The Impact of Intangibles on Base Rates
In our first two pieces this week, we highlight the latest publications of the two of the very best writers of the past 20 years (albeit in completely different fields). First, we discuss Michael Mauboussin’s latest piece on a subject which is close to our hearts in Marcellus: the impact of investment in intangibles on a company’s growth rate and its valuation. The piece focuses on how conventional analysts doing conventional forecasting are making mistakes year after year in forecasting how fast gigantic tech firms (which gigantic investments in intangibles) can grow.
Mauboussin begins by highlighting the key differences between tangible and intangible assets (and hence why the latter can fire up growth in a way that tangible assets cannot): “One important distinction between corporate tangible and intangible assets is access. Only one company can use a tangible asset at a time, whereas many can use an intangible asset at the same time. distinction is less stark as assets fall on a continuum. But the main point is that the marginal cost of sharing an intangible asset can be very low.
Intangible assets have two characteristics that are important for considering corporate growth rates. The first is that they can enjoy strong economies of scale because they are commonly cheap to reproduce and share. Economies of scale are a measure of cost per unit as a function of output. Think of software as an example. The original code may be very expensive to produce but the cost per unit sold drops rapidly because it is inexpensive to share. That is the good news.
The second is obsolescence and the related concept of sunkenness. The value of intangible assets can drop precipitously when a new and better version comes along and makes the old version obsolete. And because the old version has very limited value, the investment cost is sunk. Let’s continue with our example of software.
Once a company introduces a new operating system for a computer or mobile phone, the old one is of little relevance or value. That is the bad news.
These characteristics highlight the contrast between tangible and intangible assets that are relevant for growth rates. Intangible assets are more scalable than tangible assets. That means successful companies that rely on intangible assets can grow faster than companies built on tangible assets. As the overall mix of investments shifts from tangible to intangible, we should expect to see faster growth rates for the winners than we have seen in the base rate data.”
Mauboussin then notes that in the West over the past couple of decades capex on intangibles is more than capex on tangibles. Then he moves towards his punchline: “This provides investors with good and bad news. The good news is there will be some businesses that grow in excess of what history would suggest, creating opportunity. The bad news is some businesses will lose their positions of prominence and decline more rapidly than their predecessors did”
So what can investors do? How can they invest successfully in this brave new world? Mauboussin says that we have to stop referencing base rates from yesteryears i.e. we should try to avoid thinking that “since no other company has grown revenues at 20% for 30 years, Amazon cannot either”. In Mauboussin’s words:
“Accurate forecasts combine causal and statistical thinking in proper measure. Statistical thinking relies on identifying an appropriate reference class of past outcomes. An overreliance on base rates can lead to faulty forecasts if the statistical properties of a reference class change over time. That said, we believe that forecasters don’t use base rates as frequently as they should.
Companies grow by generating a return on investment. The nature of investment has changed markedly in recent decades, from one dominated by tangible assets to one mostly in the form of intangible assets. Intangible assets have some characteristics that distinguish them from tangible assets, including greater potential economies of scale and higher risk of obsolescence. The good news is that intangible-intensive companies can grow faster than their tangible counterparts. The bad news is they can also become irrelevant and shrink fast.
As a consequence, we should see two effects in the data: higher growth and more dispersion in the outcomes. Our analysis of the results from companies in the Russell 3000 from 1984-2020 reveals both of these. The base rate of sales growth is getting stretched from the average in both the positive and negative direction.
There are two main lessons for investors. First, it is important to be mindful of the potential shift in the base rate as the result of the rise of intangibles. Second, skillful investors may be able to identify the companies that will grow faster than expected, hence providing the potential for attractive returns.”