As Economic Intangibles Reach 90% Of Asset Value, AI's Costs Become Factor

The tech era has spurred the growth of intangible value as intellectual property, brands and network effects supplanted property, plant and equipment as the new drivers of economic wealth creation. 

AI is a classic intangible - and some of its heightened value is attributed to its expected contribution to such other factors as productivity. The question is how the massive investments in infrastructure for data storage and energy will effect that calculation. Many companies are spinning off those costs to third parties who can profit from the massive, growing demand. The question is to what degree this may effect future values. JL  

Spencer Jakob reports in the Wall Street Journal:

Fifty years ago, less than a fifth of the S&P 500’s assets were intangible - when companies' value was mostly in property and machinery rather than brands and intellectual property. Today intangible value is well over four-fifths of S&P assets, and many top-performing companies like Microsoft are “asset-light.” A low price-to-book-based portfolio returned 519% between 2002 and the middle of 2024. One based on free-cash-flow yield did more than twice as well. Free cash flow is money left over after expenses and capital expenditures that a company can return to shareholders.

The investing secret that helped make Warren Buffett a multibillionaire isn’t working anymore, though probably not for the reason you would think.

Every decade or so someone will declare that the Berkshire Hathaway boss has lost his touch—usually a cue for the reasonably priced stocks he prefers to come roaring back. Even so, value investing the way that Buffett’s mentor Benjamin Graham practiced it and Nobel Prize-winning economists defined it decades later has had too few rebounds recently.

The reason isn’t that the “Magnificent Seven” stocks such as Nvidia, Apple and Tesla have rewritten the law of gravity. Value investing just needed a tuneup. A slew of exchange-traded funds, many without “value” in their names, have given it one.

 

The classic value factor was described in a landmark paper by economists Eugene Fama and Kenneth French in 1992, and it was compelling: A portfolio of stocks that were cheap relative to their book value trounced flashier stocks to the tune of thousands of percentage points over the decades.

But the professors’ results covered a period when companies’ value was mostly in property and machinery rather than brands and intellectual property. Fifty years ago, less than a fifth of the S&P 500’s assets were intangible. Today it is well over four-fifths, and many top-performing companies like Microsoft are “asset-light.”

The results tell the story: Analysts at fund manager Lord Abbett point out that a low price-to-book-based portfolio returned 519% between 2002 and the middle of last year. One based on free-cash-flow yield did more than twice as well.

Free cash flow is generally defined as money left over after expenses and capital expenditures that a company can return to shareholders. The yield is usually calculated by dividing 12-month free cash flow by enterprise value—market capitalization plus net borrowings. 

 

“We sort of caught on to this about 10 years ago,” says Sean O’Hara, president at Pacer ETFs Distributors. Pacer’s U.S. Cash Cows Index underpins an eponymous ETF, ticker symbol COWZ, which has about $25 billion in assets. The index has returned 15.7% annually over five years, a whopping 7 percentage points better than the Russell 1000 Value Index. It even beat the plain-vanilla Russell 1000 index, dominated by the very much non-value Mag 7 stocks, by 1.4 points a year.

If imitation is the sincerest form of flattery, then the recent popularity of funds that try to capture similar effects is high praise for free-cash-flow yield. ETFs launched in 2023 alone include the tickers FLOW from Global X, QOWZ from Invesco, COWS from Amplify ETFs and VFLO from VictoryShares.

Value investing was never dead—it just had a measurement problem. Plenty of investors, including Joel Greenblatt of “Magic Formula” fame, and even Buffett himself, ignore the academic straitjacket plaguing some value indexes. Other fund managers have accounted for the rise of intangible assets by tweaking the classic book-value calculation, which also improves results. That is harder to explain, though. 

 

COWZ is simple: Its proprietary index picks the 100 highest free-cash-flow yielders out of the Russell 1000 stock index and then weights those 100 by their free cash flow in dollars, capped at 2% of the index. The fund’s yield at the end of 2024 was 7.32% or 4.7 percentage points more than the overall Russell 1000 index. A small company version, CALF (get it?), yielded 9.94%.

Will the strategy work during tough times? S&P Dow Jones Indices has constructed its own free-cash-flow-based index based on the S&P 500. It calculates that the index beat the broad market by the greatest margin during times of falling economic growth and rising inflation.

With nervousness growing over the Mag 7 stocks, COWZ’s top seven returners of cash recently—Qualcomm, Gilead Sciences, Cencora, Tenet Healthcare, Valero Energy, Archer-Daniels-Midland and Bristol-Myers Squibb—might be a sturdier alternative.

Just call them the “Munificent Seven.”