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The performance of value investing, considered one of the most important investment strategies in modern finance, has declined significantly over the past two decades. In recent years, a simple portfolio that buys undervalued stocks and sells overvalued stocks short has seen negative returns. But it is not time to declare value investing dead. Our new study shows that value investors may be missing an important variable in the composition of their portfolios: intangible assets.
To uncover the reasons for poor performance and the importance of intangibles, we first need to understand the building blocks of a value investment strategy. Value investing involves buying stocks that appear undervalued by the market. Investors analyze the deviation of a company’s market price from its fundamental value using metrics such as the market-to-book ratio. High market value stocks are commonly referred to as “growth stocks”. The idea is that high market valuations reflect future sales potential. Low market-to-book ratios identify “value” stocks that have cheap valuations relative to their underlying potential.
Market-to-book is a simple and useful measure in theory, but it suffers from an important measurement problem. The denominator of this metric – the book value of the assets – is an accounting identity based on balance sheet data. The complexity and scope of corporate activity have increased significantly in recent decades, while the rules governing the components of book assets and their calculation have remained largely unchanged. It is important that assets that arise from investments in knowledge, brands and employees, among other things, are often recorded as expenses and not recorded in the traditional market-book value ratio. These are intangible assets. Underestimating them is problematic because intangibles have grown rapidly and are now estimated to make up more than half of corporate capital in the United States. In fact, the recent underperformance of value investing coincides with the deteriorating ability of price-to-book value to measure company value.
To formally examine the effect of intangible assets on value investing, we analyzed data on thousands of publicly traded companies from 1975 to 2018. Using an algorithm introduced in our previous paper on corporate returns on capital and equity, we first took the Inventory of intangible assets at the enterprise level. Capital estimated by accumulating past investments in selling, general and administrative expenses (SG&A). We have added these to the reported book values and recalculated the price / book value ratio. It is important that we accounted for industry differences when reporting SG&A and its components by assigning value and growth companies within the industry. Sorting within the industry is critical due to the different accounting practices across different industries. This distinction, as well as our way of being based only on intangibles and companies that appear as “value stocks” only with the inclusion of intangibles, are unique in our approach to existing work on including intangibles in value investing. We then calculated the returns of a long-short-value strategy, in which value stocks are bought and growth stocks are sold short as part of our newly defined market-to-book ratio. We call our long-short equity strategy the “intangible asset” factor.
We found that the intangible value correlates strongly with the traditional value, but offers significantly improved performance. The outperformance has persisted throughout the sample period from 1975 to 2018 as well as partial periods around the internet bubble of the 1990s and the most recent Great Recession. Most importantly, unlike its traditional counterpart, the intangible asset has not shown negative returns over the past decade. A simple portfolio with intangible longs and traditional shorts also has a positive Sharpe ratio, a measure of risk-adjusted returns, which further underscores the outperformance of the intangible compared to the traditional value.
We also analyzed whether intangible asset avoids “value trap” companies that appear attractive due to the mispricing of market-to-book but will continue to decline in value rather than rebounding into a fundamental anchor. When looking at the average characteristics of companies, sorted by long and short legs of both traditional and intangible value factors, we found that intangible value actually better identifies companies with superior fundamentals of productivity, profitability, and financial soundness. In addition, value companies, which were identified in the context of the intangible market value-book value ratio, have better valuation ratios due to non-accounting ratios such as price-earnings and price-sales ratios.
The fact that value investing has recently become less important is not a reason to abandon the strategy, but rather a call to improve its execution. Value investing is strongly based on economic principles. Our results suggest that using intangibles to differentiate between real “value” companies within industries can enable investors to better measure the fundamental anchor of company value. As a result, new value investors can get positive alpha by going long on intangible value and short on traditional value.
Andrea L. Eisfeldt is the Laurence D. and Lori W. Fink Endowed Professorship in Finance and Professor of Finance at the UCLA Anderson School of Management.
Edward Kim is a PhD student in finance at UCLA Anderson School of Management.
Dimitris Papanikolaou is the John L. & Helen Kellogg Professor of Finance and Professor of Finance at Northwestern University’s Kellogg School of Management.
