Intangible Assets and Capital Allocation

Intangible Assets and Capital Allocation

Capital expenditures are the amount of  money a company invests into its operations to sustain and grow its business. It can be divided into two separate areas.

Maintenance expenditures are made to maintain the company’s current operations. They are the ordinary operating expenses a company inccurs to sustain its business. They tend to be fairly predictable in nature.

Growth expenditures are not necessary to the current operation of the company but are made to help grow the business in the future. (read intangible assets). Growth Capex then, is the deployment of capital for the purposes of generating organic growth. It is discretionary spending that will demonstrate senior management's ability to invest for the future growth of the business.

Since it can be difficult to breakdown a companies capital expenditures, Its often best to just focus on the way senior management are allocating their discretionary capital.

Management is usually thinking strategically when they make investing decisions involving their advertising and marketing budgets thus increasing the companies scope and influence in their industry. Research and development spending often mean sacrificing the street's quarterly earning targets in return for increased revenue growth in the future. Putting money aside for major merger and acquisitions targets can alter the strategic direction of a firm and enhance investor return in the long run. Share repurchase and dividend decisions again involve thinking in terms of years instead of months (quarterly earnings). Good luck finding any of these intangible assets on the balance sheet.

Capital spending in R&D as a percentage of sales, is increasing every year reflecting the shift in the underlying economy. M&A is the largest use of capital period. This isn't monopoly money we're talking about. The capital allocation skills of senior management is crucial to the long term success of the firm.

The capital allocation ability of management can be further observed by reading the bios of senior management. How have they handled managing investments in the past?  Effective capital allocation involves a different skill set than what is required from operating the company on day to day basis. If management is allocating capital effectively they will be incentivized to own significant portions of their own companies stock. Check the proxy statement. Incentives should be built into the option packages that reward long term performing metrics.

The New Economy and Intangible Assets

The New Economy and Intangible Assets

The Nation’s economy has changed a lot over the last 50 years. Half a century ago, our biggest companies extracted coal from the earth and forged I-beams in blast furnaces. Today, the prime creators of wealth for many firms are brands, patents, customer service, licensing agreements, distribution routes, intellectual property, innovative technology and even imagination. All of these are “intangible growth-producing initiatives that didn’t exist years ago.

Traditional accrual accounting treats investments made in these "intangible assets" as operating expenses (expenses that generate benefits only in the current year) whereas a manufacturing firm who put investments in plant, equipment and buildings is treated as a capital expense (expenses that create value over many years).

Accountants assume that the benefit made in investing in research and development (technology, pharmaceutical firms), brand name advertising (consumer companies) and training and recruiting (consulting firms) are too uncertain to project into the future so they are treated as operating expenses. Because of this earnings, cash flows and capital expenditures tend to be understated in these "new economy" companies.

The traditional accounting measures of book value, earnings and capital expenditures can be misleading when applied to firms with intangible assets. These intangible assets are rarely valued properly on the balance sheet as the standardization of financial statements does not allow for the recognition of these vital growth inducing initiatives. It's important to remember that investing in a company involves much more than just reading their numbers; it is also about going beyond the numbers and trying to get a sense of the real company.

This area is fertile ground for the intuitive investor who reads the annual report and begins to feel things that go beyond the reported numbers. This is where the narrative of the company comes into play (business model, industry structure, capital allocation history of management.