Every year at this time earnings dominate headlines. Most companies have wrapped up their fiscal years and have reported, or are about to report their operating results. As they do, a profusion of commentators proffer their perspectives on the reported numbers. Further, the fanfare around earnings this quarter has been even greater than usual due to the recent tax cuts and their implications.
All of the fuss over earnings begs a seemingly impertinent question: To what purpose? Why is so much attention given to earnings? The reflexive answer is, "because earnings drive stock prices, of course." If you have a pretty good idea where earnings are going, you'll have a leg up on where stock prices are going. Increasingly, however, this answer is not just misleading, but wrong. If analysts really want to understand if value is being created, they need to look beyond basic earnings and to account for the distortions caused by intangible assets.
There is no doubt that the conventions of earnings analysis remain deeply ingrained amongst investors of all types. Management teams provide guidance, Wall Street analysts make earnings forecasts (and get graded on them), earnings dominate the headlines of financial media, and there is always a slew of analysts and research companies concocting new permutations of earnings analyses to meet the demand for potentially differentiating information. Indeed, the assumption that "earnings drive stock prices" was captured well in the recent Financial Times headline [here]: "Solid earnings help push US stocks to record highs".
Despite the familiarity many have with analyzing earnings, recent research reveals that such efforts are increasingly futile. Authors Feng Gu and Baruch Lev note in the Financial Analysts Journal [here] that "the gains from predicting corporate earnings, or consensus hits and misses—an activity at the core of most investment methodologies—have been shrinking fast over the past 30 years." In short, they conclude that "earnings no longer reliably reflect changes in corporate value and are thus an inadequate driver of investment analysis." This being the case, why do so many investors still remain in thrall to earnings?
The main answer is that things have changed while many analysts have not. Gu and Lev explain that "Corporate earnings used to reflect the outcome of business operations and the consequent creation or destruction of enterprise value". As the authors concede, "Predicting consensus hits and beats was obviously a winning strategy in the 1990s and early 2000s".
During the intervening years, however, there has been a "dramatic transformation in corporate investment" which involved the migration of investment away from tangible assets and to intangible assets. The scale of the migration has been significant: "Starting in the early 1980s, investment in traditional tangible assets ... dropped precipitously from 15% of gross added value in 1977 to 9% in 2014, a 40% drop". Conversely, "the investment rate in intangible capital ... increased continuously from 9% to 14% of added value, a 56% increase."
This transition exacerbated a significant difference about intangible assets. Namely, the accounting treatment of intangibles is often different than that for investments in tangible assets. This results in the situation in which "corporate income statements now mix expenses and substantial investments". This happens because generally accepted accounting principles (GAAP) treats "value creating intangible investments", such as spending on research and development, as regular expenses. The result is that earnings (by themselves) have lost the vast majority of their information content.
The increasingly prominent role of intangible assets has done more than just undermine the usefulness of earnings; it has also significantly changed the entire proposition of investing. As Jonathan Haskel and Stian Westlake point out in their book, Capitalism without Capital: The Rise of the Intangible Economy, "there are two big differences with intangible assets." One is that "most measurement conventions ignore them [intangible assets]" (as Gu and Lev highlight) and another is that "the basic economic properties of intangibles make an intangible-rich economy behave differently from a tangible-rich one."
One of those "basic economic properties" is that intangible assets can provide greater upside than tangible assets. As Haskel and Westlake note, "intangible assets are more likely to be scalable." Further, there is always the potential that "scalability becomes supercharged with 'network effects'" and growth really takes off. If you put together intangible assets the right way, you can generate massive growth with relatively little cash investment.
The authors provide the iconic example of the Coca Cola company for which its "most valuable assets are intangible: brands, licensing agreements, and the recipe for how to make the syrup that makes Coke taste like Coke" and yet "is responsible for only a limited number of the things that happen to produce a liter of Coke."
These are not unalloyed positives, however; there are important tradeoffs that mitigate the allure of intangible assets too. For example, intangible assets typically "represent a sunk cost". In other words, since "intangible assets are harder to sell and more likely to be specific to the company that makes them," it is far less likely to be able to recover investments in intangibles.
In addition, intangible investments tend to generate spillovers in that they have the "the tendency for others to benefit from what were meant to be private investments." Tangible assets such as buildings and land "are useful to many types of business whereas a patent or a brand is "more likely to be mainly useful to the company that developed them in the first place." As a result, investing in intangibles is much riskier than investing in tangible assets.
Further, the authors conclude that these properties "combine to produce two other, more general characteristics of intangibles: uncertainty and contestedness." Investing in intangibles is uncertain because investors are less likely to recover much value from failed or aborted investments in intangibles, especially since the "the rewards for runners-up are often meager." Investing in intangibles is contested because "it is hard to prove who owns them, and even then their benefits have a tendency to spill over to others." Both of these factors make investing in intangible assets much more of an "all-or-nothing" proposition.
So how can (and should) investors make use of this background on intangible assets? One is to use it to evaluate information sources. As Gu and Lev noted, "many current practitioners took security analysis courses and started their careers" at a time when earnings analysis was still an effective exercise. The continued primacy of earnings in many research reports indicates that many analysts have been slow to adapt to the rising influence of intangible assets. As a result, investors should significantly discount frantic attention to earnings as an effort to provide a sound analytical basis for securities valuation.
Ultimately, as Gu and Lev describe, "financial investors will have to find information well beyond the current financial statements that purport to describe current businesses." Essentially this involves transforming reported GAAP numbers into something that more accurately reflects the economic operating results and financial health of a company. Only with such an effort can a judgment be made as to value creation for an individual company and comparisons be made on an apples-to-apples basis with other companies. The catch is that it requires a great deal analytical knowledge and expertise to unlock the information value of reported numbers.
Interestingly, this reality has created a bit of an information paradox. On one hand, financial information (such as earnings) is more widely available to the investing public than it has ever been. On the other hand though, the usefulness of such numbers, in the absence of sophisticated analysis and adjustment, has completely eroded. This creates an unfortunate temptation to seek data that is easily available rather than truly informative. To an unfortunate extent, the more information becomes accessible, the more important is the analytical expertise to make sense of it.
The increasing prominence of intangible assets affects the proposition of investing in other ways as well. For example, the characteristics of contestedness and uncertainty offset by potential for spectacular success substantially alter the risk/reward profile of intangible investments relative to tangible ones. These all-or-nothing propositions, which are typical for technology and biotech firms, often bear closer resemblance to venture capital investments. As a result, investors should demand commensurately high returns for projects that have such a high chance of failing.
When higher returns do not obviously compensate for higher risks, managers (and investors!) should take a pass. As Haskel and Westlake highlight, "successful capitalism depends on the idea that private firms have a reasonable expectation of receiving some of the returns from their investments." Indeed, it should not be surprising that "businesses and financial markets seem to underinvest in scalable, sunk intangible investments with a tendency to generate spillovers and synergies."
This raises another important point. Although U.S. markets have provided an environment extremely conducive to investment in tangible assets, the fact is the environment is far less conducive to investment in intangible assets. The observation that "almost no new projects are financed via the stock market" provides powerful evidence of this. Several factors contribute to this disadvantage including measurement (accounting) rules that tend to mix investments and expenses, protections for intangible properties (such as intellectual capital) that are far weaker than for tangible property and an array of policies that favor debt finance over equity finance.
The result has serious implications for the economy as a whole. Namely, it produces an economy that is less robust and engenders less competition than it otherwise would. Investors can use these insights, however, to temper estimates for economic output and to monitor public policy measures that could foster a more conducive environment for investing in intangible assets.
While the argument for digging much deeper in to earnings results may come across as so much academic droning, it is useful to remember that these are the kinds of things that seem like they don't matter at all right up until the point when they matter a lot. For instance, we discussed the unusual phenomenon of sustained low volatility in our market overview last fall [here] by stating: "In sum, the shockingly low level of risk in markets right now represents more than just a warning that markets are overdone; it represents a transformation that dramatically alters the proposition of investing in financial assets."
As it would happen, Monday, February 5, provided an almost textbook example of latent risk being exposed. On that day, volatility exploded higher nearly wiping out investors in the popular exchange traded note (ETN) XIV. While this particular vehicle had been an attractive money making proposition for years, it took only one day to erase all of those gains. In doing so it also provided a stellar example of the "dramatic alteration of the proposition of investing in financial assets".
In conclusion, the emergence of the knowledge economy is good in many respects but also contains important lessons for investors. One is to resist the temptation to get swept up in all the hoopla of earnings season. While earnings results often bring useful updates about a company's financial progress, they fall far short of signaling value creation on their own. For long term investors, the ultimate question to be answered is, "What is the underlying, intrinsic value of assets?" Investors who stay focused on answering that question increasingly need to account for the unique characteristics of intangible assets or they may be asking another question, "What just happened to my investment?"