A $28 billion strategist flags the multi-trillion-dollar roadblock
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 However, this approach is now outdated, Neuman said.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.
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