Global Value Investing
A multifaceted approach to value investing with stock valuation based on intrinsic value estimated from cash returns, appraised value of assets, and other facets of value.
Value and Growth Styles
Styles | Indexes
There is a crucial distinction between an investment approach and an investment style. Whereas a approach is based on timeless stable principles, a style changes with the unstable fashion of the times. Thus, the term "value investing" has a radically different meaning when used to describe an approach than when used to describe a style.
Likewise, there are several meanings to the term "value" when applied to investment strategies. The major denotations are accounting value (book value per share), market value (market capitalization or "size"), and economic value (intrinsic value). Measures of both accounting value and market value are sometimes used as screening criteria to filter out common stocks for further investigation. The intrinsic economic value of an operating enterprise does not lend itself to such quick and easy mechanical screening but rather requires a fuller, deeper analysis based on cash flows to the equity owners.
So-called value investing and so-called growth investing have been described as Siamese twins joined at the hip. Both are based on fundamentals from the waist down, but they differ in their emphasis on the primary source of value from the waist up.
Various sources are quoted below to illustrate both (1) the meaning of accounting measures of "value" and "growth" and (2) the arbitrary nature of mechanical stock screening using accounting measures of value as opposed to the judgment-based nature of stock selection using intrinsic economic value. The examples use convenient indexes, but indexes are not necessary to make the necessary points valid. These excerpts and quotes are considered to be "fair use" as interpreted by The Chicago Manual of Style: The Essential Guide for Writers, Editors, and Publisher, 14th edition, 1993. Chicago: The University of Chicago Press.
First, we consider Vanguard Index Trust, Prospectus dated April 30, 1996, page 19:
Value and Growth Indexes. Standard & Poor's Corporation constructs the S&P/BARRA Value and Growth Indexes semiannually by ranking all common stocks included in the S&P 500 Index by their price-to-book ratios. The resulting list is then divided in half by market capitalization. Those companies representing half of the market capitalization of the S&P 500 Index and having lower price-to-book ratios are included in the S&P/BARRA Value Index; the remaining companies are incorporated in the S&P/BARRA Growth Index. On December 31, 1995, after the semiannual reconstitution of the indexes, the S&P/BARRA Value Index consisted of 315 common stocks in the S&P 500 Index, while the S&P/BARRA Growth Index consisted on the remaining 185. Each index represented half of the market capitalization of the S&P 500 Index. [emphasis added in this paragraph]
Note: It is not possible to allocate exactly fifty percentage of the total market capitalization and exactly a full integer number of companies to each of the two sub-indexes for value and growth. On inquiry, Vanguard staff reports that S&P ranks companies by price-to-book ratio in descending order (highest to lowest), and the companies through the first full company at or over fifty percentage of total market capitalization is allocated to the growth category
Investment managers may use a number of different methods to classify stocks as "value" or "growth". There may also be other ways to define benchmarks for "value" and "growth" investing. If other methods were applied to the companies comprising the S&P/BARRA Value and Growth Indexes, the classification of the stocks as "growth" or "value" might be different.
From "The Plain Talk Library" of The Vanguard Group, we consider a brochure entitled "Index Investing: Understanding Indexing as an Investment Strategy", pages 16-17:
Value Portfolio (inception 11/2/92) attempts to parallel the total return performance of the Standard & Poor's/BARRA Value Index (a subset of the S&P 500 Index), which comprises 339 large-capitalization stocks (as of September 30, 1996) with lower price-to-book ratios and above-average dividend yields.
Note: Stocks are identified for the value portfolio based on the ex ante criteria of price-to-book ratio and market capitalization. Yet the value portfolio is described in terms of the ex post statistics of market capitalization, price-to-book ratio, and dividend yield. If yield is important, then why not include it in the screening?
Growth Portfolio (inception 11/2/92) attempts to match the performance of the Standard & Poor's/BARRA Growth Index (a subset of the S&P 500 Index), which is made up of 161 large-capitalization stocks (as of September 30, 1996) with higher price-to-book ratios and sales and earnings growth, and below-average dividend yields.
Note: Stocks are identified for the growth portfolio based on the ex ante criteria of price-to-book ratio and market capitalization. Yet the growth portfolio is described in terms of the ex post statistics of market capitalization, price-to-book ratio, sales and earnings growth, and dividend yield. If growth and yield are important, then why not include them in the screening?
Small Capitalization Stock Portfolio (9/11/89) seeks to parallel the performance of the unmanaged Russell 2000 Index, a broadly diversified index consisting of about 2,000 stocks of smaller companies.
Next, we consider Frank Russell Company, "Russell U.S. Equity Indexes: Index Construction and Methodology, October 1996", section Russell Style Index Methodology", subsection "Style Index Membership", selectively from pages 1 to 7:
Russell 1000Ò Index measures the performance of the 1,000 largest companies in the Russell 3000 Index, which represents approximately 90% of the total market capitalization of the Russell 3000 Index. As of the latest reconstitution, the average market capitalization was approximately $6.1 billion; the median market capitalization was approximately $2.6 billion. The smallest company in the index had an approximate market capitalization of $1.0 billion.
Russell 1000Ò Growth Index measures the performance of those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values.
Russell 1000Ò Value Index measures the performance of those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values.
The Russell Indexes are reconstituted annually to reflect changes in the marketplace. The list of companies is ranked based on May 31 total market capitalization, with the actual reconstitution effective June 30 of each year. Changes in the constituents are preannounced and subject to change if any major corporate activity occurs or if any new information is received prior to release.
Russell Style Index Methodology
Style Index Membership
Frank Russell Company uses a proprietary "non-linear probability" method to assign stocks to the growth and value style indexes. The term "probability" is used to indicate the degree of certainty that a stock is value or growth based on its relative price-to-book ratio and I/B/E/S forecast long-term growth mean. This method allows stocks to be represented as having both growth and value characteristics, while preserving the additive nature of the indexes, e.g., combining the Russell 1000 Growth Index and Russell 1000 Value Index equals the Russell 1000 Index, and combining the Russell 1000 Growth Index and Russell 2000 Growth Index will produce the Russell 3000 Growth Index.
The process for assigning growth and value weights is applied separately to the Russell 1000 and Russell 2000 indexes. Research indicates that valuations of small stocks on average differ from those of large stocks [emphasis added]. Treating the Russell 1000 and Russell 2000 separately prevents distortion to relative valuations that may occur if the Russell 3000 was used as the base index.
Note: There is no citation for the research used as authority for dividing the investment opportunity set into categories based on market capitalization and no definition for small and large stocks. On inquiry, these research findings are not published but rather the result of proprietary in-house work. For the latest scholarly research on this question, see fads.
For each base index (the Russell 1000 and Russell 2000), stocks are ranked by their adjusted price-to-book ratio (PBR) and their I/B/E/S forecast long-term growth mean (IBESLT). These rankings are converted to standardized units and combined to produce a composite value score (CVS). Stocks are then ranked by their CVS, and a probability algorithm is applied to the CVS distribution to assign growth and value weights to each stock. In general, stocks with lower CVS are considered growth, stocks with higher CVS are considered value, and stocks with a CVS in the middle are considered to have both growth and value characteristics, and are weighted proportionately in the growth and value index. Stocks are always fully represented by the combination of their growth and value weights, e.g., a stock that is given an 20% weight in the value index will have a 80% weight in the growth index.
For each base index (the Russell 1000 and Russell 2000), stocks are ranked by their adjusted price-to-book ratio (PBR) and their I/B/E/S forecast long-term growth mean (IBESLT). These rankings are converted to standardized units and combined to produce a composite value score (CVS). Stocks are then ranked by their CVS, and a probability algorithm is applied to the CVS distribution to assign growth and value weights to each stock. In general, stocks with lower CVS are considered growth, stocks with higher CVS are considered value, and stocks with a CVS in the middle are considered to have both growth and value characteristics, and are weighted proportionately in the growth and value index. Stocks are always fully represented by the combination of their growth and value weights, e.g., a stock that is given an 80% weight in the value index will have a 20% weight in the growth index.
Description of Non-Linear Probability Algorithm
Stock A, in Figure 1 below, is a security with 20% of its available shares assigned to the value index and the remaining 80% assigned to the growth index. The growth and value probabilities will always sum to 100%. Hence, the sum of a stocks market capitalization in the growth and value index will always equal its market capitalization in the Russell 1000 Index or Russell 2000 Index.
Note: The astute reader will recognize that it is possible for any value-screened fund including the value index funds to classify all true value companies as growth and no true value companies as value. The next section presents an example of this possibility.
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