Asset Allocation Weekly: intellectual property takes control of fixed investment


Confluence Investment Management offers various asset allocation products which are managed using top down or macro analysis. We publish thoughts on asset allocation on a weekly basis in this report, updating the report every Friday, with a podcast and accompanying chart book.

August 13, 2021

It is probably no surprise to anyone that information processing has become an increasingly important part of the economy in recent decades. By now, we’ve all got used to seeing new kinds of computers and phones every year, and we struggle to learn new software at home or at work. Whether you call it the ‘digital economy’ or the ‘knowledge economy’ what few people realize is that it is about to reach a milestone in gross domestic product (GDP) data. ) American. Therefore, this may be a good time to explore some of the trend’s investing ramifications.

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In the United States, private investment spending currently accounts for around 17.5% of total GDP, but the category naturally includes many sub-components. Investments in housing and business inventories are only a small part of the total. The largest component of the category is “non-residential fixed investment”, which is often referred to as “business” fixed investment and accounts for around 13.5% of GDP. Until the 1990s, fixed business investment was dominated by spending on machinery, equipment and structures. Investment in intellectual property – primarily spending on research and development – was a much smaller part of the category. The difference now is that intellectual property spending has exploded, mainly due to an increase in software investment. Overall, business fixed investment has grown at an average annual rate of 7.6% over the past four decades (including price changes), with software investment increasing at a rate of 10, 9% and investment in R&D at a rate of 7.1%. As a result, intellectual property is poised to become the main component of corporate fixed investment.

The implications of this development are enormous. In economic terms, the marginal cost of selling an additional software package or operating the underlying R&D may be minimal. In addition, digital products and software can have significant spillover effects, in that they can deliver value to customers beyond the basic service for which the software is designed. A good example of this is the “network effect” when the customer gets more value by joining a social media network when the network has more people. The low cost of selling additional units and the incentive to grab spillover value means there is a strong incentive for digital businesses to grow their network and grow as big as possible. The growing dominance of intellectual property in the economy is probably one of the reasons why corporate profits as a percentage of GDP have risen sharply in recent decades (see graph below). Note, however, that the enormous size of these companies is now raising concerns about stifling competition, which could lead to tighter antitrust regulations around the world.

Naturally, investors are attracted by the increasing size and profitability of companies that produce software or can efficiently exploit their digital R&D. Additionally, as other companies continue to learn how to increase their productivity using big data, data management, data analytics and artificial intelligence, they are likely less likely to reduce their investments in intellectual property. in times of recession. Indeed, investments in intellectual property continued to increase throughout the Great Financial Crisis of 2008-2009 and the recession of 2020 due to the coronavirus, as shown in the first graph above. From another point of view, the growth rate of
investment in intellectual property has had a standard deviation of only 5.2% since 2000, which is slightly lower than the standard deviation of 5.8% for overall GDP and significantly lower than the average deviation of 13, 9% for equipment and 14.4% for structures. In summary, investments in intellectual property are much more stable than investors realize. So there is a good business reason why digital technology and software companies are increasingly seen as ‘defensive’. In many environments, we favor this sector because it offers an attractive combination of good prospects with relatively less sales volatility than investors perceive.

Past performance is no guarantee of future results. The information provided in this report is for educational and illustrative purposes only and should not be construed as individualized investment advice or a recommendation. The investment or strategy discussed may not be suitable for all investors. Investors must make their own decisions based on their specific investment objectives and financial situation. The opinions expressed are current as of the date indicated and are subject to change.

This report was prepared by Confluence Investment Management LLC and reflects the current opinion of the authors. It is based on sources and data believed to be accurate and reliable. The opinions and forward-looking statements expressed are subject to change. This is not a solicitation or offer to buy or sell securities.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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