“In most companies,” he told me recently, “you don’t get the vaguest idea of how much training was cut during the last three recession years. Companies don’t report anything about brand enhancement investment or R&D investment. They report information on technology expenditures, but they don’t break it down; you don’t know how much is hardware versus software, or how much is long term versus short term. Everything is buried in a single figure for general operating expenses — one huge garbage can.”
There are dozens of ways that the contents of that garbage can could be sorted out and differentiated. Indeed, much of Professor Lev’s work consists of finding measures of intangible investment — “inputs” like the money spent on training or research, and “outputs” like the value of patents or quality of new patents. The critical step is linking such measures to financial performance — especially to changes in revenues and share prices. To accomplish this, Professor Lev tracks changes in performance over time, and statistically compares the fluctuations to particular changes in investment or other measures of intangible worth. With enough of a sample base, this allows him to estimate the financial impact of a dollar invested in this particular company in, say, process redesign or brand redefinition.
Under this kind of analysis, commonly perceived liabilities — such as marketing commissions paid to build a customer base — are often revealed as assets. “When you walk into a Circuit City and buy a cell phone,” says Professor Lev, “the mobile phone carrier might pay $200 to $300 to the retailer. Because customers stay with a carrier three to four years on average, these commissions are investments. But they show up on the balance sheet as expenses — sometimes adding up to hundreds of millions of dollars,” thereby unfairly discounting the perceived value of the most customer-driven mobile phone companies.
In the “vicious circle of harm,” analysts and investors denigrate companies for making investments in productive intangibles. Their stock price sinks and their cost of capital rises, which pressures companies to reduce spending in such intangible areas as R&D, marketing, and training. This erodes the company’s distinctive capabilities still further, which often forces it to compete on price instead of distinction. In other words, the company turns its products into commodities, and margins decline. As the cycle continues, the stock price descends further, pressuring the company to reduce investment in intangibles still more. A company spiraling down like this can lose the core of its competitive advantage without anyone’s being aware that there was ever any alternative.
Cost of Complacency
One of Professor Lev’s most intriguing examples of this spiral — but one that has gotten very little attention in the press — is his recent work on the decline of innovation in the chemical industry over the last 30 years. His findings are especially compelling because this has been one of the most fertile and creative periods in the history of materials science.
For most of its history, the chemical industry was an innovation leader. E.I. DuPont de Nemours and Company helped invent the modern research and development lab in 1903 with its famous Experimental Station (or “Ex Station”), where nylon, Lycra, polyester, Mylar, and many other well-known modern substances were invented. Other major producers, like the Dow Chemical Company, were similarly innovative through the 1970s. But then lethargy set in. As Baruch Lev and David Aboody, an assistant professor of accounting at UCLA, put it in a recent report for the Council for Chemical Research, “Evidence suggests the presence of a certain complacency, and perhaps even disillusionment with investment in innovation in the chemical industry.”