Quarterly Report 4Q2020

Review

The markets continued to wear their rose-tinged glasses for the final stretch of the year. Equity prices far and broad tended to rise strongly, in many cases setting new record levels. On the other hand, many companies and people fight an unprecedented uphill battle. As diligent investors, we must make sense of, and try to reconcile, this apparent dichotomy. As always, we view it as our most important task to question the pockets of excitement in the market and focus on our core responsibility: the careful evaluation and cautious valuation of the securities we invest in.

Outlook, thoughts and issues

How we treat intangible assets in the valuation process

It lies in human nature to search for convincing explanatory arguments to rationalize currently observed behavior and phenomena. This is also true in the world of economics and finance. For example, one of the main justifications given by market commentators in support of the historically wide equity premium afforded to «growth» vs. «value» investing has to do with the financial treatment of intangible assets. Under intangibles, we commonly understand hard-to-assess corporate assets such as brands, patents & copyrights and software development. They may include even more subjective concepts such as network effects, the complexity of supply chains and distribution networks, the skills of employees and corporate culture. The argument basically makes the point that in today’s digital and virtual world, «growth» companies’ valuation is driven by highly lucrative, cash-generating intangibles. The opposite is assumed for «value» companies which tend to be priced based on their stodgy and costly tangibles. The argument hence concludes that the «new-economy», asset-light part will continue to rise in importance in relation to the «old-economy», asset-heavy area and that the valuation discrepancy is therefore warranted. The trend is then extrapolated far into the future as this cyberspace apparently grabs an ever more dominant share of total economic activity.

It won’t come as a surprise that we do not wholeheartedly endorse this view, for one chief reason. Intangible assets also connote « goodwill », which is widely open to interpretation both in terms of accounting treatment and common use. Basically, goodwill summarizes in a number all assets that in many instances cannot be readily measured and quantified. To be clear, we do not dispute in any way the potential existence of goodwill and appreciate that it can be worth a great deal, indeed. However, robust empirical evidence also shows that the premia paid in corporate takeover transactions, which must be accounted for as goodwill by the acquirer, regularly turn out to have been too generously calculated. This will then necessitate future write-offs in the form of goodwill impairment charges to its profit and loss statement. Thus, we are highly conservative in our own assessment of what a realistic goodwill number may be.

To be sure, many of our firms themselves possess exceptionally strong and readily identifiable intangibles, for example: ABB (software development); Bunge (distribution channels); Coca-Cola Bottlers Japan (patents and branding power); Ericsson (network effects); Mitsubishi Heavy Industries (complexity of supply chain); Vivendi (copyrights and licensing fees, especially those related to its subsidiary Universal Music Group). Nevertheless, our default approach is to apply a great degree of caution when it comes to capitalizing intangibles in our financial models. Concretely put, we rarely opt to capitalize intangible assets explicitly when valuing a firm.

We are convinced that our portfolio companies offer significant margins of safety even without directly incorporating intangible assets into our valuation process. If we did, evidently the calculated margin of safety would be even higher than what is already reflected in our base-case scenario. Hence, at least as applied to our particular investment program, the market’s rationale seems to be somewhat superfluous in that it cannot properly explain away the valuation discrepancy between growth and value.

Granted, the tangible asset base required to properly maintain public infrastructure has lacked pricing power for at least 13 years running. During this time, the two-punch strike of the subprime and peripheral country debt crisis followed by Covid-19 has kept governments around the globe busy rescuing the financial system, supporting the social safety net and ultimately keeping the consumer economy going. Nevertheless, one of the central tenets of our overall investment thesis is that the tangible means of production will come back to shine once the urgent efforts to repair and improve the world’s creaking physical foundation gradually gains traction. Our balanced takeaway in the debate between tangibles and intangibles is that neither should the former be under- nor the latter overestimated. The bottom line for us is that we steadfastly adhere to our time-proven independent valuation process as opposed to adopting sweeping novel theories favoring one investment style over another.

Sincerely,

Gregor Trachsel
Chief Investment Officer SG Value Partners AG