What stocks to invest in
on the plus side…
–book value is a simple, easy to understand, concept. Discount to book = cheap, premium to book = a potential red flag.
–it’s very useful for financials, which tend to have huge numbers of often complex, short-lived transactions with hordes of different customers, and where financial disclosure may not be so transparent (financials aren’t my favorite sector, by the way). So the 30,000 foot view may be the best.
…maybe a plus?…
–in the inflationary world most of us grew up in, and that is still reflected in the financials of older companies, historical cost accounting tends to understate the current value of long-lived assets. Think: a piece of land bought in Manhattan or San Francisco in 1950 or an oilfield discovered in 1970–or 1925. Many of the older retail chain acquisitions of the past twenty years have been motivated by the undervaluation on the balance sheet of owned real estate.
…definitely a minus
–in my experience, accountants tend to be very reluctant to compel managements to write down the value of assets whose worth has been impaired by, say, advanced age or technological obsolescence.
–more important, we are living in a period of rapid change. The Internet is the most obvious new variable, although I think we tend to underestimate how profound its transformative power is. In the US, we are also seeing a generational shift in economic power away from Baby Boomers and toward Millennials, who have distinctly non-Boomer preferences and a desire to live a different lifestyle from their parents.
Online shopping undermines the value of an extended physical store network. Software (which by and large doesn’t appear on the balance sheet) replaces hardware (which does) as a key competitive edge between companies.
Warren Buffett’s key innovation as an investor was to recognize the value of intangibles like this in the 1950s. In his case, it was that the positive effect of advertising expense and strong sales networks in establishing brand power appeared nowhere on the balance sheet. In a world where his competitors were focused only on price-to-book, he could buy these very positive company attributes for free. Price to book was still a solid tool, just not the whole picture.
…vs. structural change
The situation is different today.
The Internet is eroding the value of traditional distribution networks and of other physical assets positioned to serve yesterday’s world. The shift in economic power to Millennials is likewise calling into question the value of physical assets positioned to serve Boomers.
In more concrete terms:
Tesla doesn’t need a car dealer distribution network to sell its cars. A retailer can use Amazon, or Etsy or a proprietary website, rather than an owned store network. A writer can self-publish. These all represent radical declines in the capital needed to be in many businesses today.
Millennials like organic food and live in cities; Boomers eat processed food and live in the suburbs.
This all calls into question the present economic worth, still expressed on the balance sheet as book value, of past capital spending on what were at the time anti-competition “moats.”
Another issue: I think that the institutional weight of the status quo has pressured managements of older companies into ignoring the need for substantial repositioning–including writedowns of no-longer viable assets–so they can compete in a 21st century environment. Arguably, this makes low price to book a warning sign instead of an invitation to purchase.
– What stocks to invest in