Invest Smarter by Understanding Style Classification
Intangible Assets as a Percentage of Market Capitalization
How tall is a stack of 9 trillion $1 bills?
Companies' market values are now driven by
Source: FactSet. Most/least innovative stock excess performance is derived from highest and lowest S&P 1500 quintiles based on research and development (R&D) as % of sales, normalized for market value, using one month returns for 10 years ending 04/30/19. *Baruch Lev and Suresh Radhakrishnan. "The Stock Market Valuation of R&D Leaders."
Company's book value stays the same.
Bank A Uses:
...and return to Earth. It's a lot of money!
The magnitude of the P/B metric issue has grown as a result of changes within the U.S. economy: companies have been increasingly investing in intangible assets. And this trend, we believe, is likely to strengthen.
Growth Leads the Pack
Growth has outperformed Value by
over the past 10 years
Whose advice should you trust? Actually, research suggests that you can trust yourself if you are able to distance yourself from your own situation. This self-distancing can enable you to make wiser decisions in investing and in life... Read More
Value stocks have lower prices relative to their underlying assets. In theory, a company’s underlying assets could imply earnings potential. If a car manufacturer’s factory is only operating at 50% capacity, the company’s stock price may be low relative to the company’s underlying assets and earnings that could be achieved if the factory is more fully utilized as a result of a stronger economy or the introduction of new car models.
The P/B metric is the most significant metric used when classifying stocks as Growth or Value as part of constructing indices, especially in the case of Russell, which is the dominant provider of style indices.
The Broken Tool
Cumulative Excess Return
The Inner Workings of Style Classification
How is it possible that Company A experiences no change in book value but Company B experiences a decline? Click to find out.
We believe the underperformance illustrated above is a result of the P/B metric no longer incorporating most of a company’s assets at a time when intangible assets have been growing rapidly in proportion to tangible assets. The P/B metric is no longer strongly linked to most companies’ earnings power, which was previously driven primarily by tangible assets such as factories. Therefore Value investing is no longer working, in our opinion.
Unlike many companies considered Value companies, Growth companies have successfully used intangible assets and innovation to capture market share and build durable earnings growth by disrupting their respective industries. This has led to the outperformance of companies that have invested a larger portion of their revenues in research and development.
A Multitrillion Dollar Issue
The views expressed are the views of Fred Alger Management, LLC and Alger Management Ltd. (together with their affiliated entities “Alger”) as of August 2019. Alger has used sources of information which it believes to be reliable; however, this publication is not intended to be and does not constitute investment advice. These views are subject to change at any time and they do not guarantee the future performance of the markets, any security, or any funds managed by Alger. References to or implications regarding the performance of an individual security or group of securities are not intended as an indication of the characteristics or performance of any specific sector, industry, security, group of securities, or a portfolio and are for illustrative purposes only.
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The Weak Link of the P/B Metric
To better understand this concept, consider the following example. The Russell 1000 Interactive Home Entertainment sub-industry, which consists of videogame companies, has a P/B ratio of 4.2x. What happens to the P/B if the value of intangible assets is fully accounted for? Click below to find out.
$100 million to open a virtual bank using software and digital services to acquire and service customers
Software and digital services are intangible assets, so they are generally expensed and not included in book value.
Russell 1000 Growth
The Broken Tool
Realigning Our Perspective on Valuations
S&P 1500 Index
To begin, please scroll down.
Tying it All Together
Growth stocks and even entire sectors that have high P/B valuations may be more reasonably valued than their flawed P/B metric implies.
New Economy Companies Are Different
Source: Alger. Old Economy and New Economy companies are delineated based on their percentage of tangible and intangible assets. This example is not representative of any one particular company.
While we monitor statistically accepted metrics of risk such as downside capture, beta, and standard deviation, we believe they are an imperfect shorthand intended to capture fundamental risk. Read our thoughts in the latest edition of Capital Markets... Read More
Russell 1000 Index
The style classification issue and the outdated P/B metric are growing problems. The section below focuses on shortcomings of the book value portion of the P/B metric.
The image below illustrates the considerable performance difference among innovative companies and companies that haven’t fully embraced new technologies.
The Weak Link
Investments in intangible assets are usually expensed, and thus do not appear on a balance sheet
Markets have been volatile in recent months but Growth has beaten Value over several significant measurable periods. One key factor may be that accounting standards have failed to keep pace with the changing economy.... Read More
In this three-minute video, Brad Neuman expands on the troubled P/B metric and why innovation is contributing to the divergence in the performance of the Growth and Value categories.
The flaw in the P/B metric has practical consequences for investors as explained in the following section.
Just as many individuals don’t realize they are traveling more than 1,000 miles an hour due to the Earth orbiting the sun, many equity investors are unaware of what we believe is a flawed method for allocating assets between the Growth and Value categories. The flaw involves the out-of-date price-to-book ratio. Knowledge of this problem is essential, we believe, to making better investment decisions and understanding the historical underperformance of Value stocks.
It is difficult to appreciate the scope of this situation, but consider that over $9 trillion in assets are currently indexed to or invested in the Russell indices (which include the Growth and Value style indices).
$100 million to purchase land and build branch locations
Clearly the P/B metric is an outdated tool. We believe the low P/B investing style was a significant driver in the 108% outperformance of Value versus the broad market over the 10-year period ended 1985. More recently, the portion of intangible assets has grown among corporations and the Value category underperformed during the past 10 years.
Positive performance of growth equities that has frequently occurred during past periods of weakening earnings growth can possibly help investors keep market volatility in perspective.... Read More
Company's book value declines.
A Decade of Outperformance
Let’s take a look at the earthly consequences of this multi-trillion dollar issue.
We are currently in the midst of a significant divergence between growth and value investing styles, driven by powerful secular trends impacting the equity landscape.... Watch Here
The image below illustrates how dramatic this change has been.
Click here to find out
The image below illustrates the difference in the types of assets that old economy companies and new economy companies invest in.
Traditional wisdom maintains that Growth stocks have higher market prices relative to their book values.
Book value is simply the net value of a company’s assets, such as real estate, plants and equipment. The ratio of a company’s market price to its book value is called the price-to-book ratio or P/B.
of the P/B
The image below illustrates this performance gap.
In addition to software, other intangible assets include advertising, patents and research and development. Intangible assets have become increasingly significant with new economy companies, or those that are leaders in innovation, such as information technology and ecommerce businesses. Alphabet is an example. Its most valuable asset is its Google Internet search algorithm, which is intangible.
Price-to-book value used to be a good indicator of the market’s expectation of stocks. Now, however, we believe this metric is not functioning as intended.... Read More
Research & Development
Innovative Companies Have Outperformed Over the Past Decade
Studies have shown–and our research demonstrates–that the most innovative companies grow their sales, earnings and stock prices faster*
More on Style Divergence
The Changing Face of the U.S. Economy
Russell 1000 Value
The Growing Prominence of Intangible Assets
The interaction below helps explain how intangible assets play a problematic role in calculating book value, which in turn impacts P/B.
A stack of 9 trillion $1 bills could reach the moon…
Source: Ocean Tomo. Market capitalization is that of the S&P 500 Index.
Dan Chung: The Appeal of Growth Equities When Earnings Growth Moderates
The flaw in calculating book value can easily distort our perspective when we look at the P/B of a company or even an entire industry. The following section provides a real life example of this issue.
Source: FactSet for the 10-year period as of 3/31/19, relative to the Russell 1000 Index.
Why Is Book Value Problematic?
Rather than rely solely on style classification based on the outdated P/B metric when allocating assets, we believe investors should use in-depth fundamental research to find innovative companies. We believe Growth stocks should benefit from innovation, while Value stocks that appear cheap may simply be victims of change.
In closing, we believe the accelerating pace of development and adoption of innovation is creating attractive investment opportunities while pushing the economy forward.
Charlie Munger, Warren Buffet’s long-time business partner, recently gave some advice to money managers, saying that they are “like a bunch of cod fishermen after all the cod’s been overfished."... Read More
Click here to see the impact upon the book value of each company.
Bank B Uses:
Source: Alger as of January 2019. Adjustments consist of capitalizing the last three years of research and development and advertising.