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  The Asset Revolution  

By Robert McGarvey, Principal
 
Published in Risk Management Magazine, March 2007
 
At the time of the Commercial Revolution during the 17th and 18th centuries, there were several notable episodes of economic volatility associated with growing international trade-the most infamous of which was the South Sea bubble.
 
The South Sea Company was chartered in 1711 and granted a monopoly by the King of England for trading in the South Atlantic. Speculation around this new "monopoly" of the South Sea Company was swift and excited. Unfortunately, Britain and Spain were once again drawn into war in 1718, undermining the South Sea Company's trading opportunities with the Spanish colonies in South America.
 
Like many a modern-day business tale, the significance of these commercial reverses was not immediately apparent to investors. Indeed, so popular was South Sea Company stock that investors ignored the bad news and just kept on buying. As a result, the stock continued to rise rapidly, encouraging more buyers and creating a momentum of seemingly unstoppable growth.
 
Behind the scenes, however, South Sea Company's management (not unlike the more recent Enron executives) could see the writing on the wall, and they soon began to dump their shares. Eventually word got out and the bubble burst, initiating the panicked selling of stock that led to a market crash and subsequent economic crisis in England.
 
Although many see the South Sea bubble as simply a case of stock market greed, it was in many ways a function of the unfamiliarity of risk-there was widespread ignorance on the part of management, investors, securities regulators and the public at large to the nature and scale of trading risks. This new class of assets was being incorporated into a medieval economy that had previously been very slow-moving and predictable.
 
A Steep Learning Curve
While the tale of the South Sea bubble is a story of disaster, it is by no means unique. A similar period of volatility was experienced in the United States when industrial assets were being incorporated into the economy. The years 1819, 1837, 1857, 1873 and 1893 all marked the beginning of periods of grave economic disturbance that were caused by currency fluctuations, stock market crashes, banking and liquidity crises, and trade difficulties.
 
The 1819 depression was one of the most volatile. The industrial era had begun in the United States with a great burst of nationalism, and several major economic reforms (including the establishment of a national bank and protective tariffs) were undertaken during the early 19th century to protect fledgling American industries. Beginning in 1819, with cotton prices already declining sharply, strict credit restrictions were imposed by the new Bank of the United States. Although designed to curb inflation, these restrictions triggered a financial panic that swept across the economy. Unemployment rose rapidly, banks failed, prices fell and investment collapsed. Much was learned from this self-inflicted wound, but further education was required as volatility swings in economic fortunes became regular features of the early primary stage of industrialization in the United States.
 
More recently, and as a consequence of another asset revolution, the United States experienced the great dotcom bubble. And while it is true that the crash of 2000 did incalculable damage to investors and fledgling knowledge-based companies around the world, the meteoric rise and fall of the dotcom's was historically nothing new. It became just another legend in economic history. All these famous bubbles had their roots in a brave new commercial world, with dreams of staggering new wealth based on new and unfamiliar assets.
 
In the case of the dotcom bubble, it was the digital world with its strange intangible sources of wealth that captivated so many for so long. But what none of these enormous market bubbles ever did was reverse the course of economic history-growth in trade continued to flourish in spite of these early bubbles, and this "Asset Revolution" continues today despite the recent dotcom market crash.
 
The Asset Revolution
Since the 1970s, there have been revolutionary changes taking place as Western societies transition from economies largely underpinned by familiar industrial assets to economies dominated by "intangible" knowledge and relationship-based assets.
 
Between 1995 and 2002, the world's 20 largest economies lost 22 million industrial jobs. Despite the shrinking of their industrial work forces, the output in these countries as a measure of GDP nevertheless increased by an astonishing 50%. Today, in the United States and other Western economies in particular, market services have displaced industrial production as the primary engine of growth, with studies suggesting that intangible assets now contribute over three-quarters of U.S. GDP.
 
The maturation process of a new class of assets takes time and experience. Appreciating the special risks and larger social responsibilities of new property forms are major challenges for society and management. And just as industrial assets grew and matured before they became established institutionally, so do all new property forms.
 
Computer software, which can be considered one of the most "tangible" forms of intellectual property, spent a period of time in general usage before it became protectable under law and therefore technically "ownable." It took the success of Microsoft, Oracle and others before investors and serious analysts would even consider software as a legitimate corporate asset.
 
Despite these advances, the most productive assets in the economy are still being treated as suspect-and often almost illegitimate-in the normal course of business, even in highly developed economies. It is clear that for most senior management, investors, securities regulators and the public at large, intellectual property and intangible assets are still a maturing concept, whose development will accelerate considerably over the next decade.
 
The International Accounting Standards Board (IASB) in tandem with the Financial Accounting Standards Board (FASB) have taken note of these changes in the economy and are reforming reporting standards and Generally Accepted Accounting Principles (GAAP). In modernizing accounting standards, the boards are both incorporating the new classes of intangible assets and moving away from the traditional "historical cost" model for reporting asset values. These two related areas of accounting reform (scheduled to take affect in January 2009) are designed to make financial reporting more accurate and relevant by (1) establishing a "fair value" standard in the recording of corporate assets, and (2) including the full range of tangible and intangible assets on the financial statements.
 
Managing Risk in the Asset Revolution
It is a simple truth that assets that cannot be identified, cannot be managed or protected. It is precisely at the identification stage that many of the modern risk management challenges are accumulating at the moment. Needless to say, this seemingly simple task becomes much larger and more difficult in periods of asset transformation like we are experiencing today.
 
As a consequence of the rise of intangible assets in the Western economies, the IASB and FASB have undertaken a joint program to modernize accounting standards. In the process, they have identified over 30 intangible asset classifications. These asset classifications include the more formal classes of knowledge assets, license-based intangibles (contractual), artistic- and technology-based intangibles (copyright and patented) as well as many other informal brand- and customer equity-related intangibles (contractual and quasi-contractual). It is the boards' intention to formalize reporting standards in these new asset classes and to gradually incorporate them into the mainstream of asset management.
 
But until this does reach the mainstream, what does a prudent risk manager do when upwards of 70% of the assets in the organization are unfamiliar intangibles? Although the majority of companies are becoming aware of the value of patents and copyrighted software, many remain unaware of the largest and most valuable of the intangible assets in their organization. Brands, logos, trademarks and customer equity in its various forms constitute the bulk of most company's asset wealth. These are informal relationship-based assets that are vulnerable and subject to a wide variety of unfamiliar risks. Unfortunately, the most common form this risk takes is neglect.
 
For example, many organizations have opted to outsource software development, customer relationship management and basic accounting functions to the lower-cost service providers in India and other parts of Asia. Although this makes sound bottom-line sense, it carries a variety of associated risks to key intangible assets. In outsourcing software development, vital trade secrets are often inadvertently bundled with the process and sent half-way around the world into economies where little if any legal protection of intangible assets is possible.
 
The situation is even more critical on the customer relationship front. Outsourcing customer service and relationship management carries significant risk, placing the customer experience beyond the control of the company. Outsourcing risk can be managed, but only if the key assets are identified and treated as such with sound risk minimization procedures applied consistently throughout the process.
 
The Darkening Context of Risk
The global economy-and, thus, the world of risk management-is entering a new and more volatile period. The present period of instability is made worse by the fact that the global economy has become conditioned by a prolonged period of Post-War Era stability. But if economic history has anything to teach us, there could well be stormy weather ahead.
 
All major economies, in both the developed and emerging nations, are in transition, and each is entering an exciting new stage of economic growth. With this growth, however, comes new classes of assets, which should be expected to bring inevitable economic disruption.
 
Managing those predictable periods of volatility will require insight and judgment on the part of both management and risk management professionals. At a minimum, incorporating new models for identifying and analyzing global risk and adapting to new, higher thresholds of risk will be required in order to prudently take advantage of the undoubted opportunities available in the 21st century global economy.
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Robert McGarvey is principal and founder of Beckett Advisors, a strategic marketing firm based in Los Angeles, California. He also serves on the Executive Committee for the UK-based Economic Research Council and has written a soon-to-be released book on managing risk through the asset revolution.

The Industrial Asset Revolution in Emerging Economies
The developed economies of the West are not the only nations whose economies are experiencing asset revolution. At the same time that the United States, Europe and other post-industrial economies are moving towards a "Knowledge Asset Revolution," the emerging economies of the world are simultaneously experiencing their own "Industrial Asset Revolution."
 
By taking a look at foreign direct investment (FDI) and international trade statistics, it is easy to see how industrialization in China, India and several of other Asian economies is exploding. Organisation for Economic Co-Operation and Development (OECD) countries' net direct investment outflows to the rest of the world reached record levels in 2004, with $261 billion in FDI directed toward developing countries. China and a couple of other financial centers in Asia continue to receive the lion's share of direct investment, but India is steadily making progress in establishing itself as an attractive place for FDI as well, with inward direct investment also trending upwards since the late 1990s to reach $5.3 billion in 2004.
 
But East Asia is not the only part of the world experiencing massive primary industrialization. Many of the later developing economies in Pan Europe are going through the same stage of development. FDI in South America is growing. Inflows in 2004 to Brazil ($18 billion), Chile ($8 billion) and Argentina ($4 billion) are all twice the levels of 2003. Inflows to Russia, having already picked up in 2003 also showed further growth in 2004. As in earlier years, much investment went to the hydrocarbon sectors, but there is a growing tendency towards consumer goods lately as well.

THE STAGES OF ECONOMIC DEVELOPMENT

  • Stage 1: Feudal Command Economy
    • Precapitalist
    • Concentrated economic control
    • Little or no private property ownership
    • Few, if any, markets
    • Concentrated political control
    • Economic and political stability

  • Stage 2: Mercantilism or Neo-Mercantilism
    • Early stage capitalism
    • Beginning of private property rights (trading, royal chartered companies)
    • Market (cities) begin to emerge or re-emerge
    • Concentrated politcal control and stability
    • Increasing economic volatility

  • Stage 3: Primary Industrialization
    • Accelerating capital growth
    • Rapid growth in industrial assets
    • Markets consolidate/rapid urbanization
    • Devolving political control
    • Producer-dominated politics
    • Economic volatility, political instability

  • Stage 4: Secondary Industrialization
    • Stable capital growth
    • Established industrial assets
    • Stable growth of transnational markets
    • Broadly representative political institutions
    • Consumer dominated politics
    • Economic stability, political stability

  • Stage 5: Primary Knowledge Economy
    • Accelerated capital growth
    • Rapid growth in intellectual assets
    • Rapid growth of globalized markets
    • Devolution of political power
    • Increased consumer activism
    • Economic volatility, political instability

  • Stage 6: Secondary Knowledge Economy
    • Stable knowledge capital growth
    • Established knowledge assets
    • Established intellectual property rights
    • Global market consolidation (??)
    • Continued devolving political control (??)
    • Economic and political stability (??)


 

 

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