August 2011 Archives

Technical difficulties with the blog - please stand by

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You can read -- but you can't link. That seems to be the state of the Intangible Economy blog. None of the links are working. Technicians are working on the problem -- but no estimate of when things will be back to normal.

In New York Times op-ed yesterday, Susan Hockfield, the President of MIT, made the case for manufacturing. Central to her piece ("Manufacturing a Recovery") is a description of some advanced manufacturing companies:

Like the jet aircraft made by Boeing, one of the country's largest exporters, products like these require sophisticated manufacturing equipment, operated by skilled workers, and benefit from the tight integration of design and production. With goods like these, the United States can reassert an economic advantage. If we can find ways for companies of every size to exploit the possibilities of nanofabrication, advanced materials, robotics and energy efficiency, we can create networks of innovation, joining lab research to new production processes and business models.
That tight linkage between product creation and product manufacturing has been highlighted by a number of others, most notable Gary Pisano and Willy Shih at the Harvard Business School in their HBR piece "Restoring American Competitiveness".

I would go one step further and stress the tight linkage between product manufacturing and servicing. As I have noted many time in this blog, the difference between "manufacturing" and "services" are eroding. Service activities are increasingly linked manufacturing activities. In fact, companies such as the German Mittelständler companies are successfully competing in "old" industries based on that linkage. They offer knowledge -- not low cost. Knowledge is what gives them a superior product and knowledge is what makes their services so valuable. But is it not just generic knowledge. They are selling their knowledge as a means to create solutions for their customers. Their customers want the knowledge to be specifically applied to them - not some abstract concepts. That is the "service" part of the equation. So, all of the activities described above for helping manufacturing should recognize that these manufacturing companies are already in the "service" business.

The fusion of product and service is part of the overall shift of manufacturing. As I pointed out in the Athena Alliance Policy Brief--Intellectual Capital and Revitalizing Manufacturing, manufacturing is in the process of being transformed into a much more knowledge-intensive activity. The process is analogous to the transformation of agriculture in the early 20th century. Farming did not simply move to other nations with lower-cost producers using the traditional techniques. Agriculture was mechanized--or industrialized, if you prefer. That transformation led to efficiencies that revolutionized the production of commodities and contributed to U.S. economic growth.

As manufacturing is transformed into a much more knowledge-intensive activity, it will require attention to all the inputs to the production process -- technology, worker skills, and cooperative/collaborative organizational structures. All of which are key intellectual capital and intangible assets.

Embracing the role of intellectual capital and intangible assets in manufacturing requires going beyond the narrow view of formal intellectual property. Scientific and creative property are valuable assets that include product development activities beyond the patent, new architectural and engineering designs, and social and organizational sciences research. Computerized information, including customized software and databases, are other important company assets that go beyond our definitions of intellectual property. Specific business models, organizational structures, and organizational capabilities are key elements of any company's ultimate success. Worker skills and tacit knowledge--both general and firm-specific--are assets that managers describe as leaving the company every evening and returning every morning. Brand equity, reputation, and relationships with customers and suppliers are all important. All of these forms of intellectual capital need to be explicitly developed and managed by successful manufacturing companies.

The policy question, therefore, is how do we position American manufacturers to make the transformation. It will not be an overnight leap, but a gradual process that will require sustained attention. At the heart will be helping companies understand the transformation and how to best utilize their intellectual capital.

There are a number of specific actions that could be taken to support the transformation. We should expand the Manufacturing Extension Partnership (MEP) services to explicitly include assistance in indentifying and managing their intellectual capital. Likewise, we should include intellectual capital management in Small Business Administration (SBA) training programs and Economic Development Administration (EDA) business incubator programs. We could also create a specific award and assessment program similar to the Baldrige Award.

Assistance for on-the-job training should be expanded. We should also create a program to allow businesses to use their intangible assets, specifically their intellectual property, as collateral on loans. This could provide an important source of capital to help companies finance the transformation. The government could also do more to promote innovative manufacturing through its procurement process and through the establishment of demonstration and technology diffusion programs.

Research on the manufacturing transformation should also be undertaken. But this should go beyond the traditional advanced manufacturing concept to embrace the entire transformation. For example, the concept of "design thinking" is becoming increasingly important in product development. Just like we have created Engineering Research Centers in a number of areas (including advanced manufacturing), we should create one for design thinking. Likewise, research need to be continued on new manufacturing business models and the linkages between services and manufacturing.

Next, it should be recognized that all of the activities described above for helping manufacturing also apply to services. Service industries are becoming more knowledge-intensive and need to understand and better their intangible assets. MEP could be further expanded to a offer assistance to service providers -- just as the Baldrige Award was opened up to service businesses. Promoting innovative service delivery activities the government procurement process and through the establishment of demonstration and technology diffusion programs is also just as important as in manufacturing. Likewise, research on the organizational and business model aspects of service delivery should be undertaken.

Thus, it is not just a movement to advanced manufacturing in the sense that Hockfield describes that concept -- as important as that is. What we face is a transformation of the entire production system. Companies are already in the middle of that transformation. Our public policy needs to catch up.

Regulations as an innovation forcing function

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In earlier postings, I've argued that, done right, regulations can be a driver of innovation by creating demanding customers. Here is one small example from today's Wall Street Journal -- "A GM Redesign Achieves Higher MPGs":

After rising just 10 mpg in the last 30 years, the nation's fuel economy regulations are poised to rise at least an average of two miles a gallon a year for the next decade. By 2025, the average new vehicle is required to get 54.5 miles per gallon.

Those increases are forcing companies to rethink how they design their vehicles. Honda Motor Co.'s 2012 Civic has specially coated engine pistons that reduce friction. The result is a 2% improvement in fuel economy. The 2012 Toyota Motor Corp. Camry weighs 150 pounds less than this year's model. Chrysler Group LLC put a more fuel-efficient, eight-speed transmission in its 300 sedan. The car will get more than 30 miles a gallon, compared to 27 mpg in the current model.

In the case of the Chevrolet Malibu, GM engineers spent three years on changes that eked out at least five miles a gallon, creating a car that will go at least 92 more miles on a tank of gasoline compared to the current model. Slicker aerodynamics were just part of their bag of tricks. Lighter materials, such as an aluminum roof, and computer-controls that shut off the engine when idling and open and close grille vents also were part of the mileage boosters.

The story goes on to describe numerous other changes to improve fuel efficiency. None of them are "breakthough" innovations. Rather, they constitute a steady stream on incremental innovations. But they are the type of innovations that are easily overlooked. Without the forcing function of higher goals -- in this case in the form of regulations, they are innovations that may not have even been thought of, let alone implemented.

That may the real power of regulations as a forcing function: not necessarily the breakthrough but the smaller, incremental steps. Either way, good regulations can foster innovation - just as bad regulations can inhibit it. Our task is to know the difference.

This morning Fed Chairman Ben Bernanke gave his annual address to the Fed policy symposium in Jackson Hole. This year, the topic of the conference was Achieving Maximum Long-Run Growth. In his remarks, Bernanke focused on fiscal, rather than monetary policy. While discussing the state of the economy and the deficit, he also focused on the need for improving US productivity and competitiveness:

Fiscal policymakers can also promote stronger economic performance through the design of tax policies and spending programs. To the fullest extent possible, our nation's tax and spending policies should increase incentives to work and to save, encourage investments in the skills of our workforce, stimulate private capital formation, promote research and development, and provide necessary public infrastructure. We cannot expect our economy to grow its way out of our fiscal imbalances, but a more productive economy will ease the tradeoffs that we face.

These remarks echo his comments earlier this year at Athena Alliance's conference on New Building Blocks for Jobs and Economic Growth. In those remarks (see earlier posting on highlights, transcript and video), Bernanke noted:

The topics you will address today and tomorrow, bearing on innovation and intangible capital, are central to understanding how we can best promote robust economic growth in the long run.
Over long spans of time, economic growth and the associated improvements in living standards reflect a number of determinants, including increases in workers' skills, rates of saving and capital accumulation, and institutional factors ranging from the flexibility of markets to the quality of the legal and regulatory frameworks. However, innovation and technological change are undoubtedly central to the growth process; over the past 200 years or so, innovation, technical advances, and investment in capital goods embodying new technologies have transformed economies around the world. In recent decades, as this audience well knows, advances in semiconductor technology have radically changed many aspects of our lives, from communication to health care. Technological developments further in the past, such as electrification or the internal combustion engine, were equally revolutionary, if not more so. In addition, recent research has highlighted the important role played by intangible capital, such as the knowledge embodied in the workforce, business plans and practices, and brand names. This research suggests that technological progress and the accumulation of intangible capital have together accounted for well over half of the increase in output per hour in the United States during the past several decades.
Unfortunately, as I've noted before, many of the policy prescriptions coming out of Washington focus on the generalities and not on any specifics that would foster investment in and utilization of intangibles. When they do look at innovation and intangibles, they focus almost exclusively on technology (as did even Mr. Bernanke, although he did mention other intangibles at the end). If we are to ramp up economic growth, we need to ramp up our attention to intangibles.

End the Doha Round

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I don't often agree with Claude Barfield over that the American Enterprise Institute. But on this one, I think he is completely right -- "It's Time to Dump the Doha Development Round." (FYI -- something that trade attorney Bob Lighthizer proposed over a year ago "Stifling the Economy, One Argument at a Time".) As I've written a number of times before, the Doha Round has outlived its usefulness.

In fact, I'm not sure that the Doha Round wasn't outmoded from the beginning. Back in 2001, I wrote a paper on After Doha: What The WTO Is Not Talking About. In that piece I speculated that the Uruguay Round might have been the last major comprehensive round of multilateral trade negotiations. During my Senate staff career, I was involved in the beginning and the end of the Uruguay Round. When we finally passed the implementing legislation, I mused out loud that I thought this would be the last global round of trade negotiations. None of my colleagues agreed - and some of the old hands seemed taken aback at such heresy. They argued that you can only get an agreement by linking everything in a big package. (In diplomacy - this is known as "linkage.")

But the Uruguay Round may have sown the seeds of Doha's failure. The Uruguay Round changed the internal dynamics of trade negotiation. Global trade talks have become too complex and overarching to succeed in one mega-negotiation. The dynamics that made these trade rounds work is no longer present. Trade talks aren't about just trade any more. They are talks about the harmonization of economic rules. As such, the old trade-offs no longer apply.

In previous negotiations, the focus was on tariff reduction. I'll reduce my tariffs on steel if you reduce your tariffs on autos. This allowed for a win-win (from economists point of view) situation that pushed for lower and lower tariffs. Everyone agreed that the end point was lower tariffs. The question was how to get there.

Now it is unclear how the trade-offs work, and in what direction the dynamics points. I'll lower my tariffs on steel if you increase your patent protection to 100 years? I'll allow you to subsidize your aircraft industry if you don't ban my genetically-modified beef? I'll decrease my agricultural subsidies if you reduce regulations on investment banking?

We don't have any agreement on what the end point should be. We have a general idea - "open economies" - but we differ dramatically on what that means and on the specifics.

My 2001 piece also made the point that for all the various issues being raised in the Doha Round, a major piece is missing:

Not on the table is a comprehensive look at policies toward information and other intangibles. We are moving to a knowledge economy. Knowledge is both an increasingly important input into the production process and an end-use commodity in and of itself. As the role of information increases in both our economic and social systems, issues of control of information will become increasingly central to our policy and political debates. Parts of the issue are included in the WTO agenda, such as: Trade-Related Aspects of Intellectual Property Rights (TRIPS); the work program on electronic commerce; trade and investment; and the proposal for a new discussion on technology transfer. Missing from the discussions is the recognition of the interconnection between these areas.

My gut reaction to the trade talks is that we will have to approach each of these economic regulatory issues separately - possibly in separate forums, such as the OECD and the G20. Yes, this being a negotiation, there will be linkage. But the complex web of links will not become so great as to bring the entire structure down.

I, for one would welcome, such as shift. As the I-Cubed Economy matures, these economic harmonization discussions need to be ongoing. We are still feeling our regulatory way - and the economy keeps shifting. It is not as simply a matter as hitting a zero tariff number or eliminating a trade barrier. It is an evolutionary process that we need to engage with other countries real-time and continuously.

That is much more difficult that negotiating a trade agreement - but also much more important.

So, if the Doha Round collapses, let us not take it as a sign of failure. Rather, it is an opportunity to build the new international framework for regulating the new global I-Cubed Economy.

2Q 2011 GDP revised downward

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This morning, the BEA released the second estimate of the 2Q GDP. The rate of growth of the economy was revised downward slightly to 1% for the second quarter (from an "advanced" estimate of 1.3%). The downward revision was due to more complete data, including data that showed that exports were not as strong as first thought.

As I've noted in almost every previous posting on GDP, we need to remember that these numbers are only estimates based on incomplete data. And, as I have noted before, the data has a basic problem in that it does not give us any guidance on investment in intangibles other than software. So we do not know whether companies have increased or decreased their investments in important areas such as human and organizational capital. Work is underway in the UK to survey companies on their investments in intangible assets. We should be doing the same here.

Apple loses an intangible asset - maybe

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With the announcement last night of Steve Jobs' resignation as CEO of Apple, the importance of human capital as a key intangible asset has hit home. I don't subscribe to the Great Man theory of history. But it is clear that Jobs made a difference. His key skill was in redesigning the industry - starting with Apple II and through to the iPod/iPhone/iPad. And it hasn't been limited to products. And, as I have argued before, the big breakthrough was as much the business model of iTunes as it was the iPod design.

However, it is unclear what the final impact of yesterday's announcement. Jobs will still be involved in setting Apple's future course as Chairman of the Board. Jobs has also assembled a strong team, including Jonathan Ive, who some say is the real genius behind the design of the iPod. And Apple has built a strong culture of creating a "customer experience" that feeds customer loyalty. This relationship with its customers (aka fan base) is a strong intangible asset in and of itself (see earlier posting).

Of course, it was Jobs who pulled everything together. So the real question will the Jobs vision continue post-Jobs. Or will the team slowly fade away. We are not yet in that post-Jobs future. But is it is clear that an era may be ending.

UPDATE: One of the standard intangible assets is of course IP. Here is an interesting story from the Wall Street Journal on Jobs and Apple's protection of its IP -- "Controversy Surrounded Jobs's Innovations".

Job creation in start-ups

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E.J. Reedy and Bob Litan at Kauffman Foundation have written a new report on start-ups and job creation -- Starting Smaller; Staying Smaller: America's Slow Leak in Job Creation. The report highlights the fact that the job creation slowdown predates the beginning of the Great Recession.

Interestingly, the problem has not been a lack of start ups. In fact, the report notes that the 2010 Kauffman Index of Entrepreneurial Activity was at an all time high. The reason for the job slow down has been a decrease in the average number of jobs being created by new firms:

BLS data show that new establishments opened their doors with about 7.5 jobs on average for much of the 1990s, a figure that has since declined to 4.9 jobs per new
. . .
the most recent year of data shows a cohort of new business that was smaller in number and in jobs created than in any cohort since 1994 and, in most cases, than any previously measured cohort in data dating back to 1977.

And the problem is not just that new companies start out small. They also have stayed smaller.

The average rate of employment growth from birth to age two and then age two to age five has been decreasing in all the data series, with only moderate yearly variation. So, while the levels might vary slightly in the different data series, the trends appear similar: Businesses that survive their early years of existence have been adding jobs at a slower pace than the historic norm in recent years. (emphasis in original)

So the problem is not start-up, but scale-up.

To me, this calls for a different approach to public policy. The recent focus has been on the start-up process, for example the President's Startup America (see this posting on the Kauffman blog for an update of the program). This new look at the data tells me we need to focus more attention on the growth phase. There are a number of things we could be doing to help established business grow faster. For example, we could expand the Manufacturing Extension Partnership (MEP) programs to encompasses a broader range of business assistance services (including management of intangible assets) to a broader range of companies. We could also increase funding for high-growth intangible-rich companies by allowing intangible assets (such as patents and other IP) to be used as collateral for loans. Creating a pilot program on IP backing lending at SBA would be the first step.

Bottom line: entrepreneurship is good; scaling up from start-up to high growth is better. Time we start paying more attention to the latter part of the process.

Innovation needs to be a verb. Unfortunately, most people think of it as a noun. Innovation is a thing, an outcome. As Webster's defines it: a new idea, method or device. But we also need to think of innovation as a process.

Case in point is the recent history of Motorola. As everyone now recognizes, the proposed takeover of Motorola Mobility by Google is based on access to the Motorola patent portfolio. The acquisition has little to do with Motorola's hardware technology. In fact, as a story in today's New York Times ("Motorola's Identity Crisis") points out, Google may have difficulties figuring out what to do with Motorola's hardware activities. Google already has close relations with other hardware manufacturers, such as Samsung and HTC. Getting into the hardware business could disrupt those relationship.

This is far cry from Motorola's reputation as an innovative leader. Motorola pioneered wireless communications, starting with the first "carphone" (a radiotelephone) in 1946 to the first commercial cellular phone (the DynaTAC 8000X) to the breakthrough flip phone StarTAC and the hot selling RAZR. Motorola also led in process technologies in the late 1980 with the development of the Six Sigma quality improvement program.

The acquisition could be a huge positive step for Google if it can find a way to harness the innovation processes in Motorola. Controlling the previous innovations (noun) in the form of the patents is far different from exploiting innovation (verb) capacity latent in the Motorola Mobility organization. That capacity in embedded in a variety of intangibles -- from the innovation tradition and culture to the skilled workforce.

On the other hand, maybe all that changed with the split of the company last year into Motorola Mobility and Motorola Solutions. It could be that all that innovation capacity now resides in Motorola Solutions. If so, then Google has only bought itself some innovation-as-a-noun. Innovation-as-a-verb may continue somewhere else.

Understanding the patent boom

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If you want to understand what is happening with the recent patent boom, here are two stories to read: Steve Lohr's "A Bull Market in Tech Patents" in the New York Times and Jia Lynn Yang's "Four titans of tech are racing to be king of digital age" in the Washington Post.

It is not as if companies just realized the value of IP and innovation.

It is about dominating the next technological platform.

Not that this is necessarily a bad thing if it brings greater attention to intangible assets. As a NY Times Dealbook story ("Quest for Patents Brings New Focus in Tech Deals") relates:

"Before, nobody really paid attention to patents. Now patents are emerging as a new currency," said Alexander I. Poltorak, chief executive of the General Patent Corporation, a patent licensing and enforcement firm. "I've recently received several calls from financial analysts and bankers who want to know how to value patents and what does it mean."

Unfortunately, it may be a bad thing if it only feeds the litigation mindset. The concept of intangibles asset monetization easily be dismissed as only an innovation-blocking defensive strategy. Yet the utilization and management of intangibles can be a powerful positive and innovation-inducing business strategy (see earlier posting). It would be a major lost opportunity if we can't make the positive case for intangibles right now.

And by the way, for the latest on the patent wars behind all this, check out these two stories in the Wall Street Journal -- "Cellphone Patent Disputes Piling Up" and "Founder of Priceline Spoiling for a Fight Over Tech Patents".

The next patent round -- Kodak and others

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Get ready for the next patent auction. Kodak is the latest company to sell its patents, according to the Wall Street Journal:

Investment bank Lazard Ltd. began marketing the portfolio this week, reaching out to companies that may be interested, said a person familiar with the matter. The auction will be conducted over two stages, according to a person advising a company interested in buying Kodak's digital-imaging patents.
This person says the interested company is a large, strategic buyer in the wireless industry looking to use the patents for defensive protection.
The news apparently sent Kodak stock up by 24%.

The sale is the second part of Kodak's IP strategy. The company has already licensed a number of their digital imaging patents to mobile phone companies. According to the Journal story:

The licensing strategy brought in $1.9 billion from 2008 to 2010, but the flow of settlements dried up this year, prompting the company to look more seriously at selling patents, one board member said.
One wonders how many boards are asking the same questions and how many other companies are now scouring their patent portfolios looking for anything remotely associated with wireless technologies.

The near-frenzy over wireless patents has also sparked action in another area. The Journal also reports that Canadian patent licensing company Wi-LAN has launched a hostile bid for another Canadian technology company, MOSAID Technologies:

"Combining the patent portfolios will provide a more efficient and rapid path to establishing a larger and more valuable aggregate portfolio given the combined management team's expertise and increased business scale," Wi-Lan said in a statement. It will also allow the combined entity to access capital to grow the business and fund litigation to enforce its patents, if necessary, Wi-Lan said.
Who will be next?

How intangibles actually get counted

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In a couple of recent postings, I mentioned that for an intangible asset acquired from outside, accountants try to separate out the value of particular intangibles from the overall sales price. Here is a study from Ernst & Young - Acquisition accounting: What's next for you - that describes exactly how intangibles get counted. Published in February 2009, the study looked at over 700 acquisitions across a variety of industries as reported in 2007 annual reports.

In general, the story is not necessary very flattering. The report begins but noting the difficulties in getting the data, noting that "many companies were reluctant to fair value tangible assets bought and to provide detailed information on intangible assets they acquired and how they were valued." That insight is borne out by the fact that "goodwill" continues to be the convenient catch all category for acquired assets. Goodwill accounted for 47% of total enterprise value, compared with 23% for recognized intangible assets and 30% for tangible and financial assets. In other words, almost half of the total value of the acquisitions and over two-thirds of the intangible portion of the acquisition where labeled as goodwill. So much for accountants making process in accounting for intangibles. In almost a quarter of the transactions, goodwill was the only type of intangible -- no other type of intangible was reported.

On the other hand, the report seems to indicate that the category of goodwill is used extensively to capture the value of intangibles that GAAP accounting rules do not allow. For example, descriptions of goodwill include brief discussions of workforce skills and business processes.

The uses of goodwill versus GAAP recognized intangibles varies by industry. Not surprisingly, the patent heavy industries of biotechnology and pharmaceuticals have a larger percentage of intangibles in GAAP recognized categories and less in goodwill. The consumer products industry has the largest percentage of total value (and of intangibles) in goodwill at 65%. Interestingly, this is followed by the technology industry at 60% goodwill. Telecommunications had 48% in goodwill.

A breakdown of the telecommunications industry's recognized intangibles shows that 40% of recognized intangibles were in customer contracts and relationship. For consumer products, the largest recognized intangible was brands and trademarks, at 39% of recognized intangibles (which was only 27% of total enterprise value -- meaning brand and trademarks accounted for only 10.5% of total enterprise value of the acquisitions).

All in all, an interesting look at how accountants are allocating among intangibles. And a clear indication of how far we still need to go in accounting for and reporting of intangible assets.

Buying Motorola Mobility and valuing their intangibles

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In a posting last month I noted that Carl Icahn wanted Motorola Mobility to sell off its patents which he apparently estimates have a higher value than the $4.5 billion paid for the Nortel patents. Well, Motorola Mobility decided not to sell of their patents, but to sell the entire company to Google for $12.5 billion (see stories in the Wall Street Journal and New York Times, as well as Larry Page's official Google blog posting on the deal).

Given that the accounting rules require companies to account for intangibles purchased from outside, we might actually get to see what they assign as the value of the patents.

That valuation problem - in real estate

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One of the nagging issues about intangibles is the valuation problem. How can you assign a value to an intangible asset? In the case of a market transaction -- i.e. an intangible acquired from outside, accountants try to separate out the value of particular intangibles from the overall sales price. For internally generated intangibles, they don't even try. It is easy to simply dismiss valuation of intangible assets as not precise.

I would argue, however, that precision is a function of the valuation process itself not just the nature of the asset. Take, for example, that most tangible of assets -- real estate. It has been claimed that inflated valuations were a contributing factor to the housing finance bubble. Now come the concern from the other side, as illustrated in this piece in today's Wall Street Journal - "Judgment Call: Appraisals Weigh Down Housing Sales".

William Maxwell is an expert in finance. He's a professor at Southern Methodist University's business school, has co-authored a book on high-yield debt and spent years calculating values of financial markets.
Yet there's one valuation he can't understand: the appraisal of his Dallas home.
In August 2010, Mr. Maxwell's home was appraised at $790,000 as part of a mortgage refinancing. Yet this past spring, when he tried to sell the four-bedroom home for $756,500, the appraisal commissioned by the buyer's lender, Bank of America Corp., came up with a value of $730,000. Mr. Maxwell said the appraisal killed the sale.

The conclusion: the appraisal system is broken. Of course, not everyone agrees. As the article notes:

The Mortgage Bankers Association, an industry trade group, concedes that appraisals are conservative but says they need to be, partly to protect the banks from future problems with investors who buy mortgages. "There's an extra note of caution," said Steve O'Connor, a senior vice president at the association.
And some appraisers say homeowners are just having trouble facing reality. "It's the market. It's not the changes" in the appraisal process, says Charles MacPhee, a partner with Buttler Appraisals LLC.
The article goes on to cite a number of concerns with the appraisal process: less experienced appraisers; using distressed sales as part of determining comparable prices; use of automated valuation models; processes that don't capture all of the specific features of a property.

As we look at the issue of intangible asset valuation, let us keep in mind the lessons from real estate. Valuation includes a degree of judgment. The system will never be totally precise. We need to understand and accept that fact and move on.

June trade in intangibles

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The trade deficit rose by $2.3 billion in June to $53.1 billion, according to data released this morning by the BEA. Both exports and imports were down, compared with May. However, exports dropping by $4.1 billion while imports were down only $1.9 billion. The increased deficit was due completely to goods, as the deficit in petroleum products narrowed.

Our intangible trade surplus increased very slightly in June -- up by $98 million. Imports and exports of both business services and royalties increased, with exports of business services rising slightly faster than imports.

Our Advanced Technology Products deficit also grew in June to $8.8 billion as imports grew faster than exports generally across almost all sectors. One exception was biotechnology, where exports surged in June. The last monthly surplus in Advanced Technology Products was in June 2002 and the last sustained series of monthly surpluses were in the first half of 2001.

Intangibles trade-Jun11.gif

Intangibles and goods-Jun11.gif

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Note: we define trade in intangibles as the sum of "royalties and license fees" and "other private services". The BEA/Census Bureau definitions of those categories are as follows:

Royalties and License Fees - Transactions with foreign residents involving intangible assets and proprietary rights, such as the use of patents, techniques, processes, formulas, designs, know-how, trademarks, copyrights, franchises, and manufacturing rights. The term "royalties" generally refers to payments for the utilization of copyrights or trademarks, and the term "license fees" generally refers to payments for the use of patents or industrial processes.

Other Private Services - Transactions with affiliated foreigners, for which no identification by type is available, and of transactions with unaffiliated foreigners. (The term "affiliated" refers to a direct investment relationship, which exists when a U.S. person has ownership or control, directly or indirectly, of 10 percent or more of a foreign business enterprise's voting securities or the equivalent, or when a foreign person has a similar interest in a U.S. enterprise.) Transactions with unaffiliated foreigners consist of education services; financial services (includes commissions and other transactions fees associated with the purchase and sale of securities and noninterest income of banks, and excludes investment income); insurance services; telecommunications services (includes transmission services and value-added services); and business, professional, and technical services. Included in the last group are advertising services; computer and data processing services; database and other information services; research, development, and testing services; management, consulting, and public relations services; legal services; construction, engineering, architectural, and mining services; industrial engineering services; installation, maintenance, and repair of equipment; and other services, including medical services and film and tape rentals.

Why we should be careful with the innovation numbers

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One of the things I am continually skeptical of is our measures of innovation -- who is innovative and by how much. I understand the importance of the metrics - and the difficulty of getting good data. But I think we should be careful of making blanket statements about how we are going based on a select set of measures

Here is a perfect example concerning innovation and R&D spending -- taken from an IndustryWeek case study (The Nordson Challenge: Make 'Really Good' Better). Nordson is a manufacturer of machines that apply adhesives, sealants, coating and paints. For example, they make machines that glue the layers of diapers together and apply glues to box tops. According to the case study:

To make sure it maintains its technology position, Nordson spends about 3% of its revenue on research and development. While that is the reported figure, [Nordson CEO Mike] Hilton says it is actually more like 5% to 10% because the company has a large engineering organization that is working on either applications or products, but not recognized in the R&D figures. Moreover, Hilton is working on leveraging the company's field service organization because they are "out in our customers' facilities all the time, understanding what their issues are, what are their opportunities, what they are trying to do." The company also promotes innovation through formal processes to solicit customer feedback and by conducting development programs with key customers recognized as technology leaders.
Nordson also grows by applying its core technologies to new applications. For example, much of the company's technology business is focused on the electronics industry, where its machines are used to apply adhesives and substrates for printed circuit boards, semiconductors and other products. The company is now working with lighting companies as they develop more LED (light emitting diode) products. Similarly, the company is expanding into medical applications, where it is taking its industrial technology and applying it to the dispensing of biomaterials in surgical procedure.
Here is the issue I have with the numbers: at a level of an R&D investment of 3% of revenues, Nordson is not considered an innovative company. But the description above clearly indicates that innovation is a key part of Nordson's strategy.

So how do we create innovation metrics that capture the Nordsons?

BTW -- Hilton also talked about how impressed he is with the German apprenticeship programs and had this to say about government policy:

Hilton says the United States could also learn some lessons from other countries about supporting industry. He says there is too much focus on labor costs and not enough on investment. "Why don't we make any TVs in this country? It is not because labor is cheaper in Asia. It is because their governments went in and supported the investment because it costs $3 billion to build a facility today to make flat-panel TVs."
Hilton knows that arguments against "government subsidies," particularly in these cash-strapped times, but he says that kind of investment results in jobs. "We need to find a way to move away from a 100% service economy," he says. "We need to make stuff to continue to provide the kinds of jobs that are really good-paying jobs and help support our middle class, where we want growth instead of decline."

How innovation networks fail apart

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Here is an interesting talk by Margaret Levenstein of the U of M on how the innovative networks in Cleveland fell apart. Cleveland was a Silicon Valley type location during the industrial age. But it all came to a halt with the Great Depression. Could it happen again?

This is part of the Institute for New Economic Thinking's series on 30 Ways to be an Economist.

Valuation of human capital -- the top talent

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One of the more difficult intangible valuation issues is human capital. A standard methodology for "assembled workforce" is replacement cost -- how much would it cost to hire everyone. Another method that has come about indirectly is "key man" insurance -- essential life insurance of the top talent drops dead. How much the company is willing to insure that person is a rough proxy for the value of their services -- at least the value of avoiding the disruption that the lose of their services would entail.

Here is another version, from the Economist, "The Corzine put":

MF Global, a smallish broker with big ambitions, is breaking new ground when it comes to pricing this risk. It is offering an extra percentage point of interest to investors in its latest bond issue, should Jon Corzine, MF's chief executive, quit to take a government job before July 2013.
. . .
Buyers of the $300m debt issue stand to make an extra $15m over its five-year life if Mr Corzine leaves soon.

Not sure that this is the right level. This is the company setting a level of one percentage point. It would be interesting to see how the market reacts as it sets its own valuation of Mr. Corzine's worth through trading of these bonds. Or better yet, some one could set up a market on the risk premium itself. That would be very interesting.

Groupon drops ACSOI

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Groupon has decided to drop the use of the controversial accounting metric, according to a story from Reuters. As noted in earlier postings, Groupon's use of ACSOI (adjusted consolidated segment operating income) was questionable and under scrutiny by the SEC. This measure basically dropped out any marketing and acquisition costs from expenses -- claiming that they were temporary costs, not long term operating costs. Not many people seemed to be buying it, however.

With the change, let us hope that more rationale alternative measures might be considered. For example, marketing is not a "temporary" cost. But it is a cost that has longer term implications, rather than just an immediate expense. Thus, there is a rationale for amortizing marketing (and other intangible assets costs) over some appropriate time frame. It would be interesting to see if someone is willing to use that alternative metrics -- or has Groupon messed it up for everyone.

The price of dysfunctional politics

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Late Friday afternoon, Standard and Poor's issued the following statement:

Standard & Poor's Ratings Services said today that it lowered its long-term sovereign credit rating on the United States of America to 'AA+' from 'AAA'.

As I write this on Monday morning, the ramifications of this decision are beginning to be played out. The Dow Jones Industrial Average immediately dropped and the financial system is trying to figure out what it all means and what to do -- if anything. For the first time ever, the sovereign debt of the United States of America is rated at less than the highest possible rating. That may or may not end up mattering that much in the long term. But the reasons given for the downgrading is especially ominous:

the downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges

In other words, it is not just the debt that is the problem; it is our dysfunctional politics that leaves us unable to confront our economic problems. That is a pretty damning statement about what used to be a positive intangible asset of the United States. And in S&P's view, things are likely to get worse.

July employment

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Surprise! What a difference (maybe) a day makes. Yesterday, the economic news was all gloom and doom. Today, the outlook looks a little brighter. The employment news from BLS this morning showed a gain of 117,000 jobs. A gain of 154,000 jobs private-sector more than offset job loss in the public sector [update: of the 37,000 government jobs lost, almost all of the 26,000 state government jobs lost were due to the partial shutdown of the Minnesota state government]. The unemployment rate dropped slightly to 9.1%. And June's data was revised upward to a increase of 46,000 jobs, rather than 18,000 jobs first reported (see last month's posting). Economist had expected an increase of 75,000 in July.

The number of involuntary underemployed also declined slightly. The level of involuntary underemployment remains at close to historic highs as does the percentage of involuntary underemployed in the labor force. Interestingly, the level of voluntary part time declined. I am still unclear why voluntary part time work dropped during this recession.


Part time as percent 7-1-11.gif

Treasuries still safe haven

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One of the "good" pieces of news from yesterday's market debacle is that Treasury bill and bonds are still seen as a safe haven - even after the debt ceiling debate. Investors rushed into the Treasuries market as stocks dropped. At one point yesterday, the yields on one month Treasury bill was actually negative (meaning investors were essentially paying the borrowers interest) before finally closing at zero.

On the other hand, all the uncertainty is causing more investors to seek refuge in cash. As a story in the New York Times (Nervous Investors Chase Low-Risk Assets) noted:

At the height of the uncertainty over whether the debt ceiling would be raised and with a potential default in the offing, in late July, investors pulled out more than $100 billion from money market funds and put much of it into banks, lifting fears that the funds could see a run that resembled the one after Lehman Brothers' collapse in 2008.
Since the beginning of this year through July 20th, holdings of cash in United States commercial banks surged 85 percent, or $912.7 billion, to $1.98 trillion, according to the Federal Reserve.
In a sign of just how much cash had poured into commercial bank accounts, Bank of New York Mellon said on Thursday that it would charge institutional clients with more than $50 million on deposit a fee of 13 basis points.

As the old saying goes, in hard economic times, cash is king.

Chinese innovation

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The NY Times Economix blog has an interesting piece about Moving China Up the Value Chain. The posting is an interview with Dan Breznitz and Michael Murphree from George Tech about their new book Run of the Red Queen. Their bottom line argument:
  • China should concentrate on its strengths as a process innovator, rather than on new breakthrough products.
  • Governments have an important role to play in providing funding and other support.

Note that Breznitz's earlier book, Innovation and the State looked at how the governments of Taiwan, Israel and Ireland supported the grow of information technology industries.

Some highlights. On China's innovative strength:

Dan Breznitz: One thing truly important to understanding China is the defining characteristic of today's globalization: the fragmentation of production. Today, places specialize not in specific industries but specific stages or activities within those industries.

In different places -- Taiwan, the U.S., South Korea -- there are different stages of production in each industry. The next logical step in thinking about innovation, since industries are fragmented, is that different places need different systems and different kinds of innovation. China excels in different kinds of process or manufacturing innovation. This includes design for manufacturing, organization of production, sourcing and logistics.

China's companies are extremely efficient at creating new versions, often simpler, cheaper and more efficient, of technologies and products shortly after they are invented and marketed elsewhere in the world.

Michael Murphree: There is a tendency in the business literature and discussions to equate innovation with invention, measured as the output of patents and peer-reviewed articles or new products. From this perspective, if you look at the metrics, it is believed that if you have high numbers then you are innovative and will have growth. If you don't, you'll fade. This leads to a tired dichotomy: either China is already innovating, or it's on borrowed time and will stagnate like other middle income countries. Innovation is not just invention; it's the whole array of moving and improving inventions so consumers get better, newer, and cheaper products and services. For example, consider the case of Techfaith, a Beijing company that produces innovative products that sell under other brand names but is not a contract manufacturer. A lot of what we think of as innovation is what we notice in the final gizmo, but the innovation is actually in the guts that make the device work.

On the role of the government:

Mr. Murphree: There is a belief, accepted on faith, that markets are organic and dynamic, and that if the government steps away, innovation will blossom. But there is a really clear role the Chinese government should play. At the most basic level, they should clearly define and enforce rules and regulations because markets are created by rules and laws.

Mr. Breznitz: Becoming a regulator and law enforcer is one point. But the reality is more complex. If you are to look at major innovative countries, Finland, Taiwan, Israel, and even the U.S., almost all great new technologies came in large extent thanks to government funding and pushing. Hence, apart from being the regulator, the state often stimulates and steps in. In Taiwan, the government gave training and much more to the semiconductor companies, and taught them how to make a profit. In Israel, without the state channeling money toward R.&D., pushing innovations and lowering the risk that entrepreneurs needed to take in order to do R.&D., there wouldn't have been the Israeli high-tech miracle with its hundreds of companies listed on Nasdaq. So there is an active role for the Chinese government to play.

So, if this is a correct analysis, what is the US innovation and manufacturing strategy?

The Give Investors Time to Exit US Investments Act

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In an earlier posting, I worried that the debt ceiling deal was simply a stop-gap that will allow investors time to exit US investments. A story in today's Wall Street Journal (Washington's Haggling Left Wall Street Dangling) examines what investors had been doing last week as the clock to default ticked down:

While politicians haggled, money-market funds, which pride themselves on being one of the safest investments around, rushed to sell securities to raise billions of dollars. They used part of the proceeds to pay higher-than-usual redemptions requests from jittery investors and parked the rest in cash.
The result:
The last-minute Washington deal certainly avoided a ruinous descent into financial chaos. But the discombobulated process that preceded it has scared the markets into inertia and lethargy.
But not quite complete inertia, I believe. Investors will be still looking around for alternative safe-haven investments. At least the deal will give investors time to prepare for the next politically-created debt ceiling crisis in 2013.

Think that won't happen? Think again. Here are the words of the GOP Senate, (as quoted from the New York Times Caucus blog):

"Never again will any president, from either party, be allowed to raise the debt ceiling without being held accountable for it by the American people and without having to engage in the kind of debate we've just come through," Mr. McConnell said moments before the Senate vote on the deal he worked out to raise the debt ceiling by $2.1 trillion.
In other words, he was giving the investors fair warning that the debt ceiling is now a permanent political hostage.

Valuing Border's brand

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How much are intangibles really worth? With the fight over mobile telephony patents reaching a fevered pitch, it is hard to say. According to some, much of the high value placed on these patents (including the Nortel auction) are based on the fight between Apple and Google's Android to become the dominate platform for smart phones.

So here's an alternative indicator of intangible value. According to the Wall Street Journal, the Borders brand name and website will be up for auction in September. Of course, the brand and domain name are only a partial measure of all of Border's intangible assets. But we will see if this auction sets any sort of mark for brand sales.

FYI - tip of the hat to Joff Wild at IAM for highlighting this -- his blog posting, "Another IP auction".

The deal

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It looks like the United States has managed, just barely, to not shoot itself in the head. Rather, it shot itself in the foot. In either case, the wound was self-inflicted and therefore completely unnecessary. The real question is how bad is the damage.

The deal on the debt ceiling raises the debt ceiling somewhat and imposes some spending cuts immediately, allows the President to raise the ceiling further in 2012 (enough to get into early 2013) subject to a Congressional 2/3 override, and creates a Congressional committee to recommend further cuts with automatic cuts triggered if the recommendations are not accepted.

This does nothing to help the underlying economic weakness of the US economy -- and probably will make matters worse in the short run. And it increases the old GOP bugaboo -- uncertainty. At best it buys time to rationally consider how to lower the deficit -- political breathing room. At worst, it puts off dealing with the issue until next year - in the middle of an election (hardly the time for rational discourse). And it almost guarantees that we will go through another round of political maneuvering in 2013 -- as it has made the debt ceiling vote into a mechanism for short term political leverage.

The extent of the damage to the US reputation is likely to emerge over the next few months. Watch what happens to the Treasury market over the longer term. Do investors slowly dump Treasury's? Does an alternative safe haven investment (and currency) emerge? Remember that economic decay is often a slow moving event -- witness the 1920's and the international economic role of Great Britain.

If the breathing room ends up with a relatively acceptable solution at the end, this will be a turning point. If not, the real title of the bill will be the Give Investors Time To Adjust Away From US Investments Act of 2011.

    Note: the views expressed here are solely those of the author and do not necessarily represent those of Athena Alliance.

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