Various product providers offer ETFs that track broad-based “value” indices, as opposed to “growth” or “blend” indices – however, the methodology used to select value companies varies substantially across index providers. Common fundamental ratios used in financial studies to differentiate value companies from their growth company counterparts include book to price (B/P), earnings to price (E/P), cash flow to price (CF/P), sales to price (S/P), and dividend yield (D/P).
Over time, index providers have added several other fundamental factors to distinguish between the two investment styles, including analyst projections of price to earnings ratios and projected earnings growth rates. The issue with these factors is that they assume analyst projections are correct – this would indicate passive ETF investors are comfortable with index methodologies that incorporate active forecasts when constructing value ETFs (which doesn’t appear to be a reasonable assumption) – or they are unaware of them (a more likely scenario).
In a 2008 paper written by Davis and Lee titled, “Defining Value and Growth – Implications for Returns and Turnover”, the book to market (B/M), earnings to price (E/P), and cash flow to price (CF/P) ratios were found to be strongly related to average returns over the July 1964 to June 2008 sample period. Dividend yield (D/P) produced much less reliable results. They also found that portfolio turnover is reduced when sorting companies by book to market (B/M) and dividend yield (D/P), which would be an important consideration when holding a value ETF in a non-registered account.
To make matters more confusing, Warren Buffett, in his 2000 Chairman’s Letter to Shareholders, made the following argument against placing companies into either value or growth categories:
“Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business. Indeed, growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years. Market commentators and investment managers who glibly refer to “growth” and “value” styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component - usually a plus, sometimes a minus - in the value equation.”
As can be seen in the table below, all of the listed index providers seem to agree on just one fundamental value ratio – the price to book (P/B) ratio, or the book to price (B/P) ratio [also referred to as the book to market (B/M) ratio]. Standard & Poor’s is the only index provider that uses a methodology that is void of analyst projections, and in my opinion, superior to the other methodologies which incorporate these forecasts into their value index construction.