Winter 2020 Market Insight ACCOUNTING MAYMASK THE APPEAL OF DISRUPTERS EATHERBIE CAPITAL In our view, the appeal of innovative businesses that can potentially thrive despite the ongoing trade conflict and rising labor costs is being tarnished by outdated accounting practices that do not fully value intangible assets.We believe by looking beyond this accounting issue and conducting in-depth fundamental research, investors can potentially find companies that are best positioned to weather labor and trade challenges while benefiting from unprecedented levels of secular growth. A Challenging Environment Many companies are contending with higher labor costs with wages having increased 3.7% during the 12-month period ended December 1, 2019. With that in mind, Goldman Sachs estimates that higher wages and increased input costs will limit S&P 500 margin expansion to 15 basis points in 2020. Tariffs resulting from the U.S.-China trade war, meanwhile, are curtailing economic growth and disrupting corporate supply chains with North America freight shipping declining 7.9% year over year as of the last month of 2019, according to the Cass Freight Index. Accounting Shortcomings Innovative companies are increasingly using intangible assets, such as computer software, algorithms, research and patents to disrupt their industries and capture market share. We believe these companies are frequently well positioned to thrive despite rising labor costs and trade dislocations. However, unlike tangible assets such as factories, modern accounting doesn’t fully value intangible assets, which can distort income reported by innovative businesses. The following hypothetical examples illustrate this point: • A company purchases a factory for $1 million. For accounting purposes, the value of the factory is depreciated over 10 years. The reported cost, or the expense against the company’s income, of the factory is only $100,000 annually for 10 years. • If a company spends $1 million to develop software, however, the software, as an intangible asset, isn’t fully valued. That means the full $1 million cost is recorded as a charge against income in the first year. If it were capitalized and treated as an expenditure that had value, it would be amortized over future years. For example, a five-year amortization schedule would result in an annual charge against income of only $200,000 in the year in which the software was developed and then $200,000 in each of the following four years. Amortizing the costs over five years, therefore, would enhance the earnings in the first year in which the expense occurs relative to a scenario in which the cost isn’t amortized.
Matt Weatherbie, CFA CH I E F E X ECU T I V E O F F I C E R CO - CH I E F I NV E S TMEN T O F F I C E R WE AT H E RB I E CA P I TA L , L LC
H. George Dai, Ph.D. S EN I OR MANAG I NG D I R ECTOR CO - CH I E F I NV E S TMEN T O F F I C E R WE AT H E RB I E CA P I TA L , L LC
Joshua D. Bennett, CFA S EN I OR MANAG I NG D I R ECTOR D I R ECTOR O F R E S E A RCH WE AT H E RB I E CA P I TA L , L LC
A Timely Issue We believe many companies that are best positioned to grow their earnings have business models that are based on using intangible assets to disrupt industries and capture market share. Consider the following: • Prices for products sold by innovative companies are driven, in large part, by the value of intangible assets, such as designs for novel medical devices or algorithms used for digital marketing. These types of companies may be less susceptible to the impact of rising labor costs. For many traditional manufacturers, however, revenues compensate companies for providing manual labor, such as operating assembly lines. Rising labor costs can therefore have a more direct impact on traditional companies’ earnings. • The digital economy is expanding rapidly—even though freight shipping has been declining, investments in software are growing as companies increasingly digitize their operations and create novel services. This is part of a broader trend involving the significant growth in the prevalence of intangible assets (See Figure 1). EATHERBIE CAPITAL
We believe many companies that are best positioned to grow their earnings have business models that are based on using intangible assets to disrupt industries and capture market share.
Figure 1: Companies’ Market Values Are Now Driven By Intangible Assets
Intangible Assets as a Percentage of Market Capitalization
Source: Ponemon Institute. Market capitalization is that of the S&P 500 Index.
Digital Disruption Digital advertising is an example of how innovation and intangible assets, such as algorithms that pitch targeted content to consumers, are driving secular growth. In 2018, digital advertising revenue increased 21.8%, according to the Interactive Advertising Bureau, and we estimate that it grew 19% in 2019. Even more impressive, the indispensable nature of smartphones and tablets contributed to revenue frommobile device advertising increasing 31% in 2019, according to our estimates. Revenue for streaming video and audio advertising is also growing rapidly. The Trade Desk Drives Secular Growth The Trade Desk provides a cloud-based software platform for planning, launching and monitoring advertising campaigns. It is also used to allocate spending among channels and to report and analyze campaign results. Trade Desk’s year-to-date net income as of September 30, 2019, increased 17.8% year-over-year. During that period, the company poured $84 million into technology and development, up 40% from the same period in 2018. If accounting practices allowed intangible assets to be fully capitalized, the Trade Desk’s year-to-date net income would have shown an even larger increase.
. . . the Trade Desk’s focus on the U.S., its lack of dependency on foreign supply chains and its leadership in marketing software make the company less susceptible to trade tariffs.
Additionally, as a software company, the Trade Desk isn’t dependent on blue- collar workers that have experienced the largest increase in wages. Even though the company may hire additional sales and marketing employees to manage new clients, its revenues are driven primarily by the value that its software delivers, so labor costs are less significant than for manufacturers or other “old economy” companies. Furthermore, the Trade Desk’s focus on the U.S., its lack of dependency on foreign supply chains and its leadership in marketing software make the company less susceptible to trade tariffs. Medical Devices Spark Secular Growth Glaukos Corp. and Nevro Corp. are disrupting health care with innovative medical devices. In doing so, they illustrate the value of intangible assets. Additionally, the companies’ products are highly profitable, a reflection of compelling intellectual property, so we believe the companies are unlikely to struggle as wages increase. Both companies, furthermore, are not dependent on foreign supply chains. • Glaukos provides iStent Inject for use with micro-invasive eye surgery to relieve intraocular pressure caused by glaucoma. A competitors’ product was previously pulled from the market, leaving only one other significant competitor. However, iStent’s clinical data are more robust than the data of the competing product. For the third quarter of 2019, Glaukos’ net sales increased 33% year over year and the company generated a gross margin of 87% compared to 86% for the same quarter in 2018. Its reported margin could potentially be higher if the $17.3 million that the company spent on research and development for creating intangible assets was amortized rather than fully expensed. • Nevro provides spinal cord stimulation technology for managing chronic pain. It recently received FDA approval for its newest product, the Senza Omnia Spinal Cord Stimulation System. Based on clinical data, the newer technology may be more effective at managing pain because it provides a greater range of electrical frequencies for customizing treatments.We believe the company’s deep bench of patents and superior technology, can potentially protect it from new competitors. Like Glaukos, it has a substantial commitment to developing intangible assets, having spent $42 million on research and development during the first nine months of 2019, up 20% year over year. Going Forward We continue to believe that companies with significant intangible assets are timely investment opportunities that may be less susceptible to rising wages and trade disruption. Among these types of companies, we believe only businesses that are leaders in developing innovative products will succeed while other companies will inevitably lose market share and flounder. At Weatherbie Capital, we will continue to use our research-driven investment strategy to search for the potential winners of change on behalf of our clients.
Matt Weatherbie, CFA Chief Executive Officer Co-Chief Investment Officer
H. George Dai, Ph.D. Senior Managing Director Co-Chief Investment Officer
Joshua D. Bennett, CFA Senior Managing Director Director of Research
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The S&P 500 Index is an index of large company stocks considered to be representative of the U.S. stock market. The Cass Freight Index measures the volume of freight shipping in North America. The Ponemon Institute conducts independent research on data protection and emerging information technologies. Investors cannot invest directly in an index. Index performance does not reflect deductions for fees, expenses or taxes. The Interactive Advertising Bureau is an advertising business organization that develops industry standards, conducts research, and provides legal support for the online advertising industry. The following positions represented the noted percentages of Alger assets under management as of 12/31/19: Trade Desk, Inc., 0.23%; Glaukos Corp., 0.44%; and Nevro Corp., 0.81%. All information regarding firm history, biographies, and Fred Alger Management, LLC (“FAM”) and Weatherbie Capital, LLC performance are maintained by FAM. 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