Value Investing using Index Products (Mutual Funds or ETFs)
A great deal of investing today is done on a passive basis. Pooled investment vehicles (mutual funds) or ETFs are designed to follow and track an index which is based on specified criteria. Is this an effective way to invest using a value approach? The answer my friends is not so easy. If there were what I consider to be a true value investing index one that seeks to identify stocks of good companies with good management selling at reasonable or cheap prices relative to their current and future prospects the answer would be easy. Unfortunately, in my opinion, no such value index currently exists. Instead, most value indices use cheapness (measured by P/E, P/B or P/CF ratios) alone as a measure of value with no consideration of the quality of operations, management, or future prospects. A company selling at a low P/E ratio may deserve that P/E ratio due to poor management and or future prospects for generating earnings and cash flow. (see my prior posts on the problems of looking at returns to value versus growth investing based on indices and that value and growth should be looked at together).
Let’s look at how one of the most popular suite of index products creates their value and growth style indices – the S&P 500 indices. S&P computes a number of indices in the S&P 500 suite:
S&P 500 Index (Market Weighted) – the most popular
S&P 500 Growth Index
S&P 500 Value Index
S&P 500 Pure Growth Index
S&P 500 Pure Value Index
Performance of these indices over the past 10 years, along with some average fundamental metrics, is as follows (All data from https://www.spglobal.com/ as if August 31, 2020):
At first blush, one is likely to conclude that “growth” investing is clearly the highest return over the past decade and the greatest return relative to risk while “value” investing has underperformed for the last decade. “Growth” has even trumped what S&P terms a “pure growth” approach. The worst performer was a “pure value” approach. Certainly, we have all read many articles about values underperformance the last decade (but stronger performance over the longer term). However, a great deal of the difference in returns is how the growth component (or pure growth) is determined relative to the value component. You also might be curious as to why the sum of the number of companies in the growth and value indices is 669 while the S&P 500 only includes 505. Let’s understand how the style portions of these indices are determined.
For each company in the S&P 500, a growth rank and value rank are computed. The growth rank is based on a ranking of companies on a composite of the following growth factors:
Three-Year Net Change in Earnings per Share over Current Price
Three-Year Sales per Share Growth Rate Earnings to Price Ratio
Momentum (12-Month % Price Change) Sales to Price Ratio
Effectively these ratios are measuring growth relative to price (or inversely the price relative to growth). The value rank is based on a ranking of companies on a composite of the following value factors:
Book Value to Price Ratio
Earnings to Price Ratio
Sales to Price Ratio
These ratios clearly measure value on the current price relative to some underlying fundamentals (book value, earnings and sales). However, it does not consider value relative to growth. Next S&P divides the Growth Rank by the Value Rank to get a Growth/Value Rank. Companies with the highest Growth/Value Rank score are those with higher growth rates and higher relative prices. These are classified as pure growth companies (the top 1/3 of market cap based on this score – hence not 1/3 of the companies but 1/3 of the market value of the index). Companies with the lowest Growth/Value Rank are classified as pure value companies (again 1/3 of the index based on market cap). The pure growth and pure value companies are included in the pure growth and value indices, respectively. The middle companies are classified as blended and they are distributed to the overall growth and value indices (some are allocated to both – hence the sum of these two indices exceeding 505).
Effectively, in my view the pure growth companies represent “winners.” Those with higher growth that is reflected in higher price multiples. The pure value companies on the other hand are “losers”. Some may truly be companies selling below their intrinsic value, but others are selling at lower price multiples because they have lower growth, poor management and other issues. To me this is not value. Value should be price relative to intrinsic value, where intrinsic value is a function of underlying fundamentals and future prospects – including growth prospects. The true value stocks for me are likely found in the blended category – companies with good management and decent growth prospects selling at reasonable multiples. Some value stocks can be found in the pure value category, but these indices do not distinguish between true value and just cheap. Value stocks can even be found in the pure growth category (they may be selling at high multiples but may deserve those multiples based on growth prospects).
I hope this provides a good understanding of these indices and the limitations in evaluating the performance of growth versus value using them. More importantly if you are planning to invest in a basket of securities based on these indices you need to understand what you are getting. You may be getting exposure to some value factor/stocks, but it is based on low prices AND low growth. You are at the same time getting exposure to companies in the value or pure value index that deserve the multiples they are getting (poor management, low growth prospects, value traps, etc.). This is not the ideal exposure you want. I am looking forward the creation of better value indices going forward. Admittedly, it is not easy to do as you ideally need to measure intrinsic value which is like beauty – in the eye of the beholder. However, we could at least improve on how we allocate securities to the value basket where growth is allowed in the determination of relative value. One way to do this is to use expected return models such as one where the expected return is a function of the current earnings or cash flow yield plus expected growth. Ranking stocks on this expected return would be measuring value relative to both fundamentals and growth.