What are we looking for?
Companies with intangible value overlooked by traditional metrics.
Value investing is a tried and true strategy. The classic measure of value is the price-to-book value (P/B) ratio, and countless studies have concluded that over the long haul, buying stocks with a low P/B is a way to beat the overall market. P/B is also the sole measure determining inclusion in the Russell 1000 Value Index, which is tracked by exchange-traded funds managed by the world’s two largest asset managers, BlackRock Inc. and Vanguard Group Inc. Over the past decade however, this strategy has underperformed the broad market, and underperformed stocks with high P/Bs (“growth stocks”) by even more. Perhaps this period is an outlier in the long run of history and we will see a reversion to the mean. Or, perhaps, P/B is losing relevance as a measure of value.
P/B makes a lot of sense for industrial companies whose assets are capital goods. Their book value is easy to determine – it’s what the company paid for them. Accounting for things such as innovation, brand power and management talent is less straightforward. For this reason, in almost all circumstances, research and development (R&D) spending is expensed rather than capitalized on the company’s balance sheet. This effectively means it lowers a company’s reported earnings for the current year rather than increasing a company’s reported assets (and its book value). Maybe tech companies whose value is predominantly derived from intangible assets look unnecessarily expensive relative to their industrial, more tangible counterparts.
But what if R&D spending was capitalized rather than expensed? For this exercise, we look at all Canadian and U.S. companies and screen for those who have spent at least $25 a share outstanding on R&D cumulatively over the past five years.
This yields 25 companies; next we use Refinitiv’s StarMine Combined Alpha Model – a model considering price momentum, analyst sentiment, relative and intrinsic valuation, institutional investor sentiment, short interest, insider trading and earnings quality – to identify the five most attractive companies from an investment perspective. The score shown is a percentile score relative to all other U.S. and Canadian companies.
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What we found
Of the five names in the accompanying table, the company that looks the most expensive by its P/B – Toronto-based Constellation Software Inc. at 28.2 – is the one that has spent the most on R&D per share. If the past five years in R&D spending were included in book value its P/B would be 9.3 (the P/B+RD column), lower than the North American Software & IT Services average of 10.3. Constellation is also a particularly acquisitive company, spending $565-million in 2018, and a further $60-million buying companies in the first quarter of this year.
Investors are advised to do their own research before trading in any of the securities shown below.
Hugh Smith, CFA, MBA, is manager of Refinitiv’s investment management business for the Americas.