02 Feb 2024 3 min read

Value meets vision: performance testing a modified factor strategy

By Jason Lee

In the second instalment of a two-part blog, we see how incorporating innovation capital into a value factor strategy can affect performance.


In the first part of this blog, we explored the rise of innovation capital across various sectors of the economy. Let’s now examine how incorporating innovation capital into a systematic strategy targeting the value factor can influence performance.

But before running the numbers, it’s worth taking a step back to consider the underlying risk premia behind the value factor.

Why value can pay

Essentially, the value factor can reward investors for the risk of holding securities that are likely to be experiencing financial difficulties or other economic challenges and therefore may underperform as future earnings become uncertain.1 By the same principle, investors may wish to seek compensation for the risks associated with investing in innovation capital, since the future payoff is also uncertain.

The fact that some research and development (R&D) projects fail to generate future returns should be no different from, say, a mining company investing in a new mine with heavy machinery and processing plants, only to find that the resource is not as productive as expected, making the venture unprofitable.

When it comes to valuation methods, the price-to-book (P/B) ratio relies on the book value of equity. However, tangible asset-based valuations such as the P/B ratio can lead to inaccuracies, particularly when based on reported balance sheet items only.

Arguably, P/B might misrepresent the true relative valuation of companies, as it overlooks contributions of certain intangible assets, which would impact the harnessing of the value risk premium over time. To mitigate a systematic valuation bias against companies rich in intangibles, we believe it is important to adopt valuation methods that acknowledge intangible assets such as innovation capital.2

A tale of two factor strategies

To assess the impact of including innovation capital in P/B ratios over 2000-2023, we have constructed two simple value factor strategies, both based on the STOXX North America All Cap Index, a market cap-weighted index representing a broad universe of companies in North America covering the small, mid and large market capitalisation segments.

The chart below shows the sector weight composition of the index over time, with information technology and financials the dominant sectors in 2023.


The two value factor strategies based on this index are differentiated by a tilt applied to the index using a score based on P/B ratios. The chart below shows the relative performance of the strategy that includes this adjustment versus the unadjusted version.


Across the 23-year horizon, our back-tested results show that the adjusted value factor achieved an average annual outperformance of around 16 basis points (bps) compared with the unadjusted strategy.

This adjustment for innovation allows the strategy to more effectively distinguish between traditional value stocks and those undervalued companies with growth potential, thereby potentially enhancing the capture of the value risk premium while offering diversification benefits. Notably, the average annual outperformance rises to around 40bps during the post-global financial crisis (GFC) era, highlighting the growing relevance and recognition of R&D by investors in recent times.

Controlling for the size bias

The results are consistent even when starting from an equal-weighted North America universe. By equal-weighting, we reduce the influence of the largest companies within the index and inadvertently lower the concentration to big tech names.

We observe an average annual outperformance of c.20bps across the full period, and c.19bps over the post-GFC period, suggesting that the additional premium remains persistent even when controlling for size.

A holistic approach

The inclusion of innovation capital in the P/B ratio represents a more holistic approach to value investing. This aligns the strategy with the realities of the modern economy, which increasingly relies on intangible assets to generate profits.

By incorporating innovation capital, investors can potentially uncover undervalued companies in sectors driven by innovation, leading to more informed investment decisions and an improved capture of the value premium.

This evolution in the value factor reflects the changing nature of business assets – and the need for investment strategies to adapt accordingly.


1. Source: Park H. An intangible-adjusted book-to-market ratio still predicts stock returns Critical Finance Review. 2022;11(2):265–97. doi:10.1561/104.00000100

2. Source: ibid.


Jason Lee

Quantitative Strategist, Index Solutions

Jason is a Quantitative Strategist in the Index Solutions Group, responsible for the research and development of LGIM’s bespoke systematic index strategies. Jason joined LGIM in June 2021 from the Currency Portfolio Management team at Russell Investments. Prior to that, he worked as an Analyst at Nomura International plc and at Bank of America Merrill Lynch. Jason graduated from the University of Nottingham with a BSc (Hons) degree in Economics and an MSc in Mathematical Trading & Finance from the Bayes Business School (formerly Cass), University of London. He also holds a certification in Sustainable Finance from the University of Cambridge.

Jason Lee