The power of Intangibles has been growing for the past three decades but 2020 marked the year that intangibles took center stage in the real economy.
Exceptional returns came from companies that:
Encouraged people to care (customer satisfaction, employee engagement and broader reputation); and
Nurtured a culture of creativity (problem-solving, innovation and resilience)
While the ever-growing proportion of intangible asset value versus tangible asset value has been visible in the S&P 500’s market value for several decades (see the graph below), relative performance in 2020 represented a major challenge to those who insist intangible value is insignificant, nothing new, or even a fad. At Two Centuries, we believe those who cling to traditional factors are missing the opportunity this evolution has created.
Technological progress, outsourcing, complex supply chains, and changing cultural values have propelled intangible asset value to more than 90% of the valuation of many companies.
During the global events of 2020, corporate success was inextricably related to less visible intangible components of value such as brand, reputation, company culture, and customer satisfaction. Notably, the importance of effective leadership has never been more crucial. Quite simply, the world has changed and 2020 is the rebuttal to anyone who still disagrees that intangibles have become the most important assets of a company.
Source: Ocean Tomo
The investment conversation around Intangibles is starting to “take off”.
So far, academics and investors have acknowledged the role of intangibles’ in improving the struggling Value factor (here, here, here, here) as well as providing a source of ESG alpha (here).
The latest letter from the famous value investor Howard Marks addresses the novelty and importance of intangibles:
“When I consider this new world, I think fundamental investors need to be willing to thoroughly examine situations – including those with heavy dependency on intangible assets”
-- Howard Marks in OakTree Memo Jan 2021
I think this is only the beginning. The true power of modeling intangibles will soon going be recognized at a much larger scale. Not only can intangibles improve all of the main quant factors (not just Value, but Growth and Quality as well), they can also effectively replace traditional factor investing altogether.
With the vast majority of a company’s market value coming from intangibles and most of the traditional factors having become risk factors, how is it possible to avoid intangibles in the future?
“Early in the 21st century, a quiet revolution occurred.
For the first time, the major developed economies began to invest more in intangible assets, like design, branding, R&D, or software, than in tangible assets, like machinery, buildings, and computers.
For all sorts of businesses, from tech firms and pharma companies to coffee shops and gyms, the ability to deploy assets that one can neither see nor touch is increasingly the main source of long-term success.”
-- Jonathan Haskel & Stian Westlake in Capitalism Without Capital
The world has changed, and today more people recognize intangibles as the source of improving fundamentals.
Innovation is a source of future growth.
Customer satisfaction extends the duration of sustainable growth.
Engaged employees improve margins and productivity.
Brands are a source of value.
Superior management teams discover strategies that analysts call ‘catalysts’
In the current knowledge-driven economy, some companies can achieve enormous financial success without selling anything proprietary. The most important leadership skillsets in the twenty-first century are in high contrast to the command-and-control norms of the twentieth century. Creativity and innovation throughout an organization, not just at the upper echelons, are critical differentiators as companies compete for attention, customers, and talent. Not only are intangible attributes visible in the successes of companies such as Apple, but they are also the deficiencies in those that failed to see disruption coming (Nokia, Xerox, Blockbuster) and those who cut corners that led to brand and reputation damage (Boeing, Equifax.)
Intangible assets such as employee engagement often siphoned off to Human Resources functions and long-dismissed as “fluffy” in some businesses, are increasingly proven to drive shareholder value. Granted, fundamental investors have always talked about the quality of management teams, the importance of a company’s strategic moat, intellectual property, and brand and reputation, but the focus is intensifying as is the understanding that intangible value is inherently fragile, especially when misunderstood.
“It was not the fair market value of the inventories, receivables or fixed assets that produced the premium rates of return.
Rather it was a combination of intangible assets, particularly a pervasive favorable reputation with consumers based upon countless pleasant experiences they have had with both product and personnel.”
-- Warren Buffett in 1983 Shareholder Letter
Even the father of value investing, Ben Graham, recognized the importance intangibles.
-- Benjamin Graham in Security Analysis (thanks to Jason Zweig)
Importantly, while the fundamental outcomes of intangibles appear on financial statements, the intangibles themselves generally remain invisible to traditional analysis.
Business models have become more complex, with global supply chains and the proliferation of digital networks. As a result, book value and traditional accounting methods are less useful in assessing corporate value. Companies have adjusted by providing metrics and disclosures to help stakeholders better understand the drivers of corporate value. Organizations such as the Sustainability Accounting Standards Board (SASB), which recently announced plans to merge with The International Integrated Reporting Council (IIRC), have been at the forefront of developing guidance to help companies and investors measure the value of intangibles.
“Intangible assets are the dark matter of finance. They are challenging if not impossible to precisely measure.”
- Sparkline Capital, “Investing in the Intangible Economy”
Yes, precise measurement of intangibles is challenging, but isolating themes and metrics that drive alpha is possible. Quant methods have taken over the investment world. Back in 2007 only 10% of all assets were managed using quantitative approaches, yet today you would be hard-pressed to find an investor who doesn’t measure the Value, Momentum, and Quality exposures of their strategies. The ensuing factor investing crisis will likely catalyze a new wave of creativity and innovation (see more here). Intangibles are already at the forefront of this wave.
At the same time, the continuing advancement in computing power, combined with cheaper memory, cheaper storage, and increased connectivity, have changed the playing field. Alternative datasets are everywhere. The amount of data generated about companies is more voluminous than the amount of data disclosed by companies.
ESG ratings, for example, have moved away from simple reliance on 10-Ks and other official corporate documents to including information from news, social media, and other unstructured sources. Simultaneously, machine learning has grown in efficacy allowing the extraction of meaning from raw text that enables the systematic estimation of related intangibles. These trends have unlocked the ability to measure increasingly important variables such as innovation, employee sentiment, and customer satisfaction.
So, what does this all mean for investing philosophies and processes?
Intangibles provide an opportunity but require a willingness to adapt. About ten years ago, I stopped looking for alpha in traditional quant factors. They were becoming too popular and too crowded.
I shifted my research entirely towards intangibles and dug into numerous themes to identify those that drive significant alpha regardless of sector or valuation. After years of research, I launched TCI’s flagship large-cap equity strategy, Focused Quality, because I believe that intangible-driven alpha is here to stay, and not because intangibles can resurrect value investing, or because they align with ESG factors (though they do align quite well with ESG investing).
In summary, we believe that the “Age of Intangibles Investing” has arrived. Companies that recognize, nurture and expand their intangible value will continue to outperform those that don’t, irrespective of how capital-intensive (tangible) their industry.
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