Has growth in the importance of intangible (knowledge) assets versus real assets undermined usefulness of the conventional equity value premium (based only on the latter)? In her September 2020 paper entitled “Intangibles: The Missing Ingredient in Book Value”, Feifei Li explores whether including intangible assets when calculating book value better measures firm fundamental value. She divides intangible assets into research and development (R&D) and selling, general and administrative (SG&A) components. She assumes that both depreciate at 15% annually, but only 30% of the latter translates to capital investment. She constructs intangible value factors based on the conventional value factor calculation methodology but adding either R&D assets or both R&D and SG&A assets to calculate book value. She looks at effects of these additions on both the long (value stocks) and short (growth stocks) sides of the value premium portfolio. She focuses on U.S. stocks but checks robustness of findings across UK, continental Europe, Japan and Asia ex Japan regions. Using data for U.S. stocks commencing July 1951, and for other regions commencing July 1995, all through November 2019, she finds that:
- For the average U.S. firm since 1975, R&D assets constitute 26% of adjusted book value.
- For the U.S. sample:
- The value premium adjusted for R&D assets has average gross monthly return 0.36%, compared to 0.28% for the conventional premium, with 47% higher Sharpe ratio.
- More than half of R&D-adjusted value premium improvement (0.05%) comes from the long side of the value premium portfolio.
- The value premium adjusted for both R&D and SG&A assets has average gross monthly return 0.39%.
- Findings are robust across subsamples and geographic regions.
- Results are not sensitive to assumed depreciation rate.
In summary, evidence indicates that including intangible assets in book value improves value investing outcome.
Cautions regarding findings include:
- Results are gross, not net. Including annual portfolio rebalancing frictions and continuous shorting costs/constraints would reduce reported returns.
- The methodology used is beyond the reach of most investors, who would bear fees for delegating to a fund manager.
