Systematic Application of Intangible Assets

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1 R E P R I N T E D F R O M M A R C H 3, Systematic Application of Intangible Assets GAUTAM DHINGRA is the Founder and Chief Executive Officer of High Pointe Capital Management, LLC. He founded the firm in December 1997 to implement a new approach to stock selection incorporating intangible assets such as brand equity, patents, etc. Today the firm manages over $900 million for well-known institutional and high net worth clients. He has over 20 years of experience as Portfolio Manager, Director of Investment Research, and Investment Adviser. Prior to starting High Pointe, he was a partner in Hewitt Investment Group, a leading investment advisory firm based in Lincolnshire, Illinois. He joined the firm in 1986 as Director of Investment Research and became a Partner in the firm in Mr. Dhingra holds a PhD in Finance, with a specialization in investments, from the University of Florida. He has taught courses in Securities Analysis and Derivatives at the same university. He achieved his Chartered Financial Analyst designation in He is currently a member of the Board of Regents of the 2007 Financial Analysts Seminar hosted by the CFA Institute. Prior to this, he served as VicePresident, Education, for the CFA Society of Chicago. He has written and published several articles and has been invited to speak at several prestigious investment conferences. His latest article is entitled Intangibles: The Next Frontier in Stock Valuation. Some of his other articles have been published in the Journal of Pension Benefits, Pension Investment Handbook and Pension World. TWST: Would you please start with an overview of High Pointe Capital Management? Mr. Dhingra: I founded High Pointe Capital in December 1997 with the objective of implementing some new ideas that I had developed for the management of US equity portfolios. Today, we manage approximately $950 million in assets for both institutional and high net worth clients. We manage our assets in three main products large cap value, large cap growth and small cap. All of our assets are managed in a long-only format. Our key distinguishing feature for investment management is the way we incorporate intangible assets in a systematic way to make better stock selection decisions. TWST: What are the intangible assets? Mr. Dhingra: Some examples of intangible assets would be patents or brand equity. As our economy has transitioned from an industrial, manufacturing economy to an information, services-based economy, more and more of the value of companies is tied into assets that are not on their balance sheets. There was a study done at the Federal Reserve Bank of Philadelphia a few years ago that pointed out that US companies now spend more money on intangible investments than they do on tangible assets. This study also pointed out that more than one-third of the value of US companies is now comprised of intangible assets. In fact, there was another paper done recently by the Bureau of Economic M O N E Y M A N A G E R I N T E R V I E W

2 Analysis published at the end of September 2006 that pointed out that if R&D had been counted as an intangible asset, the GDP of the US would have grown significantly. The paper went on to point out that starting in 2012, the US government does indeed plan to incorporate R&D into its GDP calculation. That would lead to a significant increase in the stated GDP numbers. So the recognition of intangibles is increasing, and we fully expect that trend to continue. TWST: What are some specific examples of these intangible assets? Mr. Dhingra: Let us say that Pfizer spent $1 billion to develop a drug. That money was written off as R&D each year as the expense was incurred. Let us say that Pfizer now is able to generate process. We wanted to incorporate the intangibles that a model based primarily on accounting data would miss. TWST: Does High Pointe now have a more complete stock valuation model than standard industry models? Mr. Dhingra: We believe so. TWST: Would you continue with your investment process? Mr. Dhingra: Our investment process starts with the evaluation of intangibles, and we do that via a metric that we have developed called the Competitiveness Score metric, or C-Score. This metric was inspired to some extent by Michael Porter s work on competitive strategy. By incorporating Porter s insights with our own thinking over time, we have developed a methodology that works as follows. Any valuation model that is based primarily on accounting data is bound to be inaccurate because accounting data does not completely incorporate all the assets. Specifically, such models completely ignore the intangible assets. We wanted to incorporate the intangibles that a model based primarily on accounting data would miss. $500 million in sales from that asset per year. If you look at the balance sheet of Pfizer, you won t see an asset because the nature of the asset is intangible. It exists only in the form of a patent, which keeps everybody else from using that patented chemical compound for 17 years. So the patent on a chemical compound is a specific example of an asset that s extremely valuable for Pfizer, but it doesn t show up on the balance sheet of the company. Another example would be the brand equity that Coca-Cola enjoys. If you ask Coke what its biggest asset is, I am sure the answer would be the brand name itself. That brand name has become valuable through years and years of heavy advertising, plus superior execution. But you would not see a balance sheet item on Coke s balance sheet that says that the Coke brand is worth X billions of dollars, even though it clearly is. It is another example of an intangible asset that s very valuable, but not on the balance sheet of the company. TWST: Do these intangible assets make the valuation of the companies inaccurate? Mr. Dhingra: Any valuation model that is based primarily on accounting data is bound to be inaccurate because accounting data does not completely incorporate all the assets. Specifically, such models completely ignore the intangible assets. So yes, a model based on accounting data is bound to be inaccurate because it is going to miss the intangibles. That was the genesis of our investment We realize that an analytical solution to the problem of measuring intangibles does not exist certainly not with the current state of the art in terms of disclosures about intangibles. So we use a non-parametric or ranking technique to score the various intangibles and ultimately add up the scores for each company to get a Competitiveness Score ranking. To be more specific, we realize that intangibles differ so much from one industry to another that it is not feasible to compare one industry s intangibles, such as patents, to another industry s intangibles, such as brand equity. So we needed to come up with common factors that are derived from intangibles, but are common across all industries. We said, What is the benefit of having patents? The benefit is that if one has a patent on a particular input, one can keep everybody else from using that product, so one creates high barriers to entry. The factor that we evaluate across industries is the degree to which barriers to entry in an industry are high. Along the same lines, when we think about brand equity and the benefit that it brings, our view is that a firm with strong brand equity is able to charge a higher price for its product than a generic that satisfies the same need. So having brand equity gives a company pricing power. While brands may not be common across all industries, pricing power, or the lack of it, is a common factor that can be evaluated across all industries.

3 This line of thinking led us to develop a list of six factors that we score for each industry. The first one is barriers to entry, the second one is barriers to exit, the third one is degree of competition, the fourth one is pricing power, the fifth one is sustainability of competitive advantage and the sixth one is value-added versus the commodity nature of the products or services. These six factors are evaluated for each industry, and we combine that with a companyspecific competitive position score on a scale of 1 to 5. We then add up the scores to develop a total Competitiveness Score for each company in our universe. We then use this Competitiveness Score as one of the explanatory factors in our statistical valuation model to find those companies that appear to be inexpensive from a quantitative perspective, and that completes the first and second step of our investment process. The third and the last step is to do fundamental analysis on the companies that appear to be inexpensive to make sure that they are indeed inexpensive and that it is not a case of the model missing out on a risk element that might explain why these companies are inexpensive. If a stock passes through all three screens and comes through as a buy candidate, we then take it through the next step, which is portfolio construction. TWST: Tell us about the portfolio construction process. Mr. Dhingra: Our portfolios of large cap growth and value holdings consist of between 20 and 30 stocks, and our small cap portfolios typically consist of about 40 stocks. Once we have identified our buy candidates, we then want to make sure that they do not lead to an undiversified portfolio with significant risk associated with it. To manage the risk, we typically limit our holdings in any one industry to two stocks at the maximum. At any given time, we have at least 15 industries represented in our portfolios. The maximum sector bet we take is plus or minus 15%, relative to our benchmark. Then we have some constraints regarding the maximum weighting we would allow for individual securities. So our portfolio construction rules are designed to manage risk while, at the same time, keeping the number of holdings small enough so that we would not dilute our alpha potential too much. TWST: Do you have benchmarks against which you can measure the performance of your three products? Mr. Dhingra: Yes. For our large cap value product, we use the Russell 1000 Value Index. We use the Russell 1000 Growth Index for the large cap growth product. For the small cap product, we use the Russell 2000 Index. Our investment process starts with the evaluation of intangibles, and we do that via a metric that we have developed called the Competitiveness Score metric, or C-Score. We realize that an analytical solution to the problem of measuring intangibles does not exist certainly not with the current state of the art in terms of disclosures about intangibles. So we use a non-parametric or ranking technique to score the various intangibles and ultimately add up the scores for each company to get a Competitiveness Score ranking. TWST: Does this Competitiveness Score also apply to the small cap product that you offer? Mr. Dhingra: It does apply to the small cap product. However, in identifying industry scores in the small cap universe, most of the time, we need to find a niche industry. What often happens is that the larger players may have such a scale advantage that if a small firm tries to compete in the same business, it is often unlikely to have a significant competitiveness score. However, there are many sub-industries or niche industries where even small companies can have a competitive advantage. TWST: What has the track record been like for the performance of your portfolios? Mr. Dhingra: Since the inception of the products, each of the products has performed very well relative to its respective benchmark. Our value product s return since inception is 15% versus 8.6% for the benchmark. The growth product s return since inception is 10.6% versus minus 1.7% for the Russell 1000 Growth Index. Our small cap product has produced a return of 13.2% versus 8.1% for the benchmark. All of the return numbers that I gave you for our performance are net of fees.

4 TWST: Is your process unique? I don t understand why everyone doesn t use a competitiveness score. Mr. Dhingra: We believe our process is truly unique. The uniqueness of it comes from two perspectives. One, I think many quantitative managers still rely perhaps too much on accounting data. Second, even those who do take into account the intangibles to some extent don t do it in a systematic, comprehensive, quantitative manner. That is where our edge is. Mr. Dhingra: Absolutely. Our portfolios have a significant bias toward service stocks. By contrast, we are underweight in the energy sector by a significant amount. Currently, our value portfolios have a 0% weighting in the energy sector, and our growth portfolios have only a 2.6% weighting in it. We are also underweight in raw materials and utilities. All of these sectors are capital intensive, and we are typically underweight in highly capital-intensive sectors. That is currently the case. As the valuation on Home Depot has come down in response to concerns regarding the slowing housing market, we have determined it to be a company with significant competitive advantages and a reasonable growth opportunity. It is producing significant free cash flow and is selling at approximately a 13 to 14 times forward price/earnings multiple. It is true that there are many investors who value or appreciate the value of intangible assets. For example, if you look at Warren Buffett s holdings over the years, they include Disney, American Express, Washington Post, Coke and Gillette. If you think about the assets of these companies, you would realize that the brand equity associated with these companies is significant. In many cases, these companies are in businesses that are oligopolies. So there are other investors who do realize the importance of intangibles. However, I don t know of anybody who has tried to systematically and comprehensively implement it across their entire universe of stocks. TWST: Do you do sector work? Mr. Dhingra: Our work is done at the industry level, so it is not at the broad sector level. TWST: How have the portfolios changed in emphasis over the last 12 to 18 months? Mr. Dhingra: Our emphasis has shifted a little more toward technology over the last 12 to 18 months, relative to our benchmarks. As many investors have chased energy stocks, raw material stocks and cyclical industrials, they have left the technology stocks in the dust. Many of them represent good values, given their above average growth characteristics, strong balance sheets and valuations that are the lowest that they have been in years. So we have been more attracted to the technology sector over the last year or so. We have continued to find good opportunities in health care as well. TWST: You mentioned that the US economy is transitioning from industrial to an information and service base. Is that reflected in your portfolios? 1-Year Daily Chart of Home Depot Chart provided by TWST: Are you able to give us some representative examples of your three portfolios? Mr. Dhingra: Yes. In our value portfolios, one of our recent purchases has been Home Depot (HD). Home Depot has some significant competitive advantages. It operates in an industry that has become more and more oligopolistic over time. There are two main national players with scale, and the power of the smaller operators has continued to decline over time. The cost advantage that Home Depot and Lowe s (LOW) enjoy has made it difficult for other smaller operators to continue profitably in the business.

5 Secondly, as the valuation on Home Depot has come down in response to concerns regarding the slowing housing market, we have determined it to be a company with significant competitive advantages and a reasonable growth opportunity. It is producing significant free cash flow and is selling at approximately a 13 to 14 times forward price/earnings multiple. That is quite attractive for a company that is a leader in its industry. We believe that growth opportunities still exist for it in places like Mexico, Canada and perhaps in other countries as well. The free cash flow yield that this company is likely to generate is approximately 4%, and that is after deducting a significant portion of its cash flow that is going toward generating growth about 2.6%. So if you add up the 3.8% that investors will In the small cap space, one of the companies we like is a company called Avid Technology (AVID). Avid is the largest supplier of digital editing software and systems for manipulating video, film and audio. We are in an early stage of high definition conversion, and as that occurs, the demand for Avid s products is likely to grow very fast. This company effectively controls the market. It has the largest market share. In fact, they bought the number two player about a year ago. So we are very positive regarding the growth prospects of Avid Technology. This company also happens to have a significant asset on its balance sheet in the form of net cash. It has about $4 a share in net cash and it produces 5% in free cash flow yield, which is quite unusual for a growth company. What we also like about Sprint is that its valuation is lower than that of its competitors. It sells at approximately 5 times EBITDA, whereas others sell at about 7 times EBITDA. We realize that Sprint has some short-term issues to overcome related to the integration of Nextel into Sprint, but we think that s simply a matter of time. Once that integration is complete, the valuations on Sprint should improve. get and the 2.6% that is being spent on meaningful and attractive growth opportunities, it makes this company an attractive holding. In our growth portfolios, we have purchased Sprint Nextel (S) in recent months. Sprint is the largest wireless pure play company, with some significant advantages in the push-to-talk market. The US wireless industry has become more consolidated over the last five years or so. Now there are three viable national players Verizon (VZ), Cingular and Sprint whereas five years ago, there were six or seven players that were competing fiercely and engaging in price wars. As the industry has consolidated, we believe the competition has become more rational, and this industry is on its way to becoming an oligopoly. What we also like about Sprint is that its valuation is lower than that of its competitors. It sells at approximately 5 times EBITDA, whereas others sell at about 7 times EBITDA. We realize that Sprint has some short-term issues to overcome related to the integration of Nextel into Sprint, but we think that s simply a matter of time. Once that integration is complete, the valuations on Sprint should improve. Given its low valuation and the reasonably good growth opportunities available to Sprint, we believe it should be an attractive stock looking forward over the 12 to 18 months. 1-Year Daily Chart of Sprint Nextel Chart provided by TWST: What about some qualitative factors like management performance and accountability? Is that part of what you look for? Mr. Dhingra: It is tempting for us to try to look at management quality. In fact, we investigated this issue some time ago

6 and realized that it was difficult to evaluate people and personalities. Instead, we realized we needed to focus on the decisions of the management. So the factor that we look at is management s capital allocation decisions. If the management s capital allocation decisions reflect shareholder friendliness, we are more likely to buy that company, whereas if the management decisions are not shareholder friendly from a capital allocation perspective, we are less likely to buy the company. If the opportunities for profitable growth for the company are significant, we like the idea of management reinvesting the money and even borrowing to grow. However, if the opportunities in The third and final reason for us to sell a stock is to make room for a substantially more promising investment. We strictly adhere to the high end of the limits on our portfolios. So in our value portfolio, if we have 25 stocks already and a 26th idea comes along that is more attractive than some of the existing ideas, we would force ourselves to get rid of the least attractive of the 25 ideas in our portfolio. TWST: Are you always fully invested or do you keep a cash position at times? Mr. Dhingra: We are always fully invested, and our cash positions are typically less than 2% of the portfolio. Avid Technology is the largest supplier of digital editing software and systems for manipulating video, film and audio. We are in an early stage of high definition conversion, and as that occurs, the demand for Avid s products is likely to grow very fast. This company effectively controls the market. front of the management are not as attractive, we like to see money being returned to the shareholder. So our evaluation of managements is based strictly on the capital allocation decisions, rather than a more subjective evaluation of the CEO or how effective the CEO has been or might be in the future. TWST: What about the sell process and the average turnover of your portfolios? Mr. Dhingra: Our sell process consists of three elements. The first one is valuation. When a stock reaches approximately 90% of our target price, we start searching for alternatives to that stock. The second reason for us to sell is associated with changes in fundamentals and in risk. If fundamentals deteriorate to an unacceptable level, we will sell a stock. One manifestation of additional risks can come in the form of a stock price decline. If a stock declines approximately 20% after we have bought it, we have to redo all of our work that led to the decision to buy the stock. This reexamination is intended to force us to second-guess ourselves, because if the market disagrees with us, we want to know why. Our reexamination is a discipline that forces us to buy more of the stock and rebalance the portfolios if our analysis concludes that the stock is a better buy after the price decline. But at the same time, if we find that we had either underestimated a risk or a new risk has come up, we will go ahead and sell the stock. 1-Year Daily Chart of Avid Technology Chart provided by TWST: What about risk management in the portfolio? How do you attempt to control it? Mr. Dhingra: We control risk through the portfolio construction rules that we discussed earlier, to limit our exposure to individual securities, industries and sectors. We try to manage the risk at an acceptable level. Our goal is to have a downside portfolio whose volatility is no higher than that of the benchmark, while maintaining the alpha potential of the portfolio relative to the benchmark.

7 TWST: Are there any other ways that you feel your approach is differentiated from that at other firms? Mr. Dhingra: The primary differentiation is the incorporation of intangibles into our decision-making process. The other factor that adds value is a systematic quantitative approach. It allows us to efficiently analyze reams of data. A fundamental overlay then allows us to overcome any potential weakness of the quantitative approach. We like to think we have built a more complete stock selection model. TWST: Do you see any possible challenges or potential problem areas looking ahead? Mr. Dhingra: For the next several years, we see the opportunities getting better for us because we believe the recognition of intangibles is going to gain more and more prominence. As that process occurs, it should benefit us since we have a head start in tackling intangibles. Over the very long term, however, it is possible that if more and more people start to incorporate intangibles into their processes, we would need to advance our state of the art to stay ahead of the pack. So that is the long-term challenge for us, but in the short to intermediate term, it represents more of an opportunity. TWST: Do you have any advice for the investor about approaching the market with this intangible philosophy? Mr. Dhingra: My advice to investors would be to focus on long-term secular changes that are occurring the shift from manufacturing to service and from tangibles to intangibles. Secular trends over time will overpower the short-term cyclical trends. My advice would be to make sure that investors don t lose sight of the long-term secular trends when they are making their investment decisions. TWST: Is there anything that we overlooked that you wanted to discuss in this interview? Mr. Dhingra: We believe that in order to add value, an investor needs to do something that is different from what everybody else is doing. We believe we have identified such a niche, and through the systematic application of this missing element of intangibles that we have discovered, we hope to continue adding value for our clients for years to come. TWST: Thank you. Note: Opinions and recommendations are as of 2/20/07. GAUTAM DHINGRA High Pointe Capital Management, LLC One North LaSalle Suite 2001 Chicago, IL (312) The Wall Street Transcript, 48 West 37th Street, NYC Tel: (212) Fax: (212) Website: