In a world that is forever changing, the principles underpinning value investing offer a rare point of constancy.
One danger of a changing world, however, is that apparent patterns can emerge that investors begin to rely upon – only for the world to change once more, the patterns to disappear and investors to be left exposed.
One way of valuing a business people have come to rely upon over the years is known as ‘price-to-book’ – a ratio that compares a company’s share price with the value of its assets minus its liabilities.
A recent piece of analysis by O’Shaughnessy Asset Management, however, suggests that changes to the way companies report their financial situation have led to the value of this metric being eroded.
Negative Equity, Veiled Value, and the Erosion of Price-to-Book argues that modern accounting methods – particularly how companies record potentially valuable intangible assets, such as their brand, and the depreciation of long-term assets, such as property – are leading to a situation where businesses that look expensive on a price-to-book basis but cheap on other measures are going on to outperform the wider market.
Our focus today, however, is not the specifics of that argument – if you want to read up on it further, you have the link – but the more general idea that investors need to be very careful about slavishly following one single valuation metric.
What works in one era may not work in another
For one thing, as we alluded to earlier, times change and what works in one era (focusing, say, on high dividend yields in the 1980s and 1990s) may not be so effective in another (such as today).
For another, there is a danger whatever you choose as a measure of performance is what you end up getting.
Investor’s Field Guide blog When measures become targets, introduced us to ‘Goodhart’s Law’. That holds: “When a measure becomes a target, it ceases to be a good measure.”
That blog also focused on the price-to-book ratio, noting what has historically been one of the most common measures of valuation “became the target around which hundreds of billions in assets built value portfolios and indexes, and along the way has decoupled from other major value factors” – for example, total yield, free cashflow and earnings before interest, taxes, depreciation and amortisation.
Metrics such as these have proved better indicators of value since price-to-book was first seen as the defining value factor, the blog suggested, before continuing: “Interestingly, if price-to-book value goes fully out of favour – don’t think we are there yet – it may finally make price-to-book a good measure of value again! Watch for big names to change their definition of value from price-to-book to something else.”
Clearly, then, there are risks to relying on a single valuation metric – whether by way of a mechanical passive strategy or in your own investment research.
And while we are certainly not dismissing the significance of the price-to-book ratio, it can be far more profitably used alongside other important measures, such as a company’s cashflow, its profitability and the sustainability of its business model.
Be wary of individual metrics, then, because regulations, technology, fashion – almost everything changes.
So what makes value immune?
Why is it ‘in this ever-changing world in which we’re living’, that for well over a century now a value investing strategy has constantly outperformed the wider market over the long term? Remember past performance is no guide to the future.
The answer is us.
Human beings are the constant – markets are cheap when we are fearful; and they are expensive when we are greedy.
We are systematically exploitable. Value investing is the system.