Knowledge Leaders US Mid-Large Innovation Analysis

In recent reports, we’ve been highlighting that innovation—as a factor represented by R&D as % of sales—has stopped underperforming and it is selling for an attractive valuation. We used the S&P 500, Russell 2000 and other off-the-shelf indexes. Today we will highlight one of our baskets of stocks and do a similar innovation analysis.

Below is the data we’ll be working with. This is an aggregation of the 182 companies that represent our Knowledge Leaders Mid-Large US group of stocks. These baskets fuel our investment strategies.

In order for a stock to get into our basket, it has go through several steps. First, we take the top 85% of stocks in the US and transform their financials by capitalizing intangible investments using our proprietary methodology. After we have adjusted financials, we run all companies through a proprietary screen designed to identify companies that possess a variety of qualities: high intangible investment, low leverage and profitability. The result is the 182 companies summarized below.

Relative to other innovation-focused indexes, like the Bloomberg R&D Leaders Index, our Knowledge Leaders basket is much more diversified across sectors. While our basket doesn’t contain any energy or utilities stocks, it does have some representation in the other sectors. While technology and health care comprise over 80% of the Bloomberg R&D Leaders Index, they represent a combined 56% in our basket.

I brought back data from Bloomberg for the trailing twelve months and then aggregated into the table above. These 182 companies spent a combined $353 billion in research and development, more than the $308 billion spent on capital expenditures.

When we adjust net income and operating cash flow by adding back R&D, the valuation picture changes pretty dramatically. On a reported basis, this basket sells for 23.4x net income and 17.1x operating cash flow. But, on an adjusted basis, the basket sells for 14.9x net income and 12.1x cash flow. These adjusted valuations are 36% and 29% cheaper than the reported stats.

How one treats investments in intangible assets has everything to do with one’s perspective on valuations in the market right now. For a portfolio of companies with at least 5% of assets represented by intangible assets, less than 50% net debt, a cash flow margin above 10% and positive free cash flow, 12.1x operating cash flow seems like a very undemanding valuation.

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