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. 

A proxy indicator for the Intellectual Capital of nations

I recently came across the book “Intellectual Capital of Nations” by Prof. Leif Edvinsson and Prof. Carol Yeh-Yun Lin and their associated research paper titled “National Intellectual Capital: comparison of the Nordic countries” which I downloaded from www.corporatelongitude.com. Both the research paper and the book present a comparative study by the authors on the Intellectual Capital of 40 leading nations in the world. Based on the outcomes of their study, the authors arrived at the conclusion that the Nordic region consisting of the five countries of Denmark, Finland, Iceland, Norway and Sweden has the most Intellectual Capital per capital among any other region in the world, which includes amongst others industrialized regions such as North America and Western Europe and regions of the emerging economies such as Brazil, Russia, India and China.

A comparative study of the Intellectual Capital of Nations, even though limited to only 40 countries in this study, is no doubt very useful. It provides a macro level view of how countries are managing their intangible assets compared to one another. This information can be gainfully used by multiple target audiences such as Multi National Corporations, Global Investment Funds, Private Equity and Hedge Funds, Multi lateral lending agencies such as IMF and World Bank, and many other institutions for a variety of purposes, such as for making investment decisions. In an increasingly globalized world this information can be also used to determine which countries have a relative competitive advantage over other countries. Hence the question naturally arises, how did the authors go about making this interesting comparison?

As the authors describe in their paper, they first deliberated on the dimensions for representing the Intellectual Capital of countries and finalized four dimensions viz. Human Capital, Market Capital, Process Capital and Renewal Capital. Next, using a two step filtering process, they then identified seven indicators for each of these types of Capital as follows:

Human Capital	Market Capital	Process Capital	Renewal Capital
Skilled labor	Corporate Tax	Business competition environment	Business R&D spending
Employee training	Cross-border venture	Government efficiency	Basic research
Literacy rate	Culture openness	Intellectual Property Right protection	R&D spending/GDP
Higher education enrollment	Globalization	Capital availability	R&D researchers
Pupil-teacher ratio	Transparency	Computers in use per capita	Cooperation between universities and enterprises
Internet subscribers	Image of country	Convenience of establishing new firms	Scientific articles
Public expenditure on education	Exports and Imports of services	Mobile phone subscribers	Patents per capita

Thereafter the authors collected (perhaps painstakingly) data for these indicators for each of the 40 countries for a period of 12 years from 1994 until 2005 from the OECD database and the World Competitiveness Yearbook. Next they normalized the data where required and added one more dimension for Financial Capital to the existing four, represented by a normalized form of GDP per capita. They finally aggregated and tabulated their findings, a summary of which is presented below:

No	Country	IC Score	IC rank	IC+FC Score	IC+FC rank
1	Finland	29.47	1	39.03	1
2	Sweden	29.25	2	38.88	2
3	Switzerland	28.46	3	38.24	3
4	Denmark	28	4	37.69	4
5	United States	27.64	5	37.52	5
6	Singapore	26.8	6	36.65	6
7	Iceland	26.13	7	35.8	7
8	Netherlands	25.84	8	35.57	8
9	Canada	25.56	9	35.27	10
10	Norway	25.45	10	35.45	9
11	Australia	24.69	11	34.34	11
12	Austria	24.26	12	33.96	12
13	Japan	24.13	13	33.73	14
14	Ireland	24.08	14	33.78	13
15	Germany	23.86	15	33.48	15
16	Belgium	23.32	16	32.96	16
17	Taiwan	23.17	17	32.55	17
18	New Zealand	22.83	18	32.19	18
19	United Kingdom	22.5	19	32.11	19
20	France	21.64	20	31.24	20
21	South Korea	20.04	21	29.28	21
22	Malaysia	19.15	22	27.81	25
23	Hungary	19.06	23	28	23
24	Spain	19.03	24	28.5	22
25	Italy	18.36	25	27.9	24
26	Chile	18.27	26	26.97	28
27	Portugal	18.06	27	27.28	26
28	Czech Republic	17.98	28	27.14	27
29	Greece	16.53	29	25.89	29
30	Thailand	16.02	30	24.17	30
31	South Africa	15.41	31	23.78	31
32	Russia	15.09	32	23.66	32
33	China	15.06	33	22.55	36
34	Poland	14.83	34	23.6	33
35	Philippines	14.5	35	21.88	39
36	Turkey	14.43	36	23	34
37	Mexico	14.13	37	22.88	35
38	Brazil	13.98	38	22.41	37
39	India	13.7	39	20.66	40
40	Argentina	13.34	40	21.99	38

* IC = Intellectual Capital, FC = Financial Capital

While I consider this work as ground-breaking, two thoughts have troubled me since. Why has anyone not followed up on this work by extending it to more than the 40 countries studied here? And more importantly, why has anyone not updated the data on the 40 countries itself from 2006 onwards? The answer to the first question is provided partly by the authors in their paper itself, where they mention that they had to remove 7 additional countries from their list because of a large number of missing indicators. Hence, perhaps data for all the remaining countries will be even more difficult to find. As to the second question, the only answer that makes sense is perhaps the fact that fetching and compiling data for such a study is perhaps too time intensive and cannot be undertaken unless it is a sponsored effort. Incidentally, the authors do mention that their effort for this paper was sponsored.

As mentioned earlier, there is no doubt that a comparative Intellectual Capital ranking of nations can be highly useful to a variety of target audiences. The question that arises therefore is how we can obtain such a ranking without going through the rigor inherent in the method presented by the authors. Can we for instance, use a proxy indicator? In other words, can we identify a commonly available macro data point for nations on which the nations would have more or less the same rank as on their Intellectual Capital? Even if this indicator was not 100% accurate, it could be useful in providing us a quick and dirty ranking of the Intellectual Capital of Nations which would be enough for the purpose of most target audiences.

As I reflected on what such an indicator could be, I wondered whether it could be GDP/capita. But higher GDP/capita is a consequence of higher Intellectual Capital, rather than a cause. Could it then be flow of inward Foreign Direct Investment? But again, inward FDI would be a consequence of higher Intellectual Capital than being a cause. And then it struck me like a bolt. It had to be Electricity consumption/capita. After all, electricity is the root cause of all modern advancements and indeed is the cause for the birth of the knowledge era. Without electricity, our civilization would still be spending a bulk of its time on menial chores such as gathering wood and lighting fires for warmth and for cooking. Electricity has freed us up from these chores to such an extent that we can hardly imagine modern life anymore without it. About the only time we realize the importance of electricity in our lives is during a power outage when we have to start hunting for match boxes and candles to cut through the darkness and suffer through sweltering temperatures since we have been accustomed for years to the comfort of air conditioned residences and offices, all due to the miracle of electricity. In short, electricity has made human kind highly productive over the course of the past century. It has taken care of our routine mundane needs, freeing us for performing higher order activities. And that we have. I imagine that mankind has made more inventions in the past one century than in all of its existence prior to that. Isn’t that a phenomenal achievement? And isn’t it attributable mostly to the invention of electricity? If so, it stands to reason that the more electricity a nation consumes per capita, the more its population will be freed up for performing higher order activities and generate more Intellectual Capital in the process.

I had the hypothesis. The next step was for me to test it. On the one hand, I had the Intellectual Capital of Nations as of 2005 as described earlier. I had to correlate this with the electricity/capita of these countries as of 2005 and check whether I could establish a high degree of correlation between the two. If so, it would prove my hypothesis. I obtained the electricity/capita of these 40 nations from nationmaster.com and used the Excel RANK function to rank the consumption of these countries from 1 to 40. I placed these ranks alongside the IC and IC+FC ranks as shown below.

No	Country	IC Rank	IC+FC rank	Electricity consumed/capita (KWh)	Electricity consumption rank
1	Finland	1	1	15461	4
2	Sweden	2	2	14860.3	5
3	Switzerland	3	3	7833.7	11
4	Denmark	4	4	6281.41	19
5	United States	5	5	12874	6
6	Singapore	6	6	7828.55	12
7	Iceland	7	7	27470.9	1
8	Netherlands	8	8	6629.96	17
9	Canada	9	10	16725	3
10	Norway	10	9	24636.1	2
11	Australia	11	11	10812.1	7
12	Austria	12	12	7317.84	15
13	Japan	13	14	7624.4	13
14	Ireland	14	13	5792.12	21
15	Germany	15	15	6614.58	18
16	Belgium	16	16	7919.93	10
17	Taiwan	17	17	8805.26	9
18	New Zealand	18	18	9404.96	8
19	United Kingdom	19	19	5789.91	22
20	France	20	20	7417.08	14
21	South Korea	21	21	7299.02	16
22	Malaysia	22	25	3105.65	31
23	Hungary	23	23	3566.95	29
24	Spain	24	22	5599.32	23
25	Italy	25	24	5239.98	25
26	Chile	26	28	2964.7	32
27	Portugal	27	26	4388.85	28
28	Czech Republic	28	27	5835.4	20
29	Greece	29	29	4891.03	26
30	Thailand	30	30	1832.4	35
31	South Africa	31	31	4493.67	27
32	Russia	32	32	5446.02	24
33	China	33	36	1684.17	38
34	Poland	34	33	3154.69	30
35	Philippines	35	39	564.21	39
36	Turkey	36	34	1790.05	36
37	Mexico	37	35	1778.07	37
38	Brazil	38	37	1976.88	34
39	India	39	40	446.29	40
40	Argentina	40	38	2296.43	33

Next, I used the Excel CORREL function to find the Pearson correlation coefficient between the IC and IC+FC ranks with the Electricity consumption/capita ranks. I found that the IC v/s Electricity consumption ranks had a Pearson coefficient of 87.15% whereas the IC+FC v/s Electricity consumption ranks had a Pearson coefficient of 88.37%. Since by definition, any coefficient value above 80% signifies a strong correlation between the two sets, my hypothesis was proved.

Now that I have established that the Electricity consumption/capita can be used as a proxy indicator for ranking the Intellectual Capital of nations, it is straightforward exercise to check where the remaining nations rank on their Intellectual Capital. We just have to look at their Electricity consumption/capita. Moreover in the years ahead, we will perhaps be able to forecast how the Intellectual Capital ranking of nations will change by studying which nations are investing more into their energy infrastructure compared to their peers.

Intellectual Capital analysis of change in Indian IT Leadership

The top four Indian IT companies – TCS, Infosys, Wipro and HCL Technologies - have declared their results for the quarter ending March 2012. While TCS and HCL have surpassed analyst expectations, Wipro and especially Infosys have disappointed. The markets have been severely harsh on Infosys in particular, dropping it by about 13% in a single day on the 13th April when it declared its quarterly results. For a company which has been the face of Indian IT around the world for decades, this was quite the drubbing. It is the fifth straight quarter when Infosys has missed its own forecasts, a very unusual territory for this IT giant. Not without reason therefore, Infosys has lost its claim as the industry bellwether and leader of the Indian IT industry, a position that is now claimed unequivocally by TCS. In fact many analysts have downgraded Infosys further. JP Morgan has placed Infosys fourth in the pecking order behind TCS, Wipro and HCL Technologies. CLSA downgraded the scrip to ‘Underperform’ from ‘Outperform’ and Deutsche Bank revised it to ‘Hold’ from its earlier ‘Buy’ rating. Technology analysts have gone further. For instance, Mint published a full page article on Infosys recently in its newspaper asking whether Infosys’s dream run has ended. For a company that employs more than 150,000 people globally, this is a serious question that begs a deeper analysis. Let’s do that using Intellectual Capital as the basis.


Let’s look at TCS first. The Intellectual Capital analysis of TCS for the past four years can be seen online here. The Knowledge Basis portion of the analysis is reproduced in the chart below.

This chart depicts the Knowledge Basis of TCS for the past four years, measured every quarter. Knowledge Basis (KB) is just the ratio of the Intellectual Capital(IC) of the company to its Intrinsic worth (IW). In other words KB = IC/(IC+NW), where IW = (IC + NW) and NW represents the Net worth of the company. As can be seen from the chart, the Knowledge Basis of TCS for the past four years has been more or less steady around the 83% mark. This is another way of saying that 83% of all assets inside TCS are knowledge assets and this number has been more or less very steady over the course of the past four years.


Now let’s turn to Infosys – its Intellectual Capital analysis can be seen online here and its Knowledge basis chart is reproduced below.

We find in this chart that the Knowledge Basis of Infosys was also around the 83% level from Jun 2008 until Dec 2009. That is when it started sliding southwards, dropping to around 74% in Dec 2011 before recovering slightly to 76% in Mar 2012. Even counting the 2% rise in the latest quarter, Infosys is still down 7% from its own benchmark of 83%. Described in other words, this means that only 76% of all assets inside Infosys are Knowledge assets compared to 83% for TCS. Considering that Knowledge assets are significantly more productive than physical or financial assets, is it a surprise to anybody that Infosys has not been delivering stellar results lately? The decline started two years ago in 2010 and has continued steadily since then, although the latest quarter results have shown an uptrend.


This brings us back to the question – has Infosys’s dream run ended? For now, it certainly has. Considering the myriad organizational displacements inside the company recently, this was perhaps inevitable. But Infosys is far from being down and out. A Knowledge Basis of 76% is very healthy even if it is low compared to TCS. It implies that an overwhelming majority of all assets inside Infosys are still knowledge assets, explaining why the company generates more than Rs 1000 cr every quarter by way of Economic value. The good news now is that the market has given away its premium for Infosys stock and the stock is now trading around its fair value ever since its latest quarter results came out. In contrast, the market has taken a strong liking for TCS and has assigned it a premium of more than 30% of its fair value. Will TCS be able to live up to its favored status? Time will tell for sure. But one thing is clear in my mind, while TCS is certainly the better run business, if you had to choose between these two great companies for your investment portfolio, Infosys is the better stock to buy at the moment!

Lifestyle enhancers

Apple, 3M, GE, Sony, Toyota, Procter & Gamble, Samsung, etc. are among some of the well known companies that have been consistently voted into the list of the most innovative companies in the world for many years at a stretch. This begs the question – how do they do it? How do these companies make the list of most innovative companies in the world with such alarming regularity? What is it that they are doing right about innovation that their competition isn’t? After all, isn’t innovation fraught with risk? Before you try and correlate the innovation success of these companies with the quantum of their R&D spend, let me dispel that notion right away. Booz and Company recently published their Global Innovation 1000 study during which they found that seven of the top 10 innovative companies were not even among the top 10 spenders on R&D. On the contrary, the R&D spend of the most innovative companies as a percentage of their annual sales was typically less than 5%, compared to more than 10% for some of the heavy hitters. This study therefore confirms the fact that you cannot throw money at innovation and expect it to happen. The reverse, however, is very true. The same study showed that the most innovative companies were able to generate a higher EBITDA as a percentage of revenue compared to the ones who were not innovating so much! So whereas money cannot generate more innovation, innovation definitely generates more money. And that is the reason why we need to understand what the highly innovative companies do right.

I had to give it considerable thought, but in the end I came to the conclusion that the most successful innovative companies produce an innovation or a series of innovations that enhances our lifestyles by a couple of notches every time. The widespread acceptance and adoption of these innovations move our entire civilization forward a notch, in much the same way that homo-sapiens has progressed through the ages - from hunters to growing their own food as farmers, then to leverage machines to do his work faster during the industrial age and finally to use knowledge to become more efficient at his work during the information age. Let me cite just two examples to make my point.

Sony invented the Walkman portable music player in the late seventies, allowing humankind for the first time to carry their music along with them. Listening to music is a basic human need, since music is the food that feeds our souls. Understanding this need, Sony’s engineers gave vent to their creative genius and designed a compact portable music player. It was a mega hit with the masses for the next two decades and many imitations followed. But if you want to buy one today, you will be hard pressed to find one. Why? Because, although the Walkman made your music portable, its magnetic audio tape based storage technology had limitations of capacity and sequential seek Another enterprising company, by the name of Apple, recognized these shortcomings at the start of the century and their design engineers put their creative minds to work to innovate a portable music player called the Ipod. They introduced digital storage technology along with massive capacity into a device that is probably a tenth of the size of the Walkman. Ipods are such a rage with the masses today that the Walkman has become obsolete as quickly as it became famous. Such is the popularity of the Ipod today that any true music lover will not be caught without one today or at least an imitation of it. However, the larger point I want to make is that in creating the Walkman and the Ipod, both Sony and Apple enabled civilization at large to progress a notch by liberating it from the clutches of unportable music players.

Let us take another example. We all know the tremendous benefits humankind has derived from the invention of the modern motor car. Transportation has become much faster due to the motor car enabling us to be more productive in our day compared to the worker of the nineteenth century. However, after a century of guzzling gas the world over, car makers realized that the motor car could not be sustained to run on gasoline forever, since the world’s oil reserves were depleting at an alarming rate. This is when car makers got into a frantic race to develop cars that could run on alternative energy sources such as electricity, solar energy, etc. Many even developed commercial variants of their alternate energy cars. However, the company that achieved the most amount of commercial success in this regard was Toyota with its Prius car. Unlike other manufacturers, Toyota did not seek to develop a purely alternate energy car. Instead they developed a hybrid, a car that can run on gas as well as electricity. Their engineers installed an electric motor alongside the petrol engine and innovated to develop a Hybrid system that makes the electric motor act as a high-output generator to produce regenerative braking during deceleration. Simply put, it means that the car is storing the braking energy as electric energy to be used later for cruising without petrol. Ingenious! In one stroke, Toyota solved multiple problems – their hybrid approach doubled the mileage of the Prius compared to other petrol only cars, their regenerative hybrid system overcame the problem of the limited battery capacity of pure electric cars and at the same time their hybrid approach ensured that the performance of the car was not compromised in any way. The Prius was first introduced in the late nineties. Since then many other manufacturers have introduced commercial hybrid cars of their own and I believe that this trend is only going to increase in the years ahead. The larger point in this example is that with the hybrid Prius, Toyota enabled its Customers to address the issues of dwindling oil reserves and pollution without compromising in any way on everything they had come to expect from a transportation vehicle such as a car. Once again, Toyota managed to push the envelope and move civilization forward by a notch with its hybrid car innovation.

The ability to innovate and introduce commercially successful products and services is to me yet another pattern of Intellectual Capital – I have coined the name ‘Lifestyle Enhancers’ for this pattern. Make no doubt, innovative ability is a rare ability and one fraught with risk. Yet it is a type of Intellectual Capital that many large companies mentioned at the start of this article have harnessed and molded into commercial success. All of these companies are household names today - some of them have come into existence only in the last decade but have made their mark very quickly with their ability to innovate at every step of their existence. Such is the power of innovation, which is only a subset of Intellectual Capital. What would it be like if a company could harness all aspects of its Intellectual Capital? Your guess is probably better than mine.

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?