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A recent article I read suggested that the poor performance of many value-oriented portfolios over the past few quarters is because value investors tend to favour companies rich with physical assets such as inventories, plant and equipment, and real estate. This made sense at a time when the primary objective of business was to build and ship products, but now companies often contract out the manufacturing and shipping, leaving them with an asset-light balance sheet. In fact, they may not have a physical product at all if they are selling software as a service, or advertising space on their own platform.

Investors have shown a clear preference for this second type of company and this is reflected in the strong performance of the FANG stocks (Facebook, Amazon, Netflix and Google), which at mid-year had contributed half of the year-to-date performance of the S&P 500. No wonder old-school value investors were left in the dust!

It is tempting for value investors to focus on tangible assets because they can kick the tires and visit the factory to check on management, but the real goal is to buy a company below its intrinsic value, which may not be dependent on physical assets. In fact, there are simple ratios that a value investor can calculate to see if a company has been investing to build an intellectual property "moat" around its product offering. We can then form a judgment as to whether or not we are overpaying for these intangible assets.

This is important because potential new competitors know that they will have to invest time and dollars if they want to capture market share. So they can either start with a greenfield entry, or acquire an existing player. They first observe how much an incumbent has spent over the past few years and then compare the valuation of the company to determine the ratio of price to spending. If the ratio is low, then it makes more sense to acquire the incumbent rather than start from scratch, especially as this will not increase the supply side of the industry. When the ratio is high, buying an incumbent is an expensive way to enter the market and so the newcomer will instead set up new greenfield capacity and this additional supply will trash margins for everyone. You don't want to be an investor in this industry if the second scenario unfolds.

If management claims that the company's competitive edge is derived from a constant stream of leading-edge new product introductions, which may or may not be patent-protected, then the focus should be on research and development spending, or what one could call the R&D moat. Management has a lot of discretion over what is defined as R&D and not all of it will be productive. But I add up the spending over the past five years and compare this number to the market capitalization of the entire company. As a potential shareholder, are we paying two times, five times or 10 times cumulative R&D spending?

There is no right answer here, but the lower the number the better. As a benchmark, the U.S. multinational drug companies such as Baxter International, Bristol Myers Squibb, Eli Lilly and Merck trade in a range of four to seven times R&D spend. These companies are so big that new products have a minimal impact on profitability, so we should be willing to pay a higher multiple for an emerging technology company – although a high ratio could also mean that the company is underspending on R&D.

The FANG stocks listed above trade between 14 and 30 times R&D, which implies that investors are either extremely optimistic about new service offerings, or more likely, they believe that the defensive moat for these companies revolves around brand name recognition and dominant market share. It is unlikely, for example, that the buyer of a Coke or Crest toothpaste has any interest in the R&D spending of Coca-Cola or Procter & Gamble. Their decision is based on habit and brand familiarity. In this case, a new competitor would have to invest substantial time and money into selling, general and administrative costs (SG&A) in order to break into the market, so this – the brand-name moat – should be the value investor's focus.

Once again, it is simple to calculate the cumulative five-year spend on this category to see what a shareholder is paying for this source of competitive strength. In the case of both Coca-Cola and Procter & Gamble, the company is valued at about two times the latest five-year SG&A spending, which isn't an extravagant price for a global presence.

The FANG stocks appear to be expensive both in terms of the R&D moat and the brand-name moat. Using either the R&D or SGA ratio, they trade between 10 and 30. Given a choice, I prefer to invest in the old economy drug and consumer product stocks: They are not cheap by traditional value investor criteria such as price-to-book value, but we are paying only a small price for brand recognition built up over the years.

Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.

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