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Large Value Index Bets Big on Economic Growth and Financials

William Hester, CFA
July 2005
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The next couple of weeks may turn out to be important ones for investors in the style indexes. That's because the peak of earnings season will bring new information and guidance for corporate profit growth. Even though analysts have been lowering their expectations for the most recently completed quarter, they've been increasing growth estimates for this year's second half. If company executives confirm this optimism, it's likely that value stocks could benefit more than growth companies.

The hopes for stronger earnings growth were reflected in stock prices in May and June. During that time the S&P 500/Barra Value Index (SVX) climbed nearly 5 percent, while its growth counterpart gained just 1.9 percent. This was one of the largest spreads between the performance of these two groups in more than a year.

Value stocks beating growth companies is not exactly stop-the-presses kind of news lately. Over the past five years the SVX has risen 3.4 percent a year, while the S&P 500 Barra Growth Index (SGX) has dropped 7.9 percent a year. Part of that reflects the post-bubble collapse of tech stocks, and part reflects an interest rate environment and economic recovery that has favored companies that trade at low price-to-book ratios (which defines "value" stocks for many indices). Value's battering of growth has been particularly strong since March, 2003.

But a bet that indexes that track large value stocks will continue to outperform probably relies on at least two assumptions. One is that a stronger economy will reaccelerate corporate profit growth. Second is that the financial sector will continue to be one of the best performing groups. Not since 2000 have investors in the style indexes placed such a big bet on the future performance of just one sector.

Profit Growth and Growth Stocks

Slowing economic and profit growth normally benefits growth stocks. That's because when profit growth slows, investors flock to the companies that will still be able to provide a stable expansion in earnings. As Rich Bernstein argues in his book Style Investing, "If only a few companies are growing, then investors will want to hold that small universe of stocks and will accordingly bid up the stocks' prices." On the other hand, when profit growth is more plentiful, investors become more price conscious and bid up the prices of value stocks.

These preferences can be seen in the data. The chart below shows the performance of the S&P 500/Barra Value and Growth indexes relative to the performance of the S&P 500 since 1975. When earnings have grown at rates above 8 percent, value stocks have outperformed growth companies. When earnings have dropped or have increased at a slow rate, growth companies have won handily.

The same pattern holds when you look at measures of economic activity. In periods where the U.S. Treasury yield curve has been steep - usually a sign that investors expect the pace of economic growth to quicken - value stocks have outperformed the composite index by more than 2 percentage points. During periods of a flatter curve, it's growth stocks that have had the advantage. Similarly, when the ISM index has been above 55 the value index has edged out growth. And when the ISM has fallen below 45 (only about 12 percent of the time over the last 30 years), the growth index has beaten the S&P 500 by more than 4 percent.

The Inside of an Index

Growth and value are terms that are sometimes tough to pin down. To the index keepers at S&P and Barra, value stocks are those with the lowest price to book ratios. Stocks are ranked by this measure and put into the value index until the companies account for half of the value of the S&P 500. The remainder of the companies end up in the growth index. The growth index has fast growing companies like Ebay and Yahoo. But it also has scores of other companies that are growing more slowly, but also more dependably. Health-care companies and consumer stocks make up more than 30 percent of the index. Investors often award these companies high price-to-book multiples partly because of the stability in their earnings.

The companies in the value index have low price-to-book ratios for a number of different reasons. One is slower growth expectations. Another is that these companies tend to be more sensitive to the economic cycle. The companies currently in the SVX have almost twice the variability in their earnings when compared to past profits as do the companies in the growth index, according to Bloomberg data.

The composition of the indexes changes each time they're rebalanced. Over time, this shifts the weights of the sectors that make up each style index. The chart below shows the make-up of the S&P 500/Barra Growth index over the past 15 years.

It's easy to see why the growth index has trailed over the past five years. In 2000, technology stocks made up more than half of the index. Even after the rebound in the benchmark indexes since 2003, the S&P Technology group is still off more than 60 percent from its 2000 highs. It now makes up a quarter of the index. Health-care stocks, the second largest component of the growth index in 2000, are still 10 percent off their highs.

Continuing with our perfect 20-20 hindsight, in June of 2000 the growth index had a fraction of a percent in energy stocks, which as a group has risen 55 percent during the period. Basic material companies, the second best performing group over the past five years, made up less than 1 percent of the growth index. Having such a large allocation to the worst performing sectors and very little exposure to the best performing groups made it nearly impossible for the index to outperform.

The value index has also seen changes in its make up. Energy stocks accounted for 12.3 percent of the value index in 2000. They now make up only 8.3 percent. Basic material stocks went from 7.1 percent of the index to 4.5 percent.

Of course that's one strength of the discipline used to creating the value index. Once a sector gets noticed and becomes more highly valued, cheaper sectors are brought in to replace them. This is why the best performing sectors have become a smaller part of the SVX.

The exception to this rule seems to be SVX's exposure to financial stocks. Even though financial stocks have been the third-best performing group during the period (and the best performing group over periods of ten and fifteen years), the group's share of the value index has grown from 27 percent to 37 percent. Financial stocks now hold the largest share of any of the style indexes since 2000, when technology stocks made up more than half of the growth index.

The financial industry has grown to become an integral part of the US economy over the past decade. As its importance has increased, so has its profits, boosted by mortgage refinancings, a steep yield curve, investment banking revenues, and generally strong financial markets. The group accounted for about 28 percent of the S&P 500's first quarter net income. That helps explain the sectors stellar performance and why it has grown to become a large slice of many of the benchmark indexes. For investors in the S&P 500/Barra Value index, the implicit bet is that the impressive run for financial stocks will continue. There's a lot of weight riding on that bet.


The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.

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