In The Oakmark Funds’ latest Q218 market commentary Bill Nygren says that value investors need to adapt their value investing strategies for today’s companies because book value is no longer a definitive indicator of economic value:
“For companies in the S&P 500 today, the correlation between stock price and tangible book value has become quite small, just 14%. This is a very big change from 25 years ago, when that correlation was 71%—or 5x stronger than it is now. Unlike 25 years ago, knowing the book value of a company today gives little clue as to its stock price.”
Here’s an excerpt from that commentary:
“My own thinking has changed drastically from 35 years ago when I was taught to favor tangible assets and to shun businesses whose value depended largely on economic goodwill.'”
Throughout Oakmark’s history, we’ve been on the lookout for situations where GAAP obscures economic value. Though value investing has always implied buying at a discount to value, the early descriptions of value relied more on assets than earnings. In 1934, Ben Graham and David Dodd wrote Security Analysis, which was quickly adopted as the Bible of value investing.
In it, Graham explains his idea of only investing when he had a “margin of safety:” he only purchases a stock when it is priced at a large discount to a company’s intrinsic value. The concept remains a core principle of value investing today, even though the idea is almost 100 years old.
Then, influenced by just having been through a depression, a company’s intrinsic value was defined as its liquidation value, and Graham proposed the following formula for computing it: start with cash; add accounts receivables, discounted by 10-25%; add inventory, discounted by 25-50%; add all other assets, discounted by 50-100%; and then deduct all liabilities. A stock passed his margin of safety test only if it sold for a large discount to this estimated liquidation value.
Over the next 40 years, stock prices were generally quite tightly tied to their book values and patient investors could often find companies that were out of favor, trading below estimated liquidation value. It was an asset-heavy economy, which made it appropriate to value businesses based on their tangible assets.
In fact, as recently as 1975, 83% of the stock market value of the average company was represented by its tangible book value. In an economy where value was derived from fixed assets, it was hard to maintain competitive advantage: If you earned unusually high returns, others would duplicate your fixed assets and your advantage disappeared.
That made it difficult for companies temporarily trading at large premiums to book value to sustain their high stock prices. So, an effective investment approach was to buy the stocks priced at discounts to book value and then patiently wait for reversion to the mean.
But, as the economy has become more asset-light, intangible assets—such as brand names, customer lists, R&D spending and patents—have become more important. Today, the relative importance of tangible assets compared to intangibles has completely flip-flopped from what it was 40 years ago. Intangibles now account for over 80% of the average company’s market value. But much like Graham, GAAP doesn’t even attempt to value those assets.
By the early 1980s, the Berkshire Hathaway investment portfolio, managed by Warren Buffett, looked nothing like the low price-to-book investments favored by his teacher Ben Graham. The portfolio included General Foods, RJ Reynolds, Time Inc. and Washington Post Co. When asked about the apparently high prices he paid for those companies relative to their book value, Buffett was fond of saying that their most valuable assets—their brand names—were not even on their balance sheets.
The Buffett quote above, citing the decreasing importance of tangible assets in determining business value, sounds as timely today as it did when it appeared in Berkshire’s 1983 Annual Report. What Buffett figured out earlier than most value investors was that conservative accounting rules overlooked the value of intangible assets. In turn, book value didn’t fully reflect the economic value of businesses with strong brands.
For companies in the S&P 500 today, the correlation between stock price and tangible book value has become quite small, just 14%. This is a very big change from 25 years ago, when that correlation was 71%—or 5x stronger than it is now.
Unlike 25 years ago, knowing the book value of a company today gives little clue as to its stock price. Investors who have relied primarily on a price-to-book mean reversion strategy have had disappointing performance for the past decade. Some even feel they “are due” for an extended positive run. That would indeed be the case if irrational exuberance were the reason that book value is currently disconnected from stock prices.
But we don’t see anything irrational about it. If book value still determined earnings power, we would expect P/E ratios to be as widely distributed as price-to-book ratios. However, that isn’t the case. Today, the P/E distribution is narrower than it was 25 years ago.
That shows that intangible assets are producing earnings and, therefore, investors have been acting rationally by attributing significant value to them. At Oakmark, we believe that the relative importance of intangible assets is more likely to continue than to reverse. As such, we think a portfolio of strictly low price-to-book stocks will continue to produce disappointing results.
Most value investors have come to realize that although book value can still be a useful metric in certain situations, such as analyzing a bank or a utility, it does not offer much insight for most companies. For this reason, book value is no longer used by most investors as a definitive indicator of economic value. Despite that, in our view, many investors have not yet considered what this means for the income statement.
Back when GAAP book value was still closely tied to economic value, a company’s annual income statement provided a pretty good approximation of the economic value added in that year. But now that economic value is not closely tied to book value, the income statement no longer provides a reliable indication of the value a company created in a particular year.
Since Oakmark’s 1991 inception, we have sought out investments whose economic value was not easily seen in the simple GAAP metrics of net income and book value. Over that time, like Buffett, we’ve owned a lot of packaged food companies when we thought increased brand advertising was understating earnings. (Interestingly, the opposite condition is present today: Some companies have slashed advertising, increasing their GAAP earnings, but still benefit from historical spending that was previously expensed.)
We owned cable TV distributors that reported net losses and negative book value while rapidly increasing their subscribers. (As with Gartner, customer acquisition costs were an immediate hit to their income, but their customers were long-lived.) We owned high-growth biotech companies that were selling at lower P/Es than mature pharmaceutical companies–once we treated their R&D expenditures as long-term investments.
As intangibles have grown in importance, so has the number of our holdings for which we adjust earnings to better reflect our view of intangible values. That has led Oakmark to invest in more companies generally owned by growth investors, such as Alphabet, Facebook, Gartner, Netflix and Regeneron. The thought process is no different than what led us to own food and cable stocks early in Oakmark’s life. Today, it simply applies to more companies.
Regardless of the changing metrics that determine a company’s value, the main concepts of value investing are the same today as 84 years ago when Security Analysis was first published:
-Investors still follow fads, get emotional and overreact,
-Which means stock prices sometimes decouple from intrinsic value,
-Allowing patient investors to invest when price is below value,
-Which creates a margin of safety.
So how can investors today determine which mutual funds are rigorously applying a disciplined value investing process and which ones are simply following trends? The relevant metrics for that have evolved, too. Because we rarely find price-to-book a useful statistic for estimating intrinsic value, our portfolios often don’t look cheap on that metric. Low P/E ratios are frequently, but certainly not always, an indication of value. Though our portfolios still typically have a lower P/E than the market, we are more frequently investing in “exceptions” where the GAAP P/E looks expensive.
For those “exceptions,” true value investors should be able to explain how they’re calculating their margin of safety: What are they getting that they don’t think they’re paying for? As an example, let’s look at the largest holding in both Oakmark and Oakmark Select, Alphabet, a stock that is primarily owned by growth managers. Alphabet’s 2018 P/E is 26 times consensus estimates, which to us seems to be in the right ballpark given the expected growth from its search business. However, the company’s $115 billion in cash, YouTube and other bets (including Waymo), in total, contribute nothing to our estimate of current earnings, despite having tremendous value. That’s what we’re getting for free, which creates our margin of safety.
At Oakmark, we commit time to writing these pieces because we want to help our shareholders understand how we think about investing. In a world where business value rests primarily on intangible assets, it’s getting harder to use a style box to understand a mutual fund’s investment approach. That’s why it’s more important than ever to spend time reading commentaries or watching interviews. They can explain a fund’s investment philosophy far better than a price-to-book ratio ever will.
William C. Nygren, CFA
You can read Oakmark’s Q218 Market Commentary here.
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