This is a summary of “Equity Investing in the Age of Intangibles,” by Amitabh Dugar and Jacob Pozharny, published in the Second Quarter 2021 issue of the Financial Analysts Journal.
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The value relevance of financial variables, such as book value and earnings, has decreased for particular industries of high “intangible intensity.”
What’s the Investment Issue?
Global accounting standards force companies to expense, rather than capitalize, their investments in intangible capital. This results in understatement of key ratios used in stock analysis, such as price to book, price to earnings, and price to cash flow.
This paper examines “intangible intensity”—that is, the extent to which the rise of intangibles has changed the relationship between conventional value metrics and share prices across a wide range of countries and industries.
How Do the Authors Tackle the Issue?
The authors construct a composite measure of intangible intensity that captures three types of intangible capital: intangible assets on balance sheets (excluding goodwill); innovation capital, such as R&D expenses; and organizational capital, such as sales and administrative expenditures.
The authors treat intangible assets as separate measures of intangible intensity because (1) accounting criteria for intangible capital are inconsistent, (2) they want to compare the effects of intangible intensity in the United States versus international markets, and (3) there are many types of intangible expenditures on balance sheets.
The authors employ their composite measure to assess the intangible intensity of companies in most industries across the world’s 14 largest economies—eight developed markets and six emerging markets. The composite classifies industries into high- and low-intangible-intensity groups using data from 1994 to 2018. The authors analyze the relationship between stock prices and book values and earnings for these two groups in the United States and internationally over time, searching for trends.
What Are the Findings?
There has been a progressive decline in the value relevance of book value and earnings for high-intangible-intensity companies, both in the United States and abroad, over the period 1994 to 2018.
For companies in the low-intangible-intensity group, the relevance of book value and earnings to value investing has remained stable in the United States. The divergence in the value relevance of book value and earnings between the high- and low-intangible-intensity groups is significant, especially among international companies.
There was a particularly sharp drop in the value relevance of these financial variables during the 1995–1999 “New Economy” period. The authors note that for international companies, this extraordinary increase in intangible investment in the mid- and late 1990s reversed course in 2000, leading to a correspondingly greater rebound in value relevance for high-intangible-intensity industries.
What Are the Implications for Investors and Investment Managers?
Value investing and other strategies that rely on book values and earnings may benefit from including consideration of intangible intensity of sectors in their investment processes.
The relationship between investment ratios—such as price to book, price to earnings, and price to cash flow—and stock prices has weakened for high-intangible-intensity companies in both the United States and abroad to an extent that cannot be ignored.