Using IC to beat the Nifty hands down
IC practitioners the world over have produced tomes of literature in the past two decades to prove the value of Intellectual Capital in the modern Knowledge economy. There is not an iota of doubt about the importance of Intellectual Capital within the worldwide IC community. Countless modern Management Gurus - including Robert S Kaplan and David P Norton, inventors of the highly popular Balanced Scorecard and Strategy Map – and other thought leaders of our times have waxed eloquent about how it is the intangible assets in an enterprise that provide lasting value and competitive advantage to the business. They have even conceptualized and published many different frameworks for discovering, measuring and managing the IC of firms.
But what about the average man on the street? Does he understand the concept of IC as easily as he understands accounting concepts such as a Balance Sheets and Income statements? What about the average investor? Does he bother at all to investigate the quantum of intangible assets within the business before making his investment decision? The answer to my mind is an emphatic NO. For all the volumes of literature produced by the IC community over the last twenty five years, the common man remains blissfully ignorant about the role of IC as a critical value driver of the modern knowledge economy. However, whenever I have ventured personally to explain the relevance and importance of IC to the average man directly, I have found ready and immediate acceptance of the concept by him or by her each and every single time. This leads me to believe that the common man is perhaps not ignorant about IC, he is just constrained. He is compelled to ignore IC because he just does not have any source that dispenses IC information to him readily. This compulsion on his part results in a lack of demand for IC related information and consequently business leaders are only too happy to not provide the supply. We are therefore left in a cycle of deadlock where there is no demand for IC because there is no supply of IC related information and there is no supply of such information just because there isn’t any demand. This cycle needs to be broken before IC can become relevant and topical in the business context. But how?
In my own small way, I have attempted to do this by enabling investors to inspect the Intellectual Capital of the 50 top Indian businesses (Nifty stocks) every quarter. This is still a proof of concept application at the moment and I call it the icTracker. The icTracker enables the investor to ask three simple and fundamental questions of every firm in the Nifty list.
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Question 1: Is the business making money?
This is the most fundamental question that any investor wants to ask. Nobody wants to invest in a loss making proposition, however the fact remains that accounting profits as published by firms in their income statements do not correctly reflect whether the business is making money. What we really want to know as an investor is whether the business is making economic profits. In other words, are accounting profits enough to cover the cost of capital and then some? We use an IC concept known as the EVA (Economic Value Added) for this purpose. EVA was popularized by Stern Stewart & Co in the early nineties. Many businesses worldwide took to this concept like fish to water, believing that this was one of the fundamental measures of success for any business. To us, it is only the first step but a very important step. We want to pick businesses that consistently have a positive and hopefully increasing EVA. In case we find that EVA is negative during some time periods, we need to probe whether it is due to genuine reasons such as large capital expenditures incurred for driving future growth. But to keep it simple, always look for consistently positive EVA.
Question 2: Do knowledge assets dominate the business?
If the answer to Question 1 is YES we move on to Question 2, where we ask whether knowledge assets are the dominating assets in the business. In other words, we want to ensure that we stay from investing in businesses that are dominated by physical or financial assets. Why? Just because we want to invest in businesses that have a high degree of competitive advantage. It has been proved repeatedly that competitive advantage is derived from Knowledge assets rather than physical or financial assets. Investing gurus such as Warren Buffet have gone to the extent of coining their own word for such advantage – moat. Buffet likes to invest in businesses that have a high degree of economic moat. And we should too. In the IC world, measuring Knowledge Basis – the ratio of the Intellectual Capital to the Total Value of the firm – gives us an idea in percentage terms whether knowledge assets dominate the business. Here we should look for a ratio of more than 50% consistently over a period of time, which indicates that the business has a high degree of competitive advantage and is also able to maintain the same over the said period of time.
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Question 3: Is the stock undervalued?
If we got this far, then clearly we have been able to identify a business which consistently makes money and has a consistently high proportion of knowledge assets. With these two simple questions we have been able to zero in on an attractive investment proposition. All that is left to ask now is whether the timing is right for making the investment. For this we check whether the stock is undervalued. How? The Intellectual Capital of the business is already computed based on the published results. The Book Assets are also available from the published Balance Sheet. Add both of them up and divide by the number of shares to get the intrinsic value of the stock. Compare this to the market price which is also available and we know instantly whether the stock is undervalued and hence a right time for investing.
That’s it. In just three easy steps that all leverage concepts from the field of Intellectual Capital, we have been able to identify a good investment for the long term. How powerful is that? I would have to say extremely powerful but perhaps it is powerful because it is extremely simple. icTracker answers the above three questions for all Nifty stocks graphically by showing the performance of the stock over the last three years. This makes the analysis even simpler – even a guided teenager can make good investment picks using this tool. But does it work in the real world? I wanted to find out myself. So I did a hypothetical calculation. I found that if I had invested Rs 1 million in the Nifty five years ago on 1 April 2006, that amount would have grown to Rs 1.714 million five years later on 31 Mar 2011. The same Rs 1 million invested in the top 5 recommendations from the icTracker on the same date would however have grown to an amazing value of Rs 5.747 million five years later. That is a return in excess of 3.35 over the Nifty! This is of course assuming that I would use the icTracker every quarter to re-balance my portfolio.
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That in short is called using the power of Intellectual Capital to beat the Nifty hands down! Have I interested you sufficiently in the power of Intellectual Capital now?
Taking IC to the mainstream
The subject of Intellectual Capital has existed for over 20 years now. The Swedish Konrad group was the first to recognize the contribution of intangible assets to the performance of a firm, way back in 1989. Based on their findings they proposed a list of 35 indicators, including indicators on Human resources and structural assets of the firm, which should be reported externally by the firm to its stakeholders. This was followed in 1996 by a more exhaustive and prescriptive approach by Brooking. She recommended that every firm should audit all of their intangible assets, the goal being to put a financial value to every such asset. The Intellectual Capital Audit was formulated for this purpose containing 30 ways to audit various types of intangibles using 158 questions ranging on a variety of issues. Many other prescriptive approaches for measuring Intellectual Capital followed, including the Intangible Asset Monitor by Sveiby in 1997, The Intellectual Capital Index by Roos & Edvinsson also in 1997, the IC Navigator by Thomas Stewart in1999, the Value chain scoreboard by Baruch Lev in 2001 and the Intellectual Capital Dynamic Value by Professor Bounfour in 2002. The growing significance of Intellectual Capital’s role in the new economy even saw the Governments of countries such as UK, Austria, Sweden, Iceland, Denmark, Germany, UK, Japan, Australia etc. develop and publish country specific guidelines on how to report Intellectual Capital. The Austrian government even went so far as to make such reporting mandatory for universities – the crucibles of higher education and learning in the country.
But for all the effort that has been put in by experts and Governments to bring Intellectual Capital into the mainstream, it unfortunately has remained on the sidelines, confined largely to the academic domain. The business world has failed to make the management of Intellectual Capital as one of its primary focus areas, despite overwhelming evidence of the benefits of doing so. For instance in India, considered the second largest Knowledge economy in the world after the US, only one large-cap company takes the trouble of publishing an Intellectual Capital Report in its Annual Report. A few others who started similar initiatives a few years ago have quietly shut those down for reasons best known to them. What could be the reason for such apathy towards Intellectual Capital by the mainstream business community?
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In the preface to his ground breaking book “Intellectual Capital”, Thomas Stewart dismisses the possibility that the idea of Intellectual Capital will become a fad like re-engineering because he argues “there is nothing to sell”. Good ideas like Intellectual Capital however, get accepted in the mainstream not merely because they are good as an idea but because they have a commercial benefit. Stewart realizes the folly of his own argument quickly and goes on to recount with striking detail in the rest of the book how Intellectual Capital is a pot of gold waiting to be tapped. He suggests that IC practitioners have an obligation to reconcile the theoretical and practical sides of Intellectual Capital by
1. Devising a knowledge management toolkit that makes and saves money
2. Designing efficient methods for identifying knowledge assets in the organization
3. Proposing methods for the governance of organizations whose main assets are intangible
4. Developing practical methods of valuing intellectual assets of the organization
This was way back in 1998. Thirteen years have passed since Stewart published his ground breaking ideas but the situation has changed little since then. Knowledge Management did assume center stage for a while in the late nineties and early 2000s, but quickly fizzled out thereafter. Perhaps the application of Intellectual Capital got too tilted towards Knowledge Management when it came to the mainstream. Many a firm tried building gigabyte sized databases for capturing and encapsulating their knowledge, only to find out it was an effort in vain. They quickly discovered that knowledge is ephemeral, its usefulness highly dependent on the context of the situation in which it is applied. Such application requires real human intelligence which cannot ever be replaced by the artificial intelligence that they tried encapsulating in their databases.
I got attracted to the field of Intellectual Capital about four years ago. From the very beginning I wanted to address the question of how to commercialize the concept of Intellectual Capital, because then and only then would the concept find widespread mainstream acceptance. With this background, I deliberately focused on the fourth suggestion made by Stewart – valuing Intellectual Assets. I reasoned that if I could devise a reasonably accurate method of valuing the Intellectual Capital of a firm at a point in time, this information could be used by potential investors for their benefit. And the more the investors benefited, more would be the acceptance of the concept. The ICTracker product was born out of this thinking. At the present time, ICTracker calculates the Intellectual Capital of the top 50 listed Indian firms once every quarter. The Intellectual Capital thus calculated is added to the published Networth of the firm to get the total firm value, which is then compared against the prevailing Market cap to make an assessment of whether the firm is over valued or under valued. The algorithm used for calculating the Intellectual Capital of the firm is based on the Intangibles Scoreboard methodology by Gu and Lev (2002). The basic approach advocated by them has been modified by me to take care of troublesome real life concepts such as minority interest, goodwill, accounting intangibles, risk premium, liquidity premium, preferred capital, employee stock options, etc. These modifications result in an output that can be practically used by investors to beat the broader market index itself. Calculations made by me show that over a period of five years from Jan 2006 to Dec 2010, predictions from the ICTracker would have resulted in a gain in excess of 43% over the Sensex and the Nifty indexes.
More importantly, I have been able to simplify the process of stock picking using the concept of Intellectual Capital into three easy steps. The first step is to check whether the firm is making money - not profits but cash. We use EVA for this purpose, which calculates the excess money the firm has leftover after paying its cost of capital. So to begin with we look for firms that are making money every quarter. Secondly, we look for the knowledge content of the firm – is that excess money coming from tangible assets or intangible assets? In general, we prefer firms that are making money from intangible assets since they have a competitive advantage in the marketplace that is hard to replicate. For this we look at the Knowledge Basis of the firm – the ratio of the firms Intellectual Capital to its total worth. We want to pick firms with a high Knowledge Basis compared to the rest of the firms in the industry. Having selected firms that are making money and that have a high Knowledge basis, the final step is to look at whether the firm is undervalued. That is the signal to make an investment in the stock, since investors will always want to buy low and sell high. That’s it. That is how simple I want the practical application of Intellectual Capital to be. As I said earlier, the product is limited to the top 50 Indian stocks at the present time but I am making efforts to include all Indian stocks in the future. If I get there, I will then focus on stocks in other Knowledge markets. Meanwhile, I invite you to comment on what else can be done by IC practitioners to increase the widespread adoption of Intellectual Capital and bring it to the mainstream.
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