the size of “gray” income in mainland China: the Wang Xiaolu study

I mentioned in my post from yesterday that in looking over the Li & Fung corporate website, I came across mention in Li & Fung’s 3Q10 China Trade Quarterly of a study by a prominent Chinese economist, Dr. Wang Xiaolu, on the size of the underground, or “gray,” economy in China.  Dr. Wang’s estimate of the gray economy in China in 2008 is RMB 5.4 trillion, or about US$ 815 billion at today’s exchange rate.  That would amount to around 30% of aggregate disposable personal income in the Middle Kingdom–an immense percentage.

The study itself, sponsored by Credit Suisse and a followup to a less extensive earlier analysis using 2005 data, can be found on Scribd.

Dr. Wang’s conclusions

Based on 2008 data:

1.  official average per capita income of the top 10% of wage earners in China =  Rmb 43614 (US$6580)   actual income = Rmb 139,000 (US$20,950).

official income of next 10% = Rmb 26500 (US$3990)     actual income = Rmb 54900 (US$8275).

2.  Two-thirds of the gray income is in the hands of the top 10% of the population.

3.  Official figures substantially underestimate income inequality in China, which is in fact even worse than in the US.  On Dr. Wang’s numbers,

–51.9% of disposable income is in the hands of the top 10% of Chinese earners  vs.  47.2% in the US

–7.8% of income is in the hands of the bottom 40% of Chinese earners  vs.  9.6% in the US.

what is “gray” income?

Gray income is money received in exchange for goods and services that is not reported to the government and on which no tax is paid.  Dr. Wang clearly seems to me to be a reformer who wants to call attention to systematic abuse of power by high-ranking officials.  His examples of gray money all seem to revolve around this issue.

His examples include the semi-legal, like:

–excessive bonuses or perquisites for high officers of government-owned enterprises, or

–excessive wedding gifts to the children of politically powerful parents.

They also include the illegal, such as:

–bribes paid to public officials

–excessive costs in public construction

–government officials profiting from land sales they control

–stock manipulation.

Dr. Wang’s methodology

his reasoning

Dr. Wang points out that official statistics on income are derived from interviews from a random sample of Chinese citizens.  Participation in the surveys is voluntary, however .  Dr. Wang maintains that:

1) all citizens questioned under report their income, and

2) many high-income people contacted decline to participate.

Together, these factors create a systematic downward bias to the official numbers.

an illustration

Dr. Wang illustrates that the official figures cannot be correct by pointing out that one can use them to conclude that Chinese citizens saved, in the aggregate, Rmb 3.5 trillion in 2008.  But data from other sources that show the increase in personal bank savings, private property purchases, and private buying of bonds and stock IPOs–in other words, that act as a proxy for the actual amount of money citizens saved during the year–total to over Rmb 11 trillion!

how Dr. Wang proceeded

In general outline,

–Dr. Wang trained a cadre of interviewers and developed a questionnaire intended to develop detailed information about expenditures on necessities like food and, in a more subtle way than the government’s survey, inquire about income.

–He created a list of potential interviewees from the friends and acquaintances of his interviewers, and selected  a subset of about 5000 of these to be actually interviewed.

–Post interview, the questioners graded the survey questionnaire based on their judgment as to the completeness and truthfulness of the answers, rejecting a bit less than 20% of the questionnaires on these grounds.

–He used the data collected from the remaining 4000+ to generate an Engel coefficient for China, that is, a relationship between expenditure on food and total income.  He then applied this coefficient to the government survey data, on the assumption that the information revealed by interviewees about expenditure on food is relatively correct.

is this scientifically correct?

No.  The biggest issue is that here’s no reason to believe that the friends and acquaintances of Dr. Wang’s interviewers are representative of wage earners in China as a whole.

Also, interviewees in the US tend to be less truthful in person-to-person interviews than in internet or mail (in the old days) surveys.  I don’t know what evidence there is in China.  I also don’t know what evidence there is that the cadre of interviewers is good at telling whether an interviewee is  being honest or not.

is this the best information we can hope for?

Probably yes.

investment implications

Even if Dr. Wang’s results are only directionally correct, they imply that disposable income in China is a quantum leap higher than official figures suggest.

If he’s right that the extra income in concentrated among the wealthiest Chinese citizens, then the market for luxury goods there may be much bigger than is commonly believed.  This would be good news for the Macau casinos and for luxury goods producers around the world–including local brands that may develop.

Severe income inequalities are a potentially politically destabilizing social issue.  This is Dr. Wang’s greatest concern, I think.  As Credit Suisse points out in its report that contains Dr. Wang’s findings, Beijing seems to concur.  It has encouraged/allowed large wage increases for factory workers in eastern China.  And it appears to be signaling it wants workers’ unions to take a greater role in ensuring that workers get a greater share of enterprise profits.

This may also be a big reason the Chinese government is opposed to a one-time large appreciation of the renminbi.  Doing so would simply validate the current, potentially dangerous, income inequalities.  Better, say, to encourage a doubling of workers’ wages over the next five years and allow the resulting demand for foreign goods push up the Chinese currency than to let “hot money” portfolio inflows do the job all at once.

a closing note

Credit Suisse points out that Greater China (the mainland, Hong Kong and Taiwan) already accounts for 28% of Swatch’s sales and 20% of Richemont’s.  Booming watch sales seems to be more evidence for the sharp male skewing of Chinese luxury consumption that Bain points out in its latest annual luxury goods survey (see my posts on Bain).

Credit Suisse’s favorite among the Macau casinos is the Galaxy Entertainment Group (0027:HK), on the idea, prevalent in Hong Kong, that the mass market is the best place to be.  That may well be true, although I’m still a bit skeptical.  But Galaxy appears to me to be the weakest of the casinos, however.  CS also thinks that the stocks of property developers stand to benefit as the world begins to appreciate how much income China has.  Myself, although I really like property stocks, I’d prefer something in financial services.

a turning point for the Chinese economy

Last Thursday, David Pilling, a columnist for the Financial Times, wrote about the views of Victor Fung, the chairman of the Hong-Kong based supply chain management company Li & Fung.   This is presumably the result of an interview with Mr. Fung, although the article doesn’t say. There are three interesting points in it.

Victor Fung himself is an influential political and business figure in Hong Kong, and a senior member of the Fung family, which has substantial commercial and property interests in Greater China, including the Hong Kong-traded Li & Fung (HK: 0494).  0494 sources garments and other manufactured items, mostly from China, but also from other developing countries, for wholesalers and retailers in the US and Europe.

The three points:

1.  The Foxconn incident signals a change in the way manufacturing is done in China.  If you recall, about half a year ago, Foxconn, a Taiwanese assembly company, had a period of labor unrest in a manufacturing complex in southern China.  Workers protested poor working conditions that had induced a number of employee suicides inside a factory town.  Under pressure from US customers like Apple, Foxconn agreed to, among other things, a 30% wage increase.  The Shenzhen plant continues to have problems, though.

Mr. Fung sees this as marking a decisive turn in manufacturing in Guangdong province in southeast China, which it doubtless is.  This isn’t new news, however.  It’s an illustration of economic forces that have been in motion for the past several years (see my post on China’s economic development model.)

In short, eastern China has run out of cheap labor and has to shift to making higher value-added products there to continue to prosper.  Manufacturers can also move labor intensive operations–as Beijing would like to see happen–to western China, where plenty of unskilled workers are still available.  That would foster greater political stability and help address the sharp income imbalances between the more affluent east and the more rural, agriculture-oriented, and poorer, west.  The gating factors, as I see them, are the availability of reliable transport for finished products to the eastern ports, and infrastructure, like continuous electric power.

More interestingly, Mr. Fung also says that:

2.  Beijing is encouraging the development of labor unions.  A first glance, this seems very odd for a government constantly worried about labor unrest–after all, that’s what Tiananmen Square was all about.  And for a socialist country as well, where criticizing the owner of a factory (that is, the government) could be seen as a political crime.  But the factories in question are typically controlled by some sort of partnership between a regional/local government and a foreign manufacturing company that has the technical know-how.  Beijing has little control over either party.  Unions may be a way to get some.


3.  For the first time ever, some Chinese clients have asked Li & Fung about sourcing shoes and garments for sale in China from countries like Bangladesh or Vietnam.  The clients are presumably domestic retailers or wholesalers who currently get their wares from unaffiliated factories in China.  This development is good news for Li & Fung, but puts another source of pressure on eastern China manufacturers to lower their costs.

In general, China factories have two possible responses:

–they can lower costs, i.e., move west; or

–they can try to get Beijing to impose tariffs or other protective measures against garment imports.

Given that this would run counter to the central government’s plan to shift labor intensive manufacturing west, I think there’s little chance of the latter happening.  But this is an area to watch.

my thoughts

Developing countries have invariably had difficulties when they have reached the point where all the available unskilled labor is used up.  Typically, the companies that use unskilled labor have developed considerable political power and are also incapable of migrating their firms to higher value-added tasks.  Such firms vigorously defend the status quo.  As a result, they often form an immovable roadblock that destroys the possibility of economic progress for years (think: Malaysia).

China is in a much better position than most.  The country still has lots of unskilled labor left.  And the current administration in Beijing isn’t particularly beholden to the Guangdong-Hong Kong manufacturing interests that, in theory at least, have the greatest interest in defending the status quo.

For an investor, it seems to me the implications of all this are simple.  For someone like me, observing from halfway around the world, there’s no reason to take the risk of owning manufacturing-related companies that derive a significant chunk of their profits from eastern China.  It’s better for now to have less exposure to specific industries/geographical areas in China, and more to the general positive effect of increasing incomes.  Financial services, though not often my favorite sector, comes to mind.

By the way, in poking around the Li & Fung website, which I haven’t done in a while, I stumbled across mention of a study on the gray economy in China which I think has investment implications.  More about this tomorrow.

3Q10 SNL Kagan numbers: pay TV declines again in the US

the pay TV industry

The pay TV business in the US has three parts:  cable TV, satellite TV and telecom TV.

cable maturing

Traditional cable TV subscriber numbers peaked in 2001, when the country had 52.4 million basic cable only households and 14.5 million with digital, for a total of 66.9 million.

The overall figure dropped by 800,000 in the recession year of 2002, although the decline was masked in industry revenues by 4.8 million households upgrading to higher-cost digital.  Aggregate subscriber numbers declined from that point, but only by a total of about 1% through 2006 (700,000 households lost over four years).  But any revenue decline from this source was trivial compared with the gains from rapid adoption of digital.  In 2007, however, the combination of aggressive marketing of telecom offerings and economic weakness sparked a sharper rate of subscriber loss.

Overall cable figures, from industry expert SNL Kagan, break out as follows:

2001     66.9 million total subscribers     14.5 million digital, 52.4 million basic only

2006     65.4 million total subscribers     32.6 million digital, 32.8 million basic only

2009     62.1 million total subscribers     42.6 million digital, 19.9 million basic only.

satellite and telecom providers gaining subscribers

Even in 2009, total pay TV industry subscriber numbers rose.  Traditional cable losses of 1.6 million household were more than offset by:

–satellite broadcasters, who added 1.4 million subscribes to end the year at 32.7 million, and

–telecom providers, who added 2.1 million subscribers to end the year at 5.1 million.

a big change over the past six months

Even through the dog days of 2007-2008, the pay TV industry steadily added subscribers, though at a relatively slow rate.  Within the industry, traditional cable steadily lost small numbers of subscribers to satellite and telecom.

In the June quarter of 2010, however, the US pay TV industry lost subscribers for the first time ever. Same intra-industry dynamic as before–cable lost a stunning 711,000 subscribers; satellite added 81,000 and telecom signed up an extra 414,000.  The net industry loss:  216,000 customers. SNL Kagan attributed the cable losses to the economy–high unemployment and the weak housing market.

In the September quarter, whose figures were just released, the story was the same:

— a net loss, the second ever, of 119,000 customers, and

–cable lost 741,000 customers, its worst performance ever; satellite added 145,000 subscribers, telecom 476,000.

SNL Kagan points out that this is normally the seasonal peak for subscriber additions, so what’s going on with cable can’t simply be the economy.

what’s going on?

I think three factors are involved:

1. The continuing sub-par economy is probably the trigger for consumers’ rethinking their spending priorities.   It is a bit unusual, though, that the rethink is coming with such a lag.

2.  Cable has raised its prices to a level that it is providing a pricing umbrella that made the financial decision to enter the pay TV industry easier for telecom companies.  This will likely prove a horrible strategic mistake in a capital-intensive industry.  Even if the telcos eventually conclude they can’t be profitable, they will turn their attention to recovering as much of their invested capital as they can.  In other words, the billions they’ve spent on TV means they can’t simply exit the industry.  So they won’t stop discounting.

3.  New, cheaper forms of entertainment distribution have emerged.  Netflix and Hulu, together costing about $20 a month, are leading examples.  Ironically, both require the high-speed internet that cable delivers.  But they’re the iTunes store to cable’s CD albums.  They’re cheaper; they’re more flexible; and they offer on-demand service.  In addition, buying a $15 cable will allow you to display streaming content on your wide-screen TV.  Newer TV models connect directly to the internet.

More confirming evidence:  look at the resistance cable companies have put up to broadcast networks’ demands for higher retransmission fees; look at the more basic “basic” services cable companies are offering.  Time Warner, for example, is offering basic for the first time without ESPN, to lower the cost.

my thoughts

Cable is in trouble on two fronts.  One is from a kind of “creative destruction,” the emergence of competing technology that’s newer, better, cheaper.  In this regard, it’s somewhat like the music companies were ten years or more ago.  The second is a more traditional kind.  Faced with competition, cable ceded the low-end market to the telcos and preserved profits by moving up-market.  That strategy–the same one GM used when faced with Japanese competition–has backfired.

higher gold prices ahead: the 3Q10 report of the World Gold Council

The conclusion is mine, but the support comes from the just released 3Q2010 report of the World Gold Council, a leading authority on the yellow metal.

The highlights:

world demand

Identifiable world demand is actually up by 12% year on year, despite a 28% rise in the US dollar gold price over that time.  Buying of gold, year to date, breaks down into the following categories by tons:

jewelry 1468.3 t, up 8% year on year,  comprising 52% of demand

Industrial/dental 320.5 t, up 13% year on year, 11% of demand

investment 1350.2 t, up 19% year on year, 37% of demand.


Geographically, third quarter consumer demand (i.e., excluding industry and central banks) breaks out as follows:

India     33.2% of demand.   Purchases up 28% year on year, mostly jewelry

Greater China     22.2%     purchases up 16% year on year, mostly investment

Middle East     9.7%     purchases down 10% year on year, mostly lower jewelry

United States     8.9%     purchases up 8% year on year;  jewelry down, investment up

Western Europe     7.6%     purchases down 3% year on year

Turkey     6.8%     purchases up 35% year on year, virtually all investment

Vietnam     3.3%     purchases up 17% year on year; jewelry down, investment up

Thailand     3.2%     purchases up 139% year on year;  jewelry down, investment up

Russia     2.6%     purchases up 17% year on year, on jewelry demand

everybody else     2.5%.

Industrial demand, which is primarily for technology products, has already rebounded to the pre-crisis levels.

Central bank activity has been, from a private investor’s point of view, really odd.  Until 1Q09 and at prices at or below $900 an ounce, central banks were heavy sellers.  Since then, they have turned into big net buyers.  Russia has added 46.2 t to its stockpiles, Thailand 15.6 t, Sri Lanka 6.9 t and the Philippines 4.2t (through late August).

Investment demand breaks out into three categories:

–hoarding of bars, coins, medals–mostly in developing countries, which accounts for 55% of investment and is up by about a third vs. 2009,

–ETFs and similar products, which accounts for 33% of investment and is down by about 40% year on year, and

–“other” identified retail investment–mostly coins bought in the US and Europe, which accounts for 12% of investment and is  also down by more than 40% year over year.

world supply

Happily, supply is much more straightforward than demand.  It comes from:

mine production     62% of supply, up 3% year on year

recycling     41% of supply, down 1% year on year

central bank sales     -3% of supply (since central banks have turned net buyers)

my thoughts

On the supply side first, I don’t think there’s any reason to expect a large increase in the supply of gold from current levels.

Yes, higher prices will make new gold mining projects (which can be developed relatively quickly) economically viable.  At the same time, however, prudent mining practice calls for existing mines to process progressively less gold-rich ore as prices rise.  That way, they maintain profits in boom times, but save higher grade ore for a rainy day.

Again, higher prices should mean more recycling.  But one of the reasons for the sharp increase in recycled gold over the past few years is the recession-induced development of a gold recycling industry in the US.  Output here has presumably reached a steady-state level.  More important, the World Gold Council thinks the rest of the world has pretty much run out of gold lying around to be recycled.

Central bank sales are harder to figure.  Luckily, they’re not that large in the overall scheme of things.  On the IMF still has about 50 t. of gold to sell.  On the other, Russia is carrying out a program to increase central bank holdings of gold.  And some smaller, less stable governments, appear to want to remain net buyers as well.

As to demand, the figures above should make it clear that gold is a developing world phenomenon.  The US and Western Europe make up only 16.5% of consumer demand and 12% of non-ETF investment purchases. (By the way, Japan isn’t mentioned on the consumer list.  That’s because Japanese individuals have been net sellers of gold this year.)

India alone is a third of the overall market for gold.  It and China together make up more than half of global demand.  In India, buyers want pure gold, to serve both as adornment and savings.  The same is true for China, though 18k jewelry has been making inroads.   So demand in both places should be a function of economic growth.  If the two were to intend to buy gold next year at only half the current pace–and I think that’s a very conservative estimate–this would mean almost over a 6% increase in total demand.

Absent an increase in recycling, which the WGC says is unlikely, I don’t see where the extra gold will come from.  Even ignoring demand from fiscally unstable areas like Turkey or Vietnam, or continuing central bank buying, as positive factors, it think this spells higher gold prices in 2011.







EFPR Global: equity fund flows “surge”

the data

EFPR Global, a data service based in Cambridge, Massachusetts, reported yesterday that investors around the world poured over $15 billion into the equity funds it watches during the week ending November 10th.  This makes the period the best for equity fund inflows since the first half of 2008–before the collapse of Lehman.

According to EFPR, investors put money into virtually all types of equity funds–US, Europe, commodity sector, global and emerging markets.

Bond funds continue to gain assets, but investor enthusiasm for sovereign debt of the US and the EU has clearly begun to wane.

Just published data from the Investment Company Institute, the trade organization for US-based fund companies, only cover flows through November 3rd.  But they confirm a lot of what EFPR is saying.  The ICI numbers show a slowdown in inflows to bond funds, as well as continuing support for equity funds focused on non-US markets.  But the best the ICI can say for US-oriented equity funds is that net redemptions have slowed down.

what to make of this

It’s tempting to say that the “dumb money” that continued to withdraw money from stocks while they were on their way to nearly doubling is now starting to buy back in at much higher prices.  On the idea that “dumb money” stays dumb, this would be a sign that equity markets are near a peak.  IN other words, we should look at the inflows as a contrary signal.

This was my first reaction.  But I’m not sure it’s the right reading of the situation.

In my opinion, there are two reasons for the change in behavior:

1.  I think investors are concluding that layoffs at their firms have ended and that corporate profits are improving.  Therefore their present jobs are secure.  As a result, they won’t need their savings any time soon.  This means they can, at least with new money–if not with investments they already hold–take a more aggressive posture.

Put another way, for most individuals their human capital–their ability to do economically useful work–is their greatest asset.  When the income flow from work is uncertain, it’s no time to take on even more risk with investment capital.  And vice versa.

2.  To some extent, the large amount of publicity about QE II has underlined how little scope there is for government policy to depress interest rates further.  So quantitative easing may be a signal for bond investors to take some profits out of bonds and put them somewhere else.

You might say that this is giving more credit to individuals for having investment savvy than they are due.  On the other hand, we know hedge fund managers are on their way to underperforming the S&P for the eighth year in a row.  And traditional long-only professionals typically end up deep in the top quartile just for matching their indices.  So who’s left as the winners of the investing game?  Brokers and individuals.

Even if you think what I’m saying is crazy, there is still a huge amount of individual money on the sidelines that I think will eventually be pulled into the stock market.  So two or three weeks of positive money flow is at worst a signal for greater attention to the behavior of individuals, not for becoming ultra-defensive.

WMT, DIN: more signs of a stabilizing/strengthening domestic economy

the data

–WMT reported earnings before the New York open this morning.  While comp store sales in the US were down for the third fiscal quarter (ends in October), the company has seen sequential improvement in year over year comparisons for the past several months. And it expects comps to turn positive over the holiday season.

–DIN (Dine Equity, parent of Applebee’s and the International House of Pancakes) reported September quarter earnings on November 2nd.  On of the most striking aspects of the recent recession (to me, anyway) has been the reversal of a decades-long trend of American consumers away from preparing/eating meals at home in favor of take-out and eating in restaurants.  Applebee’s, which DIN acquired in 2007, had its comps turn negative in 2006–and stay there.  But third quarter comps for company-owned stores were +3.3%.  Franchisees’ were +3.8%.

It’s not just Applebee’s.  According to the Financial Times, a trade source, the Knapp Track Report, shows the casual dining industry has been comping positive for about four months.  This is the first time since 2006 this has been happening.

–ATVI recently released its latest enter in the Call to Duty series, named Black Ops.  Black Ops had sales of $360 million in the US and UK during its first day (5.6 million copies).  That’s a video game record, and about 20% higher than first-day sales of the mega-hit Call of Duty:  Modern Warfare 2, which was last year’s entry.  Gamers tell me MW2 is the better game.  What’s changed is the economy.

–In its recent earnings call, DIS reported that bookings for its theme parks and resorts were up 5% year on year so far in the fourth quarter, at rates that were 5% higher than a year ago.  It’s a small thing, but higher room rate normally produces lower occupancy, as DIS’s results over the last year illustrate.  The idea is to trade the two variables off against one another in a way that makes revenue (rooms sold x room rate) the highest.  It’s a significant sign of strength when both metrics are moving up at the same time.

what this means

From early in the year, it has been clear that affluent Americans were beginning to feel their jobs were secure and that they could begin to spend a little more freely than they did in 2009.  In fact, sales of luxury goods have been surprisingly strong in the US recently (see my posts on the annual Bain luxury goods report).

These data suggest that everyday Americans have been adopting a similar, more positive outlook–probably starting in the summer.  They’re signs that people think their jobs are safe, that layoffs in their firms are at an end.

This conclusion is reflected in the latest Employment Situation report from the Department of Labor Statistics, which shows the US added about 159,000 private sector jobs in October, and which revised up the August and September figures to 143,000 and 107,000–a gain of 93,000 for the two months over the prior month’s estimate.

It seems to me the evidence points to the US having reached an inflection point where the economy is beginning to heal itself.  Slowly, it’s true, but healing nonetheless.  I’d read the 7%-8% drop in the 30-year bond over the past two weeks as the start of the process of normalization of interest rates, a process that will go on until the 30-year bond yields over 5% and the 10-year yield breaks through 4%.

For stocks, the situation will likely be more complex.  In the past, stocks have held up well during the post-crisis transition period (see my post from April on this topic). The critical question this time around, though, is what individuals do with the mammoth amount of money they’ve poured into bond funds over the past few years.  Do they simply stop allocating money to bonds for a while?  or do they actually withdraw funds?  Where does this money go?  I presume it makes its way into stocks.

measuring equity performance using style indices: growth vs. value

value vs. growth

It’s been my strong impression that in the US market growth stocks have outperformed value stocks this year.  I get that impression, among other things, from looking at my own portfolio (remember, I’m a growth investor).  This wouldn’t be surprising, since in a typical business cycle recovery value stocks outperform strongly in the first year.  But as pent-up demand is gradually satisfied and the economy slows a bit, growth stocks typically take over market leadership.


But I know I look mostly at growth stocks.  So I thought I’d check the IWD and IWF ETFs.  These are securities that track the Russell large-cap value and growth stock indices, respectively.  They show a neck-and-neck battle until the past couple of months, when the growth index pulls out in front.

Indices like these are the best we have.  And from a practical money management perspective, if a client were to hire me as a money manager and specify the Russell 1000 Growth Index as my benchmark, it would be simple enough to construct a portfolio whose under- and overweights would be geared to that index.

how good are style indices?

But are such indices really good representations of the relative performance of growth and value stocks?   Not so much.  The reason has to do with the academic tilt to their construction.  To be honest, I don’t have a better solution.  And as you’ll see in a moment, the way the growth index is composed may give a manager benchmarked against that index a slight performance advantage.  So I’m sure these style indices are here to stay.  You just have to remember that the growth index in particular has some drawbacks.

Here’s what I mean.

The idea of style indices has its genesis in the reasonable question, posed by academics, as to whether either a value discipline or a growth investing discipline has an inherent advantage over the other.  Their method was to divide a stock index with broad market coverage, like the S&P 500 or the Russell 1000 into value and growth components and then study the relative performance of the two.

constructing a style index

They proceeded as follows:

1.  They defined value stocks, reasonably, as those with some combination of low price to book (or net asset value), low price to cash flow, and low price to earnings.

2.  Using various weightings of these three factors, or other similar ones, they constructed a ranking of index constituents that ordered them from being the most value-like (scoring the best on the value stock variables) to the least.

3.  Using this list, they (usually) took the half exhibiting the best value characteristics and called it the Value sub-index.  They called the other half of the list the Growth sub-index.

4.  They compared the performance of the two sub-indices.

Looking at the relative performance of the sub-indices over time is itself interesting:  until the Nineties, relative outperformance of either style is short-lived.  Starting in the recovery of 1992, however, Growth and Value each have multi-year periods of significant outperformance.

The overall academic conclusion, supported by the sub-indices, is that Value trumps Growth over long periods of time.

the error in logic

The academics make two assumptions that have no factual, or logical for that matter, support.

–They assume that every stock can be characterized either as growth or value.  This allows them to define growth as being what’s left over when value stocks are separated out.  hey don’t consider that there may be a set of “clunkers,” or stocks no one in his right mind would touch (even though there’s research showing that bad-performing stocks persist in underperformance far longer than good stocks in their outperformance).  They all get tossed into the growth pile.

–They assume that the growth stock universe and the value stock universe are mutually exclusive–that growth investors somehow refuse to buy fast-growing companies unless their price-earnings multiples were already high.  That would be crazy.  At the beginning of this year, for example, AAPL–a classic growth stock–was trading at 10x earnings, with no debt and cash making up a quarter of its market value.  Has AAPL been a growth stock for the past five years?  Yes.  Has it been a value stock, too?  Yes, again.  But which sub-index is it in?  Depending on how a particular style index is constructed, it could be either.

Of these two errors, I think the first is the more serious.  My suspicion is that the supposed underperformance of a Growth sub-index is because of the presence of clunkers.

Why don’t growth investors make more of a fuss over their investing style being maligned?  I think it’s the same reason why professional investors don’t make a fuss about many of the other crazy, erroneous things taught about investing in business schools.  Why invite more competition?