Time to Refresh What Value Means
While select equity factors have historically outperformed the broad equity market over the past 50 years, investors should be careful about assuming that what has worked to identify the right factors in the past will work in the future. The value factor is a good example. As technology and service companies become a larger part of the global economy, the traditional and simpler value metrics don’t work as well. Here is what investors can do.
As we move towards a more services-led economy, corporations are increasingly reliant on “intangible assets” such as ideas, organizations, and corporate culture to create profit. This shift from a manufacturing- and a commodity-based economy to one that is more reliant on technology affects how investors define the value factor. Traditionally, value has been defined as the market equity price per share over book value (equity on the balance sheet) per share. Low price-to-book value companies tended to perform better, as outlined in 1993 by University of Chicago professors Eugene Fama and Kenneth French. This provided the basis for the value factor.
We believe that the fundamental underpinnings that drive the value factor still apply: Value stocks are often viewed as distressed stocks, thus offering higher returns as compensation. Behavioral biases that result in over extrapolation of past growth too far into the future bid up prices of growth stocks, offering a premium for value stocks.
But the traditional definition of value is approaching its expiration date. This is largely due to the fact companies are increasingly relying on organic growth of intangible assets that come about from research and development that are reflected as expenses on the income statement rather than as assets in the balance sheet, a key component in the book value calculation. An energy company, with its plants and large equipment, has more tangible assets that are better reflected in current accounting practices. In reality, research and development may result in profits just like plants and equipment, but accounting practices haven’t caught up to today’s reality.
Diversify the Metrics
We find that changes in accounting tend to affect book value first, earnings second and then cash flow, a very distant third. So it makes sense that there’s much less ambiguity around cash flow than book value and other metrics.
It also makes sense to diversify the metrics to measure value, starting with cash flow, then earnings, and other more dependable metrics to create a mosaic of value measurements to arrive at a better outcome. Exhibit 2 shows how companies with the highest cash flow historically outperformed those with most attractive (lowest) price-to-book ratios.
Neutralize and Combine
This troubling issue not only can skew comparisons between individual companies, but between sectors (variation in intangible assets) and regions (variation in accounting practices) as well.
All of this has to be considered when creating the definition of value, which is key to separating what is real value and what isn’t. With more than two decades of researching factors and investing in them, we have learned a few ways to combat this when we design our portfolios.
First, we keep our factor investments sector and region neutral, meaning we don’t overweight or underweight sectors versus the market. This helps to remove some of the noise that can hurt the purity of the factors we are targeting.
Also, we combine factors. The quality factor — which includes companies with strong cash flows and efficient management — can be combined with value to potentially improve performance. We have found that this helps to avoid “junky” value stocks that may show low price-to-book valuations but that don’t have strong underlying business.
No Simple Metric
The simple answer to the value problem is that there is no simple metric. Our definition for value takes a more 360-degree approach that considers price-to-book among other measures such as cash flow and earnings. Portfolio design matters, and having the right factor definitions that haven’t passed their expiration dates are a key part of that design.
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