Knowledge Leader Spotlight: 3M Co (MMM) by Eric Bush, CFA – Gavekal Capital Blog
There is a common misconception that older companies can’t or won’t innovate and that innovation only occurs in an industry when a new company enters to disrupt the status quo. However, in our research into the Knowledge Effect, we have found that it takes a strong organizational commitment to innovation in order to remain on the cutting edge of one’s industry and has little to do with the age of a company. Innovation doesn’t happen by taking a “seat of your pants” attitude towards knowledge investments in research and development (R&D) and firm specific resources. Rather, it takes a persistent and a consistent commitment to intangible investment to become a Knowledge Leader. A company like 3M (ticker: MMM), which has been around since 1902, exemplifies this long-term strategic commitment to innovation.
Data note: All data is intangible-adjusted
Out of 88 industrial companies in North America, 3M is the fifth largest investor in R&D as a percentage of sales at 5.8% of sales. This ratio of R&D to sales has been fairly consistent over the past 35 years. 3M has invested 6.1% of its sales on R&D on average annually going back to 1980. As regular readers are aware, however, R&D is just one component of the total intangible investments that a company makes. Firm specific resources, which includes codified information, employee education, and brand equity, are also important in creating sustainable competitive advantages for a company. 3M invests another 6% of sales annually on average on firm specific resources for a total intangible investment rate of 12% of sales each year. Given that 3M had over $30.3 billion in sales in 2015, that that is a lot of money going into intangible investments every year! 3M invests nearly 1.7x as much on intangible investments each year as they do on traditional tangible investments.
Thanks to these innovative investments 3M has some of the highest gross margins in the industrial sector. 3M has the 12th highest gross margin, at 48.7%, out of all North American industrial companies. 3M’s strategic focus on innovation has led to a decrease in the amount of PPE it carries on its balance sheet. In 1980, 33.3% of its asset base was PPE. This ratio has fallen all to the way to 20.4%. And as 3M moved to a more tangible-light asset mix, its gross margins have increased from 44% to nearly 49%.
In addition to fatter margins we can see that intangible investments have also helped to increase 3M’s profitability and cash flow generation. Return on invested capital has increased from 19.8% in 1980 to 26.2% currently. 3M’s free cash flow margin has increased from a paltry 1.93% to a healthy 28.2%. And its operating cash flow margin has increased from 10.6% to 33%.
The academic research is clear that companies that invest more than their industry peers in intangible investments tend to experience excess stock market returns as intangible investments are overlooked by the general financial community. It is not the fault of investors, however, that these investments are overlooked. The forced expensing of intangible investments due to current accounting rules creates an informational gap between companies and investors about what the true asset base a company is using in order to create future profits. This informational gap is what ultimately leads to persistence outperformance such as the fact that Knowledge Leaders have outperformed the market for 8 consecutive years.