Fixing value


by Carl Van Nieuwerburgh, Fund Manager Quantitative Equity

There are plenty of definitions for value stocks in the investment industry, but in the academic literature one dominates. Typically, the book-to-market ratio has been used to segregate value from growth stocks. Nobel prize winners Eugene Fama and Kenneth French chose this ratio to capture the value premium in their asset pricing model.

The book-to-market’s usefulness for selecting value stocks, has recently been challenged. Not only has its track record degraded, but the question arises on to which extent a company’s book value captures the economic value of modern corporates. Indeed, accounting rules are more suited to track the value of physical assets like factories, machinery and stores on the balance sheet. They are less convincing in tracking the value of intangible assets whose significance has grown over time. Asset-light companies may outsource their production and sell on-line, resulting in intellectual property, brand image and recognition as important determinants of their value.

For prudence sake, the US Generally Accepted Accounting Principles (GAAP) treats Research and Development (R&D) expenditures as expenses rather than investments, even though they can bear fruit for years to come. The same goes for expenditures that create a brand image and recognition, with their effects lasting longer than one year. A part of Selling, General and Administrative expenses (SG&A) leads exactly to that, so a fraction of this line on the income statement, can also be seen as an investment rather than an expense. Ignoring this might be prudent, but because a considerable part of a company’s value cannot be found on its balance sheet, financial analysts have become critical over this practice.

Capitalising R&D and a fraction of SG&A costs are proposed as a solution. This would do justice to the long-term nature of the benefits they bring. Every year, these costs can be considered an investment -increasing (intangible) assets, shareholders equity and the net income of a company. Logically then, the stock of these accumulated intangible assets is depreciated every year -reversing over time the initial positive effect.

The accumulated R&D capital is referred to in the literature as ‘knowledge capital’ and the accumulated fraction of SG&A as ‘organisation capital’1. Whereas the depreciation rate for the latter is fixed across industries, the knowledge capital’s depreciation rate depends on a company’s activity. A pharmaceutical company can hope for a long life for any new drugs it develops given efficient patent protection, whereas the value of a technology hardware manufacturer’s intellectual property typically decays faster.

Significant upward book value adjustments can thus be justified for companies such as Netflix, Amazon, Apple and Alphabet. Their adjusted book-to-market ends up higher than the book-to-market calculated with the book value found in the financial statements.

Another book value correction that can be justified is the deduction of any goodwill registered on the balance sheet in the process of acquiring other companies. Indeed, the rationale for the book-to-market ratio is to capture the difference between a company’s market value and the net asset value of its investments. The exclusion of goodwill from the book value puts companies grown organically on an equal footing with companies that have searched external growth. Again, the relative attractiveness of a company like Apple that has essentially grown organically, will improve versus competitors that searched external growth. This correction is increasingly having more impact as goodwill has become more important on US companies’ balance sheets over the last decades.

While the capitalisation of R&D and a fraction of SG&A does not apply to financial companies, the exclusion of goodwill is a correction that is applicable to this sector as well.

It can be deduced that technological companies will look comparatively more attractive after the book value corrections above. In what follows though, the focus is on the merits of a value investment strategy that uses the adjusted book-to-market ratio to rate companies in every sector. Sectors are weighted in proportion to their weight in the overall universe in the simulated strategy, eliminating the usual value sector biases. The book value adjustments follow the methodology of Park (2019) and the data comes from FactSet. Stocks are selected within the MSCI USA from December 2000 until October 2020.

DPAM’s empirical evidence summarised in the table is strongly supportive for making these book value adjustments. They increase the first quartile portfolio return with 3% per annum compared to a standard price-to-book (PB) investment strategy. Additionally, the fourth quartile return decreases with 1.2% leading to an impressive gain of more than 4% for the performance spread between the first and last quartile.

The adjusted PB -called the PiB (price-to-intangible-adjusted-book)-, also outperforms the dividend yield (DY) and price-to-earnings (PE) strategies. Note that in this study, the DY, PE and PB factors are defined as the forward 12 months ratios based on consensus analyst forecasts gathered by FactSet. The PiB on the other hand, is calculated with historical financial statements. Because the PiB ratio is handicapped by its backward-looking character compared to the other strategies, its outperformance can even be more appreciated.

Importantly, the PiB’s better returns are not associated with higher risk metrics compared to the PE and PB strategies. The DY strategy has a lower drawdown and volatility though. Still, this year it proves more defensive than the DY strategy, as can be seen in the calendar year chart.

1 30% of SG&A is capitalized and subsequently depreciated at a 20% depreciation rate (see e.g. Park, 2019).

Excess return quartile portfolio vs. MSCI USA and interquartile return spread.
Annualized figures for 31.12.2000 – 12.10.2020

Source: DPAM, FactSet and MSCI, 26.10.2020

This chart shows the annual return spreads between the first and the last quartile portfolios. Several observations can be made. Firstly, the PiB factor is clearly still a value factor. The ebb and flow of its success are visibly tied to the success of the other value factors. Secondly, its superior return relative to the PB investment strategy, is not due to one outlier. In fact, there is only one year out of twenty (2007), in which its performance is notably below that for the standard PB. Finally, while the PiB factor has also been caught in value’s downturn over the last few years, it managed to limit the damage significantly better.

Q1-Q4 performance spread for US value strategies
(sector neutral, 31.12.00 – 12.10.20)

Source: DPAM, FactSet and MSCI, 26.10.2020

It can be concluded that capitalising R&D and a part of SG&A expenditures, while deducting goodwill from corporates’ balance sheet conceptually makes sense. Additionally, it brings demonstratable added value to a value investment strategy. While there is some discretion in implementing these corrections -e.g. with respect to the depreciation rates-, the PiB’s benefits are important, even in the US large cap universe. This market is of course characterised by a higher presence of technological companies. Future research could test the strategy in Europe, as well as the merits of an intangible-adjusted earnings yield.


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