In many respects, the style of value investing is built around shareholder equity and book value.
Benjamin Graham and David Dodd built their net-nets investment strategy on book value, with the logic that if you could buy a stock for less than liquidation value, you would make money. Since Graham and Dodd published their landmark text, Security Analysis in 1934, many other studies have reached the same conclusion, particularly the research by Eugene Fama and Kenneth French.
However, over the past two decades, the business world has changed dramatically. The most valuable assets are now no longer tangible assets, such as refineries and steel mills, but instead intangibles, such as brands, intellectual property and data.
This has produced an interesting environment not just for value investors but investors in general. Often, these companies have negative shareholder equity, big red flag for investors, but the value of intangibles is not reflected on the balance sheet.
As it turns out, these companies are not as financially unstable as it first appears. A new research paper from Travis Fairchild at O’Shaughnessy Asset Management notes that from 1993 to 2017 firms with negative book value and companies that looked expensive on a P/B basis outperformed the market 57% of the time.
This is because book value massively understates the value of companies that have devoted billions to marketing and investment in intellectual property.
Fairchild gives the example of Coca-Cola, which has spent $90 billion on advertising to build the Coca-Cola brand, but none of this spending on the balance sheet. Similarly, “Boeing has spent over $100 billion designing aircrafts, and all that investment does not create an asset.”
These are not the only examples:
“The only place brand can show up as an asset on the financials is goodwill and it will only show a value when the brand is acquired, brands grown internally and organically are held at $0. According to balance sheets the Netflix brand is worth $0, Tesla’s brand is worth less than $60 million and the Nike brand (which is the most valuable asset Nike has) is worth less than $139 million. Let’s revisit the Domino’s example. Fourteen years have passed since their IPO with negative equity and not only is Domino’s not bankrupt, but they substantially outperformed the market. How much was their brand worth at the time of their IPO? In 2004, they had been building their brand for 43 years, they were the number one pizza delivery restaurant in the country, owned 20% of the market, and had spent $1.2 billion dollars in advertising in the recent five years but their goodwill was only $20 million. Domino’s intangible assets were understated in this case and therefore so was shareholder’s equity; every $1 that their brand is understated also understates book value by an equal amount. McDonalds is similar, they are one of the most valuable brands in the world, estimated to be worth $42 billion, but their brand is carried on their balance sheet less than $2 billion.”
The study concludes by suggesting that far from being a drawback, companies with negative shareholder equity produce better returns for investors over the long term.
Specifically, Fairchild’s data shows negative book value companies have outperformed in 57% of rolling three years periods from 1993 to 2017. What’s more, companies considered the most expensive 33% by book value but the cheapest 33% by other value metrics outperformed in 91% of rolling 3-year periods.