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Page 1 of 5  In 1964, Supreme Court Justice Potter Stewart famously defined hard - core pornography by saying, "I know it when I see it." Many in the investment community feel the same way about "growth" and "value" - otherwise known as style. While everyone seems to "know" what the terms mean, few can agree on a specific way to define them. And so, not surprisingly, they get thrown around with a nonchalance that's maddening.
The problem is particularly acute in the world of active mutual funds, where there are "growth funds" invested in utility companies and "value funds" invested in high-octane tech stocks.
Illustration By Greg Hargreaves
But even in the world of index investing, one man's growth is another man's value.
The problem of defining growth and value has come front-and-center recently, thanks in part to the growing popularity of asset allocation strategies, which often use style-based index funds and exchange-traded funds (ETFs) to position portfolios along the risk/reward continuum. There are now at least six major index providers offering eight different style breakdowns of the U.S. equity market, each with a different definition of growth and value. For a sophisticated investor, understanding the differences between the available style indexes can play a key role in executing a fine-tuned asset allocation strategy.
An Evolving Standard
Now is a particularly important time to compare and contrast the available style indexes, as the industry has entered a period of rapid change. In the past six months, two of the most established names in style investing-Wilshire Associates and Standard & Poor's-have announced dramatic overhauls of their indexing methodologies. In both cases, the companies have scrapped long-standing, simple systems of sorting stocks into growth and value in favor of much more complicated methodologies. And in both cases, the companies have turned away from a heavy reliance on book value to focus more on earnings growth.
The two cases are worth examining in-depth, as they point towards an emerging consensus on how best to define style.
The Curious Case Of Wilshire Associates
In December 2004, Dow Jones Indexes and Wilshire Associates announced plans to roll out a new set of style indexes covering the full range of the U.S. stock market. The new indexes would break all 5,000 stocks in the Dow Jones Wilshire 5000 into the usual style categories: Large Cap Growth, Large Cap Value, Mid-Cap Growth, Mid-Cap Value, Small Cap Growth, Small Cap Value and Micro Cap.
Here's what Dennis Tito, CEO of Wilshire Associates, said at the time: "With the introduction of the new Dow Jones Wilshire Style Indexes, financial professionals will now have comprehensive benchmarks for not only the broad U.S. market but also for the U.S. market segments that matter to them most-growth and value."
What's curious about Tito's statement is that Wilshire already had its own set of style indexes. In fact, Wilshire has offered style breakdowns of the Wilshire 5000 for close to a decade.
Significantly, however, the new style indexes use a different methodology to divvy up the marketplace. Whereas Wilshire previously relied on just two measures to define growth and value, in the new collaboration with Dow Jones, they'll be using six. The change suggests that, in creating the new indexe s , Wilshire believed that the old definitions could be improved.
Here's what changed. Under the old system, stocks were categorized based on just two criteria:
• Price/book ratio
• Price/earnings ratio.
Critically, the price/book ratio was given three times the weight of the price/earnings ratio. In other words, a stock could sport a very low price/earnings ratio, but if its price/book value was high, it was classified as a "growth stock."
This focus on book value traces its roots back to the "father of value investing," Benjamin Graham, who put book value (or a variant thereof) at the heart of his investment analysis. This pedigree was enhanced by Eugene Fama and Kenneth French, who used book value as the sole determinant of style in their famous Three Factor Model.
Despite the historical pedigree, however, many think that a heavy reliance on book value introduces a significant sector imbalance into style analyses. Book value, after all, is dependent on tangible assets-things like factories, cash and inventories. Legitimately valuable intellectual property-things like brands, patents, goodwill and relationships-do not factor into the calculation at all. As a result, style indexes that emphasize book value tend to overweight capital-intensive industries in the value category. Companies like Microsoft, in contrast, can never qualify for "value" status, no matter how low their stock price goes, because so much of their value is tied up in intellectual property. In an Information Age, this bias towards physical assets represents a real liability.
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