Two Desirable Characteristics Of Innovative IndustriesMay 06, 2015
The most innovative companies in the world tend to exhibit two highly desirable characteristics: high return on invested capital (ROIC) and low long-term debt as a percentage of total capital. There are fundamental reasons for these characteristics. First, innovative companies are very profitable because they invest heavily in an knowledge, or intangible, investments such as R&D, employee training, brand building, and codified information. Knowledge investments, which are not accounted for on traditional balance sheets as an asset, help to deliver above average profitability over the long-run. In addition, knowledge investments are almost always entirely financed by equity since banks are conservative institutions that prefer to lend against physical collateral. Consequently, innovative firms tend to have less debt on its balance sheet.
In the two scatter plots below, we are using data from the MSCI All-Country World Index. As we stated, knowledge activities do not show up on traditional financial statements, so we have adjusted financial statements to include intangible assets and investments. To measure knowledge intensity, we look at the level of intellectual property as a percentage of total firm assets. In the first chart, we are plotting the median ROIC (y-axis) of an industry group against the median IP as a % of total assets (x-axis) of an industry group. As the median ROIC increases, we tend to see a subsequent increase in the knowledge intensity of the industry. Industries such as banks and utilities are located on the bottom left side of the chart, while more innovative industries such as semiconductors and household and personal products are in the top right side of the chart.
In the second chart, we are plotting the median long-term debt as a percentage of total capital (y-axis) of an industry group against the median IP as a % of total assets (x-axis) of an industry group. Here the relationship slopes downward as firms with greater knowledge intensity tend to have lower levels of long-term debt. In this chart, real estate and transportation companies are at the top left side of the chart while the more innovative industries such as pharmaceuticals, biotech and life sciences are at the bottom right side of the chart.