Intangible Capital in Factor Models

Fully expensing intangible investments has potential distorting effects on factor investing based on book-to-market, investment, and profitability. Incorporating intangible investment/capital into the conceptual frameworks and empirical factor models of Fama and French (1993, 2015) and Hou, Xue and Zhang (2015) highlights the importance of separating tangible from intangible investments and addressing the effects of intangible investment on profitability and other valuation metrics. We show that existing empirical factor models grossly understate the relative importance of the value factor. Incorporating intangibles significantly improves these factor models, especially over recent decades during which intangible investments have become increasingly important.