Chalk it up to the Law of Unintended Consequences. In 1974, the Financial Accounting Standards Board (FASB) ruled that companies must expense, rather than capitalize, all of their spending on R&D, employee training and brand building.
Yet we know intuitively that these kinds of investments in staff training, product research and more robust marketing efforts bring a clear payoff. Such investments, in theory, should build a more valuable company.
NYU Professor Baruch Lev set out to prove it. In a landmark series of studies published in the 1990’s, Lev showed that firms that invest in knowledge-building—whether it is spent on staff, markets or products—delivered outsized market returns. This anomaly was dubbed the “Knowledge Effect.”
He was quick to distinguish between truly innovative companies and those that produced merely copycat research. He noted that “Knowledge Leaders are pushing innovation forward, while Knowledge Followers are just trying to keep up with the innovational spill-over effects created by Knowledge Leaders.” He found that Knowledge Leaders had higher “future market share, future sales growth and future return on assets”
Two decades later, the Knowledge Leaders Developed World ETF (KLDW) was launched to capitalize on Lev’s research, and it now has a three-year track record to attest to the merits of this approach.
The Investment Penalty
In response to the FASB accounting changes from the 1970’s, some firms may have been tempted to skimp on items like R&D and staff development because such spending depresses near-term earnings, notes Bryce Coward, portfolio manager and deputy chief investment officer at Knowledge Leaders Capital in Denver.
Equally important, investors have lacked a way to assess how spending on innovation can add value. As Coward and his team wrote in a 2015 research paper, “this information deficiency has led investors to make a systematic error in the way they assess the prospects of companies that invest significantly in knowledge.”
Addressing that short coming is a key tenet of the Knowledge Leaders Developed World Index, which deploys a screening process that aims to add back the perceived value of R&D and other similar intangible investments.
The index starts with a universe of roughly 2,000 mid- and large-cap companies in 22 developed markets. From there, the herd is culled to reflect firms with the following attributes: they spend at least 5 percent of sales on knowledge investments or have 5 percent of their intangible-adjusted assets represented by intellectual property assets; generate over 20 percent gross margins; have asset-to-equity ratios below 3.0; have less than 50 percent net debt as a percent of capital; have a positive trailing seven-year average return on invested capital; have at least a 10 percent operating cash-flow margin on average over the last seven years; and have a positive trailing seven-year average free-cash-flow margin.