The Impact of Intangibles on Base Rates

New note from Michael Mauboussin highlight the impact of intangible assets, intangible intensive firms grow faster than their tangible counterparts but also face a greater risk of being overtaken by their competitors. Implying a higher standard deviation in the distribution of growth rates for intangible-based versus tangible-based industries.

Implication for base rates is the past distributions are not prologue given the impact of intangibles.

"...suggests two hypotheses that we can test. The first is that intangible-based businesses can grow faster than what the base rate data show...the right tail of the distribution of growth rates is extending outward from the average. Amazon’s results provide anecdotal evidence for this. The second is that we should observe greater variance in the distribution of growth rates for intangible-based businesses. That means that the left tail of the distribution of growth rates is also spreading further from the average. BlackBerry’s 26.7 percent average annual revenue decline in the past decade through February 2021 is a case in point....Companies grow by generating a return on investment. The nature of investment has changed markedly in recent decades, from one dominated by tangible assets to one mostly in the form of intangible assets. Intangible assets have some characteristics that distinguish them from tangible assets, including greater potential economies of scale and higher risk of obsolescence. The good news is that intangible-intensive companies can grow faster than their tangible counterparts. The bad news is they can also become irrelevant and shrink fast. As a consequence, we should see two effects in the data: higher growth and more dispersion in the outcomes. Our analysis of the results from companies in the Russell 3000 from 1984-2020 reveals both of these. The base rate of sales growth is getting stretched from the average in both the positive and negative direction. There are two main lessons for investors. First, it is important to be mindful of the potential shift in the base rate as the result of the rise of intangibles. Second, skillful investors may be able to identify the companies that will grow faster than expected, hence providing the potential for attractive returns...."

Evidence: “.. We calculated the median sales growth rate for companies in each of those categories using the constituents of the Russell 3000 from 1984-2020. We also examined the standard deviation, a measure of the dispersion, of the distributions. Exhibit 1 showsthe results for the full sample.

Michael Mauboussin and Dan Callahan, "The Impact of Intangibles on Base Rates," Morgan Stanley, June 23, 2021,
https://www.morganstanley.com/im/publication/insights/articles/article_theimpactofintangiblesonbaserates.pdf

The sales growth rates, measured either as the median or average, consistently go from highest for companies that are most intangible-asset intentive to lowest for those that are least intensive. While the short-term numbers are noisy, the relationship holds true over 1-, 3-, 5-, and 10-year periods. Consider the median compound annual sales growth rates over five-year periods. Growth was 10.4 percent for healthcare, 7.9 percent for technology, 6.0 percent for consumer, and 5.0 percent for manufacturing. The median across all companies was 6.5 percent. This supports the first hypothesis. The standard deviation of the growth rates follows the same pattern. Where intangible asset intensity is high, the standard deviation is also high. Assuming these distributions are normally distributed, an imperfect but illustrative assumption, about two-thirds of healthcare companies had 5-year sales growth rates between -18.0 and 43.2 percent. The comparable figures for manufacturing companies were -7.0 and 19.2 percent. This is consistent with the second thesis....One silver lining was the ability of digital companies, built largely on intangible assets, to thrive in the chaos. We examined the sales growth rates of the companies in the Russell 1000, the largest one thousand companies in the U.S., to see which companies fared well. Healthcare and technology, the industries with the highest intangible asset intensity, represented over 60 percent of the top 20, 50, and 100 growers despite being only 29 percent of the universe (see exhibit 2)...."