Thursday, June 9, 2011

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?