Why tech investors' redefinition of "value" is meaningless

One of the strange things you notice after meeting hundreds of fund managers is that most of them are apparently value investors. Even when the largest holding in their portfolio trades on 30 times earnings, it’s a value stock because the market is drastically undervaluing its ability to generate cash or its dominant long-term position, or some similar explanation. 

This has become slightly less common in recent years as value stocks have badly lagged the market (using a strict definition of value to mean stocks that are nominally cheaper than average on metrics such as price/earnings or price/book). But investors still feel compelled to paint themselves as shrewd bargain hunters, rather people who like to buy firms that are growing quickly or simply shares that are going up.

Redefining value

Combine that quirk with the fact that not holding tech giants such as Apple, Amazon or Microsoft is highly risky for a manager’s performance right now, and you can see why a lot of investors will go a long way to suggest that these stocks are really value plays. Perhaps the most bizarrely contrived way to do so is the idea that investors should add an estimate of the total value of these firms’ intangible assets onto their book value (ie, the value of their assets minus their liabilities as given in their accounts) so that metrics such as price/book can be more useful in valuing them. One recent example is a proposed US value exchange-traded fund (ETF) that aims to use artificial intelligence to estimate intangible assets from financial statements and patent filings. Its top three holdings? Amazon, Alphabet and Facebook.

It is certainly true that book value does a bad job of capturing the full value of assets – not just for tech, but also other sectors such as consumer firms with valuable brands. That’s because the spending that creates these assets – eg, research and development (R&D) or marketing – is mostly expensed rather than capitalised and never appears on the balance sheet. 

But even if you try to allow for this in a transparent way, by capitalising prior R&D spending, the mega-cap tech stocks still have a price/book ratio much higher than the average stock, calculates asset manager Research Affiliates (Alphabet was the lowest, on a premium of about 60%). And even bothering to do so seems topsy-turvy. A firm’s assets only have value if they produce profits. So rather than wasting time estimating a notoriously inaccurate accounting entity (book value), focus on these. Alphabet, for example, trades on a p/e ratio of 33. It has a cash-generating advertising business and lots of smart engineers, and its moonshot projects are a bet on the future. It’s exciting. I hold it. But don’t pretend it’s a value stock by any definition.

I wish I knew what intangible assets were, but I’m too embarrassed to ask

An intangible asset is anything that a company owns that isn’t physical. Decades ago, the majority of assets were either buildings and machinery – often referred to as plant, property and equipment (PPE) – or financial assets such as cash or securities. These are known as tangible assets. However, over time intangibles have grown to become a greater proportion of assets for many firms.

In some sectors, intangible assets may now be a far more significant part of a company’s value than tangible assets, even though much of this may not be fully reflected in its accounts. Valuable (and sellable) intangible assets include intellectual property, such as patents, copyrights and trademarked brands. Since the money that a firm spends on creating and maintaining these assets is usually classed as an expense for accounting purposes, these cumulative value of these outgoings is generally not recorded in the balance sheet (let alone any additional value created over and above the initial outlay). This differs from capital expenditure on physical assets, which will be recorded. 

Often, the only time most intangibles will be measured is as goodwill in an acquisition. When one company buys another, it will typically pay a premium to the estimated fair value of its target (fair value will be an adjusted version of the value of a company’s assets minus its liabilities). Goodwill is the difference between the acquired company’s fair value and the price paid. In theory, this is the estimated value of intellectual property, as well as any value placed on a skilled workforce or loyal customers.

The real value of these intangibles may be difficult to measure (and buyers often pay too much). So goodwill may be a bad guide to what the assets are actually worth. The value of goodwill must be reviewed each year and reduced if necessary. It is not increased even if the assets are now worth more.