Superstar companies know how to deploy digital capital

They spend what it takes to put information technology to productive use

What has caused the emergence of superstar companies that dominate their sectors? Is it the recent state of anti-trust enforcement? Or do these firms thrive because, for some reason, they are more productive than others? The answer makes an enormous difference to how policy makers across the globe should respond.

One thing that leading companies have in common, it turns out, is that they spend what it takes to put information technology to productive use. New research from the Hutchins Centre on Fiscal and Monetary Policy at Brookings finds that they make significantly higher investments in 'digital capital' than other firms do. This insight helps explain widening differences in companies' market share and productivity - and raises the question of whether generally accepted accounting measures should evolve.

It was already becoming clear, thanks to earlier work from McKinsey, that leading companies spend substantially more on intangible assets. "A key distinguishing feature of superstar companies is their investment in intangible assets, such as software, data, brands, customer contracts, supply-chain partnerships, and even training," McKinsey said. "The capitalised spending on intangibles accounts for one-third of superstars' invested capital, four times the share of bottom-decile companies."

The new Hutchins Centre analysis, conducted by a team of economists from MIT and the University of Pennsylvania, digs deeper into the resources needed to make information technology effective. Anyone who has worked in a business knows that spending on a new computer system or software package is often useless unless that spending is effectively translated into how the business runs. Additional spending to make information-technology investments work well - for example, on employee training and improved business processes - is what the researchers call digital capital. These costs are often much larger than the IT itself.

Yet this type of spending has been poorly measured - it's typically classified as current expenditure rather than investment. And the measurements themselves are difficult to make. To provide estimates of companies' digital capital, for example, the researchers were forced to use IT employment as a proxy, relying on detailed LinkedIn profiles of IT workers. The researchers examined more than 5,000 companies, and have data on more than 275 running from 1987 to 2016. This is the first effort to provide these sorts of estimates over such a large sample, and the crude measures also show how much the phenomenon has been neglected.

Digital capital investment varies substantially across companies, the researchers found, and helps to explain market valuations. The superstar firms have been pulling away from others in their spending. This is true even among the smaller set of companies for which the researchers have data since 1987 - a group that excludes newer tech firms such as Alphabet or Facebook. Digital capital spending often takes two to three years to manifest in productivity, the researchers found, but it explains twice as much of the variation in growth rates across companies as IT spending itself does.

As they conclude:

We find evidence of striking firm-to-firm heterogeneity in digital capital value, with most of the value concentrated in a small group of superstar firms with market values in the top decile. Inequality in digital capital among firms is growing as the top firms pull further away from the rest. Moreover, per-capita digital capital stocks are substantially greater in firms with more educated workers. These findings are consistent with the emphasis that technology-intensive firms place on making investments in training and skills. Our findings suggest that the higher values the financial markets have assigned to firms with large digital investments in recent years reflect greater digital capital quantities, rather than simply higher prices for existing assets. In other words, they reflect genuine improvements to firms' productive capacity. I am left with two broad takeaways.

First, this measure of digital capital, though imperfect, helps to explain market valuations. And this suggests policy makers should figure out other ways to measure this important type of intangible capital.

Second, and more broadly, far too little attention has been paid to the sources of variation across companies, which can have macroeconomic consequences. The evidence to date suggests management quality plays a crucial role, and so does the skill with which firms incorporate IT spending. And the two may interact. As another research team recently argued, "It may also be that only the better-managed firms fully realize the returns to intangible investment."

Companies and chief executives should realise that the age of average is over - and excellence in management and in translating IT investments into practice pays off. (Bloomberg)