In his recent interview with The Investor’s Podcast, Jim O’Shaughnessy explains why price to book is dead. Here’s an excerpt from the interview:
O’Shaughnessy: Specifically to that factor [price to book], I wouldn’t advocate investors don’t really look at it anymore. And that is based not on my opinion, but on very deep research that we did. We published several papers about it, we had a podcast about it, and it has to do with the changing nature of valuing businesses. Price to book was great for industrial type companies, and typically price to book, a low price to book, was very good going forward. A high price to book meant probably over priced.
The other thing about price to book even back then is if you do get a horrible bear market, like they got in the crash of 1929 and the ensuing depression, price to book is also a pretty good proxy for bankruptcy risk. So if you actually look at the behavior of low price to book stocks in the thirties, you will see that there was an inversion, with the stocks that had the highest price to book doing much, much better than the stocks with the lowest price to book, because in fact, they did go bankrupt because of the economic situation of the depression.
But flash forward to today, the idea of brands as intangible assets is self-evident. I mean, why is Apple valued at what it’s valued at? A big part of that is its brand. Same with Nike, same with virtually any kind of company you’re thinking about, Amazon. So the intangible aspects that valuing brand brings to the table sort of negate the whole raison d’etra of price to book in the first place. So we actually removed it from our composites.
We use composites of factors for all of our algorithmic selection of securities. And the challenge there is that often people are really, really reluctant to change their mind about something that’s been working well for them. I know there are some other asset managers who still claim price to book is quite good.
Again, I’m basing this just on, you’re too young, but there was a show called Dragnet and Joe Friday was this cop who never smiled. And whenever he interrogated somebody, it was, “Just the facts now, just the facts.” And so that’s what we’re looking at, just the facts. And since there are a huge number of other valuation metrics that we can and do use, we saw this is a pretty easy choice to make. I mean, something that had worked very well, a lot of academic studies on… I mean, French Fama, which got the ball rolling, used price to book, many, many other academic studies did as well.
I have it in my book, of course. In this edition of the book I hedge a bit, because we hadn’t gotten all of the other deeper research, but even when we included the 30s, because we got the CRSP data, which is the data from the University of Chicago Center for Research and Security Pricing, thus the acronym and we’re able to run it, we’re like, “This is something that is material. This is something that we didn’t know at the time. Now we have this new data,” and so we were removed it.
You can watch the entire conversation here:
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