Microsoft was the most valuable company in the world in 2006, worth US$250 billion. On its balance sheet were traditional assets of $3 billion, just 1% of its market value. The balance of the value was made up of product design, the ideas generated through its research and development program, its brand, global supply chain and internal structures, and human capital built up through training.
Corporate investment is increasingly in intangibles. Capitalism without Capital: The Rise of the Intangible Economy explains what is fundamentally different about intangible investment and why it matters. “The investment element of GDP,” say authors Jonathan Haskel and Stian Westlake, “is where the animal spirits of the economy bark, and where a recession first bites.” In the United States and the United Kingdom, investment in intangible assets now exceeds that in tangible assets.
A gym today looks similar to Gold’s Gym in Venice Beach, Los Angeles, established in 1965 and featured in Arnold Schwarzenegger’s 1977 breakout movie, Pumping Iron. But if you sign up for a BODYPUMP class, you are powering the intangible economy. The programs are designed and owned by Les Mills International, a company in New Zealand. In 2005, these classes were available in 10,000 venues, in 55 countries, with an estimated 4 million participants a week.
This is not simply an IT story. “The rise of intangible investment,” the authors note, “began before the semiconductor revolution, in the 1940s and 1950s.” Software and data processing are part of the story, but it also includes the growth of brands, as well as organizational innovations (e.g., kaizen lean production techniques at Toyota and Six Sigma quality control at General Electric). Today’s successful manufacturing businesses are those that have invested heavily in intangible assets.
Intangible investment comes in three forms:
Computerized information, such as software
Innovation, including research and development
Economic competencies, including branding, the organizational capital built into distinctive business models, and training
The heart of the book is an explanation of the “four S’s” that differentiate intangible investments: scalability, sunkenness, spillovers, and synergies. All four can be illustrated by the story of how EMI used the proceeds of the Beatles’ record sales to develop the CT scanner, only to watch GE and Siemens turn its invention into a commercial success.
Music rights are scalable. Beatles records could be pressed again and again at minimal cost.
When EMI pulled out of the CT scanner business, it recouped very little of its investment in R&D, specialized knowledge/expertise, and brand because of the sunkenness of these costs.
Where EMI failed, GE and Siemens were able to use the technology developed by EMI and build successful businesses. They benefited from spillovers.
Intangibles become more valuable when combined. The development of the scanner came from the cauldron of EMI’s research on computing, imaging, and electrical engineering, combined with the expertise of doctors. Such synergies are often both large and difficult to predict.
These four properties combine to produce two more general characteristics. First, there is greater uncertainty about the value of intangible investment compared with tangible investment. The combination of sunkenness and spillovers may mean the investment will yield nothing, as in the case of EMI. Alternatively, the combination of synergies and scale can lead to unexpected success, which creates option value for the owners of intangible assets.
Second, intangibles tend to be contested. As the authors explain, “People and businesses will often vie to see who can control them, own them, or benefit from them.”
What are the implications of the foregoing for investors? Intangible assets are more readily funded by equity than by debt. When things go wrong, intangible assets offer little in the way of collateral value. Most developed countries’ tax systems, however, favor debt over equity.
Furthermore, intangibles’ option-like quality makes them a good fit for private equity funding, with the flexibility to draw down capital when it is required. For example, the distinct stages of biotech development mean companies need to go back to capital markets again and again.
In addition to funding, venture capital firms in Silicon Valley provide “informal links between portfolio companies, allowing them to exploit the synergies of intangibles.” These links are an ingredient in the persistence of performance of the best venture capital firms.
Capitalism without Capital also describes the link between the rise of intangibles and other challenges—namely, secular stagnation, rising inequality, and the impact of changing investment patterns on public policy. It is not a difficult read, but interpreting the many lessons for investors is challenging. It is a challenge that is highly recommended for CFA charterholders.