Many of the world's most valued companies have relatively few tangible assets when compared to 50 years ago. Why? And what are the implications for investors and the rest of the economy? Mike Sharples is the managing partner of MKS Wealth Management. He serves on Higher Rock's Board of Advisors and always provides a keen insight on the direction of the economy and the stock market. I encourage you to read his most recent blog. Thanks Mike for granting us permission to share your newsletter.
I read an interesting book recently, “Capitalism without Capital” by Haskel and Westlake. The authors discuss the impact of “intangibles assets” on our economy and on the valuation of companies. In the last 50 years intangible assets have grown to overtake tangible assets as the larger percentage of many company’s assets and economic production. One of the ways of valuing a company is to count the value of assets it owns. Tangible assets include equipment, manufacturing plants, buildings, and inventories of “stuff”; think of an automobile manufacturer. Contrast those assets to intangible assets which include software, databases, business processes, branding, design, market research, and created entertainment; think of Amazon. We’ve known for decades now that our economy has changed from a manufacturing economy to a services economy and thus more reliant on intangible assets.
The economic engines of production for any company are its capital assets and its labor. Today when most companies invest in capital assets to help grow their business they are increasingly investing in intangible assets (investing in research, business systems, software, etc.). This kind of capital investment presents two major problems. First, is a company’s ability to borrow money to make the investment. Banks can value “hard” tangible assets (buildings and equipment) to determine how much money to lend the company, but what exactly would be the value of Google’s search engine, for example? The second issue is valuing a company in terms of its stock price, especially with respect to its ability to grow earnings.
The authors, Haskel and Westlake, recount the story of the company “Electric & Musical Industries” better known today as EMI. In the 1930’s EMI owned a record company called “Parlophone”, and in the 1960’s that was the “Beatles” record label. EMI also made the first transistor commercial computer (the EMIDEC 1100 in 1959 by Godfrey Hounsfield), as well as guided missiles, color TV cameras, and other products. The money the Beatles made for EMI (peaking at $650/second in today’s dollars) along with the expertise of researcher Godfrey Hounsfield and his team, and grants from the British government, led to the development of the first “computed tomography scanner”, the CT scanner (today known as a CAT scanner). The accurate 3D representation of patients’ soft tissue was a revolutionary medical breakthrough. Although the CT Scanner was not an initial commercial success for EMI, the patents held by EMI and licensed to General Electric and Siemens in the 1970’s led to their commercial success and numerous medical treatment advances. This story helps illustrate four key characteristics of intangible investing with implications for those intangible-rich companies and economies. According to the authors, the key intangible investing characteristics are “scalability”, “sunkenness”, “spillovers”, and “synergies”.
- Scalability - refers to the asset being used many times over and in multiple places and/or at the same time.
- Sunkenness - refers to the intangible asset being difficult to sell, the understanding that it’s difficult to get money back out of the investment if the company wants to reverse the investment decision.
- Spillovers - means that its relatively easy for other companies to take advantage of the intangible investment; for example, the Apple iPhone created a new category of smartphones, followed by lots of quick imitators.
These characteristics along with the continued rise of intangible investing make for a very interesting economic landscape and one that is becoming more difficult to quantify using the existing, “old econometric” tools. Valuations of company stock, particularly companies with a great deal of intangible assets, are perhaps very deserving of the higher P/E ratios when compared to their “old economy”, tangible asset heavy companies. Additionally, comparisons of stock valuations from beyond 25 years ago may not be very helpful in judging the future potential of the stock market with the intangible-rich companies that make it up. Innovative companies with consistent cash flows certainly seem like something to look for as potential investment opportunities.
- Synergies - recognizes the “combinatorial” aspect of technology an innovation with the bringing together of ideas (or technologies) in new ways; think about the idea of networked computers giving rise to a World Wide Web, giving access to an exponential amount of information, which gave rise to search engines, which gave rise to on-line shopping, which gave rise to …..(?)
One of my biggest concerns at the beginning of the year was that the Fed would raise interest rates and significantly reduce their Balance Sheet this year, and thereby strangle potential economic near-term growth. The “militant” interest rate raising rhetoric of December 2018 has now morphed into a “holding pattern” at this point. I believe this posture is encouraging to the market and our economy for this year’s outlook. There are still plenty of issues to be watchful of; China Trade, Brexit, and the general political environment, but at least the Fed is in the positive column (for now).
Measuring our economic growth using metrics from the 1970’s seems to have several potential flaws in today’s world of intangible-rich companies. What to measure and how to measure it is an evolving discussion that I’m watching with great interest. For example, I’m not convinced the “Housing Starts” is as great a measure of economic prosperity as it was in the 1940’s-1970’s. People are much more mobile than 50 years ago and their desires to remain mobile and unencumbered by home ownership seems to be more the norm at this time. In addition, no one was buying “smart phones” 50 years ago. Consumer spending has changed over the last 50 years.
Many of the analysts I’ve read predict a continued grind higher for the markets this year. They also predict continued periods of volatility, so be ready, but the recession predictions remain very low for 2019 at this point. Remember two 5% corrections and one 10% correction is “normal” market behavior over a 12-month period, so be ready for “normal”. The key in my mind is not to get “faked” out by headlines but rather to watch the economic health of the companies we’ve invested in. This seems like a year when quality matters more than “hype” so I remain cautiously optimistic for 2019.
Mike Sharples CFP®
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