This article originally appeared in the NZ Herald.
One of the major challenges facing investors is that fast-growing US companies have a strong focus on intangible assets, instead of the more traditional physical assets.
Intangible assets include software, brands, human networks, intellectual property, patents, market research and employee training, while physical or tangible assets include bricks and mortar, as well as equipment.
This raises the question of how to value intangible-intensive companies as most of their investment is expensed, and has a negative impact on earnings, while physical investment is capitalised.
In 2000, the largest listed US companies were General Electric, Exxon Mobil, Merck, Citigroup and Wal-Mart, all with a strong focus on physical assets. They have been replaced by Apple, Amazon, Microsoft, Google and Facebook, which have more emphasis on intangible assets.
A comparison of the five largest listed United States and New Zealand companies illustrates that our largest companies still have a stronger focus on physical assets.
The figures in the table, which contain the balance sheet figures of these US and NZ companies, can be summarised as follows:
- The five largest NZX entities have 78.3 per cent of their total assets in property and equipment while the five largest US companies have only 16.7 per cent in this asset class
- The US companies have a 9.9 per cent balance sheet exposure to goodwill and intangibles but this figure is understated because most of this expenditure is expensed, rather than capitalised
- The NZ companies have 6.9 per cent balance sheet exposure to goodwill and intangibles but excluding Spark the figure declines to just 0.7 per cent. Spark’s intangible assets are software, capacity, spectrum licences, goodwill, work in progress and others
- The US companies are generating massive operating cash flows with 54.8 per cent of their balance sheet assets represented by cash and marketable securities compared with only 2.5 per cent for the five NZ companies
- Apple, Amazon, Microsoft, Google and Facebook have total cash and marketable securities of US$589 billion and only US$208b of debt while the five NZ companies have cash and securities of just $0.5b and $4.9b of debt.
Investing in intangible assets, rather than physical assets, is not confined to these five US companies.
Uber is a massive taxi company that doesn’t own taxis and Airbnb is a major accommodation group that has minimal property assets.
Les Mills International, the Auckland company with a range of Bodypump fitness trademarks, has been hugely successful with these trademarks licensed in 100 countries.
The delisting of Xero was a blow to the NZX because it was our largest intangible-intensive company although a2 Milk has some of these characteristics.
The milk company has total assets of $548 million, with the main components being $240m of cash, a $105m investment in Synlait Milk and only $10m worth of property, plant and equipment.
Intangible assets can be scaled more quickly than physical assets.
For example, Facebook can quickly add 100 million new customers whereas Auckland International Airport would have to build new terminals, runways, carparks and roads to facilitate an additional 5 five million passengers per annum.
Ironically, Facebook doesn’t have major capital expenditure commitments but has US$44b of cash and marketable securities and no debt while Auckland Airport has $2.2b of debt, minimal cash and massive capital expenditures ahead.
New Zealand’s main airport can’t cope with existing passenger numbers, never mind further growth.
A 2016 New Zealand Motu Economic and Public Policy Research study by Nathan Chappell and Adam Jaffe, called “Intangible investment and firm performance”, concluded: “we find no evidence that higher intangible investment is associated with higher productivity or higher profitability”.
This conclusion was surprising and may indicate that it is difficult to measure intangible investment in New Zealand and/or we are investing in the wrong intangibles.
Source: Herald graphic
Non-physical assets clearly facilitate more scalability, which would be a major positive for most New Zealand businesses.
Jonathan Haskel and Stian Westlake wrote in their recently published book Capitalism Without Capital: The Rise of the Intangible Economy that their central argument “is that there is something fundamentally different about intangible investment, and that understanding the steady move to intangible investment helps us understand some of the key issues facing us today: innovation and growth, inequality, the role of management, and financial and policy reform”.
They note that intangible investment has outstripped tangible investment in the United States since the late 1990s and since the early 2000s in the United Kingdom.
Haskel and Westlake wrote that “the rise of intangibles might be expected to increase inequality both of wealth and income. Increasingly intangible-intensive firms will need better staff to create synergy with their other intangible assets. Firms will screen them more thoroughly and pay them more handsomely.”
“As for wealth inequality, the spillovers from intangibles make living in cities even more attractive, forcing up housing prices and wealth for those fortunate enough to own.
More speculatively, we suggest the cultural characteristics required to succeed in an intangible economy may help explain the socio-economic tensions that underlie populist politics in many developed countries”.
In other words, the authors contend the spectacular growth in intangible investment has been partly responsible for Donald Trump, Brexit and Italy’s Five Star movement.
They believe that the supporters of these popular movements hold traditional views and find it difficult to accept the changes resulting from the growth of intangible-intensive firms.
Several academics, including Feng Gu and Baruch Lev, who published the book The End of Accounting and the Path Forward for Investors and Managers, are arguing that the growth in intangible investments should be leading to a different investment approach.
In their paper, “Time to Change Your Investment Model” published in the Financial Analysts Journal, they contend that “accounting regulators were — and still are — asleep at the wheel, treating the value-creating intangible investments as regular expenses”.
The expensing of intangible investment has reduced the earnings of these companies even though this investment may create huge shareholder value in the long term.
Thus, companies that invest heavily in intangibles are being penalised by earnings-focused investors while companies that don’t invest in this area are treated more favourably.
Gu and Lev argue: “GAAP-based reported earnings no longer reflect the periodic value changes (growth) of most business enterprises, and thus conventional earnings-based security analysis has lost much of its usefulness for investors in recent years”.
This comment partly explains why Amazon’s share price continues to rise even though its earnings growth has been relatively modest.
Gu and Lev write: “we assert that a shift of focus for security analysis and valuation is called for — from the prediction of earnings or related accounting measures to a comprehensive evaluation of an enterprise’s competitive advantage through a careful consideration of its operating strategic assets and their deployment”.
This assessment would include:
- Carefully measuring a company’s strategic intangible assets
- Assessing whether a company is enhancing and defending its strategic assets
- Questioning whether these assets are being optimally deployed to create maximum value.
The change in US sharemarket leadership to Apple, Amazon, Microsoft, Google and Facebook clearly demonstrates that intangible investing, brand strength and a dominant market position has enabled these companies to create value for consumers and investors.
Only time will tell whether these companies can defend their strategic position and generate sufficient earnings to satisfy investors who look at companies from an earnings perspective, as well as a competitive advantage position.