A strategy favored by value investors for many decades, picking stocks whose market values are below book value, may no longer have validity, according to research by Inigo Fraser-Jenkins, head of global quantitative and European equity strategy at Sanford C. Bernstein & Co., as reported by Business Insider.
In their influential work published in 1934, Security Analysis, Columbia Business School professors Benjamin Graham and David Dodd laid out many principles of value investing used to this day, including seeking stocks that trade below book value. Master investor Warren Buffett has called Graham’s 1949 work, The Intelligent Investor, “by far the best book on investing ever written.” However, Buffett’s reputation has suffered in recent years as Berkshire Hathaway Inc. (BRK.A), a colossus with a $520 billion market cap, has failed to beat the market. During the current bull market, from March 9, 2009 through June 28, 2019, both the S&P 500 Index (SPX) and Berkshire stock are up by 335%. In 2019, the year-to-date gains are 4.0% for Berkshire versus 17.3% for the S&P 500.
Significance for Investors
Buffett himself has noted the diminished utility of book value. “The annual change in Berkshire’s book value…is a metric that has lost the relevance that it once had,” he wrote in his 2019 annual letter to shareholders. “Accounting rules require our collection of operating companies to be included in book value at an amount far below their current value, a mismark that has grown in recent years,” he added.
A key premise behind Graham and Dodd’s framework is mean reversion, by which stock valuations and returns adjust to long run averages. Stocks that trade below their intrinsic values, based on a variety of metrics, eventually should recover in price.
Looking at the last 10 years, however, Fraser-Jenkins and his team found that mean reversion has not occurred, as cheap stocks have tended to remain cheap and expensive stocks have tended to get even more expensive. They believe that the dominance of high-growth tech stocks and the effects of quantitative easing (QE), by which central banks have pushed interest rates to historic lows, are key reasons why traditional value investing has broken down.
Low interest rates mean low discount rates for projected earnings and cash flows, boosting the valuations of companies that are expected to deliver robust growth far into the future. The dominant tech stocks, meanwhile, have such high expectations for future growth, leading to ever-expanding valuation multiples in the market.
Finally, the Bernstein team notes, many successful companies today, notably tech firms, have much of their value in the form of intangible assets such as brand names and intellectual property. Such intangibles typically are not recognized on the balance sheet, leading to severely understated book values.
“Value is currently trading at the biggest discount ever, and offers the largest premium over the last 30 years,” according to a note to clients from Dubravko Lakos-Bujas, chief U.S. equity strategist at JPMorgan, as quoted in Barron’s. He looked at the median forward P/E ratios and the price to book ratios of the cheapest and most expensive S&P 500 stocks to draw this conclusion.
After meeting with Chinese President Xi Jinping on Saturday, President Trump announced that trade talks between the U.S. and China are “right back on track” and that new tariffs are on hold, CNN reports. If this boosts the market on Monday, value stocks may continue to lag, at least for now.