Investing in Hidden Assets

The traditional definition of a value stock relies on a low market price relative to the book value of the company's assets minus debt. However, this misses the value of all the assets that aren't on balance sheets: internally developed patents, close connections with customers, and institutional knowledge. Although accounting ignores these assets, the market certainly doesn't; these intangibles can produce higher returns for a business than any investment in real estate or factories.

This screen identifies fast-growing firms with substantial intangible assets that should produce wealth for years to come. These firms already have the market somewhat excited, but their true potential still has not been priced into the stock. The screen can be created in Morningstar Principia and Advisor Workstation.

Our first priority is to identify the companies where the market believes much of their value does not appear in the accounting books. We screen for a high price/book ratio, which implies that the company is expected to produce very high future returns off a small base of tangible assets. It is a good sign that the company has some major intangible assets enabling those high returns. For our P/B minimum, we will use 6.0, which is 50% higher than the average P/B ratio of Russell 3000 stocks at the time of the screen.

PB Ratio Current > = 6.0

Because the book value is the accounting value of its tangible assets minus the value of its debt, any screen for companies with high P/B will identify a lot of highly leveraged companies with tiny book values due to their high debt load. These companies do not necessarily possess any valuable intangible assets and are extremely risky in the current credit crunch. To eliminate any highly leveraged companies from our screen, along with any companies that have insufficient cash to fuel future growth, we will narrow our search to companies with Morningstar Financial Health Grades of B or better.

And Financial Health Grade > = B

Plenty of companies have valuable intangible assets, but many of them are mature large-cap names whose major growth happened years ago. The other set of companies that our high P/B ratio screen produces are very cyclical companies that are currently on the upswing: mining companies, small oil producers, and some luxury-goods companies. To isolate the smaller, high-growth firms with unique advantages not on their balance sheet, we will limit the screen to companies in the aggressive growth and speculative growth buckets.

And ( Type = Aggressive Growth
Or Type = Speculative Growth )

Because we are searching for companies that derive most of their value from intangible assets rather than easily accounted for equipment and property, we have to be especially careful not to pay too much. To make sure that we can expect a solid return on our investment, we tap into the research of the Morningstar stock analysts and their estimates of the future cash flows for each of the companies. By narrowing our search to stocks with Morningstar Ratings of 4 stars or more, we will identify stocks that our analysts believe are undervalued. These stocks will be primed for higher growth and profits.

And Morningstar Rating > = 4 Stars

Finally, given the current macroeconomic troubles and threat of recession, we want to avoid investing in the smallest companies. Small firms generally possess only inchoate intellectual property or competitive advantages, which can make the value of their intangible assets much harder to assess. Small companies are also the canaries in the economic coal mine, suffering the most during a recession because of their greater difficulty finding new capital. To reduce these risks, we will only consider companies with a market capitalization of $1 billion or more.

And Market Cap > = 1,000.00

Our screen found six stocks on Aug. 22, 2008.

Monsanto MON
Monsanto is, at its heart, a powerful R&D engine. The firm continues to plug an average of 10% of sales into its research efforts, but this belies the full scope of the firm's R&D machine. As Monsanto has gained a larger share of the global seed market, more companies have sought to team up with the seeds giant to codevelop the next generation of seed technologies. Monsanto offers partners access to its best-in-class production and distribution capabilities, and this provides a crucial platform to leverage its plant technologies without the prohibitive expense of developing or purchasing its seed platforms. Collaborations will turbocharge Monsanto's research engine.

BioMarin Pharmaceutical BMRN
BioMarin Pharmaceutical is a relatively young biotech specializing in treatments for rare diseases. It is amassing a portfolio of genetic disease therapeutics, and we think the firm's profitable start to 2008 will be sustainable over the long run. BioMarin's latest approval could be the most promising opportunity yet. Kuvan was recently approved to treat mild to moderate phenylketonuria, one of the most common metabolic disorders. Given Kuvan's steep price, we think it has blockbuster potential.

Fastenal FAST
As the name suggests, Fastenal focuses on fasteners--everything from nuts and bolts to screws and anchors. By offering more than 300,000 types of fasteners (and 380,000 maintenance, repair, and operations products) through its 2,000-plus stores, Fastenal provides far more selection and convenience than broad-line or regional distributors. Also, the company's 12 North American distribution centers and in-house truck fleet provide a highly efficient path to market. Fastenal's vast footprint of efficient stores is a salable attribute when pitching national and government accounts. As these customers consolidate vendors in search of lower costs, Fastenal will continue to steal market share from small, independent players.

Corporate Executive Board EXBD
Corporate Executive Board provides best practices research to approximately 4,700 corporate clients. The firm has built a large base of research and staff that would be very difficult for any new entrant to match quickly, and it benefits from a strong network effect. Having a large membership base means that the company has more empirical data on best practices and a larger peer network. This improves the quality of the company's programs, which attracts more clients and widens the competitive advantage.

Alnylam Pharmaceuticals ALNY
Alnylam is a pioneer in therapeutics based on RNA interference, a recently discovered mechanism that occurs naturally in cells and silences overexpressed genes, such as cancer-inducing or viral genes. Intellectual property will be critical in determining who profits from RNAi therapeutics, and while many patents are still being processed, Alnylam has a dominant position. Though it's still in its early days, we think this company has a shot at becoming a leading biotechnology firm.

Autodesk ADSK
Autodesk will continue dominating the market for computer-aided design software. Its products are the de facto standard in digital design. The firm benefits from its customers' high switching costs: It takes time to learn a new design software application, and operational disruption and downtime costs discourage companies from changing providers. Substantial growth opportunities in emerging economies, new 3-D design products, and subscription fees for heavy users should help significantly increase revenues and profitability.