60 BriefingInvestment strategies The EconomistNovember 14th 2020
2 gible assets, the residual $1bn is counted as
an intangible asset—either as brand value,
if that can be appraised, or as “goodwill”.
That distorts comparisons. A firm that has
acquired brands by merger will have those
reflected in its book value. A firm that has
developed its own brands will not.
The second important aspect of intan-
gibles is their unique characteristics. A
business whose assets are mostly intangi-
ble will behave differently from one whose
assets are mostly tangible. Intangible as-
sets are “non-rival” goods: they can be used
by lots of people simultaneously. Think of
the recipe for a generic drug or the design
of a semiconductor. That makes them un-
like physical assets, whose use by one per-
son or for one kind of manufacture pre-
cludes their use by or for another.
In their book “Capitalism Without Capi-
tal” Jonathan Haskel and Stian Westlake
provided a useful taxonomy, which they
call the four Ss: scalability, sunkenness,
spillovers and synergies. Of these, scalabil-
ity is the most salient. Intangibles can be
used again and again without decay or con-
straint. Scalability becomes turbo-charged
with network effects. The more people use
a firm’s services, the more useful they are
to other customers. They enjoy increasing
returns to scale; the bigger they get, the
cheaper it is to serve another customer. The
big business successes of the past decade—
Google, Amazon and Facebook in America;
and Alibaba and Tencent in China—have
grown to a size that was not widely predict-
ed. But there are plenty of older asset-light
businesses that were built on such network
effects—think of Visa and Mastercard. The
result is that industries become dominated
by one or a few big players. The same goes
for capital spending. A small number of
leading firms now account for a large share
of overall investment (see chart 3).
Physical assets usually have some sec-
ond-hand value. Intangibles are different.
Some are tradable: you can sell a well-
known brand or license a patent. But many
are not. You cannot (or cannot easily) sell a
set of relationships with suppliers. Thatmeans the costs incurred in creating the as-
set are not recoverable—hence sunken-
ness. Business and product ideas can easily
be copied by others, unless there is some
legal means, such as a patent or copyright,
to prevent it. This characteristic gives rise
to spillovers from one company to another.
And ideas often multiply in value when
they are combined with other ideas. So in-
tangibles tend to generate bigger synergies
than tangible assets.
The third aspect of intangibles to con-
sider is their implications for investors. A
big one is that earnings and accounting
book value have become less useful in
gauging the value of a company. Profits are
revenues minus costs. If a chunk of those
costs are not running expenses but are in-
stead spending on intangible assets that
will generate future cashflows, then earn-
ings are understated. And so, of course, is
book value. The more a firm spends on ad-
vertising, r&d, workforce training, soft-
ware development and so on, the more dis-
torted the picture is.
The distinction between a running ex-
pense and investment is crucial for securi-
ties analysis. An important part of the
stock analyst’s job is to understand both
the magnitude of investment and the re-
turns on it. This is not a particularly novel
argument, as Messrs Mauboussin and Cal-
lahan point out. It was made nearly 60
years ago in a seminal paper by Merton
Miller and Francesco Modigliani, two
Nobel-prize-winning economists. They di-
vided the value of a company into two
parts. The first—call it the “steady state”—
assumes that that the company can sustain
its current profits into the future. The sec-
ond is the present value of future growth
opportunities—essentially what the firm
might become. The second part depends
on the firm’s investment: how much itdoes, the returns on that investment and
how long the opportunity lasts. To begin to
estimate this you have to work out the true
rate of investment and the true returns on
that investment.
The nature of intangible assets makes
this a tricky calculation. But worthwhile
analysis is usually difficult. “You can’t ab-
dicate your responsibility to understand
the magnitude of investment and the re-
turns to it,” says Mr Mauboussin. Old-style
value investors emphasise the steady state
but largely ignore the growth-opportuni-
ties part. But for a youngish company able
to grow at an exponential rate by exploiting
increasing returns to scale, the future op-
portunity will account for the bulk of valu-
ation. For such a firm with a high return on
investment, it makes sense to plough pro-
fits back into the firm—and indeed to bor-
row to finance further investment.
Picking winners in an intangible econ-
omy—and paying a price for stocks com-
mensurate with their chances of suc-
cess—is not for the faint-hearted. Some
investments will be a washout; sunken-
ness means some costs cannot be recov-
ered. Network effects give rise to winner-
takes-all or winner-takes-most markets, in
which the second-best firm is worth a frac-
tion of the best. Value investing seems saf-
er. But the trouble with screening for
stocks with a low price-to-book or price-to-
earnings ratio is that it is likelier to select
businesses whose best times are behind
them than it is to identify future success.Up, up and away
Properly understood, the idea of funda-
mental value has not changed. Graham’s
key insight was that price will sometimes
fall below intrinsic value (in which case,
buy) and sometimes will rise above it (in
which case, sell). In an economy mostly
made up of tangible assets you could per-
haps rely on a growth stock that had got
ahead of itself to be pulled back to earth,
and a value stock that got left behind to
eventually catch up. Reversion to the mean
was the order of the day. But in a world of
increasing returns to scale, a firm that rises
quickly will often keep on rising.
The economy has changed. The way in-
vestors think about valuation has to
change, too. This is a case that’s harder to
make when the valuation differential be-
tween tech and value stocks is so stark. A
correction at some stage would not be a
great surprise. The appeal of old-style value
investing is that it is tethered to something
concrete. In contrast, forward-looking val-
uations are by their nature more specula-
tive. Bubbles are perhaps unavoidable;
some people will extrapolate too far. Nev-
ertheless, were Ben Graham alive today he
would probably be revising his thinking.
No one, least of all the father of value in-
vesting, said stockpicking was easy. 7By the few, not the many^3Sources:BEA;BloombergUnited States, estimated share
of total business investment, %05101520251999 2005 10 15 20Top 10 listed firmsTop 50 listed firmsListed tech firms