Tuesday, July 16, 2013

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
  1. Switching Costs – When a business creates high switching costs for its customers, it automatically creates a moat e.g. Banks, Credit Cards, etc.
  2. 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.
  3. 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.
  1. 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.
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                                  
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.

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

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. 

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