Fundsmith & Intangibles...

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25th Jan '19 by Johns

11 comments 2134 reads

In today's scvr Paul mentioned the high value of intangible assets on NCC's balance sheet, giving a negative tangible asset value which he describes as a deal breaker. In the past I have usually taken a similar view but I'm starting to question that. Recently I was reading through Fundsmith's owners manual in which they state that although it may seem counter intuitive they seek to buy businesses which do not rely on tangible assets. They prefer businesses with intangibles that can be hard to replicate, such as brand names, patents etc.

I can totally see the logic of this and it will change the way I assess certain companies. But I'm curious to know what others think about this...

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Johns

Premium Member

11 comments

smegster

25th Jan '19

The way I would see it, intangibles like brand name (Coca Cola), patents (Apple) etc are preferred by Fundsmith because they to help to create a moat which protects the companies from competition. In most cases these types of intangibles are not listed on the balance sheet. The other type of intangibles are accounting intangibles, where the company converts a cost into an asset (which is then amortised), this help to boost profits in the short-term but can destroy profits in the long-term as there is no guarantee that the "asset" has any value (there might be large future write-downs). In NCC (LON:NCC) case, what kind of value do the intangibles actual have, probably not much as it is unclear how they protect it from competition and it is unclear how much actual value they would have if the company gets into financial trouble (how much would someone pay for the NCC (LON:NCC) name?).

mmarkkj777

25th Jan '19

Good Thread and good comment.

I ignore intangibles and go for NTAV if I'm going for a deep value purchase where I'm looking for a good margin of safety. However, if I'm going for a med-long term growth stock I'll accept, even go for, significant intangibles if I can understand them (and understand their future value to the business and earnings increases).

Coke for example the Brand value is obvious. Pharmas, the IP is obvious. Other companies, not so.

If I'm trading I don't really care, because the price change will hardly be infuenced by any asset values.

timarr

25th Jan '19

There are two meanings of the phrase "intangible" which are related but not the same. The first is the accounting issue that Paul mentions - these are usually due to acquisitions where the price paid is higher than the tangible value of assets acquired. The "intangibles" are required to make the books balance.

The second is what the Fundsmith description covers:

... brand names, dominant market share, patents, distribution networks, installed bases and client relationships.

Some of these, such as acquired patents, might show up on directly on the balance sheet, but generally they don't. The value of such intangibles is that they allow the company to make an above average return, as measured by return on capital, in perpetuity, because they can't be competed away.

These types of intangibles are very valuable indeed, but it's not at all obvious if NCC (LON:NCC) has any of them. Based on a ROC of 6%, you'd probably think not.

timarr

JohnEustace

25th Jan '19

The Fundsmith owner manual says:
“The kinds of intangible assets we seek are brand names, dominant market share, patents, distribution networks, installed bases and client relationships. Some combination of such intangibles defines a company’s franchise.”

They look to invest in businesses that generate a high cash return on equity through repeat sales, usually but not necessarily, to consumers.

aflash

25th Jan '19

Smoking thread.

OK so what about small cap v large cap?

Lesser known brands, networks & relationships but still valuable. Think CALL (Cloud Call).

SSON (Smithson investment trust)
(For the less informed-recently launched, trading at a slight premium to NAV, not run directly by Terry Smith but under his supervision- acronym = Small & Mid cap Investments That Have Superior Operating Numbers)

Lists its top 10 holdings:
Masimo
Rightmove
Check Point
Equifax
Verisk Analytics
Sabre
GDK Global
Recordati Spa
Halma
Verisign

HLMA (Halma) catches the eye because large cap and misses the question. Nevertheless Price to Tangible Book 126 meets at least that criteria and they have a reputation for excellence.

Take some time to go through the intangibles but wanted to comment while the subject is hot.

mmarkkj777

25th Jan '19

Hi Timarr,

I agree, but what if there is an acquisition which involves both types: i.e. both "goodwill" and IP and brand value. This has still to be be mentally separated and some kind of values associated to the latter (the former although valuable to the acquirer has little residual value and can be competed away). I guess the trick is to try to understand the business as much as possible and think...How much would I be prepared to pay for it if I was buying the whole company now, Warren Buffett style.

Personally, I don't like to invest longer term in companies that do acquisitions, as I find them tough to value. Not enough competence with complex accounts.

doug2500

25th Jan '19

Negative tangible asset value implies a weak balance sheet to me so while I wouldn't be averse to large intangibles I wouldn't want it coupled with a weak balance sheet.

I actually view them a 2 different things albeit overlapping. How strong the balance sheet is is a stand alone item for me, and negative TAV would imply an amber flag needing further understanding at least.

Obviously some intangibles have a significant value so there's a lot of judgement here rather than hard and fast rules (I think)

timarr

25th Jan '19

I agree, but what if there is an acquisition which involves both types: i.e. both "goodwill" and IP and brand value.

Not sure what the question is. It's clearly possible to acquire genuinely valuable intangible assets - I'd say the Kraft takeover of Cadburys was an example. However, the value of intangibles in the Fundsmith sense is as a moat - a barrier to entry.

Tangible assets can be replicated unless protected by patents or other IP (which are intangibles of course). Intangible assets, on the other hand, are difficult to replicate: the Coca Cola brand can't be copied and Coke has been successful for a long time despite the recipe being publicly available. Competitors can copy the drink, but not the brand.

So roughly what you're looking for is a company with a consistently high return on equity. Once you've found that then you need to figure out whether that return is based on something tangible, which may eventually be copied, or intangible, which probably can't. Figuring that out can't be done from the balance sheet, by looking at the "value" of intangible assets listed there, it involves trying to understand the company.

Note that Fundsmith have other criteria - the share price must be a reasonable multiple of FCF and the company must be relatively lightly geared. As they say, it's very easy to overpay for growth and that rarely ends well, even if the company outperforms.

timarr

simoan

25th Jan '19

Of course, one of the other reasons Fundsmith look to avoid companies with lots of tangible assets is that they often wear out and need replacing periodically, which means Capex, which in turn decreases free cashflow. They are looking to invest in companies where the free cashflow is predictable over a long period of time due to relatively low capex requirements.

Tbh I think Paul sometimes doesn't give enough slack to software companies when it comes to high intangibles leading to negative NTAV. They are not manufacturing anything so they would naturally have few tangible assets and any IP built up over several years would mean relatively high intangibles. Yes, the IP is difficult to value to an outsider but that's just the nature of the beast.

All the best, Si

Johns

26th Jan '19

I agree that NCC's intangibles may not necessarily be particularly value, it was more the principle generally I was referring to. I got impression from Paul's comments that he would avoid companies that have a negative TNAV, But if a company has a strong brand which isn't even on it's balance sheet, then a negative TNAV may not be a concern at all. It could even be argued that for a company to require a lot of tangible assets is a weakness rather than a strength.

simoan

27th Jan '19

I have no idea why Paul even mentions TNAV tbh. It's something an old style deep value investor might look at as downside protection but I've never paid any attention to it with no adverse effects in 20 years of investing. I concentrate more on investing in profitable and growing companies, and if things go wrong, sell up!

The truth is that most of us would have sold out of a company where the future was in such doubt that you're left clutching to the hope that tangible assets are worth what they are valued at on the balance sheet. In a fire sale they rarely are. If something goes very wrong, tangible assets can provide some protection - look at Laura Ashley Holdings (LON:ALY) as an example - but it doesn't stop the share price getting hammered and being left at a significant discount to those assets.

And even where a liquidation takes place it takes ages to get your money back and you need to take into account the time value of that money. As an example, I recently got a notification from my broker that there was a further 0.5pps payment (I believe relating to the sale of the company HQ building) from the liquidation of Bond International, and that's taken over two years.

All the best, Si

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Johns

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