Kelly Hofer, for the Haskayne School of Business
Sept. 26, 2019
Popular stock market strategy victim of rise of knowledge economy
A popular money-making strategy that performed well on the stock market in the past century hasn’t really worked in recent times, says a researcher at the Haskayne School of Business.
“There has been this hue and cry in the popular press about the recent demise of value investing,” says Dr. Anup Srivastava, PhD, an associate professor and Canada Research Chair in Accounting. “But it’s not just for the last six or seven or eight years that it’s been dead. It’s more like 30 years because of a fundamental shift in the economy, which is unlikely to reverse soon.”
Value investing, which helped build the fortunes of investors like U.S. billionaire Warren Buffett, has been used by everyone from average people to billion-dollar mutual and pension funds. But long-term structural changes in the economy that began in the late 1980s, epitomized by the rise of information-driven giants such as Microsoft, Google and Facebook, have fatally undermined value investing, says Srivastava.
Companies now monopolies
Despite giving reliable returns for almost 60 years starting from 1930, the strategy stopped working from the late 1980s, he says. “The knowledge economy has won.”
“We have never seen this kind of trillion-dollar stock market capitalization for one company, such as for Amazon, Apple and Microsoft. These knowledge companies have surpassed the erstwhile AT&Ts and Standard Oils to become the new monopolies.”
This phenomenon was described in a recent study that was co-authored by Srivastava and Dr. Baruch Lev, PhD, Philip Bardes Professor of Accounting and Finance at the Stern School of Business at New York University.
Value investing is based on identifying companies whose performance is being seriously underestimated by the stock market. The idea is to buy their shares today, making money when stock prices inevitably rise to reflect such companies’ true value, says Srivastava.
These returns can be turbocharged by also selling short overpriced or glamour stocks whose performance is being overestimated by the stock market, with additional money being made when their share prices fall, he says. Such simultaneous buying of undervalued stocks and short selling of overvalued stocks is called a hedged value strategy.
Yardstick increasingly flawed
Although there are many ways to estimate undervaluation, the most common one involves the price-to-book value ratio, or P/B, says Srivastava. This is the ratio of a company’s market capitalization (share price multiplied by the number of outstanding shares) divided by its book value (its assets detailed in its accounts minus its liabilities or debts), he says.
It is the main component of Russell and S&P stock market value indices, says Srivastava. Undervalued stocks supposedly have a low P/B ratio, he says.
While this P/B metric worked well in the industrial era, it became increasingly flawed with the rise of the knowledge economy, he says. The concept of book value cannot be applied to companies that largely rely on intangible or soft assets such as innovation, strategy, software, brands and customer data, he says.
“Walmart has land, store buildings, inventory, trucks and so on that can be measured and reported on books,” says Srivastava.
“What does Facebook have? Does it have those physical assets? We accountants don’t know how to measure the intangible assets of companies like Facebook, so we don’t present them. Book value can’t be used as a metric to identify what is cheap and what is expensive for knowledge firms.”
Some proponents of value claim to rely on earnings or cash flows, but those yardsticks are “equally flawed because they are also calculated after deducting intangible investments,” he says.
'Creative destruction' slows down
While the value investing strategy stopped giving reliable returns from the late 1980s, it had a brief reprieve during the dot-com crash of the early 2000s, says Srivastava. “There was a flight of capital from dot-coms to more traditional, physical intensive companies with high book values, so value investors made money during that brief period.”
But there likely won’t be any further comebacks soon for value investing, he says. The current situation reminds him of the American railway magnates of the 19th century who created unprecedented transportation monopolies that controlled the flow of goods.
This time, the monopolies are based on controlling the flow of data or information derived from monitoring the activities and preferences of people using online platforms, says Srivastava.
“Just look at Amazon,” he says. “As consumers, we provide our information to get products and services, and Amazon is not willing to pass that information to a competitor. What choice does a supplier have today, other than to yield to Amazon’s wishes? Google, Amazon, Microsoft, Apple, and Facebook seem to have become the monopolistic utilities of recent times.”
Small firms are much less likely to challenge these monopolies through the natural cycle of creative destruction that allows new firms to regularly displace large companies, says Srivastava. “It’s almost impossible to displace Amazon, Google, or Facebook today, because of their monopolies over data. The creative destruction process has totally slowed down.”