“What will he do?” Anne asked me.
She referred to my son Will, who joined in our dinner party on Saturday night. As I explained to her, Will graduates this year, with a degree from St. John’s College. After about 4 times as much formal schooling as Abraham Lincoln, Will is prepared for almost nothing. But at least he has read the classics and can quote Aristotle to provoke bar fights.
In France, students are not educated. They are ‘formed,’ prepared to do something. A young man without a ‘formation’ is forced to become a manual laborer.
“Well, he as a good foundation in the humanities,” Anne said generously.
“Yes,” I replied, “he has intellectual capital.”
And so, dear reader, I come to the subject of today’s letter: intellectual capital. Does it really make businesses more valuable than their balance sheets reveal?
Le Monde, France’s equivalent to the Washington Post or New York Times, adds to readers’ intellectual capital every day – giving them ideas, information, and misguided opinions masquerading as news. Colleges and universities add billions of dollars worth of intellectual capital to the nation’s stock every year. Does it really pay off? Is intellectual capital something real – or just another big, empty phrase? I will leave that for another day and stick to investments today.
The q ratio compares the price of a company’s stock to the replacement cost of its assets (roughly, book value). Over the long haul, the q ratio has been fairly stable and had a predictive quality. Whenever stocks were extremely expensive relative to their underlying asset value – or extremely cheap – the odds increased that stock prices would soon move to bring q back to its mean.
As I have previously reported, q is now very much in overvalued territory and seems to be anticipating a return to much lower stock prices. In fact, in their book, Valuing Wall Street, authors Andrew Smithers and Stephen Wright, calculate that the Dow should fall to somewhere between 1620 and 4590 in order to bring it into line with previous correction episodes.
But an alert DR reader reminded me that James Tobin himself, creator of the q ratio, came to believe that it had become irrelevant to the New Economy. His point was that businesses had much more “intellectual capital” than appeared on the balance sheets. If you increased the denominator of the ratio – that is, the replacement cost of the business – by the actual value of this intellectual capital, the ratio would fall into more common territory. It would show, perhaps, that stocks are not overvalued after all.
Intellectual capital is not something new. One has only to gaze at the face of Notre Dame cathedral a few blocks from my office to see that even hundreds of years ago people knew how to do extraordinary things. Stonemasons and architects spent their lifetimes perfecting their skills. If you had put a value on their enterprises – you would be a fool to neglect the level of craftsmanship they could turn out.
But why would you ignore it? You could see from the output, comparing my stonewalls to the fa?ade and flying buttresses of Notre Dame, that the medieval builders had far more intellectual capital than I do. I may know more about the derivatives market…or more about tobacco farming…but intellectual capital in the abstract is useless. It only has value when it is applied to a specific purpose. It is the output that gives it value. A man could 20 years studying computer science at MIT – and then get a job tending bar in Cambridge. Of what value is his intellectual capital?
People have always had intellectual capital – and always applied it to improve their standards of living. They built pyramids and bridges, raised crops and laid out railroads…they turned out TVs, radios, automobiles, microwave ovens – and all manner of other devices – by the millions. Yet only now, in another humbug contrivance of the Information Age it is thought that businesses might be worth more because of the “intellectual capital” held by the workers behind the scenes.
If the capital is worth anything at all, it has to be because makes things better in the real, physical world. Otherwise, it might be like faith or sunrises – which make things better, but not in a way you can capitalize.
“The Labor Department’s figures [for] ‘average gross weekly earnings’ …for the 10 years since 1990,” reports Dr. Kurt Richebacher, show “an overall increase from $259 to $271. This was a gain of 4.6% over the whole period, or less than half a percent per year.”
If this intellectual capital has any value, it’s not doing the much good for the people who are supposed to have it.
But if employees are not getting the money, maybe it is showing up in earnings? Earnings have been rising by 15% per year since 1990 – twice as fast as GDP. But it appears to have little to do with extra productivity. “The main source of the prolonged profit improvement during the 1990s,” notes Dr. Richebacher, “was a sharp decline in the corporate interest bill…In 1990, corporate interest accounted for 6.3% of national income, in 1995 for 3.7% and in 1998 for 3.3%. This decline has actually provided two- fifths of the profit advance over this period.”
What’s more, a look at Price/Earnings ratios show stocks to be extremely overvalued – even after the bear market of last year. The Dow is trading at nearly 19 times earnings – or 50% above its average. Even if there is intellectual capital at work – it is not enough to bring the P/E ratios into line with historical standards.
So, if there is intellectual capital lurking under the balance sheets of U.S. firms – what does it do?
Unless there is a measurable output – intellectual capital is a worthless as an analyst’s recommendation. And if there is measurable output – there is no need to pretend that the business is worth more than it appears to be worth, thanks to the illusive “intellectual capital.”
Stay tuned…more tomorrow from your very own intellectual capitalist,
Paris, FranceJanuary 9, 2000
“Dad, could I get a job in your business?” Will asked me.
“Of course,” I replied. “But it might be better to work for one of our competitors; wreck their business first.”
*** ‘It’s the economy, stupid!’ That thought must have occurred to investors in the wee hours of last Thursday morning. “They were reminded,” says the Chicago Tribune, “that a slowing economy and lower corporate profits were behind the [Greenspan’s rate] cut, and the markets promptly gave back the rally.”
*** Both the Dow and the Nasdaq gave back a little more of the rally on Monday. The Dow fell 40 points. The Nasdaq dropped 11. Breadth, however, was reasonably good with 1,613 stocks advancing on the NYSE and 1,330 declining.
*** The winners yesterday were the gold mining companies – up 6% as measured by the HUI. The losers were the biotechs – down 5%. Could this be a trend in the making?
*** New Era of Networks announced a larger loss than investors had expected for the 4th quarter; investors cut the stock by 44.9%. The world’s biggest company, GE, fell 4%.
*** Good old Philip Morris, meanwhile, was the day’s top performer.
*** “It isn’t a sure thing,” said Byron Wien, investment strategist at Morgan Stanley Dean Witter & Co., recently quoted in NYTimes article, “that just because the Fed eases, the stock market goes up. The key differentiating factor is whether we are in a recession.”
*** As long as the economy is healthy – lowering the cost of credit will boost economic activity and feed into stock prices. But after a credit bubble splurge people get spent out – they lose their appetite and ability to take on more loans. Even though the Fed lowers its Funds and Discount rates – the lower rates don’t necessarily reach borrowers. Lenders demand higher rates to compensate the greater risk of default. And borrowers – faced with falling asset prices – know that the real rate of return on the borrowed funds may be extremely negative. In such case, the Fed can cut rates – but nothing will happen. It is said to be “pushing on a string” – to use a phrase from the dismal science.
*** Moody’s estimates that the rate of default on junk bonds will rise 50% this year. Personal bankruptcies, too, are increasing sharply.
*** “Everyone remembers what happened when the Fed eased in 1995 and 1998,” Wien explained, “but both were because of financial crises not recessions.”
*** “In June 1989,” the NYTimes adds, “after a period of rising interest rates, the Fed began to ease, initially cutting the Fed funds target rate to 9.5625%. The day of the first cut, the S&P 500 stood at 326. About 18 months later, when the Fed funds were at 7%, and the nation was in recession, the S&P had risen a mere 2 points.”
*** “This economy is unraveling at a very rapid rate,” Mr. Wien concluded. Montgomery Ward is going ‘chapter’. There was one corporate bond default on each of the first 4 business days of the New Year – bringing the total for 2001 to $1.3 billion in less than a week. In the last quarter of ’99, LTV and Wheeling-Pittsburgh filed ‘chapter’ – bringing the total to 9 U.S. steel makers to go bankrupt in the last 2 years. Two of California’s leading utility companies are close to bankruptcy. And Xerox is selling off pieces of its business to try to stay alive…while the entire movie theatre industry seems to be in ruins. More below…
*** California lawmakers are considering a proposal to take over the power system. “Deregulation’s not working,” said the state’s treasurer. The state, of course, has big advantages…as he pointed out. It can force people to pay taxes – it doesn’t need to wait for permission for a rate hike. This allows it to borrow at lower rates – permitting the state to pile up much bigger losses over a much longer time. Plus, it has the power to ignore its own permit, land use, environmental, health, safety and other silly regulations that make it so hard for honest companies to make money.
*** Russia seems to be on the verge of a default, too. It owes its western creditors – the ‘Paris Club’ – about $48 billion. That may not seem like much to you and me – but it’s a lot for a country that, for 70 years, ran everything the way California is proposing to run its power system.
*** The euro slid a little – but still closed above 95 cents.
*** “The true, key source of this fateful boom and the bubble is all too conspicuous in the monetary data,” wrote Dr. Kurt Richebacher in a recent report. “Since 1995, broad money has increased a stunning $2.6 trillion, or 60%. Total credit supply has surged $9.3 trillion, or 54%, to $26.5 trillion. But the most violent crescendo has taken place since late 1998, after the Fed’s easing in the wake of the Asian-Russian crisis. Broad money in the short span of time since then has virtually exploded by $1.5 trillion (27%) and overall credit supply by $5.3 trillion (25%). Compare these astronomical money and credit figures with annual nominal GDP growth since end-1998 of around $775 billion.”
*** We drove back into Paris on Sunday night. There was a lot of bellyaching, but all of the children headed off for school on Monday morning without a hitch. Paris is cold, gray and rainy – wonderful weather, actually, for sitting in a brightly lit bar (such as the Le Paradis next door) with a large caf? cr?me.