One of the main reasons I formed Quent Capital was to research and invest in companies globally that are rich in intangible assets. I felt that difficult-to-measure assets such as human capital, brand value, innovation, customer relationships, and worker satisfaction were not being accurately measured in the price of stocks. In fact, factors such as these, which aren’t measured through standard GAAP accounting, often account for the bulk of a firm’s value and are a principal determinant of its future success.

I was introduced to the topic of intangible assets and related accounting deficiencies in the late 1990s when I read papers by Josef Lakonishok and other academics. I had a first-hand experience with these valuation issues through my asset-management and advisory business, which I founded and grew for 25 years before selling it several years ago. I invested substantial sums of money in brand marketing, intellectual property, research, team building, and business alliances, yet investments such as these tended to reduce profits and not appear on the balance sheet. Fortunately, the value of these intangibles was realized and acknowledged when I sold the firm to a public company.

My experience has driven home to me how the distinction between “value” and “growth” investing has broken down in the markets over the past few decades due to the increasing importance of intangible assets (which also include market share, shelf space, customer service, and entrepreneurship) that are not captured in financial statements. For instance, two or three decades ago, the single ratio of price/book value was often used to determine whether a security belonged in the value or growth camp. Today, since a company’s most valuable assets may not even appear on its balance sheet, sometimes the best “value” stocks are simply mispriced “growth” companies, and the best growth companies may more accurately be described as value companies. The old definitions need to be updated. What we used to think of as assets vs. the assets of today’s world are different.

Of course, measuring the value of intangibles is evolving quite rapidly. For example, the abundance of data, today often called “the new oil,” helps to improve the ability to measure valuations. Generally speaking, the more data you have, the more accurate your predictions will be. I recently discussed some of these trends with a true pioneer in the field, Baruch Lev, professor of accounting and finance at NYU’s Stern School of Business and co-author—with my good friend Feng Gu from the University at Buffalo—of The End of Accounting and the Path Forward for Investors and Managers.

One of the important adjustments I make in valuing companies is for R&D, which in standard accounting is expensed on the income statement but not capitalized on the balance sheet. R&D is the lifeblood of technology companies and critical for a business’ future growth prospects and profitability. Many managers of listed companies eschew heavy long-term investment in R&D since it suppresses earnings in the short term. Lev takes valuing R&D a step further, suggesting that too much attention is given to the quantity of research spending, and not enough to analyzing the quality and results. A better way to assess R&D, he says, is to measure the value of patents (an outcome of R&D), in part by researching how often the patents are cited by subsequent patents.

These days, machine learning and the efficacy of algorithms are critical ingredients for success in many of the companies in which I invest. Lev has studied these rapidly evolving intangible assets. He cites the example of the insurance business. Insurance companies collect premiums from customers and must forecast future liabilities (by far their largest cost) on those premiums. For his research, Lev obtained 15 years of data from a multitude of insurance companies and compared the predictive power of machines vs. company managers in estimating those costs. He discovered that the machines dramatically outperformed the managers. “Whatever you want to say about machines, they don’t try to cheat you,” he quips.

I am proud to have Lev, who helps me to update and refine my thinking on investing in intangible assets, as a collaborator and friend.

Listen to our full conversation: Baruch Lev: The End of Accounting. 

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