Addressing the Failure of the Value Factor – ValueWalk Premium
Value investing

Addressing the Failure of the Value Factor

The last decade has seen a marked reduction in the performance of systematic, quantitative value strategies, and particularly so for U.S. markets. One critique has been that the growing importance of intangibles, and the failure of the accounting system to record their value on financial statements, renders value measures anchored to current financial statements, such as book value, useless. New research shows how to address this failure.

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In their 2020 study, Explaining the Recent Failure of Value Investing, authors Baruch Lev and Anup Srivastava suggested that capitalizing research and development (R&D) expenditures and selling, general and administrative expenses, and amortizing this “asset” over industry-specific schedules yield adjusted, and possibly improved, measures of book equity and earnings. Their empirical analysis suggests an improvement for value strategies using such adjustments. Data vendors (e.g., Credit Suisse, HOLT and New Constructs) are now attempting to correct for multiple limitations embedded in the financial reporting systems.

One way that academics and fund managers have tried to address the problem is to use alternative value metrics such as price-to-earnings (P/E), price-to-cash flow (P/CF) and enterprise value-to-earnings before interest, taxes, depreciation and amortization (EV/EBITDA). Many fund families (such as AQR, BlackRock, Bridgeway and Research Affiliates) use multiple metrics. Another alternative is to add other factors into the definition of the eligible universe. For example, since 2013 Dimensional has included profitability as a screen in their value funds. A third alternative is to add back to book value an estimate of the value of intangibles, such as R&D expenses.

Noël Amenc, Felix Goltz and Ben Luyten contribute to the literature with their study, Intangible Capital and the Value Factor: Has Your Value Definition Just Expired?, published in the July 2020 issue of The Journal of Portfolio Management. They examined two methods of addressing the issue of the value of intangibles. They estimated knowledge capital by, “capitalizing past R&D expenses via the perpetual inventory method. For each year, the past year’s knowledge capital stock is depreciated and the current year’s R&D expenses are added to calculate the current amount of knowledge capital. Organization capital is obtained similarly. We capitalize 30% of selling, general, and administrative expenses (SG&A) expenses, assuming that the remaining 70% are expenses to generate income in the current period. For each year, these estimated values for knowledge and organization capital are added to the standard book value of equity. The amount of goodwill to be deducted is directly taken from Compustat. We refer to this alternative as the intangible-adjusted book-to-price ratio (iB/P).”Their analysis was based on annual accounting data for fiscal years January 1975 through December 2017. Following is a summary of their findings:

  • Including unrecorded intangibles in the book value increases the value premium and aligns with risk-based explanations: Intangible capital exposes firms to shocks in financing conditions in the economy; firms with high organization capital are exposed to a risk of key talent leaving; talent dependency increases risk exposure to financing constraints because key talent will tend to leave financially constrained firms when financing conditions deteriorate; and knowledge capital is risky because firms may have to abandon R&D projects in times of financial stress, leading to additional losses in bad times. Firms with high capital, whether physical or intangible, are thus riskier.
  • Many valuation alternatives deliver higher returns than the standard book-to-price measure. The standard book-to-price ratio delivered a return of 2.2% per year. Earnings-to-price, sales-to-price, and cash flow-to-price led to significantly positive returns ranging from 2.8% to 4.2%. Including intangible capital in the book-to-price ratio led to a return of 4.8%. Only the dividend yield factor failed to deliver a positive return.

Value Factor

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