Fama/French Asset Pricing Model
Fama/French dramatically popularized the use of Book to Price as a factor for value. Their 3-factor asset pricing model outlined how market performance could be explained using the market risk premium, size and value. The paper used data from 1962-1989 and was published in 1992. Additionally, Eugene Fama later went on to win the Nobel Prize in Economics.
In a follow up paper in 2013, Fama/French introduced a 5-factor model and gave remarks on the original 3-factor model. “With the addition of profitability and investment factors, the value factor of the FF three-factor model becomes redundant for describing average returns in the sample we examine” (Fama & French, “A Five-Factor Asset Pricing Model”, Abstract). Although book/price remains in their 5 factor model, they write that the factor is fully explained by profitability and growth.
In the past 5-10 years, investors have seen drastic underperformance from traditional value factors. Russell style indices, which use sales growth, earnings growth, and book/price to determine value and growth, have seen a strong divergence in performance since the 2008 recession.
Russell Value/Growth Anomalies
In addition to the dramatic difference in returns, notable classification errors occur in Russell large cap indices:
WEN (Russell 1000 Growth): Wendy’s grew their total assets from $4.7B in 2010 to just under $5B in 2019, roughly 5% total growth in nine years. However, because they repurchase shares consistently, their book/price levels appear inflated from shrinking book equity.
AZO (Russell 1000 Value/Growth): Similar to Wendy’s, Autozone repurchases shares every year. In fact, AZO has repurchased nearly 80% of shares outstanding since the late 1990’s. Since the firm continuously returns capital to shareholders through dividends and share repurchases, book equity is negative, and the firm has a negative book/price. This negative value is omitted from Russell’s methodology, leading to a roughly equal blend of AZO in value and growth style indices
ORLY (Russell 1000 Growth): O’Reilly Automotive operates in the same industry as Autozone, and has also repurchased a significant amount of shares over the last decade. This repurchase activity has not pushed book equity negative, and ORLY is classified solely as a growth stock due to the low but non-negative book equity value.
To be clear, Applied Finance is not ultimately interested in the nuances of value/growth designations, as we view the world in a market-oriented manner. For the reasons we outline below, however, we do see book/price as a broken variable in these classification methodologies.
Applied Finance believes that there are a few broad trends that have skewed book/price as a value indicator over the past few decades. In 1982, the SEC loosened rules on stock buybacks (adjustment to Rule 10b-18 of the Securities and Exchange Act of 1934). Since then, buybacks have become an immensely popular method of returning capital to shareholders.
Source: S&P Global
When stock is repurchased, cash is deducted from total assets alongside an equal deduction of book equity to satisfy accounting equations. The growing popularity of share buybacks has significantly contributed to the prevalence of “artificially” low or negative book equity. In turn, this has skewed book/price as a factor to represent value. Companies that constantly return capital to shareholders should not automatically gravitate towards growth on the value/growth spectrum.
Capital mix has gradually transitioned from tangible to intangible assets over time. Over the past 5 years, the current S&P 500 constituents have gone from $240B in annual R&D expenses in 2015 to over $350B last year.
Applied Finance Database
GAAP accounting treats research and development costs as immediate expenses, rather than capital investments. However, firms do not simply pay for research/development of intellectual assets and never see benefits. Companies, especially in the technology and healthcare sectors, make ongoing intangible investments for future profitability.
As the US has further developed into a service economy, the relative proportion of intangible vs tangible capital has changed over time. An economic measure of total invested capital, including intangible assets from R&D expenditures and inflation adjusted capital, would better capture the residual equity of common shareholders. Book equity derived from GAAP measures, however, ignores these adjustments. A simple ratio comparing book equity to market prices without further consideration of growth and profitability that may be a function of intangible investment provides a completely inadequate valuation or style measure. Stay tuned for a follow-up piece where we evaluate an alternative measure for assigning style classifications.
For an overview of adjustments we make to begin evaluating companies for our investment strategies, you can read ECONOMIC MARGIN®.
We will be publishing a follow-up piece where we evaluate an alternative measure for assigning style classifications. Make sure to join our newsletter to receive updates.