If you know what the FANG stocks are, then you’re probably aware that over the last few years the markets have been especially kind to technology companies with outsized growth prospects. Just the fact that a subset of these companies have their own acronym demonstrates how popular it has become to invest in high-growth companies.
Similarly, you may have heard that value investing has fallen out of favour among many investors. In fact, a Google search for the phrase “is value investing dead” returns 19,200 results (19,201 after we publish this!); for comparison, a search for the phrase “is Jon Snow dead” returns 19,000 results. So this topic is undoubtedly on people’s minds.
It’s easy to see why some people may think that value investing is a thing of the past: the following chart shows how the Russell 1000 Growth Index has outperformed the Russell 1000 Value Index over the last five years. We consider ourselves value investors, so charts like this pique our interest: we have an inherent interest in whether our chosen profession is more or less dead than the King of the North.
But what is value investing? If you’re reading this blog you must have at least some notion of the term. For the people who determine what stocks to put in the Russell 1000 Value Index, it’s easy. They use one metric: price-to-book (“P/B”) ratio. That is to say, stocks with low P/B ratios are included in their value index.
The P/B ratio has long been a popular choice to define what is a value investment and what isn’t. In The Intelligent Investor, Ben Graham, the father of value investing, wrote that the price paid for a company “should not be more than 1½ times the book value last reported”. As The Intelligent Investor was originally published in 1949, it’s fair to say this metric has enjoyed some longevity.
What is book value?
We should probably pause here to review what book value is, for those of you who have better things to do than read financial statements every day. Also called “net asset value”, it’s simply the value of the assets a company has minus its liabilities, as reported on its balance sheet. For example, if a company purchased a $10 million factory and had $6 million in principal outstanding on the loan it used to fund the purchase, its book value would be $4 million. If this same company had one million shares outstanding, its book value per share would be $4.00. Adhering to Ben Graham’s rule of thumb, a value investor wouldn’t pay more than 1½ this book value per share – $6.00 – to purchase a share in the market.
Since public companies have to report their book value, this information is widely available. And since modern computers allow us to multiply any number by 1½, it’s quick and easy to figure out what stocks trade at a price lower than Ben Graham’s value threshold.
Now, some of you may be wondering why anyone would pay up to 1½ times the book value of a company to buy its shares. After all, if a company had assets of $x and liabilities of $y, shouldn’t the company simply be worth $(x-y)?
Unfortunately, it’s not that simple. And it’s not that simple thanks to the accounting profession. You see, accountants have decided that companies do not have to report what their assets are currently worth. Instead, they can report the historical cost of the asset. So if a company bought a plot of land 25 years ago for $100,000, they can report the value of that land on the present-day balance sheet at $100,000, even though it’s likely worth a great deal more than that today.1
So Ben Graham’s rule of paying up to 1½ times book value is a crude adjustment that recognizes that a company’s assets are probably worth more than the value reported on the balance sheet. This adjustment worked well in 1949 when most public companies were… I dunno… railways or radio manufacturers or steel companies or fallout shelter builders. Basically, it worked well when most public companies had a lot of tangible assets on their balance sheet.
A lot has changed since 1949
Fast forward to 2019 and some of the most visible public companies have very few tangible assets. Let’s take the FANG stocks as an example. Facebook (FB-NASDAQ), Amazon.com (AMZN-NASDAQ), Netflix (NFLX-NASDAQ) and Google (GOOGL-NASDAQ) all own a lot of servers and buildings. But these tangible assets are a drop in the bucket compared to the code written to create these companies’ proprietary software. And accountants are really, really bad at coming up with rules to accurately quantify the value of software code.
The result? Facebook has a book value of $84 billion compared to a market capitalization of $510 billion (6.1x P/B), Amazon has a book value of $43 billion compared to a market cap of $918 billion (21.3x P/B), Netflix has a book value of $5.2 billion compared to a market cap of $155 billion (29.8x P/B), and Google has a book value of $177 billion compared to a market cap of $860 billion (4.9x P/B).
Based on Graham’s rule, none of these FANG stocks are anywhere close to being value investments. But that was a rule made for a different time. Modern-day accounting rules do such a horrible job of accurately capturing the asset value of many of today’s technology companies that book value has become useless in some sectors. The people who set the rules for the Russell 1000 Value Index likely know this. But the ease with which a P/B ratio can be calculated supersedes their concerns.
So how does Cowan Asset Management define value investing? Not by using any one metric. Instead, we adopt the philosophy that we want to buy a company for less than its intrinsic value. If a company has high growth prospects but its current stock price doesn’t reflect these opportunities, great! We’ll happily buy it! Similarly if a company’s stock price is lower than its current book value, but the book value reflects outdated assets that are worth much less than their original cost, we won’t buy the company. We believe the trick to identifying proper value investments is to take the time to make up our own minds about what a company is truly worth, not simply trusting accountants’ estimates.
1Nothing in this post is accounting advice. We believe that the accounting explanations we give are generally correct, but the rules are far more complex than we are making them out to be. Please don’t ask us to write an exhaustive blog post about accounting rules. Nobody wants to read that.