Intangibles Investment and Asset Quality

Treating intangibles-creating expenditures as investment, while measuring ROE, results in a better measure of firm quality: firms with higher intangibles-adjusted profitability have higher future cash flows. Our quality factor has smaller left tail risk and co-tail risk with the market due to higher down-market risk of the short side, and a significant Fama-French model alpha (2.9%). Its performance is due to superior asset selection on the long side and superior market timing on the short side. The adjusted measure adds explanatory power for the cross-section of stock returns relative to a large array of existing models.