Invest Smarter by Understanding Style Classification
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 The flaw involves the out-of-date price-to-book ratio.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).
Let’s take a look at the earthly consequences of this multi-trillion dollar issue.
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.
The Inner Workings of Style Classification
The Weak Link of the P/B Metric
The Broken Tool
Growth stocks and even entire sectors that have high P/B valuations may be more reasonably valued than their flawed P/B metric implies.
The Changing Face of the U.S. Economy
Realigning Our Perspective on Valuations
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
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
Dan Chung: The Appeal of Growth Equities When Earnings Growth Moderates
Growth Leads the Pack
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
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
A Multitrillion Dollar Issue
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
To begin, please scroll down.
More on Style Divergence
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.
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.
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.
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.
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.
Investments in intangible assets are usually expensed, and thus do not appear on a balance sheet
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.
Source: Ocean Tomo. Market capitalization is that of the S&P 500 Index.
S&P 1500 Index
Innovative Companies Have Outperformed Over the Past Decade
Cumulative Excess Return
The Weak Link
The Broken Tool
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
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$100 million to purchase land and build branch locations
Company's book value stays the same.
Bank A Uses:
Company's book value declines.
How tall is a stack of 9 trillion $1 bills?
Click here to find out
New Economy Companies Are Different
Research & Development
The Growing Prominence of Intangible Assets
Companies' market values are now driven by
Intangible Assets as a Percentage of Market Capitalization
A Decade of Outperformance
Growth has outperformed Value by
over the past 10 years
Russell 1000 Growth
Russell 1000 Value
Russell 1000 Index
Source: FactSet for the 10-year period as of 3/31/19, relative to the Russell 1000 Index.
Studies have shown–and our research demonstrates–that the most innovative companies grow their sales, earnings and stock prices faster*
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."
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.
A stack of 9 trillion $1 bills could reach the moon…
...and return to Earth. It's a lot of money!
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 interaction below helps explain how intangible assets play a problematic role in calculating book value, which in turn impacts P/B.
The image below illustrates the difference in the types of assets that old economy companies and new economy companies invest in.
The image below illustrates how dramatic this change has been.
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.
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.
The flaw in the P/B metric has practical consequences for investors as explained in the following section.
The image below illustrates this performance gap.
The image below illustrates the considerable performance difference among innovative companies and companies that haven’t fully embraced new technologies.
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.
Tying it All Together
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.
Investing in the stock market involves gains and losses and may not be suitable for all investors. Growth stocks tend to be more volatile than other stocks as the prices of growth stocks tend to be higher in relation to their companies’ earnings and may be more sensitive to market, political and economic developments. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Technology companies may be significantly affected by competition, innovation, regulation, and product obsolescence, and may be more volatile than the securities of other companies. Past performance is not indicative of future performance. Investors whose reference currency differs from that in which the underlying assets are invested may be subject to exchange rate movements that alter the value of their investments.
The S&P 500 Index is an unmanaged index generally representative of the U.S. stock market without regard to company size. The S&P Composite 1500 is an unmanaged index that covers approximately 90% of the U.S. market capitalization. The Russell 1000® Growth Index is an unmanaged index designed to measure the performance of the largest 1000 companies in the Russell 3000 Index with higher price-to book ratios and higher forecasted growth values. The Russell 2000 Growth Index is an unmanaged index generally representative of common stocks designed to track performance of small -capitalization companies with greater than average growth orientation. The Russell 3000 ® Growth Index is an unmanaged index designed to measure the performance of those Russell 3000 ® Index companies with higher price-to-book ratios and higher forecasted growth values. The indices presented are provided for illustrative purposes, reflect the reinvestment of dividends and do not assess fees and expenses that would have the effect of reducing returns. Investors cannot invest directly in any index. The index performance does not represent the returns of any portfolio advised by Fred Alger Management, LLC and actual client results might differ materially than the indices shown. Comparison to a different index might have materially different results than those shown.
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The following position represented the noted percentages of Alger’s assets as of June 30, 2019: Alphabet Inc., 2.45%.
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Click here to see the impact upon the book value of each company.
How is it possible that Company A experiences no change in book value but Company B experiences a decline? Click to find out.
Software and digital services are intangible assets, so they are generally expensed and not included in book value.
Why Is Book Value Problematic?
of the P/B
Bank B Uses:
$100 million to open a virtual bank using software and digital services to acquire and service customers
Source: Alger as of January 2019. Adjustments consist of capitalizing the last three years of research and development and advertising.