Value investing is defined as an investment opportunity having a low price relative to recent profits and/or future profit potential, or relative to the book value of the assets of the target investment. This approach dates back to the 1930’s, and has been more recently popularized by Warren Buffett. However, owing to the nature of the digital economy that we live with today, the tried-and-true methods of value investing are struggling to perform.
Reliance on company furnished information: Value investing relies upon the published information about the company’s accounts – not only the income and expense accounts, but more notably assets and underlying equities. This information was not always clear or discernable until the Securities Act and the Securities and Exchange Act were passed in the 1930’s after the Great Depression. One of the requirements was for each publicly listed company to provide an annual audit by an independent auditing firm. This served to upgrade the amount and quality of information provided about a company’s assets, liabilities, and underlying equities, as well as profitability. In today’s world, many of the best investments do not enable the investor to easily put his hands around all that the company is worth. Amazon, one of the most lucrative and valuable investments in the economy over the past two decades, earns a profit of about 4.1% of each sales dollar. However, for many years dating back to the mid 1990’s the company’s capitalization grew by leaps and bounds without showing any profit at all. How, then, does an investor determine value in such an investment as that?
Increase in intangible assets: The future of value investing as an on-going investment strategy is becoming less and less relevant as more of the economy becomes intangible. In years gone by, if an investor owned an agribusiness for example, he would be able to tangibly determine about how much of a crop the business would be likely to produce compared to the value of the land and equipment used. The same could apply to automobiles as management’s usually determine ahead of time what their production targets would be in order to line up materials. This could then be compared to the value of the factories and equipment the company uses. But the standard evaluation of certain companies can be impacted by the amount of intangible assets it holds on its books.
Evaluating intangible assets: Intangible assets come in many shapes and forms such as patents, software licensing, even a trained workforce or company culture could qualify. But the most common intangible is known as goodwill. Just exactly where does goodwill come from? It is the excess of the cost of an acquisition of another company over the book value of that company. If Company A buys out Company B for $40 million, but the books show the value of Company B as $30 million, the leftover $10 million becomes an intangible known as goodwill on the acquiring company’s books. How are other intangibles measured? By their very nature intangibles other than goodwill do not have clear cut boundaries that investors can look at and evaluate. In some cases, R&D costs along with software development wind up being capitalized making the evaluation of that asset category more complicated. Even goodwill can be muddled by the size and number of acquisitions a company makes. In any case, the more leeway a company has with the valuation of intangibles, the more leeway that same company has to meddle with its reported net earnings.
Conclusions: The appeal of old-style value investing is that the strategy looks at assets that are more concrete than what we often find in today’s digital world. Not every company on the stock exchanges has a plethora of intangible assets. But those that do inhibit value investing calculations of comparing current prices to the net book value of a targeted investment. In today’s digital world, the methodology behind value investing of selecting stocks with a low price to book value could just as well point out a company whose best years are behind them, not coming up.
Sources: Briefing Investment Strategies, The Economist, November 14th 2020.