Can The Marriage of Two Knowledge Followers Produce a Knowledge Leader?

Most of our readers are familiar with our process that seeks to identify what we refer to as Knowledge Leaders or, quite simply, companies that consistently invest in knowledge-intensive activities such as research & development, advertising, and employee training.  Common attributes of knowledge leaders include, but are not limited to, less volatile earnings and sales growth, lower adjusted ROE, and a larger stock of intangible capital on their balance sheets.  While Knowledge Followers may also invest in important intangibles like R&D, research suggests that they do so in less productive ways and with less profound results.

Which brings us to the news that Communications Equipment manufacturer Nokia sealed a deal to purchase rival Alcatel-Lucent-- which sent shares of the latter up ~15% yesterday (followed by a decline of about the same magnitude today).  While neither of these MSCI Europe members passes our screening process to become a Knowledge Leader, their peers in the Information Technology sector have a higher than average pass rate relative to the other developed regions.  So where do these two companies miss the mark?  Alcatel-Lucent hasn't been able to maintain a positive seven-year average with respect to its free cash flow margin and neither company has managed to generate a positive average ROIC over the same time period.  In addition, while Nokia manages to score in the 50th percentile with respect to our quality metric (mostly due to a strong balance sheet), Alcatel-Lucent only ranks in the 30th percentile.

Taking a closer look at the fundamentals for the sector, we see that (true to Knowledge Follower form) both companies invest a fair amount of capital in knowledge-related activities such as R&D and advertising:



Which produces the expected increase in intellectual property assets on their balance sheets:



In fact, their collective asset bases are more than $23 Billion larger when intangible investments are properly accounted for:

Reported


Intangible-Adjusted


While this investment would seem to suggest that investors should view these two companies in a positive light, further examination shows us where such conclusions break down (at least with respect to the search for Knowledge Leaders).
Worse than average gross margins and negative net margins weigh on the companies' abilities to generate solid profitability in a competitive environment:





And cash flow metrics reveal just how much they lag industry peers:



But, you may ask, in the absence of solid fundamentals, can the case be made for a value investment?  Though each of the stocks trade at a discount relative to the MSCI World Index on a P/CF basis...



Both of them still trade a a premium to their respective 10-year averages:



And, finally, looking at them through the lens of our point and figure methodology, we see that (in both cases) significant rallies going back to 2012 appear to be faltering at levels of long-term resistance.  While those may yet be overcome, much of the picture painted by the fundamentals would seem to suggest a tough road ahead for this duo.

The information listed above is for example purposes only and should not be construed as the Investment Advisor’s opinion or investment outlook.