Is intellectual capital the next big investment theme?
When you think of thematic investing, words like risky, narrow and short-term fad could easily come to mind.
After all, several coal mining, nuclear and even shipbuilding investment funds launched when commodities were all the rage 10 years ago, the majority of which no longer exist today.
Popular themes at the moment include robotics, artificial intelligence and renewable energy, and while these areas would appear long-term, sustainable trends, the same thing was said about the aforementioned commodity, energy and transport products a decade ago.
Taking a thematic approach to investing can be a sensible path to follow but isn’t a guaranteed road to riches. It requires you to take a view about how long a trend will stay positive and whether following this trend will give you an edge over the market.
With is in mind, we’re intrigued by another emerging theme which is innovative in nature. The premise of this theme is investing in companies which can make good money from intellectual capital – i.e. brand names and their own research and development (R&D).
This includes both the innovative tech firms pumping loads into R&D, and also others that simply have a really strong brand name – the likes of Coca-Cola, Nestlé and L’Oreal for example.
What is intellectual capital?
It is made up of intangible assets including research and development, and brands.
Company accounts tend to not treat intellectual capital as an asset. An asset is the result of capital expenditure but intangibles are treated as an operating expense.
LEARNING FROM THE TREND
DWS recently launched investment fund DWS Invest CROCI Intellectual Capital to give investors access to a selection of these names.
While the fund is not currently available for retail investors, the premise behind the product does give investors useful insight into the power of intellectual capital and how you may want to incorporate the same thinking when looking for stocks to buy.
DWS views intellectual capital as a better way to access earnings growth because firms with relatively little physical capital (such as factories) and a larger amount of intangible assets are driving structural change in the global economy.
Its research shows that companies which have intellectual capital are already earning more than companies which don’t have intellectual capital and will continue to do so in the future, and it argues that such intangible assets have become the strongest engine of growth in modern economies.
Popular sectors for intellectual capital
FOCUS ON R&D
It attempts to measure intellectual capital by viewing R&D expenses and advertising expenses, i.e. developing the brand, as capital expenditure, putting the cost of each one onto the balance sheet in its research of a company.
Often these firms are the same large caps that virtually everyone knows, like Apple and Facebook, but it does exclude other giants that could be in for a tough time, such as some of those in the materials and energy sectors.
Francesco Curto, head of active and passive research at DWS, says this part of the market is ‘eating the breakfast, lunch and dinner’ of the other part of the market.
Data from DWS covering 787 large companies between 2007 and 2018 shows a 0.6% decline in annualised earnings for those without intellectual capital, compared to 3% growth for companies which invest in R&D and 3.4% for those with a strong brands.
Curto says: ‘If you buy equities with the long-term in mind, you cannot ignore there is a structural change happening in the economy.’
DWS forecasts that by the end of 2019 firms with intellectual capital will have grown their earnings in real terms by more than two thirds in the past decade. In comparison, it believes those without intellectual capital may see earnings fall by more than a quarter compared to their peak in 2007.
Curto adds that 40% of the broader global benchmark today has seen a decline in earnings growth, and is at risk going forward due to their lack of investment in intellectual capital.
Estimated economic life of tangible assets
Pharmaceuticals (R&D) 10 to 15 years
Chemicals (R&D) 4 to 7 years
Automotive (R&D) 5 to 7 years
Engineering (R&D) 4 to 7 years
Technology (R&D) 2 to 4 years
Consumer Goods (Brands) 4 to 15 years
UNDERSTANDING INTELLECTUAL CAPITAL
Breaking down how to look at companies with intellectual capital, Jessica Singleton, an investment specialist for index investing at DWS’ Xtrackers arm, uses Google owner Alphabet as an example.
‘Google properties account for nearly all of Alphabet’s revenues, but what the figures fail to mention for example is that Alphabet is a pioneer in driverless cars. When you think about Alphabet, you think about Google, etc, but that misses a huge part of what they’re trying to do,’ she says.
Alphabet’s self-driving car start-up Waymo accounted for only $154m of its $39.27bn revenues in the last three months of 2018.
While it may not seem much now, a recent note from investment bank UBS estimates that by 2030 Waymo could be raking in $114bn in annual revenue, highlighting its huge potential in the long-term.
Investing in companies with intellectual capital seems to make a lot of sense, so why haven’t more people looked at this before?
‘When you think about R&D and brands, it’s not a normal source of capital,’ says Curto. ‘On the balance sheet it doesn’t exist. R&D is written off in the profit and loss statement because (accountants) don’t know how to measure it precisely.’
As a final point, spotting a company that spends money on R&D isn’t enough when looking for suitable investments. DWS says innovation must ultimately generate profits and value for investors.