Intangibles and the Performance of the Value Factor

The article “Intangibles and the Performance of the Value Factor” first appeared on Alpha Architect blog

Systematic factor-driven value strategies have underperformed broad market indices (such as the S&P 500) over the past 15+ years. That has led many to question whether intangible assets, such as patents and proprietary software, are properly treated. Current accounting standards, which require companies to expense—rather than capitalize—their outlays on activities that create intangible capital, lead to an understatement in the book value of equity. (In October 1974, the FASB issued SFAS No. 2, mandating that all R&D expenditures be expensed for fiscal years starting January 1975 or later.) Moreover, because the amounts spent to create intangible capital are expensed immediately, and the corresponding revenues that such expenditures generate are earned during future periods, reported earnings are likely to be misstated. Baruch Lev and Feng Gu, authors of the study 2016 study “The End of Accounting and the Path Forward for Investors and Managers,” provided evidence that, due to these reasons, the contemporaneous correlation of book values and earnings with stock prices steadily fell from 80% to 25% over the 1950–2013 period.

The increasing role of intangibles, according to a study published in 2022, is highlighted by the fact that R&D expenditures increased from 1% of company expenditures in 1975 to 7.5% in 2018 and that in 2015 services’ share of GDP stood at 74% in high-income countries and at just under 69% globally—service companies typically use less tangible  capital and more intangible capital than manufacturers. While expenditure for the creation of intangible capital has greatly increased, accounting standards have not adapted to this increase.

Another study found that in 1963, intangibles were only about 25% of the tangible portion of book value for the US stock market as a whole. By the mid-1970s, that proportion had increased to 50%, and by the early 2000s it had redoubled, reaching 100%. However, since then the relative proportion of intangible to tangible capital has remained steady.

Given the dramatic increase in spending on intangibles (not just research and development and advertising expenditures but expenses related to human capital) relative to capital expenditures on plant and equipment, it should not be a surprise that researchers, including the authors of the 2020 studies, “Explaining the Recent Failure of Value Investing,” “Intangible Capital and the Value Factor: Has Your Value Definition Just Expired?” and “Equity Investing in the Age of Intangibles,” the 2021 studies “Value of Internally Generated Intangible Capital,” and “Reports of Value’s Death May Be Greatly Exaggerated,” and the 2022 study “Intangibles: The Missing Ingredient in Book Value,” have focused on the impact on equity valuations and returns resulting from the change in the relative importance of intangible assets compared to physical assets.

The authors of each of the aforementioned studies found that the increasing importance of intangibles, at least for industries with high concentrations of intangible assets, has played an important role in the cross-section of returns and, thus, should be addressed in portfolio construction. Not accounting for intangibles affects not just value metrics but other measures, such as profitability, which often scale by book value or total assets, both of which are affected by intangibles—and investors recognize at least some of their value. However, the research noted that while adjusting for intangibles would have improved the performance of the value premium, it would not have saved it because a significant factor in the underperformance of the value premium was an increase in the valuation spread between growth and value stocks.

A Different Approach

Amitabh Dugar and Jacob Pozharny, the authors of the 2021 study “Equity Investing in the Age of Intangibles,” took a different approach to investigating whether the rise in the level of intangible capital weakened the contemporaneous relationship between stock prices and key financial statement variables such as book values and earnings. To address the mismeasurement of earnings and book value and its impact on their relationship with stock prices, they built a composite measure of intangible intensity (II) for both US and international companies. Their II measure included three types of intangible capital: intangible assets reported on the balance sheet (excluding goodwill), innovation capital created by R&D expenditures, and organization capital resulting from SG&A expenses. They used their composite intangible intensity measure to rank all sectors (except Banks, Insurance, and Diversified Financials) by intangible intensity and classify sectors into either the low or the high intangible intensity category and then examined the contemporaneous association of stock prices with book values and earnings. They concluded, as you would expect, that the association is higher in low II sectors than in high II sectors in both the US and the next 14 largest economies of the world by GDP, including eight developed and six emerging market countries. Building on this study, Dugar and Pozharny, along with Andrew Berkin, investigated the effects of intangible intensity on stock returns in developed international markets in their 2022 study “The Impact of Intangible Capital on Factor Performance Efficacy.” They found that the return prediction ability of the book-to-market factor had declined for companies that belong to highly intangible intensive sectors, but that was not the case for firms in low intangible intensity sectors.

Latest Research

Combining the design used in their prior studies with company-specific adjustments to book values and earnings for intangible capital, Berkin, Dugar, and Pozharny, studied the efficacy of the Price-to-Book-Return on Equity (PB-ROE) model across various levels of intangible intensity (II) in their study “Classical Stock Valuation in the Modern Era of Intangibles,” published in the June 2024 issue of The Journal of Investing. They adjusted book values for all companies to include the unrecorded intangible capital deemed to have been created by their annual R&D expenditures and 30% of their annual SG&A expenditures. They then amortized the imputed R&D capital and SG&A capital annually at the rate of 15% and adjusted reported annual earnings in a corresponding manner, by adding back the R&D expenditures and 30% of the SG&A expenditures for the current year and subtracting amortization expense on both types of intangible capital at the rate of 15% every year. They then estimated P/B-ROE regressions within subsamples of publicly listed US companies in low and high intangible intensity sectors. Their sample period was 1964-2021. Following is a summary of their key findings:

• During an era when the proportion of intangible to tangible capital was much lower and a key component of the expenditures incurred to create intangible capital (R&D) was permitted to be capitalized, stock prices were more closely aligned with book values and earnings. During this period financial statements more accurately reflected the true value of the intangible capital created by R&D expenditures for both low and high II companies. Compelling companies to expense R&D outlays after 1975 reduced the value-relevance of book values and earnings.
• The explanatory power of the regression fell in both groups. However, the relationship between P/B and ROE remained positive for companies in low II sectors throughout the test period but turned negative (perverse) for high II companies during parts of the test period.
• Subperiod analysis confirmed that differences between the two groups in the behavior of the ROE slope coefficient over time corresponded to changes in both the accounting standards governing capitalization of R&D expenditures and the intangible intensity of companies.
• The correlation between average annual intangible intensity and average annual ROE slope coefficient was negative, with the relationship driven by high II sectors—the higher the intangible intensity, the worse was the relationship between P/B (value) and ROE (profitability).
• Even after adjusting book values and earnings, the explanatory power of the regression declined noticeably over the 1964–2021 period for companies in both groups.
• After making the adjustments to book values and earnings, the PB-ROE model performed well in both high II and low II sectors.
• Intangible intensity was positively related to ROE variability, confirming the intuitive belief and the FASB’s contention that future cash flows from intangible capital investment are inherently uncertain—the slope of the ROE coefficient in the PBROE regression was adversely impacted by ROE variability (the lowest ROE variability quantile had the highest slope and vice-versa).
• Among low and medium ROE variability companies, ROE slope coefficients for high II and low II sectors were comparable. However, among high ROE variability companies, the coefficients were slightly higher for high II sectors than for low II sectors.

Their findings led Berkin, Dugar, and Pozharny to conclude:

“We infer that the explosive growth in intangible capital expenditures combined with inadequate accounting for such expenditures has weakened the relationship between stock valuation and profitability, especially for companies in high II sectors. Making adjustments to book values and earnings to properly account for such expenditures is very helpful but does not fully resolve the issue.” They added: “In practice, return on equity is an important component of many investment models including DDM, and we show that its effectiveness can be improved by adjusting book values and earnings for intangible capital expenditures and using it judiciously based on the intangible intensity of sectors.”

Further Research

Savina Rizova and Namiko Saito, authors of the 2021 study, “Internally Developed Intangibles and Expected Stock Returns,” estimated the value of internally developed intangibles systematically across global markets over time by accumulating the historical spending on R&D (to capture the development of knowledge capital) and SG&A (to capture the development of organization capital) and amortizing them at fixed rates. While they too found that adding estimated internally developed intangibles would have had a slightly positive impact on the value premium over the long term and would have mitigated (but not eliminated) its underperformance in recent years, they also found that this impact was primarily driven by differences in sector weights – adjusting for sector differences largely eliminated premium differences. Their findings led them to conclude:

“Our research does not find compelling evidence that we should include estimates of internally developed intangibles in company fundamentals such as book equity. The estimation of internally developed intangibles contains a lot of noise. Perhaps due to this high level of noise, we find that estimated internally developed intangibles provide little additional information about future firm cash flows beyond what is contained in current cash flows.”

The result was that adjusting for internally generated intangibles did not improve upon the use of a combination of traditional value metrics plus sorting for profitability. I spoke with the AQR research team and learned that their conclusions are broadly consistent with those of Dimensional—industry-adjusting book-to-market equity captures much of what intangibles are providing in terms of excess returns.

Interestingly, Rizova and Saito also found that, “while the ratios of estimated internally developed intangibles to assets vary across sectors, they have been stable over time for each sector.” Their findings are why Dimensional’s value strategies do not attempt to adjust for internally generated intangibles. Instead, they use the traditional HML metric but also sort for profitability.

Their findings are consistent with those of Berkin, Dugar, and Pozharny in that they agree that there are limitations in the financial reporting of intangibles. They both combine the use of profitability with other value metrics, allowing them to analyze how the relationship between stock prices and financial metrics differs between companies and high and low II industries.   

Investor takeaway

Academics and fund managers have been trying to address the issues related to intangibles not being on the balance sheet through various methods. The research we reviewed highlights the potential benefits of going beyond adjustments to book values, pointing to an investment framework that can differentiate companies by their intangible intensity and evaluate the efficacy of different types of factors (such as valuation, profitability, and investment) according to how they are affected by intangible intensity.

There are various ways to address the issues we have discussed. One is to use alternatives to price-to-book (P/B) as the value metric, such as price-to-earnings (P/E), price-to-cash flow (P/CF) and enterprise value-to-earnings before interest, taxes, depreciation and amortization (EV/EBITDA). Many fund families (such as Alpha Architect, AQR, BlackRock, Bridgeway and Research Affiliates) use multiple value metrics (such as P/E, P/CF, P/S and EBITDA/EV), some of which indirectly provide exposure to the profitability factor. Another alternative is to add other factors into the definition of the eligible universe. For example, since 2013 Dimensional has included a sort for profitability in their value funds. A third alternative is to use an estimate of the value of intangible R&D and organizational expenses. A fourth way to address the issue is to apply what some call “contextual” stock selection, using different metrics or different weightings of those metrics depending on the intangible intensity. For example, if book value is not well specified for industries with high intangibles, it may be less effective in those industries than in industries with low intangibles.

At any rate, at least for most practitioners, the exclusive use of the traditional HML factor to build a value portfolio is no longer standard practice. In fact, none of the value funds I use in my portfolio exclusively use HML to construct its value funds. Stay tuned, as we are likely to see more research on this important subject.

Larry Swedroe is the author or co-author of 18 books on investing. His latest is Enrich Your Future.

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