Brad Neuman: A Multitrillion Dollar Issue

September 2019 Update:

Expecting a Reversion to the Mean in Style Investing?  Expect to Be Disappointed.

In an important paper, professors Baruch Lev and Anup Srivastava at the Stern School of Business and Haskayne School of Business at the University of Calgary, respectively, detail severe structural problems with the traditional definition of value investing that have important implications for style classification and investing. The main issues discussed are the use of price-to-book value and the inherent “glaring accounting deficiencies of intangibles.”  The paper makes the following points:

  1. Accounting deficiencies have adversely affected value investing as the corporate investment rate in intangible assets, which are missing from book value, has increased

  2. Capitalizing intangibles changes the classification of about half of stocks and improved the performance of the “value” strategy in 35 of the past 39 years

  3. Stocks are spending longer time periods in the same category, contravening the traditional expectation of mean reversion of value stock performance 

  4. The most important variable in moving from value to growth is a company’s investment in research and development

  5. The likelihood of a resurgence in value investing “seems low” in the author’s opinion

Please See Brad’s Original Blog From January 2019 Below:

Charlie Munger, Warren Buffet’s long-time business partner, recently gave some advice to money managers, saying that they are “like a bunch of cod fishermen after all the cod’s been overfished. They don’t catch a lot of cod, but they keep on fishing in the same waters. That’s what’s happened to all these value investors. Maybe they should move to where the fish are.”

Why would Munger suggest that investors’ perspective of value should change? Maybe it’s because the economy and stock market have changed.

For several years now, we have been raising the idea that current methods of style classification may have a structural issue, contributing to the dramatic 44% outperformance of growth as compared to value over the past decade.i Indeed, one article a couple of years ago detailed our ideas under the headline “Is Growth the New Value?”

The biggest issue we see is that accounting standards have failed to keep pace with the changing economy. This is a problem because style classification affecting the allocation of trillions of dollars of assets is determined in large part by the accounting-dependent metric of price-to-book value.ii

As we detailed in our 2019 Market Update, we believe book value is no longer representative of or tied to a company’s true earnings power. That is because over the past 40 years, companies’ investment rate in physical capital fell by 35% while the investment rate in intangible assets grew by almost 60%.iii What’s the big deal? Intangible assets are generally not represented in book value! While you can go to the balance sheet to find a large portion of the value represented by an automobile manufacturer’s production facilities or a retailer’s inventory, you won’t find such financial line items for assets like the value of Google’s search algorithm.iv

In fact, capitalizing intangible spending such as research and development (R&D) and advertising may change price-to-book values significantly. For example, when we made those adjustments to the Russell 1000 Growth Interactive Home Entertainment sub-industry (i.e., video games), the price-to-book value declined from 4.2x to 2.8x, which is actually below the weighted average price-to-book value of the Russell 1000 Value index. So are these growth stocks, as they are currently classified (the weighting is over 8x higher in the Russell 1000 Growth than the Russel l 1000 Value) or are they value stocks?

Recent research from NYU professor Baruch Lev shows that adjusting price-to-book values by capitalizing R&D and selling, general and administrative (SG&A) expenses would dramatically improve performance of the lagging traditional price-to-book value metric.v Clearly, the concept of what is growth and what is value has been obscured by accounting.

As a result of these accounting issues, investors may be inadvertently allocating capital based on business models—with New Economy digital companies that utilize intangible assets classified as growth irrespective of their valuation while Old Economy companies that utilize tangible assets may be classified as value. As long as this persists, it may be an incremental tailwind for the growth style of investing. While we are not suggesting that value investing will always underperform, understanding the flaws in the methodology is critical because the only thing worse than achieving poor investment results is doing so by believing you are invested in something that you are not.

​iRussell 1000 Growth total return relative to​ Russell 1000 Value total return for 10 years ended December 31, 2018 ​

ii There is approximately $9 trillion in assets under management benchmarked to or invested in products based on the Russell U.S. Indexes, which use a composite value score to weight or classify stocks. Price-to-book value makes up 50% of that score. The other 50% is comprised of the I/B/E/S forecast medium-term growth (2 year) and sales per share historical growth (5 year) statistics, respectively.

iii Baruch Lev and​ Feng Gu, “The End of Accounting,” John Wiley & Sons, 2016.

iv In Google’s 10-K it says that capitalized costs (those that would appear on the balance sheet) were “not material” despite the fact that it spent approximately $43 billion in R&D over three years​

The views expressed are the views of Fred Alger Management, LLC as of October 2019. These views are subject to change at any time and they do not guarantee the future performance of the markets, any security or any funds managed by Fred Alger Management, LLC. These views are not meant to provide investment advice and should not be considered a recommendation to purchase or sell securities.​

This material must be accompanied by th​e most recent fund fact sheet(s) if used in connection with the sale of mutual fund shares. Fred Alger & Company, LLC serves as distributor of the Alger mutual funds.
Risk Disclosure: Investing in the stock market involves gains and losses and may not be suitable for all investors. Investment return and principal value of an investment will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. Many technology companies have limited operating histories and prices of these companies' securities have historically been more volatile than other securities, especially over the short term. Technology companies may also face increased competition, government regulation, and risk of obsolescence due to progress in technological developments.​