You have to tip your hat to the consulting Firm born of ERISA, Frank Russell and Associates. They managed to find a business annuity from licensing fees.
There are 11 S&P industry sectors19. Where did they come from? Standard and Poor’s convenes what I have heard called a conclave on a regular basis to decide exactly what companies can be in the flagship index, likewise the Mid cap index and the small cap index. A committee makes that decision. Then, companies can be classified by SIC codes into industries. I remember reading in the first definitive book on Amazon that Jeff Bezos put an enormous amount of effort into having Amazon classified as an IT company instead of a Consumer Discretionary—books, y’know—in order to juice up the multiple. You can assume that this is what actually led to emphasizing AWS as a business, it was and remains a big tech firm allowing analysts to categorize Amazon differently.
Fundamental analysis and earnings multiples
Company executive teams—especially Chief Executives—are judged on the performance of their stock’s price. One way to have good performance is to convince Wall Street that you are in a faster growing sector than they thought you were in. This will lead to an earnings multiple increase which, by definition, leads to a higher stock price.
Basic Fundamental Analysis leads to Licensing Fees
So, if the Standard and Poor’s folks handpick the companies and then divide them into industry groups, why not come up with a simpler approach and then, drafting off of Markowitz, make the argument that if you overweight or underweight these groups you will get better market opportunities than just buying the S&P 500 index? Seems like a way to try to improve portfolio performance while conveniently generating advisory fees, doesn’t it?
Hence the Russell growth and value indices were born. Furthermore, the stocks change a bit every year when, on July 1st, the deck is reshuffled and because of comparative metrics, 23 companies go from value to growth and growth to value. Wall Street Strategists tell their advisors which of these sectors to emphasize growth or value to enhance returns.
Wall street analysts make an annual game of predicting which companies will switch from value to growth and growth to value because theoretically this should cause stock prices to move (Note that this is also done with additions and deletions from the S&P and Dow indexes for the exact same reasons.
Now when you hear your research department suggest overweighting large cap value over growth, or small cap growth over value, you know from where these things came. Russell is a genius! Would it be that tough to say, overweight financials and industrials, or IT and communications services? Probably not, but that isn’t part of the conversation anymore, its growth over value or value over growth. This, the ultimate simplicity.
Is there merit to this strategy? Perhaps. This strategy over overweighting growth or value; large or small, and other combinations of groups of stock by their industry or company size has been back-tested to demonstrate that there is merit to these subtle weighting exercises. However, our experience has not shown that real people have ever made real money from this type of strategy.
Back to owning real stocks. If you take a look at the S&P sectors, you realize that by and large there are four sectors of the economy that are generally considered value: financials, energy, consumer staples, materials, utilities and industrials, all cyclical industries. Likewise, IT, telecommunications services, healthcare, and consumer discretionary are considered growth. While there are annual differences based on companies rebuilding their portfolios, these differences happen over time and not magically on the last day of June.
Please join me in concluding there is no real merit in the idea you achieve a greater return in dynamically overweighting and underweighting growth and value. This does not help you build wealth. Buy and manage the stocks. Cynics will say their hairsplitting change exercises are primarily there to create commissions in what are generally considered revenue-starved summers on wall street.
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