by Nawar Alsaadi.

Back in the 1970s, tangible assets were the dominant form of assets on the balance sheets of most S&P 500 companies, with 83% of assets being tangible (buildings, factories, mineral reserves, etc.) and 17% intangible (intellectual property, brand name, R&D capabilities, trade secrets, etc.). Today, the equation has flipped on its head, with 90% of S&P 500 assets being of an intangible nature, according to financial services consulting firm Ocean Tomo.

Source: Ocean Tomo, LLC Intangible Asset Market Value Study, 2020
*Interim study update as of 7/1/2020

This evolution from tangible to intangible assets is closely tied to the growth in knowledge work and the digitization of our economy. This in turn means that financial wealth creation is increasingly tied to technological innovation and business models that are light on tangible assets. Despite this being a fascinating topic in its own right, the purpose of today’s blog is not to discuss the changing nature of corporate assets, but rather to focus on a novel concept that I would like to call “stranded intangible assets.”

A threat to corporate value

The concept of stranded intangible assets is modelled on its cousin, stranded assets, which was introduced by Carbon Tracker in the early 2010s to increase awareness about carbon intensive assets, and the likelihood of these assets losing their value due to the ongoing transition to a low-carbon economy. Mark Carney, former governor of the Bank of England and the Bank of Canada, further publicized the concept in a keynote speech at Lloyd’s of London in September 2015.

The stranded assets logic extends to intangible assets since they too are subject to the global transition to a more sustainable and equitable economy. Intangible assets, like all assets, drive their value from an implicit economic return assumption. For example, a well-known food brand drives a portion of its valuation from the fact that consumers will pay a premium for a branded product. Likewise, a technology company valuation is often tied to the intellectual property it possesses and the assumption that this intellectual property will continue to generate economic value for the foreseeable future. An efficient auto manufacturer valuation is likely to encompass an economic intangible value for the company’s manufacturing know-how and its superior supply chain management capability. In a relatively stationary world, most of these assumptions would be sound, but in a rapidly changing world, they need to be constantly re-examined.

To underpin the rapidity of change today, one only needs to read the latest consumer preferences report from IBM Institute for Business Value where it was revealed that 84% of consumers today put a premium on sustainability when selecting a brand compared to 77% in September 2019. Most notably, of the 14,000 people surveyed, the percentage saying sustainability is “extremely important” jumped 22% in 18 months, from 45% to 55%. Powerful and fast-evolving trends of this nature have major implications for the assumptions underpinning intangible assets around the world.

ESG is better suited for an intangible world

Conventional financial analysis is poorly designed to capture, evaluate, and incorporate such non-financial factors as the evolving perception of sustainability in consumer preferences. As intangible assets capture the lion’s share of corporate valuations, financial wealth preservation becomes increasingly subject to the solidity of the non-financial assumptions underpinning these valuations. Unlike financial analysis, which is confined to the numbers on an income statement and/or balance sheet, ESG analysis focuses on non-financial factors, which are intangible by nature, and thus directly connected to intangible asset assumptions.

Let’s go back to the examples I cited earlier, and the stranded intangible assets risks associated with them. A global food brand can rapidly lose its value should its products prove to be detrimental to human health, and societal preferences were to change toward a healthier diet. A technology company’s intellectual property could become worthless overnight if its technology were dependent on exploiting personal data, should consumers and governments cease to tolerate the invasion of personal privacy. An auto manufacturer’s know-how and its superior supply chain management could become valueless if the company only produced cars with internal combustion engines. Much of the intangible value embedded in such companies would never be unlocked if that value were based on the assumed continuation of an unsustainable business model.

How many companies in your portfolio might be subject to such risks? And how much of the intangible assets underpinning the valuation of S&P 500 companies will never be realized due to erroneous assumptions around unsustainable business models? In a world where most corporate value is intangible in nature, valuation sensitivity to evolving sustainability trends and practices will only gain in intensity. Companies and investors that are attuned to such sustainability risks stand to win the future by reorienting their companies and capital toward sustainable business models.