Why Innovation Matters to Investors

To read much of the investment guidance on investing in technology, one feels transported back to the 20th or even 19th centuries. It is all too frequently couched in terms of reduced  labor costs and increased productivity. Nice, certainly, but in an economy based increasingly on returns to intellectual capital, this is strangely myopic and, for many enterprises, probably not decisive.

Certainly for nations like China that have competed up till now on that labor cost basis - and which has seen its labor cost rise four-fold in the past decade - this is an issue. But even the Chinese recognize that competing with Bangla Desh or Vietnam to be the lowest cost provider is not the path to sustainable global economic competitiveness.

The most successful nations and enterprises, instead, will employ technological innovation as a force multiplier. Strategic investment in and deployment of innovations will differentiate them: in their ability to deliver goods and services faster through a more efficient supply chain; in their desire to provide consumers with greater selection at a lower cost and with greater convenience; and by enhancing their capacity to anticipate customer needs; or in all of the above.

The benefits of investment in innovation accrue not just to tech firms like Apple or Google but to the myriad institutions that find ways to incorporate it into their managerial model: from auto companies to airlines and from consumer goods manufacturers to retailers. 

The point is not that innovation delivers linear cost savings but that it provides the opportunity to create exponential improvements in both financial and operational performance by enabling first mover advantages from which the net present value of future cash flows can be established and then built upon. That is why, for investors, innovation is not simply a cost-benefit trade-off but the key to profitable growth. JL

Ewen Watt comments in the Financial Times:

The rapid diffusion of technologies is one reason why it is harder for companies to maintain competitive advantages: just 63 per cent of S&P 500 companies a decade ago are still in the index today. It becomes important to invest in companies that can weather the disruptive effects of innovation and harvest its benefits.

Innovation has been accelerating since the invention of the steam engine, and the pace is increasing. Consider the telephone: it took 56 years for Alexander Graham Bell’s invention to reach half of US households; by comparison, smartphones took seven years to hit the same adoption rate.

Innovation could be defined as the application of invention (think about the 12-year gap between the accidental discovery of penicillin and the first patient treatment with penicillium). Today’s low-growth disinflationary period mirrors the great deflation of 1873-96, a period of high innovation as entrepreneurs sought to lower costs and widen markets.

Why should investors care about innovation? Technological change is at the intersection of employment, nominal economic growth and inflation risk – the focus areas of global policy makers. Innovation is disinflationary (suppressing wages and prices) but can hurt employment (producing more with fewer people). This helps explain why central banks are prepared to risk falling behind the curve because they see little inflation risk and focus on increasing employment.Tech optimists argue that we are on the cusp of a productivity renaissance. Pessimists counter that the productivity boon from the internet era is waning. We are optimists. The next leg of innovation has far to go: exponential increases in computer power, machine learning and the ability to analyse vast reservoirs of data back this view. Many companies, industries and investors have yet to tap these data riches.

The rapid diffusion of technologies is one reason why it is harder for companies to maintain competitive advantages: just 63 per cent of S&P 500 companies a decade ago are still in the index today, according to Thomson Reuters. It becomes more important to invest in companies that can weather the disruptive effects of innovation and harvest its benefits. It also means that predicting whether a company will be around in a decade is going to become tougher.

On a macro level, innovation can erode an important competitive advantage of emerging markets: cheap labour. Businesses faced with rising wages can automate or move to cheaper locations. Even developed economies can benefit: selected US companies are “reshoring” some production, lured by cheap energy and proximity to end markets. At the same time, Chinese factory wages have risen fourfold since 2002 and are forecast to continue on that trajectory. Yet the substitute for Chinese labour today is not just workers in Vietnam or Bangladesh; it is robots. China is already the second largest importer of robots and will shortly take pole position.

In a nutshell: if you lose your labour cost advantage, you had better come up with something else. Quality of education will probably be a key determinant of success here. Asian economies such as China and South Korea are well ahead of other emerging regions in this respect – particularly in the important areas like maths and science. Developed economies in North America and Europe still score well on this metric, but are losing ground.

Innovation is an important driver of productivity – a key determinant of sustainable long-term growth. But productivity growth has slowed down in the US, China and most of Europe, as ageing populations have reduced the number of hours worked. Rising debt-to-GDP ratios in developed economies are another potential drag on growth, as is any increase in income inequality. Inflation remains a tug of war between two opposing forces: deflation in stuff you want (gadgets), inflation in everything you need (food and housing). The net impact: lower inflation than in recent decades.

Low nominal growth and bond yields mean financing will stay cheap for companies, which is good news for equity holders: bond markets are effectively subsidising equities by allowing companies to cut debt service costs and extend maturities. At the same time, innovation is lowering the capital expenditure needs of companies, enabling them to do more with less. In turn, companies have less need to borrow and issue bonds than in the past, and this lower supply, combined with an appetite for income from yield-hungry investors, means the hunt for yield is unlikely to get any easier.