The global growth of companies with relatively limited physical assets presents challenges for investors
- Many companies today have relatively limited physical assets
- Intangibles pose difficult accounting challenges for companies
- Brand names have a value but it may depend as much on the sector as on name recognition
- Quant managers face the greatest challenges
Economic growth has always been driven by new ideas which have led to new products. The industrial revolution of the eighteenth century was testimony to that with the harnessing of steam energy, the building of canals and the creation of factories. It laid the foundation for the developed technological world that we know today.
A key difference with the eighteenth century is that global growth is today being driven by companies that have relatively limited physical assets. This is most obvious in the case of the US FAANGs (Facebook, Apple, Amazon, Netflix, Google) and their Chinese equivalents (Alibaba and Tencent). However, sectors such as pharmaceuticals also have assets which consist predominantly of intellectual capital from research and development. The accounting profession, however, has not been able to keep up with these profound changes that have become apparent over the past couple of decades.
Dealing with intangibles might have been small matter a century ago but in today’s world it has led the accounting profession to impose a huge burden on the corporate sector to produce statutory accounts that are not fit for purpose. Indeed, says Ian Bishop, head of accounting at Roche, the Swiss-based global healthcare firm: “What we do regarding the financial reporting of intangibles is diligently undertaken and absolutely compliant. But it is useless in the technical meaning of the word useless – it has no use.”
In his view, the most egregious example of this is in statutory balance sheets. Bishop argues they produce “fake assets” in the form of goodwill and are a complete mess when it comes to dealing with intangibles. Any companies that do not have a traditional physical capital-intensive business model have balance sheets that do not adequately show economic value.
Technology companies, for example, have a problem when it comes to intangibles. Oracle spends enormous amounts on research and development (R&D) which, points out CT Fitzpatrick, CEO of Vulcan Value Partners, is not reflected in its balance sheet in any meaningful way at all, yet the present value of the cashflows arising from the R&D is enormous.
The problems are likely to get considerably worse. Mark Carney, governor of the Bank of England, has argued that climate change will undeniably have an impact on a company’s performance and position, and meaningful metrics, data and financially relevant information for the markets to act upon is key.
Ravi Abeywardana, a committee member of the Institute of Chartered Accountants in England and Wales, points out that climate change will hit companies’ book values via several accounting categories including intangibles. “Brand and internally generated goodwill, currently outside the scope of financial statements, may change based on how an organisation transitions to a low-carbon economy,” he says. It is unclear how this will play out via international accounting standards.
It is particularly bizarre that the number on the balance sheet for goodwill and intangibles is completely situational. Two similar companies can have different balance sheets depending on whether the company has grown organically or via acquisitions.
In the latter case, as Francesco Curto, co-head of research at DWS, points out, an acquisition of a $100bn (€90bn) company can result in $40bn of goodwill plus $40bn attributed to patents. Yet the patents existed before the company was acquired. They were reported only after the acquisition when accountants could establish the value of such assets. Even this accounting is not complete and is reported as $40bn of price premium over the stated assets.
In the pharmaceutical industry such a procedure is a recipe for chaos. “If you develop drugs yourself, the value of R&D is typically not on the balance sheet, you just expense the costs,” says Bishop. “If you purchase the asset in an asset deal, it is put at the cost value; and if you acquire it by way of an M&A deal, it is on at fair value – a third methodology. So you have three completely different ways of setting numbers for what is arguably the most significant part of our business.” Making comparisons between pharmaceutical companies is fraught with difficulties as a result.
Roche grew without undertaking any mega mergers, in contrast to Novartis. But, points out Bishop, merger accounting was still allowed when Novartis was combined, so the legacy balance sheet items were simply combined. The rules had changed when Sanofi merged with Aventis and, as a result, the combined balanced sheet had a large item for goodwill. The three companies have different balance sheet figures that shed no light on their relative value but just reflect different paths to growth.
Curto argues that the accountancy profession has created confusion in its treatment not only of intangibles but even of physical assets. Identical aircraft built by Boeing or Airbus and owned by different airlines, can have completely different depreciation schedules on balance sheets driven by local tax regimes, giving rise to different valuations. “The way the accounting profession is doing it is wrong and accounts are not serving investors well,” he says.
It is clear that in the case of R&D by a pharmaceutical company, today’s investment will only produce revenues some time in the future. But it is still as valid an investment as a steel plant in China. Moreover, both require assumptions when calculating their worth. There is plenty of information available on the R&D pipelines of pharmaceutical companies through regulatory filings, and while it may take a decade before earnings can be obtained, there could be 15 years of cashflow thereafter before patents expire.
A steel plant in China may be seen as a solid asset with a lifetime of 20 years but that assumes that China will continue to experience the demand for steel that it has had over the past couple of decades when it accounted for a large fraction of total global consumption of steel.
Fixing the challenges around statements of intangible capital may not be easy. Brand names certainly have a value but this may depend as much on the sector as on the name recognition. Although Roche is a long-established brand name that has international credibility how much is it worth on its own and how would it be valued? “Even if Roche is as well-known as Amazon or McDonalds, no one says whenever I have a serious illness, I always buy Roche,” says Bishop.
Perhaps not surprisingly, Fitzpatrick avoids the financial sector altogether. “Financial companies have a combination of assets which are hard to value, combined with very high leverage, so their net equity values are very unstable,” he says.
Vulcan’s approach focuses on free cashflows of companies when it comes to assessing value, as cashflows are the one item that is not subject to manipulation. “Our free cashflow figures are very different from IFRS [International Financial Reporting Standards] and GAAP [Generally Accepted Accounting Principles] profits,” says Fitzpatrick. Vulcan does not capitalise R&D expenditure in its analysis but it does discount free cashflow to restate balance sheet items.
While finding an accounting solution to the issue of intangibles is not easy, Bishop argues that what we have now is the worst of all worlds. “The only saving grace is that everyone knows it is rubbish.” But for investors, mis-valuing balance sheets does give rise to real problems in investments.
Curto points out that there are plenty of value-driven exchange-traded funds (ETFs) based on concepts such as price/book ratios as a measure of value. If balance sheet items such as book value are nonsense, the dangers are evident.
Fitzpatrick argues that, despite the current problems, the worst thing that can happen is to distort the relationship between balance sheet and income statements: “If you did not expense R&D and instead treated it as a large asset and as a capital expenditure, you would be increasing profits, but you are paying everyone in cash, so you can have a situation where net income materially deviates from free cashflow.”
Moreover, as Bishop points out, research in the pharmaceutical sector is different from R&D in, say, the automotive industry: “There, you know you will get a car that will work and it is just a question of how much will it sell? In our industry, you can research a drug and take it all the way, but it might not work in the end, or one of your competitors might have a better one and everyone uses that and not yours.”
As a result, pharmaceutical companies expense all R&D until the late stages when they receive approval in the main markets. “Otherwise you can spend the money, stick it on the balance sheet and you may find in three years’ time, it is not worth anything. In the meantime, you have overstated your profits.” Pure research in any industry must always be expensed for this reason.
The outcomes when a research idea starts to produce revenues can also be a problem. Roche, says Bishop, is transparent about its pipeline of news on drug development. “The job of the analyst is to make the judgement between our pipeline and those of our peers. We have our own business plans, but it does not mean we stick them all on the external balance sheets and P&L statements.”
When Roche acquires someone else’s research project, it is put on the balance sheet at the price paid for it. Whatever is spent afterwards on it is expensed. Acquisitions through M&A deals are put on the balance sheet at market-participant value and anything afterwards is expensed.
Quant investment managers face the greatest challenges when dealing with intangibles. If the premise is that an objective quantitative stock-selection methodology can analyse a universe of 1,500 stocks or more in a systematic manner, the financial data clearly has to be presented in a consistent manner. Book values, as Simon Harris, head of GMO’s global equity team, explains, can be ridiculous. As book value is the difference between assets and liabilities, companies with large leverage can show negative book values, while others can show anomalously large figures.
“If you look at earnings/book ratios, 16 of the top 100 global companies either show negative book values, or have ratios above 60%,” Harris says. McDonald’s has a negative book value, yet its brand is arguably one of the world’s most recognised.
Harris finds three areas where book values can be misleading. Intangibles is the largest but there are also the impact of inflation accounting and share buybacks and issuance. To undertake systematic quantitative analysis, GMO does capitalise R&D and also items such as advertising spending. Items are then depreciated on a linear basis.
It remains to be seen whether the accounting profession will rise to the challenge of dealing with intangibles. There is certainly a case for it since, as Bishop points out, whenever a large company goes bust, people ask what the accountants are doing.
Bishop sits on an advisory committee to the International Accounting Standards Board which will shortly be looking for agenda topics for potential changes. One idea is to undertake a fundamental reappraisal of the whole area of intangibles. Finding an acceptable solution is unlikely to be easy but action seems overdue.