A Blog by Jonathan Low


Oct 2, 2016

Investors Now Prefer Companies With Fewer Physical Assets

In an era in which intangibles - like innovation, research, intellectual and human capital - generate greater returns than traditional tangible assets, it stands to reason that investors would value them higher.

The question is to what degree managers respond strategically rather than just following the trend. JL

Barry Libert and colleagues report in Harvard Business Review:

In the digital age, the physical assets big companies have acquired are becoming burdensome. Inventory depreciates and must be moved. When geographic needs change, land is difficult to acquire or offload. Equipment must be maintained in a world becoming virtual and augmented by technology. These assets prevent companies from adapting, and weigh them down. The industries with the highest multiples (are) those with the lowest percentage of physical assets.
Having physical stuff just isn’t as great as it used to be.
At home, we’re Marie Kondo–ing our way to minimalism, buying experiences rather than things, and using services — Netflix, Spotify, Uber — rather than owning assets such as movies, music, and cars. The companies that provide those services and enable us to share what we have (insights, relationships, assets) with others not only are valued more highly by investors but also are relatively asset-light themselves. Amazon has only a handful of brick-and-mortar stores, Uber doesn’t manage a fleet of cars, and Ebay doesn’t manage a supply chain.
This is quite a shift. Since the industrial revolution, companies have raced to accumulate the most raw materials, properties, plants, and equipment, believing that owning and having more was the equivalent of being worth more. For many years it was. General Electric, General Motors, Exxon Mobile, and Walmart were able to use their scale and size to compete and grow.
But suddenly, in the digital age, the physical assets that the big industrial companies have acquired are becoming more and more burdensome. Inventory depreciates and must be moved around. When geographic needs change, land is difficult to acquire or offload. And equipment must be maintained in a world that is becoming virtual and augmented by technology (VR and AR). In some cases, these assets are preventing companies from adapting, and weighing them down. It’s the corporate equivalent of having a closet full of old VHS tapes and CD cases.
The traditional asset-heavy corporations that used to be at the top of everybody’s most-admired lists are starting to look old-fashioned, slow-moving, and inflexible — particularly to investors.
For further evidence of this, we examined the 2015 S&P 1500 Index, a mix of small-, medium-, and large-cap stocks, and separated the index based on industry sector according to FactSet’s industry classification.
We then examined each industry’s average Net PP&E (property, plant, and equipment) as a percentage of total assets — in layman’s terms, the percentage of physical assets (land, buildings, vehicles, etc.) that companies own compared to other assets.
We also looked at each industry’s average revenue multiple, measuring how highly (or not) companies are valued in relation to their revenue.
For example, Health Technology had an average multiple of 5.1, meaning that investors pay $5.10 for every $1 of revenue generated. On the other hand, Consumer Durables has a multiple of 1.3 — investors pay only $1.3 for every $1 of revenue generated.
What we found wasn’t surprising: The industries with the very highest multiples were those with the lowest percentage of physical assets.

We broke the chart into four quadrants, based on the groupings we observed. In the lower left are builders, which include industries such as utilities, energy, transportation, and retail. These industries are asset-heavy, with PP&E making up more than 30% of total assets. They are also value-light, with multiples topping out around two.
In the lower right are asset-light industries, which we call servers. Although these industries have lower PP&E on average, they are still using nonscalable assets, namely human beings, to provide services. This scaling limitation seems to have an effect on enterprise value, and their multiples also fail to rise much higher than two.
On the top half of the chart, things get interesting. On the top right are creators; this is where the most value is being created these days. The health technology and technology services industries are creating highly scalable, and highly desirable, intangible assets. Thus, they have low PPE but high multiples. You’ll notice that the finance industry is included in this group as well. But its location on the chart is due mostly to the inclusion of real estate investment trusts (REITs), which pay out high dividends to investors.
Finally, in the top left we have dreamersYou’ll note this category is empty. There are no industries with a high proportion of physical assets and a high revenue multiple. And, given the rapid and continuing virtualization of assets by technology, we suspect there never will be.
As we mentioned previously, physical assets have a number of drawbacks, compared to digital, intellectual, and relationship assets. Although there will always be a place in the market for companies who extract, manufacture, move, and sell physical things, from a value-per-dollar perspective they just can’t compete with companies that create, curate, and develop intangibles. They can’t scale as rapidly or as cheaply.
In the future many more companies will go the way of Uber and Airbnb, leveraging a network’s assets: our cars, homes, insights, skills, and relationships.
It’s also possible that we will eventually see the rise of a few stars that manage to garner high multiples in asset-heavy fields. Tesla is one such contender, although it seems likely that the value of its new ideas and intellectual property will need to offset its massive investments in physical assets ($5 billion in battery technologies alone).
If companies want to change their business models, break out of the norms of their industries and beliefs about value, and earn the highest values from investors, they’ll need to adopt a new perspective. This will include the use of digital platforms to harness the power of networks outside their four walls.
To get there, traditional leaders of physical-asset industries will need to:
  • Examine their beliefs about how their industries and organizations create value. Are physical assets still working for them? Increasingly, the clear answer will be no.
  • Adopt some new beliefs about technology, value, and business models. They should also invert industry norms and find new ways to meet customers’ needs while using digital platforms as a foundation.
  • Reallocate capital. As Warren Buffet has said: “The heads of many companies are not skilled at capital allocation. Their inadequacy is not surprising…given their training and development. But today, capital allocation is Job 1. And investing in today’s digital business models is critical.”
The bottom line: To avert further value destruction in the industrial and service sectors of our economy, leaders have a lot of work to do — including changing beliefs, using technologies, and reallocating capital. There is no way out besides forward in a world where, increasingly, less is more.


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