It's been a tough time for value investors. Earlier this year, a research report from Goldman Sachs noted that value investing -- selling higher-valued stocks and buying undervalued ones -- no longer provided investors with the same overperformance as it once had. In fact, the strategy would have resulted in a cumulative loss of 15% over the prior decade, while the S&P 500 has nearly doubled.
That's a significant shift: In 1997, Professors Eugene Fama, a Nobel prize winner widely considered the father of modern finance, along with Kenneth French, published a research study showing that during the 20-year period ended 1995, the difference between investing in low book-to-market multiples (value stocks) versus high multiples (growth stocks) was 7.6% per year.
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The retreat from value investing has been particularly tough for billionaire David Einhorn. After underperforming the S&P 500 by 10.9 percentage points year to date through September, the value-oriented hedge fund manager seemed despondent in his investor newsletter (emphasis mine): "The market remains very challenging for value investing strategies, as growth stocks have continued to outperform value stocks. The persistence of this dynamic leads to questions regarding whether value investing is a viable strategy."
Everybody's favorite culprit
Amazon's most valuable assets at its 2017 robotics challenge. Image source: Amazon.com.
Both Einhorn and cable mogul John Malone have identified the culprit that's destroyed traditional value investing: Amazon.com (AMZN -2.56%). After jokingly calling the company the "Death Star," Malone noted that the richly valued company would disrupt every industry on the planet. Einhorn wrote, "Our view is that just because Amazon can disrupt somebody else's profit stream, it doesn't mean that Amazon earns that profit stream. For the moment, the market doesn't agree."
Value can no longer simply be assessed by a balance sheet
Traditional value isn't dead, but rather the definition of value has changed. Fama and French used price-to-book as their dominant metric. Broadly, this favors more "stuff" on the books -- assets such as plants, machines, equipment, and buildings. A report from 13D research, by way of The Reformed Broker, noted that the five largest companies by market capitalization in 2007 were mostly in asset-heavy industries: PetroChina, ExxonMobil, General Electric, China Mobile, and Bank of China, and were worth a collective $2.3 trillion.
Today, the top five companies are Apple, Alphabet, Microsoft, Facebook, and Amazon, which are now worth $3 trillion with fewer assets (excluding cash) and 44% fewer employees.
However, the assets are the employees, who drive considerable revenue and dominate their respective markets through scale. For example, Facebook and Alphabet collectively are expected to take 63.1% of all U.S. digital advertising spending, according to eMarketer, and take nearly 100% of the year-on-year growth.
GAAP does a poor job of accounting for 21st-century value
The issue for value investors is it's hard to measure non-tangible assets and employee quality, but it's necessary. In 2013, Bloomberg noted that as little as 7% of the value of large corporations is from tangible assets, with intangibles such as patents, trademarks, and copyrights accounting for more than 90%. Unfortunately, generally accepted accounting rules do a poor job of accounting for intangible assets on both the balance sheet and the income statement. Employees are not a bookable asset, and using the price-to-earnings ratio is a poor metric to value companies with high intangible assets, because the internal costs of patent development are mostly expensed as occurred -- not capitalized, where they appear on the balance sheet -- while the economic benefits often occur later and over multiple periods.
Value investors need to incorporate intangible assets into their analysis, because these trends are only accelerating. It isn't that value investing is dead -- it's just the definition of value has changed, and investors need to change along with it.
