An Adaptable Investment Approach to an Ever-Evolving Economy
The makeup of the economy in 2021 looks drastically different than the markets of the 1920s. While innovation has continued its push forward throughout the world, the composition of today’s biggest companies looks quite different than it did 100 years ago. A century ago, business investment was largely characterized by tangible (physical) investments, such as factories and machinery, as the world changed in the industrial age and post-World War I. Over the past few decades, we have seen companies build incredible value through intangible (non-physical) assets. These investments in software, patents, intellectual property, and research and development led US GDP per capita to increase 20x over the past 60 years, from $3,000 in 1960 to an astonishing $65,000 in 2019.
Since the dawn of time, humans have been forced to adapt and change, first for survival. Investment analysis is no different. Today, service industries account for two-thirds of U.S. GDP, and 4 out of 5 private-sector U.S. jobs are within the service sector.
Tweedy, Browne Company LLC is a $13 billion asset manager with an investment philosophy rooted in the Ben Graham style of deep value investing. Tweedy’s roots started as a securities dealer in the 1920’s, moving to a well-respected asset manager. However, times have changed from the Ben Graham style of investing, forcing firms like Tweedy to update their investment process and how they evaluate investments. At Madison, we believe strongly in taking a holistic investment approach, not beholden to a handful of specific valuation metrics; rather, we adapt and change our tools to suit the job.
Below we included a few excerpts from Tweedy’s most recent annual letter to shareholders, discussing their approach to incorporating intangible assets in today’s changing market.
Tweedy, Browne Fund: Letter to Shareholders “Intangible Assets”
“According to the book Capitalism Without Capital: The Rise of the Intangible Economy by Jonathan Haskel and Stian Westlake, investments are defined as “things that [a] cost money, [b] are expected to generate a longer-term return, and…[c] the company making the investment has a reasonable chance of enjoying a worthwhile portion of the return itself.” Today, there is virtually universal agreement that over the last several decades, the economy has transitioned away from “tangible” investment in physical items (think buildings, factories, vehicles, and machines) and towards more “intangible” investment (think software development, product design, research and development (R&D), employee training and brand advertising).
In light of the change in our economy from tangible investment to more intangible investment, many professional investors believe the accountants have it wrong. They believe current accounting policies are antiquated and no longer reflect today’s economic reality. In their view, intangible investment spending should be…similar to the treatment of tangible investment. Thus, the argument goes, for a fast-growing business that invests heavily in intangible investment, reported assets are understated, reported book value is understated, and reported earnings are understated. They believe that, without material adjustments to reported financial statements, traditional value investing strategies that attempt to select stocks based on quantitative metrics such as low price-to-book value or low price-to-earnings are fundamentally flawed. Hence, the value investor’s failure to appropriately recognize the inherent value of intangible assets has led the strategy to underperform in recent years.
…Tweedy, Browne does not purchase a stock solely based on any rote quantitative metric… in our view, statistical cheapness, in isolation, is not a sufficient reason to purchase a stock. Moreover, we agree that there is some merit to the notion that book value has become less relevant over time as an anchor of valuation, given the long-term trend towards a more asset-light, often service-based global economy. Today, we find book value most helpful in our valuation of only a small subset of industries, namely banks and insurance companies.
While we believe that in certain circumstances the adjustment to capitalize (create an asset) and amortize (expense) “intangible investment” spending over a multi-year period to correct (increase) reported earnings could make some sense, we believe its broad use could also lead to problems…Over what time period should product design benefit a business…is it reasonable to assume that most/all intangible investment spending will lead to future economic benefits over a multi-year time horizon? To us, broadly capitalizing and amortizing “intangible investment” seems like a potentially dangerous extrapolation that could be used to rationalize ownership of a highly valued security…several historical high profile accounting frauds centered around aggressive cost capitalization of ordinary expenses…to inflate earnings (WorldCom being the most famous example). We believe that accounting standards by design are meant to be conservative. Furthermore, our appraisals of underlying intrinsic value are meant to be conservative. Thus, we don’t think it makes sense to broadly re-write income statements and balance sheets to adjust for intangible investment spending.
Notwithstanding the above, there are a handful of situations where adjusting reported earnings for intangible investment has more intuitive appeal. One such example is a truly dominant, wide-moat, platform business which benefits from both network effects and economies of scale (i.e., Google). While such businesses are rare, there are examples where high upfront fixed costs indeed mask very attractive underlying economics. This results initially in reported losses, yet as the business scales, it often leads to very high incremental margins on future revenue growth. One such example that we purchased later in the fiscal year was Alibaba.”
We believe it is important for investors to analyze companies differently, ultimately determined by how they create long-term, per-share value for investors. As an example, JP Morgan, a multi-national bank, should not be valued in the same light as a software company like Microsoft. Their products, competitive dynamics, and means of creating value for shareholders are vastly different. So why would we use the same analytical tools and framework to value these potential investments? At Madison, we take an adaptable approach to the financial world. We study the drivers of enterprise value that steer market cap higher. The education process is never done, as the world around us is ever-evolving.
Important Note: This material is for informational purposes only and is not intended to serve as a substitute for personalized investment advice or as a recommendation or solicitation of any particular security, strategy or investment product. The opinions expressed herein are those of the named advisors at the time written. Actual economic or market events may turn out differently than as presented. © 2021 Madison Wealth Management