Eoin Treacy's view -
The primary task of an investor is to anticipate revisions in expectations. This requires an understanding of price-implied expectations and having a sound thesis for why the market will revise those expectations. The primary purpose of financial accounting is to provide a company’s external parties, including current and prospective shareholders and creditors, with the information they need to make informed economic decisions.
Earnings are deemed to be “the single most important output of financial reporting.”42 It used to be that earnings were on the income statement and investments were recorded mostly on the balance sheet. The rise of intangible investments means that the bottom line is now a mix of earnings and investment. The goal of this report is to allow an investor to untangle these pieces and assess them properly.
Earnings are less relevant for value today than in the past. This is because of the rise of intangibles and the increase in non-recurring, or ancillary, items reported in earnings.43 We focus on the former, but investors seeking to understand value must thoughtfully deal with both.
Baruch Lev, a professor of accounting at New York University Stern School of Business, argues that earnings have become less relevant for value over time.45 He supports this claim by analyzing the correlation between contemporaneous earnings and market value. He further develops a proxy for intangible investment, R&D plus SG&A spending as a percentage of assets, which allows him to separate the universe of stocks into those that are above the median, the “top spenders,” and those below, the “bottom spenders.”
Exhibit 7 show the results of this analysis by decade from the 1950s through the 1990s and from 2000 to 2016. A couple of features stand out. First, there is a monotonic decline in earnings relevance for the top spenders. This coincides with the rise of intangible investment. Second, the relevance gap between the top and bottom spenders, which was modest in the 1950s, grows over time. The earnings relevance for companies that rely mostly on intangibles is low, and reclassifying investment improves the signal.
The long-running underperformance of value versus growth has confounded many traditional fundamental investors. The continued outperformance of the technology sector, where there is a paucity of earnings but ample performance, raises important questions for value investors.
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