Thirty US and UK stocks with an intangible edge

The dilemma, I admit, is a false one. If you want to run a business that makes toothbrushes, you will still need to train your toothbrush salespeople, market and build your toothbrush brand, and cultivate good relations with your bristle suppliers. You might even want to invest in research and development (R&D) and patents to build the next generation of toothbrushes.

Even in the case of a simple and largely commoditised product, companies need to invest in the things you can’t see just to be competitive. Put differently, every business, to some degree, is involved in the production and trading of intangible assets.

Unfortunately for investors, it can be hard to tell how this is done, and who does it well.

That’s a problem, because many of the greatest sources of returns in the stock market in recent decades have come from firms that cared a lot about intangible assets. In the shift to a services and digital-led economy, investors who recognised the value of research, technology and human capital have been well rewarded.

We have some solid evidence to support this, thanks to a 2021 study by researchers at the University of Rotterdam. In an analysis of returns from the Russell 3000 index of US stocks between 1989 and 2020, the researchers showed that firms with higher rates of intangible asset creation outperformed the market by 4.6 per cent a year, making it a greater predictor of stock price performance than size, value or profitability.

Not only did these long-term average returns come with lower volatility than the broader market, but similar results were achieved even after removing big technology outfits. To the researchers, this suggested that the intangibles effect is a consistent feature across sectors, and not simply skewed by a handful of highly profitable companies with outsized investments in human and knowledge capital.

Last year, we sought to incorporate this research into a stock screen that gets around the problem of finding which firms prioritise intangible asset creation.

Key to this hunt is the ‘intangible intensity’ metric, which the 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.

Show me your workings

To illustrate how a company’s intangible asset creation can be disguised by its balance sheet and conventional accounting, consider Meta (US:META) – owner of Facebook, WhatsApp and Instagram.

Few companies have had a better track record of creating and then monetising intangible assets. Meta’s founder, Mark Zuckerberg, is one of the wealthiest people on the planet not because he has spent lots of money on reliable servers, staff room bean bags and computer equipment – although he has undoubtedly done that – but because his social media empire has invested heavily in software development, intellectual property, brand recognition, and human and organisational knowhow.

Since 2021, these investments have come under heavy scrutiny from investors, as the company has gone all-in in its bid to establish a leading position in the development of the metaverse. Despite some heavy cash burn, shareholders have little to show in the way of new intangibles or book value growth, as the table below shows.

But apply the Rotterdam academics’ metric to Meta’s financial statements, and the result is a rate of intangible asset creation that has few parallels in corporate America. Whether these intangibles will prove of any use is a separate question, even if four decades of evidence (and Meta’s own track record) offer some comfort.

Intangible returns

Our Intangible Edge screen’s inaugural picks from the end of February 2022 proved a mixed bag.

In both the US and UK versions, ‘short’ portfolios of stocks with the lowest intangible asset intensity ratios – and weighted heavily to extractive and industrial sectors – easily outperformed both their benchmarks and the ‘long’ selections. Unsurprisingly, given many of those same shorts were among the largest and best-performing stocks in the FTSE All-Share last year, the cohort of richly valued UK longs fell well short of the market's return, declining 6.1 per cent on a total return basis. The All-Share index, by contrast, grew 8.9 per cent.

The situation was reversed in the S&P 500, where intangibles-heavy sectors such as software and pharmaceuticals represent a much bigger slice of the market by value. Our 2022 picks just edged out the benchmark by 2 percentage points, a decent result in a punishing year for highly rated growth companies.

Either way, one year isn't likely to tell us much about the relative performance advantage of intangible-rich companies. In 2022, macroeconomic conditions, equity risk premia and estimates of the net present value of future cash flows held far greater sway over share prices.

By disregarding these criteria, as well as market momentum and forecasts, the screen sticks rigidly to a principle that has worked well over four decades. For this reason, I have not added new tests this year.

Despite trying out filters measuring changes in sales, profits and assets per employee, I have failed to work out how these metrics might be usefully and consistently applied to identify companies or sectors that build knowledge or organisational capital more effectively than others. Neither will I continue to highlight the ‘short’ portfolios of stocks with low intangible asset intensity, as despite their recent success, I am less sure which of these stocks’ features are being highlighted.

Eagle-eyed readers will notice that many of last year’s Intangible Edge stocks – three-fifths of both the US and UK screens – make a return in 2023. Because capital formation is a slow process that highlights spending priorities over several years, my guess is that the screen is likely to keep re-selecting past favourites, which is a plus for hypothetical dealing costs when we reshuffle the portfolios each year.

Another reason to feel positive is that two of last year’s selections – UK-listed security software outfit Avast and Nasdaq’s health information technology group Cerner – were acquired in 2022. Given M&A was essentially dead last year (in the US, at least), that represents a decent strike rate for our screen’s picks and shows blue-chip investment committees see plenty of value in the kind of asset that never appears on a balance sheet.