Has your value definition just expired?
Index providers question whether book-to-price provides a suitable definition of the value factor. They argue that intangible assets such as brand capital and technological know-how play an increasing role, but are not recognised in reported book values.
Many providers prefer to combine several accounting ratios to define value. They argue that a composite of valuation measures using earnings, sales or cash flows will be better able to capture the true value of a stock.
Such comments reflect the idea that value indices should mimic the traditional investment practice of active managers, who search for securities that are under-priced relative to their true value. But it would be naïve to think that a combination of accounting ratios could capture the true value of a stock. The value factor was never meant to provide a view on securities valuation. Instead, factor investing builds on insights from asset pricing that have identified patterns in the cross section of expected returns. Exposure to the value factor captures differences in expected returns across stocks that reflect compensation for risk.
In particular, value firms tend to be riskier than growth firms because their value is mainly made up of assets in place – rather than growth options. Firms with high capital stock will have difficulty downsizing to adapt to an economic shock. This leads value firms to suffer in bad economic times.
From this perspective, omitting intangible capital from the book value is problematic if it contributes to risk like physical capital does. If intangible capital is costly to reverse, holding a large stock of intangible capital may increase a firm’s risk and lead to compensation for stockholders. Empirical research has shown that investment in intangible capital is indeed costly to reverse and increases systematic risk.
Intangible capital also exposes firms to shocks in financing conditions in the economy. For example, firms which rely on specialised know-how are exposed to a risk of key talent leaving the firm. Such talent dependency increases the risk exposure of firms to financing constraints, as key talent will tend to leave financially-constrained firms when financing conditions deteriorate. Similarly, highly innovative firms may have to abandon R&D projects under financial stress, leading to additional losses in bad times. More generally, firms cannot use intangible assets as collateral, exposing them to a risk of tighter financing constraints in bad economic times.
There is a simple answer to the problem that reported book value excludes intangible assets: we can adjust book values to include unrecorded intangibles. The academic literature has established measures of intangible capital. Rather than dismissing book-to-price as outdated, we can update how it is measured by including intangible capital in the book value.
Economists recognised early on that intangible capital is a crucial part of firms’ capital stock. In addition to physical capital (property, plant and equipment), firms invest in knowledge capital and organisation capital.
Knowledge capital is created through research and development (R&D) that leads to know-how in the form of patents, improved processes, and better product quality. Consequently, it can be estimated using data on R&D expenses. Organisation capital is created through investment in training, advertising and organisational design and leads to a skilled workforce, brand recognition, and customer relationships. A part of selling, general and administrative expenses can thus be used to estimate organisation capital.
Recent research conducted by Scientific Beta assesses an intangible-adjusted book-to-price factor and compares it to other valuation ratios. (A version of the paper, Intangible capital and the value factor: has your value definition just expired?, has also appeared in the Journal of Portfolio Management).
We find that the intangible-adjusted book-to-price factor produces a strong value premium, which remains significant when accounting for exposures to other factors, at 2.09 per cent per year. The intangible adjustment thus improves investment outcomes for multi-factor investors. For an investor who held exposure to six factors, including intangibles in the book-to-price factor increased the Sharpe ratio by more than 10 per cent historically.
The intangible-adjusted book-to-price factor also aligns closely with the risks of the standard book-to-price factor. This alignment with a risk-based explanation is important for investors who are trying to capture a premium that will likely persist, even when it becomes widely known. The intangible-adjusted value factor leads to cyclical variation in market betas and earnings. Value stocks with high intangible-adjusted book-to-price also have higher operating leverage than growth stocks with low book-to-price. These observations suggest that value stocks are riskier than growth stocks.
Using alternative valuation ratios does increase returns compared to book-to-price. However, this improvement is explained by implicit exposures to other factors, such as quality and low risk. Due to this factor overlap, changing from book-to-price to other valuation ratios reduces the Sharpe ratio of multi-factor portfolios. For example, switching from book-to-price to earnings-to-price reduces the Sharpe ratio by 11 per cent for an investor who holds exposure to value and profitability. When using a composite value definition instead of book-to-price, the Sharpe ratio reduces by a similar amount. When adjusting for multiple exposures, the premium of a composite value factor is not distinguishable from zero, at -0.41 per cent per year.
In addition, we show that an intangible-adjusted value factor adds value for investors who are already exposed to a composite value factor. On the contrary, composite value factors do not add value for investors who are already exposed to the intangible-adjusted value factor. We conclude that composite value factors are fully subsumed by an intangible-adjusted value factor, which makes them useless for investors who have access to the intangible-adjusted book-to-price factor.
Combining various valuation metrics is an old recipe from the 1990s. Back then, investors did not have access to other factors, such as quality and low risk. But investment practices have changed. Many investors now hold portfolios that combine multiple factors. Therefore, picking up implicit exposure to other factors in a composite value definition does not improve investment outcomes.
Such composite value definitions may indeed be approaching their expiration date. Book-to-price on the other hand is still looking fresh, especially when unreported intangible capital is included.
Felix Goltz is research director and Ben Luyten is quantitative research analyst at Scientific Beta.