Non-Physical Economy

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DIVE DEEPER: TRIUMPH OF INTANGIBLE ASSETS

Recently, our colleague and friend Clay Finck, host of Millennial Investing, showed us a chart highlighting the changing composition of S&P 500 companies over time, from primarily tangible assets to now almost entirely intangible assets.

We are, of course, all likely familiar with the transition towards a digital economy over the past few decades, but the change in balance sheet compositions is truly striking for the largest companies.

See for yourself below:

In the 1970s, tangible assets made up around 83% of total assets for companies in the S&P 500 at the time, and the trend towards intangibles became particularly accelerated in the 1990s, with intangible assets rising to 68%.

In 2020, the number is approximated at 90% for intangibles, and it has probably trended higher in the past two years.

So what should we make of this?

Explained

Tangible assets are much more intuitive to understand. These include things like real estate, equipment and machinery, buildings, inventories, etc. whereas intangible assets are by definition more abstract.

These could be intellectual property like patents, trademarks, and copyrights, or it could even be the value of your brand in terms of consumer recognition or network effects.

The other defining part of intangible assets is known as goodwill. This only originates on companys’ balance sheets from mergers and acquisitions, and it happens when a purchasing company pays a price above the identifiable net asset value of the target company.

In other words, if company A buys company B for $1 billion, even though the book value of company B is $900 million, then that $100 million differential reflects the so-called ‘goodwill’.

Company A may pay a premium, because company B has an excellent corporate culture, great leadership, strong relationships with suppliers, sophisticated internal software, valuable customer data, or years of effective research and development, among many other non-tangible factors.

What to know

Today’s economy and stock market are profoundly different than in past eras. For investors, accounting for the value of tangible assets in valuing companies was a much more straightforward process than it is today, as one could clearly estimate the value of a company’s buildings or factories.

Famous investors like Warren Buffett don’t deny this either. Stock picking in past decades was just easier due to less convoluted business models, simpler technologies, and less efficient financial markets.

Example

Part of the reason stocks like Tesla are so controversial, is that it’s incredibly difficult for engineers, nonetheless Main Street and Wall Street investors, to determine just how valuable its intangible assets are.

While one person might tell you that Tesla’s designs for a self-driving system is the future of automobiles, others say it’s deeply flawed, or that its battery technology is inferior to competitors.

And the reality is that these values remain deeply uncertain even to those with a deep understanding of the technology, given the range of possible future outcomes for emerging innovations.

Takeaway

It’s okay to admit that you don’t know. For Buffett, who by the way is 91 years old, not investing in things he doesn’t understand has become a golden rule.

On the other hand, famed value investors like Bill Miller, have built on the Buffett legacy and used his values to effectively pick tech stocks like Amazon in their early years.

There was a time when tangible-asset heavy railroad companies were at the forefront of ‘tech’ and innovation, yet these have come to epitomize 20th-century “old economy” stocks to many now.

And many of today’s high-flying tech companies like Amazon and Alphabet (Google) may become stodgy old firms in just a few decades, epitomized in more recent years by stocks like IBM, Microsoft, and Cisco.

Even for seemingly non-tech companies though such as Coca-Cola, intangible assets are a huge source of value on their balance sheet in 2022. The influences of the non-physical economy are unrelentingly pervasive.

For investors today, even those not explicitly making bets on companies known for their technology, understanding the accounting behind intangible assets is a minimum for valuing most stocks.

Tell us – How do you account for intangible assets when calculating a stock’s value? (Just hit reply to this email!)

WHAT IS THE KELLY CRITERION?

Have you ever been perplexed about how much you should invest in a stock? Or wondered the best way to allocate the capital you have?

Wonder no more, because today, we’ll learn how to calculate this yourself using The Kelly Criterion.

What is it?

The Kelly Criterion is a mathematical formula used to determine what percentage of an investor’s capital should be allocated for each investment to maximize long-term growth. It’s also known as “Fortune’s Formula,” defining the maximum threshold of how much you should invest in a given stock.

The Kelly Criteria was created by John Kelly while working at AT&T’s Bell Labs. Gamblers first adopted it to determine how much to bet on horse races.

It was later adapted by some well-known investors, including Warren Buffett, Charlie Munger, Mohnish Pabrai, and Edward Thorpe. And famously, Thorpe applied the criterion to win at blackjack, which worked so well for him, that he was permanently banned from casinos in Las Vegas. Here’s his book on it.

We like to clone what smart investors do with their portfolio, and learning the Kelly Criteria is a great tool to optimize your long-term capital growth.

So What?

Let’s look at how we could use the Kelly Formula through a simple game of heads and tails where you have $1 to bet.

Here’s the scenario: If the coin comes up heads, you win $1.50. If it comes up tails, you lose $1.

In this bet, do you put all of your money on the coin flip?

Of course not, because you have a 50/50 chance of losing your entire stake in just one flip. However, the win would be bigger than the loss while the odds are 50/50.

How do we work out how much to bet then?

The Kelly Formula tells us what to do.

How much to bet?

The Kelly Percentage = W – [(1-W)/R], where W is the win probability, and R is the ratio between profit and loss in the scenario.

So, in our coin toss example, we’ve got the following formula:

K% = .5 – (1 – 0.5) /1.5 = 0.167 or about 17% of your available balance

So, in this case, it would be wise for your first wager to be .17 cents.

If you lose, you still have the bankroll to try several more times again.

One thing to keep in mind, the Kelly Criterion only works if you have a profitable opportunity. It doesn’t work in a game like roulette, where the casino has greater odds of winning over time.

Takeaway

We can also apply the formula to the world of investing.

As value investors, we may only have 10-20 great opportunities in a ten-year period.

So, how would it work for us? Unlike a coin flip, it’s much harder to predict the probability of winning with a stock, but we have to give it our best guess. We are trying to be mostly right and not terribly wrong in our estimates.

Take your best educated guess, using past returns you’ve experienced for your probabilities and expected returns, and plug in the values.

Try not to be put off by all the numbers. There are calculators and spreadsheets to help you. We like this nifty calculator here to play with to determine what the Kelly Criterion would suggest is your ideal allocation.