More and more lately I have been researching patents and IP Valuation. I believe that this is an field that has the potential to be big in the future and am very interested in the area. Anyways, like pretty much everything I approach this whole idea of "a knowledge economy" that everyone is talking about with a heavy dose of skepticism. Today while browsing the website of Ocean Tomo, one of the leaders in this area, I came across quite an interesting chart that I thought I would share and write about. This chart shows the intangible assets as a percentage of the market value of the S&P 500. For a more in-depth article, go here for one of their white papers.
Since this is sales literature and comes from a white paper not academic paper, there will be no discussions of weaknesses or critiques of the data by the author, in looking at this I came up with a few questions which I hypothesized some answers about below.
1. In the paper they had a chart where they show this data, the chart begins in 1973 the same year of (ding ding ding) Bretton Woods, what did the data look like before 1973?
I have not put together this data yet, and will try to find it or get it together. I find it very curious that they started the data the same year as Bretton Woods, especially considering some of my other hypotheses. If anyone knows anything or has this data please let me know.
2. What does cheap credit have to do with intangible asset values?
Intellectual Capital - essentially knowledge and ideas, are only converted to real assets if they are given enough actual capital in order to be realized. Intellectual Capital without financial capital is worthless. From 1973 to now money the trend has been cheap money. Therefore the value of IP has been able to be unlocked. The returns on such investment have been large. This has caused the winners to be those who invest heavily in IP and the market has rewarded them. Working capital has been reinvested into R&D and returns have compounded at large rates as returns on intellectual capital have a long-tail type distribution. At the same time, it seems that competition has caused those companies who do not invest in intellectual capital to either start doing so or perish. This has put a bit of survivorship bias into the S&P 500, which is of course market cap weighted. The emergence of the Technology as a major component of the S&P has also caused this to increase - however this may not be completely independent.
When a corporate executive is doing cost-benefit analysis for investment of working capital they usually use some version of either NPV or IRR, which takes projected cash flows and discounts them by some factors. The cost of capital is a main discounting mechanism and when the cost of capital is low, longer horizon cash flows are worth more than more near term cash flows. Investment in intellectual capital is usually defined by no cash flows or negative cash flows early on and then one or more very large cash flows later in time. A low cost of capital essentially makes it cheaper to take risk and the formulas used when making corporate financial decisions validate this idea. As the cost of capital increases, cash flows further out will start to shrink and money and projects that are investments in R&D and other types of intangible assets will start to fall further down the totem pole.
3. If intangible assets have been such a bull run, wouldn't it be a good time to sell? Furthermore, since tangible assets MUST make up a portion of most company's balance sheets, aren't we at almost a point at which they can NOT make up a greater portion, and if so, why would an investor want to invest in intangible assets and take the extra risk over tangible assets?
I think this is may be the case. The chart above is based on market value and not on book value. The book value is listed in the white paper and is around 43% - still a large number when you realize that these are non-monetary assets. The fact that people are saying this is a new knowledge economy makes me believe that this may be top of bubble of the knowledge economy. Much like a writer whose muse is cocaine or LSD or anything really, once that thing is taken away either by choice or by intervention of outside forces, their can no longer turn their ideas into words - which are then converted into earnings. Our "knowledge economy" may be very similar. Dollars are our muse and as long as dollars keep flowing, our ideas keep becoming reality. Once the punch bowl is empty, our ideas may not be gone, but can not be translated into projects which then can be translated into earnings. Economic writer's block would be a great term for such a phenomena.
It makes sense that IP securization and IP auctions are starting to gain popularity. Many companies may want to cash out these intangibles before they disappear into thin air. People buying the notion of a new knowledge economy may soon find that they are stuck holding a bunch of good ideas and nothing else.
4. What happens to the S&P 500 if this relationship reverses?
I have a feeling that if this relationship begins to reverse the S&P 500 may not look so great. As companies are less and less able to keep feeding their ideas and wait out for that big lumpy payment, they will have to cut their losses. The first effect of such a relationship may be positive since R&D costs are recognized as operating cash flows and are expensed as incurred companies may benefit from the realization of revenues of past R&D investment while not spending money on new ones. Other types of projects may be capitalized and expensed as incurred. Companies may not find any projects with NPV's that are positive and instead buy back stock or pay dividends instead. I believe we may have already begun to see this with the flurry of buybacks. This may then be accompanied by a multiple implosion as these intangible assets disappear into thin air.
It may also explain some other phenomena the popularity of Private Equity, M&A, and the market leadership of the past couple years. In Ocean Tomo's white paper, they show the sector breakdown of the chart above for 1975 and 2005. In 1975 three sectors had intangible assets make up a large portion of their market cap. These were Consumer Staples (51%), Health Care (73%), and Technology (63%). Everything else was quite small. In 2005, the top three were Consumer Staples (94%), Healthcare (89%), and Consumer Discretionary (88%). The lowest were Energy (69%), Financial (64%), and Utilities (62%). If you look at the Select Sector SPDR's performance table you can see how these have done in various time periods. Over the past 5 years the leaders have been Energy, Utilities, and Materials (which happened to be 4th behind Financials on Ocean Tomo's chart). The laggards have been Consumer Staples, Healthcare, and Consumer Discretionary. Technology was a laggard up until recently. So the Industries who had sizable intangible assets have underperformed in the recent credit boom, where those who did not have thrived. What is more is that these who have thrived are companies who have many TANGIBLE assets. Since intangible assets may just be some sort of goodwill, many of the companies within these industries have intangible assets that probably represent the premium that people would pay for their tangibles - basically the definition of goodwill. This shows how the knowledge economy may be mostly a myth, and rather just a factor of ability to buy tangible assets. Therefore, with respect to credit, those with the smallest spreads from 1973 have intangible assets that are less affected by credit conditions. Private equity has bid on those who had really little to no intangible assets in 1973 - utilities, materials, industrials, telecom, and consumer discretionary. Most of the premium in these companies may reflect this private equity bid and be entirely goodwill - NOT intellectual property. Therefore many companies in the S&P would get hit hard as both goodwill and actual ability to invest in IP goes away.
Please let me know if you have any insight on this as I find it quite interesting. I'm going to look further into this but these are simply some hypotheses that I came up with going over this particular piece of information.
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