Why Growth Stocks Aren't Growing, and Other Problems with the Growth Indexes and ETFs (IVE, IVW)

When it comes to investing, it may be said that there are two types of people in the world: growth investors and value investors, writes XTF Advisors. Of course this is an oversimplification, but in general growth investors look for stocks with above-average earnings growth, and are usually willing to pay a premium, while value investors search for stocks with more dependable, albeit typically slower earnings growth, and are usually more sensitive to valuation.

The mutual fund industry has for decades offered funds designed to appeal to each type of investor. Naturally, exchange traded funds followed suit, with issuers bringing several products to market in this area. Two of the biggest are the iShares S&P500/Barra Growth (AMEX: IVW) and iShares S&P500/Barra Value (AMEX: IVE) funds. Both were listed five years ago in mid-2000.

As you might have guessed from the title, however, there’s just one little problem: Growth hasn’t grown any faster than Value. In fact, between 2000 and 2004, earnings for the basket of stocks in the Growth fund (IVW) grew at a compound annual rate of just 6.4%, compared with a growth rate of 8.0% per year for the basket of stocks comprising the Value fund (IVE). Even going forward, using consensus estimates for long-term growth—which are notorious for being overly-optimistic, but we’ll go with them for now—the difference in earnings growth between the two funds is surprisingly small, at 12.1% for Growth and 10.6% for Value. Add in the higher dividend yield for the Value fund, and the difference between the anticipated total returns narrows to less than 1.0%. So we have a situation where the earnings growth of Growth might be better than that for Value over the next five years, but probably by no more than the rate at which it lagged over the previous five.

What gives? The answer has to do with index construction. These particular ETFs are constructed by ranking all 500 constituents of the S&P 500 in terms of price-to-book value (P/BV). The market capitalization of the entire index is divided in half, with high P/BV stocks assigned to Growth, and low P/BV stocks assigned to Value. Well as it turns out, price-to-book value is closely correlated with return on equity (ROE) but has almost no relation to earnings growth!

A bit of financial theory may be in order to illustrate the unintended consequences of using P/BV—and by association ROE—to separate growth stocks from value stocks. Examining ROE is important because unlike net income or EPS, it tells investors not just how much profit but how well companies generate a return with the capital entrusted to them by shareholders, one of the most important questions a shareholder can ask. But looking at the big picture, some slow-growth sectors such as Consumer Staples are able to maintain exceptionally high returns on equity—and hence high P/BV multiples—because their established franchises are “cash cows

Comments

[Roger Nusbaum:]

There are studies that show the slope of the yield curve plays a role in the growth value issue. A steeper curve allows mature "value" companies to access capital markets through debt offerings, steeper curve= favorable conditions for successful bond issues. A flatter curve allows less mature "growth" companies to access capital throught secondary stock offerings. Stock offerings would be too dilutive to a more mature company and a flatter curve makes secondaries more appealing when debt is less so.

While this all sounds good to me it is odd that this notion hasn't helped growth very much lately, but I think its worth knowing.

2005 Sep 13 01:12 PM