Legendary investor Charlie Munger once said “The whole concept of dividing [indices] up into ‘value’ and ‘growth’ strikes me as twaddle. It’s convenient for a bunch of pension fund consultants to get fees prattling about and a way for one adviser to distinguish himself from another.”
McDonalds, Yum Brands, Starbucks, Dominos, Home Depot, Dell, Dunkin Brands and Autozone – these are companies that are in the Russell 1000 Growth Index that perhaps should not be. If anything, these are all deep value names, but because of distortions in accounting rules, they look like growth companies from current style conventions. Value, blend and growth categories today are determined by a number of commonly known factors. For example, Russell indices uses earnings growth, sales growth, and book/price to determine style. These variables attempt to describe a firm’s growth and capital structure by using simple to understand metrics that many investors acknowledge.
While earnings and sales growth can provide reasonable proxies for a firm’s growth, book/price offers a poor view of a company’s capital structure. Share repurchases, inflation on PP&E, and the immediate expensing of R&D under GAAP accounting skew the book value of assets and equity reported today.
In theory, growth companies become value companies. In reality, growth companies become value companies, and then become growth companies again.
Newer firms that are rapidly growing through external financing are the stereotypical examples of growth firms. Once firms mature and profits stabilize, they then become value stocks. However, as companies continue to increase their capital with off balance sheet items and re-distribute capital to shareholders, they gradually appear to become growth stocks later in their lifecycle.
The end result of these effects is that investors may not have exposure to what they think they do. Today, value stock indices consist of mid to late-life companies, while growth stock indices contain both newer and deep value firms.
In addition to constituent issues, current value/growth metrics lead to tremendous weight shifts in certain markets. Since style creators attempt to equalize categories by market cap, count dynamics can change drastically. For example, only 72 companies in the S&P 500 are pure growth stocks (using Russell methodology), while 290 are pure value stocks.
Data as of 11/6/20
The current style classification system leaves much to be desired. A better measure would be to examine a company’s use of external financing. Applied Finance has done extensive research on a factor it calls “Financing Yield” and believes it is a superior determinant of value vs growth. By taking a firm’s net use of external financing to raise cash or return capital to shareholders/bondholders, and dividing by enterprise value, we can better categorize the value/growth characteristics of a company. The diagram below shows the theoretical layout of Financing Yield against the Fama/French growth and profitability factors.
Additionally, using Applied Finance’s live database from 1998 through 2020, we can see that companies that consistently return capital to shareholders tend to outperform firms using external financing. Furthermore, risk characteristics such as return/volatility and max drawdown in the high yield bucket are much more favorable than in the low yield bucket.
Applied Finance Database: 2×3 Factor Portfolios formed on Size and Financing Yield.
Point-in-time factor construction with monthly rebalancing from October 1998 to June 2020. Cap-weighted returns.
Investors should be conscious of how ongoing changes within the market and within companies can affect their investment strategies. Applied Finance believes that the current style methodologies were an initial good idea that became twisted over time and can misinform investors today. A modern approach to style and view of external financing appears to be necessary in an age of growing intangible investment and share repurchases.
Recommended Reading:
Valuation Beta: Addressing the Inadequacies of Book to Price with Valuation, Stewardship, and Leverage
Asset pricing model research has been dominated by the book to price (HML) factor following its introduction in the Fama French 3 Factor model in 1992. Over the initial study horizon of 1963 to 1991, book to price delivered performance characteristics that essentially absorbed the cross-sectional return information of numerous other factors, including leverage and earnings to price, on an ex-ante basis. Ongoing refinements to asset pricing models tend to build upon the foundation of this initial three factor research, highlighting the broad acceptance of these specific factors when seeking to explain cross-sectional returns. It has also become commonplace to refer to book to price simultaneously as a valuation factor (cheap vs. expensive, Asness, Frazzini, Israel and Moskowitz, 2015), a style factor (value vs. growth, Zhang, 2015, as well as Russell, S&P, and Morningstar style methodologies), and a leverage factor (high vs. low leverage, Penman, Richardson, and Tuna, 2005). In this paper, we provide compelling evidence that asset pricing models based on direct measures of intrinsic value, stewardship (which loosely aligns with style based on the reliance on external financing for early-stage growth stocks and the return of capital to shareholders for mature value stocks) and leverage offer substantial improvements in minimizing residual alpha compared to models that conflate book to price as a proxy for these competing themes.
Executive Summary
- Book to price is an inadequate proxy for a robust measure of intrinsic value. Portfolios formed on the classification error between intrinsic value and book to price provide a significant unique source of alpha.
- The dividend discount model tautology that motivates Fama French’s transition from the three-factor model to the five-factor model lacks completeness as a comprehensive valuation framework. The preference towards negative growth as an independently sorted factor misrepresents the role of growth in creating shareholder value.
- A factor based on excess intrinsic value over book equity directly focuses on the dynamic relationship of profitability and growth in wealth creation, subsuming single year levels of profitability as an asset pricing factor.
- The dividend discount model framework that motivates independent preferences towards high profitability and low growth supports a financing yield factor that emphasizes flows to shareholders. This factor provides parsimonious benefits, rendering both profitability and growth redundant, while also capturing stewardship attributes by addressing the agency issue in corporate governance.
- Ex-post studies of book to price provide a stark contrast to characteristics delivered on ex-ante basis. On an out of sample basis, the book to price factor is subsumed by a direct measure of leverage.
- A valuation-based asset pricing model that incorporates excess intrinsic value, financing yield and leverage drastically improves the explanatory power of cross-sectional returns compared to other commonly studied asset pricing models.
- Active managers should incorporate intrinsic value in stock selection. Factor-based strategies are incomplete when valuation beta and stewardship beta are ignored. The negative alpha associated with passive investment further diverges from zero with a higher degree of significance against a valuation- based asset pricing model.
