In our Rule Maker Steps we emphasize analyzing a company's financial statements to assess its performance and quality. Unfortunately, the financial statements don't have all the information investors need to measure a company's value. The accounting system behind the financial statements we find today was devised during the fifteenth century, and it's focused on telling us about a company's tangible assets.
As a result, the financial statements fall far short of providing the requisite information about the most important group of assets for today's leading companies -- intangible (or knowledge) assets. These assets can be in the form of better business models or technological edges, or in patents, trademarks, goodwill, etc. Intangible assets are often the result of research and development activities in the form of innovative products, or new marketing efforts that build brand value.
According to a study by George Washington University economist John W. Kendrick, between 1929 and 1990 spending on intangibles grew to nearly 63% of total business investment in the U.S. On the other hand, investment in traditional brick and mortar assets represented only 31% of business investment. It's hard for me to imagine that investment in intangibles hasn't grown to be an even larger portion of total investment over the last decade.
One of the knowledge assets investors are probably most familiar with is patents. For early stage companies, patents can be quite important. When it comes to Rule Makers, however, other knowledge assets are much more important.
It's easy to find an article reminding us that Lucent Technologies' (NYSE: LU) business portfolio contains over 18,000 patents. But this patent portfolio doesn't mean Lucent will be able to overcome the problems it's had over the last year. Lucent's problems are deeply rooted in management inefficiencies. All the patents in the world won't solve those problems. I believe that a strong, new management team is the only thing that can turn Lucent around.
In his book Common Stocks and Uncommon Profits, Philip Fisher said, "& when large companies depend chiefly on patent protection for the maintenance of their profit margin, it is usually more a sign of investment weakness than strength."
The market leadership we demand of Rule Makers is based much more on manufacturing strengths, a talented sales force, management vision, and other advantages than on a jungle of patents.
There can even be disadvantages to patents, since they become public documents. That means rivals see them, and, while they can't use whatever has been patented unless they license it from the designer, they can design around patents. One of the advantages of unpatented manufacturing know-how and process technology is that it can't be copied.
Becton Dickinson (NYSE: BDX) is the leading manufacturer of hypodermic needles and syringes. The key to its success is that its needles are sharper than its competitors (sharper needles are actually more comfortable to the user than blunt needles). Manufacturing sharp needles is governed by process technology that can't easily be copied.
Intel's (Nasdaq: INTC) manufacturing prowess is key to its success. Its "Copy EXACTLY!" method of ramping up new factories is quick and efficient, and allows Intel to duplicate yields from existing plants and decrease time to market. This approach to manufacturing isn't patented.
Fisher said it best: "...it is the constant leadership in engineering, not patents, that is the fundamental source of protection." Engineering leadership cannot readily be copied, yet engineers can design around patents. Even if they can't, the patent advantage isn't sustainable. Eventually the patent expires and knock-offs flood the market. A company's position as a leader in manufacturing expertise is much more difficult to overcome.
In the pharmaceutical industry, companies often come up with similar drugs. Success is often based on which company can market its products better. For example, Pfizer (NYSE: PFE) has an agreement to co-market Celebrex with Pharmacia (NYSE: PHA). Merck (NYSE: MRK) manufactures and markets Vioxx. These two patented products are very similar in terms of what they can be prescribed to treat and both are safer for the stomach than products like Ibuprofen. When I asked a doctor who prescribed Vioxx for me why he chose it over Celebrex, he essentially told me that he alternates prescriptions of the two drugs, and that he'd be happy to prescribe either one for me. He's actually conducting his own study to determine which is more effective.
Celebrex has a bit of a lead over Vioxx because it was approved first. But, over the long haul, the success of the marketing efforts to sell these products will have a big impact on which generates more sales. One of the primary reasons that Pfizer was chosen to co-market Celebrex was its marketing strength. Once again, an unpatented process drives success.
The success of companies that primarily sell services is also driven by unpatented process. The key for these companies is often the strength of the sales organization. As a matter of fact, the failure to recruit, train, and retain successful salespeople can constrain a company's growth opportunities when it enters new markets.
The bottom line is that when you're trying to determine what makes a company thrive relative to its rivals, you should look beyond patents, and get a feel for how well its manufacturing, marketing, and sales organizations perform.
Have a great night. I'd also like to wish a Happy Hanukkah and a Merry Christmas to all.
Phil Weiss, TMF Grape on the Discussion Boards
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