What are we looking for?
Companies with good long-term prospects undervalued by short-term investors.
In recent years, both investors and leaders of public companies have complained about the negative long-term effects of short-termism – too much attention being paid to quarterly earnings targets at arbitrary dates, rather than long-term value creation. In fact, according to a survey done by Financial Analysts Journal, 80 per cent of chief financial officers said that they would cut research and development spending (which creates long-term value) in order to meet short-term earnings targets.
Another trend we’ve seen in the market is the extraordinary rise of intangible value relative to tangible or book value. In 1975, only 17 per cent of the assets of the S&P 500 were intangible, according to the Sustainability Accounting Standards Board. By 2015, that share has risen to 84 per cent. A third trend is the rise of responsible investing, with US$82-trillion of institutional assets (more than half of the global total) now managed by signatories to United Nations Principles for Responsible Investment (UN PRI).
What brings these three trends together is the fact that intangible assets – such as intellectual property, human capital – create benefits for shareholders in the longer term and can’t be valued using traditional accounting methods. According to Wiley Finance, traditional financial statements now explain as little as 5 per cent of the value of a company. The value of these intangible assets is derived from the value society places on them and this value is particularly sensitive to the long-term environmental, social and governance (ESG) factors that the aforementioned UN PRI signatories integrate into their investment decisions.
All this considered, we will look for companies that have missed their most recent quarterly earnings target and have a high percentage of intangible assets and good ESG practices.
Starting with the S&P 500 as a starting universe, we screen for all companies who missed their Wall Street earnings forecast during the most recent quarterly earnings season.
Among these, we screen for those companies whose book value of tangible assets is less than 15 per cent of the company’s market value; in other words, intangibles represent more than 85 per cent. (Note: If a company has more in goodwill and other intangibles than total equity, this ratio will be more than 100 per cent.)
Finally, we use Refinitiv’s ESG Score and require a minimum of 85 per cent to identify those names whose intangible value has less downside risk. However, company-reported ESG data are not audited like financial data, so we also consider third-party-reported controversies. For example, Boeing Co. passed all of our screens thus far and has an ESG score of 91 based on their latest reported ESG data (2017), but it has had 56 ESG controversies (identified by Refinitiv) since this last ESG report. To avoid these types of companies, we require that there be no more than one controversy over this time frame.
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What we found
The screen yields four companies, in four different sectors, and some interesting cases. To highlight one:
Santa Clara, Calif.-based Agilent Technologies Inc. provides equipment and technology for medical labs. Fully 21 per cent of its revenue comes from China, and recent softness in Chinese pharmaceutical’s spending on quality control instruments led to Agilent missing its previous quarter earnings target by 1 US cent.
In China, domestic pharmaceutical companies enjoy protection from competition and higher margins than their free-market foreign counterparts – to the detriment of consumers. The government has recently eased this protection, leading to lower margins for domestic producers and industry consolidation, rather than investment in new equipment. However, the longer-term outlook for the Chinese market is promising as millions of Chinese join the middle class and can afford to spend more on medicine. It appears that here we have a short-term reason for a small, short-term earnings miss – which caused Agilent stock to trade down 10 per cent – even though the longer-term outlook remains positive.
Investors are advised to do their own research before trading in any of the securities shown below.
Hugh Smith, CFA, MBA, is the manager of Refinitiv’s investment management business for the Americas, and is a director on the board of the Responsible Investment Association of Canada.