Intellectual Capital has the same connotation as Economic Moat

Economic Moat is a term that is very familiar to value investors worldwide. The legendary investor Warren Buffet is credited with having coined this term. Investopedia defines it to be the competitive advantage that one company has over other companies in the same industry. The wider the moat, the better it is for the company as it helps the company to keep the competition at bay. 

Stockopedia identifies 5 advantages that companies with wide moat hold over the competition:

1. Intangible Assets

a.    Brands – business identities that have a positive recall in the minds of consumers

b.    Patents – exclusive rights over a product/service granted by the government to the inventor for a limited period.

c.    Regulatory approvals – licenses granted to business by the government creating barriers to entry for others

2. Switching Costs – When a business creates high switching costs for its customers, it automatically creates a moat e.g. Banks, Credit Cards, etc.
3. Network Effects – When a business creates a product/service that is used by everybody else, the network effect of usage of that product/service creates a high switching cost and therefore a high moat for the business e.g. pdf format for document interchange developed by Adobe Inc.
4. Cost Advantages

a.    Cheaper Processes – Businesses that are able to do the same job using cheaper processes develop a cost advantage and hence a moat

b.    Location – Businesses that have a location advantage develop either a cost or a revenue advantage or both, and thereby develop a moat.

5. Greater Scale or Niche

a.    Distribution Networks – A business that can influence the distribution channel to give preference for selling its products has a natural moat over its competition.

b.    Manufacturing Scale – A business can develop a moat by using economies of production scale to derive cost advantages

c.    Niche Markets – A business can also develop a moat by targeting its products and services towards niche markets.

The concept of economic moat as described above is straightforward really. Businesses that have a wide economic moat can dictate the price they can charge their customers and thus generate greater profits. It is as simple as that. The difficulty arises when we try to identify companies having wide economic moats in practice. There is no known formula for a quantitative calculation of economic moat. Hence the determination of wide moat companies remains the exclusive domain of astute investors who have a lifetime of expertise in this area. And sometimes even they get it wrong. Is there any hope therefore for the rest of us?

Let us look at the advantages enjoyed by wide moat companies once again. It is obvious that every single advantage enjoyed by companies holding a wide moat as outlined above are intangible in nature. We should therefore be able to categorize these advantages into one of the three forms of Intellectual Capital – Human, Structural and Relational. Let us run through the list and attempt that -  

• Brands, patents and regulatory approvals are all part of the structural capital of the business.
• High switching costs are created because of the relationships that the business develops with the Customer and the quality of the service that it provides – this is therefore an aspect of the relational capital of the business.
• Network effects that result in high switching costs also falls in the same category – relational capital
• Cost Advantages due to cheaper processes or location advantage are part of the structural capital of the business
• An influence over the distribution channel is part of relational capital of the business
• Manufacturing scale is an aspect of the structural capital of the business
• And finally serving niche markets is another instance of relational capital of the business.

If we dig deeper, we are sure to find elements of Human Capital behind each of these capitals, since it is people ultimately that make Structural and Relational Capital work, but that is beside the point. The larger point that I want to make is that Economic moat as defined and understood by investors is nothing but a manifestation of the Intellectual Capital of the business. To confirm this correlation between Economic moat and Intellectual Capital, let us read the investors understanding of Intellectual Capital. Turning to Investopedia once again, we find that it defined there as follows:

The value of a company's employee knowledge, business training and any proprietary information that may provide the company with a competitive advantage. Intellectual capital is considered an asset, and can broadly be defined as the collection of all informational resources a company has at its disposal that can be used to drive profits, gain new customers, create new products, or otherwise improve the business.

The key point of this definition is that Intellectual Capital is an intangible asset that provides competitive advantage to the business that in turn can generate greater profits. Strikingly similar to the definition of economic moat, you will agree. The definition of these two terms establishes the qualitative correlation between them and it establishes my proposition that economic moat is a manifestation of the Intellectual Capital of the business. However to be sure, I wanted to establish a quantitative correlation as well. For this purpose, I turned to the icTracker, a web based tool that calculates and reports the Intellectual Capital of leading Indian and US businesses every quarter.

Two terms from icTracker are of particular relevance for this purpose – EVA and KB. EVA stands for Economic Value Added and is a registered trademark of Stern Stewart & Co. It denotes the money left over from the post tax net operating profit of the business after paying its cost of capital. KB stands for Knowledge Basis – a ratio of the Intellectual Capital to the total assets of the business. The ‘total assets’ of the business in icTracker is defined as the sum of the Intellectual Capital and Net Worth of the business i.e. the sum of the intangible assets and the assets on the books.  

According to the theory behind economic moat, companies with wide moat have a competitive advantage which results in greater profits. This is the equivalent of saying that companies with high amount of Intellectual Capital – higher at least than the assets listed on its books - will generate a positive EVA. In order to compare the Intellectual Capital of business of different sizes, we do not use the absolute value of Intellectual Capital (calculated by icTracker) itself. Rather we use the ratio KB which as has been said earlier is the proportion of intangible assets of the business to all of its assets. KB simply makes the Intellectual Capital of all businesses comparable. With these definitions in place we can now compare all companies in the icTracker database along two dimensions. Along the rows, we will count the number of companies that have a positive EVA or a negative EVA. Along the columns, we will count the number of companies that have a KB greater than 0.5 (indicating more intangible assets than traditional assets) or less than 0.5. The following table shows the number of Indian companies split along these two dimensions for the quarter ended March 2013.

INDIA	KB < 0.5	KB > 0.5
EVA < 0	131 (40%)	50 (16%)
EVA > 0	17 (5%)	126 (39%)

There were 324 Indian companies in the icTracker database at the end of March 2013. Note that 126 of the 324 companies that have a KB greater than 0.5 are generating a positive EVA. Correspondingly, 131 of the 324 companies that have a KB less than 0.5 are generating a negative EVA. Therefore added together 79% of the Indian companies seem to be following the economic moat theory for the March 2013 quarter.

We also have two exceptions though –

• 50 of the 324 companies have a KB greater than 0.5 but are still generating a negative EVA. In other words, these companies have a high amount of Intellectual Capital but are unable to translate that into economic profits. The possible reasons for this could either be excessive capital employed by these businesses or a higher cost of capital.
• We also have 17 companies that are generating a positive EVA despite having a KB less than 0.5. It means that these companies are generating economic profits despite having lower Intellectual Capital. One possible explanation for the performance of these companies could be seasonal or temporary demand.

Nonetheless, companies in these two categories are exceptions to the economic moat theory.

Next I extracted the same data for the quarter ended March 2013 for US companies, which I have summarized in the table below                                  

USA	KB < 0.5	KB > 0.5
EVA < 0	30 (21%)	23 (15%)
EVA > 0	12 (7%)	86 (57%)

There were 151 companies in the icTracker database as of March 2013. From this data we can see once again that 78% of the total 151 companies in the database follow the economic moat theory, whereas the remaining 22% fell in the category of exceptions.

The icTracker database calculates the Intellectual Capital of all leading companies in India and in the USA every quarter from March 2005 onwards. It therefore has data for every quarter for every company that it tracks for the past eight years. That is 32 quarters of rich data! Therefore I went one step further in my analysis and pulled out similar data for each quarter since March 2005, organized it along the two dimensions as above separately for Indian and US companies and then summed up the totals. My idea was to establish that my proposition holds true not only for a single quarter but also over the long term. The results are shown below for both India and the USA.

India	KB < 0.5	KB > 0.5
EVA < 0	2763 (29%)	1748 (18%)
EVA > 0	530 (6%)	4435 (47%)

USA	KB < 0.5	KB > 0.5
EVA < 0	827 (17%)	796 (16%)
EVA > 0	410 (8%)	2792 (58%)

Over the long term, we can see that 76% (47 + 29) of Indian companies and 75% (58 + 17) of American companies follow the economic moat theory.

These results lead me to the conclusion that economic moat is nothing but a manifestation of the Intellectual Capital of the business. This is not to say that businesses without Intellectual Capital cannot have economic moat – clearly that is possible as we have seen in the exceptions. We also have some cases where businesses with high Intellectual Capital are not able to generate economic profits. However, the numbers of companies in these two categories are clearly a minority. When more than 75% of the most highly traded and publicly listed companies in two different and far apart geographies such as India and the USA are shown to be conforming to the economic moat theory, we have to conclude that Intellectual Capital has the same connotation as Economic Moat. In other words they mean one and the same thing. 

Using IC to beat the Nifty hands down

IC practitioners the world over have produced tomes of literature in the past two decades to prove the value of Intellectual Capital in the modern Knowledge economy. There is not an iota of doubt about the importance of Intellectual Capital within the worldwide IC community. Countless modern Management Gurus - including Robert S Kaplan and David P Norton, inventors of the highly popular Balanced Scorecard and Strategy Map – and other thought leaders of our times have waxed eloquent about how it is the intangible assets in an enterprise that provide lasting value and competitive advantage to the business. They have even conceptualized and published many different frameworks for discovering, measuring and managing the IC of firms.

But what about the average man on the street? Does he understand the concept of IC as easily as he understands accounting concepts such as a Balance Sheets and Income statements? What about the average investor? Does he bother at all to investigate the quantum of intangible assets within the business before making his investment decision? The answer to my mind is an emphatic NO. For all the volumes of literature produced by the IC community over the last twenty five years, the common man remains blissfully ignorant about the role of IC as a critical value driver of the modern knowledge economy. However, whenever I have ventured personally to explain the relevance and importance of IC to the average man directly, I have found ready and immediate acceptance of the concept by him or by her each and every single time. This leads me to believe that the common man is perhaps not ignorant about IC, he is just constrained. He is compelled to ignore IC because he just does not have any source that dispenses IC information to him readily. This compulsion on his part results in a lack of demand for IC related information and consequently business leaders are only too happy to not provide the supply. We are therefore left in a cycle of deadlock where there is no demand for IC because there is no supply of IC related information and there is no supply of such information just because there isn’t any demand. This cycle needs to be broken before IC can become relevant and topical in the business context. But how?

In my own small way, I have attempted to do this by enabling investors to inspect the Intellectual Capital of the 50 top Indian businesses (Nifty stocks) every quarter. This is still a proof of concept application at the moment and I call it the icTracker. The icTracker enables the investor to ask three simple and fundamental questions of every firm in the Nifty list.

Question 1: Is the business making money?
This is the most fundamental question that any investor wants to ask. Nobody wants to invest in a loss making proposition, however the fact remains that accounting profits as published by firms in their income statements do not correctly reflect whether the business is making money. What we really want to know as an investor is whether the business is making economic profits. In other words, are accounting profits enough to cover the cost of capital and then some? We use an IC concept known as the EVA (Economic Value Added) for this purpose. EVA was popularized by Stern Stewart & Co in the early nineties. Many businesses worldwide took to this concept like fish to water, believing that this was one of the fundamental measures of success for any business. To us, it is only the first step but a very important step. We want to pick businesses that consistently have a positive and hopefully increasing EVA. In case we find that EVA is negative during some time periods, we need to probe whether it is due to genuine reasons such as large capital expenditures incurred for driving future growth. But to keep it simple, always look for consistently positive EVA.

Question 2: Do knowledge assets dominate the business?
If the answer to Question 1 is YES we move on to Question 2, where we ask whether knowledge assets are the dominating assets in the business. In other words, we want to ensure that we stay from investing in businesses that are dominated by physical or financial assets. Why? Just because we want to invest in businesses that have a high degree of competitive advantage. It has been proved repeatedly that competitive advantage is derived from Knowledge assets rather than physical or financial assets. Investing gurus such as Warren Buffet have gone to the extent of coining their own word for such advantage – moat. Buffet likes to invest in businesses that have a high degree of economic moat. And we should too. In the IC world, measuring Knowledge Basis – the ratio of the Intellectual Capital to the Total Value of the firm – gives us an idea in percentage terms whether knowledge assets dominate the business. Here we should look for a ratio of more than 50% consistently over a period of time, which indicates that the business has a high degree of competitive advantage and is also able to maintain the same over the said period of time.

Question 3: Is the stock undervalued?
If we got this far, then clearly we have been able to identify a business which consistently makes money and has a consistently high proportion of knowledge assets. With these two simple questions we have been able to zero in on an attractive investment proposition. All that is left to ask now is whether the timing is right for making the investment. For this we check whether the stock is undervalued. How? The Intellectual Capital of the business is already computed based on the published results. The Book Assets are also available from the published Balance Sheet. Add both of them up and divide by the number of shares to get the intrinsic value of the stock. Compare this to the market price which is also available and we know instantly whether the stock is undervalued and hence a right time for investing.

That’s it. In just three easy steps that all leverage concepts from the field of Intellectual Capital, we have been able to identify a good investment for the long term. How powerful is that? I would have to say extremely powerful but perhaps it is powerful because it is extremely simple. icTracker answers the above three questions for all Nifty stocks graphically by showing the performance of the stock over the last three years. This makes the analysis even simpler – even a guided teenager can make good investment picks using this tool. But does it work in the real world? I wanted to find out myself. So I did a hypothetical calculation. I found that if I had invested Rs 1 million in the Nifty five years ago on 1 April 2006, that amount would have grown to Rs 1.714 million five years later on 31 Mar 2011. The same Rs 1 million invested in the top 5 recommendations from the icTracker on the same date would however have grown to an amazing value of Rs 5.747 million five years later. That is a return in excess of 3.35 over the Nifty! This is of course assuming that I would use the icTracker every quarter to re-balance my portfolio.

That in short is called using the power of Intellectual Capital to beat the Nifty hands down! Have I interested you sufficiently in the power of Intellectual Capital now?

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.

Intellectual Capital – What’s in it for me?

“What’s in it for me?” IC practitioners, the world over, have probably heard this question more often than not. Answering it, I am quite sure, is not so easy since the answer fluctuates greatly depending on both the background of the person asking the question and his or her specific interest in the field of Intellectual Capital. Nonetheless, let me take a stab at answering this question as generically as possible, using illustrations along the way to convey a larger point.

Intellectual Capital, we know, is a set of intangibles that coalesce to give an individual or a firm a distinct competitive advantage in the marketplace. Want to see the proof? Ask yourself why you prefer to drive an extra mile to do your weekly grocery shopping at a store which looks much cleaner, is well lighted, has spacious aisles, offers free parking and always has all your items in stock. Wait, don’t bother - the answer is in the question itself. However did you ever stop to wonder whether the factors that made you go out of your way and ‘prefer’ a specific grocery store were purely a matter of chance or could it be that someone deliberately crafted these things just to attract and retain demanding customers such as yourself? Intellectual Capital, like most other good things in life, does not happen on its own – it has to be made to happen. The promoters of the grocery store you prefer probably surveyed customers like you on the various factors that would attract you to their store week after week, on the items that are most consumed by you, on the type of store layout you prefer, etc. before even putting a business plan together. The success of that plan was ensured from day one because by responding to the survey, you ensured that the grocery shop owner could fabricate a store that had a competitive advantage and by visiting it regularly you ensure that he can perennially raid your wallet every single week!

Still need more proof? Let me ask you – have you ever changed your dentist, your insurance agent, your tax advisor, your stock broker, your travel agent or even your barber? If you answered yes to any of these, just think of the reason for the change. Was it because the service that you were receiving had become routine? Was there a lack of personal touch? Were you getting herded in along with others? Were you missing individual attention? All in all, was that extra something missing in the service? Yes? You bet. That extra something is called ‘value-add’ in management jargon. Value addition happens when your service professional goes beyond the boundaries of performing the routine transaction and does something exclusively for you. For instance, your dentist could offer you an annual free check-up, your insurance agent could review your existing cover and suggest changes to suit your lifestyle, your stock broker could offer buying and selling tips and your barber could just subscribe to that latest fashion magazine that you could read while you are waiting your turn. Come to think of it, these value additions do not cost much – in most cases they are offered free – but they are the difference between why you stick with your current service professional or decide to take your business elsewhere. These value additions are a part of the Intellectual Capital of the Service Professional and they can literally be the difference between bloom and gloom (not to mention doom) for him or her.

Are you starting to get the point? Intellectual Capital may sound a mouthful, but it is present everywhere if you only care to see. In today’s knowledge era, it has come to be the difference between growth and stagnancy, between prosperity and paucity, between success and failure and even between survival and extinction. The days of plain old order taking are over. Insurance agents, travel agents, stock brokers and other professionals made money hand over fist in the last few decades only because they were in the agency business. If you needed an air ticket you had to buy it through your travel agent. If you needed to invest in stocks you had to talk to a stock broker. Likewise, if you needed an insurance policy you had to solicit an insurance agent. Order taking is best done by computers in the Information era. Computers are far cheaper than humans, can work 24 hrs a day, do not get tired, do not need supervision or food and do not make mistakes. All forms of agency businesses have already been replaced by Internet portals that are housed in giant data centers running multiple computers in redundant fashion. Those agencies that have not yet been hit with this reality are only counting their last days.

So how does this affect me, you say? I am a manager inside a big firm and am therefore insulated from all this change. Do you believe so? Nothing could be further from the truth. What is true for self employed professionals and businesses is true for corporate professionals as well. Look closely at what your job function is, once again. Is your department providing HR support services? Are you the training manager in your firm? Or are you a line manager in charge of production scheduling? Are you? Then you have reason to worry. Know this. HR support services are being increasingly provided by self supporting HR portals from vendors such as SAP and Oracle. Training, or more importantly learning, is increasingly assuming the form of CBT (Computer Based Training) that is delivered to the trainee on his computer in a digital format at the time of his choice. And production schedules in manufacturing shops are being increasingly generated by ERP (Enterprise Resource Planning) software installed in-house. In short then, is your job function one step closer to being taken over by a computer? Is it a candidate for automation? If it is possible, it will happen. Obtaining competitive advantage through ruthless cost cutting is one of the most common outcomes of the Information era and it is bound to affect you as well. The only question is when.

What then should I do, you ask? The answer is strikingly simple too. Have you seen that poster of man rising from the posture of an ape many eons ago first to stand erect on his own two feet, then to walk, run and then use his hands for making tools for hunting? You couldn’t have missed it. That picture just got updated with an additional image towards the end – man using his brain. And that is what you need to do. I know by now, that you need proof. This time proof is easier. The Information era rewards those who use their brains much more than those who use their hands. I am not referring to the class distinction between white collar and blue collar workers here, although that would have been sufficient to make my point. But I ask you instead to follow the money trail. Tell me, which are some of the best paid professions? Go ahead name a few. Here, let me help you out. Investment Bankers, Surgeons, Fashion Designers and Lawyers who are at the top of their field are still people who are making money by the fistful. I am sure you wouldn’t grudge a New York lawyer his hourly rate of $400 – he is worth it you say. Similarly you wouldn’t stoop to bargain the price of a Louis Vuitton handbag would you? The name itself is worth more you say. Or would you negotiate the fees of the heart surgeon who is scheduled to perform a bypass surgery on your spouse next week? Definitely not, right? Well then ask yourself, why you would be willing to pay exorbitant sums to these people? The answer is because they have spent their lifetime in gathering specific knowledge and know how it can be used for your benefit. That is their Intellectual Capital. They are specialists. The Information era punishes generalists by replacing them with computers and rewards specialists with fame and fortune. The message is clear now - develop your own Intellectual Capital and become a specialist.

Intellectual Capital v/s Intellectual Property – What’s the difference?

One question frequently pops up during my presentations and discussions on Intellectual Capital with industry captains – “Aren’t you referring to Intellectual Property?” My answer is always an emphatic NO followed by a brief explanation of the difference between the two. Soon however, the multiple recurrence of this question prompted me to apply my mind to answering this question more definitively. So here goes.

I start first with the dictionary meaning (Webster’s) of the three words:


Intellectual – showing a notable mental capacity; guided or developed by relying on the Intellect.


Capital – an advantage or asset


Property – something owned; right of possession

Next, I extrapolate the above definitions to infer the meaning of the two phrases on hand as follows:


Intellectual Capital – An advantage or asset that is developed from the use of notable mental capacity.


Intellectual Property – A right or possession that is developed from the use of notable mental capacity.

This is as far as we can get using the dictionary. But the difference between the two phrases is already starting to emerge. While both IC and IP are developed from the use of intellect or mental capacity, IP has explicit ownership rights associated with it whereas IC does not. This is not to say that IC cannot be owned. It just cannot be owned explicitly, meaning to say that unlike IP which can be patented explicitly, IC does not usually have a legal title of ownership attached to it. This is the essential difference between the two. However by no means is this all. There are many more differences lurking underneath this academic perspective of the two phrases, of which I enumerate seven differences below in no particular order:

1. IP can be legally protected – Most countries around the world have patent protection laws that enable individuals and firms to register and patent their intellectual property – most notably their inventions and innovations. Patent protection laws are mainly responsible for the decision of firms to invest in R&D activities in industries that thrive on the output from continuous research - such as Pharmaceuticals and Biotechnology. IC on the other hand resides within the confines of the firm’s boundaries and needs to be protected where necessary using any combination of secrecy, discipline, procedure, agreements, contracts, etc.


2. IC is more intangible than IP – At the time of patenting an IP, the owner has to make a full disclosure of the property by including relevant drawings,  descriptions, prototypes, etc. that clearly explain the functioning of the intellectual property. This makes the IP somewhat tangible, since even if the IP in question is a process, it can be visualized and understood clearly from the documents available in the patent file. IC on the other hand is much more intangible and moreover it usually has no accompanying documentation. For example if the IC of an auto ancillary firm is to produce world class spark plugs, then such IC is perhaps the outcome of a judicious combination of stringent procurement standards, quality controlled manufacturing processes, automated testing systems, continuous skill enhancement of workers, empowerment on the assembly line, a wholesome rewards and recognition policy and a brand that has been nurtured and built over the years. Each of these intangibles may be resident in and owned by different departments within the firm, but it is only when all of them come together in the right combination that IC, and hence competitive advantage, accrues to the firm.


3. IC is a process, IP is an event – The question that arises from the foregoing paragraph is “Surely with a little additional effort, IC can be converted into IP?” After all there are many benefits to be had from the advantage of legal protection. This is easier said than done. This is because IP is the outcome of a research project which is outcome based – meaning the research process leads to a definite invention or innovation which can be patented. Once patented, the IP becomes static. IC on the other hand is highly dynamic. In the example that we have seen previously, the auto ancillary firm may have  to continuously invest in brand building, scour suppliers for lighter and longer lasting raw materials, investigate newer and more effective training methods, ensure industry leading rewards program, etc. to sustain its IC and competitive advantage in the marketplace. Thus unlike IP, IC to my mind is a continuous improvement process.


4. IP can be traded – This property arises from the fact that IP has an associated ownership title. Therefore, like other tangible assets, it can be traded, rented, leased, bought, sold, sub-let and loaned for financial consideration. IC on the other hand, is relevant only within the context of the firm that has developed the IC and hence it cannot be traded like IP in the same way.


5. IP has a life – This is one of the key differences between the two. All patents have a life depending on the type of the patent. For instance in India, patents for food, drugs and insecticides have a life of 7 years and all other patents have a life of 14 years. The patent expires at the end of its life, at which point the Intellectual Property becomes public property, available for the general benefit of mankind. IC on the other hand does not have a finite life. For instance, the formulation used in making the popular Coca Cola drink is knowledge that is confined within the company for more than hundred years now. The secret formulation and its use is Intellectual Capital that is a closely guarded secret and that has provided the Coca Cola Company with a sustained competitive advantage. Had the company chosen to patent the formulation instead, the secret would have been out in the open by now and the process of making Coca Cola would not have been so mysterious anymore! Correspondingly Coca Cola would not have been such a desirable brand anymore.


6. IP does not necessarily provide Competitive Advantage – This difference is very important. IP protection laws ensure that the returns from the investments made in developing the IP accrue solely to the owner of the IP and not to unscrupulous overnight raiders. This does not necessarily mean that IP leads to a competitive advantage. In fact, just the opposite may be true. Remember the clash between Matsushita’s open VHS format and Sony’s proprietary Betamax format in the nineties. Even though Betamax had better technology, Matsushita obtained the competitive advantage by licensing VHS technology openly and inexpensively to its competitors thus driving Betamax out of the market.


7. And finally, IC is a superset of IP – Even in the case where firms invest in and patent their IP, they still have to do many other activities to successfully market the IP. Some of these include material management, production planning and control, quality control. Safety, Branding, Promotions, Advertising, Dealer development, etc. Each of this activity is perhaps an island of Intellectual Capital within the individual department. When done consistently and in a coordinated manner, the islands join together and appear to give the IP an image which is larger than life, leading to its successful marketing. But therein lies to my mind the biggest difference between these two – IC is a superset of IP. In other words, a firm may be able to obtain competitive advantage without IP, but it cannot obtain competitive advantage without IC

An asset that appreciates with time

We live in very interesting times. The economic transformations that are changing the fundamental s of our social behavior and the very fabric of our life are tremendous. For instance, email was unknown in the corporate world prior to 1990. Today in a span of just under 20 years email has become so pervasive that, most if not all, businesses would be unable to function efficiently without email communications. Mobile phones were largely unknown prior to 1994. Today, in a span of 15 years the mobile phone has become so ubiquitous that it has rapidly shed its image of a luxury item and now become a necessity. In the Indian context, ATM banking was largely unknown in the country prior to 2000. Today in a span of just 10 years ATMS have proliferated so fast and so much that some banks have actually started limiting the number of teller assisted cash withdrawals that customers can make each month.
Economic change is not only happening, it is happening more and more rapidly. Consider this. Until the 1800s, farming was the main occupation of people. The primary requirement for farming is land - the more the better. Unfortunately, the land that we have inherited is not only limited but with time the increasing population has only hastened to increase the per capita demand on it. In the 19th and 20th centuries the focus shifted from farming to manufacturing, driven to a large extent by the industrial revolution. The spotlight during this time was on increasing productivity, using machines in place of human labor. Machines had a huge advantage over humans – they could work faster, they produced output of consistent quality, they did not get tired and they could work all three shifts if needed. During these two centuries machines came to dominate our lives like never before – their acceptance eased by their promise of freeing us from drudgery and making more free time available for our creative use. While machines changed our lives forever during the industrial era, it took many centuries for the focus to shift from farming to manufacturing.
Yet the next change happened within the next 200 years, when we crossed over from the industrial era into the knowledge era. Today machines are no longer a source of competitive advantage. If I can buy a machine so can the competition. The increased productivity that both of us have is not enough of an advantage anymore. To sell our goods, we both need to add value. There are various ways of adding value – but all of them require leveraging the intellectual capital of the organization to provide a product or a service that is superior to what the competition can provide. This in turn requires the systematic management of Intellectual Capital, since that is the very source of competitive advantage in the knowledge era. In fact, unlike physical assets like machines and land which get depreciated over time and financial assets which get depleted with time, intellectual capital is the only asset that appreciates with time. Doesn’t this sound a bit like having your cake and eating it too? Yet it is true. Very few businesses have realized this truth since we are still in the formative years of the knowledge era. But those that have will surely survive and even thrive in this era and survive into the next.