Our intangibles screen smashes its US benchmark

In fact, you might have heard a fancy name for this phenomenon: ‘dematerialisation’. To economists, this is the process of making the same (or more) amount of goods with less physical material. Consider, in one anodyne example, what is required to be a retail investor today: an email address, internet connection and an online bank account. A century ago, the whole process required share certificates, trips to bank and broker offices, and piles of written correspondence.

Of course, it’s questionable just how much the economy has dematerialised. For one, much of the primary production essential to our lives has simply been transferred well out of sight (and to other countries or continents). Second, many of the raw materials we rely on involve ever-greater amounts of energy and waste. Third, as AI chip manufacturer Nvidia (US:NVDA) is proving, some of the highest technological barriers to entry remain in the physical hardware that allows our apparently ‘invisible’ software to function.

Be that as it may, intangible assets matter. Today, fevered speculation around the potential for artificial intelligence may have contributed to Nvidia closing in on a $2trn market cap, but this valuation is also the product of decades of investment in the intellectual property and human and organisational capital needed to build products that its largest data centre customers are now falling over themselves to pay for.

Still, just because the form of many of today’s most lucrative assets has changed, doesn’t mean investors can easily value them. And given intangible assets have routinely proved a key ingredient in market outperformance in recent decades, that’s a problem.

What then is the private investor to do? While intangible assets will always be hard to measure – in large part because accounting standards do not recognise them as true assets – a 2021 study by researchers at the University of Rotterdam came up with a proxy for firms with higher rates of intangible asset creation. By applying their formula to US stocks between 1989 and 2020, the researchers were able to both trounce the market, and find a greater predictor of stock price performance than size, value, or profitability.

Two years ago, we set out to codify this research in a stock screen – which we called the Intangible Edge – by building our own variant on the academics’ intangible asset creation proxy.

Key to this hunt is the ‘intangible intensity’ metric, which the researchers defined as the ratio of internally created intangible assets to total assets. To calculate intangible assets, the past five years’ R&D spending is added to 30 per cent of selling, general and administrative (SG&A) expenses, as proxies for knowledge and organisational capital formation, and then subject to five-year straight-line depreciation.

To get the denominator (total assets), the numerator (intangible assets) is added to period-end total assets, less goodwill. Stocks are then ranked based on their intangible asset intensity, and the top 15 stocks in both the FTSE All-Share and S&P 500 are selected for the following year.

Last year, I showed how these steps worked in practice by applying them to Meta (US:META). The Facebook parent, whose platforms have made it one of the world’s leading creators of intangible assets, subsequently posted a total return of 152 per cent, making it the largest single contributor to our screen, and one of the biggest risers in the entire S&P 500 index.  

On the face of it, we can question the degree to which intangibles swung things. In 2022, the triple threat of fading investor confidence in the group’s capital projects, a possible recession and rising interest rates all conspired to hand the shares a beating. Then, over the next year, improved confidence in the monetary and economic backdrop pushed equities higher, Meta’s included. Then again, a big factor in the reversal in investor sentiment was the group’s attachment to the AI narrative (itself a product of intangibles creation), while its strong earnings highlighted the power of hard-to-measure investments (again, in its intangible asset base).

Meta’s wild success is also a reminder that intangible assets aren’t all created equally. For a clear demonstration of this fact, look no further than the relative performance of the UK and US versions of our Intangible Edge screen.

Another disappointing run-out for the UK selections meant that after two years, it is more than 20 percentage points adrift of its benchmark, the FTSE All-Share. Despite a recent rally that has in absolute and relative terms has been stronger than the index, its inability to avoid sink-or-swim situations has cost it dearly.

By contrast, having broadly tracked the S&P 500 since we launched the screens at the start of 2022, the US version of the screen has pulled away in recent months. In a stonking year for the index, the 15 selections eclipsed the market by almost 8 percentage points on a total return basis.

How then, do we interpret the disparity in these results and returns to date? While it’s still early days for the screens, a couple of factors are becoming apparent. For the UK stocks, a wide tracking error and lack of correlation to the index suggests its picks’ fundamentals and business models are a departure from what we might consider an ‘average’ UK share.

As to why they have underperformed so badly, sentiment has clearly played a role. Having reaped huge gains from backing intangible-rich stocks in the past, investors in the US market are likely to be more open to corporate spending on hard-to-account assets – at least compared with the UK market. But a bigger factor is likely to have been the diversity of sectors identified by the UK screen, which in 2023 included industrial machinery, shipbroking, gambling, and food manufacture. This is due to a relative paucity of major internet, software and technology names, and may have resulted in a focus on intangibles that are either of lesser quality or aren’t backed up by the kind of economic and competitive moats that make US companies so successful.

In 2023, the US screen was more adept at identifying intangibles-rich success stories. Another way of saying this is that the screen went big on software firms – as it is wired to do – and because technology firms rebounded hard in 2023, overweighting the sector looked very good in hindsight. The fact that a third of the US screen’s 15-stock selections posted total returns above 50 per cent, while impressive, suggests to me that this is a bit of leveraged play on S&P 500 tech sentiment.

At more than 28, the average forward earnings rating on this year’s US selections also leaves little room for error. Then again, within this grouping – which like all the screens in these pages are highlighted as ideas for further research, rather than ready-made portfolios – are a couple of software firms (Trimble (US:TRMB),and F5 (US:FFIV)) whose mid-teens ratings belies their heavy spending on intangible asset creation in recent years.

Both Trimble and F5, along with 10 of the remaining 13 stocks in the US version of the screen, are returnees. The ratio is slightly lower in the UK, where eight out of the 15 were also in the 2023 screen. That’s in part a reflection of the screen’s ambivalence toward other traditional fundamental metrics such as valuation or forecast earnings growth, but also a reminder that capital formation – especially the intangible variety – is a slow process that takes place over several years. Details of each of these stocks are included in the table below as well as a downloadable spreadsheet in the online version of this article.

Source: FactSet