Value Investing and Growth Investing are commonly contrasted against each other, i.e. value vs. growth, as if they are mutually exclusive. As EverEdge Chief Investment Officer Francis Milner shares, Intangible Asset Investing is emerging as an alternative approach which captures the persisting merits of both Value and Growth.
Investors broadly fit into two groups: Value Investors and Growth Investors. Both groups utilize vast tools, models, and methods to inform their investment decisions; and while individual investors apply different processes, the principles and objectives of each investor is consistent with the broader group of value or growth.
Value vs. Growth
Value Investors search out and invest in companies which are priced below their intrinsic or ‘fundamental’ value in order to profit from higher relative dividend yield and/or expected capital gain when such companies are correctly valued by the market. Such investors make decisions through detailed comparative analysis of fundamental financial data including assets, liabilities, revenues, costs, and past performance. The ratio of price-to-book value per share (Price to Book ratio) has historically been used as a key financial metric to identify temporal mispricing of a company’s intrinsic value.
Value investing became influential through the work of Benjamin Graham and David L Dodd in 1934, when they published their book Security Analysis which established an analytical approach to assessing the intrinsic value of a company. Warren Buffet is a notable follower of Graham and Dodd’s approach which has helped him amass a personal net worth of ~$80 billion and become one of the world’s most successful long-term investors.
Growth Investors search out and invest in companies, industries, or sectors that are currently growing and are expected to continue their expansion over a sustained period, and where whose earnings are expected to increase at an above-average rate compared to their industry sector or the overall market. As a result, growth investing tends toward emerging companies and/or companies with new innovations, products, and technologies. Growth investors also make decisions through detailed comparative analysis of financial data but with a clear focus on determining growth potential rather than temporal mispricing (value investing). The ratios of price-to-book value per share (Price/Book ratio) and price-to-earnings (Price/Earnings) have historically been used as key financial metrics to identify high growth companies.
The influence of Growth Investing also emerged in the 1930s, led by T. Rowe Price and his “Growth Stock Philosophy” which saw him invest in the early growth stages of a company including IBM in the 1950s. Today the T. Rowe Price Group is a global heavyweight in investment management, with ~$1 trillion in assets under management.
The Apparent Demise of Value Investing
Value Investing and Growth Investing are commonly contrasted against each other, i.e. value vs. growth, as if they are mutually exclusive. We don’t ascribe to this view and instead see an alternative approach emerging which captures the persisting merits of both – Intangible Asset Investing – expanded on below.
Unfortunately, since ~2007 value investing as a strategy has underperformed and has been exacerbated by the global pandemic which has accelerated investment into high-growth industries such as technology and healthcare. This shift away from “value” is confirmed by both academic literature and industry research, which have overwhelmingly found that value-based investment has underperformed growth-based investment for the past 10 – 15 years. Never-the-less, ardent followers of this strategy point to long-term performance of value vs. growth and find comfort in the statistical logic of “mean reversion” i.e. that over time the valuation metrics of an individual company will revert toward the industry average and thereby correct any mispricing of intrinsic value.
Will such underperformance persist? Or will reversion to the mean and correction of value just take longer than before?
Renowned value investor Ted Mr Aronson, whose hedge fund AJO Partners closed its doors in October 2020, wrote in his farewell letter to investors “The drought in value — the longest on record — is at the heart of our challenge… We still believe there is a future for value investing; sadly, the future is unlikely to arrive fast enough — for us.” Peter Hargreaves (Hargreaves Lansdown) sees a more permanent state demise for value-based strategies and stated “I shall be bold here and make a prediction for 2021 — much of the ‘old economy’ will not return to prior highs, and value investing based on simply choosing companies that are ‘cheap’ is dead.”
Redemptions from value focused funds have been significant in recent years, with many such funds closing shop. AOJ Partners suffered a decline of ~$20 billion in AUM before shutting down and International Value Investors (IVA) shrank from a peak of ~$20 billion AUM to ~$1 billion prior to liquidation in March 2021. There are many more less notable funds that have experienced a similar fate as capital has been redeemed and redeployed toward growth strategies.
Impactfully, Warren Buffet recognized the decline in value-based metrics in his annual Shareholder Letter for Berkshire Hathaway on 23 February 2019; “Long-time readers of our annual reports will have spotted the different way in which I opened this letter. For nearly three decades, the initial paragraph featured the percentage change in Berkshire’s per-share book value. It’s now time to abandon that practice … The fact is that the annual change in Berkshire’s book value – which makes its farewell appearance on page 2 – is a metric that has lost the relevance it once had”. For many this was clear evidence that value investing is dead; however, a more objective read and interpretation of Buffet’s statement is that the financial inputs and metrics used to determine value (historically at least) are no longer appropriate. In other words, value investing is not dead per se. but traditional methods of implementing value-based strategies no longer work. We would argue further that the principles of value-based investing remain robust and credible but that investors continue to focus on irrelevant inputs, financial metrics and analytical methods to inform their decisions.
Beyond Value vs. Growth
Growth Investment appears to have risen to the top, not merely due to survivorship bias, but rather due to a significant shift toward the intangible asset economy where businesses can scale exponentially without the need for equivalent investment in fixed asset infrastructure. 50 years ago, intangible assets explained just 17% of shareholder equity value with the remaining 83% accurately captured in the financial statements. Today however, intangible assets comprise more than 90% of shareholder equity value and businesses of all shapes and sizes are racing to acquire intangible assets that improve or protect market share and margin. This evidence suggests that Growth Investing is justifiably a more effective approach; however, a deeper assessment reveals that Growth Investing suffers from a similar reliance on irrelevant financial inputs and metrics.
Both Growth and Value based strategies rely on reported financial data and information disclosures of the companies which they target. For example book value per share is a critical metric for both strategies but in the words of Buffet this metric “has lost the relevance it once had”. Given that both strategies rely on deep financial analysis and utilise similar metrics such as book value per share, why does reliance on this irrelevant metric still work for Growth Investing but not Value Investing? The short answer is it doesn’t.
The outperformance of Growth Investing is best explained by the quality of assets which are (at present) largely off-balance sheet and intangible for high growth companies. Analysing and understanding the quality and value of intangible assets provides a far better explanation to both the outperformance of Growth Investing and the underperformance of traditional Value Investing.
An Intangible Investment Lens
Both industry and academic research are adapting swiftly to the changing drivers of company value and now widely acknowledge the critical importance of key intangible assets for a business. We go further and assert that Intangible Asset Investing is a better strategy to achieve the objectives both value and growth investors, capturing the merits of both strategies by identifying the source of value and growth with a view to determining whether or not it will persist.
Assessing business performance and potential via an Intangible Asset lens, focusses our attention on aspects of the business which are critical to future performance but which are not accurately reflected in financial statements or typical business disclosures. This approach gives disproportionate weight to understanding the quality and strength of a business’s intangible assets, which include among other things:
- Contractual rights
- Trade Secrets (formulas, recipes and methods)
- Networks & Relationships
These assets are largely off-balance sheet, poorly understood, and commonly mispriced; however, they are central to both comparative and sustainable competitive advantage. In the modern world of global trade, companies rarely outperform based on tangible assets alone. Even gold mines require survey’s, resource estimates, approvals, permits, and know-how to monetise the underlying asset (gold). The absence of these key intangibles reduces the value of the tangible assets. Put simply, its not what you have, its what you can do with what you have.
An effective understanding of a business’s intangible assets enables investors to determine two important things:
- Firstly – An effective understanding of intangibles provides a clear view on the component parts of value which underpin past and current performance (Value Investing)
- Secondly – An effective understanding of intangibles provides a clear view the ability for performance to be sustainable into the future or perhaps even better or worse (Growth Investing)
In the same way that we might apply a specific methodology or process to valuation of physical assets, each category of intangibles needs to be assessed appropriately. By way of example, the existence of a granted patent does not mean that the patent is relevant or even valuable. Effective assessment of this type of intangible asset entails a detailed review of the patent claims and all relevant prior art, which must then be contrasted against the form of technology, the addressable or target market for commercial use, and the capabilities of the business to penetrate their target market.
Intangible Asset Investing does not ignore standard financial data and metrics; but instead seeks to correct the inputs to determining both value and growth. This is necessary because of the growing disconnect between accounting standards and company performance.
Prominent academic and accounting critic Baruch Lev has found that accounting standards fail to reflect the value of key intangible assets in financial reports. Lev also states that accounting does a better job of explaining the value of assets which are “largely irrelevant to companies’ growth and competitive edge like inventory, accounts receivable, or plant and machinery”. While these assets “remain prominently displayed on corporate balance sheets”, assets which underpin growth and profitability are ignored such as patents, data, code, formulations, brands, IT, or unique business processes. This mismatch is typically more acute for early-stage companies when investing in activities that create intangible assets (e.g., research and development or customer acquisition).
The Best of Both
Intangible Asset Investment is emerging as a superior strategy for proponents of both Value and Growth investing. This approach requires deep analysis and understanding of a company’s Intangible Assets in order to inform investment decisions.
Effective Intangible Asset Investment enables investors to:
- Identify the source of a company’s value
- Measure and quantify this value
- Assess how long such value will persist
Recent research by Columbia Threadneedle shows that 95% of senior investment decision makers agree that a company’s intangible assets contain important information about the future strength of a business model. 88% also agreed that conventional valuation methods (such as discounted cash flow) are inadequate without thorough consideration of intangible assets. Given the limited focus on reporting and disclosure of intangible assets, there is significant latent value (and risk) in many businesses, resulting from the lack of measuring and managing intangible assets effectively.
Intangible Asset Investing captures the merits of both Value Investment and Growth Investment without reliance on irrelevant inputs and financial metrics.