The Rise of Intangibles (and Fall of Earnings Quality)
– David Wanis, August 2021
People often remark that we find ourselves in an increasingly intangible world – like this is a new phenomenon we are just experiencing. Observing the components of value in the S&P 500 attributed to either tangible or intangible assets you can see that this change really happened over 35 years ago. Prior to 1975, most of the world was described and valued by its physical underpinnings. In the decade between 1985 and 1995, the world flipped and we went from property, plant and equipment to people, ideas and brands as being the dominant source of value. According to the Ocean Tomo Intangible Asset Market Study (Dec 2020), intangibles share of S&P 500 value was 17% in 1975, 32% in 1985 and 68% in 1995.
The trend has continued in the 25 years since, such that intangibles now account for 90% of market value. Intangible value dominates, but it is not recent.
There are real and broad reaching implications of this change for investors – mostly positive. When the world shifts, we can sometimes lose track of how our existing beliefs, models and institutions transfer (or fail to transfer) into the new world. We have found some pretty big gaps to which investors should be alert.
This is water
There are these two young fish swimming along, and they happen to meet an older fish swimming the other way, who nods at them and says, “Morning, boys, how’s the water?” And the two young fish swim on for a bit, and then eventually one of them looks over at the other and goes, “What the hell is water?”
– David Foster Wallace
Most of investment history has happened in a tangible world. Institutions and standards were set, agreed to and in most cases consistently applied across the corporate world for decades. For example, a pie warmer or fax machine or bucket wheel excavator were all agreed to be considered productive assets with a useful life of more than one year. As such, the cost of these items was capitalised – meaning it was recorded as an asset on the balance sheet – and then depreciated through the P&L over the useful life. The Australian Taxation Office (and every auditor) has a schedule containing thousands and thousands of specific assets and the agreed useful life for each which is consistently applied by all companies (and raised by their auditors if not).
This is boring background noise for most investors, something so well ingrained and expected in the foundation of company financial accounts that it is rarely given a second thought. It is the water in which all investors have been swimming.
The move to an intangible world completely changes this foundation assumption. In an intangible world we are currently replacing accounting standards with management discretion. This should make investors far more alert to what management can do with this discretion.
What are these intangibles? We looked at tangible assets. A physical item that is productive to a business over many years. Intangibles are really the result of human endeavours. An idea. Some code. A preferred position in the consumers mind from previous good experience (aka brand). The cost of this is time, in the form of people’s wages. We are now seeing some employee payroll expenses normally expensed being estimated by management as being an asset, and capitalised.
In the absence of agreed standards, auditors are flagging to shareholders just how much judgement and discretion management have in making these determinations. This cycle has played out before, and it tends to end when shareholders demand management no longer have discretion over how they treat expenses and everything is expensed in the year incurred. We are not in that part of the cycle, in fact we are aggressively heading in the other direction.
Management judgement or manipulation?
We are witnessing a rapidly increasing number of Australian small companies that capitalise their expenses as an intangible asset. Those capitalising more that 5% of expenses have moved from a relatively rare occurrence (just under 3% of small companies) in FY2006 to surprisingly common at almost 15% of companies in FY2020.
In small caps, the median EBITDA margin is 15-20%, so moving 5% of expenses to the balance sheet is equal to a 25-33% increase in reported EBITDA. In fact, just removing 1% of expenses from the current year can be worth 5-7% increase in EBITDA and over one quarter of small companies are capitalising intangibles at this level.
We believe investors should form an objective view on the true underlying economics of a business and not rely on management accounting discretion. In a market that moves on the reported (and adjusted) EBITDA number far more than anything happening on the cash flow statement, the potential to arrive at a fundamentally different conclusion to the market is as great as it has ever been.
U.S companies are the global market leaders in intangible value creation. Google spends almost US$30bn a year on R&D and doesn’t capitalise a single dollar. Only 1% of S&P 500 companies and only 2% of the NASDAQ 100 capitalise more than 5% of their expenses.
Almost 15% of Australian small companies are doing the same.
Today, the small cap universe is said to be awash with companies offering a generational opportunity to disrupt, grow and profit. Given the narrative around the attractive economics of these businesses, and the resulting valuation the market affords them, it seems strange so many are resorting to the age-old trick of using accounting to flatter the P&L when the global leaders and the companies they strive to emulate eschew such an approach.
Value creation that builds upon intangibles allows companies and their shareholders to capture a far greater share of value created from well executed ideas with less capital employed in the process. This is an incredibly positive development for shareholders and the economy overall. The cost of failure to the real economy is much lower based on capital employed. Share market value of these companies can be many multiples of capital employed which is the failure risk we try to avoid.
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