Value stocks may have done a lot better than you think

However, had book value been defined differently to include intangible assets, as many believe, the value drought would not start until December 2016, less than four years ago. That’s according to a recent study by Duke University’s Campbell Harvey, Dartmouth’s Juhani Linnainmaa, and Research Affiliates’ Robert Arnott and Vitali Kalesnik.

Had that accounting change happened, says Prof Harvey, far less ink would have been spilled in recent years about whether value strategies were no longer working.

‘No sense’

Intangible assets refer to a company’s investments in things like research and development, patents, and intellectual property. Generally accepted accounting principles (GAAP) treat such investments as an expense rather than an asset on the balance sheet, so intangibles are not viewed as something that potentially adds value to a company, but rather as something that reduces it. “It doesn’t make sense,” says Prof. Harvey.

Not treating intangibles as assets might have made more sense when our economy was dominated by manufacturing and agriculture. But book value excluding intangibles is becoming increasingly irrelevant in an information-based economy. According to the most recent study, “In 1963, intangible assets represented only 25% of the physical portion of the book value of the US stock market as a whole. By the mid-1970s that number had doubled, and by the early 2000s it had doubled again. This ratio has been around 100% ever since.”

To make matters worse, GAAP is inconsistent in the treatment of intangibles. On the one hand, what a company itself spends on intangibles is treated as an expense. On the other hand, if it acquires another company, it can add to its book value what that second company spent on intangibles.

To examine what difference it would have made if intangibles had been consistently included in book value, the authors of this new study undertook the Herculean task of recalculating the book value of every company for every year back to 1963. Not surprisingly, for many companies, including intangibles made a big difference. In fact, some companies that were previously in the growth camp have now been placed squarely in the value category.

A recent example is Dell Technologies,

Dell -2.44%

which has a negative book value according to the applicable accounting regulations. That means it’s the quintessential growth stock, with a price-to-book ratio infinity. However, when Dell’s intangible assets are included back into book value, not only does the company have positive net worth, but its price-to-book ratio is low enough to make it a value stock, the researchers found.

Another example is NetApp inc

NTAP -4.41%

Using the current accounting treatment of book value, the price-to-book ratio is more than double that of the broader market, making it a solid growth stock. However, when intangibles are included, the price-to-book ratio falls well below market levels, putting the stock in the value camp.

Making the immaterial tangible

Cumulative outperformance of value stocks versus growth stocks since June 1963

Using an expanded definition of book value that includes intangible assets

Using the traditional definition of book value

$1.00 invested

in June 1963

Using an expanded definition of book value that includes intangible assets

Using the traditional definition of book value

$1.00 invested

in June 1963

Using an expanded definition of book value that includes intangible assets

Using the traditional definition of book value

$1.00 invested

in June 1963

Using an expanded definition of book value that includes intangible assets

Using the traditional definition of book value

$1.00 invested

in June 1963

find summit

To calculate the market-wide effect of including intangibles in the definition of book value, the researchers separated the stocks into the growth and value categories, using the same process as the traditional definition. For both the original and new definitions, the researchers calculated the cumulative outperformance of value over growth since mid-1963.

Using the traditional definition, as you can see from the attached chart, value peaked in December 2006 relative to growth. If you include intangibles, this peaked in December 2016, 10 years later.

However, since 2016, value has lagged significantly behind growth, even when intangible assets are included in the calculation of book value. So it would be going too far to claim that the exclusion of intangibles is the sole cause of the value drought of recent years.

The other main reason, according to Prof. Harvey, is that growth stocks have performed particularly well in recent years. In other words, what has happened over the last four years is that value stocks have not done particularly badly, rather growth stocks have done exceptionally well.

So if there’s one anomaly on Wall Street right now, it’s a bubble among the highest-flying growth stocks. So the sensible conclusion isn’t to give up value, but to pull some money off the growth table, he says.

Mr. Hulbert is a columnist whose Hulbert Ratings tracks investment newsletters that pay a flat fee for the review. He can be reached at [email protected].