Biggest companies get bigger by investing in intangibles

There is abundant anecdotal evidence that software, intellectual property and new technologies have had a deep impact on business practice in recent years.

The management of retail inventory, pricing airline tickets, the supply chains of cellphone manufacturers, the development of drugs by pharmaceutical firms or the provision of mortgage credit to households have all undergone radical changes. 

However, the effect of these changes has been surprisingly difficult to detect in economic data. Productivity growth in the U.S. has been low, both relative to the 1990s decade and to the longer-run U.S. trend.

{mosads}One place where the economic data do seem to line up with the anecdotes is in the measures of investment in these new factors — software, intellectual property, business processes and branding, collectively known as “intangible capital.”

The most recent national estimates suggest that investment in these factors has in fact outpaced traditional investment in equipment and structures; it now represents 14 percent of value added, up from 8 percent in the early 1980s. Intangibles have become a central part of the capital stock of U.S. firms.

Our recent research shows that the growing importance of intangibles may have had widespread macroeconomic effects, even if it is not recognizable in productivity numbers.

We argue, in particular, that intangibles may be partly responsible for two important macroeconomic developments over the past decade: the persistent weakness in traditional investment and the rise in industry concentration. 

The ongoing weakness of traditional investment since the mid-2000s has been something of a puzzle, in particular given historically high corporate valuations. Estimates suggest that the shortfall of traditional investment rates, relative to valuations, could be as high as eight percentage points, or about half of their level in the 1980s and 1990s.  

But this “investment gap” may simply reflect the growing importance of intangibles. Our research shows that, in a world with intangibles, traditional measures of the value of physical capital (such as the ratio of market value of the firm to book value of its physical assets) will overstate its true value, and thus firms’ incentive to invest.

We estimate that this simple mechanism can explain 30 percent to 60 percent of the apparent shortfall of investment. 

The market structure of a number of U.S. industries has also been undergoing deep change. Recent research shows that concentration has risen in many sectors — the largest firms have become more dominant over time.

There is a lively and ongoing debate about whether this trend should be interpreted as a sign of rising market power or of growing productivity advantages of industry leaders.

Our work shows that in many industries, the increase in concentration has gone hand in hand with rising intangible investment. Not only that, but within industries, intangible investment tends to be concentrated among market leaders and to be associated with gains in market share.

Our view is that this connection is not happenstance. In fact, the special economic properties of intangible assets may have enabled the shift toward higher concentration. 

A key feature of intangible assets is that they can easily be copied and scaled up. Consider, as an example, Blue River Technology. Blue River is a small firm specializing in differentiating weeds from crops in the field by using optical recognition and machine learning.

It was purchased by John Deere for $300 million in 2017 despite having essentially no sales and few physical assets. The entirety of its capital lay in intangibles, associated with plant-identification algorithms, software and capabilities. Such intangible capital can be readily scaled up, across different product lines, boosting efficiency and future sales.

Such scale effects are common to many intangibles, and we find particularly strong evidence of their impact in the U.S. retail/consumer sector.

Walmart in the 1990s and Amazon in the 2000s likely achieved market dominance partially by developing inventory management and distribution processes — a form of capital that is largely intangible — and characterized by scale economies. 

At the same time, intangible assets can also help market leaders entrench their dominant position and strengthen market power. Some forms of intangibles, in particular intellectual property, are “excludable” in the sense that legal protections limit competitors’ ability to copy or replicate.

The sharpest example of exclusion is perhaps drug and device patents. The patent for Lipitor, owned by Pfizer, is estimated to have been the most valuable patent ever, generating revenues of over $100 billion over its life.

We find strong evidence that markups — the difference between revenue and variable operating costs and a traditional measure of market power — have increased substantially in the health-care sector, particularly so among firms with high stocks of intangible assets. 

One theme that emerges from our research is that no single story explains the many changes in market structure across the range of industries in the U.S., although intangible capital may have played a role in a large number of them.

This calls for looking into more detail at specific industries and documenting carefully how the growing importance intangible capital connects to changes in markets in those industries. 

The growing importance of intangible capital also poses potential challenges to monetary and other policymakers. We outline some in our research. Intangible capital tends to be shorter-lived than machinery and structures, so investment is likely to become less responsive to changes in interest rates.

This effect is exacerbated by the fact that intangible assets can seldom be used as collateral, which limits their role in backing credit available to firms. 

Better measurement and reporting of intangible investment would refine these implications and potentially help to support the development of both a richer understanding of and readier markets for intangibles. In this area, national accounting has been ahead of the financial information reported by the private sector.

The increasing importance of intangible investment and its role in a changing economy makes these changes more pressing now than ever. 

Janice Eberly is the James R. and Helen D. Russell professor of finance and faculty director of the Public-Private Initiative at the Kellogg School of Management at Northwestern University. Nicolas Crouzet is an associate professor of finance at the Kellogg School. Eberly and Crouzet presented their research at the most recent Jackson Hole Economic Policy Symposium.