Firms Now 5/6 Dark Matter!

Scott Sumner:

We all know that the capital-intensive businesses of yesteryear like GM and US steel are an increasingly small share of the US economy. But until I saw this post by Justin Fox I had no idea how dramatic the transformation had been since 1975:

Wow. I had no idea as well. As someone who teaches graduate industrial organization, I can tell you this is HUGE. And I’ve been pondering it for the week since Scott posted the above.

Let me restate the key fact. The S&P 500 are five hundred big public firms listed on US exchanges. Imagine that you wanted to create a new firm to compete with one of these big established firms. So you wanted to duplicate that firm’s products, employees, buildings, machines, land, trucks, etc. You’d hire away some key employees and copy their business process, at least as much as you could see and were legally allowed to copy.

Forty years ago the cost to copy such a firm was about 5/6 of the total stock price of that firm. So 1/6 of that stock price represented the value of things you couldn’t easily copy, like patents, customer goodwill, employee goodwill, regulator favoritism, and hard to see features of company methods and culture. Today it costs only 1/6 of the stock price to copy all a firm’s visible items and features that you can legally copy. So today the other 5/6 of the stock price represents the value of all those things you can’t copy.

So in forty years we’ve gone from a world where it was easy to see most of what made the biggest public firms valuable, to a world where most of that value is invisible. From 1/6 dark matter to 5/6 dark matter. What can possibly have changed so much in less than four decades? Some possibilities:

Error – Anytime you focus on the most surprising number you’ve seen in a long time, you gotta wonder if you’ve selected for an error. Maybe they’ve really screwed up this calculation.

Selection – Maybe big firms used to own factories, trucks etc., but now they hire smaller and foreign firms that own those things. So if we looked at all the firms we’d see a much smaller change in intangibles. One check: over half of Wilshire 5000 firm value is also intangible.

Methods – Maybe firms previously used simple generic methods that were easy for outsiders to copy, but today firms are full of specialized methods and culture that outsiders can’t copy because insiders don’t even see or understand them very well. Maybe, but forty years ago firm methods sure seemed plenty varied and complex.

Innovation – Maybe firms are today far more innovative, with products and services that embody more special local insights, and that change faster, preventing others from profiting by copying. But this should increase growth rates, which we don’t see. And product cycles don’t seem to be faster. Total US R&D spending hasn’t changed much as a GDP fraction, though private spending is up by less than a factor of two, and public spending is down.

Patents – Maybe innovation isn’t up, but patent law now favors patent holders more, helping incumbents to better keep out competitors. Patents granted per year in US have risen from 77K in 1975 to 326K in 2014. But Patent law isn’t obviously so much more favorable. Some even say it has weakened a lot in the last fifteen years.

Regulation – Maybe regulation favoring incumbents is far stronger today. But 1975 wasn’t exact a low regulation nirvana. Could regulation really have changed so much?

Employees – Maybe employees used to jump easily from firm to firm, but are now stuck at firms because of health benefits, etc. So firms gain from being able to pay stuck employees due to less competition for them. But in fact average and median employee tenure is down since 1975.

Advertising – Maybe more ads have created more customer loyalty. But ad spending hasn’t changed much as fraction of GDP. Could ads really be that much more effective? And if they were, wouldn’t firms be spending more on them?

Brands – Maybe when we are richer we care more about the identity that products project, and so are willing to pay more for brands with favorable images. And maybe it takes a long time to make a new favorable brand image. But does it really take that long? And brand loyalty seems to actually be down.

Monopoly – Maybe product variety has increased so much that firm products are worse substitutes, giving firms more market power. But I’m not aware that any standard measures of market concentration (such as HHI) have increased a lot over this period.

Alas, I don’t see a clear answer here. The effect that we are trying to explain is so big that we’ll need a huge cause to drive it. Yes it might have several causes, but each will then have to be big. So something really big is going on. And whatever it is, it is big enough to drive many other trends that people have been puzzling over.

Added 5p: This graph gives the figure for every year from ’73 to ’07.

Added 8p: This post shows debt/equity of S&P500 firms increasing from ~28% to ~42% from ’75 to ’15 . This can explain only a small part of the increase in intangible assets. Adding debt to tangibles in the numerator and denominator gives intangibles going from 13% in ’75 to 59% in ’15.

Added 8a 6Apr: Tyler Cowen emphasizes that accountants underestimate the market value of ordinary capital like equipment, but he neither gives (nor points to) an estimate of the typical size of that effect.