Summarize the following research paper: ""Intangible Value
Executive Summary
Value                                investing has struggled over the past decade. We believe this is due to its failure
to              incorporate intangible assets, which play an increasingly            crucial role in the modern
economy.    We consolidate                    our prior research to construct a firm-level measure of
intangible                          value. We find that expanding intrinsic value to include intangibles can help
restore value investing to its former glory.
The Death of Value
The                    building chorus of investors singing of the “death of
value”                  has reached a crescendo. They claim value investors
have        lost the plot, dogmatically          clinging to dying businesses
as                        the world passes them by. Few are listening to the faint
objections                    of value investors, buried in the depths of a
thirteen-year drawdown.
We                        have spent a lot of time thinking about the future of
value                    investing. Ultimately, while we do not believe value is
dead                  - Ben Graham’s framework of buying stocks below
intrinsic                      value is both timeless and sensible - we do believe
that his metrics for intrinsic value need to be updated.
Graham                  established the principles of value investing in the
days                    of railroads and steel mills, when intrinsic value was
almost                  fully tangible. However, over the past century, the
economy    has transformed    from industrial    to informationbased.                Today’s dominant firms build moats using not
physical                but intangible assets, such as intellectual property,
brand equity, human capital, and network effects.
Value                investors should adapt by expanding their definition
of                    intrinsic value to include not just tangible but also
intangible value.
Intrinsic Value = Tangible Value + Intangible Value
While        simple in theory, quantifying        intangibles is actually
challenging            as we cannot rely on standardized    accounting
statements.              While alternative data can provide valuable
insight, they tend to require special tools to process.
Over                    the past year, we have written several research papers
using                  machine learning to quantify specific aspects of the
intangible        economy. This paper consolidates      this sprawling
research into a single firm-level measure of intangible value.  
We                will show that a value strategy that incorporates    this
intangible              value measure alongside traditional metrics (e.g.,
Fama-French) would have avoided value’s recent travails.
Exhibit 1
Value Is Dead, Long Live Value! ✊
Source: Ken French,                  Sparkline. Tangible Value is a long-short portfolio of
the                            top and bottom quintiles of U.S. equities on book value / market value,
market        cap weighted (per Fama-French).            Intangible Value is the same
except        it uses our intangible-adjusted            intrinsic value metric. We exclude
transaction          and financing costs for comparability    to Fama-French.    From
12/31/1959 to 4/30/2021. See important backtest disclosure below.
The Hero’s Journey
Adventures of the Oracle
Before          we get into the construction          of this intangible value
factor,                              we want to tell a story. In this case, it is the story of
Warren                  Buffett, the 90-year old paragon of value investing,
who                    has evolved his investment style over his long career
with the changing economy.
Buffett                      began his illustrious career as a direct disciple of Ben
Graham.                    The father of value investing, Graham was active in
the              industrial age, when intrinsic value was synonymous
with                  tangible book value. Security analysis came down to
assessing                    the value of a company’s hard assets and buying
firms priced below liquidation value.
1
June 2021
Kai Wu
Founder & Chief Investment Officer
<PRESIDIO_ANONYMIZED_EMAIL_ADDRESS>
Intangible Value | Jun 2021
Buffett                    was a great student and achieved success in applying
his                mentor’s framework. He called it “cigar-butt investing,”
buying                  mediocre companies at bargain prices for that one
last                puff. Berkshire Hathaway, originally a struggling textile
mill, is a perfect illustration.
However,                  with the help of his business partner, Charlie
Munger,                  Buffett gradually evolved his style to instead focus
on                  “wonderful businesses at fair prices.” This coincided with
the                    rise of the great American consumer brands, such as
Coca-Cola.                  Buffett bought Coke not because of its tangible
assets                      (it has very little), but because of its wide intangible
moats - its strong brand and management (human capital).
But                      his journey was not yet done. In 2016, after eschewing
technology                stocks for decades, Buffett made a massive
investment                  in Apple. After delivering a whopping $65 billion
profit,                  Apple now comprises 20% of Berkshire’s entire value.
Buffett                        has called it the “best business I know in the world”
due          not only to its technological          superiority but even more
so to the value of its “ecosystem” (network effects).
Exhibit 2
The Hero’s Journey
Source: Sparkline
The Asset-Light Economy
Buffett                explicitly recognized that the economy had greatly
transformed since the days of his mentor, saying:
“The                  four largest companies today by market value do
not                      need any net tangible assets. They are not like AT&T,
GM,                    or Exxon Mobil, requiring lots of capital to produce
earnings. We have become an asset-light economy."
In              the 1930s, the dominant industries were asset-heavy
railroads,                  autos, oil, utilities, chemicals and steel. Today, the
most                  important industries are asset-light. As seen below, the
percentage            of U.S. public company market capitalization    in
high-intangible                industries has grown from around 0% to
50% over the past century.
Exhibit 3
The Asset-Light Economy
Source: Ken French,                  Sparkline. We manually divide SIC industries into 9
intangible                  industries (hardware, software, chips, drugs, medeq, labeq, hlth,
bussv,              persv) and 40 tangible industries (e.g., transportation,      oil, steel,
autos, chems, utilities, banks, retail, telecom, household). As of 4/30/2021.
Importantly,              Buffett recognized that this economic shift
necessitated                  an expansion of the definition of intrinsic value
beyond                hard assets. Over the years, Buffett has accumulated
several                  intangible “moats,” which he has added to Graham’s
framework alongside tangible value. 🏰
Exhibit 4
Four Intangible Moats
Source: Sparkline
Intangible                  assets are quickly becoming the primary form of
economic                value. Firms with loyal customers, top talent,
innovative            products, and network effects are increasingly
2
Intangible Value | Jun 2021
dominating        economic activity. In Investing        in the Intangible
Economy    (Oct 2020),              we conducted an in-depth analysis of
the                    rising role of intangibles. We showed the following chart,
which      provides a (conservative) bottoms-up        estimate of the
contribution                    of intangibles to the capital stock of U.S. public
companies.
Exhibit 5
Can’t Touch This 🔨
Source: S&P, Sparkline. As of 2019.
Intangibles                currently comprise roughly half of the corporate
balance      sheet. More importantly,              this ratio is very likely to
expand                  further in the future. Hard assets will become
increasingly irrelevant as “intangibles eat the world.”
Expanding Intrinsic Value
Let’s return to our original equation:
Intrinsic Value = Tangible Value + Intangible Value
In                        the days of Ben Graham, the final term in this equation
was          a mere rounding error. Intrinsic value    and tangible
value    were functionally            equivalent. However, as we’ve seen,
intangible value                  is a significant and growing part of the
economy and can no longer be ignored.
We                    highly doubt that Graham intended value investors to so
strictly                      adhere to the specific metrics used in his books. The
lessons        are in his frameworks            and mental models. As the
world                    shifts from railroads to airplanes to flying cars, the
principles                  of value investing will always hold. The intelligent
investor                    is one with the mental dexterity to apply these
frameworks to the changing problems of his day.
Quest for Intangible Value
Challenge Accepted
Buffett                      is not the only famous value investor to recognize the
rising      role of intangibles.          In a recent letter, Howard Marks
wrote:
“Value                  investing doesn’t have to be about low valuation
metrics.                      Value can be found in many forms. The fact that
a                  company grows rapidly, relies on intangibles such as
technology                    for its success and/or has a high p/e ratio
shouldn’t                      mean it can’t be invested in on the basis of
intrinsic value.
Many                    sources of potential value can’t be reduced to a
number.        As Albert Einstein purportedly      said, ‘Not
everything                that counts can be counted, and not
everything                  that can be counted counts.’ The fact that
something              can’t be predicted with precision doesn’t
mean it isn’t real.”
Like                    us, Marks argues for a more expansive definition of
intrinsic                  value. He correctly urges investors not to conflate
value        investing with low price-to-earnings      ratios. Such
backward-looking              metrics largely ignore the mostly future
value of intangible investment (e.g., R&D).
Moreover,                Marks urges investors not to ignore important
sources                  of value just because they cannot be measured
precisely.                      We will take up this challenge. We will show that
intangible                value can indeed be quantified, albeit requiring
the      use of non-traditional                data and a little bit of machine
learning wizardry. 🧙
The End of Accounting
“The                  constant rise in the importance of intangibles in
companies’ performance          and value creation, yet
suppressed    by accounting        and reporting practices,
renders financial information increasingly irrelevant.”
- Baruch Lev and Feng Gu, The End of Accounting (2016)
The                        first stop in our quest to quantify intangible value will be
financial              statements. GAAP accounting provides a consistent
and                  structured way for companies to report their financials
over                  time. The problem is that accounting principles were
originally              developed centuries ago and have remained
mostly unchanged despite the rise of the modern economy.
3
Intangible Value | Jun 2021
The      use of centuries-old          accounting principles to evaluate
intangible-rich                companies like Apple cannot be expected to
produce                    great results. Lev and Gu show that metrics like
book                  value and reported earnings have been steadily losing
explanatory                    power (at a rate of 6 percentage points per
decade).                    This is quite concerning as book value and earnings
anchor two widely used valuation ratios (i.e., P/E and P/B).
Exhibit 6
The End of Accounting
Source: Lev      and Gu (2016),                  Sparkline. Metric is the adjusted R-squared of a
regression of market value on reported earnings and book value. As of 2013.
The                    table below shows how GAAP accounting treats each of
the four intangible pillars (or doesn’t, as is often the case).
Exhibit 7
GAAPs in Intangible Coverage
Source: Sparkline
Financial statements’            reporting on intangible assets is
extremely inadequate,        providing minimal and inconsistent
coverage                  of even basic intangible metrics such as employee
retention, relationships          with external partners, innovative
activity, and brand investment.
The                only potentially helpful accounting data on intangibles
are        R&D and SG&A expenditures.            SG&A is a catchall that
includes              marketing, sales, personnel, and other overhead
costs                      not directly tied to goods sold. Lev and Gu advocate
capitalizing                      R&D and a portion of SG&A. This allows us to
create                a balance sheet asset for this intangible investment,
which                would otherwise be punitively deducted from annual
net income as an expense per current practice.
However,                      as we will later show, while sensible, this does not
materially      improve the performance          of value investing in
practice.                  We believe this is due to the weak relationship
between                input cost and output value for intangible
investment.                  The goal of accounting is to capture “historic
cost.”                  However, the ex-post value of intangible investment is
extremely                  uncertain. A $10 million research project can be
worth                            $1 billion or $0; an ad campaign can go viral or flop; a
top engineering                hire can be 10-100 times more productive
than                    a median one; and network effect feedback loops can
be either virtuous or vicious.
The                      upshot is that we need to move beyond the limited
information                    in financial statements. We need to find ways to
directly                  quantify the value of intangible assets, opposed to
just the historical costs of their creation.
The Dark Matter of Finance 🔮
The information                  economy has driven a steep decline in the
relevance                  of tangible assets. In their place, we have
intangible                    assets. We like to call intangibles the “dark matter
of                  finance,” for while intangible matter holds the financial
universe together, it is not visible to the naked eye.
Fortunately,                  the digital age has also triggered an explosion
of                      new data and tools, enabling us to start exploring this
brave                      new world 🔭 . Data is growing at an exponential rate,
doubling                      every year or two. However, most of this new data
is unstructured,                  taking the form of text, images or audio.
Unstructured        data is large, high-dimensional,      noisy, and
generally not amenable to traditional statistical techniques.
4
Intangible Value | Jun 2021
Exhibit 8
Unstructured Data Is Eating the World
Source: IDC, IBM
This                  is where machine learning comes into play. In Deep
Learning        in Investing (Jul 2020),          we discuss how recent
advances                  in natural language processing (NLP) give us the
ability          to make sense of unstructured        text data. We
reproduce                  the exhibit below to highlight the massive growth
in NLP models over the past few years.
Exhibit 9
NLP 🚀
Source: Sparkline (adapted from HuggingFace). As of July 2020.
There          are troves of valuable information      about companies’
intangible                assets buried in the vast ocean of unstructured
data.      Unlike financial statements,          this data is scattered
across                  dozens of sources and cannot be extracted with
standard                      tools. However, this is arguably a good thing. It is
unlikely                    that much alpha can be found in tangible value,
given                    that any halfway decent quant can spin up a
price-to-book                  strategy given Compustat, an EC2 box, and a
few hours without checking Twitter.
The Artificial Intelligent Investor
Over                        the past year, we’ve done a series of deep dives into
specific              intangible assets. We now seek to operationalize
this                  research by building a single cohesive measure of
firm-level                    intangible value, which we can then use to build
an intangible-aware value strategy.
All                these papers are freely available in the research section
of                      our website, so rather than repeat the rationale for each
analysis,                  we will merely focus on collation. More specifically,
we                    aim to organize the dozens of disparate research threads
into a handful of major themes.
We’ll                  conduct this clustering analysis using a NLP technique
called                    topic modeling. First, we split the papers into smaller
sections.                  Second, we run a topic model over these
paper-sections                  to identify salient themes. Finally, we use an
ML algorithm called TSNE for visualization.
Exhibit 10
Research Map 🗺
Source: Sparkline
The                    sections naturally fall into nine broad themes. The most
central                clusters form around the four intangible pillars:
innovation,                human capital, brands, and network effects. Five
other                    research topics radiate out from this core. These five
research              branches center on the concepts of intangibles,
monopolies, value investing, NLP, and machine learning.
These                  papers contain dozens of actionable ways to quantify
intangibles              such as disruptive innovation, workforce quality,
patent                    value, and hiring pull. We will build a composite
measure                of intangible value that combines these individual
5
Intangible Value | Jun 2021
metrics.                  However, please note that the composite will also
include                  many metrics not described in the papers above.
Our                    research efforts produce more ideas than we can write
about.
We                        build the composite in two steps. Before we build the full
composite,                      we first assign each metric to one of the five
pillars.                      We then average the metrics at the pillar level to
produce                  five sub-scores. Since any individual metric can be
quite                  noisy, combining many metrics helps produce a more
robust                  valuation. From here, the composite value score is
simply the sum of the scores of each of the five pillars.
This intermediate                step helps us deal with the correlation
structure                of individual metrics. For example, an AI-intensive
firm                          may display its AI prowess in the form of having many AI
patents                and AI-skilled employees (compared to its market
cap).                  However, since these two metrics are correlated, they
should                    be used in concert to triangulate the underlying idea
of innovativeness.
Importantly,                    most of these metrics are scaled by price. Thus,
they                    do not measure the total quantity of intangibles owned
by                      a firm but instead quantify the share of intangibles we
obtain                      by buying a fixed dollar amount of the firm’s equity.
For                    example, we don’t care about how many total patents
IBM                      has, but rather how many patents we obtain per dollar
invested                      in IBM. Think of it like the “dividend yield,” except
that instead of buying dividends, we buy patents.
Value                    investing is all about getting value for your money.
Traditional                valuation ratios measure the quantity of tangible
assets                    obtained for a given dollar of investment. Our metrics
are conceptually              identical, except they focus on intangible
sources                      of value (e.g., # patents, # PhD employees, $ brand
equity                      per dollar invested). Our hope is that this metric helps
us find efficient ways to obtain intangible assets.
Intangible Value
Setting the Table 🍽 🧂
Now                        that you’ve seen how the sausage is made, it’s time to
eat!                        Remember that all this work was done in order to create
a                    measure of intrinsic value that includes both tangible and
intangible value.
To                      whet our appetite, let’s start by sampling some of the
companies that are strong on each of the intangible pillars.  
Exhibit 11
Notable Intangible Companies
Source: Sparkline
While                anecdotal, these examples are quite intuitive. Firms
like                  Nvidia and Moderna invest heavily in innovation; Nike
and                    Harley in brand; Google and Goldman in talent; and
Uber and Twitter in creating network effects.
For                    our second course, we’ll drill down even further. The
next    exhibit decomposes    four well-known companies’
balance sheets into the five tangible and intangible pillars.
Exhibit 12
Balance Sheet Decomposition
Source: Sparkline. As of 5/28/2021.
First,                      we see that Boeing’s value is primarily derived from its
intellectual                    property; it has invested over $100 billion in R&D
since                    its inception. In contrast, Boeing has no tangible value;
6
Intangible Value | Jun 2021
in                      fact, it even has slightly negative tangible book value due
to an accounting quirk with share buybacks.
Like                Boeing, Google and Coca-Cola are asset-light firms.
However,                        unlike Boeing, Coke’s value lies not in its IP but its
brand.            Since inception, Coke invested a comparable    $100
billion                in building intangible value. However, this investment
was                in advertising rather than research. Meanwhile, Google
enjoys            a nice diversified mix of intangibles.        At the other
extreme,                the insurance company Aflac is mostly composed
of tangible assets. 🦆
By                  now, you’ve probably noticed a strong industry effect.
The            next exhibit performs the same decomposition      but at
the aggregate sector level.
Exhibit 13
Sector Balance Sheet Decomposition
Source: Sparkline. As of 5/28/2021.
Tangible value                is most important for real estate, utilities,
materials,                energy, and financials. However, it comprises less
than                        half of total value in six of the 11 sectors. Moreover,
these    six intangible-rich            sectors dominate the stock market,
comprising over 80% of S&P 500 market capitalization.
Of        the intangible assets, intellectual property        is the most
important          for tech and healthcare; human capital      is critical
for                not only tech and healthcare, but also communications
and    financials; brand equity            drives the most value in
consumer discretionary        and staples; and network effects
matter most for communications and technology.
The Death of (Tangible) Value
Our                    hypothesis is that value investing has struggled due to
the                    rise of intangible assets. Now that we have a quantitative
measure                    of intangible value for each company, we can test
this empirically.
We                    will first divide our investment universe into two groups:
intangible-rich companies            (top quartile on intangible share)
and everyone else.                  From here, we can run a traditional value
investing strategy in each universe separately.
The                    next exhibit shows that tangible value has continued to
work                      reasonably well, as long as you avoid running it on
high        intangible companies. Not surprisingly,      tangible value
has                  been an ineffective tool for evaluating firms composed
mainly                        of intangible assets. A classic case of trying to fit a
square peg into a round hole!
Exhibit 14
Old Value in the New Economy
Source:            S&P, Sparkline. Blue line is performance          of the traditional value
factor                              in a universe consisting of the top quartile of the top 1000 largest U.S.
firms                                on intangible share. Red line is the same but in a universe of all other
stocks.                          The traditional value factor is a long-short portfolio of the top and
bottom                          quartiles of stocks on price to book, earnings, sales, and cash flow
(both                    trailing and expected). We exclude transaction and financing costs.
From 12/31/1994 to 5/28/2021. See important backtest disclosure below.
In Value              Investing Is Short Tech Disruption (Aug 2020),    we
argued                    that value investors have struggled due to an implicit
(losing)                  bet against disruptive technology. We now see that
the                      “short disruption” bet is part of a broader bet against
intangibles in general (of which innovation is but one pillar).
7
Intangible Value | Jun 2021
The                    good news is that traditional value investing still works
as                      long as you only invest in companies for which tangible
value                      still matters. The bad news is that the universe of
companies                  for which tangible value still matters is steadily
and irrevocably shrinking!
Fixing Fama-French
Of                    course, there’s no reason to restrict ourselves to tangible
value                    when we now have a metric that also includes
intangible            value. If built correctly, our intangible-aware
intrinsic                      value metric should be able to find cheap stocks in
both high- and low-intangible universes.
Our                first step is to define a baseline “Tangible Value”    factor.
We              use the value factor defined by Fama    and French,    given
the                    paper’s lofty status as the canonical academic work on
quantitative                    value. Fama and French use book value as their
measure                  of intrinsic value. They build a long-short portfolio
of                  the top and bottom quintiles of stocks on price-to-book.
We                      use the market cap weighted version of their strategy to
reduce the risk of deceptive results from illiquid small-caps.  
Exhibit 15
You Hate to See It 🙈
Source: Ken French,                  Sparkline. Tangible Value is a long-short portfolio of
the                            top and bottom quintiles of U.S. equities on book value / market value,
market        cap weighted (per Fama-French).          Fama and French exclude
transaction          and financing costs. From 12/31/1959        to 4/30/2021. See
important backtest disclosure below.
The    historical performance    of Tangible Value      reflects the
tribulations                  of many value managers. After many decades of
consistent outperformance      of +5.4% annualized, Tangible
Value                    has floundered over the past decade. Even after the
rebound        from the recent Covid-reopening        rally, it would
have to climb a further +280% to get back to trend.
Now                      that we have established a baseline, we next want to
evaluate        the impact of augmenting          this baseline with a
measure                  of intangible value. We will test two different
approaches to quantifying intangibles.
First,        we build a “GAAP    Intangible Value”      factor that
augments                book value by adding intangibles derived from
capitalizing                    R&D and a portion of SG&A found in GAAP
income statements (per Lev and Gu).  
Second,        we create an “Intangible Value”          factor that uses our
definition                  of intrinsic value that includes both tangible and
intangible    value. Importantly,          this factor goes beyond
accounting                data to use measures of intangibles extracted
from unstructured data using NLP.
The                      next exhibit focuses on the past decade, which is the
period                  during which traditional value has struggled. We find
that GAAP-derived            intangible assets were only marginally
helpful.      The real improvement            comes once we unlock the
power of non-accounting, unstructured data.
Exhibit 16
Intangible Improvements
Source: Ken French,                  Sparkline. Tangible Value is a long-short portfolio of
the                            top and bottom quintiles of U.S. equities on book value / market value,
market        cap weighted (per Fama-French).              GAAP Intangible Value is the same
except                          it adds capitalized R&D and SG&A to book value. Intangible Value is
the            same except it uses our intangible-adjusted          intrinsic value metric. We
exclude transaction          and financing costs for comparability        to Fama and
French.                  From 12/31/2009 to 4/30/2021. See important backtest disclosure
below.
8
Intangible Value | Jun 2021
Finally,                    let’s put it all together. We find that, while Tangible
Value                  has decayed with the declining relevance of tangible
assets, Intangible Value              has continued to perform in line
with value’s long-term historical trend.
Exhibit 17
O Drawdown, Where Art Thou?
Source: Ken French,                  Sparkline. Tangible Value is a long-short portfolio of
the                            top and bottom quintiles of U.S. equities on book value / market value,
market        cap weighted (per Fama-French).            Intangible Value is the same
except        it uses our intangible-adjusted            intrinsic value metric. We exclude
transaction          and financing costs for comparability    to Fama-French.    From
12/31/1959 to 4/30/2021. See important backtest disclosure below.
Dissecting the Portfolio
The          previous section analyzed the performance        of the “value
factor,”                    which is a long-short strategy. We’ll now examine a
long-only                      version. This is basically just the long side of the
Intangible Value factor with a few modifications.
We                start with the U.S. large- and mid-cap investment
universe                    (roughly the Russell 1000). We rank each stock on
our intangible-augmented              value score and buy the cheapest
150                    stocks. Within these stocks, we allocate more weight to
stocks                  with higher scores and, to increase portfolio liquidity,
market capitalization.                  For ease of exposition, we will call this
the Intangible Value “portfolio” (opposed to “factor”).
The                      next exhibit shows the top ten holdings of the Intangible
Value                      portfolio. For context, we also include stocks in the top
ten of the S&P 500 but not in the Intangible Value portfolio.
Exhibit 18
Top Holdings
Source: S&P, Russell, Sparkline. Weights are percentages. As of 5/28/2021.
At                        first blush, the very top of the portfolio doesn’t look too
exciting.                      This is due in large part to the unique situation
today                  where the largest companies also happen to be
among      the most intangible-rich.        As discussed in The
Platform      Economy (Dec 2020),          firms like Google, Microsoft
and        Amazon are digital monopolies          that use intangibles to
create                  wide moats, enabling them to sustain high growth
rates at a historically unprecedented scale.
That              said, we still notice some important differences,
especially                compared to Russell 1000 Value and Growth.
Value                    has nearly zero exposure to Big Tech, while Growth
has                  a massive 36% position. Further, the Intangible Value
portfolio                      does not have any Tesla or Visa or Berkshire, J&J,
or                  JPMorgan, although they are among the largest holdings
of these three indices.
As                        you go down to the bottom 140 positions, the names and,
more importantly,              weights diverge further. Rather than show
all                    positions, we will analyze the portfolio on the aggregate
dimensions                      of industry and style factors. We will first look at
industry group exposure.
9
Intangible Value | Jun 2021
Exhibit 19
Industry Exposure
Source:            S&P, Russell, Sparkline. Weights are percentages.        The blue text
highlights the top 5 industry groups for each portfolio. As of 5/28/2021.
The                    Intangible Value portfolio has a large allocation to the
stocks                most central to the modern knowledge economy:
software,          hardware, pharma, media and semiconductors.    In
contrast,                    traditional value has a hard time bringing itself to
buy                companies composed of intangible assets. This results
in      a portfolio concentrated    in old-economy      industries such
as capital goods, banks, and financials.
We                        will next break out the factor lens 🔍 . We calculate the
aggregate                exposure of each portfolio to both traditional
“style factors” and custom intangible factors.
Exhibit 20
Factor Exposure
Source:                    S&P, Russell, USPTO, Sparkline. Earnings, book, sales, R&D, S&M,
and                      patents are calculated over a trailing 12-month window. Patents and
PhDs                          are scaled by billions (e.g., # patents per $1 billion market cap).
Patents                  are from USPTO. S&M is sales and marketing expenditures.
Platforms              are based on metric defined in The        Platform Economy (Dec 2020).
Expected                  Growth is consensus analyst expected long-term growth of
earnings        per share. All calculations            are weighted averages with weights
equal to portfolio position size. As of 5/28/2021.
On              traditional metrics (i.e., size, value, growth, profitability),
the                      Intangible Value portfolio has a profile similar to the S&P
500                  and between that of traditional value and growth.
However,                  it has a much greater exposure to intangible
assets.                  Each dollar invested in the Intangible Value portfolio
buys                  around twice the quantity of R&D, marketing, patents
and                      PhDs compared to a dollar invested in the S&P 500.
While                          this is somewhat by design, it is useful to see that this
advantage                  doesn’t come at the cost of materially worse
valuation ratios, growth or profitability.
Finally,        we backtest the performance          again to make sure
nothing                  was lost in translation from the long-short factor.
This                    time we’ll add simulated transaction costs and 50 bps
of fees and expenses to make the backtest more realistic.
Exhibit 21
Intangible Value
Source:                      S&P, Russell, Sparkline. Intangible Value is a long-only portfolio of
the                            top 150 stocks from within the top 1000 U.S. stocks on intangible value
score,                      weighted by score and modified market cap. We simulate transaction
costs                            and include 50 bps of fees and expenses. S&P 500, Russell 1000 Value,
and          Russell 1000 Growth are (uninvestable)          index returns. From 12/31/1994
to 5/28/2021. See important backtest disclosure below.
We                  find that the Intangible Value portfolio would have
outperformed        the S&P 500. Interestingly,      despite currently
having                  factor exposures in between those of Russell 1000
Value and Growth, it would have also outperformed both.
10
Intangible Value | Jun 2021
Think Outside the Style Box 📦
Style Boxed In
As quantitative          managers, we have benefited professionally
from          the rising tide of factor-based        investing. However, we
believe      that the “factorization”          of the investment industry
has                      at this point reached an excessive level and is now
actually contributing to its stagnation.
As            the investment industry has become institutionalized,
active                managers have been forced into so-called “style
boxes.” Popularized    by Morningstar,        this framework divides
the        world into a two-dimensional            matrix based on value vs.
growth and large vs. small cap.
Exhibit 22
Style Boxes
Source: Morningstar, Sparkline
The                  style box framework defines value and growth as
diametric          opposites. According to this framework,      in the
same                          way that a stock can’t be both small and large, it can’t
be                      both value and growth. Managers are expected to pick an
allegiance                      to one box and only one box. Traitors who step
out of their lane are summarily fired for “style drift!” ☠️
Joined at the Hip
We                  believe that the style box orthodoxy has shackled
managers        to an obsolete formulation          of value and stifled
attempts                      to expand the definition of value to that which is
relevant today.
In                      fact, we are not alone in this thinking. Warren Buffett
addressed this topic decisively:
“...                      there is no such thing as growth stocks or value
stocks,                  the way Wall Street generally portrays them as
being                contrasting asset classes. … anybody that tells
you,                      ‘You ought to have your money in growth stocks or
value                stocks,’ really does not understand investing. …
And                        I just cringe when I hear people talk about, ‘Now it’s
time                    to move from growth stocks to value stocks,’ or
something                  like that, because it just doesn’t make any
sense.”
Instead, he advocated:
“Most                analysts feel they must choose between two
approaches customarily          thought to be in opposition:
‘value’          and ‘growth.’ Indeed, many investment
professionals                      see any mixing of the two terms as a form
of intellectual cross-dressing.
We                        view that as fuzzy thinking ... In our opinion, the two
approaches                    are joined at the hip: Growth is always a
component            in the calculation of value, constituting    a
variable                whose importance can range from negligible to
enormous                    and whose impact can be negative as well as
positive.”
Buffett understands                  that the style box portrayal of value as
being necessarily              short growth is ridiculous. Value and
growth      are not mutually-exclusive.        Companies with wide
intangible                  moats can be both growth and value. Just
because                    one identifies as a value investor doesn’t mean he
has to restrict himself to buying only 💩 -cos!
Value        investing (in a philosophical        sense) simply means
buying                stocks below intrinsic value. And intrinsic value
absolutely should take into account firms' growth prospects!
Beyond Style Boxes
We                  believe the Intangible Value portfolio provides a purer
expression    of “Grahamian”              value than does style box value.
Its      style box categorization              will be merely incidental to the
opportunity                    set available at the time. If cheap stocks happen
to          be found mostly among old-economy,      asset-heavy firms,
the                  strategy will be labeled “value.” If the best opportunities
tend        to be in high-growth,    asset-light compounders,      it will
be considered “growth.”
Exhibit                  23 shows the correlation of the Intangible Value
portfolio to the value and growth style boxes over time.
11
Intangible Value | Jun 2021
Exhibit 23
Shifting Style Boxes
Source:                            S&P, Sparkline. Style Box Value is a blend of price to book, sales,
earnings,                        and cash flow (both trailing and expected). Style Box Growth is
analysts’                  consensus forecast long-term growth in EPS. Lines display
cross-sectional position-level              correlation of the Intangible Value portfolio
with the above. As of 5/28/2021.
The                Intangible Value portfolio’s style box exposure has
evolved significantly                    over time. In the late 1990s, it was both
staunchly “pro-value”    and “anti-growth,”      betting heavily
against unprofitable, speculative          dot-com stocks. In this
period,                    many stocks with no intrinsic value ended up getting
bid            up based on fantastic growth expectations.        In order to
avoid                  these companies, the portfolio held large positions in
industrials, utilities, and materials.   
This                    positioning helped avoid much of the losses from the
burst                        of the dot-com bubble. In contrast, the S&P 500, due to
its        cap weighting scheme, mechanically        increased its tech
exposure                      from 5% to 35% as valuations surged in the 1990s,
only to suffer when the bubble subsequently burst.
However,            as the world has become increasingly    intangible,
tangible                    value has become a much less useful metric. Over
this                period, many traditional “style box value” managers
suffered            from large implicit bets against innovative,
information-era                  firms. By not shackling itself to the value
style                    box, the Intangible Value portfolio was free to rotate
toward      these modern, intangible-rich          firms. The freedom to
dynamically        adjust to an ever-changing opportunity        set is an
important benefit of “thinking outside the style box.”
Today,                  the Intangible Value portfolio actually has a small
positive                    exposure to both style box value and growth. After
all,                    it’s 2021, and there’s nothing wrong with a little
“intellectual cross-dressing!” 👘
Uniting the Tribes ⚔️
For                    many years, the moral superiority of value investing was
dogma,                  but value’s recent stumbles have created a power
vacuum                    in the investment world. This has opened the door
for                      a bevy of contenders for the throne, such as thematic
and memetic investors, who pay little mind to valuation.
More importantly,                many investors no longer seek “growth at
a                      reasonable price” but simply “growth at any price.” This is
a                      natural response to a long, raging bull market fueled by
low                  rates and aggressive stimulus. However, signs of froth
are                        emerging in many segments of the market, if not also the
market                        as a whole. And, as we saw in the dot-com bubble,
investing without a margin of safety can be perilous!
On                      the other hand, growth investors kind of have a point.
Traditional                    value portfolios do seem junkier than in the past.
Ignoring              intangible assets biases value investors toward
stagnant      firms in old-economy        sectors like financials,
industrials,          energy, utilities, and materials. Concerningly,
these      portfolios are increasingly concentrated        in low margin,
cyclical, and commodity businesses.
Lacking                a reasonable alternative, the investment world has
been                    cleaved into two warring factions. Both sides have dug
in      their heels, contributing      to unhealthy polarization.    Their
positions    are increasingly            disjoint (e.g., 2% big tech
ownership                    by Russell 1000 Value and 36% for Growth). The
constant              tug-of-war between the two camps is contributing
to                  market instability in the form of the massive value-growth
rotations we have experienced over the past several months.
We                    believe that investors have a third option, which avoids
having                  to make this false choice between “growth” and
“value”.                  A more holistic definition of intrinsic value should
produce                an acceptable framework for both factions. This
should        allow investors to incorporate        the intangibles that
drive                        growth in the present day, while still keeping an eye on
valuations.                By giving companies credit for their intangible
assets,            we believe investors can own high-quality,    modern
portfolios without abandoning the value paradigm.
12
Intangible Value | Jun 2021
Conclusion
Value                  investing has struggled over the past decade. We
believe                      this is due to its omission of intangibles, which are
becoming                the dominant form of value in the information
economy.                  We show that adding intangible value to the
traditional                definition of intrinsic value would have helped
value avoid its recent travails.
Intrinsic Value = Tangible Value + Intangible Value
Measuring        intangibles can be challenging.          Due to the many
limitations              of structured accounting data, investors must
seek                    out alternative data sources in their quest to quantify
intangibles.            Since these datasets are generally unstructured,
investors must equip themselves with modern NLP tools.
We                        believe value investing has a bright future if we can break
the                  style box orthodoxy and embrace a more modern
conception                      of value. We are fortunate that the digital age has
armed                      us with powerful new data and tools for this grand
adventure. Let’s get value investing back on track!
Kai Wu
Founder & CIO, Sparkline Capital LP
Kai              Wu is the founder and Chief Investment      Officer of
Sparkline        Capital, an investment management      firm applying
state-of-the-art              machine learning and computing to uncover
alpha in large, unstructured data sets.
Prior        to Sparkline, Kai co-founded    and co-managed
Kaleidoscope      Capital, a quantitative          hedge fund in Boston.
With            one other partner, he grew Kaleidoscope      to $350
million        in assets from institutional        investors. Kai jointly
managed                all aspects of the company, including technology,
investments, operations,          trading, investor relations, and
recruiting.
Previously,                      Kai worked at GMO, where he was a member of
Jeremy Grantham’s              $40 billion asset allocation team. He
also                  worked closely with the firm's equity and macro
investment                teams in Boston, San Francisco, London, and
Sydney.
Kai                  graduated from Harvard College Magna Cum Laude and
Phi Beta Kappa.
Disclaimer
This          paper is solely for informational              purposes and is not an offer
or                              solicitation for the purchase or sale of any security, nor is it to be
construed                    as legal or tax advice. References to securities and
strategies                    are for illustrative purposes only and do not constitute
buy      or sell recommendations.              The information in this report should
not be used as the basis for any investment decisions.  
We      make no representation                or warranty as to the accuracy or
completeness                  of the information contained in this report, including
third-party              data sources. This paper may contain forward-looking
statements    or projections              based on our current beliefs and
information                    believed to be reasonable at the time. However, such
statements                  necessarily involve risk and uncertainty and should not
be                      used as the basis for investment decisions. The views expressed
are as of the publication date and subject to change at any time.""