Three Reasons Why Value Investors Should Beware

Many investors fear this rally is overheated, while others are smacking their foreheads wondering how they missed another epic race higher.
However, both groups have nothing to fear.
True, the rally is certainly overheated … and a pullback is long overdue. But I don’t expect such a pullback to last too long, especially if it’s deep (which I don’t expect). Too many dollars are chasing too few equities. The result has been – and will likely continue to be – higher prices.
So investors should not fear a forthcoming massive decline – a la the previous two summer swoons. Moreover, value investors will have yet another chance to buy that dip.
One argument many bearish investors have is that the price-to-book ratio (P/B) is extremely high. The P/B ratio is a common metric that compares a company’s market value to its liquidation amount. Value investors use it in order to determine if a stock is underpriced.
Though this argument appears correct on the surface, value investors cannot use this ratio with the same success and accuracy now compared to past years.
The S&P 500 has a P/B ratio of 2.5. This means that the index trades at 2.5 times the net value of its assets. A value of one is common, although higher values are acceptable if you believe the company will create more value than normal from assets. International equities have a P/B ratio of 1.5.
Naturally, investors are concerned that the high P/B ratio from U.S. companies indicates that either we’re in a bubble or a large pullback is coming. Additionally, U.S. equities are priced much higher than their foreign counterparts.
However, I’d urge that wise group to consider three things.

What Value Investors Need to Know 

First, the U.S. is the proverbial “nice house in a bad neighborhood.” The global economy isn’t growing at a fast clip, and the EU could dip back into recession. The U.S. isn’t growing at a fast rate either, but its size offers investors stability, and they’re willing to pay a premium for that safety net.
Second, the depreciation schedule for U.S. companies is aggressive. This lowers the value of assets quicker than normal resale values. Lowering the asset value elevates the P/B ratio.
Finally, the P/B ratio doesn’t account for intangible capital. In a time when software, apps and digital platforms are commonplace, you’d think the bean counters would have better incorporated intangible capital on the balance sheet  … but they didn’t.
The research and development costs are reflected in earnings, although intangible capital has no place in the asset section of a balance sheet. Is’s app store worthless? Of course not. But to accountants it is.
The expansion of software and other intangibles has grossly distorted the P/B ratio, and comparing the current multiple to historical norms is useless.
However, I still like this valuation metric, and believe it has a purpose. But in order to unlock its potential, analysts should attempt to value intangible capital or only use it to value banks. The current ratio, which is high by historical levels, is likely grossly overstated, and value investors should not let it sway them from buying the dip.

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