1950. Rowe Price Associates is now T. Rowe Price Group, Inc. – a publicly listed global investment management firm. And the T. Rowe Price Growth Stock Fund is still operating. According to Mr Price, a growth stock should be able to retain growth in purchasing power terms, meaning that earnings of the enterprise should increase at a rate more than the existing level of inflation. He stressed that a cyclical upside in the earnings of an enterprise should not be perceived as the growth of the firm, and the opposite is true when earnings of an enterprise are under strain during a cyclical slowdown. Mr Price often held stocks for decades and noted that Growth Stocks should be held until the growth in the enterprise is exhausted, or the enterprise is no longer a Growth Stock. He published a list of stocks that were owned by him in the 1930s and 1940s, delivering outstanding returns. These stocks were Black & Decker, 3M, Scott Paper, IBM, Pfizer, DuPont, and Merck & Co. Investors chase Growth Stock to realise long-term capital appreciation from the investments, which are expected to deliver better-than-average growth in the share price. Growing companies carry the potential to outperform income stocks since growing companies reinvest their profits instead of distributions to exhibit further growth. Must Read: How To Identify A Growth Stock? What are the features of Growth Stocks? High earnings multiple: As a result of high expectations from the market participants, Growth Stocks usually trade at a high earnings multiples. Not all growing companies pay dividends, the potential returns from growth investments are likely to be realised through capital appreciation. But investors may also feel that the stock is overvalued given its high multiple. Another legendary Growth Investor – Philip Fisher, noted that sometimes high price-to-earnings multiple indicates the intrinsic value of a company rather than discounting for expected growth. Stocks of businesses with long growth run way tend to sustain high multiples as time is in favour of the business. Many growth stocks across the world have traded at high multiples in the era of ultra-low interest rate. Read: Popular Names Under Growth Versus Value Scanner: TLS, XRO, LLC, SPT, PBH Target market: Growing enterprises often have a large target market, allowing the business to grow since there are a large number of customers. It is important that the target market is growing because a slowly-growing target market would also impact the growth of the company. Usually, growth companies are found lead the market be it in terms of scale, industry leading margins, over all market share, etc. A new entrant in the industry: A business could be a growth business when it is a relatively new player in the industry that is challenging other players to gain market share. Since the business is new to the industry, the level of the growth realised by the business could be better-than-average. On account of scale. A small cap company growing strong: Baby Bunting Delivers Strong Profitability Growth New product development & innovation: It is crucial for growing enterprises to continuously develop new products driven by innovation, which would require investments in research and development. A disruptive new product in any industry developed by a business has the potential to gain market share due to its value to the customers. High reinvestment rate: A successful growth enterprise would need to continuously improve its processes and products to deliver a better return on invested capital with sustainable debt. Growth Stocks generally exhibit a high growth rate due to their high reinvestment, which is applied to new product development, enhancement of standard business practices or enter new markets and geographies, especially with high growth potential. A growth stock raising capital: Afterpay to raise 1 billion in Fresh Capital Sound management: Management of a business is responsible for the many important decisions in a firm, whether it is purchasing new machinery or acquiring a business. Investors also study the past projections and compare those to realised results by the firm, allowing investors to form a view on management skills. Qualities of a good management read: 5 Traits of a Good Management Team It also becomes imperative for investors to evaluate how the business has performed in times of distress like an economic slowdown, and how the management of the business has been able to navigate the business out of the crisis. Investors also prefer leadership that has delivered results consistently and has a reputation for thinking out-of-box. Studying management style of leadership would enable the investor to know the risks associated with the decision-making. Moreover, the management team is responsible for capital allocation decision and prudent use of capital that is deployed in the pursuit of growth. What are the risks associated with Growth Stocks? Capital allocation: Capital allocation is a crucial exercise undertaken by the management, and investors carefully evaluate these decisions by management. Since Capital Expenditure would deliver benefits in the future, there always remains a risk of underachievement by the business. It is also important for investors to question the funding sources and the rationale behind those sources. Businesses could take up a huge debt to fund the growth plans, but when the expected outcomes are not realised – the return on capital will deplete. More on return on invested capital: What Is Return On Invested Capital (ROIC)? Growing competition: A new entrant in a market with disruptive products remains a major threat to all existing companies in the industry. As competition grows, the management needs to be proactive and responsive to the underlying change in the industry. Moreover, it is equally important for management to know what their peers are developing and launching in the market. When a business is not paying attention to how its competition is evolving, it could well trigger a crisis for the business. Small & growing enterprises: In most of the cases, a growing enterprise would be a small business seeking to expand and grow due to its relatively small penetration in the target market. Since small businesses have less diversified revenue streams, new business model and lack of experience in the market, these factors could impact the businesses when growth in the target market slows down, especially during times of cyclical slowdown. How to select growth stocks? Growth businesses tend to be leader in a particular category as discusses above. Investors can look for businesses that have shown consistent growth in revenue, margin, market share- if not growth at least sustain market share and show growth in other parameters. These stocks tend to be in good momentum; thus stock price is usually seen trading near or at 52- highs. Growth stocks typically do not provide dividend as they reinvest capital back into the business. Look for good management pedigree as they are the stewards of the business. The management of a growth stock in the 21st century is expected to build a business that is not just robust but also antifragile. To know more on antifragility read here: Developing Antifragility was Essential Pre Covid-19; Now It Is A Must- Taleb Your Go to Guru
What is intrinsic value? Intrinsic value refers to the calculated value of an asset, investment, or a company. The value of an asset or investment can be calculated by financial models or other sophisticated measures. In finance, intrinsic value can be understood as the value that an investor is willing to pay for an investment, given the risk associated with it. Intrinsic value can be understood as a perceived value and not the actual value. Therefore, it may not always be equal to the current market price of an asset or an investment. It is a measure based only on internal factors, unlike other measures, which rely on relative tools to assess an investment. The most basic measure of intrinsic value is the net present value of an investment. Intrinsic value is also used in options pricing. The intrinsic value of an option refers to the difference between the market price of an underlying asset and the exercise price of an option or a warrant, but not less than 0. What are the factors affecting intrinsic value? Investors can use fundamental analysis to find the intrinsic value of an investment. This method involves looking at the qualitative as well as the quantitative measures. Qualitative measures involve the business model, governance, and market factors. These items are specific to the business. Quantitative factors include financial ratios and analysis of the financial statement. These factors depict how well a business does. There are other perceptual factors which help businesses calculate the relative worth of an asset. These factors can be arrived at through the help of a technical analysis. An asset or a company may be overvalued or undervalued, depending on the strength of the model used to calculate the value. Both qualitative and quantitative measures are used to calculate the value of an asset. How is intrinsic value calculated? There are various methods of calculating the value of an asset or a company, which are used by financial analysts. These include: Discounted Cash Flow Analysis: In this method, an analyst determines the future cash flow attached to an investment and discounts this value to the present day. This method involves the following steps: Forecasting the future cash flows of a company (or investment). Arrive at the present value of each cash flow. Add the present discounted values to find the intrinsic value. The future cash flows can be arrived at with the help of the previous cash flow statement. The past streams of cash can be a good projection of how a company or an asset would perform in the future. After the future cash flows are estimated, the subsequent process is not as difficult. The formula for present discounted value can be used to find the intrinsic value. The formula is: In the formula, C1, C2,…Cn refer to the estimates of the future cash flows for periods 1, 2,…n, and r refers to the discount rate or interest rate offered on other investments. A present value analysis is the opposite of a future forecast as it discounts the value obtained in the future down to the interest set up in the current time. Financial metric: There can be financial metrics which depict the value of a stock. These include the Price-to-earnings ratio. The formula to use P/E ratio to calculate intrinsic value is: In the formula, r refers to the expected growth rate of earnings. The value obtained from this method would give the intrinsic value of a single share. Asset-based valuation: This is a relatively simpler method of valuating the intrinsic value of a company. The negative aspect of using this method is that it does not incorporate any prospects of future growth in a company. Asset-based valuation may also give a value which is lesser than other methods of valuation of a company. What are the problems with intrinsic value analysis? There is no rigid method to which analysts must feel constrained. The valuation of future cash flows might be different from analyst to analyst. The model used to arrive at the intrinsic value can also differ among companies and analysts. This makes intrinsic valuation a subjective analysis method. The assumptions used to make a present value measurement can vary. The intrinsic value is sensitive to any changes in the model used to determine it. Most importantly, intrinsic value analysis is only a projection of the future and not an accurate measure. It can’t be used to make future predictions and is to be understood only as an estimate. The differences in valuations obtained by various methods make the method more subjective and drives the measurement away from the real value. How is intrinsic value analysis useful? Intrinsic value helps investors analyse which stocks are trading for lesser than their estimated value. Buying a share which is trading for less than the intrinsic value could prove to be beneficial to an investor. However, investors must be careful before using intrinsic value as an analysis tool. Certain analysts might undervalue a stock, while others may overvalue it. Each method of measurement must be analysed carefully, before being accepted as a valid tool to decide.
The stock that is issued at a relatively higher price than the actual value of the issuing party’s assets is watered stock. It is often referred to as overvalued stock, as they are deemed to be artificially inflated in value. This is often a part of a scheme to deceive investors and is difficult to sell. There are two main reasons for the book value of assets to be overvalued- excessive issuance of stock via a program or inflated accounting values.