In the financial markets, investors and market experts use a plethora of different terms to refer to certain specific situations. Understanding the meaning of these terms is crucial if you wish to make well-informed investment decisions that could get you closer to your financial objectives.
In this article, we are going to explore one of the most important terms that are frequently used in the Indian financial markets - outperform.
What is the meaning of the term outperform?
In the context of the financial markets, the term ‘outperform’ or ‘outperformance’ is used to describe a situation where an asset generates returns that are higher than those of its benchmark over a certain predetermined period.
Usually, market analysts and mutual fund houses measure the performance of an asset relative to a particular index over a specified period. This benchmarking is often done to gain insights into how the asset has performed. So if an asset is said to have outperformed its benchmark index, it essentially means that it has delivered higher returns relative to the returns produced by the benchmark.
Exploring the significance of outperform
Now that we have defined outperformance, let us now try to understand its significance and how it is used by different market participants.
Investors often use outperformance as a key metric to evaluate the performance and success of investment options. They may also use it to get an idea of the competence of fund managers and the strategies they use.
By checking to see if assets have outperformed their benchmarks, investors can compare the performance of different investments and gain insights into their ability to generate returns over time. An asset that consistently outperforms its benchmark index is often viewed favourably and is likely to enjoy higher liquidity due to increased demand.
Market analysts, meanwhile, use the term outperform in a slightly different context. They use it to rate assets based on their likelihood of delivering higher returns than their benchmark. For example, if market analysts assign an outperform rating to a stock, they expect the stock to outperform its benchmark index in the future. However, it is essential to note that simply because analysts expect a stock to outperform does not mean that it will actually produce higher returns than its benchmark.
Outperformance - An example
Let us now take up a hypothetical scenario to understand the concept of outperformance in the context of the financial markets.
For this illustration, we are going to take the stock of a large-cap company - ABC Limited and an equity-focused mutual fund - Fund A. Both of these two assets have the same benchmark index, the Nifty 50, which is a broad representation of the stock market as a whole.
Over the previous financial year, the stock of ABC Limited has delivered an average return of 12% per annum. The mutual fund, meanwhile, has delivered a return of 14% per annum. The benchmark index, Nifty 50, however, has only managed to deliver a return of 10% per annum.
Comparing the three, it is evident that both the stock of ABC Limited and Fund A have outperformed the Nifty 50 index. Furthermore, since the stock and the fund have the same benchmark index, they can also be compared with one another. In doing so, it becomes clear that the mutual fund, with its 14% per annum return, is the most favourable investment option.
However, such a comparison between the stock of ABC Limited and the mutual fund would not have been possible had they had different benchmark indices.
Also read: What are stock options?
What are some key factors that contribute to the outperformance of an asset?
There are many factors that contribute to an asset outperforming its benchmark index. Here is a closer look at some of the most important ones.
- Favourable market conditions
Ideal market conditions are one of the major factors that play a significant role in an asset outperforming its benchmark. For example, positive industry trends, low interest rates and buoyant investor sentiment are all favourable market conditions that could potentially drive cyclical stocks to deliver higher returns relative to their benchmark. - Effective investment strategies
The type of investment strategy used can also influence an asset’s ability to outperform its benchmark. This is very relevant in the case of mutual funds, where fund managers use various investment strategies, ranging from momentum investing to value investing, to outperform their respective benchmarks. - Superior financial performance
Superior financial performance, both at the company level for stocks and the fund level for mutual funds, is another key driver of outperformance. Strong revenue growth, increasing profit margins and other healthy financial metrics are likely to attract investor interest and outperform in the long run. - Strong asset selection
In actively managed mutual funds, effective asset selection could be crucial for outperformance. For example, funds that spend the time and effort to thoroughly research and invest in undervalued stocks are likely to outperform funds that have sub-par asset selection methodologies.
Conclusion
With this, you must now be aware of the meaning of stock outperformance and how significant it is. Outperformance indicates that an asset has performed better than its benchmark and is often used as a key metric to evaluate its attractiveness.
However, when evaluating an investment option, it is important to also consider factors other than whether it has outperformed its benchmark. These factors include your risk profile, financial objectives and investment horizon, among others. This way, you can ensure that you choose the investment option that is right for you.
