Last week, value investors enjoyed a brief moment in the sun.
As news of a COVID-19 vaccine broke, “old economy” value stocks like airlines, banks and oil firms soared.
Value investing was back. And that was a welcome change.
After all, value stocks have had a decade from hell.
Just compare the return of the iShares Russell Top 200 Value ETF (NYSE: IWX) with that of the iShares Russell Top 200 Growth ETF (NYSE: IWY).
Growth stocks have trounced value stocks by more than 3 to 1 over the past 10 years.
What’s worse, growth stocks’ outperformance only accelerated after the onset of the global pandemic.
Professional investors know that value investing isn’t a timing tool.
Still, over an entire decade, you’d think that the market would come around.
The trouble is… it hasn’t.
And value investing’s faithful are… well… losing the faith.
A small army of academics and analysts is struggling to explain away value’s lagging performance.
It’s a courageous effort but all too unconvincing in the end.
The four most dangerous words in investing may be “This time it’s different.”
But this time around, it really might be.
Just as Einstein’s theory of relativity superseded the Newtonian paradigm of classical physics…
Value investing should be superseded by a new paradigm but not abandoned entirely.
Let me explain…
The Origin of Value Investing
Value investing boasts an impressive academic pedigree.
In Security Analysis, first published in 1934, Columbia professors Benjamin Graham and David Dodd offered an analytical framework for calculating a firm’s “intrinsic value.”
Value investing was a radical approach for its day.
Remember, investors were still digesting speculative excesses that gave way to the stock market crash of 1929.
Graham and Dodd provided investors the tools to value a stock.
For example, a price-to-book value below 1 means a company is trading below the value of its net assets – that is, its assets minus its liabilities.
That generally made the stock a buy.
Today, thanks to computers, you can identify and analyze value stocks with a few clicks of a mouse.
Graham and Dodd’s approach worked well for many decades… until it didn’t.
And you can chalk up that shift to the rise of “intangible assets.”
The Intangible Difference
In 2017, exasperated value investor David Einhorn declared, “Value investing may be dead, and Amazon and Tesla killed it.”
Here’s why he may be right…
Value investing stems from an era when cash, factories, tools and machinery determined a company’s value.
That’s far from the case today.
Amazon (Nasdaq: AMZN) trades at 19 times its book value. Netflix (Nasdaq: NFLX) trades at 21 times book value. Even a manufacturing company like Tesla (Nasdaq: TSLA) trades at a price-to-book of 24.
In 2020, a company’s value is far less linked to its ownership of physical assets than it used to be.
And that reflects a fundamental transformation of the economy.
Today, contract manufacturers can assemble any gadget or garment.
The value of an iPhone or a pair of Nike’s athletic shoes is its design, not the factory that produces it.
That’s why Apple products say “Designed in California,” even though they are made in China.
Much of the value of today’s companies is in intangibles.
Think of Google’s search algorithm… or Microsoft’s Windows operating system… or a consumer brand like Coca-Cola.
Complex supply chains, the skills of a company’s workforce and even a company’s culture are significant sources of value.
Network effects also upset the value investing paradigm’s applecart.
Companies like Facebook and Netflix enjoy increasing returns to scale. The additional marginal cost of a new customer is nothing.
Yet a dyed-in-the-wool value investor would value each of these intangible assets at zero.
Time to Shift the Paradigm?
Value investing offers mathematical rigor and an attitude of skepticism in financial markets governed by Mr. Market’s mood swings.
But with its inability to tackle intangibles, value investing doesn’t offer all the answers.
So does that mean we should consign value investing to the dustbin of history?
Not so fast.
The history of investing boasts a long line of alternative valuation methods that turned out to be bunk. (Remember when analysts valued internet companies by the “number of eyeballs”?)
My philosophy is to be flexible.
I’m happy to embrace any approach that works… and to abandon anything that doesn’t.
As the economist John Maynard Keynes observed, “When the facts change, I change my mind. What do you do, sir?”
And if Graham – a contemporary of Keynes’ – were alive today, I’d bet the 2020 edition of Security Analysis would look very different from the 1934 edition.
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