A $28 billion strategist flags the multi-trillion-dollar roadblock

Brad Neuman explains how a widely used metric overinflates the value of many companies

A $28 billion strategist flags the multi-trillion- dollar roadblock keeping investors from the stock market’s most hidden gems – and explains his strategies to outsmart it Akin Oyedele Mar. 26, 2019, 5:58 AM

Richard Drew/AP

§ Value stocks have clearly underperformed growth stocks throughout the bull market. § Investors have been led astray by a widely used metric that overinflates the value of many companies that would be considered undervalued by other measures, according to Brad Neuman, the director of market strategy at Alger. § In an interview with Business Insider, he laid out two strategies to circumvent this perceived flaw, and to identify the stocks that are truly undervalued.

The tussle between growth and value stocks has produced a clear winner during this bull market .

Growth stocks, belonging to companies whose earnings are expected to increase at an above-market rate, have outperformed their counterparts considered as undervalued. The latter category — value stocks — are the darlings of stock pickers who are always on the hunt for companies the broader market does not yet appreciate. This performance gap is the result of "something strange," according to Brad Neuman, the director of market strategy at Alger, a $28 billion growth-fund manager. His gripe is with price-to-book ratio, an indicator that gauges a company's stock price relative to the value of its net assets. This ratio is a significant part of the methodology that dictates which stocks on the Russell 1000 are classified as value. The multi-trillion-dollar problem with this ratio lies in the exchange-traded funds and indexes loaded with value stocks, Neuman said. The issue even impacts active fund managers, who peer over their shoulders to compare their performance to value benchmarks. To understand why Neuman sees price-to-book value as a problematic way to pick value stocks, it's worth unpacking why it is used in the first place. Investors care about price-to-book value because they see a strong link between a company's book value and its earnings power. Neuman provided the example of a fictitious car plant with the machinery to create 100,000 cars. In the event of an economic recession, output capacity would be impaired and maybe even cut in half to 50,000 cars. The value of the machinery would remain on the balance sheet but the company's stock price would fall with the broader market, pulling down its price-to-book ratio. A diligent value investor could find this automaker with a reduced price-to-book ratio and buy the stock. The bet would be that when the recession is over, the plant will return to producing 100,000 cars again, increasing its profits and stock price as a result. In short, all this investor had to know was that the company's underlying assets, represented by its book value, had the potential to lift its earnings once the macro environment returned to normal. However, this approach is now outdated, Neuman said. "The accounting hasn't kept up with the evolving economy and business models," Neuman told Business Insider by phone. "The accounting is now broken." What has changed over the years is that investments in intangible assets have superseded investments in tangibles, Neuman said. A higher share of spending is assigned to intellectual property, marketing, training, human resources, and other items that don't appear on balance sheets as assets like machines do. Such intangibles are written off as expenses instead. If they were capitalized onto balance sheets instead, the price-to-book ratio would be a more accurate gauge of value for many sectors, Neuman said.

He cited video gaming as one such sector. If spending on ads for new games were to be capitalized on gaming companies balance sheets, their price-to-book-value ratios would fall from 4x to 3x, Neuman said. In other words, a single accounting tweak that's more in tune with the times suddenly makes them appear cheaper. That example constitutes the first of two approaches Neuman recommended to update the definition of "value" as it exists in various indexes and ETFs. It's labor intensive, and involves understanding the value of assets, as well as products in the research and development pipeline, that are not expressed on a company's financial statements. An example is the value of Google's search algorithm, Neuman said. Neuman's second piece of advice to circumvent the existing definition of value is to substitute the price-to-book ratio for R&D spending as a share of sales. The idea is that the more a company is spending on innovating, the greater chances that it will have what it needs to grow its earnings in the future. Ultimately, innovation is what guides Neuman's approach to investing because it is what secures future profits. And it's where the real value is created today. As of December 31, the most innovative companies had outperformed the S&P 1500 by over 3 percentage points annually over the prior 20 years, and about 4 percentage points for the past 10, he said. "Most ink is spilled on where we are in the economy," Neuman said. "But it's not as important as innovation, which is always growing."

This article reprint was originally published by Business Insider on March 26, 2019. Please note that Business Insider is an indepen- dent publication and the performance cited in the article does not represent the experience of any individual investor.

The views expressed are the views of Fred Alger Management, Inc. and Alger Management Ltd. (together with their affiliated entities “Alger”) as of April 2019. Alger has used sources of information which it believes to be reliable; however, this publication is not intended to be and does not constitute investment advice. These views are subject to change at any time and they do not guarantee the future performance of the markets, any security, or any funds managed by Alger. Risk Disclosures: Investing in the stock market involves gains and losses and may not be suitable for all investors. The value of an investment may move up or down, sometimes rapidly and unpredictably, and may be worth more or less than what you invested. Stocks tend to be more volatile than other investments such as bonds. Growth stocks tend to be more volatile than other stocks as the prices of growth stocks tend to be higher in relation to their companies’ earnings and may be more sensi- tive to market, political, and economic developments. Past performance is not indicative of future performance. Investors whose reference currency differs from that in which the underlying assets are invested may be subject to exchange rate movements that alter the value of their investments. Important Information for US Investors: This material must be accompanied by the most recent fund fact sheet(s) if used in connection with the sale of mutual fund shares. Fred Alger & Company, Incorporated serves as distributor of the Alger mutual funds. Important Information for UK Investors: The distribution of this material in the United Kingdom is restricted by law. Accordingly, this material is provided only for and is directed only at persons in the United Kingdom reasonably believed to be of a kind to whom such promotions may be communicated by an unauthorized person pursuant to an exemption under the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005 (the “FPO”). Such persons include: (a) persons having professional experience in matters relating to investments and (b) high net worth bodies corporate, partnerships, unincorporated associations, trusts, etc. falling within Article 49 of the FPO. Most of the rules made under the FSMA for the protection of retail clients do not apply, and compensation under the United Kingdom Financial Services Compen- sation Scheme will not be available. Important Information for UK and EU Investors: This material is directed at investment professionals and qualified investors (as defined by MiFID/FCA regulations). It is for information purposes only and has been prepared and is made available for the benefit investors. This material does not constitute an offer or solicitation to any person in any jurisdiction in which it is not authorised or permitted, or to anyone who would be an unlawful recipient, and is only intended for use by original recipients and addressees. The original recipient is solely responsible for any actions in further distributing this material and should be satisfied in doing so that there is no breach of local legislation or regulation. Certain products may be subject to restrictions with regard to certain persons or in certain countries under national regulations applicable to such persons or countries. Alger Management, Ltd. (company house number 8634056, domiciled at 78 Brook Street, London W1K 5EF, UK) is authorised and regulated by the Financial Conduct Author- ity, for the distribution of regulated financial products and services. FAM and/or Weatherbie Capital, LLC, U.S. registered investment advisors, serve as sub-portfolio manager to financial products distributed by Alger Management, Ltd. Fred Alger & Company, Incorporated is not an authorized person for the purposes of the Financial Services and Markets Act 2000 of the United Kingdom (“FSMA”) and this material has not been approved by an authorized person for the purposes of Section 21(2)(b) of the FSMA.

Fred Alger Management, Inc. 360 Park Avenue South, New York, NY 10010 / 800.992.3863 / www.alger.com


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