Getting non-physical

Investing is all about the gap between an asset’s fluctuating price and its intrinsic value. Most investors describe themselves as value investors, even when their stockpicking isn’t mainly based on accounting metrics such as book value or earnings. Of course, no one wants to overpay for stocks. The rising importance of intangible assets, as opposed to physical ones, is changing company valuation. Intangibles are the dark matter of finance: they constitute the vast majority of the universe, but can’t be measured directly. The upcoming recovery is likely to continue to present opportunities for cheaper and smaller cyclicals, for value stocks that do well in a reopening economy. But, over longer horizons, the structural case for tech and tech-enabled stocks remains strong.

The rise of intangibles: The global economy is shifting from one where factories, machinery and equipment are crucial to one where ideas, information and brands matter to a greater extent. This key structural change means that, in today’s service-led economies, what makes companies valuable isn’t their ownership of physical assets. Rather, the value increasingly is in intangibles: assets you can’t touch and see, but of huge value because they’re what makes a company unique. Take a smartphone. Its value is mostly in its software and multi-media applications, not in its production, as this is done by contractors assembling components made by third-party suppliers worldwide.

Accounting flaws: Markets are volatile as investors constantly re-evaluate the price of an asset versus its intrinsic value. The price of a stock shifts up and down depending on greed and fear. Its intrinsic value comes from the firm’s earnings power. This approach relies mainly on company accounts: valuation is based on a multiple of future profits and the book value of the firm’s assets. Of course, profits are revenues minus costs. If a chunk of costs is not current expenses like electricity or rent, but spending on intangibles that will generate future cash flows, such as advertising or research and development, then earnings and book value may both be understated.

Here’s why this matters:

Market call #1 | The world’s not going back: Intangibles can be used repeatedly and are often characterised by network effects: the more people use a firm’s services, the more useful and cheaper they become to other customers. This is why industries become dominated by a small number of big players. For long-term investors, the tech sector is a case in point. We believe it remains structurally supported. But intangibles tend to generate bigger synergies than tangible assets more generally: with increasing economies of scale, a firm that rises quickly will often keep on rising, as ideas multiply in value when they are combined with each other.

Market call #2 | The reopening decree: Looking at more immediate horizons, recent vaccine news suggests that, as the population builds immunity and governments lift lockdowns, a bounceback in activity from next spring is likely, as those vaccines facilitate reopening, while monetary and fiscal overstimulation stays in place. This will trigger a number of trends we expect to last through 2021: a rally in assets that outperform when growth accelerates, with more to go especially in some of the equity sectors, factors and regions most affected by the pandemic; a further rise in breakeven inflation; and continued dollar weakness as uncertainty diminishes.

Meanwhile, expect more policy action…

Europe in the spotlight: The euro area is going through a bout of deflation and the euro exchange rate has strengthened further, adding to the disinflationary impulse. The European Central Bank is likely to boost its asset purchase programme this Thursday. The last scheduled European Council for 2020 will try to unblock the approval of the recovery fund backed by joint debt issuance and attempt to finalise a Brexit deal, which remains uncertain for now. In the US, a virus relief package of over $900 billion will likely be unveiled as soon as this week. We expect extra stimulus, though the timing and composition remain unclear.

Daniele Antonucci | Chief Economist & Macro Strategist