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A $28 billion strategist flags the multi-trillion-dollar roadblock keeping investors from the stock market's most hidden gems ' and explains his strategies to outsmart it

Published by Business Insider on Tue, 26 Mar 2019


Value stocks have clearly underperformed growth stocks throughout the bull market.Investors have been led astray by a widely used metric that overinflates the value of many companies that would be considered undervalued by other measures, according to Brad Neuman, the director of market strategy at Alger.In an interview with Business Insider, he laid out two strategies to circumvent this perceived flaw, and to identify the stocks that are truly undervalued.The tussle between growth and value stocks has produced a clear winner during this bull market.Growth stocks, belonging to companies whose earnings are expected to increase at an above-market rate, have outperformed their counterparts considered as undervalued. The latter categoryvalue stocksare the darlings of stock pickers who are always on the hunt for companies the broader market does not yet appreciate.This performance gap is the result of "something strange," according to Brad Neuman, the director of market strategy at Alger, a $28 billion growth-fund manager.His gripe is with price-to-book ratio, an indicator that gauges a company's stock price relative to the value of its net assets. This ratio is a significant part of the methodology that dictates which stocks on the Russell 1000 are classified as value.The multi-trillion-dollar problem with this ratio lies in the exchange-traded funds and indexes loaded with value stocks, Neuman said. The issue even impacts active fund managers, who peer over their shoulders to compare their performance to value benchmarks.To understand why Neuman sees price-to-book value as a problematic way to pick value stocks, it's worth unpacking why it is used in the first place.Investors care about price-to-book value because they see a strong link between a company's book value and its earnings power.Neuman provided the example of a fictitious car plant with the machinery to create 100,000 cars. In the event of an economic recession, output capacity would be impaired and maybe even cut in half to 50,000 cars. The value of the machinery would remain on the balance sheet but the company's stock price would fall with the broader market, pulling down its price-to-book ratio.Read more: Stocks just traded like they do right before recessions beginand one of Wall Street's biggest bulls warns a 'big test' of the worst-case scenario could failA diligent value investor could find this automaker with a reduced price-to-book ratio and buy the stock. The bet would be that when the recession is over, the plant will return to producing 100,000 cars again, increasing its profits and stock price as a result.In short, all this investor had to know was that the company's underlying assets, represented by its book value, had the potential to lift its earnings once the macro environment returned to normal.However, this approach is now outdated, Neuman said."The accounting hasn't kept up with the evolving economy and business models," Neuman told Business Insider by phone. "The accounting is now broken."What has changed over the years is that investments in intangible assets have superseded investments in tangibles, Neuman said. A higher share of spending is assigned to intellectual property, marketing, training, human resources, and other items that don't appear on balance sheets as assets like machines do. Such intangibles are written off as expenses instead.If they were capitalized onto balance sheets instead, the price-to-book ratio would be a more accurate gauge of value for many sectors, Neuman said.Read more:A former Tesla investor explains why he thinks Elon Musk is the wrong person to lead the company, why he dumped the stock, and what he's now buying insteadHe cited video gaming as one such sector. If spending on ads for new games were to be capitalized on gaming companies balance sheets, their price-to-book-value ratios would fall from 4x to 3x, Neuman said.In other words, a single accounting tweak that's more in tune with the times suddenly makes them appear cheaper.That example constitutes the first of two approaches Neuman recommended to update the definition of "value" as it exists in various indexes and ETFs. It's labor intensive, and involves understanding the value of assets, as well as products in the research and development pipeline, that are not expressed on a company's financial statements. An example is the value of Google's search algorithm, Neuman said.Neuman's second piece of advice to circumvent the existing definition of value is to substitute the price-to-book ratio for R&D spending as a share of sales. The idea is that the more a company is spending on innovating, the greater chances that it will have what it needs to grow its earnings in the future.Ultimately, innovation is what guides Neuman's approach to investing because it is what secures future profits. And it's where the real value is created today. As of December 31, the most innovative companies had outperformed the S&P 1500 by over 3 percentage points annually over the prior 20 years, and about 4 percentage points for the past 10, he said."Most ink is spilled on where we are in the economy," Neuman said. "But it's not as important as innovation, which is always growing."SEE ALSO:Stocks just traded like they do right before recessions begin ' and one of Wall Street's biggest bulls warns a 'big test' of the worst-case scenario could failJoin the conversation about this storyNOW WATCH: The founder and CIO of $12 billion Ariel Investments breaks down how his top-ranked flagship fund has crushed its peers over the past 10 years
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