How Knowledge Investments Translate Into Superior Profitability

Regular readers are by now well versed in our belief that companies that invest in more knowledge assets, or intangible assets, than their peers leads to a sustainable competitive advantage that manifests itself in superior margins and profitability. We call these knowledge intensive companies Knowledge Leaders. For those that are not as familiar, please check out our three part series for the academic foundation and the real-time application of the Knowledge Effect. One of the most important takeaways of the academic literature on knowledge investments is that research shows that knowledge intensive companies end up having higher “future market share, future sales growth and future return on assets” than their less knowledge intensive peers (Lev, 2005). In today’s post, we thought we would show illustrate to our readers the statistical differences between Knowledge Leaders and Knowledge Followers. As always, the data we are using is intangibly-adjusted, in USD and we are looking at all mid and large cap companies in the developed world.

Let’s begin with the most basic assumption that Knowledge Leaders invest more in intangible assets than Knowledge Followers. Investments in intangible assets fall into two broad categories: research and development (R&D) and firm specific resources. Firm specific resources is a catch-all for other intangible investments such as advertising, brand building, employee training, and codified information. The median Knowledge Leader invests 2.7% of its sales in R&D  compared to the median Knowledge Follower which invests just 0.06% of its sales in R&D. The median Knowledge Leader invests 6.9% of its sales in firm specific resources compared to the median Knowledge Follower which invests 2.3% of its sales in firm specific resources. Overall, Knowledge Leaders spend about 4x more on intangible investments than Knowledge Followers. This leads to the median Knowledge Leader having over 7x more intellectual property assets on its balance sheet than the median Knowledge Follower. The median Knowledge Leader has over 15% of its assets in long-term intellectual property.

 

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Because investing in knowledge investments creates a unique capital stock, Knowledge Leaders are able command greater profit margins. For those that are familiar with Warren Buffet’s “moat’ concept, a unique capital stock helps to create the moat for a company to maintain its competitive advantages.  The median Knowledge Leader has a gross margin of 41.6% while the median Knowledge Follower has a gross margin of just 24.2%. Knowledge Leaders have higher gross margins in nine out of ten sectors.

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Under the archaic accounting rule SFAS #2, knowledge investments must be immediately expensed in the period they occur. This creates a massive distortion on company financial statements as investors have limited information on the innovative activities corporations are undertaking. Because this conservative accounting rule is in place, conservative institutions like banks will not loan money for knowledge investments since there isn’t any physical capital attached to the investment. This leads to a situation where knowledge investments are almost always entirely equity finance and consequently, the balance sheet of Knowledge Leaders is much more liquid and less levered than Knowledge Followers. Knowledge leaders have more cash and less debt as a % of total capital than Knowledge Followers.

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The good news is that Knowledge Leaders are not sacrificing return by having a more liquid, less levered balance sheet either. In fact, the median Knowledge Leader has superior return on assets (ROA), return on equity (ROE) and return on invested capital (ROIC).  If we break out Knowledge Leaders by sector its very apparent that this profitability superiority is wide and broad based.

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All in all, the unique capital stock created by knowledge investments enables Knowledge Leaders to command higher margins, keep a more flexible balance sheet, and derive greater profitability than their less knowledge intensive peers.