Friday, May 6, 2011

Taking IC to the mainstream

The subject of Intellectual Capital has existed for over 20 years now. The Swedish Konrad group was the first to recognize the contribution of intangible assets to the performance of a firm, way back in 1989. Based on their findings they proposed a list of 35 indicators, including indicators on Human resources and structural assets of the firm, which should be reported externally by the firm to its stakeholders. This was followed in 1996 by a more exhaustive and prescriptive approach by Brooking. She recommended that every firm should audit all of their intangible assets, the goal being to put a financial value to every such asset. The Intellectual Capital Audit was formulated for this purpose containing 30 ways to audit various types of intangibles using 158 questions ranging on a variety of issues. Many other prescriptive approaches for measuring Intellectual Capital followed, including the Intangible Asset Monitor by Sveiby in 1997, The Intellectual Capital Index by Roos & Edvinsson also in 1997, the IC Navigator by Thomas Stewart in1999, the Value chain scoreboard by Baruch Lev in 2001 and the Intellectual Capital Dynamic Value by Professor Bounfour in 2002. The growing significance of Intellectual Capital’s role in the new economy even saw the Governments of countries such as UK, Austria, Sweden, Iceland, Denmark, Germany, UK, Japan, Australia etc. develop and publish country specific guidelines on how to report Intellectual Capital. The Austrian government even went so far as to make such reporting mandatory for universities – the crucibles of higher education and learning in the country.

But for all the effort that has been put in by experts and Governments to bring Intellectual Capital into the mainstream, it unfortunately has remained on the sidelines, confined largely to the academic domain. The business world has failed to make the management of Intellectual Capital as one of its primary focus areas, despite overwhelming evidence of the benefits of doing so. For instance in India, considered the second largest Knowledge economy in the world after the US, only one large-cap company takes the trouble of publishing an Intellectual Capital Report in its Annual Report. A few others who started similar initiatives a few years ago have quietly shut those down for reasons best known to them. What could be the reason for such apathy towards Intellectual Capital by the mainstream business community?

In the preface to his ground breaking book “Intellectual Capital”, Thomas Stewart dismisses the possibility that the idea of Intellectual Capital will become a fad like re-engineering because he argues “there is nothing to sell”. Good ideas like Intellectual Capital however, get accepted in the mainstream not merely because they are good as an idea but because they have a commercial benefit. Stewart realizes the folly of his own argument quickly and goes on to recount with striking detail in the rest of the book how Intellectual Capital is a pot of gold waiting to be tapped. He suggests that IC practitioners have an obligation to reconcile the theoretical and practical sides of Intellectual Capital by
1. Devising a knowledge management toolkit that makes and saves money
2. Designing efficient methods for identifying knowledge assets in the organization
3. Proposing methods for the governance of organizations whose main assets are intangible
4. Developing practical methods of valuing intellectual assets of the organization
This was way back in 1998. Thirteen years have passed since Stewart published his ground breaking ideas but the situation has changed little since then. Knowledge Management did assume center stage for a while in the late nineties and early 2000s, but quickly fizzled out thereafter. Perhaps the application of Intellectual Capital got too tilted towards Knowledge Management when it came to the mainstream. Many a firm tried building gigabyte sized databases for capturing and encapsulating their knowledge, only to find out it was an effort in vain. They quickly discovered that knowledge is ephemeral, its usefulness highly dependent on the context of the situation in which it is applied. Such application requires real human intelligence which cannot ever be replaced by the artificial intelligence that they tried encapsulating in their databases.

I got attracted to the field of Intellectual Capital about four years ago. From the very beginning I wanted to address the question of how to commercialize the concept of Intellectual Capital, because then and only then would the concept find widespread mainstream acceptance. With this background, I deliberately focused on the fourth suggestion made by Stewart – valuing Intellectual Assets. I reasoned that if I could devise a reasonably accurate method of valuing the Intellectual Capital of a firm at a point in time, this information could be used by potential investors for their benefit. And the more the investors benefited, more would be the acceptance of the concept. The ICTracker product was born out of this thinking. At the present time, ICTracker calculates the Intellectual Capital of the top 50 listed Indian firms once every quarter. The Intellectual Capital thus calculated is added to the published Networth of the firm to get the total firm value, which is then compared against the prevailing Market cap to make an assessment of whether the firm is over valued or under valued. The algorithm used for calculating the Intellectual Capital of the firm is based on the Intangibles Scoreboard methodology by Gu and Lev (2002). The basic approach advocated by them has been modified by me to take care of troublesome real life concepts such as minority interest, goodwill, accounting intangibles, risk premium, liquidity premium, preferred capital, employee stock options, etc. These modifications result in an output that can be practically used by investors to beat the broader market index itself. Calculations made by me show that over a period of five years from Jan 2006 to Dec 2010, predictions from the ICTracker would have resulted in a gain in excess of 43% over the Sensex and the Nifty indexes.

More importantly, I have been able to simplify the process of stock picking using the concept of Intellectual Capital into three easy steps. The first step is to check whether the firm is making money - not profits but cash. We use EVA for this purpose, which calculates the excess money the firm has leftover after paying its cost of capital. So to begin with we look for firms that are making money every quarter. Secondly, we look for the knowledge content of the firm – is that excess money coming from tangible assets or intangible assets? In general, we prefer firms that are making money from intangible assets since they have a competitive advantage in the marketplace that is hard to replicate. For this we look at the Knowledge Basis of the firm – the ratio of the firms Intellectual Capital to its total worth. We want to pick firms with a high Knowledge Basis compared to the rest of the firms in the industry. Having selected firms that are making money and that have a high Knowledge basis, the final step is to look at whether the firm is undervalued. That is the signal to make an investment in the stock, since investors will always want to buy low and sell high. That’s it. That is how simple I want the practical application of Intellectual Capital to be. As I said earlier, the product is limited to the top 50 Indian stocks at the present time but I am making efforts to include all Indian stocks in the future. If I get there, I will then focus on stocks in other Knowledge markets. Meanwhile, I invite you to comment on what else can be done by IC practitioners to increase the widespread adoption of Intellectual Capital and bring it to the mainstream.

1 comment:

Mary Adams said...

Great discussion Abhijit! I learned a few things about the history and totally agree with you about the current need for a practitioner conversation. I hope this can be a preface to our IC Practitioners inaugural call on June 14.

Please RSVP if you can come. We will be announcing internet "call-in" info soon.