ITA Wealth Management

Why do we continue to advocate a portfolio tilted toward value and away from growth oriented stocks? Let me begin by quoting from Arnott, page 4 of his book, “The Fundamental Index,” where he writes, “In the two-year period from March 2000 through March 2002, the average U.S. listed stock returned more than 20 percent, whereas the S&P 500 lost more than 20 percent.” How is it that the average stock did so well during what many of us remember as one of the worst bear markets in our lifetime? Arnott also provides the answer to that question. Hear what he has to say.

“In the first two years after the tech bubble burst, the traditional indexes–and the index funds tracking them–were down, while the average stock was up, precisely because the indexes had loaded up on the pricey high-flying growth companies. Many of the companies getting higher allocations were trading at multiples of earnings–or for those with no earnings, multiples of sales–which were without precedent. At the peak of the bubble in March 2000, almost 30 percent of the Russell 2000 Index, the popular small-cap market index, consisted of companies that had no earnings. Most of these companies had never had earnings in their entire history.”

The indexes that declined in price were populated by companies with high multiples and it is precisely these high multiples that factored into the very market capitalization that determines the make up of the index. As stocks become less attractive, by the very makeup of the index, they begin to take on a greater role in the index. This is precisely Arnott’s argument as to why one should construct an index around such metrics as sales, cash flow, book value, and dividends rather than capitalization.

Market capitalization is a fancy term for a straight forward concept. It simply means multiply the price of the stock times the number of outstanding shares. It is easy to see that if a stock runs up in price its market capitalization increases without improving any of the fundamentals such as sales, earnings, cash flow (or better, free-cash flow), book value, or dividends.

When we tilt our portfolios toward value ETFs such as VTV, VOE, and VBR, we are moving the portfolio toward companies that have lower Price/Book Value and they pay, on average, higher dividends. Arnott wants to take this one step further and construct ETFs based on the fundamentals of sales, cash flow, book value, and dividends. The big problem, as I see it, is that he also lays on significant fees to build these indexes. Only time will tell if the performance of the fundamental indexes merits the high fees.

Lowell Herr

Photograph:  Art at Elan Gallery & Gifts, West Linn, Oregon