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By Alex Bryan

Growth companies are notorious for delivering subpar stock returns over the long run because lofty expectations for future growth are often incorporated into their stock prices. This creates a treadmill effect, where companies must live up to expectations in order to provide an average rate of return. Yet, in forming these expectations, investors tend to extrapolate past growth too far into the future and discount the impact of competition. In order to avoid the expectations treadmill, it is necessary to go beyond consensus growth expectations and high valuation ratios to identify stocks with the potential to enhance value through growth. This has made it challenging to offer attractive passive exposure to growth stocks. Passive value funds hold more than 4 times the assets of their passive growth counterparts. In fact, the iShares MSCI EAFE Growth Index (EFG) is the only foreign-growth index fund available. The opposite is true in the active universe, where growth funds soak up more than 50% more assets than value funds.

Growth indexing has come a long way during the past two decades. Prior to the mid-1990s, many value and growth indexes carved up the market solely by valuation, which was used as a proxy for growth. However, high valuations do not always correspond to high growth. For example, a company with low risk should trade at a premium to a comparable company with higher business risk, even when their expected growth is the same. This approach also under-represents companies in asset-intensive industries, which trade at lower multiples of book value than companies with similar growth prospects and fewer assets on the balance sheet. While valuations still play a critical role in nearly all value and growth indexes, most now also incorporate explicit growth forecasts and history as additional selection criteria.

Yet, undisciplined growth can destroy value. For instance, during the past decade, many gold miners kept dividend payout ratios low, reinvested in marginal projects, and issued new equity to finance acquisitions. The resulting dilution created a significant drag on returns. From 2005 through 2012, the FTSE Gold Mines Index total market cap grew at 16% annualized, while the index only returned 7.7%. Most growth indexes penalize companies for dilution by measuring earnings and sales growth on a per share basis. But accounting earnings do not include a charge for the opportunity cost of shareholder capital. Consequently, firms that use their assets inefficiently can destroy value, even while increasing their earnings per share. In order to create value, a company's return on invested capital must exceed its weighted average cost of capital. While most growth indexes overlook this issue, CRSP penalizes companies for undisciplined growth by incorporating return on assets into its selection criteria. The CRSP US Large Cap Growth Index will soon be accessible through Vanguard Growth ETF (VUG), which is switching from the MSCI US Prime Market Growth Index.

Most index providers carve up the full market into value and growth halves. While this approach dilutes style purity, it allows growth indexes to mitigate some of the problems associated with investing in high-growth stocks. This broad reach allows quality companies with strong competitive advantages to anchor these portfolios. These stocks tend to hold up slightly better during market downturns than their value counterparts.

Stocks that fall in the middle of the value-growth spectrum might possess both strong value and growth characteristics or neither. MSCI, Russell, and S&P allocate stocks that do not exhibit a dominant style to both the value and growth indexes, assigning relative weights based on the strength of their value and growth characteristics. However, this approach can create high turnover and significant overlap between the value and growth indexes.

CRSP takes a different tack. It fully allocates each stock to either the value or growth index and applies buffer zones that require a stock to exhibit dominant characteristics of the opposing style in order to move over. While this approach may reduce the index’s style purity, it mitigates turnover and minimizes the overlap between the value and growth indexes.

S&P offers pure value and growth indexes that only include stocks with dominant style characteristics, which are available through Guggenheim S&P 500 Pure Growth (RPG) and Guggenheim S&P 500 Pure Value (RPV). This screens out low-growth stocks that may be overvalued, though it also screens out stocks that score well on both these metrics. Doubling down on its style bets, S&P weights these holdings by the strength of their style characteristics, which gives these indexes a mid-cap tilt. Since their inception in 1995, these indexes have outperformed their broad value and growth counterparts by 2.8% and 2.9%, respectively. Yet, these returns came with higher volatility, as distressed and speculative growth companies tend to carry bigger weights in the pure value and growth portfolios.

A Better Way Forward
A portfolio containing stocks that score well on both value and growth dimensions might offer a more attractive risk-reward profile. This "growth at a reasonable price" approach is how many active managers think about value. Dividing the growth style box by valuation and forming a portfolio of the stocks in the more attractive valuation bucket could help screen out the speculative growth stocks most likely to underperform.

Adding profitability metrics to traditional growth selection criteria also may offer cleaner exposure to companies with the capacity to create value through growth. According to research by Eugene Fama and Kenneth French, stocks with a high ratio of adjusted profits/book value (similar to return on equity) tend to generate higher returns than stocks with low earnings/book value. While they argue that this factor is distinct from value, it may be related. Profitability (or lack thereof) tends to persist, even if growth does not. Yet, it appears that the market does not correctly value this long-term earnings power. High-growth stocks with weak earnings power may be more likely to earn disappointing returns on capital in the future. The Fama-French profitability factor could screen many of these companies out. DFA recently announced it may add this profitability factor to its fund lineup.

Broadening the definition of growth to include momentum may further improve performance. Momentum is based on this premise: Securities that have recently gone up in value will continue to go up in the short run, and those that have lost value will continue to underperform. Stocks with positive momentum historically have generated positive excess returns in nearly every market studied over long time horizons. This effect may exist because investors tend to anchor their beliefs and underreact to new information in the short run, such as quarterly earnings surprises. Therefore, momentum may contain information about future growth that is not fully captured in consensus growth projections and valuation ratios. A few years ago, S&P started to include price momentum as a growth factor in its style indexes. However, the other major index providers have yet to follow suit. Investors can capitalize on this approach through iShares S&P 500 Growth Index (IVW).

Recommendations
Vanguard Growth ETF and iShares S&P 500 Growth Index are currently two of the better growth-focused index funds on offer. VUG charges a razor-thin 0.10% expense ratio and will soon track an index that screens for companies with disciplined growth, which could help reduce its exposure to low-quality growth companies. IVW introduces a moderate quality tilt in a different way. The S&P 500 Index, IVW’s selection universe, imposes a basic profitability screen that helps weed out more speculative names. Additionally, because IVW incorporates momentum into its selection criteria, it may have greater exposure to companies that are more likely to beat consensus expectations.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

Source: Fixing Growth Index Investing To Improve Long-Term Performance