The invention of the CT scanner in 1971 was an unalloyed good for the human race.
It transformed medical imaging. It improved treatment for millions of patients. It won a Nobel Prize and a knighthood for Godfrey Hounsfield, its inventor.
But one group got little benefit from this wondrous invention: the shareholders of EMI, the company which funded its development.
EMI seemingly did everything right. It had a world-class R&D team. It invested in software to make the system run, in partnerships with hospitals, and in building a specialist sales force. It was generously supported by the British government.
But to no avail. In a matter of years, rivals from the US and Germany had learnt how to make their CT scanners, and outcompeted EMI. By the late 1970s, the huge global market was dominated by Siemens and GE.
EMI’s failure to profit from its investment holds an important lesson for the modern economy. The kinds of investments that EMI made to bring the CT scanners to market – R&D, marketing, software development, and building new businesses – are what economists call “intangible”.
Unlike standard fixed assets like factories, machines or computers, you cannot touch or feel them. But they are valuable nonetheless.
Importantly, these assets are becoming much more common. Researchers Baruch Lev and Feng Gu of New York University showed that only 25 per cent of the variation in market capitalisation of public companies that listed since 2000 can be explained by fixed assets on their balance sheet. For companies listing 50 years ago, the figure was between 70 and 80 per cent. Intangible assets make up much of this gap.
This trend looks set to continue as the economy becomes more knowledge-intensive.
This creates a growing problem for the economy as a whole. As EMI’s shareholders found, the problem with intangible investments is that your competitors might reap the rewards.
These spillover effects have proved off-putting to equity investors. Unwilling to take a risk on intangible investment that may not pay off, shareholders have often favoured the bird in the hand and rewarded companies that give cash back to shareholders rather than investing it in R&D or new products.
Indeed, research by Alex Edmans of the London Business School showed that chief executives whose stock options are due to vest imminently cut R&D in the hope of a short-term bump in their stock price, and that valuable intangibles like organisational capital are often not priced into stock valuations.
Debt investors have their own reasons to be wary of intangibles. If a business fails, its tangible assets – like buildings or plant – can often be sold. Brands, proprietary processes, and ideas are usually much harder to sell off.
If equity markets and debt providers are both wary of intangibles, and if intangibles represent a growing proportion of the investment that business make, that presents a problem for the economy as a whole. We’d expect to see an investment shortfall, and low productivity growth. And indeed, this is in broad terms what seems to be happening in many rich countries today.
But there are important opportunities amid this crisis. Businesses which are good at learning from their competitors – so-called “fast followers” or “open innovators” – will find more opportunities in an intangible economy.
Governments that invest in risky intangibles like research and creative content can encourage private investment, especially if they can build strong links to businesses.
Private investors, like venture capitalists, who can take a long view and scrutinise the growth potential of intangible investments more carefully can also prosper, though as private investment grows it brings with it concerns over governance and liquidity.
And there is a role for accountants to play, by providing better valuations of intangible assets.
Above all, though, there is an opportunity for investors who can out-analyse their competition.
Careful analysis can tell the difference between intangible investments that will secure a return for the firms that make them, and ones that won’t. But this requires the kind of detailed scrutiny of management and industry knowledge that not all analysts can muster.
One sign of this is that companies with more concentrated shareholdings, whose shareholders have more time to analyse their plans, seem to get more credit for their intangible investments than more widely held firms.
This suggests that, in an intangible economy, there’s more value out there for informed stock-pickers. If we want the economy to prosper, we should encourage them.