Bill Nygren of Harris Associates discusses how tangible book value may no longer be a good indicator of a company’s potential value.
Nygren: Tangible Book Value May No Longer Be A Good Value Indicator
Q3 hedge fund letters, conference, scoops etc
Transcript
The world today unfortunately has become very binary. It's hard to find centrists either in the media or in the population. And that's the same thing we find in the investment world.
You have people who believe in value you have people who believe in growth and despite for almost 30 years of saying value and growth really aren't opposites the way the investment community works especially the adviser community. They think of value and growth as being opposites of each other.
We've never been a believer in that. We think growth is a part of value. It's a good thing when you can buy an inexpensive stock that also has good growth. Moving this more into an accounting discussion one of the fundamental principles of accounting. Is matching. That you want to match the expenses during the period that it generates revenues. You build a plant you expect that plant to last for 40 years. The expense of that doesn't go through the income statement you put it on the balance sheet you depreciated over 40 years and the expense comes through as a depreciation expense and that works really well for heavy industrial companies.
The balance sheet isn't what it used to be. As we've moved from an asset heavy to asset light economy as recently as 1975 83 percent of a stock price on average was represented by the tangible book value of the underlying business. And you can see by decade how that shift has just continually move toward intangibles being much more important than tangible assets. And today almost 90 percent of the average stock's price is based on intangible values rather than tangible. What's happened because of this is the tie with tangible book value has become broken. Back in 1975 there was a 71 percent correlation. Today that correlation is down to 14 percent.
If you know the book value of a company today you have almost no ability at all to guess where its stock price is going to be the value investors who have clinged to an approach that only looks at tangible book value have been going through a really really difficult period because the reversion to the mean isn't working anymore. What's really valuable in this economy isn't so much the plants and the machines you have it's become intellectual capital and other assets and you've seen price to book fail as a measure for delivering excess returns for the past decade.
The value approach as measured by the Russell index has underperformed the market. You can see it underperformed sharply in the Great Recession and after a brief recovery price to book has still failed to deliver excess returns. The most important thing to remember here is that most of the most significant investments firms are making. Today. Are for intangible assets assets that don't have a building tied to them. They don't have a piece of equipment tied to them. And what that's done is it started to destroy the linkage between the financial statements the value investors depended on for so many years. If you look at the change in book value one year to the next.
The difference is primarily net income. Dividends would be a reduction from that but for simplicity let's just look at a company that doesn't pay dividends. So the change in that book value when book value is a good indicator of business value was a pretty good indication of how much value was added to the company during a year. But if we fast forward to today.
