Everybody’s Styling

April 21, 2005


Here's what changed:

Under the old system, stocks are assigned to the growth or value sectors based on just two criteria:

  • Price/book ratio
  • Price/earnings ratio (based on analysts' projected forward earnings estimates)

Critically, the price/book ratio is given three times the weight of the price/earnings ratio. In other words, a stock can sport a very low price/earnings ratio, but if its price/book value is high, it is classified as a "growth stock."

This focus on book value certainly had and continues to have its supporters. The father of value investing, Benjamin Graham, put book value (or a variant thereof) at the heart of his investment analysis; Fama and French used book value as the sole determinant of style in their famous CAP-M analysis.

But despite the historical pedigree, many think that a heavy reliance on book value introduces a significant sector imbalance into style analyses by overweighting capital-intensive industries in the value category. Book value, after all, is dependent on tangible assets - things like factories, cash and inventories. Legitimately valuable intellectual property like brands, patents, goodwill and relationships do not factor into the calculation at all. As a result, companies like Microsoft - solid companies with reliable earnings -can never qualify for "value" status, no matter how low their stock price goes, because so much of their value is tied up in intellectual property.

The new Dow Jones/Wilshire system takes a wildly different approach, weighting each of six component measures equally:

  • Trailing earnings growth
  • Trailing revenue growth
  • Price/book ratio
  • Dividend yield
  • Projected forward price/earnings ratio (based on analyst estimates)
  • Projected future earnings growth (based on analyst projections)

Not surprisingly, this six-part evaluation creates different results than the two-part calculation used previously by Wilshire. Book value features much less prominently, and a much greater emphasis is placed on earnings: Three of the six factors relate directly to earnings (past growth, forward P/E ratio and forward earnings growth). This difference - between a reliance on earnings and a reliance on book value - lies at the heart of the ongoing debate about the best way to define "style."

In the press release announcing the planned launch of the new indexes, Dow Jones and Wilshire said the six-part evaluation "is among the most sophisticated being used by index providers." Incredibly, they added the following: "Six factors are used for style classification -- some index providers use as few as one or two factors…"

Imagine how Wilshire felt about that! All of a sudden, their long-standing style indexing methodology was singled out as inadequate - in their own press release!


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