A change in how US GDP is calculated to include research and development spending as fixed investment confirms the economic importance of intangible assets
We believe that a company’s intangible assets can be vital in enabling it to sustain excess financial returns. Indeed, we have designed our investment process around this philosophy. So the 31 July adjustment to US national accounts to include research and development spending as fixed investment as opposed to a cost of production is particularly relevant to us. It serves as explicit recognition of the significant economic importance of intangible assets.
The changes were announced by the US Bureau of Economic Analysis in its comprehensive revision of the US national income and product accounts (NIPAs), a process which is completed every four years. The BEA is tasked with implementing “changes in definitions and classifications that update the accounts to more accurately portray the evolving US economy”.
The change in the US treatment of research and development spending from a cost of production to an investment which will be capitalised and subsequently depreciated may seem something of a technicality. However, the scale of the potential uplift to GDP measures is substantial (it will result in a $300bn+ boost to US GDP) and the shift in approach is a huge development which serves as further recognition that intangible assets can be vital in creating value for shareholders.
R&D is only one type of intangible asset, yet its inclusion in the US accounts will lift its GDP by about 3 per cent in a change which is being applied retrospectively all the way back to 1929. And it is not just the US that is changing its data measurement to reflect the changing dynamics of today’s economies. The US changes have been in the offing since the BEA began running an R&D satellite account in 2006 and are designed to move the US closer to international guidelines agreed in the System of National Accounts 2008 which, importantly, other developed economies are due to fall in line with by 2014. The UK Office for National Statistics has made similar moves to create an R&D satellite account.
Clearly, the capitalisation of R&D spending is one of the easier steps to take in the accounting recognition of intangibles in that it is easily measurable and the link to potential future earnings is fairly intuitive when one considers the accumulation of patents which could result – pharma industry research being perhaps the best example.
The growing significance of intangibles at the aggregate economic level which this accounting change signifies is mirrored by their importance at the corporate level.
Our investment process is designed around investing in companies that we believe have economic advantage assets which create barriers to competition and allow companies to consistently earn excess financial returns.
It is intangible assets which we believe competitors find hardest to replicate, thereby enabling these barriers to be created, and specifically we look for possession of intellectual property, strong distribution channels and/or a high level of recurring business.
To illustrate the power of these intangibles, it is worth considering a relatively rare instance of a business that has fulfilled all three of our criteria – Rightmove.
Over the 12 years since launch, Rightmove has established a dominant position in the online property advertising market and has built a distribution capability that, in our opinion, acts as a strong barrier to competition. The website Rightmove.co.uk was originally launched in 2000 by Countrywide before the company was brought to the UK stockmarket in an initial public offering in 2006. Rightmove also has substantial intellectual property associated with its web and mobile platforms and through its estate agents listing subscriptions and it exceeds the 70 per cent recurring revenue criteria necessary to be considered in possession of an economic advantage intangible asset.
Rightmove.co.uk is the UK’s largest property portal and – according to Experian’s Hitwise study – in January 2013 it became the UK’s sixth most popular website (by page views) behind only the global brands of Facebook, Google, YouTube, eBay and Amazon and ahead of BBC News.
The company’s business model allows it to operate with high margins and generate strong cashflow.
This is despite the fact it has minimal fixed assets and derives almost all of its earnings power from virtual – or intangible – assets.
In contrast to many consumer-facing businesses, Rightmove’s distribution network is not physical. As at the end of April, the company had 18,526 advertisers generating an average revenue of about £600 per month and during April the company’s website received 1.25 billion page views.
So even though the website, brand and agent network are intangible, they have very real ability to generate high financial returns and as such should be viewed and valued in the same manner in which a physical asset would be.
We have designed our investment process with these types of intangible assets in mind – those which are hardest for other companies to replicate and therefore most likely to provide barriers to competition and
generate economic advantage and higher shareholder returns.
Julian Fosh is co-manager of the Liontrust Special Situations fund