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Requiem for Value Investing

Value investors are asking themselves, will the promise of value investing return to prominence? The answer is multi-faceted. Indeed, value investors experienced under-performance versus the broader market and growth stocks for the last thirteen years. A secular change transpired that gave life to the dominance of growth stocks, which may persist. Capital consumption and intensity are declining. Intellectual property investment is approaching equipment investment in amount. The result is unprecedented corporate profits. In a service dominated world where global trade, value resides in the income statement and not on the balance sheet. Caveat emptor for traditional value investors.

Photo: Riccardo Annandale on Unsplash

Value is in the income statement, not the balance sheet.

In a service-based business,

people are the value proposition, not the invested capital.

- Jason Prole

Value investing expired over the last thirteen years as growth investing dominated. Investors look at the high multiples for growth stocks, particularly in US technology and see a reversal in the making. These investors see a bubble in technology stocks that mirrors 1999, which popped and brought the return of value investing for the following decade. The argument for value investing endures. Buy assets at a fair price. What if the asset changed from a capital good to people and intellectual property? In an economy dominated by services, not goods, the argument is compelling for changing how to measure value.

In the world of value investing, understanding the intrinsic value of a company is paramount. This evaluation uses the price-to-book, price-to-earnings, and price-to-sales measures to assess the value. A company must invest in some capital equipment, which impacts the first two measures. Over the last two decades, fixed capital consumption declined and peaked in 2009 at the prior 50-year average (exhibit 1). Companies are using less fixed capital to deliver their sales.

Exhibit 1. Fixed Capital Consumption (% National Product)

Source: Federal Reserve Economic Database

The cause linking this outcome is two factors. First, increasing global trade permits companies to outsource manufacturing, which is a well-documented feature of the US economy over the last twenty years. A capital good on the balance sheet is now an expense on the income statement. Thus, the level of capital investment decreases.

A decrease in capital expenditures implies that assessing value is inherently more difficult because fewer assets to value exist. Equipment investment in the US declined from about 7% of the economy to less than 6% over the last two decades (exhibit 2). The relevance of book value declines in this environment. Earnings could increase as investment costs decline for the same level of sales. The increased costs of purchasing the required goods may make this outcome less impactful. The result is declining ability to assess tangible value

Exhibit 2. Equipment Investment (% of GDP)

Source: Federal Reserve Economic Database

Second, the increased efficiency of capital goods permits companies to invest less for more. In an increasingly service-based economy, it is the people and the intellectual property that dominates investment. The former is a variable expense on the income statement, and the latter is notoriously hard to value.

Intellectual property may not even appear on the balance sheet for internally generated ideas. For example, Apple’s iOS for its mobile phones contains value created close to fifteen years ago. It’s not evident that this value was ever recorded on the balance sheet because the derived code came from people’s work, not capital. It is no longer what you own that provides value. Instead, it is what you know.

The growth of intellectual property investment is steadily upward (exhibit 3). This outcome is the expectation in an economy dominated by technology and service. Companies increasingly invest in intangible items, rather than tangible goods. This action is particularly relevant when the intangible items need only reflect the historical cost. Apple could reflect the intellectual property of its iOS at the cost in 2006 when it’s smart-phone market share was minuscule compared to the market leader, Blackberry. The implication is that even if the value reached the balance sheet it was a trivial value.

Exhibit 3. Intellectual Property (% of GDP)

Source: Federal Reserve Economic Database

Value investors face an unenviable task. They must evaluate assets that are increasingly a smaller proportion of the business, and the assets that remain are fiendishly hard to value. In an efficient market, these outcomes would suggest that there should be more value from the exercise of evaluating companies. The performance shows otherwise.

This outcome is surprising given the profits for US companies, which is about two percent higher for the last two decades than the average over the prior fifty years (exhibit 4). Companies are more profitable than ever. Yet, value remains elusive, and growth dominates.

Exhibit 4. Corporate Profits (% of GDP)

Source: Federal Reserve Economic Database

The problem is where growth occurs. Trillion-dollar technology companies dominate the provision of critical sectors (e.g., advertising and web services) that other businesses require. Their unrivaled profits indicate that they possess pricing power. So, even as other companies move assets from the balance sheet to the income statement, they do not necessarily capture all the potential value. The value resides in the income statement of the service providers, particularly in technology. Thus, unless there is a credible action for anti-trust against the technology monopolies, an investor is well served by focusing on the intangible value embedded in their income statements.

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