The Times, they are A-Changing

The Times, they are A-Changing

I wanted to follow up and let you know that Bill Nygren, the Portfolio Manager for Oakmark Fund and Oakmark Select presented at our sales conference last week and had some great points about how to value companies in the world we live in today, and why the Morningstar style box can be misleading. Since we do get questions about how he might own a stock like Netflix or Alphabet in a value portfolio, I thought this might help.

In 1975, 83% of assets on the balance sheet for the average S&P500 company were tangible, today only 13% of the assets are tangible.

In the days of Benjamin Graham, defining value was much more straightforward and easy to categorize. Low price to book value was an accurate picture of value, because most companies were “asset heavy”.

Example: a company buys a machine to manufacture a good, this expense is amortized over the expected life of the machine, and therefore the entire expense does not impact the balance sheet all at once, immediately. Future value creation is accounted for. Today, when a company spends money on something like R&D to develop new products, that expense hits the balance sheet immediately, all at once, even though the return on that investment may carry on for 10 years. This affects ratios like P/E and P/B immediately with a large up front expense, making “asset light” companies look more expensive using existing GAAP accounting methods.

Example: If a company like Netflix spends on advertising—that expense is added to the balance sheet immediately, even if the average expected subscriber is a customer for 10 years. Oakmark would adjust that advertising cost over of the expected life of the customer, which would lead to a lower P/E or price to book.

With existing GAAP accounting, cost of acquiring a customer is expensed up front, immediately, even if the customer lasts a lifetime. In 1975 there was a 71% correlation between the stock price and tangible book value for S&P500 companies, today there is only a 14% correlation, though low price to book is still used to define value stocks in indexes like Russell and by Morningstar, etc. Overall, value investing is the same today as it was over 80 years ago. Investors follow fads, get emotional and over-react; this creates a gap between price intrinsic value, creating a margin of safety and the opportunity to make money.

 via Raymond James, Jeffrey Saut