The value investing conundrum has continued this year – chiefly, whether value investing has made a permanent return from the dead. The answer will, unsurprisingly, depend on your definition of value.
Historically, a stock was confined to the ‘value’ bucket when its stock price was considered to be low relative to the net assets of the business – in other words, a low price-to-book (P/B) ratio. Traditionally, most businesses have generated profits by deploying capital into productive physical assets (such as plant and equipment) and then earning a return on that capital by producing a product to sell. 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. This was confirmed by both academic studies and real-world experience.
Value investing was a success. Until, one day, it wasn’t – leaving many investors scratching their heads.
The world of business seems to have reached terminal velocity over the past couple of decades largely thanks to the rise of the internet. Many companies no longer have a need to invest in huge factories and machinery to earn a profit – all they need is a website to get started.
The companies that do invest heavily can deploy it into intangible assets, which include types of intellectual property, such as trademarks. However, accountants don’t “count” these investments on the balance sheet – and so they aren’t recognised as 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.
Perception vs reality
This accounting choice has significant implications for how profitable a company appears. Tangible investment can be ”capitalised”. That is, the amount invested can be spread over the useful life of the asset. If a firm buys an asset for £100 with an expected life of 10 years, that investment can be spread out at £10 per year. In contrast, the same £100 investment in an intangible asset will have an immediate £100 impact in the financial accounts.
As a result, a thriving company would display both lower earnings plus a lower book value than a traditional company deploying 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.
The conclusion is that “value” doesn’t necessarily come from a cheap-looking price-to-book ratio. Instead, we believe that a lot of value is hidden – often in optically expensive stocks. Below are three examples.
Electronic Arts
On paper, Electronic Arts (EA) trades at around 4.5x the value of its book equity (price to book). However, accounting rules mean that all the company's historic research & development and sales & marketing spend is ignored by this typically “value-oriented" valuation metric. When we adjust the balance sheet to show all the assets which have been created though investments, which under the rules are simply expensed in the year incurred, we see that EA's asset base is much larger. And so, what looks like a 4.5x P/B company is actually trading at just 2x price to book.
Visa
Another example, Visa seems to be trading at 8.3x book equity but, it trades at 7.8x book equity (capitalising expenses over 10 years).
What many investors overlook here is the replacement cost. To compete with Visa, a new start-up network would have to be built from the ground up at likely great cost, and would take many years to create the ‘everywhere, all the time’ network effect that both Visa (and Mastercard) enjoy.
Howdens Joinery
Howdens trades at 4.5x book equity, but a closer look tells us that it actually trades at 2.3x book equity (capitalising expenses over five years). Howdens sells exclusively to trade businesses, so its sales and marketing spend today leads to repeat business over many years, with the same customers, versus a company that sells direct to a consumer audience who might only buy from them once in a lifetime.
When looking at high quality, technology-driven businesses, this alternative approach – by matching period of revenues with their associated costs – better reflects the true economics of the business than the traditional value approach of yesteryear. If costs incurred today lead to sales over five years, shouldn’t they be treated the same regardless of whether those costs went into new machinery or marketing spend on improving customer loyalty? We think they should and doing so reveals hidden value.
Aziz Alnaim is portfolio manager of the Mayar Responsible Global Equity fund. The views expressed above should not be taken as investment advice.