Intangible value, or value investing in the new economy
Many things have changed since the 1990s. When I graduated from college in 1994, I didn’t have “email” (the term was coined in 1993), and I was just starting to hear about how a computer could have “windows.” The very next year, Windows 95 was suddenly on all of our PCs, and perhaps even more surprising to some, a couple of years later, the star-of-the-2000’s-stock market Apple was on the verge of going bust. We have all moved on from our dated habits from 25 years ago. No more listening to Hootie & the Blowfish or driving Ford Escorts. So, why are asset managers still using an outdated measure of firms’ fundamental value for value investing?
The US capital stock is vastly different today than in 1995. Rather than consisting mainly of hard equipment, intangible assets are now the most important assets of the country’s largest firms. The value of firms’ intellectual property, customer and supplier relationships, and organizational capital is much greater than the value of their property, plant, and equipment. Yet, the overwhelming majority of intangible assets do not appear on firms’ balance sheets. I strongly believe (and have compiled evidence to support this belief) that this is why traditional value strategies have underperformed over the most recent decades. But, does this mean we should abandon one of the most powerful concepts in asset management, value investing? Of course not! It will always make financial sense to buy cheap and sell expensive. But, just like our operating systems and playlists, the method by which we measure cheap vs. expensive must be updated to fit the modern e-economy.
Traditional value strategies are based on firms’ market-to-book ratio. Value-factor portfolios overweight firms whose market value is too low relative to their fundamental value, with fundamental value measured as the book value of the assets on firms’ balance sheets. Intangible value is based on the same basic idea – buy cheap and sell expensive. However, it uses a more modern anchor for fundamental value, one that is more suitable for modern US firms (especially large ones). Intangible value adds accumulated investment in things like customer capital and brand loyalty, as well as employee know-how and logistical systems to firms’ book value when measuring fundamental value. The updated value measure accomplishes two things.
First, because the updated fundamental value in intangible value is still measured relative to market value, it is a true value measure.
Second, intangible value strongly outperforms traditional value.
Figure 1: Cumulative Returns of Traditional and Intangible-Adjusted Value
Figure 1 shows the substantial outperformance of intangible value over traditional value for three subsamples, a long sample back to 1975, a post-internet revolution sample starting in 1995, and a more recent subsample starting at the onset of the Great Financial Crisis. As you can clearly see in the figure, the two value strategies exhibit similar behavior– despite measuring value differently. What’s more striking is by how much intangible value outperforms traditional value in all three subsamples. In the middle figure, it is easy to see that this outperformance became very pronounced in 1995 – right around the introduction of email and high-performance operating systems.
My previous academic research on this topic has come to a similar conclusion; intangible value can be a more effective way of capturing the value factor and avoiding value traps. While value investing is here to stay, we need more modern ways of measuring it that reflect the progress made in technology since the early 1990s.
The opinions referenced in this article are those of Andrea Eisfeldt. Andrea is an Academic Advisor to Vise.
October 20, 2021