Some investors prefer growth and others choose value, just as some diners like meat and others favor fish. But unlike mealtime proteins, growth and value can be difficult to define. Yes, investment professionals should immediately know growth and value strategies when they see them. But in some cases the difference between growth and value has been blurred. How do you benchmark your growth versus value approach?

Possibly, you defer to one of the major index providers. All of them segment many of their market measures into growth and value subindexes. But each index provider uses a different set of criteria to separate growth from value. That means it may not be so easy to tell the meat from the fish.

"There isn't any one precise, scientific, everybody-agrees-on-it definition," concedes John Prestbo, editor and executive director of Dow Jones Indexes. "Everybody's feeling the leg of the elephant and trying to describe what the beast is." And attempts to describe the beast date back about a quarter century.

In the mid-1980s, Russell Investments noticed two broad classes of equities. To determine which category a stock fell into, Russell looked at each company's book value. A security with a high book value relative to its market price was deemed a value stock. Everything else was considered a growth stock.

Rolf Agather, managing director of index research and innovation at Russell, says the book-to-price ratio was fairly good at describing value, but "growth managers complained that it wasn't really a good measure of growth."

So the company added another factor to determine growth stocks. Until recently, the variable Russell used to define growth was analysts' consensus estimate of long-term earnings growth. This year, the long-term growth estimate was replaced by two elements: the consensus estimate of medium-term (two-year) growth and historical five-year sales growth.



Other index providers use different variables to separate growth and value. Dow Jones employs six, as does Standard & Poor's, though they don't use all of the same factors. MSCI uses up to eight items in determining style classifications.

"Most people cannot, for the life of them, define growth, but pretty much everyone can define value," says Richard Hoe, a financial planner in Tulsa, Okla., who is in the value camp. "If you can buy something that's worth $1 for 80 cents, then that's good," he says. "The word growth makes me run for cover."

"I think there should be a uniform definition of the two camps," Hoe says, though he adds, "I don't know how you'd get everybody to agree."

Indeed, index providers differ on other essentials, too. "You really need to look under the hood," advises Srikant Dash, managing director at Standard & Poor's Indices. (The companies even disagree on the plural form of the word index. Dow Jones and Russell favor indexes; S&P and MSCI use indices.)

Dash notes that index suppliers have various ways of defining market sectors and capitalization size, observing that the Russell 2000 is a very different universe from the S&P SmallCap 600. He contends that advisors, who may devote a great deal of effort to due diligence before picking active managers, often don't do the same for indexes that they may be using via exchange-traded funds. "You still need to do that onetime research in understanding what an index is and how an index is being defined," Dash adds.

When it comes to defining value, all of the major index providers include the book-to-price ratio or its inverse, price-to-book, as a yardstick. Russell continues to use it as the sole determinant of value.

Other index shops add additional variables, but don't shun book value. "On the value side, you'll see some sort of consistency" among index providers around book value, says Raman Subramanian, executive director for index research at MSCI. "There is no single definition of how you identify growth stocks."

"When you buy a growth index, you're looking for something that is going to predict growth in the future," says Martin J. Gruber, professor emeritus of finance at NYU's Stern School of Business. "It's really very, very difficult."

Historically, value has outperformed growth, except in periods like the late 1990s technology bubble. The sad ending to that episode may be a reason many planners remain skeptical of the growth approach.

Jennifer Cole, a financial planner in Sandia Park, N.M., avoids portfolios that are exclusively growth. "My clients are mostly near-retirees or retirees," she says. Referring to heavy volatility, she says they can't afford "going up by the stairs and down by the elevator." As for finding growth for her clients, Cole notes, "There's enough of it elsewhere," and cites the growth opportunities of broader-based funds.



For investors interested in growth, there's still the question of how to define it. As noted, Russell recently eliminated estimates of long-term earnings growth from its methodology. "Fewer and fewer analysts nowadays are willing to put out that longer-term estimate," Agather explains. Consequently, he says, the robustness of the indicator was diminished.

MSCI still uses a long-term earnings growth estimate, but not in the small-cap area, where there may be few analysts following a stock. "If there's not enough coverage, it's a meaningless factor," Dash argues. For smaller stocks, the consensus earnings estimate "may be a consensus of one."

Both Dow Jones and Russell use industry averages for companies lacking a sufficient number of estimates. MSCI excludes any missing variables from its calculations.

S&P is the only major index provider to use no estimated variables in separating growth from value. Although that eliminates the uncertainty of projection, advocates of estimates contend it's like driving a car looking only through the rearview mirror.

Prestbo recognizes that people can dispute the accuracy of forecasts, but defends the use of forward-looking variables, saying that estimates "are being used to make investment decisions. We use them because that's what the market is looking at." In addition, Dow Jones uses two current and two historical factors.

The fact remains, however, that analyst projections can be far off the mark. Nevertheless, Subramanian dismisses the argument against using earnings growth estimates. "What we are looking for here is a growth trend," he says.

Once they decide which factors to use in determining growth and value, index providers have to separate stocks into the two groups. That isn't always black and white.



Gruber recalls serving on mutual fund boards years ago when the firm's growth fund manager made a presentation arguing for the purchase of IBM stock. It was followed immediately by the value manager's pitch for purchasing the same stock. The story illustrates a common problem in index construction.

"Almost all companies will have both growth and value characteristics," Prestbo says.

That realization has led Russell and MSCI to place some stocks in both growth and value indexes. If, for example, a stock's characteristics indicate that it is 60% growth and 40% value, those percentages of its market capitalization are in the respective style subindexes.

Prestbo counters: "We think that kind of defeats the purpose. Our approach is that a company is growth or value."



Standard & Poor's straddles both camps. The company offers overlapping style indexes that divide the market into growth and value, with percentages of some stocks' capitalization in each. As with the MSCI and Russell benchmarks, the totals add up to the entire market cap of the parent index. But S&P also calculates "pure growth" and "pure value" indexes.

For the pure style measures, roughly one-third of all stocks exhibit characteristics of both styles, and are eliminated. The rest are separated into growth or value indexes and weighted by their relative style attractiveness. The result, Dash argues, is more suited to tactical moves, while the overlapping style indexes are a better choice for strategic allocations.

All of the variations of growth and value can be confusing for both planners and their clients, especially if they are using index-based ETFs or mutual funds. "It's a problem if the index is not doing what you think it's doing," observes Raymond Benton, a planner in Denver. Many of the managers selected by his firm "aren't locked into style boxes. As you take that direction, the specific makeup of the benchmark becomes less and less important." Furthermore, Benton says, style classifications are misleading because they are based on "characteristics of assets, not characteristics of managements."

Even planners who accept defining style by asset characteristics are sometimes unhappy with the way the index industry has dealt with the question. "I like companies that are reasonably priced that have good cash flow," Cole says. She would like benchmarks based on a combination of return on capital and price-to-earnings to separate growth and value, and is frustrated that such measures aren't standard in the index business. "I can't do it that way because the world doesn't work that way," she says.

And there is skepticism in the profession about existing ways of measuring style. When it comes to value stocks, Erika Safran, a financial planner who practices in New York City, says, "Maybe there's a reason that they're cheap." She cites Citigroup, which some value advocates touted as attractive as it declined in price. "The only time it was well priced was when it was $1," she says. Safran doesn't recommend individual stocks to her clients, preferring to invest in funds.

Cole echoes Safran's fears about individual value stocks. "Something doggy and cheap can get even cheaper," she says.

Planners say clients rarely ask about the growth and value strategies or, for that matter, which indexes they should look to for benchmarking. "Our clients are not necessarily concerned that they outperform the market. They're much more concerned that they don't get killed in the downdraft," Benton says.



He attributes most of the profession's concentration on indexes to modern portfolio theory, noting that if you accept that approach, indexes are important because they determine what you choose. On the other hand, if you don't follow modern portfolio theory, indexes are "guidelines and points of reference and not that important," he says.

Which indexes planners decide to use, either for their own reference or for allocating assets for clients, may be influenced by habit and comfort level. "Advisors have trust in certain of these sources that they use," Safran says. "I think sometimes that ends up being a business model, not so much an investment decision."

So, is one index provider's meat another's fish? Or are advisors and investors looking at the wrong part of the menu?

"If you went to six different restaurants and ordered coq au vin, you'd get six slightly different variations of the recipe," Gruber says. He believes it's the same with indexes - if Dow Jones, MSCI, Russell and S&P each made coq au vin, they'd all serve chicken in wine, but with their own take on seasonings and presentation.


Joseph Lisanti, a financial writer in New York, is former editor-in-chief of Standard & Poor's weekly investment advisory newsletter,The Outlook.

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