Obsolete and misleading measures
A few years ago I started reading comments to the effect that ‘value stocks’ were underperforming ‘growth stocks’ and that, in time, this cycle would have to correct itself. Apparently, research and back testing had shown that ‘value stocks’ are expected to perform well over the long run.
I found it curious that ‘value stocks’ were underperforming because my portfolio built on value investing principles seemed to be doing quite well.
I decided to try to find out what was going on. My reading taught me about smart beta and factor ETFs, that come in a variety of flavors. These styles include ‘value stock’ ETFs, ‘growth stock’ ETFs and a host of sector and themed ETFs as well as all the plain vanilla broad market index trackering ETFs.
The rise of ETFs
It seems that in a 1992 paper, Fama and French proposed a three factor model that could potentially capture a value premium and thus outperformance. Subsequently other factors were identified including momentum, quality, size, market beta, profitability and on and on. From this research a giant segment in the investment industry was born. It is called smart beta or factor investing. The basic idea is that investment funds can be created that follow factor rules in a systematic way. Thus, an investment ETF can be created and maintained using computer algorithms with three claimed benefits: 1/ It can produce acceptable investment returns compared to various benchmarks; 2/ It can reduce costs, particularly management expense ratios; and, 3/ It can avoid the mistakes that behavioral bias prone stock picking managers make. This is all explained by Swedroe and Berkin in The Incredible Shrinking Alpha, How to be a successful investor without picking winners, 2nd ed 2020. This sounds pretty good on the surface.
How ‘value stocks’ and ‘growth stocks’ fit in to the ETf story
What we are going to do is look at how ‘value stocks’ and ‘growth stocks’ fit into all of this. It is my view that the distinction between ‘value stocks’ and ‘growth stocks’ is a false dichotomy. I really don’t think there is such a thing as a ‘value stock’.
Investopia explains the difference this way: “Growth stocks are those companies that are considered to have the potential to outperform the overall market over time because of their future potential. Value stocks are classified as companies that are currently trading below what they are really worth and will thus provide a superior return.”
The ETF industry
ETF providers (with assets under management) (AUM) such as BlackRock iShares unit: $2.117 trillion; The Vanguard Group: $1.619 trillion; State Street Corp. (STT), the sponsor of SPDRs: $881 billion; Invesco Ltd. (IVZ): $308 billion; Charles Schwab (SCHW): $214 billion, create ETF products that are sold to investors.
Investors judge the ETF products in large part on their performance. To measure performance one needs benchmarks. The industry has created style indexes for this purpose.
We are told that “Russell created the industry’s first style indexes to provide investors with accurate benchmarks for measuring the growth and value equity market segments. With over $3.5 trillion in assets and approximately 98% of institutional style-oriented products benchmarked to the Russell style indexes, this ground-breaking innovation has now become the industry standard and has paved the way for the creation of more style- specific benchmarks.
Russell style indexes are built using three highly representative growth and value characteristics. Our style indexes use one value characteristic, book-to-price ratio (B/P) and two growth characteristics, medium-term forecast earnings growth rate based on I/B/E/S two-year forecasts and sales-per-share growth rate based on five-year historical sales.” (Emphasis added)
Relative returns Growth vs Value
And here is how the two main ‘value stock’ and ‘growth stock’ indexes have performed relative to each other over the last 25 years:
This is telling me that ‘growth stocks’ have seriously outperformed ‘value stocks’ since 2007. Before then, from the bursting of the Dot Com bubble in 2000 to 2006, ‘value stocks’ outperformed.
Vanguard reports on Growth vs Value
In the fall of 2020 Vanguard looked back and reported: “It’s been a banner period for growth equity funds, such as Vanguard U.S. Growth Fund, which posted the highest absolute return among Vanguard’s active equity funds over one-, three-, five- and ten-year periods through July 2020. The growth tailwind, combined with superior stock selection, led to the stellar results.
Meanwhile, value funds, or those straddling growth and value, also rebounded strongly from the market lows in March, but returns were modest when compared with their growth counterparts. Many investors believed that the next downturn would lead to the reversal of growth’s bull run, but instead, the unique environment gave extra momentum to the upswing.” (Emphasis added)
The great hope of investors in the value funds has to be that the tables will turn just as in the period 2000 to 2006. The problem is that the benchmark is rooted in obsolescence.
The straw man
Many value index funds track this Russell value index. Other value funds are benchmarked to the Russell value style index. Remember, Russell says it uses one ‘value characteristic’, book-to-price ratio (B/P). There are two problems with using such a ‘value characteristic’:
First, as a measure of value, book-to-price is obsolete. Second, investing in stocks with low book-to-price ratios will result in a portfolio of stocks completely out of step with today’s economy. There may have been a time when book value meant something. For at least the last 25 years it has been an obsolete measure of a company’s assets. This is because most investment today is in intangibles of lasting value that isn’t recorded on balance sheets. Back tests showing some usefulness in the measure years ago are of little use today. Today, investing in stocks with low book to price ratios will result in a portfolio of stocks with very little investment in intangibles, the very kind of investment that companies need today to compete. See my posts here and here.
The false dichotomy
Does this distinction between ‘value stocks’ and ‘growth stocks’ make any sense?
Warren Buffett is reported by The Economist magazine in its February 2, 2013 edition to have said: “Market commentators and investment managers who glibly refer to growth and value styles as contrasting approaches to investment are displaying their ignorance, not their sophistication.” (Emphasis added)
In discussing the two customary approaches to investing ‘value’ and ‘growth’ Buffett confesses to earlier fuzzy thinking and says:
“In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive. In addition, we think the very term ‘value investing’ is redundant. What is ‘investing’ if it is not the act of seeking value at least sufficient to justify the amount paid?” (Buffett, The Essays of Warren Buffett: Lessons for Corporate America, Cunningham 1998) p85.
Buffett wrote years ago:
“Whether appropriate or not, the term ‘value investing’ is widely used. Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics – a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield – are in no way inconsistent with a ‘value’ purchase.” (Buffett 1998) p.85 (Emphasis added)
I wrote about the essence of value investing recently in a post here.
Is there such a thing as a ‘value stock’?
What Buffett is telling us is that there is no such thing as a ‘value stock’. A stock is piece of a company. It may be a good company and it may be a bad company. If it isn’t growing it may not be worth much. It may be a cash cow with no future. Just because it is cheap (by any measure you care to choose), doesn’t make it a good company and doesn’t make it a good investment. And price-to-book and price/earnings are both obsolete.
My conclusion is that from an investing point of view there there is a false dichotomy between ‘value stocks’ and ‘growth stocks’. That is, a true investor makes no distinction. A stock with rapidly growing sales and earnings can be a value purchase if bought at a very attractive price. A stock with steady, if unspectacular, growth can be overpriced and not a value proposition if not available at an attractive price.
Are ‘growth stocks’ a valid class?
There is also a problem with calling some companies ‘growth stocks’ and thinking they are good to invest in. As Warren Buffett tells us:
“Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor.” (Buffett, 1998) p86. (Emphasis added)
As a result, growth by itself as an indicator can be misleading.
This post has explored what it means to invest in a value ETf or a growth ETF and what is meant by a ‘value stock’ and a ‘growth stocks’. My own conclusion is that I would rather invest directly in a well-constructed portfolio of common stocks than invest in many products created by the investment industry.
I do see the benefits of broad index tracking ETFs such as Vanguard’s VOO, an S&P 500 index tracking fund, which will provide a satisfactory return. These may be good solutions for my children who are not particularly interested in individual stocks. I am also trying to keep an open mind about multi factor ETFs. But that is another story for another day.
An issue with ETFs is a false sense of real diversification. See my post here.
A further issue with ETFs is that investors are engaging in price accepting behavior. See my post here.
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