Over the past few years, it has become commonplace among the world’s largest corporations to stretch the rules of accounting as far as possible to squeeze every last dollar and cent of earnings out of business. For investors and analysts who are trying to calculate an accurate intrinsic value of a business, this Wall Street trend of financial alchemy and smoke and mirrors has made life tough. Aggressive opaque accounting for the 21st century is not just limited to the income statement.
The rise of the intangible corporation
Intangible assets on the balance sheet have become a huge part of corporate America during the past two decades. Last year merchant bank Ocean Tomo published a study on the makeup of public company balance sheets in the S&P 500 between 1975 and 2015. The figures showed that at the end of 2015, 84% of assets held by S&P 500 companies were intangible by nature, up from only 17% in 1975. This explosion in intangibles is making life harder for value investors. It’s almost impossible to come up with an independent valuation of these assets.
Last year Bloomberg (with the help of Colin Mayer, a professor at the University of Oxford) likened the new “intangible corporation” to an idea from Shakespeare’s “As You Like It”:
“The mindful corporation — sans machines, sans man, sans money, sans everything.”
Facebook’s $22 billion offer for WhatsApp is the perfect example of a “mindful corporation” and its value.
But as noted above, “mindful” and “intangible” corporations are difficult to value and evaluate. The sheer volume of companies, which now have a higher value of intangible assets on their balance sheet than tangible assets raises the question about just what is in the “book” value figure many analysts tout when computing a firm’s valuation.
For many US companies, particularly in the S&P 500, intangible assets are now worth significantly more than shareholder equity, which means the calculation of these intangibles has to be spot on. Otherwise there is no shareholder equity. This is extremely concerning. If companies are willing to stretch accounting rules to their limits to arrive at the most favourable income figures, can they be trusted to produce conservative valuations for intangible assets?
Head to emerging markets for tangible assets?
Last week analysts over at CLSA suggest that the rise of intangibles may explain some of the recent rise in demand for emerging market equities. Indeed, according to the research outfit’s analysis, Asia-Pacific’s “book” is significantly more tangible than S&P 500. Specifically, the cash-to-market percentage of the MSCI Emerging Markets Index is approximately 20%, almost double that of global peers. Moreover, this peak of 20% is a level not seen since the financial crisis.
Given the tangibility of cash, the book value of emerging market equities is more trustworthy than that of developed market peers. Maybe it is better to stick to those markets when you can actually tell what company owns and how much that asset is worth without having to rely on optimistic assumptions from accountants.