“If R&D capitalization is instead taken into consideration in an assessment of value, the denominator in multiples gets bigger -- and a broader range of companies can show that they have value,” a Wellington team led by Gregg Thomas wrote in a report.
Knowledge Economy
To complicate matters, when a firm buys another, the intangibles of the target company end up listed on the acquirer’s balance sheet in modern accounting. When the latter develops such assets on its own, however, the book value stays the same. To fix this, analysts typically turn a firm’s R&D as well as a fraction of selling, general and administrative expenses into an asset on the balance sheet that is then amortized, as if it is buying a building.
The thinking goes that just like regular capital investments, such intangible spending brings future benefits and shouldn’t be treated as expenses for that period.
With that tweak, Microsoft Inc.’s 2020 after-tax profits, for instance, would be 17% higher and its investments 70% greater, according to an analysis adapted from academic research by Morgan Stanley Investment Management’s Michael Mauboussin.
While discretionary stock pickers are free to adjust their math, these changes can be momentous for quants who invest based on factors like how cheap a share is relative to fundamentals. An academic paper found that in a 929-stock value portfolio, more than a quarter dropped off the list after incorporating intangibles into book value.
“This factor is extraordinarily important to our assessment,” said Lauren Goodwin, a strategist at New York Life Investments. “The inadequacy of our traditional financial statements to give us that information as investors has meant that some of these style calls -- value versus growth is just a great example -- are less straightforward.”
No Tangible Benefits
Dimensional Fund Advisors, a $527 billion quant, is resisting the newfangled approach. In a recent study, it showed value portfolios that capitalized intangibles would still have lost money over the past decade and any edge disappears once the firm’s profitability is taken into account.
“You would not have been saved from the underperformance of value stocks,” head of research Savina Rizova said. “There is a lot of noise in the estimation of intangibles.”
Yet for a large swath of the asset-management world watching tech stocks tear higher every year, it’s at least worth a shot.
“Is looking at R&D just a way to justify how expensive stocks are? I don’t think that’s an issue,” said Rumpf at MFS. “It’s important to be aware of places like this where the accounting system doesn’t do a great job of capturing firm value.”
--With assistance from Sarah Ponczek.
This article was provided by Bloomberg News.