Investing for Growth and Value

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Last week, two good friends with whom I discuss investing more or less every week wanted to know: “What is the difference between growth stocks and value stocks?”

With American parochialism, I turned to the products of three grand investment firms that have managed growth and value mutual funds and ETFs for decades:

BlackRock, www.blackrock.com, manager of iShares ETFs.
State Street Global Advisors, us.spdrs.com, manager of SPDR ETFs (pronounced like “spider”).
Vanguard, www.vanguard.com, manager of Vanguard ETFs.

Here are the ticker symbols of 18 ETFs I considered:

Large Cap
Mid Cap
Small Cap

Searching the websites of the three firms, one immediately encounters disappointing non-definitions of Growth and Value, such as, in the case of IVW, “INVESTMENT OBJECTIVE. The iShares S&P 500 Growth ETF seeks to track the investment results of an index composed of large-capitalization U.S. equities that exhibit growth characteristics.”

Growth and Value are “style” characteristics of investment strategies. By perusing the prospectuses of the funds, I find that each of the 18 ETFs defers the question of the definition to the index the ETF tracks. All 6 large cap ETFs use the S&P 500 Growth and Value Indexes (us.spindices.com). These indexes don’t define Growth and Value, but they use a process to determine whether a stock is a Growth stock or a Value stock. The Index Construction section of the Methodology document describes giving each company a Growth score and a Value score.

The Growth score summarizes three measurements:
Three-year change in earnings per share, excluding extraordinary items, divided by price per share.
Three-year sales per share growth rate.
Momentum, 12-month percent price change.
The 500 companies in the S&P 500 are ranked from 1 to 500, the company with the highest score having a rank of 500.

The Value score summarizes three measurements:
Book value to price ratio.
Earnings to price ratio.
Sales to price ratio.
The 500 companies are ranked with the company having the highest Value score having a rank of 500.

The 500 companies are then sorted in ascending order of the ratio of the Growth rank to the Value rank (G/V). The companies in the top third of the list will have the highest G/V values. These are the “pure” Growth companies. Similarly, the companies with the lowest G/V value are the “pure” Value companies near the bottom of the list. And the companies in the middle of the list are hybrids.

The S&P indexes put portions of a hybrid’s market capitalization in both the Growth and Value indexes, which is why you can find some companies among the holdings in both ETFs. This bothers some of us, so the three firms offer “pure” Growth and Value ETFs as well, but I digress from the question of definition, and I want to get back to that.

The iShares mid cap Growth ETF IWP uses the Russell Midcap Growth Index (www.ftse.com/products/downloads/Russell-US-indexes.pdf). Russell combines one ranked Value variable, book to price ratio, and two ranked Growth variables, the I/B/E/S Institutional Broker’s Estimate System (financial.tr.com/ibes) 2-year earnings growth estimate, and 5-year sales per share historical growth, to produce a composite value score (CVS). A stock with high CVS is a Value stock, and a stock with low CVS is a Growth stock. Both the Growth and Value indexes contain proportions of the same stock, weighted according to its CVS.

For VOE and VOT, Vanguard uses the CRSP U.S. Mid Cap Value Index and Growth Index (www.crsp.com/products/investment-products/crsp-us-mid-cap-value-index) which builds a Growth metric from long and short term future earnings growth, 3-year historical earnings growth current investment-to-assets ratio, and return on assets, and a Value metric from ratios of book to price, future earnings to price, historic earnings to price, dividend to price and sales to price.

Each definition of Value seems to include some form of high book value to price ratio. Each definition of Growth seems to include earnings growth (historical or forecast) and historical sales growth. The differing definitions implicit in methodologies continue as one looks at additional ETFs and their indexes.

So there are no standard definitions of Growth and Value stocks. I think that, historically, the terms were invented to appeal to investors’ emotional hopes for their investments. Dr. Dennis Martin points out the term “value stock” was seldom used before World War I, after which people used it most frequently in the 1930s. “Growth stock” emerged in frequent use only after World War II. Marketers, quantitative analysts and lawyers have tortured the definitions ever since.

Take caution, dear reader, of the numerous and diverse hazards of investing.

Disclosure: I own some shares of SLYG.

My thanks to friends who inspired and critiqued early drafts of this article.


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