Ideas Farm: Higher intangibles = higher returns for investors

I’m banging the 'intangibles' drum once again. It’s in so much need of banging!

December 2, 2021

"Intangible intensity" could be the best single predictor of stock market returns
Be an investor not an accountant
All this year's drum-banging in one final jam on intangibles for 2021
Loads of new idea-generating data

This year I’ve banged the drum on the subject of 'intangibles' a lot ('Finding hidden value', 25 February 2021). And recent research that attempts to quantify the advantage to investors from paying attention to this issue means I’m having one last bash for 2021.

Over several decades, intangible investments have become increasingly important for the world's most innovative businesses ('infuriating intangibles', 22 April 2021). Intangibles consist of things such as software development, drug discovery, intellectual property, brands and even operational processes. This type of spending creates the knowledge and 'organisational capital' on which the most successful businesses of the modern age are built ('Forget traditional valuation', 29 Apr 2021).

So what, we may ask? The 'so what' is that accounting standards treat intangible investments in a very different way to tangible ones (Baruch Lev podcast: “Financial reports are irrelevant”, 25 Feb 2021). Tangibles are things such as property, machinery and vehicles. Stuff you can touch and feel.

The primary purpose of a company’s accounts is to match revenue against the costs that are incurred to generate it. When a company makes tangible investments, that means recording the spending as an asset on the balance sheet. The asset’s value is then slowly fed through the income statement to match its cost against the revenue it helps produce during the investment’s useful life. A process known in accountancy jargon as depreciation. This gradually reduces the asset’s value to zero (presuming there’s nothing left to sell at the end).

This broadly seems sensible. Wouldn’t it make sense if intangible investments were treated the same? Well, they’re not. Instead, most intangible spending is effectively swept under the carpet. It never finds its way onto the balance sheet. More often than not it is treated as a day-to-day cost rather than a long-term investment to be matched against the sales it helps generate long into the future.

True, there are some genuine reasons for this accountancy mis-match. Intangible assets are often difficult to identify and value ('Profiting from unorthodox value', 6 July 2021). Also, such investment is often of the win-or-lose variety ('Growth rates rising', 22 July 2021). For instance, a promising drug being developed by a pharma company can require huge expenditure only to prove worthless should it flop at the final stage of trials. Alternatively, it could be approved, become a blockbuster and generate insane returns on the money invested.

All the same, intangible spending could be recorded as assets on the balance sheet and then either accounted for over its useful life if a success, or written off sharpish if it proved a failure ('Further Reading: Reinventing Intangibles', 25 February 2021). And failure is intrinsic to much intangible investment. Seeing this process in action would be valuable in deepening investors' insights into how the best innovative companies monitor and manage this part of the value-creation process (eg average time to failure, average spend to failure, failure/success spend etc). This knowledge could help significantly improve capital allocation by investors and companies alike.

As things stand, though, the treatment of intangibles depresses the reported profits of many of the world’s most innovative companies. It hides important information on how companies manage and embrace the failures that accompany successful innovation. It also causes balance sheets to massively understate the value of the asset belonging to successful intangible-intensive companies.

A recent piece of research by Dion Bongaerts, Xiaowei Kang and Mathijs van Dilk of the Rotterdam School of Management has taken the important step of quantifying what investors can gain by simply focusing on intangibles.

The academics used recognised methods to estimate the intangible intensity (estimated intangible assets as a percentage of estimated total assets) of Russell 3000 companies from 1989 to 2020. They then tested a strategy of going long on shares of the most intangible intensive and short on the least. This logged an average annual return of 4.6 per cent. That was better than any of the five most widely-recognised factors that explain stock performance.

The moral of the story? Just because accounting bodies think it’s best to treat most intangibles as day-to-day costs does not mean investors can also afford to do so.

External link on intangibles:

Intangible assets and the cross-section of stock returns, by Dion Bongaerts, Xiaowei Kang and Mathijs van Dilk of the Rotterdam School of Management, 21 Sep 2021