Interview with Morningstar Fund Analyst Scott Cooley By John Spence April 16, 2002

Scott Cooley is a senior mutual fund analyst with Morningstar. He recently sat down with us to chat about valuations, diversification, and the importance of understanding index methodology.

IF: Have small caps finally caught up with large caps? Are small caps fairly valued in comparison with larger companies?

SC: Small-cap stocks are definitely cheaper relative to large-caps if you look at price-to-book (p/b) and price-to-earnings (p/e) ratios, but the discrepancy in valuations isn't as extreme as it was a few years ago. The gap has closed over the last three years in particular. Right now, the funds in our large-cap blend category have a p/e of 38.8, while the small-cap blend funds are at 25.2.

I don't have a crystal ball, but smaller companies could be more attractive if the U.S. economy rebounds because they tend to more domestically focused than the big multinational companies.

IF: What's the best way to measure equities? Growth rates, p/e, p/b, dividend yields, other measures?

SC: Well, you definitely have to look beyond the two traditional measures of valuation: p/e and p/b. I think it's becoming generally accepted that p/e is a somewhat flawed measure because it can be manipulated to a certain degree through accounting. Price-to-book ratios are especially unreliable in the large-cap area. For example, the S&P/Barra indices use p/b ratios alone to classify stocks in terms of valuations, which leads to problems. Let me provide an example of what I'm talking about.

Tech companies that did a lot of acquisitions of other companies in the late 1990s have lots of goodwill, which adds to book value and makes the company look a lot more like a value stock. Firms using a technique called "purchase accounting" can overstate the real worth of their tangible and intangible assets. During an acquisition, the firm must book a balance sheet item called "goodwill" to account for the difference between what it paid for the acquired firm and the current market value of the assets of the firm.

When JDS Uniphase acquired [optical-networking firm] SDL in 2000, it booked tens of billions of dollars of goodwill. At the time, SDL had little in the way of assets, but JDS Uniphase believed that SDL products would generate significant profits down the road.

As tech companies booked significant amounts of goodwill, their book values increased, and they became value stocks under S&P's classifications. It was particularly noticeable in the S&P 500/Barra Value and Barra Growth indexes. In early 2001, S&P and Barra considered JDs Uniphase a value stock, even though it traded at more than 10 times sales.

That led to some weird results in 2001. The year 2001 was clearly a year for value over growth, but the S&P/Barra large-cap indexes didn't reflect that. The Russell large-cap style indices, on the other hand, showed a wide gap between growth and value.

Index	2001 returns
S&P/Barra Large Cap Growth	-12.72%
S&P/Barra Large Cap Value	-11.72%
Russell 1000 Growth	-20.42%
Russell 1000 Value	-5.59%

In short, individual factors taken individually can be misleading. Barra relies only on p/b ratios. Until recently, Morningstar only looked at 2 factors: p/b and p/e. We now use a 10-factor model that includes growth measures.

IF: Is it time to flee high U.S. valuations or are foreign markets still correlated with our domestic market? What's the argument for investing overseas?

SC: Diversification always makes sense, even during the times when domestic and international stocks move in lockstep. The most common argument you hear against international stocks and funds is: Why pay the higher costs when the correlation is so strong? Why expose yourself to the uncertainties associated with international and especially emerging markets?

I think the events of 9/11 have shown us the flaw in that argument - we were reminded that we can and do face the same issues. In the U.S., we thought we were immune to the geopolitical issues associated with terrorism, but obviously we're not.

I think the case for international investing is very strong, especially now when international markets are cheap compared to their historical norms. Also, why not hedge your domestic bets if you can?

IF: Let's talk about index fund management for a moment. Here's some of the bigger problems facing index fund managers: turnover, the cost of buying and selling, and avoiding front-runners. How do managers deal with these issues?

SC: John Bogle has been saying publicly that he's very concerned about turnover in the indexes tracked by the Vanguard funds. For example, the turnover in Vanguard's small-cap growth index fund was 136% as of 3/31/2002.

Dimensional Fund Advisors (DFA) are definitely innovators in indexing. They're willing to tolerate tracking error in their funds, and they have demonstrated they can add value through trading.

Vanguard anticipates index changes to a certain degree. I think Vanguard index fund manager Gus Sauter has learned to adapt to the front-runners - he's definitely good at playing their game. He manages to pick up a few basis points over the indexes he tracks, and there's consistent evidence that he outperforms the Russell 2000 small-cap index in the short-term when the index does the annual rebalancing in June. I bet he's one heck of a poker player.