We hear a lot about value versus growth and especially lately with growth outperforming value over the last year, three years, five years and 10 years. Well, growth and value as defined by Standard & Poor's 500, anyway.
When you say the word value most investors think of the classic Ben Graham and Warren Buffett (Trades, Portfolio) definitions. Both emphasized stocks trading cheaply with Buffett also heavily weighting the quality of the business. Most traditional investors would say that value stocks would be companies trading at a cheap multiple to some measure of earnings power or cash flow such as net income, free cash flow, EBITDA or Buffett’s “owner earnings.”
Most would define growth stocks as roughly the opposite –Â stocks that are expensive versus some measure of cash flow or earnings. Well, this isn’t exactly how S&P 500 does it, and it leads to what I believe are some pretty big issues with the index.
S&P 500 has a document, available here, that details how the indices are constructed. I copied the most important graphic below. It shows exactly how the S&P 500 defines growth and value (each factor is equally weighted and companies are then sorted based on their growth and value scores with some overlap between the two indices).
There are issues with two of the definitions S&P 500 uses for value. It uses sales to price and book value to price. While these measures may have been appropriate for the stock market in Ben Graham’s day when a large portion of stocks were in similar asset-heavy industries such as manufacturing, energy or utilities, they are wholly inappropriate for today’s diverse market.
Take for example information technology companies whose primary asset is intellectual property that is hardly ever recorded on the balance sheet at anywhere near its true value. Thus, information technology firms will tend to always trade at low book-value-to-price ratios even when they appear quite cheap based on earnings or cash flow. The same thing applies to the sales to price ratio. Again, we can use the IT sector as an example. Many companies in that sector are software companies with lush profit margins. Because they have such high margins they will always trade at low-sales-to-price ratios versus, say, a Walmart (WMT, Financial) that struggles to squeak out single-digit margins.
What this means is, rather than separating stocks based on what most investors think of when you say value or growth, it tends to separate stocks based on industry.
Below is the sector breakdown for the S&P 500 Growth Index.
Below is the corresponding sector breakdown for the S&P 500 Value Index.
To help you see the sectors differences easier and how the weightings compare to the S&P 500 as a whole, I put together the table below (numbers are rounded up to the nearest one-tenth so things won’t add up perfectly). The table is designed to be read from the inside out so to speak. The center column has the weights of each sector for the S&P 500. Then on either side of that column you have the corresponding weights for that sector in the growth and value indices. Then to the left (for growth) and the right (for value) of that you have the difference between that index and the S&P 500.
| Sector | Difference | Growth | S&P 500 | Value | Difference |
| Info. Tech. | +11.7% | 32.4% | 20.7% | 7.8% | -12.9% |
| Financials | -8.3% | 7.6% | 15.9% | 24.6% | +8.7% |
| Health Care | +2.8% | 17.5% | 14.7% | 12.1% | -2.6% |
| Consumer Disc. | +5.1% | 18% | 12.9% | 7.5% | -5.4% |
| Consumer Staples | -0.4% | 10.4% | 10.6% | 11% | +0.4% |
| Industrials | -1% | 9% | 10% | 10.9% | +0.9% |
| Energy | -5.2% | 1.4% | 6.6% | 12.2% | +5.6% |
| Utilities | -3% | .3% | 3.3% | 6.5% | +3.2% |
| Telecom. Svcs. | -1.7% | 1% | 2.7% | 4.5% | +1.8% |
| Materials | -.2% | 2.4% | 2.6% | 3% | +0.4% |
The S&P 500 Growth Index is basically a fund that overweights technology, health care and consumer discretionary stocks at the expense of financials, energy and utilities. The S&P 500 Value Index is the polar opposite, heavily overweight financials, energy and utilities. The problem is that these sectors have vastly different characteristics other than price that affect their returns.
The table below shows the return on assets for each sector. (I chose return on assets since the information was readily available, but any type of capital efficiency measure such as ROE, ROIC, etc., should be sufficient to show the relative difference between sectors).
| Sector | Return On Assets (ROA) |
| Information Technology | 10.98% |
| Consumer Staples | 9.01% |
| Consumer Discretionary | 8.81% |
| Health Care | 7.23% |
| Industrials | 7.19% |
| Materials | 6.65% |
| Energy | 6.08% |
| Utilities | 2.81% |
| Telecommunications Services | 1.27% |
(Computed using Morningstar analysis of Vanguard Sector ETFs for each sector April 17, 2015)
As we can see sectors that the S&P 500 Growth Index is overweight have stellar ROAs while the S&P 500 Value Index is overweight sectors like Utilities and Energy that have some of the lowest ROAs. As we explained earlier the fact that price to book and price to sales make up two-thirds the value weighting means that asset heavy sectors will almost always be disproportionately represented in the value index. It also means that stocks that might be traditionally regarded as value stocks show up in the growth index. For instance the S&P 500 Growth Index has significant weightings in Apple (AAPL, Financial) (P/E of 10), Verizon (VZ, Financial) (P/E of 11.6), Intel (INTC, Financial) (P/E of 12.3), IBM (IBM, Financial) (P/E of 9.7), and Cisco (CSCO, Financial) (P/E of 13). Instead of being filled with just expensive stocks the Growth Index is made up predominantly of high return on capital companies, some trading cheaply and some not (Facebook [FB], Amazon [AMZN], Netflix [NFLX], Alphabet [GOOG][GOOGL], etc.).
Which is better, value or growth?
An investor who was interested in indexing could easily avoid S&P’s silly value and growth definitions and simply invest in the S&P 500 index. However, I’ve come across defined contribution plans and annuity (or other type of insurance) sub accounts that do not give investors the option of a broad market index and instead have growth and value index funds. What should those investors do? (Sure you could just equally weight both, but where’s the fun in that?)
Well right now we are in the midst of one of the deepest routs in oil and other commodity prices in history, which has weighed heavily on energy firms' earnings. Despite the Federal Reserve hiking rates, we are still firmly in the middle of a period of below-average interest rates, which has pressured financial firms' earnings. It’s likely that interest rates will eventually rise over the coming years (although likely not very quickly) and that commodities prices will recover somewhat. Couple this with the fact that the S&P 500 Value Index trades at 15.3 times earnings (14.1 times forward earnings) compared to 21.7 times earnings (18.2 times forward earnings) for the S&P 500 Growth Index, it would seem like the Value Index is a pretty good bet.
I would agree that, over the next few years, the value index has a pretty good shot at outperforming if interest rates rise and commodity prices recover somewhat. Over the long term the superior economics of the sectors that are overweighted in the growth index mean it should do better in the long run. If you’re someone investing for the next 30, 20 or even 10 years, the Growth Index, which is overweight companies with much more attractive economics, will see the better performance of the two indices.
