Is Book Value Irrelevant?

There are two drop-dead great reads I’ve come across in the past few days that address a topic with big implications for value investing – maybe for all investing.

This weekend’s Barron’s cover story asks the question of whether it’s time for value investing to start outperforming again. It’s been an okay strategy, quantitatively speaking, throughout the post-crisis period but relative to growth investing, it’s been terrible.

Barron’s:

To be fair, value stocks have had a good run, just not quite as good as growth stocks. Over the past decade, the Russell 1000 Value index has returned 102%—not too shabby, but significantly less than the 178% for the Russell 1000 Growth, and behind the broader market’s 137% return.

Questions are being asked about if the corporate landscape has changed so much that we need to junk this metric entirely and think about a new way to measure the assets of a company. This is because book value captures the hard assets of a firm (equipment, physical facilities, etc) and misses what have become the defining advantages of the modern business – the brand, the intellectual property, the human capital, the competitive moat, the market share and the degree of consumer lock-in.

So by building portfolios that are overweighted toward companies that trade are less expensive book-to-market valuations – a mainstay metric used by both active and passive value strategies – are investors missing the most important corporate traits to be tilting towards? Are they tilting toward the opposite of this era’s biggest winners?

Barron’s reporter Reshma Kapadia continues:

But there’s a problem with price/book: today’s economy. Price/book, perhaps the most conventional measure of value, evaluates stock prices based on a company’s book value—the worth of all tangible assets but no intangible ones. Price/book and similar accounting-based metrics worked better in an industrial-based economy, when companies owned valuable tangible assets, like manufacturing plants and equipment. Today’s service economy is filled with companies whose biggest assets are their brands, intellectual property, or customer loyalty, which don’t show up on the balance sheet.

Dyed-in-the-wool value investors who have relied upon balance sheets and book-to-market metrics will tell you that nothing’s changed at all, and that mean reversion will soon balance out the huge disparity between growth and value stocks. They’ll dismiss these concerns about the lagging factor performance as yet another example of “This time it’s different” thinking. Maybe they’ll be right.

But the problem goes beyond the growth vs value paradigm that has always existed. The popularity of stock buybacks, as opposed to dividends, is also wreaking havoc with surface analysis of simple equity valuation techniques.

My friends at O’Shaughnessy Asset Management have an important take on this. In their April commentary, OSAM focuses on what’s wrong with traditional balance sheet quantitative analysis and the things it’s missed. Travis Fairchild writes:

Balance sheets prepared under generally accepted accounting principles (GAAP) are doing an increasingly poor job of reflecting the value of shareholders equity. Recent trends have tended to bias assets well below market value which has led to the increased frequency of negative equity and Veiled Value stocks. Those tend to fall into three main categories, that we will cover in detail:

1) Understated Intangible Assets: brand names, human capital, advertising, and research and development (R&D) are rarely represented on the balance sheet

2) Understated Long Term Assets: assets are often depreciated faster than their useful lives

3) Buybacks and Dividends: when buybacks and dividends exceed net income, they create a decrease in equity which can accelerate distortions

It would be a disservice to summarize Fairchild’s note here, it’s much better for you to read the whole thing to understand the points he’s raising.

I highly recommend both links for serious investors.

Sources:

Are Value Stocks Ready to Grow Again? (Barron’s)

Negative Equity, Veiled Value, and the Erosion of Price-to-Book (O’Shaughnessy Asset Management)