By Trevor Muchedzi
- An increasing number of companies in developed countries are deriving most of their value from their investments into intangible assets rather than tangible ones;
- By their very nature, intangible assets have different economic characteristics compared to the tangible assets which drove the third industrial revolution for the last 50 years;
- Companies built on intangible assets behave differently in terms of industry competitiveness, how they create, capture and distribute value and how quickly they can scale up their businesses;
- Since 2010, companies that derive most of their value from intangible assets have grown their earnings and thereby value at a much faster pace than those that still heavily rely on tangible assets;
- For investors, this seismic shift provide a new world of ever expanding investment opportunities.
The quiet revolution…
2010 was a historical year for Africa and South Africa in particular. For the first time, the continent hosted the FIFA Soccer World Cup tournament which brought a great deal of optimism for the future. But far away from the buzzling soccer stadiums and eardrum-popping sounds of the vuvuzela, a rather more quiet revolution was taking place. For the first time ever, corporate investments into creating intangible assets outstripped investments into tangible assets in advanced economies. This was the momentous, although less glamorous occasion that marked the end of the third industrial revolution and ushered in a new era in which our everyday life became firmly rooted in digitization (the 4th industrial revolution).
An increasingly irrelevant economic theory
Jonathan Haskel and Stian Westlake, in their brilliant book: Capitalism Without Capital went into great length explaining this new phenomenon, highlighting the different characteristics between intangible and tangible assets and their impact on industry competitive dynamics, value creation and the ability of companies to scale globally. This transition is very important and has a huge implication in terms of how investors frame their risk-reward analysis and how they value the companies that make intangible assets.
In their book, Haskel and Westlake outline four reasons why investments by companies into intangible assets behave differently:
- They are a sunk cost. If the investment doesn’t pan out, there is no residual physical asset like machinery that the company can sell off to recoup some of its money;
- They tend to create spill overs that can be taken advantage of by rival companies. Uber’s biggest strength is its network of drivers, but it’s not uncommon to meet an Uber driver who also picks up rides for Lyft;
- Intangible assets are more scalable than a physical assets. After the initial expense of producing the first unit, the product can be replicated ad infinitum for next to nothing; and
- There are more likely to have valuable synergies with other intangible assets. For example, when Facebook acquired Instagram in May 2012, Instagram had 50 million active users. By integrating it into its ecosystem, Facebook drove the rapid adoption of Instagram to about a billion users now.
Bill Gates in his book review of Capitalism Without Capital summarized the pronounced effect of this transition to intangible assets (you can read the full article here). One of the first lessons in Economics 101 is the supply and demand diagram which essentially shows how the global economy during the third industrial revolution worked:
One of the most important underlying assumption that this chart makes is that the total cost of production increases as supply increases. Ceteris Paribus (an economics lingo for all things constant), the cost of making 10th unit of a product is the same as the cost of making the 21st unit because each product requires a certain amount of materials and labor. The same is true for the other things that dominated the world’s economy for most of the 20th century, including agricultural products and property.
However, intangible assets don’t work like that and this is where things get interesting. Companies spend significant amounts of money upfront, mainly R&D costs, developing the product/solution. Once the initial product is commercially viable, additional units can be produced ad infinitum for next to nothing. A good example of this is cloud based accounting software, the cost of producing and distributing additional units is essentially zero.
This has three implications, mainly:
- Companies which derive most of their value from selling intangible assets have very low Cost of Goods Sold and this normally translate to higher profitability and free cash flows;
- Such companies can scale globally at an exponential rate; and
- Because of this, intangible assets create winner-take-all market dynamics which create natural or unregulated monopolies with extremely high pricing powers.
Ecosystem: the positive flywheel
As Haskel and Westlake note in their book, intangible assets are more likely to have valuable synergies with other intangible assets. To cement their dominance, once a company has established its foothold in a particular market, the next phase is to build an ecosystem of complementary products/solutions. Such an ecosystem usually create positive network effects, a phenomenon wherein increased numbers of people or participants improve the value of a good or service. As such, customers of intangible assets derive more value from being inside the ecosystem than outside. This is because an ecosystem of intangible assets makes it easier for such companies to profitably share the value/benefits of their product/services with their customers, mainly through lower prices, which in turn makes the customers inherently interested in these companies continuously growing.
Impact on profitability and hence value
As alluded to above, because intangible assets can be scaled exponentially at very low marginal costs, companies that derive most of the value from intangible assets tend to be very profitable and have higher free cash flows. The table below provides a synopsis of the average profitability for a number of different industries. The key takeaway is that companies which derive a higher proportion of their income from intangible assets are more profitable than companies that rely more on tangible assets.
|Industry||Average gross profit margin||Average net profit margin|
|Social media platforms||80% – 90%||35% – 45%|
|Software as a Service||75% – 85%||15%- 25%|
|Semiconductor||55% – 60%||18% – 20%|
|FMCG Manufacturers||45% – 55%||9% – 11%|
|Real Estate Developers||35% – 40%||10% – 13%|
|Retailers||20% – 30%||2% – 4%|
I also came across this graph below on Twitter which drives home the impact of intangible assets on corporate earnings and by extension company valuation. There are a couple of key takeaways from the graph:
- There was a breakout around 2010 where earnings from tech enabled businesses took off;
- The growth in earnings from intangible assets is exponential; and
- Lastly, the divergence in earnings reflect the ability of businesses built on intangible assets to scale quickly, become dominant market players and wield tremendous pricing power.
So where does this leave investors?
There are a number of implications of this transition we are going through and it will take time for the investment world to embrace them. On the surface as has been proven over the last 10 years, companies built on intangible assets grow very rapidly. Uber was founded in March 2009 and 10 years later, the company will IPO at a rumored valuation of US$120 billion, a feat that took the most successful 3rd industrial revolution companies over 40 years to achieve. A number of other new age companies follow a similar script. In addition, the way investors value companies built on intangible assets is also changing, more so for companies in high growth phase. Traditional metrics like P/E ratio are increasingly becoming meaningless given that GAAP requires R&D costs to be expensed rather than amortized. New metrics and/or models have to be developed as the nature of businesses change.
In part two of this series, I am going to delve into the some of the investment themes I am excited about over the next 10 to 20 years. These include: collaborative / productive software products, cloud based identity management, content streaming, payments, data-driven targeted advertising platforms, autonomous driving, DNA sequencing and genetic analysis and food delivery. I believe we will see tremendous growth in these areas and I will highlight a number of potential investment play for investors.
Until then, happy 2019 and happy investing