It’s an urgent question because value stocks – traditionally low price-to-book ratios – have been lagging growth stocks for at least a decade. And while value stocks have returned after similarly long lag periods in the past, some researchers doubt whether they will do so again.
That’s because a growing percentage of companies’ market value now comes from intangible assets – such as patents, trademarks, and research and development costs – that are either ignored or inconsistently accounted for in book value calculations. Therefore, according to the researchers, the price-to-book ratio has lost relevance.
If they’re right, we can’t expect stocks with the lowest of these odds to reassert their historical dominance over stocks with the highest odds. And it may require using a new metric that measures value more precisely so that investors are comfortable again following a value strategy.
What is clear is that value as a stock-picking style has been a laggard in recent years. Over the past decade, growth stocks (represented by the 50% of stocks with the highest price-to-book ratio) outperformed 1.9 annualized percentage points, according to data from Dartmouth College Prof. Kenneth French. That’s a huge reversal from the last eight decades, when value (the 50% of stocks with the lowest price-to-book ratio) outpaced growth by 4.6 percentage points annualized.
There can also hardly be any doubt that intangible values have gained in importance. According to Ocean Tomo, an intellectual property consultancy, 84% of the S&P 500’s market capitalization comes from intangible assets, up from just 17% in 1975.
Lose relevance
Baruch Lev, professor of accounting and finance at New York University, strongly argues that the increasing importance of intangible assets is the main cause of the loss of importance in book value. He says the accounting treatment of intangible assets – under GAAP or generally accepted accounting principles – is both obsolete and inconsistent: for example, if a company invests in the development of patents, its brand, or efficient business processes, GAAP requires that the investment be treated as an expense rather than an asset. However, if the company purchases an intangible asset rather than generating it itself, GAAP requires that it be listed as an asset on its balance sheet.
“Every aspect of the financial report is affected by this outdated treatment of intangible capital in the industrial age,” argued Prof. Lev in his 2016 book “The End of Accounting and the Path Forward for Investors and Managers.” with Feng Gu, Professor of Accounting and Law at the University at Buffalo. “And given the likely increasing role of intangibles in creating business value, the decline in the usefulness of financial reports will almost certainly continue.”
Where is the value?
The shares were divided into five groups or quintiles according to their price-to-book ratio. The graphic shows the average portfolio holdings of all value funds by quintile. (If these funds had only invested in pure value, the rightmost column would be 100% and the other four would be 0%.)
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Of course, not everyone is ready to write the price-to-book ratio obituary. In an interview, Kent Daniel, a finance professor at Columbia University and former co-chief investment officer at Goldman Sachs, admits that GAAP’s treatment of intangible assets leaves something to be desired. But he says the price-to-book ratio has always been an imperfect and noisy measure of a company’s value. For example, book value has never “captured the value of a company’s growth prospects”. Failure to fully and accurately reflect the value of intangible assets does not necessarily mean that it is unable to distinguish between undervalued and overpriced stocks.
In fact, according to Prof. Daniel, some researchers have found that the book-to-value ratio actually allows better differentiation between companies with the most R&D spending than companies with the least spending. Investing in R&D is, of course, one of the most significant categories of intangible assets.
Another indication that the price-to-book ratio may still be relevant comes from the forecast of the return on the S&P 500 over the next 10 years. Its record since 1975 is better than in the previous five decades.
Book value problems
If the price-to-book ratio is still reasonably effective, why has it lagged behind growth in recent years?
One answer comes from a study due to appear in the Journal of Financial Economics. Ray Ball, professor of accounting at the University of Chicago and co-author, says the cause of the deterioration is that book value is dominated by one of its two main components.
This offensive category is “equity brought in,” or the sum of all past stock issues by a company, minus share buybacks. Although a ratio of price to capital contributed per share never had a great predictive value, it had no impact on the effectiveness of the price-to-book value ratio as long as the capital brought in made up a small proportion of the book value, says Prof. Ball. But as it grows The price-to-book ratio has lost a lot of its importance in the share.
The other important component of book value is retained earnings, and Prof. Ball says the ratio of price to retained earnings per share remains as effective an indicator as it has ever been in predicting stock returns. His recommendation to investors who have previously relied on the price-to-book ratio is to focus on this modified ratio based on retained earnings instead.
Prof. Ball’s recommendation points to a broader topic shared by many value-oriented consultants: “Value” is viewed more as a reflection of many different indicators and not just as a book value. In a 2015 study in the Journal of Portfolio Management, Clifford Asness, co-founder of AQR Capital Management, and three colleagues mentioned the ratios of price to earnings, dividends, cash flow and sales. The study found that a composite value indicator based on these many different metrics would provide better risk-adjusted returns than the price-to-book ratio alone.
A long wait
However, regardless of how value has been defined, the fact remains that value stocks have been, on average, bleak over the past decade. But Prof. Daniel reminds us that value had a similar long time behind it in the 1990s, when it lagged behind growth and then roared again after the Internet stock bubble burst.
“I would suspect that something similar will happen in the future, but I’m not sure,” he says, “and I’ve been wrong for a long time!”
Mr. Hulbert is the founder of Hulbert Financial Digest and a senior columnist for MarketWatch. He can be reached at [email protected].
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