New research from Dimensional Fund Advisors, a leader in systematic factor investing, suggests that adjusting for intangibles – such as patents, licenses, computer software, branding, and reputation – is not helpful in identifying differences in expected stock returns. Estimating the value of internally developed intangibles may introduce many arbitrary assumptions into systematic investment processes with no consistent tangible benefit.
Dimensional’s Global Head of Research, Savina Rizova, PhD, and co-author Namiko Saito, PhD, summarize their deep-dive research on intangibles in a paper called Intangibles and Expected Stock Returns. The paper challenges the narrative that intangible assets should be fully accounted for on the balance sheet because of their recent growth in importance. Rizova and Saito note that intangible assets have always been part of the economic landscape and capital markets.
“Mickey Mouse, a key brand for Disney, was introduced to the world as the main character in the animated film ‘Steamboat Willie’ in 1928,” Rizova and Saito observe. “Disney has been a publicly traded company with this important intangible since 1940."
There are two types of intangibles: externally acquired and internally developed. Externally acquired intangibles are reported on the balance sheet and reflected in valuation metrics such as price-to-book. Internally developed intangibles, on the other hand, are expensed on the income statement and reflected in metrics like operating profitability.
In contrast to the emerging narrative, Dimensional’s analysis suggests that while externally acquired intangibles have grown over time relative to companies’ assets, internally developed intangibles have accounted for a fairly steady fraction of assets.
Dimensional is one of the first asset management firms to detail the complexities of valuing internally developed intangibles and the potential issues associated with incorporating those values into investment strategies. Rizova and Saito point out that there are many arbitrary assumptions required when estimating the current value of a firm’s internally developed intangible assets. Because this value is already baked into the price at which that firm’s stock trades, there is no clear benefit to using these estimates when making investment decisions.
“Internally developed intangibles do not go through a market valuation process, while externally acquired intangibles go through a competitive market valuation,” Rizova and Saito write. “There is more uncertainty around the value of internally developed intangibles."
Due to the high uncertainty around the value of internally developed intangibles, Rizova and Saito find that these intangibles appear to contain little additional information about future sales and profits beyond what is contained in current company financials. The research finds that incorporating estimates of internally developed intangibles into relative price and profitability metrics does not yield consistently higher value and profitability premiums.
Given the issues involved in the estimation of internally developed intangibles, the paper also examines the impact of removing externally acquired intangibles from the balance sheet as an alternative approach to infer differences in expected returns across companies with different sources of intangibles. The researchers find no compelling performance benefit from excluding externally acquired intangibles from fundamentals.
The takeaway for investors? According to Rizova and Saito, “Investors are better off continuing to incorporate externally acquired intangibles reported on the balance sheet and not adding noisy estimates of internally developed intangibles to value and profitability metrics."
Dimensional’s research arrives at a moment when the investment industry is seeking explanations for the decade-long underperformance of value stocks relative to growth stocks. Rizova and Saito caution against abandoning valuation theory or trying to backtest the way to a conclusion.
“Just like the equity premium, the value premium is volatile and can go through pronounced periods of negative returns,” said Rizova. “Through robust research and implementation, we focus on pursuing premiums the right way, not the easy way."