By Mark Hulbert, MarketWatch
Universal/Courtesy Everett Collection
Value stocks are dead: Long live value.
Value in this case refers to stocks trading for low prices relative to book value. Such value-stock strategies rest on a solid academic foundation: On average over the past century, stocks with low price-to-book ratios have soundly beaten stocks that trade for high such ratios (a.k.a. growth stocks).
But not in recent years. Over the last decade, for example, the ishares S&P 500 Growth ETF /zigman2/quotes/208542267/composite IVW -0.15% has beaten the iShares S&P 500 Value ETF /zigman2/quotes/206097129/composite IVE -0.37% by more than three percentage points annualized —14.7% to 11.6% when taking dividends into account, according to FactSet.
Despite repeated predictions that value would soon make a comeback, it has failed to do so. Year to date through Sep. 11, for example, the S&P 500 Value ETF is lagging the broad S&P 500 /zigman2/quotes/210599714/realtime SPX -0.29% by 0.6 percentage points — and lagging the S&P 500 Growth ETF by 0.9 percentage points.
Hence the growing popularity of the “value is dead” argument. Those advancing this argument point out that, though now is not the first time in which value has lagged growth for several years in a row, it never has done so for as long or as much as it has in recent years.
Furthermore, adherents of the “value is dead” hypothesis have compelling arguments above and beyond value’s disappointing recent showing. Perhaps the most powerful come from Baruch Lev, a professor at New York University. In his recent book ( The End of Accounting ) and studies , Lev has argued that book value has become largely irrelevant.
I won’t try to do full justice to Lev’s arguments and refer those of you who are interested to his book and studies. But his reasoning boils down to the improper accounting treatment of intangible assets. That was perhaps less of a problem many decades ago, when such assets represented a relatively small portion of a company’s true value. But not today.
For example, according to Ocean Tomo , a consulting firm, 84% of the S&P 500’s market capitalization now comes from intangible assets (in contrast to just 17% in 1975). This is especially true of high-tech firms.
Still, I wouldn’t give up on value stocks just yet: the strategy continues to work. Take, for example, the power of the price-to-book-value ratio (PBK) to explain the S&P 500’s subsequent one- and 10-year returns. (Specifically, I measured the r-squared in an econometric model that used the PBK in a given year to predict the S&P 500’s one- and 10-year subsequent return, on an inflation-adjusted and dividend-adjusted basis.) Notice from the chart below that there has been no noticeable decline in the PBK’s predictive power at the one-year horizon, and that its predictive power for subsequent 10-year returns is higher than in previous decades.
To be sure, the PBK’s higher explanatory power in the post-1990 period traces in large part to what happened when the internet bubble burst. The PBK hit an all-time high (overvalued extreme) just as that bubble was bursting, and though it can count that as a huge and undeniable success, it is just one data point. Still, as you can see from the PBK’s record when predicting the market’s one-year return, it certainly doesn’t appear as though the PBK is any less effective than in earlier decades. (Note carefully that, as with any indicator, predictive power at the one-year horizon will be lower than at the 10-year horizon.)
Further evidence that the PBK still has predictive power comes from the performance of the investment newsletters my auditing firm monitors. The two newsletters at the top of my ranking for 10-year risk-adjusted performance, for example, consistently pick stocks that have extremely low price-to-book ratio s— value stocks, in other words.
I hasten to add that, just because the PBK ratio may still have some role to play, doesn’t mean it can’t be improved upon. One recommendation for such improvement comes from Ray Ball, an accounting professor at the University of Chicago: Focus on just one of the two components of book value (retained earnings) and ignore the second (contributed capital — total share issuance over the years, less shares repurchased).
Ball and several co-researchers provide the basis for this recommendation in a recent study : They found that contributed capital has never been a good proxy for value, and therefore has always reduced the PBK’s effectiveness. However, this was less of a problem many decades ago, when contributed capital represented a relatively small portion of total book value. This portion has grown dramatically in recent years, however, as companies have issued increasing amounts of stocks — resulting in, among things, a less-effective PBK ratio.
The upshot, according to Ball: Instead of focusing on the price-to-book ratio, rely instead on the ratio of price to retained earnings per share.
This raises a broader point about value investing: Never rely on just one indicator of value. Among the value-oriented newsletters I monitor, the editors focus on a host of metrics in addition to the PBK, such as the ratios of price to earnings, dividend, cash flow and sales. In this regard I refer you to a 2015 study in the Journal of Portfolio Management by Cliff Asness, founding co-principal of AQR Capital Management. He and several co-authors found that a composite indicator based on the many individual value ratios has produced better performance in the past than any individual ratio alone.
The bottom line? Is price-to-book ratio the only measure of value you should use? No. Can that ratio be improved upon? Absolutely. But neither of these answers means that value is dead.