The recent value underperformance raises a reasonable question: Is this time different? Put another way, is this a new normal for value investors, with the value premium gone or even negative? Many narratives are being offered to suggest that value investing no longer has merit. They generally fall into one of the following categories. Our first two are the simplest, and the easiest to dismiss. The next five are structural changes in the economy, which ostensibly make the value factor newly irrelevant. None fare particularly well in empirical testing.

The final three are the most important and are demonstrably accurate. Intangibles are not captured by book value, so the B/P-based HML is a poor way to distinguish between growth and value. A widening valuation spread between growth and value simultaneously pushes down the past performance for B/P HML and, with value now at the cheapest relative valuation in history, pushes up the likely future performance. And we have a left-tail extreme outlier, in both current relative valuation and recent relative performance. We return to these narratives after briefly reviewing the narratives that have less merit. We propose a return decomposition that suggests that intangibles, revaluation, and a left-tail outlier are all important elements of value’s travails. The evidence for the other narratives is weak. It is beyond the scope of this paper to test all of the narratives, but our approach addresses the most important empirical predictions for all of them.

Was value merely lucky in the past or is it now arbitraged away by its own popularity?

Overfit factor. A particular strategy may have been a product of data mining discovered by multiple testing and working only in the backtest due to overfitting.11 Given the amount of evidence, the economic theory, and the long investment management practice behind value investing, this is a doubtful explanation, further contradicted by the still-positive structural return for the HML value factor, net of revaluation.

Crowded trade. Value is a popular factor, widely accepted as a legitimate factor throughout the academic and factor-investing communities. Smart beta, and its cousin factor investing, have been among the fastest growing strategies in the past decade, attracting, by some measures, US$1 trillion or more (per Morningstar). These flows have ostensibly led to crowding, so that the value factor has been “arbitraged away.” If the crowding narrative were correct, then the value premium would be structurally impaired for as long as crowding persists. Value investors’ trades, however, should boost the prices (and valuation multiples) of value companies, relative to those of growth companies, to a point where the profitability and migration effects exactly cancel. The opposite has happened: value has become cheaper relative to growth, to an unprecedented extent.

Have structural changes in the economy made the value factor newly irrelevant?

Technological revolution, hence better growth stocks. This narrative suggests that today’s growth stocks are growing faster and earning more profit than the growth stocks of the past. In the last decade, we have witnessed the emergence of a vast digital sector, leveraging technological prowess to take over large parts of the macroeconomy. The recent success stories of the FANMAG stocks are captivating. These enterprises have driven many established companies out of business. These US-based tech companies are collectively vastly profitable. The combined capitalization of the FANMAG stocks was US$6.15 trillion in mid-2020, exceeding the stock market capitalization of every country in the world except for the United States and China. These six stocks are worth more than the entire publicly traded economy of economic powerhouses such as Japan, the United Kingdom, or Germany. This narrative suggests that the disruptive new technological leaders can drive outsized monopolistic profits, while the old brick-and-mortar value companies are choked into irrelevance.

If this narrative is correct, then we should expect that value investing may be structurally impaired for a prolonged period of time. Empirically, we should expect that growth companies would have already become even more profitable and faster growing relative to value companies than they were historically. The evidence contradicts this thesis.

Less migration. We hear several reasons that migration may be slowing. For instance, the more-monopolistic structure of many industries compared to a few decades ago makes it harder for new companies to gain market share. Also, as the valuation of growth and value diverge, it becomes more difficult for companies to migrate from growth to value, and vice versa. A related argument suggests that both the markets and the economy have evolved to a point where value stocks stay cheap and growth stocks stay richly priced, slowing the migration that drives the value-stock advantage. The more-stable valuations could also, in part, be driven by market participants’ increased sophistication, allowing them to more often “get it right” on the relative valuations of most companies.

If any of these narratives is correct, then we should observe a lower portion of value’s return attributed to the change in style (i.e., value stocks migrating toward growth, and growth stocks migrating toward value). Empirically, we find that migration is essentially unchanged from the past.

Low interest rates. In the last decade, we witnessed a long period of zero or near-zero interest rates—with no historical precedent—with US$11.6 trillion of government bonds worldwide trading at negative yields at the end of June 2020.12 In the standard Gordon formulation, low interest rates should have a disproportionate valuation impact on longer-duration and lower-yielding assets, unless the low interest rates are driven by a similar-magnitude drop in growth expectations. Liu, Mian, and Sufi (2019) suggest that industry leaders can disproportionately benefit from low interest rates to generate outsized monopolistic profits.

Although the economic mechanism is different, the implications and empirical predictions of this narrative are very similar to those suggested by the technological revolution narrative. Arnott et al. (2020) show, however, over the 1926–2020 period, that there is no meaningful relation between interest rate levels, or changes in rates, and the value premium. In addition, they document that value companies benefit more from low interest rates given they often carry more debt than growth companies.

Stranded assets. The market value of an enterprise reflects the value of the future use of assets owned by a company. As the economy and regulations evolve, certain types of assets can significantly depreciate in value or can become associated with material future liability. Particularly, as environmental, social, and governance (ESG) issues rise to the top of the public’s and regulators’ concerns, the old business models of energy, tobacco, gambling, and many other types of companies—overwhelmingly value stocks—may take a strong hit. Although the ESG conversation is as important and influential as it has ever been, it is merely another form of creative destruction that has been with us since the dawn of civilization, and which almost always afflicts value stocks relative to growth.

The growth of private markets. The number of listed stocks has more than halved in just 23 years, from over 7,500 in 1997 to barely 3,600 today.13 There are many reasons for the decline (not least being the regulatory environment for publicly traded companies), but one narrative suggests that part of the decline may be due to the growth of private equity investors who buy potentially undervalued stocks and take them out of public markets. Such activity leaves fewer value opportunities and potentially lowers the expected return on value.

This narrative suffers from two logical inconsistencies. First, most private equity investors are seeking growth not value. Second, given the growth of private equity, the buying pressure should increase the prices of deep-value stocks when they become, and are, private equity targets. So, on the one hand, some stocks that would fall into the value portfolio may disappear, but on the other hand, the activities of private equity investors should elevate the prices of certain value stocks before they disappear.

Let’s turn our attention to the narratives that demonstrably have merit.

The Trouble with Intangibles

The B/P ratio is one of many ways to define value. Intrinsic value is another definition, introduced by Graham and Dodd (1934). Indeed, they specifically cautioned against the use of B/P as a substitute for intrinsic value.14 In today’s economy this warning is ever more relevant, as companies’ intangible assets—intellectual property, brand, patents, brands, software, human capital, reputation capital, customer relationships, and so forth—are often at the core of their ability to generate and maintain profit margins, yet are almost totally ignored by the book value. Book value only captures the traditional tangible capital locked in bricks and mortar and in financial assets such as cash and other securities.

From an accounting viewpoint, book value can only capture the value of intangibles through contributed capital, or goodwill, in a corporate acquisition.15 This makes the B/P ratio vulnerable to misclassifying intangibles-heavy companies as expensive because book value understates the firms’ assets, and to misclassifying intangibles-light companies as cheap. Is there a better, more-objective measure of a company’s assets, including its intangibles?

Let’s presume that companies invest in research and development (R&D) and selling, general, and administrative (SG&A) expenditures because they expect to earn their money back within a reasonable span. Accordingly, following Peters and Taylor (2017), we capitalize all R&D expenditures as knowledge capital and apply a 30% share of SG&A expenditures as capital related to human capital, brand, and a company’s distribution network.16 Suppose these sums are added to book value, rather than expensed, much as if the expenditures were used to buy a building, then amortized away over a suitable span. After all, no one will buy a building or invest in R&D unless they expect this investment to be profitable within a reasonable span. After we capitalize both R&D and 30% of SG&A expenses, we then amortize those expenses, much as a building is depreciated, with the perpetual inventory method used by Peters and Taylor.17

Figure 1 plots the ratio of capitalized intangible capital to the book value of equity for all publicly traded companies in the United States. We show the equally weighted average for the growth and value portfolios (selected on the basis of B/P, not intangibles-adjusted B/P), as well as the market average, from 1963 to 2020.

In 1963, if we capitalize R&D and 30% of SG&A (then amortize both away), the book value for the US stock market goes up by just over 30%. A lot has changed since then. In the last three years, capitalized intangibles have tripled to nearly 100% of tangible book value. As of 2020, even for value stocks, intangible capital exceeds 50% of tangible book value, and for the average growth stock, intangibles are nearly twice as large as book value and have exceeded book value for nearly 20 years. It is very clear that book value is a tired, outdated metric for distinguishing between value and growth stocks.