30 stocks with an Intangible Edge

According to the World Intellectual Property Organisation (WIPO), a UN agency, intangibles comprised around 90 per cent of the market value of S&P 500 companies in 2020.

How so? Per the report on which it is based, to get to 90 per cent, you simply subtract a company’s net tangible assets (that is, total assets less its stated intangibles, less total liabilities) from its market capitalisation. The ratio has been climbing steadily for decades. In 1985, it was 32 per cent; in 1995, 68 per cent.

Though I reached a similar figure for the present day – or to be exact, 92.9 per cent, which suggests that long-term trend has continued – I’ve got some reservations about this formula.

For one, it pre-supposes that the accounting value of tangible assets always reflect their real economic value, or the value that a long-term investor is willing to place on it. Plainly, while tangible assets are much closer to their actual value than whatever a company says its intangibles are, it’s rarely a one-to-one thing. Second, the ratio breaks down when a stock trades to a discount to book value. As General Motors (US:GM) currently proves, this does sometimes happen to US blue chips.

Three, when you deduct a company’s tangible assets from its net assets, you get a negative value for about a third of the index. This, as far as I can tell, is down to the piles of goodwill that sit on acquisitive US firms’ balance sheets, which is itself a recognition of the power and importance of intangible assets.

Why mention this obscure ratio and its limitations? First, to make the point that the global economy runs on intangible assets. This is especially true of so-called advanced economies, where the biggest profits are made from services and hyper-specialisation. Second, to show that measuring each of these invisible chains – the contracts, relationships, know-how, brands and patents – is a huge challenge.

It is a problem that can be tackled qualitatively. For proof, look no further than Warren Buffett. Though he grew up obsessed with numbers, ruthlessly focusing on profits and companies priced at less than their book values, his later success owes much to an instinctive feel for intangibles.

How else to explain his decades of faith in Coca-Cola (US:KO) and Apple (US:AAPL) and American Express (US:AXP), still among some of the largest holdings in Berkshire Hathaway’s (US:BRK.B) shrinking stable of shares? These firms’ human capital, branding, franchise, intellectual property are each incredibly hard to value, and yet go a long way to explaining their enormous success. A similar effect is evident in companies backed by traditional assets. At a certain scale, oil and gas (another Berkshire favourite) is as much about network effects as it is about underground reserves.

You could be forgiven for finding this a bit ephemeral and squishy. More to the point, it’s not as if we can simply bottle Warren Buffett’s judgement.

Fortunately, there is a way to approximate companies’ investments in intangible assets, which is where our Intangible Edge stock screen comes in. It’s based on the work of a research team at the University of Rotterdam, which in 2021 came up with a proxy for firms with higher rates of intangible asset creation. Handily, when backdated, the formula both smashes the US market and acts as a consistent predictor of stock price performance than other classic factors like size, value, or profitability.

For the past three years, we have used the screen to look for stocks that score highly on a ‘intangible intensity’ metric, which the Rotterdam researchers defined as the ratio of internally created intangible assets relative 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.

The first thing to say here is that just because a stock has a high intangible asset intensity, doesn’t mean its returns will be high, too. Though our schematic is looking for stocks whose intangibles intensity is somewhat hidden from view (and which also tend to perform well), the screen itself does not adjust or filter for current trading, forecasts or valuation.

As such, it shouldn’t be a surprise that within both the UK and US cohorts, returns vary significantly.

However, for the first time, the UK cohort bested both its own high-performing benchmark and the US selections over a year. Two takeovers out of 15 stocks – the now-completed buyout of Darktrace by Thoma Bravo, and the pending acquisition of Spirent Communications (SPT) by Keysight (US:KEYS) – played a big role, though I suspect an average forward earnings multiple of 18 (versus 28 for the US screen) also helped.

2024 Stocks Performance

A total return of 19.6 per cent from the 2024 selections was particularly welcome after a very challenging two years for the UK screen. Higher quality UK-listed services stocks could not catch a break in 2022 and 2023, during which time the FTSE’s stodgier old economy stocks held up well. So it was encouraging to see the gap with the index close a little, even if returns have largely plateaued since the summer, and the all-time total return from the screen is just 7.2 per cent, compared to 29.2 per cent from the All-Share.

By contrast, last year’s US selections struggled to keep up the momentum shown at the start of 2024. However, the fact that it has largely kept pace with the S&P 500 since February 2022, despite its limited exposure to the so-called Magnificent Seven big tech stocks, has been impressive. Only Amazon (US:AMZN) carried the flame in 2024, meaning less than 7 per cent of our selections were weighted to the grouping – compared to around 28 per cent for the broader index at the start of the year.

The screen’s all-time total return of 46.2 per cent is just a shade below the index’s 47.9 per cent.

While the US selections were let down by a few drifters, it was edifying to see two of the much more lowly valued software firms highlighted last year – Trimble (US:TRMB),and F5 (US:FFIV) – perform so well. This year, cloud security group F5 returns, alongside 11 other stocks that also made the grade in 2024.

There’s a similarly low rate of churn among UK stocks, as you might expect from a screen that focuses on a single metric. While this isn’t ideal from the perspective of fresh ideas generation, this accidentally patient approach to stock selection should at least help to control for other stock variables, while recognising that returns from high levels of intangible asset creation may not be instantaneous.

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.