Intangible Assets & Warren Buffett's Investment in Apple

How intangible investments determine a company's growth rate

Five new technologies of the fifth revolution have changed the world: microprocessors, control systems, computers, software applications, and smartphones. Historically, the difficulty of predicting cash flows has troubled investors in the technology sector. The constant innovation and disruption inherent in technology make those calculations difficult. This is largely why Warren Buffett remained idle in technology investing. However, in 2016, he made a historic investment in Apple. Let’s explore the factors that influenced his decision.

IBM

Buffett’s first technology investment was not in Apple but in IBM in 2013. In the past, IBM and Apple were indirect competitors. IBM focused on producing low-cost computers primarily for enterprise clients, while Apple focused mainly on luxury consumer electronics. As low-cost hardware became cheaper, IBM struggled to compete in the enterprise computer production business. Instead, they pivoted to be an enterprise IT consulting and services business.

Even though IBM struggled in the 2000s, Buffett saw something particularly attractive about the company that others seemed to have missed. The IT industry is resilient because its revenues are recurring and tied to the non-discretionary budgets of large corporations and government organizations. In Buffett's mind, this new business model developed a moat-like quality since corporations and governments rarely switched IT providers.

Ultimately, IBM's new strategic business model struggled to grow revenues because of unforeseen lower-cost alternatives in the cloud storage industry. Amazon Web Services (AWS), Microsoft Azure, and Google Cloud developed enterprise IT infrastructure that stole IBM’s market share. Buffett learned a harsh lesson.

Apple

Approximately 26 percent of the world’s 8 billion people own an Apple product. On average, Apple has sold about 15 percent of the world's smartphones but captures 85 percent of the world’s smartphone profits. Apple has two main product divisions: Hardware and services. Their hardware products include the iPhone, iPad, iMac, Macbook, Apple Watch, Apple AirPods, and Apple Vision Pro. Their service products include Apple One, Apple TV+, Apple Music, Apple Arcade, Apple Fitness+, Apple News+, Apple Podcasts, Apple Books, Apple Care, iCloud, the Apple Credit Card, and the App Store. Apple's critical business segment is its service products.

As of 2023, Apple Services generated more than $80 billion in revenue, representing 20 percent of Apple's total $400 billion sales with a significantly higher percentage contribution to net income. Apple has over 1 billion people paying for services via the App Store. Apple’s Services is the fastest-growing division responsible for the company's tremendous growth these past few years. By 2020, over one-third of Apple's enterprise value was attributed to its future growth. Combining a highly profitable hardware division and a high-return services business created an era of unparalleled profitability.

Intangible Assets

Companies grow by generating above-average returns on investments measured by profits. An investment can either be tangible or intangible. Tangible investments are fixed and physical assets—think brick-and-mortar, equipment, and trucks. Intangible assets, such as research and development, software, and pharmaceutical chemical compositions, lack a physical existence. The distinction between the two is that with tangible assets, only one company can use them at a time. However, with intangible assets, multitudes can use them simultaneously.

Companies with intangible assets benefit from substantial economies of scale. Think about software. Although it costs a lot to design the original code, the cost per unit significantly drops as it is inexpensive to share. Millions of customers can use the new software at the same time. Notably, companies that rely on intangible investing can grow faster than companies dependent on tangible assets.

Returning to Apple, its return on intangible investments increased faster than its return on investment from tangibles, increasing the company's growth rate. This will remain true as long as the return from the company’s intangible investments exceeds the cost of capital.

Intangible Asset Accounting

Under generally accepted accounting principles (GAAP), which were born at the beginning of the Industrial Revolution, a company's cost for tangible investments is not expensed through the income statement but rather capitalized on the balance sheet as an asset. The asset is depreciated over its life—sometimes 5, 10, or 20 years, depending on the type of investment. Conversely, GAAP rules dictate that a company's investment in intangibles must be expensed through the income statement and, as a result, do not appear on the balance sheet. Companies with high intangible investments typically trade at higher multitudes of earnings and book value than those relying mainly on tangible investments.

Apple's value-generating intangible investments are not found in the customary GAAP analysis. Intangible investments for companies in the Russell 3000, encompassing most US equity stocks, were nearly $1.8 trillion in 2020, more than twice the tangible investments, totaling $800 billion. Adjusting for intangible investments has a more significant effect on some industries than others. The mix between intangible and tangible investments determines the magnitude of impact. The return on invested capital (ROIC), adjusting for intangible investing, is higher for industries such as pharmaceutical, biotechnology, internet software, and internet retailing services.

Intangible Asset Valuation

The value of a business is equal to the steady-state value + future value creation. Steady-state value is the net operating profit after normalized tax divided by the cost of capital plus additional cash. A company’s future value is the investments it makes multiplied by its return on capital minus the cost of capital times the competitive advantage period over the cost of capital. A business's positive future value creation becomes the cash it produces over time, but only if the cash return as a percentage return on the company's invested capital is above the cost of capital.

The main takeaway is that a company that earns on investment above the cost of capital creates value. A company that earns on investment below the cost of capital destroys shareholder value, and a company that generates a return equal to the cost of capital neither creates nor destroys shareholder value, no matter how fast or slow it grows.

ROIC & Growth Rates

A company that earns 100 percent return on invested capital (ROIC) is worth more than a company that earns 15 percent, the average ROIC for the S&P 500. Why? A company that returns 100 percent ROIC has more capital to reinvest into the business. High returns on invested capital turbocharge a company's intrinsic value as long as the incremental returns on investment remain substantially higher than the cost of capital. Once a company earns above the cost of capital, the faster it grows, the more valuable it becomes, and sales growth becomes the toggle switch for determining intrinsic value growth.

Network Effects, Path Dependency, and Switching Costs

Apple's ecosystem, built through intangible investments in its service businesses, convinced Buffett to invest. The hardware division generated an astounding supply-side economy of scale, and the services division generated another equally impressive demand-side economy of scale. Apple's network effect and economies of scale continue solidifying its industry dominance.

Positive experiences give us pleasure and satisfaction, and we want to relive them. Someone with a positive experience with a product tends to return to the product. Behavioral psychologists label this the lock-in effect. Software products, explicitly operating systems, can be challenging to master initially. Once we become proficient in using a product or software, we resist changing to another. This creates a technological lock-in effect called path dependency.

Researchers have studied how lock-in and path dependency prevent users from using a competitor's product, even if they find it superior and less expensive. Network effects, positive feedback, lock-in, and path dependency all result in high switching costs. Sometimes switching costs are literal — as in switching technologies and software can cost money — but in many cases, switching costs are purely psychological. Apple has 2 billion hardware users and 1 billion paid service users. The dissuasion associated with switching costs has generated a wide economic moat around Apple's future cash flows.

Berkshire Hathaway's Investment

Over the past 12 years, Apple bought back 10.6 billion shares, reducing the shares outstanding by 40 percent. In dollar terms, the share repurchase retired $592 billion of stock. Over the same period, Apple paid $140 billion in dividends, bringing the total return to shareholders to $732 billion, almost equaling the market cap of Berkshire Hathaway at $784 billion. No company in history has ever come close to accomplishing the financial returns of Apple. In 2016, Buffett acquired 400 million Apple shares, costing $15.9 billion. Berkshire's stake makes up 31.90% of its stock portfolio and is its largest holding. Those Apple shares are currently worth $90.4 billion, representing a 470 percent return.