The tempests of change are blowing relentlessly across the globe and the investment world is no exception. Central to this evolution is the growth of intangible assets, ranging from brands and patents to franchise agreements and digital platforms. Accounting practices, however, have failed to keep pace with the advancement of non-physical assets, essentially distorting a company’s accounting earnings and book value figures. This is rendering traditional company valuation metrics, such as the price-book (P/B) and (to a lesser extent) price-earnings (P/E) multiples, increasingly irrelevant.
The development is particularly concerning for value investors who historically have paid close attention to these ratios when making investment decisions. Unless the accounting framework changes, they should use them with caution to avoid value traps or, even worse, companies in structural decline. Indeed, earlier this year SKAGEN Global scrapped the P/B metric from its internal portfolio reporting dashboard and no longer relies on it when screening for potential new investments.
Despite the topic being highly relevant, it remains vastly underappreciated and three areas, in particular, merit further discussion:
1. Intangible assets are increasingly the main driver of value creation
Over recent decades, intangible assets have grown rapidly in tandem with the digitization tsunami and now comprise 84% of the S&P 500 index market value compared to only 32% in 1985. [1], [2] Company capex is nowadays directed more towards digital than physical resources; between 1985 and 2017 the investment rate for intangible assets in US private industries rose from 10% to nearly 15% while falling from 14% to around 10% for tangible ones.[3]
Intuitively, this development aligns closely with our perception of software solutions and data content (intangibles) replacing paper mills and machinery manufacturing (tangibles) as the primary source of future value creation.
A case in point is the asset management industry. Historically, business growth was equated with opening new offices (fixed assets) but today, the same business plan would be executed by hiring software engineers to build an IT platform (intangible asset) for digital distribution to new clients. We see this pattern repeated in virtually every industry segment and yet may only be at the infancy of the digital revolution.
2. Accounting standards do not adequately capture the impact of intangibles
In traditional accounting, fixed assets are usually capitalized on a company’s balance sheet and subsequently amortized over their expected useful life.
For intangible assets, the accounting treatment differs based on whether the asset was created internally or purchased from a third party. Generally speaking, intangible assets developed in-house are immediately expensed through the income statement while the same assets acquired externally would be capitalized on the balance sheet (and subsequently amortized). Besides the obvious inconsistency, this treatment assigns zero asset value on the balance sheets of companies investing large sums of capital into internal product research, brand-building advertising or state-of-the-art software development.
A direct consequence of this method is that reported earnings become depressed. Expressed in finance jargon, the company is currently under-earning, despite typically investing ahead of future revenue generation.
Conversely, companies that don’t invest significantly in intangibles may well be over-earning. This is not to cast doubt on the adequacy of current accounting standards for such companies, but they are typically asset-heavy and capital intensive, and less likely to generate significant long-term shareholder value based on their life cycle stage and the heightened risk to their business model of commoditization.
3. Traditional valuation metrics are losing their predictive power to identify “value”
If accounting principles no longer fully reflect a company’s true financial status, it is unsurprising that their corresponding valuation metrics, based on earnings or book value, carry less weight.
Value investors have historically sought out companies trading at low P/B or P/E multiples. When today’s old-economy companies rose to dominance several decades ago, low P/B ratios were a useful tool to identify undervalued equities. However, research shows that a low (unadjusted) P/B multiple has gradually lost its predictive power of equity value creation over the past 35 years.[4]
Similarly, the P/E ratio for a company that is temporarily under-earning (due to digital investments) will look artificially high and investors may rashly conclude that the stock is prohibitively “expensive”. Conversely, a company over-earning will have an artificially low P/E ratio and the stock may erroneously be deemed “cheap” (though “value trap” may be a more fitting label).
Investors can rectify this paradox by adjusting reported accounting figures but many appear to take them at face value and therefore base investment decisions on misleading valuation multiples. This also questions the validity of comparing valuation multiples over long stretches of time, whether for an index or a stock. Companies themselves increasingly report adjusted earnings, a practice which goes some way to addressing misleading P/E ratios but raises another set of concerns.
It is also worth noting that P/B and P/E represent two of the three variables used to determine stock inclusion in the widely followed style index, MSCI World Value.[5] Could this outdated classification methodology be a reason for the long-term underperformance of value indices post the financial crisis?
In conclusion, low P/B and P/E multiples should no longer instinctively and unreservedly be considered a North Star for attractive investments because they increasingly – but not always – signal value traps, rather than value opportunities, due to the impact of intangible assets. Still, evaluating intangibles forms a core part of value investing to find companies that trade below their long-term intrinsic value with an attractive risk-reward profile.
Inertia, simplicity and skewed incentives hamper accounting progress
If the rise of intangible assets is driving valuation metrics based on traditional accounting figures toward obsolescence, why do financial market participants still report and rely on them?
This is a valid question. We believe there are three related factors which are delaying the implementation of updated accounting principles that would be more suitable for today’s digital world.
1. No superior alternative is immediately available.
Although accounting practices are arguably behind the curve, there is no credible substitute currently available to resolve the problem. The situation is further complicated by the fact that the corporate world comprises both old-economy (few intangibles) and new-economy (many intangibles) firms, necessitating a common set of accounting standards that cover both company types, as well as those in transition. However, complexity is not a valid excuse for inaction. Some 50 years ago mankind put a man on the moon. Compared to this remarkable feat, improving global accounting standards seems like a relatively mundane task. Nevertheless, this difficulty plays into the hands of status quo bias, a well-documented human cognitive preference that favours preserving the current state of affairs.
2. Simplicity trumps complexity.
Valuing intangible assets such as brands, data sets or digital platforms is inherently more difficult than estimating the fair value of fixed assets such as a building or a piece of machinery. Additionally, quickly extracting a couple of accounting-based figures from a company’s financial statements to compute a P/E or P/B multiple that supposedly give a valuation snapshot is far more convenient than conducting bottom-up fundamental analysis across its asset base to derive a fair value of the stock. This shortcut is particularly tempting and convenient at a time when quantitative algorithmic trading reportedly outnumbers fundamental stock picking by nine to one (measured by volume) in the equity market.*
* CNBC. Just 10% of trading is regular stock picking, JPMorgan estimates. June 2017.
3. Financial intermediaries lack incentives to add valuation clarity.
The dirty little secret of the investing world is that brokers, investment banks and other middle-men who earn a commission on equity trading have no real interest in promoting higher transparency, in our view. A valuation framework that is opaque, disparate and subjective makes it easier to argue creatively that virtually any security is under or overvalued, thereby encouraging its owner to trade. This practice facilitates the legal peddling of purportedly undervalued securities ad nauseam to less-informed investors. Suffice to say, some very powerful forces in the fi nancial markets have little reason to better align accounting practices with the modern corporate world.
References:
[1] AON. 2019 Intangible Assets Financial Statement Impact Comparison Report. Global edition. April 2019.
[2] While goodwill undoubtedly inflates the figure, we believe that other intangible assets, which arguably are materially undervalued, to some extent compensate for this effect.
[3] Lev, Baruch. Intangibles. Stern School of Business, New York University. July 2018. Note that the investment rate represents non-residential business investment relative to business sector gross value added.
[4] Lev, Baruch, and Feng Gu. The End of Accounting and the Path Forward for Investors and Managers, 2016.
[5] MSCI. MSCI World Value Index (USD) Fact Sheet dated 28 June 2019. P/E is on 12 months forward basis. The third variable is dividend yield. Available at www.msci.com.