Investment in intangible assets such as data and design now outstrips that in physical things in many countries. But what does the rise of ‘capitalism without capital’ mean for companies, markets and economies?
Picture a gym. You’ll probably imagine a room cluttered with dumbbells, running machines and yoga mats: physical equipment designed to build physiques. But one of the most influential players in the gym industry owns hardly any physical things at all.
In the mid-1990s, Auckland-based Les Mills International created an exercise programme called Bodypump, consisting of intensive workout routines synched to music. The advent of cheap video technology enabled the company to expand rapidly, as the routines were filmed and distributed to instructors beyond New Zealand, who must complete an online course to obtain a license. Bodypump now has four million participants a week across 55 countries.
The value of this lucrative business lies in a mixture of intangible things: marketing savvy, intellectual-property rights, music-royalty agreements and a flair for high-tempo choreography. As a result, it has been able to grow in size and scale far more quickly than a traditional gym, which would need to stockpile more weights and cross-trainers to accommodate additional customers.
Bodypump is emblematic of a wider trend. Across different sectors and countries, companies are investing heavily in intangibles such as design, intellectual property and human capital. As digital platforms replace physical infrastructure, asset-light insurgents such as Uber and Airbnb are outmanoeuvring their rivals. Amazon, Facebook and other technology giants are harnessing the ephemeral forces of data and AI to grow at an unprecedented pace and scale.
This is not simply a story of digital disruption: the rise of the intangible economy has deeper implications. At a macroeconomic level, it might explain such puzzles as slowing productivity and secular stagnation. The growth of intangible investment is also subverting the workings of markets by calling into question traditional measures of corporate value, creating new challenges and opportunities for investors.
All that is solid melts into air
According to some estimates, corporate investment in intangibles such as software, design, branding and research and development now outstrips investment in traditional assets in many advanced economies, including the US, the UK and much of Western Europe (see figure 1).
In itself this is unremarkable. Changes in the nature of corporate investment have occurred repeatedly throughout history; think of railways supplanting canals or desktop computers replacing typewriters. What makes this latest transition significant, however, is that intangible assets are different from tangible ones in several fundamental ways. The most obvious is that they are difficult to reduce to figures on a spreadsheet: it is difficult to count something you can’t see.
Diane Coyle, a professor of public policy at the University of Cambridge, was one of the first experts to notice the trend towards intangible investment in the late 1990s, during the run-up to the Dotcom bubble. Her book The Weightless World, published in 1997, explored the difficulties in trying to quantify the economic contribution of companies focused on web-based services and design. Two decades on, this has become even more difficult in an era of machine learning, artificial intelligence and global data streams.
“We don’t have any good statistics on data – we know the volume of data being carried over networks is going up, but not what companies are doing with it or what they’re using it for. Emails might contain blueprints or just chit-chat. There’s a lot we don’t know in terms of the measurement of intangible assets,” says Coyle.
This problem is compounded by the fact many intangible assets are what economists would call ‘public goods’, in the sense they are more or less inexhaustible. Because millions of people can access and use intangible assets at the same time, the question of ownership – especially intellectual-property rights – becomes difficult to settle.
Capitalism without capital
In their recent book Capitalism without Capital, Jonathan Haskel and Stian Westlake argue intangible assets have several other distinctive characteristics. They suggest these traits are prompting shifts in corporate behaviour and reshaping the deeper workings of economies.
“The shift to intangible investment matters because intangible assets have very different economic properties to tangible assets,” explains Haskel, a professor of economics at Imperial College London. “We call the economic properties ‘the four Ss’. The first is that intangible spending is often scalable. That is to say, if a taxi company wants to carry more passengers, it has to order more taxi-cabs; whereas if Uber wants to carry more passengers, it can simply scale up its software.”
Haskel says intangible assets are also ‘sunk’, which means they have little residual market value, making it difficult to recoup the investment. Consider Monarch Airlines, the British carrier that went bankrupt on October 7, 2017. Within a week, 10 of its 35 planes – its main physical assets – had been returned to lessors. By contrast, it took several months to resolve whether Monarch’s creditors would receive any money for its intangible assets, such as its rights to landing slots at UK airports.
Intangibles have two other key characteristics. They create spillovers that can be readily shared or copied by rival firms. But they also create synergies which in some cases encourage inter-firm cooperation or mergers.
“The MP3 protocol, combined with the miniaturized hard disk and Apple’s licensing agreements with record labels – along with its design skills – created the iPod,” Haskel says. “Tangible assets have synergies too – between the truck and the loading bay, say, or between a server and a router – but not on the same radical and unpredictable scale.”
Intangible assets help explain the defining trends of the past two decades
The distinctive traits of intangible assets can help to explain many of the defining trends of the past two decades. Disruptors have risen to prominence by focusing their investments on enormously-scalable intangibles such as digital platforms, user networks and data flows. Spillovers mean design innovations quickly become widespread, which is why every smartphone now looks and feels more or less like a descendant of Apple’s pioneering iPhone.
Companies’ growing investment in intangible assets has made everyday life better in many ways: improving communication networks and furnishing consumers with free services. But the vast economic benefits that some had anticipated have not yet come to pass. Erik Brynjolfsson, a professor at the Massachusetts Institute of Technology and director of the Initiative on the Digital Economy at MIT, argues it is only a matter of time.
“There’s a lot of pent-up innovation in areas like machine learning,” says Brynjolfsson. “What you see in laboratories is remarkable, but most of it hasn’t really made its way out into the marketplace yet. That doesn’t mean those benefits are not coming; I think they’re in the pipeline. This is very common with fundamental technologies, going back to electricity or the steam engine. It can take literally years or decades before the full impact of investment in these core technologies happens in an economy.”
By contrast, Haskel and Westlake argue the peculiar characteristics of intangible assets may actually be causing economic harm. One issue is the dynamic between spillovers and synergies, which do not always cancel each other out. The bigger companies get, the more effectively they can take advantage of synergies and prevent the associated spillovers (such as by taking out costly protection on their intellectual property). This tends to enshrine the power of the leading firms and might explain the growing dominance of tech giants such as Apple and Google.
More troublingly, this trend may be contributing to stagnant productivity across advanced economies. If smaller companies are unable to bridge the gap to their larger competitors, they are likely to cut spending on new ideas and processes, and so overall corporate investment declines despite breakneck innovation among the leading or ‘frontier’ firms.1 Haskel and Westlake point out this may necessitate increased government investment to take up the slack, especially when it comes to intangible assets that generate lots of spillovers, as firms may be wary of investing if they cannot be certain of reaping the benefits themselves.
GDP reform: a long time coming
Part of the problem facing policymakers in the era of intangible assets is that they are not easily captured in traditional economic metrics such as gross domestic product (GDP). While some intangible investments are recorded in national accounts, such as software and databases and scientific R&D, many are not. This has led some to question whether GDP needs to be tweaked or even replaced as the primary index of economic health.
“If you are trying to value spending and income, GDP remains the most relevant statistic. But it is not perfect,” says Stewart Robertson, senior economist for the UK and Europe at Aviva Investors. “It is quite easy to measure the number of widgets coming out of a factory, but quantifying the economic value being produced by digital and creative industries is much more difficult. In an economy that is evolving in these directions, it is legitimate to ask whether GDP is still fit for purpose.”
The difficulty in measuring intangible assets can lead to a skewed sense of how an economy is performing, as some regions are more likely to benefit from digital and service industries than others. Cities with sectoral clusters will do well in an intangible economy, because they facilitate synergies, while rural areas will be left behind.
Both Coyle and Haskel argue GDP should be reformed to give a more holistic picture of how economies are faring amid the rise of intangibles. Haskel believes corporate investment in the design of new goods, services and processes, as well as the curation of big data and labour training, should be incorporated into national accounts.2 Coyle, meanwhile, says GDP could eventually be replaced with a ‘dashboard’ of different metrics that show how easily individuals and companies can gain access to assets, including intangibles such as intellectual property and data (see boxed text).
Financing the intangible economy
Investors face similar challenges to economists and policymakers in finding their bearings in the new intangible world. If intangible assets are largely invisible in GDP figures, they are also rarely recorded in traditional corporate accounts, which skews measurements of corporate value.
It can be risky for banks or bond investors to lend to a company that relies on ‘sunk’ intangible assets that cannot be sold on in the event of a default. This lack of collateral is likely to mean traditional lending will make up less of the financing mix for intangible firms, or that lending will need to take innovative new forms. Governments in Singapore and Malaysia have begun working with the UK Intellectual Property Office and other organisations to subsidise bank loans against intellectual property, which may be one way to increase the availability of intangible-backed loans.3
For equity investors, the chief question becomes whether the elevated share prices of intangible-intensive companies such as the tech giants are justified, as they incorporate assets whose value it is difficult to measure precisely.
Take Netflix, a classic example of a company with a scalable platform. As of December 31, 2017, the firm owned property, plants and equipment worth $319 million, according to its report and accounts – considerably less than its market capitalisation of almost $150 billion. The bulk of the difference lies mostly in the company’s intangible assets – brand value, a content library, recurring subscriptions and vast stores of data on its billions of users.
Research recently published in the Harvard Business Review confirms S&P 500 companies with fewer physical assets are consistently showing much higher revenue multiples compared with those with lots of physical assets. Health technology had an average multiple of 5.1, while an asset-heavy industry such as consumer durables had a multiple of 1.3.4 These figures are even higher among the biggest technology companies: Amazon has traded on an average price/earnings ratio of 490.2 over the last five years, according to Morningstar figures.
Some have warned the soaring share prices of big tech firms – which, at time of writing, seemed to have resumed their upwards trajectory after Facebook’s data privacy scandal caused a wobble across the sector in early 2018 – are evidence of a new bubble. But given the continued secular shift towards intangible assets, these firms may have plenty more room to grow.
There may be a useful comparison to draw with the fate of the Nifty 50, the high-priced US growth stocks of the late 1960s and early 1970s. Despite high valuations at the time, Nifty 50 firms in healthcare and consumer staples – which spent heavily on R&D and were often light on tangible assets, like today’s big tech firms – tended to outperform the S&P 500 over the next 30 years (although many of them also de-rated viciously during the 1973-‘74 bear market).
Research from Baruch Lev and Feng Gu shows technology companies’ investments in software and design are usually expensed when calculating earnings, while investments in physical assets are capitalised. While these investments might not be captured in a company’s report and accounts, they can pay off handsomely over the longer term, which may justify those elevated share prices.5
If a company’s financial accounts are no longer a useful guide to future earnings, how should investors respond? One possible solution would be to diversify among different companies in an intangible-intensive sector. This has the benefit of insulating a portfolio against the spillovers that can spread between tech-focused firms.
Another is to adopt a more focused approach, undertaking comprehensive research and analysis to go beyond the information available in an annual report and determine how a firm’s investments in intangibles are likely to bear on its prospects.
Jason Bohnet, head of technology, media and telecoms research at Aviva Investors in Chicago, cites Adobe Systems as a good example of a company whose investment in intangibles transformed its outlook. In 2010, Adobe stopped offering physical products to customers with a permanent license, and shifted to a more asset-light, cloud-based model driven by recurring subscriptions.
As well as conducting in-depth research into a company’s intangible investments and business plans, Haskel and Westlake recommend focusing on its organisational structure and the quality of its leadership. For instance, they point out Amazon’s tightly-coordinated organisational structure is proving particularly effective, allowing it to coordinate intangible investments and exploit synergies across business lines.
Ultimately, there are few hard and fast rules for navigating the intangible economy. The landscape is changing fast, and the old waypoints may no longer be a useful guide as apps, data-driven platforms and automated algorithms come to play an ever greater role in our lives. One thing is certain: there is no going back. For better or worse, we are living in an immaterial world.
1 See Haskel and Westlake, Capitalism Without Capital (2017). See also ‘Are monopolies a danger to the United States?’, Banque de France research note, February 2018
2 See ‘Improving GDP: demolishing, repointing or extending?’ written by a team led by Haskel. The paper shared the 2017 Indigo Prize in economics with ‘Making the future count’, by Coyle and Benjamin Mitra-Kahn.
3 Capitalism Without Capital
4 ‘Investors today prefer companies with fewer physical assets,’ Harvard Business Review, September 2016
5 ‘Time to change your investment model,’ Financial Analysts Journal, November 2017