INVESTMENT

Value Factor Pain: Is It Indomitable?


Great storytelling can be the most powerful human skill. The empires were created by solitary individuals whose captivating descriptions persuaded their compatriots to join in the work. On the right hand, these descriptions can bring hearts and minds together to achieve a common goal that is of greater benefit, as John F. Kennedy challenged his fellow Americans to go to the moon.

With the wrong hands, however, telling great stories can lead to impossible destruction. And this is especially true of money.

Investors waste billions of rupees every year following false and misleading stories. Perhaps a charismatic founder – Adam Newman of WeWork, for example – convinced them that the technology stock of a traditional theorized real estate company should be valued. Or an asset manager agrees to buy their subject-based securities while trading at their peak, say cryptocurrency in 2017 or marijuana stocks in late 2018 and early 2019. Housing prices have never fallen nationally, with many believing they cannot fall. Appeal to the authorities, or Shame Misconceptions, thus giving investors false comfort in flawed investment proposals.

Take the recent performance of Value Factor, which is defined as buying a company with a low price book quality and shortening the quality of the book from a high price. The strategy has disappointed over the years. “It’s turned out to be a bad environment for values ​​and this time is different,” some say. Why? This is because intangibles have increased as a percentage of valuations of fast-growing technology companies and thus prices have become obsolete.

We are suckers for the story and it is difficult to resist that it is a simple and intuitive application. Evaluate technology companies on traditional thematic value-to-quality By Sounds like an old method. We’ve all seen how tech companies have changed modern life, from how we meet colleagues (virtually through zoom) to how we order groceries (from couches). Combining all of this creates an interesting narrative that is easy to accept: value-for-money investment over the past decade has been so challenging because the market caps of tech companies are almost entirely based on intangibles.

But is this narrative correct? Are Intangibles Responsible for Poor Value Performance?

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The Rise of the Intangibles

From an accounting perspective, intangibles are resources that are not enough or material that we cannot touch. They are a hodgepodge of brand value, client loyalty, goodwill, innovation and corporate culture among others. Not all intangibles are unique and directly comparable between firms.

AOL included 12 127 billion in goodwill when it bought Time Warner in 2000, for example, and so was paid a substantial premium to Time Warner’s book equity. Today, that transaction is widely seen as a failure because the joint venture wrote 99 99 billion in greetings during a 2002 vulnerability test. This may sound like a lot of money, but it is a fraction of the indomitable value that lies in the current market capitalization of FAANG stocks. Of these five companies, the average ratio of book equity to market capitalization is 8% so they have some real assets. Netflix, for example, has a market capitalization of more than 200 200 billion, but only 8 8 billion in book equity.


FAANG Stock: Book Equity vs. Market Capitalization, US Billions

Source: Factor Research

For traditional pricey price investors, the high price-to-quality quality of the FAANG quintet and many other technology stocks have made them the main candidate for shorts. Yet these companies have generated external returns, so their shortened value factor has contributed to performance.

But the technology sector is much more influential in the US stock market than in Europe or Japan. Intangibles increased from 2009 to 2020 as a percentage of market capitalization in the U.S. market, reflecting the rise of FAANG technology giants. But Europe has not seen similar growth in the last decade and the proportion of Japan where it was in 2013.


Immovable / market capitalization across the stock market

The line chart describes the value of the indomitable thing as a% of the market cap of the stock market
Source: Factor Research

Intangibles vs. Value Factor Performance

To compare the growth of intangibles as opposed to value factor performance, we look at Kenneth R.

The higher the ratio of intangibles we get, the worse the performance of the value factor. Since the growth of intangibles as a percentage of market capitalization is due to strongly performing technology stocks, this is not unexpected.

But in Europe or Japan where the value factor has worked terribly, the intangibles have not increased significantly. If Intangibles were really the culprit, then the value factor in this market should not have performed so badly.


Long-short value factor across the market based on price-to-book

Source: Kenneth R. French Data Library, Factor Research

So far the analysis has focused on the core value factor defined by price-to-book quality. But book pricing is not particularly informative and is currently one of the worst ways to evaluate a company. It may be relevant in the real estate or financial sector, but it is not particularly applicable to other industries.

Earnings and cash flow-based attributes are more reasonable approaches to stock selection. No matter how fast a company grows, if it can’t make a profit or create at least a positive cash flow in the medium to long term, it’s probably doomed. For example, with the exception of damaged Netflix, FAANG stocks have grown rapidly And Produces attractive profit margins.

So what if we measure long-to-low value factor performance in the United States based on price-to-book, price-to-income, and price-to-cash flow quality? The trends across the three metrics are basically the same from 2009 to 2020. This is further evidence that indomitable growth does not explain the poor performance of the value factor.


Long-Short Value Factor in the United States: Different Metrics

Chart depicting the long-short value factor in the United States: various metrics
Source: Kenneth R. French Data Library, Factor Research

What drives the value factor?

What if Intangibles does not explain the poor performance of the standard?

Various theories have been proposed, but no sensitivity has been raised. Our research indicates that investors will buy cheap stocks when they are comfortable with the market environment. This is a simple theory based on behavioral bias. Companies that trade in low valuations get into trouble, and investors are more likely to bet on them when the outlook is gentle rather than risky.

There are many ways to measure market structure using market structure, underlying volatility or similar metrics. For example, the performance trends of the value factor and yield curve have been very similar in the last decade.

Lower expected economic growth is an explanation of the reduced yield curve. Which would not be good for struggling companies. In such an environment, it would seem intuitive to follow companies with the prospect of better growth and ignore cheap companies until the outlook improves.


Value Factor vs. Yield Curve in the United States

Chart comparing value factor vs. Ulysses curve
Source: Kenneth R. French Data Library, Fred, Factor Research

More thoughts

Isn’t the growth of intangibles as a percentage of market capitalization related to value factor performance? Obviously not. But it is a symptom rather than a disease. In other words, reciprocity is not equal to effectiveness.

Yet the same can be said about yield curves and other metrics that measure risk perception. In order for cheap stocks to re-apply widely, animal spirits need to be revived.

But a structural transition from growth to value requires more than a general narrative. In the end, it’s all about economic growth.

And when we can expect That Covid-1 vaccine will increase in 2021 for vaccination, the chances of crossing next year are even more bearish. Terrifying demographic profiles across the most developed and many emerging markets will create challenging headwinds over the next few years. And it will take more than a good story to get over them.

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All posts are the author’s opinion. As such, they should not be construed as investment advice, or the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.

Image Credit: Getty Images / Urbajan

Nicholas Robben

Nicholas Robben is managing director of Factor Research, which provides quantitative solutions for factor investing. Previously he founded Jacada Capital, a quantitative investment manager that focused on equity market neutral strategies. Previously, Rabener focused on real estate across the property class at GIC (Singapore Investment Corporation Government). He started working for Citigroup at Investment Banks in London and New York. Rabner holds an MS in Management from the HHL Leipzig Graduate School of Management, is a CAIA charter holder, and enjoys endurance sports (100km ultramarathon, Mont Blanc, Mount Kilimanjaro).



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