Buttonwood: Out of Touch
How intangible assets are changing investment?
WHEN you work as an equity analyst at an investment bank, your task is clear. It is to comb all the statements made by corporate executives, to scour the industry trends and arrive at an accurate forecast of the company’s profits. Achieve this and your clients will be happy and your bonus cheque will have many digits.
But is all this effort worthwhile? Not as much as it used to be, according to Feng Gu and Baruch Lev, writing in a recent issue of Financial Analysts Journal*. The authors imagined that investors could perfectly forecast the next quarter’s earnings for all companies. They then assumed that investors bought all the stocks that they expected to meet or beat the consensus of analysts’ forecasts; and that investors could short (ie, bet on a declining price) the stocks of those that were predicted not to reach their estimates. They made their investment two months before the end of a quarterly reporting period and got out of their positions one month after the quarter ended (by which time the earnings have been reported).
In the late 1980s and 1990s, this would have been a highly successful strategy, achieving excess returns (over those achieved by stocks of similar size) of 4% or more every quarter. But these abnormal returns have dropped: in recent years they have been only 2% a quarter. A similar effect appeared when examining the returns that would have been achieved by perfectly predicting those companies that achieved annual earnings growth.
Although an excess return of 2% a quarter would still be highly attractive, it would require a perfect forecasting record. That suggests the number-crunching performed by fallible analysts and investors produces much lower returns.
The intriguing question is why those returns have been falling. The authors argue that the decline is because of the rising importance of intangible investments in recent decades (in areas such as software or trademark development). Such investment may be a big driver of value growth.
Accountants have struggled to adapt. If a company buys an intangible asset, such as a patent, from another business, it is classed as an asset on the balance-sheet. But if they develop an intangible within the business, that is classed as an expense, and thus deducted from profits. As the authors note: “A company pursuing an innovation strategy based on acquisitions will appear more profitable and asset-rich than a similar enterprise developing its innovations internally.”
As a result, the authors argue, reported earnings are no longer such a good measure of a company’s profits, and thus may not be a useful guide to future share performance. To test this proposition, they divided companies into five quintiles based on their intangible investment. Sure enough, the more companies spent on intangibles, the lower the excess return available to those who correctly forecast the earnings.
The paper’s message echoes the themes of a new book** by Jonathan Haskel and Stian Westlake, which explores the impact of the growing importance of intangible assets in modern economies. The book finds a link between the poor productivity record of many leading economies since the crisis of 2008, and the sluggish rate of investment in intangible assets since then.
The problem is that intangibles have spillovers. A company may undertake expensive research and development, but the gains may be realised by other businesses. Only a few companies (the likes of Google) can achieve the scale needed to take reliable advantage of their intangible investments. Unlike machines and equipment, intangibles may have limited resale value. So the risks of failure may put businesses off intangible investment.
This is both good news and bad news for investors. On the one hand, it may explain why profits have remained high relative to GDP. In theory, high returns should have attracted a lot more investment and the resulting competition should have driven down profits. But the difficulty in exploiting intangibles may have prevented that. On the other hand, the reluctance of many businesses to invest in intangibles may restrict their scope for growth in future. Investors looking for growth stocks will face a restricted choice and such companies will be so apparent to everyone that they will command a very high valuation. Not so much the “nifty fifty” stocks that were fashionable in the early 1970s, as the nifty five or six.
* “Time to Change Your Investment Model”, Financial Analysts Journal, Vol 73, number 4
** “Capitalism without Capital: The Rise of the Intangible Economy”, published by Princeton University Press