Which Small Value Methodology is Best?

Different indexes use different methods to divide the market; so the natural question is, which way is best?

The "small" part of the question is the easy part: almost all major indexes use market capitalization to set cutoff levels and determine weightings within the index. However, some newer offerings (including the S&P "pure" value indexes introduced in 2005) are experimenting with different weighting methods. You should have a healthy skepticism about the timing: a weighting that's more favorable to small caps, introduced during a market that's been kind to small caps... Expect the backtested recent performance numbers to be spectacular (and irrelevant).

"Value" is more interesting. Indexes use different ratios (like price-to-book or price-to-earnings) and categorize the cheap stocks as "value" stocks. So now the question is, which of these ratios make sense?


Some Logic

Using P/E, Price-to-Cash Flow, or Price-to-Dividend (the last is the reciprocal of the dividend yield) to measure value has a special logical appeal, since the denominators of these ratios reflect a company's ability to produce profits, which is where stock returns ultimately must come from. One problem is that earnings is a volatile number and would result in a lot of turnover in the index; so some kind of witchcraft (like using "projected" earnings, or adding other ratios) may be desirable for smoothing.

Price-to-Sales (P/S) has been popularized by books like What Works on Wall Street, but it's a poor measure when comparing companies in different industries, for example.

Price-to-Book has its own special problem. Take a look at this snapshot of two indexes at the end of 2005:

Style Index Representative
P/E * P/B *
Large Value Russell 1000 Value IWD 14.15 2.58
Small Value Russell 2000 Value IWN 16.45 2.18

   * P/E and P/B ratios from iShares as of 12/16/2005. See the styles page for a description of these indexes.

Based on the P/E ratios you would say that Small Value had gotten pricey. (Common wisdom would have agreed: small caps had been enjoying quite a run.) But the P/B ratios imply the exact opposite, that it's the Large Value stocks that were more expensive. What we are probably seeing here is an artifact that causes the book value of large companies to be relatively understated (and the P/B to be high) compared with small companies. (A different way to say this is that when you screen for low P/B you unintentionally introduce a bias toward small companies.) The way this artifact works: companies' assets are valued at their acquisition cost, not their current (inflated) cost. So the older a company is, the more understated its book value is likely to be. And there is a correlation between old companies and big companies.

(See the "free lunch" comment near the bottom of the previous page.)


Some Value Families

Here is a list of some popular value indexes and the methodologies they use.


Value Family Methodology Availability
S&P / Barra Low P/B (extinct)
Russell Low P/B (50%), projected earnings growth rate (50%) iShares IWN
MSCI Low P/E1* (33%), P/Dividend (33%), P/B (33%) Vanguard VISVX
Morningstar ** Low P/E1* (50%), P/Cash Flow (12.5%), P/Dividend (12.5%),
P/B (12.5%), P/S (12.5%)
iShares JKL
S&P /
Low P/Cash Flow (25%), P/Dividend (25%),
P/B (25%), P/S (25%)
2 Flavors (regular and "pure" **)




*   E1 is projected earnings for next year
**   These are "deep" value: see the next page


Morningstar Snapshot
These families are listed in chronological order, and you can spot some obvious trends: toward more complexity (more factors), more human intervention ("projected" numbers), and more profit-related measures (earnings, cash flow, dividends).

If you try the Morningstar Snapshot for some of these, you'll see (among other things) that their sector weightings can vary radically.


Some Professors

Fama and French recommend using low Price-to-Book only, and define "value" in their three factor model that way.


...and Some Buffett

When you say things like Investment Methodology you invite Warren Buffett to run in and throw a pie in your face. Here's a friendly quote:

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... 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.

(Splat.) On the other hand, Buffett has advocated low-fee index funds for average investors. So if you keep costs in mind, keep examining the logic of your choices, and choose a non-extreme weighting in your portfolio (like mostly TSM plus some Small Value), then even The World's Greatest Investor wouldn't have a problem with that... right..?


Article Contents
Small Value Intro
Why Small Value?
Which Small Value?
Checking Significance
Checking Valuations
Books & Links

Article Contents
Index Funds Article


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