Our long-time readers are
familiar with the work of Professor Baruch Lev of the NYU Stern School of
Business, whose research forms the basis for the Knowledge Leaders investment
strategy. In his decades-long study of financial records, Lev first discovered a link
between a firm’s knowledge capital and its subsequent stock performance,
ultimately identifying a market inefficiency that leads highly innovative
companies to deliver excess returns. We call
this market anomaly the Knowledge Effect.
In a new article in Financial Analysts Journal, Lev
and co-author Feng Gu continue to advance the findings on intangibles. The
article, “Time to Change Your Investment
Model,” identifies that earnings
prediction has lost “much of its relevance in recent years.”
As a form of predicting
corporate results, “earnings no longer reliably reflect changes in corporate
value and are thus an inadequate driver of investment analysis.”
The basis for this shift, the authors explain, occurred after the
emergence of the semiconductor.
“Starting in the early 1980s, investment in
traditional, tangible assets (structures, factories, machinery, inventory) –
considered assets by accountants and reported accordingly on the balance sheet
– dropped precipitously from 15% of gross added value in 1977 to 9% in 2014, a
40% drop.
In contrast, the investment rate in
intangible capital (R&D, patents, information systems, brands, media
content, business processes) – mostly expensed in corporate income statements –
increased continuously from 9% to 14% of added value, a 56% increase. This
radical business model transformation came to be known as the knowledge – or
information revolution, an irreversible trend in developed economies.”
As a result, for companies,
“the only way to survive and prosper in such a competitive environment (is)
through constant product and process innovation, achieved primarily by
investing in intangible assets.” Therefore, “earnings’
usefulness to investors declines sharply for companies that increasingly rely
on intangible value-creating assets.”
For these reasons, “GAAP-based reported earnings no longer reflect
the periodic value changes (growth) of most business enterprises, and thus
conventional earnings-based security analysis has lost much of its usefulness
for investors in recent years.”
In summary, the authors observe:
“The disappointing returns on
managed funds in recent years should raise doubts about the continued
usefulness of conventional security analysis. Our extensive empirical evidence
on the loss of relevance of GAAP numbers, in both this article and our recent
book, confirms these doubts. Certain major investors have already departed from
the status quo. … We propose a different course: Rather than replace analysts
with robots, substitute an improved investment methodology for an outdated
one.”
If you’re interested in reading
Lev and Gu’s article, download it here. Stay tuned for more on Professor Lev’s
research in early 2018 and an in-depth Q&A on his latest research on
intangible capital.
