- The value factor’s poor performance was one contributor to the underperformance of value strategies over the past decade.
- We investigate whether value-factor definitions can be enhanced by accounting for the ever-growing importance of intangible assets when it comes to driving revenue and growth.
- Using a global universe, we show that capitalizing research and development expenditure positively impacted the performance of the book-to-price ratio and had a minor impact on earnings to price.
In Value-Performance Anxiety, we discussed the value factor’s poor performance across regions over the past decade (see exhibit below). This underperformance has raised concerns among investors, perhaps less about the factor’s efficacy to explain risk, and more about its long-term premium. Our previous research also demonstrated that the poor performance of the value factor drove the underperformance of value strategies during the past decade, to a certain extent.
In this second blog post in our series, we further probe the underperformance of value over the past decade and investigate whether the historic definition of value remains relevant or has evolved. We specifically look at whether a company’s valuation may need to reflect research and development (R&D) investments companies make as they look for competitive advantage.
Book-to-Price and Earnings-Yield Performance Across Different Global and Regional Models
The GEMLT, USE4, EEM and EULT models apply to global, U.S., emerging markets and European equity markets, respectively.
One popular explanation for the value factor’s recent underperformance is that traditional valuation ratios used to measure value (distinguish cheap from expensive) are outdated. The traditional ratios have relied on fundamental accounting measures such as book value and earnings; but, over time, market dynamics and business models have changed drastically. Company growth and earnings are increasingly driven by intangible assets1 in today’s tech-heavy environment with capital-efficient business models. Existing valuation ratios fail to reflect this component.
Back to Basics
Academicians and practitioners have researched multiple ways to incorporate intangible assets into valuation ratios. Their empirical results demonstrated improvement in extracting a premium from the value factor, with a focus on the U.S. market.2
Here, we expand the universe to a global one and focus on capitalizing3 R&D expenses.4 While physical purchases such as plants and equipment are considered assets and amortized over their useful life, R&D expenditure is not recorded as an intangible asset, based on most accounting standards; it is expensed immediately. The benefit of R&D expenditure in profit and growth, however, is generally reaped over several years. Therefore, valuation ratios derived from assets or earnings may overestimate the valuation of companies and industries with higher R&D expenditures (i.e., make them look more expensive).
In our analysis, we assess the behavior of pure value factors, eliminating the impact of other style, industry or country factors.5 Specifically, we examine book-to-price (B/P) and earnings-to-price (E/P) ratios, two of the broadly used valuation ratios that are affected by how R&D expenditure is accounted for and also used in the construction of the MSCI Enhanced Value Indexes.6
Adjusting for R&D in Valuation Ratios
Moving R&D investment from the income statement as an expense to the balance sheet as an intangible asset affects the book value of a company and therefore its B/P ratio. One less expense also increases company earnings, and therefore E/P gets adjusted.
The R&D adjustment follows four steps:
- The current-year R&D expenses are capitalized as R&D assets on the balance sheet.
- R&D assets are depreciated over time.7
- The current-year R&D expenditure is added back to earnings and the depreciated R&D assets are deducted from earnings as an expense.8
- Book value is adjusted accordingly.9
R&D Adjustment Impacted Performance
Over the 20-year period ending December 2020, the R&D-adjusted B/P factor outperformed its unadjusted counterpart on an absolute and risk-adjusted basis. The R&D adjustment for the E/P factor, however, didn’t help long-term performance, as absolute return for the R&D-adjusted E/P was in line with the unadjusted, and the risk-adjusted return was lower.10
The difference in the impact on performance between the two ratios may be partially due to the fact that, for an R&D-heavy company, adjusting for R&D can mean a significant permanent increase in its intangible assets, which impacts its B/P ratio when compared cross-sectionally with other companies.
On the other hand, while earnings increase when we add back the current year’s R&D expenditure, the previous years’ R&D assets are depreciated and deducted from earnings. So, while earnings may be slightly changed from year to year, the R&D adjustments may largely cancel each other out. Thus, earnings and E/P ratios are not as affected.
The Impact of R&D Adjusment on Value Factors Over the Last 20 Years
|Return||Risk||Return/Risk||Avg |t-stat|||% |t-stat| >2|
What About Value’s So-Called ‘Lost Decade?’
When we look at the past two decades, we see that R&D adjustment helped improve the performance of B/P in each. For adjusted B/P, the performance dip in the lost decade of the 2010s, as compared to 2001 to 2010 was slightly lower than that of unadjusted B/P. The adjustment for the E/P factor had opposite impacts across the two decades. Adjusted E/P had a negative impact from 2001 to 2010, and a positive one from 2011 to 2020.
The Impact of R&D Adjustment on Value Factors over Each of the Last Two Decades
It’s also important to look beyond performance to a factor’s explanatory power (the ability to explain cross-sectional variation of return). To do so, we looked at B/P and E/P’s ability to increase the cross-validated R-squared (CVR2), or CVR2 gain, by determining the difference between the CVR2 of the GEMLT with and without each factor.11 As shown in the exhibit below, the R&D adjustment had some positive impact on the explanatory power of the two value factors, and was again more pronounced for the B/P factor.
Slight Improvement in Value Factors’ Explanatory Power After R&D Adjustment
Keeping Value Relevant to Business Evolution
As business models have evolved over recent decades, there has been more focus on the increasing role of intangible assets in terms of driving profits and growth across sectors. In this blog post, we expanded on previous research by asking whether intangibles help enhance the definition of the value factor. Using a global universe, we showed improvement in the performance and also explanatory power of value over the past decade — value’s lost decade, in particular for B/P12 — which means it may be worth evolving analysis to include such additional measures that reflect changing company fundamentals.
1Intangible assets are those not physical in nature, including intellectual property such as patents and trademarks, as well as goodwill and brand recognition.
2For instance, see Lakos-Bujas, D. 2020. “Revisiting Value.” J.P. Morgan Global Quantitative & Derivatives Strategy.
3In accounting, capitalization refers to the process of expensing the costs of attaining an asset over the life of the asset, rather than the period the expense was incurred. Rather than listing the asset as an expense, it is added to the company's balance sheet and depreciated over its useful life.
4A few research papers have also proposed adjusting traditional ratios like B/P for selling, general and administrative expenses (SG&A). Our analysis suggests that improvement achieved by adjusting for SG&A was insignificant.
5We use the MSCI Global Equity Model for Long-Term Investors (GEMLT) to measure and assess the performance of the value ratios and the adjustment applied. The universe is a global one consisting of large-, mid- and small-cap stocks across developed and emerging markets.
6Enterprise-value-to-cash-flow-from-operations ratio (EV/CFO) also is used in the MSCI Enhanced Value Indexes but is not impacted by the R&D adjustment discussed.
7R&D assetst = (R&D assetst-1) * (1 - depreciation rate) + R&D expensest; (the subscript indicates the year, t indicates the current year and t-1 is the previous year)
The rate of depreciation for R&D assets depends on many factors and varies from industry to industry and company to company. Academic and practitioner researcher have used various rates in their studies, including industry-specific rates and applying the variation to a handful of industries. While using industry-specific depreciation rates is intuitive, coming up with an accurate rate is not straightforward. For simplicity and to avoid arbitrary numbers, we use a constant depreciation rate of 20%. To ensure the robustness of the approach and results, we repeated the analysis using other constant depreciation rates (10% and 30%) as well as industry-specific rates reported in previous research. In all cases we saw minor changes in the performance of the factors. In addition, the cross-sectional correlation between the factors using different rates were close to 1, indicating that the choice of a depreciation rate around 20% did not significantly impact factor exposures.
8Adjusted earningst = earningst + R&D expensest - (R&D assetst-1) * (depreciation rate)
9Adjusted book valuet = book valuet + R&D assetst
10 B/P and E/P are normalized and included in GEMLT, replacing GEMLT’s existing B/P and E/P factors, in turn, for our analysis. Using multivariate regression, we calculate the return associated with adjusted and unadjusted B/P and E/P. Factor returns are the returns of hypothetical long-short portfolios with exposure to one of the target factors (e.g., E/P) and no exposure to any country, industry or style factors.
11For details of CVR2 and CVR2 gain calculation see:
“Barra Global Total Market Equity Model for Long-Term Investors.” MSCI Model Insight, December 2015.
12U.S. stocks were similar: Adjusted B/P outperformed unadjusted over both 2001 to 2010 and 2011 to 2020; adjusted E/P outperformed from 2011 to 2020 but underperformed from 2001 to 2010.