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Nick Crail Fund Manager

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Innovation – Is it investable?

30 Jul 2018
Innovation is a word bandied about by many a CEO, an increasingly irritating buzzword that can mean many things. The Oxford dictionary defines innovation as “…to make changes in something established, especially by introducing new ideas or products”.

If you search the term in Google, there are many more nuanced definitions, all a bit vague. Across industries on company websites and in annual reports the term is featured in most strategic visions.
 
From an investment perspective, one needs to look through the emotive language and truly gauge whether a company is innovating and if it should be doing so in the first place. Simply increasing a company’s reliance on technology does not make that company innovative. Certainly, relative to its own processes and history, the company is innovating, but not necessarily relative to its competitors and that is primarily what an investor should be looking for.

The definition of disruption is also worth looking at, as this should be the practical consequence of innovation. In the Oxford dictionary it is defined as a disturbance or problem which interrupts an event, activity or process. For business, this could mean an existing industry or revenue source gets displaced.

Innovation can disappoint when it fails to disrupt quickly enough (or at all), especially if a degree of hype has been created around a concept. The value of ideas can be overestimated and valuations pushed to unsustainable and unreasonable levels. Consider the tech bubble in the late 90s or cryptocurrencies today. During the tech bubble, there was no doubt that the internet would displace more traditional businesses, however, share prices blew beyond revenue generated and ultimately led to disaster. Blockchain technology is innovative and eventually will disrupt markets, however, it is not currently doing so at the rates implied in peak values of certain cryptocurrencies (hence recent weakness). It is also important to consider execution in innovation. Google survived the technology bubble because the internet changed the world and it had a better concept and was better managed than its failed peers. Who is to say the same will not be true for one or two cryptocurrencies as well?

How do we identify the ‘Googles’ of tomorrow and how does one reduce the risk of investing in innovation as a concept?

1. Revenue generation
Rather invest in companies that are already generating significant revenue and are not just marketing an idea. For example, pharmaceutical manufacturers will deliver a good narrative around ground-breaking products, but regulatory clearance is often pending, meaning that they could either strike gold or continue requiring finance (largely from investors). We prefer investing in late cycle innovative companies who have already proven demand and monetisation of their products.

While some of these companies remain unprofitable, it is largely because they invest significantly in scaling business models that have already been proven. Amazon accounts for over 50% of online purchases in the United States, yet revenue from e-tail does not hit the bottom-line to the same extent as the company continues building out distribution in new geographies (like India for example).

2. Profitability
Identify companies that are already making profits, or at least are not expanding losses. Companies delivering significant losses could be vulnerable to ecosystem shocks, particularly if they are highly leveraged. Tesla and Uber are examples of fantastic, highly innovative ideas that are already being executed and are generating revenue, but are both losing billions of dollars a year. Risk of loss to equity holders is significant should an unprofitable company fail to deliver on expectations (either revenue, cash flow, or break-even targets).

3. Cash/ Balance sheet
Once you have isolated companies that are generating significant revenue, preferably also reflected in the bottom line, one’s focus must move to the balance sheet and cash flow statement. Companies with good balance sheet strength can defend their market positions and enter into new markets. Metrics to look at include net debt to equity and cash generation. We prefer companies that generate operating cash as opposed to having it locked up in working capital. Companies such as Tencent, Amazon, Facebook, Alphabet, Salesforce, and Adobe are strong cash generators and are currently in net cash positions (the cash and cash equivalents on their balance sheets exceed debt).

4. Market share
Innovation should have the consequence of either displacing existing offerings or creating new markets. Either way, a successful innovation led company will exhibit an acceleration in market share. It is key to understand the growth of the market and to develop a view on the opportunity set available to the company. Recently, Barack Obama made a speech at the 2018 Nelson Mandela Annual Lecture in Johannesburg and he said “the biggest challenge for your new president when we think about how we're going to employ more people here is going to also be technology, because artificial intelligence is here and it is accelerating, and you're going to have driverless cars, and you're going to have more and more automated services, and that's going to make the job of giving everybody work that is meaningful tougher, and we're going to have to be more imaginative, and the pace of change is going to require us to do more fundamental reimagining of our social and political arrangements, to protect the economic security and the dignity that comes with a job.”

It is possible to invest in companies that are making significant revenue, exhibiting strong cashflow generation, are profitable, and continue to gain market share. Examples include Alphabet (the owner of Google), Facebook, Amazon, and Tencent (Naspers owns 30%). The risk to investors is still high as growth stocks tend to discount major future gains into their prices, however, the risk of these companies going out of business is remote due to the strength of their respective balance sheets.

There are also some exciting innovators meeting the above criteria outside of pure technology plays. Companies in the healthcare sector, specifically in in hip replacements, stents, orthopaedic braces, and dentistry are proven innovators. Align Technology, for example, is a company that primarily manufactures braces, however, instead of using metal and elastics, they manipulate teeth through 3D printed clear retainers which are swopped out almost on a weekly basis. This company has been around for 20 years and continues to find growth in new markets and through continued product innovation. Align generated just short of US$1.5 billion in revenue last year, and delivered EBITDA of $400 million. It remains ungeared.

Unfortunately, investors will have to look abroad to access the front line of innovation. South African companies still generate the bulk of revenue from legacy businesses and tend to use innovation to defend market share, as opposed to disrupting the market. As an example, MTN has innovated with value added services, but the bulk of its revenue stream is still derived from traditional voice and data where pricing trends are against the incumbents.

Thankfully, offshore markets have never been more easily accessible and the possibility to successfully invest in true innovators globally is entirely possible.