Technology is disrupting traditional business models. Intangible assets now account for some 80% of S&P 500 Index assets. But traditional accounting poorly captures their value and return on investment, impacting earnings forecasts and shareholder returns.
Charles Roth: Hi. Welcome to another episode of Away from the Noise, Thornburg Investment Management’s podcast on key investment topics, economics and market developments of the day. I’m Charles Roth, global markets editor at Thornburg. We’re joined today by Sean Sun, who runs our international equity growth strategies. Sean is back on Away from the Noise after recently discussing gaming and the future of social, uh, act, interaction in a digital world. If you’re interested in the fast-evolving life in the meta-verse, check it out. Today, um, we’re going to delve into how Sean values growth stocks and, and the rise in the value of intangible assets, which in so many respects are far more important to understanding the return on investment needed to assess future earnings. Such an understanding is also important just in terms of the growth-to-value stock rotation that we keep hearing about. Let’s first talk about that, Sean. How, how do you think about value and, and whether it’s taking over leadership from growth?
Sean Sun: Thanks for having me on, Charlie. So, that, that’s a good question. When people think about value and value stocks, I think you, they go back to the definition that was kind of created by, um, Eugene Falma and Kenneth French in their kinda 1992, three-factor model that they created. To them, a value stock was defined as a stock with a low price to book; and when you’re looking at low price to book companies as a value stock, that, that is what these, kind of, smart beta models and factor models still use today. They define value stocks as low price to book. On the flip side, a growth stock isn’t necessarily a high price to book stock. You know, these factor models define growth stocks as having generally higher sales growth trends or higher earnings growth trends projections. And so, when I’m thinking about what is a growth stock and what is a value stock, I’m looking at those things, like, uh, how fact is it growing, and then, on the value side, really, is it optically cheap on price to book or price to earnings? I think the problem with, what we’re seeing these days in terms of leadership in the markets is that growth stocks are doing much better than value stocks; and that is a function of quite a few different things, but a big part-a that is just the low rate, low inflation environment we’ve seen lately and for quite some time. Growth stocks have been ahead of value stocks pretty consistently since two thousand and eleven. That’s coincided with this period of low inflation, central banks taking down rates towards kind of the lower-bound and, and a bunch of other factors.
Charles Roth: One of the things that comes up in the discussion of growth is momentum stocks, and I’m not really sure that those are the same as growth stocks. There may be a correlation over the last decade, but if I’m not mistaken, you could have defined for the latter end of the oughts, so, say, mid-2000s to some point in 2008, commodity stocks, oil stocks and, and mining stocks as momentum stocks simply because of the velocity and the price rises. Is growth and momentum, are they related, or, or how do you think about the differences there?
Sean Sun: Yeah. So, growth and momentum are technically different factors from a quantitative standpoint. Growth is expected growth, and momentum is simply price action; has the price been going up? You can have a value stock be a momentum stock. For instance, leading into the financial crisis when we were building a financial bubble, banks were performing really well, and banks are generally low-ish priced to book; but there, for that period, going into the financial crisis, they were momentum stocks because they were going up, similar to the example you get about commodities. These days, with growth stocks doing so well, you’re seeing many growth stocks also become momentum stocks simply because of that underlying price action. Momentum investors are not fundamental; they’re systematic. They’re just looking for the price action. These quantitative funds are just looking for the price action. They don’t really care what’s going on under the surface; and with growth stocks doing well for a variety of reasons because they’re disrupting legacy companies because lower rates justify, kind of, higher multiples and long-duration growth assets, you’ve seen a correlation between those two factors and so, those two types of stocks as of late.
Charles Roth: Let’s get into a little bit about how you value growth stocks as a growth investor, specifically how you think about intangible versus tangible assets, given the rise of intangibles, uh, in terms of the value that they provide for a target company that you’re looking at for potential inclusion in your portfolio and, really, how that has changed over time. First off, what is a tangible asset and, and what are intangible assets, and what are characteristics of both?
Sean Sun: A tangible versus intangible asset. Typically, a tangible asset is something that is kind of a hard, real asset; a building, machinery, etcetera, something that, you know, a company, it would show up as cap-ex; cap-ex, and then sit on the balance sheet, or retained earnings, or whatever. An intangible asset tends to be assets which, you know, are harder to measure. Big categories of intangible assets, for instance, are, like, intellectual property or, like, software licenses or software code, or rights to things, or, or brand value is a huge, huge part of intangible, or customer, or supplier relationships, or rights to certain assets or goods, or spectrum, or things like that. There’s a different between what is kinda har, hard, you can kinda almost touch and feel, versus what is a little more nebulous. But what’s been going on is that traditional value investors are really focused on price to book, and price to book really only measures tangible assets; but our economy and our world has been evolving more towards value being imbedded in stuff like intellectual property and to stuff like soft or into muh, kinda more digital goods as opposed to physical stuff such that, when you’re valuing a company purely on tangible book, you’re really missing a whole lot of imbedded value there. And I think that is one thing that traditional value investors have missed over time, and they really need to take more time and effort to kind of adjust book value for some-a these intangible assets. And I’ll give you the example in terms of an asset that is intangible technically but actually can generate a ton of cash flows or retirement is actually quite valuable, and that intangible asset is really software. So, if you look, if you go back into time and you look at, say, private equity activity, the whole paradigm in private equity is you need hard assets and stable cash flows to put leverage against. And as a result, there was very little software buyout activity decades ago, almost zero. But as of late, you started to see that really smart private equity firms, like, say, like a Vista Equity, are doing a lot of software deals. And that is because the smart money is essentially realizing that software assets are extremely valuable streams of cash flow that you can actually put leverage against, and you can engage in a buyout deal. You know, to give you an interesting, interesting stat, there was about a hundred and twenty-one billion dollars of software deals in 2019; so, a pretty, pretty huge amount of software buyout activity.
Charles Roth: How do you value those streams from, say, uh, a subscription model? What would be, uh, a fair price? What would be a high price? What, what would be a price at which, if you already own the stock, you think, well, this has for now kinda petered out and, and maybe I should start trimming? How, uh, how do you think about those revenue streams in, in valuing a stock?
Sean Sun: Yeah. So, with revenues coming from, say, a SAS software company, I’m looking at the expected cash flows over time. You know, what’s interesting is that, you know, we all agree that capital expenditures is an investment for growth. We all generally agree that research and development is an investment for growth. But the problem with research and development spending is that, you know, it’s expensed on the income statement as it’s incurred; thus, it doesn’t generate a tangible asset, but it clearly is generating these intangible assets like software code or patents or drugs or whatever the case may be, that’ll generate cash flows over time. I think there’s a very similar phenomenon going on with SAS software companies in terms of the sales and marketing dollars that they spend to acquire new customers, and these new customers that they acquire tend to, because it’s a subscription service for the software, and they tend to have generally low return rates, once the software’s been implemented by a company, it’s kinda rare, assuming things are running well, that you’d rip and replace that software. I see that sales and marketing spending at software companies can generate quite a bit-a lifetime value over time. So, there’s this metric I like to use with SAS software companies, is I like to look at what the lifetime value is to customer acquisition cost; and whenever that lifetime value exceeds the customer’s acquisition cost by quite a bit, that’s the sign of a really healthy software company. And so, I’m using that metric to kind of inform the multiple I pay for the underlying company ’cause I’m really trying to figure out what the future cash flows are over time; what the future cash flows could look like if the company continues to invest sales and marketing into acquiring more subscription revenues.
Charles Roth: So, you mentioned R and D and how, it’s expense. So, you would actually think that R and D would better be put as a capitalized segment on the balance sheet and that SG and A, selling general administrative expenses, some portion of that should actually also be on the balance sheet. It should be capitalized. And that’s how you would, then, feed into your estimates of what the actual amount of investment is going on, or, or I guess, I guess the question is, do investors nowadays, does the market nowadays under appreciate the amount of investment going on because there’s too much being placed on the income statement and expensed rather than on the balance sheet and capitalized?
Sean Sun: I think it makes a lot of sense to adjust book value for things like R and D, parts of SG and A that go towards investments for essentially growth, such as grand building or a, or customer acquisition, and I think, if you do that, if you capitalize R and D and you capitalize parts of SG and A, capitalize parts of sales and marketing, really adjust the book value for that, you know what happens is that you’ll have a better sense of what the true value is of a company, and there have been academic papers written about this where, if you adjust book value for that, you’ll actually end up with better investment results. So, I think it’s important as a fundamental investor to not just look at only the, the optical metrics but to dig a little deeper to the bottom of fundamental analysis, make adjustments where it makes sense to capitalize R and D or capitalize parts of sales and marketing or SG and A in your pro forma analysis to get you to what this company is really worth. And I’ll give you the, and interesting example. So, if you look at, say, the Dow Jones industrial average, there’s actually three components in the Dow Jones industrial average that have negative book value. The, those three stocks are Home Depot, McDonald’s, and Boeing. So, these three stocks have negative book value; thus, they essentially have infinite price to book value rations; but no one would say that these are worthless companies or not great companies in any way. So, what that says to me is that intangible assets are clearly worth a lot, but traditional accounting does a poor job of assessing their value; thus, as an investor, you have to go beyond traditional accounting and do your own analysis.
Charles Roth: That’s a very interesting point with the Dow; but I’ve also seen some charts. In fact, I saw one from you in your presentation to the investment team at Thornburg that involved the S and P, which is worth close to 30 trillion. Uh, you have roughly 29, and intangibles within that now represent roughly 24 trillion; so, take three-quarters of the S and P, is now comprised of intangible assets is, that, that’s kind of a striking thought. I mean how, how do you think about that?
Sean Sun: I think it’s a reflection of kind of how our world has evolved and where value is being created these days; and so, the, at, at the time of this podcast, the S and P 500 is worth roughly 29 trillion in total market cap, but the actual underlying book value of the S and P 500 is only roughly 4 trillion; thus, a huge amount of the S and P is value, that the market is valuing it at is in these intangible assets, and if you look at the top largest companies in the S and P 500 these days, it’s companies that derive their value from intangible assets, like an Apple, like a Google, Microsoft, Amazon, Facebook. And, and Facebook benefits from network effects, which is a very, which is clearly an intangible asset; but it’s interesting because the great thing about network effects is it makes a val, it makes the value of a good or service increase as more and more people use it. Not only do more people wanna go on Facebook when you have, uh, more users on there, but they get, they get scale benefits from kinda all the servers and such that they’re running, and they get user benefits because you have, you’re connecting with more friends and things like that, and it basically comes together to create a platform-type business where there is very little hard investment required outside of servers, but there is a huge amount of intangible value in the user base, in the network effects, and also in the, all the algorithms, digital algorithms they’ve created to target ads to these customers or even nudge them to improve the engagement.
Charles Roth: I would imagine that ridesharing is a similar dynamic, though. You have, the more drivers you have and the more people who contract those drivers, then you, you, you, you have sorta the dynamics from both sides, the supply as well as the demand side, growing.
Sean Sun: Yeah. That’s very true, and you know, that’s another case where instead of decreasing returns to scale in some kinda the older industrial-type businesses, a business like that has increasing returns to scale and increasing, uh, value as it scales up in terms of each side of the platform. But if you go back just a few decades ago, the top companies in the S and P 500 were more tangible companies, like a GE, Exxon, Coca Cola, Altria, Walmart, etcetera. So, it’s a interesting shift in our, in our economy.
Charles Roth: And one last point. You went over the acquisition that Gilead had undertaken of Immunomedics, and you mentioned the book value of Immunomedics against the purchase price. Can you talk about that for just, uh, a second?
Sean Sun: Yeah. So, Gilead is buying this company, Immunomedics, for 21 billion dollars for this val, really valuable cancer drug that they have developed; but not only because of this high-potential cancer drug, because of what type of good this cancer drug represents. So, there’s this concept of rival versus non-rival goods; and with a rival good, only one person can use it at a time; and that typically applies to kinda tangible assets, hard assets, piece-a machinery or whatever. But with a non-rival good, it’s something that many people can use at once; for instance, a piece-a software, or in this case, a drug that you can make many, many times and give to many, many people. And then there is also a concept of excludability; you know, how well can you control what, your product that you’re taking to the market. With this cancer drug, it’s excludable because it’s patent protection around it. So, that allows the company that owns this drug, Gilead, if this deal goes through, to not only provide it to a whole swath of people but also exclude competition on the drug, as well, which makes it extremely valuable; and hence, the 21 billion dollar purchase price over just a 600 million dollar book value of this company.
Charles Roth: Well, thank you, Sean.
Sean Sun: Thanks for having me.
Charles Roth: Today’s episode was produced and edited by Michael Nelson. You can find us on Apple, Spotify, Google Podcasts, or your favorite audio provider, or by visiting Thornburg-dot-com-slash-podcasts. Subscribe, rate us, and leave a review. Please join us next time on Away from the Noise.
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