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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)

Capital Risk - Fixed Capital Consumption as a Percent of National Income

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)

Capital Risk - Equipment Investment as a Percent of Gross Domestic Product