Reports of value investing’s demise have been greatly exaggerated…
By Abdulaziz Alnaim, Portfolio Manager, Mayar Fund
If I was given a dollar for every time someone told me that value investing is dead over the course of my investment career, I probably could have retired by now. Of course, it is undeniable that many self-proclaimed value investors have had a difficult ride over the past 15 years. There have been periods of underperformance before but never this long and never this deep. The relative underperformance of value indices against the wider market since the end of 2006 is approximately 60% depending on which index is used.
The big question is why this dip has been so large and lasted for so long. While some people have argued that it proves that the value premium never existed, the empirical data supporting the existence of a value premium is too strong to dismiss.. Another argument being made is that value investing simply became a crowded trade, but that is inconsistent with the strategy’s relative valuation widening and it isn’t supported by fund flow data either. A far more likely explanation, I think, is that the economy evolved and many value investors have not evolved with it.
Traditionally, value stocks have been defined as those with a low price-to-book ratio (“book” is a company’s shareholders’ equity or net assets). Historically, most businesses generated profits by deploying capital into productive assets (such as plant and equipment) and then earning a return on that capital by producing a product. As a result it made perfect sense to expect that, if an investor paid a lower price to acquire the productive assets of a company (indirectly by buying the shares), that investor would earn a higher return on their money. Experience (and later Fama-French) provided ample supporting evidence for this argument. Value investing worked!
But the world of business has changed over the past couple of decades. Many companies no longer need to deploy so much capital to earn a profit and, even those who do, mostly deploy it into intangible assets that accountants don’t “count” on the balance sheet and so aren’t part of that old “book value”. Such businesses are often referred to as “asset light” even though in reality the productive assets haven’t disappeared – it’s just that the accountants choose not to count them.
So, while in the past there was a strong relationship between a company’s shareholder equity and its profitability, that is no longer the case.
Further, because accountants immediately expense instead of capitalizing investments into intangible assets, a growing business would now have both lower earnings and a lower book value than an old-fashioned one that requires physical assets. These “asset light” businesses would, holding everything else equal, have a higher price-to-book and a higher price-to-earnings multiple. They appear more “expensive” and are thus included in the growth indices instead of the value ones even though someone doing a proper valuation job would conclude that both companies are equally valued.
An ever-increasing part of today’s economy is comprised of these asset-light businesses and traditional valuation tools are creating an irrational bias against them within value portfolios.
And we’re not just talking about technology companies here. A barbershop with a loyal and recurring client base is a very valuable business and its loyal clients are really an asset, even if it doesn’t appear on its balance sheet. In fact, I think much more of a real asset than the barber’s chair they sit on, which does show up on the balance sheet.
Another example is subscription businesses. Such businesses often spend a lot of money upfront on advertising and other marketing activities to acquire customers. They then recoup their investment over the lifetime of the subscription. That spending doesn’t appear on the balance sheet and reduces earnings in the short term, making the company look more optically expensive for users of traditional valuation multiples than it really is.
Ideally, I think that accounting rules should be updated to measure and reflect the true economic performance of companies. Alas, neither I nor most investors have the ability to make that happen and so until the accountants change their minds, I think we must adjust how we look at things.
If value investors continue to fixate on traditional valuation metrics, they will find themselves confined to an ever-shrinking part of the market and one that is not representative of the overall economy.
At Mayar we try to figure out the true earning power of the companies we invest in by normalizing earnings to better reflect the company’s earning power in a steady state and we look at long term cash flows to better capture customers lifetime value. We want to buy companies at a low multiple of their “real” earnings and not what the accountants say they’re earning. It’s not perfect and it requires a lot of judgment calls but as John Maynard Keynes said, it’s better to be roughly right than precisely wrong.