Value investing is dead – long live value investing. That seems to be the conclusion drawn by the author of an article a colleague recently sent me. The article, titled “Robot Tried to Fix Value Investing and Ended Up Buying Amazon,” all but dismantles many of the long-held beliefs that have guided value investing for decades. It’s not that traditional value factors such as P/E or P/B are necessarily dead, but that the antiquated accounting practices aren’t capturing the true value of today’s companies that are increasingly driven by information technology, resulting in depressed earnings.
Intangible Assets Increasingly Driving Value Creation
Put more simply, with traditional accounting practices, a company’s intangible assets, which are increasingly comprised of intellectual capital, R&D, and digital assets, are not factored in the plus side of the balance sheet, but rather the negative side as expenses. So, for instance, the algorithms that drive Amazon’s state-of-the-art logistics systems, developed with billions of dollars of R & D, are not considered assets to the company, even though it’s what has made Amazon a nearly $2 trillion company.
In the digital age, intangible assets are increasingly becoming the primary driver of value creation, yet traditional valuation methods largely ignore them. Amazon’s digitally mapped logistics system should be counted as an intangible asset. The challenge is no one quite knows how to place a value on it. It’s easy to value Amazon’s tangible assets, such as its warehouses, but their value is dwarfed by the value of its digital assets and intellectual capital, which are less transparent.
As the article points out, this results in knowledge-intensive firms ending up with much lower book values and higher costs, making them look more expensive than they really are.
At the core of the article is the introduction of a new large-cap ETF – Qraft (QRFT) — that uses artificial intelligence to measure these intangible factors to more accurately value companies that rely on them to grow their earnings. At least through back-testing, their AI-driven investment framework has done pretty well, outperforming the S&P 500 by double digits over the past year.
We Happen to Agree
As I pointed out to my colleague, the companies we own are clearly not value stocks in the traditional sense. For instance, we own F5 Networks (FFIV), primarily a software and services company. F5 has minimal tangible assets and has a tangible book value that hovers around zero, making its price to tangible book value appear extremely high.
In fact, the last company we owned that could be considered a traditional value stock was Aflac, which we bought in 2015 and subsequently sold. All the other companies we own do not fit the conventional value model.
My break with traditional value investing came when I saw Warren Buffett on CNBC extolling the virtues of Amazon, which he has never owned. But he pointed to Amazon as an example of being able to run a phenomenal business with no assets. That was a remarkable and timely break from the traditional value investing doctrine and an epiphany for me.
But Value Investing is Still Value Investing
Although the companies in our portfolio might look different than those we owned just a few years ago, nothing has really changed with our investment philosophy. To me, the unshakable foundation of value investing is viewing investments as buying pieces of businesses based on fundamental analysis at a price that reflects an adequate margin of safety (a wide discount to the net present value of future cash flows). That is value investing. And yes, until someone comes up with an accounting framework fit for the times we live in, relying on the old simple formulas like low P/E or low P/B may be setting you up for a value trap.
