Powerful technological advances fuel economic growth by enabling economies to create more value with fewer inputs. That’s been true since the invention of the steam engine during the first Industrial Revolution to the Fourth Industrial Revolution still unfolding now.
Today the speed and impact of technological breakthroughs are exponential and unprecedented. Easy access to super computing power; rapid developments in artificial intelligence; robotics and automation; hyperconnectivity between the physical and digital world; and biological innovations are the driving forces behind technological breakthroughs that continue to transform society.
And yet, many portfolios lack exposures to innovation. Therefore, the question for investors becomes how best to identify and capture the economic benefits of innovation.
Innovation Premium Delivers Capital Appreciation
For some investors, innovation stocks may seem just too risky. And it’s true that companies developing and leading technological innovation face greater risks — from the cost of completion and uncertain future cash flows to the risk of obsolescence.1 But there is something that compensates investors for taking on these risks: the Innovation Premium.
Empirical research shows companies that drive technological innovation deliver higher shareholder returns.
Companies ranked in the top 20% for innovation had double the shareholder returns of their industry peers, according to research by Arthur D. Little, the world’s first management consulting firm, which examined the shareholder returns of 338 Fortune 500 companies between 1987 and 1996.2
And strong research & development (R&D) activity, an important driver of innovation, correlates to significant positive stock returns that asset pricing models like Fama-French 5-factor and 3-factor models cannot explain.3
While the Innovation Premium may be attractive, it’s important to understand why innovative companies tend to outperform. Some researchers argue that innovative companies are able to provide higher quality products and services and create a wide economic moat, leading to greater pricing power and higher profitability.
Other researchers consider outperformance through a behavioral finance lens. Certainly, uncertainties along the path from patents to final products, the velocity of disruption, new products’ impacts on competition and industry structure, and long-deferred profits are all ¬challenging for investors to analyze. And the difficulty in processing this less tangible information can cause markets to underreact to news about the prospects of firms’ innovations, resulting in the mispricing of innovation stocks.4
Capture Early Stage Growth of Innovation Companies
Taking advantage of mispriced innovative stocks requires identifying and investing in innovative companies in their early stages. For example, some of the most-recognized innovative brands — Amazon, Netflix, Microsoft, and Apple Inc. — were included in the S&P 500 Index more than eight years after filing their initial public offering (IPO).
By the time Apple Inc. was included, the iPhone had already been in market for two years and was the company’s largest contributor to revenue growth. In fact, all of the aforementioned innovative companies experienced significant revenue growth and stock price appreciation and outperformed the broad market for many years before being included in the S&P 500 Index, as shown below.
Given the underrepresentation of innovators in the S&P 500 Index in their early days, most investors’ portfolios likely missed out on significant capital appreciation during the initial stage of growth.
Exponential Growth Creates Long-term Investment Opportunities
Since innovative companies derive a large percentage of their value from future inventions — and from future cash flows generated by the monetization of those inventions — uncertainty around new technology development, customer adoption, and market structure change can impact their valuations significantly. Changes to the risk-free rate and investors’ risk sentiment also drive big valuation movements by impacting discount rates.
But because secular innovation trends can transcend monetary and market cycles, innovation stocks offer greater capital appreciation potential than the broad market over long-term investment horizons. In other words, innovation trends can supersede financial market boom and bust cycles and reward investors over the long term. A good example of this? The internet services and infrastructure industry.
In the eight years between 1995 and 2002, the Federal Reserve Bank conducted two rate-hiking cycles, increasing the policy rate from 3% to 6% between 1994 and 1995 and from 4.6% to 6.5% between 1999 and 2000. During the same period, internet services and infrastructure stocks saw seven of their largest yearly drawdowns ever. But none of those reversed the exponential increase in internet users and internet use cases that supported the industry’s incredible growth, which ultimately drove its outperformance over the broad market and the broader Technology sector in the subsequent 20 years.
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Footnotes
1 Richard P. Rumelt, “Theory, Strategy and Entrepreneurship,” 1987.
2 Ronald S. Jonash and Tom Sommerlatte,”The Innovation Premium: Capturing the Value of Creativity,” 1999.
3 Alessandro Grandi, Bronwyn H. Hall, Raffaele Oriani, “R&D and Financial Investors,” UC Berkeley, 2009.
4 David Hirshleifer, Po-Hsuan Hsu, Dongmei Li, “Innovative Efficiency and Stock Returns,” Journal of Financial Economics, Vol. 107, 2013.
5Holmes and Schitz (1990), Ueda (1997) and Takii (1999), “The Information Technology Revolution and the Stock Market: Evidence.”
6 Holmes and Schitz (1990), Ueda (1997) and Takii (1999), “The Information Technology Revolution and the Stock Market: Evidence.”
7 Dane Rook, Adam Salvatori, John van Moyland, and Paul Rosa, “Innovation Patterns: Upgrading Sectoral Classification for the Fourth Industrial Revolution,” March 2017.
Glossary
Fama French Three Factor Model
An asset pricing model named after economists Eugene Fama and Kenneth French that expands on the capital asset pricing model (CAPM) by adding size and value factors to CAPM’s market risk, or beta, factor. The Fama-French model is based on data showing that value and small-cap stocks outperform markets regularly. In the fund industry, Fama and French’s insights fueled the rise of style boxes and, more recently, the rise of ‘smart beta’ indices and ETFs.
National Bureau of Economic Research (NBER)
A private, non-profit, non-partisan group that conducts economic research and disseminates findings among academics, public policy makers, and business professionals. Key focus areas include developing new statistical measurements, estimating quantitative models of economic behavior, and analyzing effects of public policies. NBER data surrounding the occurrence and duration of recessions are frequently cited across the financial services industry. NBER is based in Cambridge, Massachusetts.
S&P 500® Index
A popular benchmark for U.S. large-cap equities that includes 500 companies from leading industries and captures approximately 80% coverage of available market capitalization.
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Originally Posted March 10, 2023 – A Case for Investing in Innovation
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