Christopher A. Hopkins, CFA

Christopher A. Hopkins, CFA

Value investing: Out of favor or out of time?

Two generations of investors came of age under a rubric known as value investing. Put simply, the concept involves identifying securities that are currently selling for less than their fair or intrinsic value due to some misperception by market participants. The approach has a certain inherent logical appeal with the added benefit of having worked for most of the time between the 1970s and 2007.

Value investing may be broadly contrasted with an alternative perspective that seeks to identify companies that are expensive now but can expand rapidly to eventually justify a higher price. This perspective, generally called growth investing, has vastly outperformed value over the past 16 year with only brief exceptions. This prolonged reversal begs the question: is value investing an anachronism, or should we perhaps reconsider how we apply it?

Although the term wasn’t yet in use, the concept of value investing traces to the pioneering academic work of Benjamin Graham and David Dodd at Columbia University in the aftermath of the Great Depression. Their work represented the first systematic effort to estimate the “correct” price of a stock based on fundamental factors like earnings, assets, and dividend payouts. This fundamental analysis allowed investors to identify securities whose current market price was below their estimate of the theoretically correct value, suggesting an opportunity for profit (if their estimate was right, and if the market eventually agreed).

The Graham and Dodd school flourished over a half century thanks in part to its most famous disciple, Warren Buffett, and owing to its success in practice became received wisdom and attracted a host of practitioners who produced superior returns up through the financial crisis of 2007.

Since then, not so much, as many value practitioners remain frustrated by the lack of success of a philosophy which is intellectually appealing and empirically sound. Yet growth has, with only brief interludes, smoked value over the past decade and a half. For example, the ETF tracking the S&P 500 growth index has eclipsed its value counterpart by over 200 percentage points since 2007. What changed?

Some of the performance differential can be attributed to a secular shift in the macro economy. Since the financial crisis, monetary policy has been extraordinarily loose as the Fed has tried to offset anemic economic growth. Low interest rates are good for growth stocks, as cheap capital allows more risk taking and supports a longer runway for a higher anticipated return. Between 2008 and 2022, real interest rates (after inflation) remained low or even negative. Value stocks tend to outperform when inflation and interest rates are somewhat elevated as occurred during value’s salad days between 1970 and 2006. In 2022, growth stocks got clobbered as the Fed hiked rates while value investments regained some lost ground. So far in 2023, value is back on its heels as inflation continues to abate.

More importantly, however, are structural shifts that are all around us but whose effect on valuations are harder to capture. The modern service-oriented economy is more digital, dependent on software, processing, cloud computing, virtual transactions, and communications. While we still need mines, factories, and transportation, they comprise a smaller share of economic activity. The shift to more digital assets throws sand in the gears of the traditional valuation machinery.

Graham, Dodd, and their intellectual progeny ciphered valuations in large measure by assessing tangible assets; that is, physical means of production. One important value metric is the price to tangible book (P/B) ratio which divides the stock price by the total value of the hard assets of the company on a per share basis. In Valueland, a low P/B ratio may point to an undervalued stock. In 1950, GM was the world’s largest corporation and valuing the automaker was a relatively straightforward (if cumbersome) task: add up the economic value of the machinery, buildings, work in process, and raw materials. But what about a company like Apple, whose worth is dominated not by factories (Apple outsources most of its manufacturing), but by intellectual property like patents, technology, concepts, creativity, and processes? How many printing presses does Facebook need? These intangible assets do not show up in the traditional metrics like price to book.

Here’s why it matters. In 1975, tangible assets made up 83% of total assets for the companies in the S&P 500. Today, only 10% of their balance sheets are hard assets; 90% of the reported assets for S&P 500 companies are intangibles.

Intangible assets also distort other widely used valuation indicators like price to earnings (P/E), since most of the massive expenditure of these companies on research and development are not capitalized (added to book value) but are expensed just like payroll or the electric bill, decreasing current profits even though the expenditure may generate future revenue as surely as a dump truck or a welding robot. The pervasive shift toward intangible assets renders many of these traditional value markers less relevant or even inoperable.

That is not to suggest that the idea of value investing is invalidated. On the contrary, the key to long term investment success is discovering value that is not yet fully recognized by the market or which eventually materializes. In that sense, all successful investing is value investing: buying low and selling high remains an immutable principle. However, the old tools of the trade need an upgrade for the evolving digital economy and perhaps even a redefining of “value.”

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