By: Phil Kernen
The use of investment indexes has grown significantly over the last few decades, with individual investors and portfolio managers using them as tools to measure investment returns. Most of the biggest index owners have created indexes designed to carve up the market between the best-known styles – growth and value stocks, terms frequently referred to explain market behavior. But the rules for dividing markets into these two styles often produce illogical results.
Broad market indexes have been around for a while, but the idea of style indexes is relatively recent. Consider one organization offering a wide array of broad market indexes and subsets based on company size. It recognized that some investment managers focused on identifying companies they believed would multiply and generate above-average returns. Other managers focused on finding undervalued companies relative to their long-term fundamental prospects. In response, it broke their various subsets into style indexes – value and growth.
The original methodology was straightforward, assigning companies entirely to growth or value indexes based on a single ratio, book-to-price, reflecting famed investor Benjamin Graham’s traditional metric used to discover undervalued companies. It classified companies above a midpoint as growth stocks and those below as value stocks. Subsequent research found that investment managers didn’t view every company as exclusively growth or value, holding many stocks in both styles in a single portfolio.
From 1995 on, the organization assigned each company a growth or value weight based on several subjective metrics to determine expected growth values and ranked them. Companies around the midpoint reflect proportionally weighted placements in both indexes. It may seem strange to discover companies that are part of both growth and value indexes, but this is why. Overall, 70% of names reside in either growth or value, and 30% reside in both.
Every fourth Friday in June, the style indexes are reconstituted to reflect changes that occurred over the prior year. The shifting weights can often make this one of the highest-volume trading dates as investors tracking the indexes race to conform. Following the 2022 rebalance, well-known names whose presence in the growth index will dwindle as their presence in the value index becomes more pronounced include Netflix, Paypal Holdings, and Meta Platforms, which now holds the 6th largest weight in the value index. Gamestop will make the same trip and exit the growth index entirely. Procter & Gamble is the only company that resides in the top 25 of each style index – 21st heaviest weighted in growth and 10th in value.
A different index provider started with a similarly simple approach, splitting the market into growth and value based on price-to-book ratios. In response to competitors, it too adopted more complicated methodologies constructed using a variety of subjective growth and value factors. Allocations between value and growth differ slightly: 33% of stocks will rank exclusively in either the growth or value baskets, while 34% will rank in both.
Every third Friday in December, the style indexes are reconstituted to reflect changes that occurred over the prior year. The recent 2022 rebalance cut the weights of many fast-growing technology names in half, including Microsoft and Amazon.com, and completely removed companies like Meta Platforms and Netflix. And sector shifts are material. The information technology sector weight declined from 42% to 33%, while the healthcare sector weight increased from 13% to 20%, and the energy sector increased from 2% to 8%.
Such changes reflect the momentum-driven methodologies applied and the unorthodox outcomes that can result based on market behavior. Meta and Netflix do not fit the traditional mold of undervalued companies with steady cash flows and dividend streams. They continue to invest heavily into initiatives supporting their next phase of growth that could redefine their futures. Energy producers are not suddenly growth companies simply due to their overwhelming stock performance in 2022. Responding to investor demand and political pressure against carbon energy, most have behaved like the value companies they are, reducing investment budgets and applying their substantial free cash flow towards returning capital to shareholders through share buybacks and dividends.
Whether you use style indexes like growth and value as tools to measure investment returns or guidelines for investment, the subjectivity embedded in the rules to split the market means that no two are exactly alike. Keep that in mind the next time someone tells you indexes are all the same.