How Equity Investors Are Making The Value of Intangible Assets Visible: Podcast

Podcast Episode 003: Transcript

Celina. Welcome to “Human Led Research Tested,” the Active Quantitative Equity podcast – a series of in-depth conversations with experts from State Street Global Advisors. Our goal on this podcast is to bring investment processes to life. I'm Celina Rogers and I'm here with Alejandro Gaba and Chen He to talk about a crucial issue for equity investors – how to make the value of intangible assets visible and useful when choosing stocks. Intangible assets are non-physical assets that generate economic benefit to their owners. Some examples include patents, drugs in development, software, and brands.

It's often very difficult to assign value to these kinds of assets but investment in intangibles in the United States and in Europe has grown dramatically in the past few decades. Indeed investment in intangibles has outstripped investment in physical assets in the United States since the 1990s.

With that in mind our active quantitative equity (or AQE) team is deeply engaged in research aimed at extracting useful information about intangibles and putting it to work in the AQE investment process.  To tell us more about that I'd like to introduce two people who played key roles in that work: Alejandro Gaba, and Chen He both with our AQE team. Hi Alejandro.

Alejandro. Hi Celina.

Celina. And hello Chen.

Chen. Hi.

Celina. Alejandro. Very briefly could you outline your role on the AQE Team.

Alejandro. Sure. I'm the head of quantitative research for the AQE team. I basically oversee our research efforts including the research team and our research agenda.

Celina. And Chen your role.

Chen. I'm the senior researcher at the AQE and I work with Alejandro's team.

Celina. Marvelous. So intangibles are the topic of the day. I gave a very brief explanation of them but perhaps Chen, Alejandro you could tell us more about what intangibles really are in practice to you when you're thinking about how to incorporate them into the investment process.

Alejandro. So as you described before intangible assets are the nonphysical assets that can generate value for owners or firms and   there's a myriad of intangible assets out there. Depending on the sector and industries that you talk about – they can be marketing oriented from trademarks to brand value and they can be technology oriented, whether it's patents or drug pipelines under development.

Chen. And also things like human capital.

Celina. Ahh, Very important. So when you think about something like human capital where is that typically recorded in financial statements.

Chen. I think it's completely missing. It's not recorded anywhere in the financial statements.

Celina. So there's been a bit of movement actually to think about how to sot of think through new methods of trying to record the value of these kinds of assets.

Chen. I think they've been spending a lot of time looking at this and trying to improve ways of sort of assessing and evaluating the value of these intangible assets and how to record them in the books. Yes.

Celina. But your task in AQE is different from that though. So a financial standards board is looking at how to better reflect economic value created in financial statements.  In your case though you're looking for something a bit different?

Alejandro. I mean our task is to be able to find information that is that helps us better understand the expected return dynamics of companies in our universe and capturing the relative value of these intangibles can be a significant tool that we can use in our tool kit to be able to better forecast returns going out.

Chen. Our goal is not try to accurately estimate the intangible asset value per se. Our goal is trying to extract useful information from the intangible assets by using some simple model. We believe that if you apply a good model consistently across firms you can extract useful information across the firms.

Alejandro. The key is that as a quantitative investor we are definitely not trying to be extremely precise about the forecast of returns of any single individual company – we're actually looking for traits or characteristics of firms that allows us to rank these firms and be able to make assessments about the differential performance of portfolios of these firms and quite diversified portfolios for that matter.

Celina. So just to step back a little bit.  You start with a set of key questions. Can you articulate those, those first important questions.

Alejandro. Sure. The three key questions that we posed ourselves at the beginning of our undertaking in this research project was one: are more broadly intangibles mispriced by investors? Question number two:  Are there ways in which we can proxy for both the value and the quality of these intangibles. And finally – in which industries and sectors are these intangibles more prevalent or more important to think about them?

Celina. What's the very first step that you took to start to pursue that process?

Alejandro. Right. So the first step we undertook is debating amongst ourselves, in terms understanding why is it that they could be mispricing associated to intangible assets very broadly?  And the understanding that there are behavioral biases in investors particularly around intangibles so you might think about very well-known behavioral biases like limited attention – people being able to focus only on things that are more immediate more available to them. Investors may be overly focused on short term profits as opposed to thinking about longer term fundamentals of companies which in many instances derive future value for these firms. Other elements that we thought about – the tendency of investors to overpay for lottery-like assets and clearly a early startup biotech company with a single drug trial that has overwhelming odds of failure but tremendous payoffs if they happen to be successful, that's very indicative of our lottery-like payoff, and we do see the tendency of these to be overpriced.

Celina. Why is it so important do you think for active equity investors to be able to incorporate this improved understanding of intangibles and their potential to influence stock performance?

Alejandro. Well it's extremely important because over time it has become clear that assessments that don't account for these intangible assets that we talked about, can be sometime misleading. So whether it is not capturing the value of the brand that a company has, or if I'm not capturing the fact that early stage company has spent a substantial amount of research and development and has assets that can materialize into tangible over the near future, we think accounting for intangible assets can allow us to capture mispricings in the market.

Celina. Hm, hmm.

Chen. People believe that all the return comes from taking extra risk. So if there's an extra return as Alejandro mentioned that comes without taking extra unit of risk then it's an anomaly relative to the market efficiency hypothesis.

Celina. All of which points to something that is going a bit unspoken here – that is these sorts of anomalies are incredibly difficult to identify and new sources of information that might give you know an edge if you will to the investment process here are also very difficult to identify. And so is this is this sort of search for ways to understand and value intangibles part of that effort to kind of extend that horizon?

Alejandro. Absolutely. That's exactly why we're tasked as a research team is to be able to do a continuously search for improvements in the way that we understand firm dynamics and ultimately an ability to better predict returns and risk profiles of these companies and be able to deliver better outcomes for our clients.

Celina. What are some of the primary challenges that that you encounter?

Chen. If they are not recorded in the financial statements then we have to either find a proxy or find alternative data sources and if they are recorded in the financial statements but in an inappropriate way then we have to correct the way they are recorded and extract useful information.

Celina. And in addition to that, there are outdated accounting practices potentially that make it difficult to capture the value of intangibles.

Chen. Right. So one example is the R&D. So under the current accounting rule R&D is expensed in a single year and we believe that is not the correct way to do things because if you think about the benefits of R&D it really benefits firms in the longer term, multiple years to come. So we believe that a better way is trying to capitalize the R&D over the years dependent on which industry.

Celina. So how did you go about addressing some of the challenges and evaluating and understanding intangibles through your research?

Chen. We always start with rigorous economic rationale and for example, we start with the rationale that we firmly believe R&D is very important. It's an indicator that can drive firms future returns and also it may be related to providing new strategic options for firms. After having a strong economic rationale we start with collecting data, cleaning data and we come up with a economic model that we believe can extract useful information from the data and then we rigorously tested the data. So only after going through all these rigorous processes we can say if we are successful in the process or not.

Celina. One question that you asked yourselves was how can you better measure the value and the quality of intangibles. Can you talk a bit about looking at value versus quality and how each is important in its own right.

Alejandro. In the case of intangibles I think it is even more paramount to think about the issue of quality of these assets because as we discussed before, clearly it was the uncertainty in the payoffs of these assets or the potential value of these assets that leads to some of the accounting rules to be able to completely ignore them and acquire and give them zero value. So we undertook an effort to not just proxy the value of the intangibles which we took over by looking at R&D programs and by using, for example, longer term forecasting sales from the analyst community – but also to think about hypotheses that would actually be able to more precisely indicate the likelihood that those payoffs will be of higher quality or have less relative uncertainty.

Celina. Interesting…

Alejandro. So as next step in we proceeded to test these hypotheses and to be able to ultimately assess with as much certainty as we can in confidence that the actual hypotheses we have is actually valid. And what we were able to answer is that our approach was not ignoring intangibles was doing better at predicting the returns of these companies. Not only were we able to improve our ability to generate returns but also our ability to generate those with lower risk.

Celina. Another dimension of research that you undertook recently was into pharmaceutical drug pipelines. What did that reveal?

Alejandro. So that was a very important laboratory for us to kind of think about the concept the quality of intangibles and do so in a way in which we can pinpoint the precise nature of the intangible asset at hand in pharmaceutical and biotech companies, clearly in the business of developing new drugs – the development cycles for drugs is extremely long  – on average about a decade which six or seven years are spent in clinical trial stages. We've hypothesized that firms which have drug development pipelines that are riskier in nature – whether because they’re earlier in development stages or whether because they are less diversified – an extreme case will be a biotech company that has one drug trial that has just started and has an overwhelming odd of failure – would be mispriced relative to firms that actually had drug development pipelines that are more mature, closer to completion, and have more drugs to be able to generate diversification.

Celina. What are the most important things that every equity investor needs to know or look out for when it comes to intangibles?

Alejandro. The first thing that they need to do is they need to know they're out there and that there's a lot of them and that they represent an even bigger proportion of investments of firms and the relative value of firms.  So that's number one.

Celina. Chen do you have something?

Chen. I think people need to be aware whenever they're using traditional valuation method metrics like a P/E P/B to evaluate firms they have to take into consideration the effect of intangibles.

Celina. So what new questions are you looking forward to exploring through your research?

Alejandro. We are continuing to invest a significant amount of our resources in sector industry specific modeling by which different questions around intangibles are going to be a part of that. We also continue to look at better ways of establishing the ESG characteristics of firms. More broadly we’re entering very interesting work in the areas of machine learning and alternative data sets, natural language processing, so we have a very full agenda coming up and we’re very excited about that work.

Celina. Do you feel that the work that you've done in understanding intangibles and incorporating intangibles to the investment process is a source of competitive advantage for you in AQE?

Alejandro. Definitely. It is an area that we strongly believe we've done some extremely interesting work that bears tremendous improvements in our ability to predict returns and that we think is ignored by some of our competitors and we clearly believe that our research agenda going forward will further increment this advantage.

Celina. On a more personal note what brought you to this form of investing – y’know, what brought you to quantitative investing in particular?

Chen. I think I'm always fascinated by how the financial markets work. Ever since my college years. Actually I invested a little bit of my own money during the college years. As a matter of fact my college years coincided with the establishment of the first stock exchange in China. So I saw it you know from non-existent to becoming a becoming a very, very sort of a big industry over the years.

Alejandro. My career path is not uncommon to many quants in the industry. I actually came down from the hard physical sciences – when I was 14 years old. I picked up the brief history of time by Stephen Hawking and at that point then I decided I wanted to study cosmology and so therefore I did my undergrad in physics and then went to a grad program in astrophysics,  and then over time as I was doing a degree in astrophysics I realized that I desired something more tangible out of looking at things and making use of you know inferences and logic and using mathematics and statistics and my parents both are economists and I know you know finance was always and economics were a topic of discussion at the dining table and I became fascinated by financial economics and decided to change career and get into a Ph.D. program in finance at the University of Rochester and ultimately develop the skills in financial economics that allow me to undertake my career in quantitative investments.

Celina. Interesting. So to find something more tangible you went – more tangible than astrophysics reverted to financial markets. That I'd never really thought about it that way. Perfect.

Thank you so much for joining us today.

Alejandro. Thank you Celina it was a pleasure to be here.

Chen. Thank you too.

Celina . For those of you interested in more information on investing with active quantitative equity please visit us at SSGA dot com slash AQE.


Alpha: Alpha is used in finance as a measure of performance. Alpha, often considered the active return on an investment, gauges the performance of an investment against a market index or benchmark which is considered to represent the market’s movement as a whole. The excess return of an investment relative to the return of a benchmark index is the investment’s alpha.

Forecasting: The use of historic data to determine the direction of future trends.

Human capital: Human capital is the stock of knowledge, habits, social and personality attributes, including creativity, embodied in the ability to perform labor so as to produce economic value.

Intangible asset: An intangible asset is an asset that is not physical in nature. Goodwill, brand recognition and intellectual property, such as patents, trademarks and copyrights, are all intangible assets. Intangible assets exist in opposition to tangible assets, which include land, vehicles, equipment and inventory. Additionally, financial assets such as stocks and bonds, which derive their value from contractual claims, are considered tangible assets.

Quality: Quality has long been established as an investment approach, dating back to Benjamin Graham, but it is less well accepted as a factor, especially when compared with value, size, yield, momentum and low volatility. Quality is defined by low debt, stable earnings, consistent asset growth, and strong corporate governance. Investors can identify quality stocks by using common financial metrics like return to equity, debt to equity and earnings variability.

Price to Book: The price-to-book ratio, or P/B ratio, is a financial ratio used to compare a company's current market price to its book value. It is also sometimes known as a Market-to-Book ratio. The calculation can be performed in two ways, but the result should be the same each way.

Price to Earnings: The price/earnings ratio (often shortened to the P/E ratio or the PER) is the ratio of a company's stock price to the company's earnings per share. The ratio is used in valuing companies.

R&D (research and development): Research and development (R&D, R+D, or R'n'D), refers to innovative activities undertaken by corporations or governments in developing new services or products, or improving existing services or products.

Signal: A term used interchangeably with Alpha, is a measure of performance, the excess return of an investment relative to the return of a benchmark index.

Valuation: A valuation is the process of determining the current worth of an asset or company.


The views expressed in this material are the views of Alejandro Gaba & Chen He through the period ended September 20, 2018 and are subject to change based on market and other conditions.

This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.

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Exp Date 10/31/2019