Why Value-Focused Portfolios Disappoint

Value stocks “have had a decade from hell” says The Economist. Over that period their returns have lagged behind the average for the American stockmarket as a whole by more than 90 percentage points.

For almost a century the dominant ideology in investment analysis has been Value – a conservative view of firms placing more weight on their record and current realities, less on their future prospects and the momentum of their shares. But for years companies selected according to such “fundamentals” have underperformed their “growth” rivals.

Value investing seems to produce backward-looking portfolios dominated by old giants in stodgy, unfashionable industries. It has consistently understated or even ignored the message that the place to be invested is an elite of technology or tech-enabled shares: Apple, Alphabet, Facebook, Microsoft, Amazon; in China Alibaba, Tencent.

As the industrial age gives way to the digital age the intrinsic worth of businesses is no longer well captured by old-style valuation methods. There has been a shift in importance from an economy where factories, office buildings and machinery were key to one where software, ideas, brands and general knowhow matter most.

Intangible assets such as data, ideas, reputation, now account for more than one third of American business investment. Their costs appear in published accounts as expenses but not as investments. The value they add to worth is ignored or at least seriously underplayed.

Some sophisticated institutional investors try to adjust for this, but it is easy to miscalculate how much firms are reinvesting. That is a key factor — firms’ ability to reinvest heavily at high rates of return is crucial for their long-run performance.

The backbone of economies used to be tangible – that is physical – capital. But now what makes companies distinctive and therefore valuable is no longer primarily their ownership of physical assets.

The spread of manufacturing technology beyond the rich world has taken care of that. Any new design for a gadget or garment can be assembled to order by contract manufacturers from components made by any number of third-party factories. The value in a smartphone or a pair of fancy athletic shoes is mostly in the design, not the production.

In service-led economies the value of a business is increasingly in intangibles – assets you cannot touch, see or count easily. It might be software; think of Google’s search algorithm or Microsoft’s Windows operating system. Other examples are a consumer brand such as Coco-Cola, a drug patent, or a publishing copyright.

A lot of intangible wealth is even more nebulous.

Complex supply chains or a set of distribution channels, neither of which is easily replicable, are intangible assets. So are the skills of a company’s workforce. In some cases the most valuable asset of all is a company’s culture: a set of routines, priorities and commitments that have been internationalized by the workforce. It can’t always be written down. You cannot easily enter a number for it on a spreadsheet. But it can be of huge value all the same.

Accounting for intangibles is chaotic because of uncertainties. The more leeway a company has to turn running costs into capital assets, the more scope there is to manipulate reported earnings. And not every dollar of R&D or advertising spending can be ascribed to a patent or a brand. That is why, with few exceptions, such spending is commonly treated in company accounts as a running cost like rent or electricity, not an investment.

Intangibles have important implications for investors. Earnings and book value have become less useful in gauging the value of a company. Profits are revenues minus costs, but if a chunk of those costs are not running expenses but actually capital investments in intangible assets that will generate future cashflows, then earnings are understated. And so is book value. The more a firm spends on advertising, R&D, workforce training, software development, the more distorted is the picture.

For a young company able to grow at an exponential rate, future opportunity will account for the bulk of valuation. For such a firm with a high return on investment it makes sense to plough back profits rather than distribute them, and to borrow to finance further investment .

As an investor, how can you address the problem of intangibles, assuming you want to stick with principles of a system that made men like Warren Buffett rich, rather than switching to the higher-risk strategy of growth investing?

A simple measure for intangibles

Investment Bank Morgan Stanley says, in a recent excellent and detailed report about intangibles, that investment in them is largely going to be found in the income statement “within ‘selling, general and administrative (SG&A), which capture costs not directly related to making good or providing a service.”

Unfortunately there is no easy way to differentiate spending needed to maintain  current operations from spending to pursue value-creating growth. However Baruch Lev, a New York professor of accounting, has developed a comparatively simple index for intangibles – R&D plus SG&A spending as a percentage of assets. It enables you to compare one company with its peers. Research has shown that you are likely to do better buying firms with high intangible asset value.

My own final comment about value investing is that you should not depend completely on standard metrics such as price-to-earnings, price-to-book and free cash flow.  Take into account factors that cannot be rated mathematically such as competence of management, service efficiency, corporate reputation, abundance of new products, excellent design, marketing vigour — intangibles that increasingly determine investment value.