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If you’re a rich Latin American you’re probably just back from Punta del Este. Qué bueno! The Uruguayan beach town is a fabulous mix of Miami and the French Riviera. And almost as expensive due to years of cash flowing in to escape the inflation in neighbouring countries such as Argentina. What’s nicer than an ocean-view apartment to preserve your wealth in real terms?
Physical assets have always had this appeal. But modern economies are not the same as they were half a century ago when inflation last reigned supreme. Nowadays, things you can touch are less relevant. Land, buildings, resources and financial securities still make up the bulk of national balance sheets. In the west, however, the value of brands, patents, software, data, research and development and so on, has outpaced tangible asset growth for decades.
UK intangible investment now exceeds £200bn annually — a fifth more than tangible investment. Unlike the latter, though, intangibles and high inflation have never coexisted at scale for long. One day they might. Although December consumer prices in America and the UK were cooler than expected on Wednesday, the relief rally in equities and bonds shows just how nervous markets are.
Should prices rise further from here, equity holders have much to worry about. That is because corporations have driven the global explosion in intangible assets. For example in 1975, when headline inflation in the US was in double digits, almost 85 per cent of company assets was tangible stuff such as plant and machinery, transportation equipment and inventory. In the intervening half century the split has reversed. Intangible assets now account for 90 per cent of S&P 500 balance sheets. This occurred as inflation fell to almost a side show. Therefore, most equity owners have never pondered what happens to their intangible-heavy stocks if consumer prices surge.
In theory, high inflation should have no effect on the value of tangible or intangible assets. But things are much harder in practice. For starters, intangible assets are slippery to value. There are no traded prices. The “expected future economic benefit” of a trademark, say, is anyone’s guess at the best of times. Companies already spend fortunes paying accountants to arrive at intangible asset values they are happy with. Add high and volatile inflation and imagine how accurate such estimates become.
With global mergers and acquisition volumes approaching $4tn last year, this is cause for concern. Even with low inflation, the prevalence of intangibles raises the likelihood that companies overpay for each other. This normally happens in two ways. Either future profits or historical asset values are overstated. Most likely both. So it is unhelpful when analysing companies that accountants cannot resolve a long-running dispute. Namely, whether something such as an R&D department is an asset that needs to be on a balance sheet and depreciated like a machine, or an expense on a profit and loss account. Both can be fudged but some consistency would be welcome.
Worse, the value of “internally generated” intangible assets such as customer databases or trade names are not recognised, full stop. Until, that is, someone comes along and buys the company at which point they pop into view as “goodwill” on the balance sheet. The more deals, the more goodwill builds up. Until it doesn’t. This time last year Walgreens, a US pharmacy, wrote down $12.4bn of goodwill related to a historical acquisition.
Perhaps the biggest risk from high inflation is that such “badwill” can stay hidden. Why? Because it sits on a balance sheet at a constant value (provided it isn’t written down) no matter what happens to inflation. So as revenues and profits zoom upwards in line with higher prices, the intangible assets that help to generate them remain fixed at “cost”. This boosts returns.
Thus even the worst dealmaking chief executive is a genius if inflation is high enough. Goodwill that would have been written down in periods of low inflation can now sit there for years. Until some idiot buys the company.
What of the question of whether intangible assets are good inflation hedges? Certainly an income-generating patent can hold its value, as should a highly trained workforce. But be honest. If your country became Venezuela tomorrow, would you rather own a factory and its land or an R&D department? A state of the art robot or a copyright?
And you might also suppose something as ethereal as a brand is the last thing you’d want. Wrong, say marketing types. Brand loyalty is even more valuable when price hikes fray customer nerves. But academic research on inflation in emerging markets is unequivocal. People switch to cheaper alternatives. Or buy a condo in Punta.
