Taste Testing Investment Style Sausages

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When you’re ready for a meal of assorted chopped up pieces of meat, blended into a tightly wrapped package, you’ll often choose sausages.  Just as shoppers will look for their favorite brand of sausage, investors select their benchmarks based on brand name, with Russell and S&P in the lead.

Only a few style-conscious consumers read the label, and that’s true in the grocery market and in the world of portfolio management.

But would we make the same choices if we knew which factors are combined to make these investment-world sausages? After all, the indexes we use affect our decisions every day. First and foremost, asset allocations are based on the style make-up of the market.  For example, we might misallocate if some stocks are being called growth that could be better viewed as value. Moreover, performance evaluation relies heavily on comparisons to style indexes.

In the current financial crisis, the choice of factor largely dictates whether financial stocks are classified as value or growth. A Price/Book (P/B) factor assigns most financials to value, whereas the alternative three-factor model assigns financials to growth. Because financials are 16% of the market, this style assignment disagreement causes significant differences in performance between indexes that employ these disparate factors.  Prior to the current crisis, both classification approaches agreed that most financials were value stocks.

Dissecting the popular index sausages

Russell and S&P use P/B to divide the universe of stocks into value and growth. High P/B is growth and low P/B is value. The idea is that a stock priced near its cost basis is inexpensive - a good value. But as Laurence Siegel states in a CFA Research Foundation monograph, “Book value is mostly a historical accident. It is the accounting profession’s estimate of the company’s value; it reflects what the company paid for assets…includes the goodwill of companies acquired.” Not all indexes, however, are constructed using P/B. Some use price/earnings ratios (P/E) combined with other factors like dividend yield.

P/E is a growth measure. Investors will pay more for current earnings if they expect those earnings to grow. Dividend yield is a value measure, since dividends are generally paid by companies with established product lines who would rather pay out earnings to shareholders than invest in new projects.    The idea of using both a value and a growth measure is that one confirms the other. A high P/E and a low yield signify growth, just as a low P/E and high yield indicate value. Stocks with offsetting value-growth characteristics generally fall in a middle section we call “Core.”

Some researchers use P/E, yield and forecast earnings growth to predict the equity risk premium. Stock prices are forecast to grow according to the following formula:

Growth = Dividend yield + earnings growth + Price/Earnings expansion or contraction