As investors, it’s easy to get caught up in headlines about things like Snap’s $23bn market cap or Tesla overtaking Ford and GM to become the most valuable US auto maker. While well-intentioned and interesting, that sort of narrowly focused news coverage gives the impression that innovation is a phenomenon reserved for tech-centric unicorns whose business models (and profits) may not be obvious to casual observers. In reality, corporate innovation may have its roots in the tech sector, but it is much more broad than that and indeed has far reaching implications that are often lost to investors.
Today’s General Purpose Technology and Moore’s Law
Taking a step back, let’s quickly review the state of the general purpose technology (GPT) that is at the heart of the innovation boom we’re witnessing: the semiconductor. The semiconductor today is the computational counterpoint to the steam engine during the first industrial revolution. While the steam engine transformed industry and society by providing an endless source of rotary motion, the semiconductor gives us a limitless source of binary logic with which we can use to solve some of the most complicated problems facing business and society today. The good news, as we highlighted a few weeks ago here, is that the pace of semiconductor improvement known as Moore’s Law – the concept of a doubling of semiconductor performance every 24 months – is for the most part alive and well. The implication is the ability to make faster and cheaper binary computations, which then facilitates all sorts of technologies like the things we read about in the news everyday: AI, big data and cloud computing, 3D printing, pharmacological innovation, etc. But also important is that the improvement in our GPT facilitates all sorts of innovation that almost never gets a headline in the WSJ: the data science of modern day logistics systems, smart farming, building one’s brand through earned social media rather than purchased advertising.
The following is our rough coverage of the 2021 Sohn Investment Conference, which is being held virtually and features Brad Gerstner, Bill Gurley, Octahedron's Ram Parameswaran, Glenernie's Andrew Nunneley, and Lux's Josh Wolfe. Q1 2021 hedge fund letters, conferences and more Keep checking back as we will be updating this post as the conference goes Read More
Industrializing the Innovation Process
So with our GPT on solid footing, let’s turn our attention to why we are so focused on corporate innovation as investors. Simply put, corporate investment in innovation leads to a positive feedback loop of profits (the manifestation of competitive advantage) and cash flow, balance sheet strength, more investment in innovation, higher profits, stronger balance sheets, and so on. We call this circle of life, “industrializing the innovation process”. As we will see in the charts below, the knock-on effects of innovation investing are obvious and measurable.
One way to measure corporate investments in innovation is to compare the share of intangible investment to total capital investment (intangible + tangible investment). Why do we focus on intangible investment? It’s the category that encapsulates things like scientific R&D (development of a new chemical compound), and non-scientific R&D (development of consumer products), codified information development (databases), employee training (teaching employees how to use software), and brand. We find that Knowledge Leaders (red line), which are the most highly innovative companies, allocate about 65% of every investment dollar to intangibles compared to just 46% for all companies (blue line).
As it turns out, returns on intangible capital investment (AKA innovation investment) are considerably higher than returns on tangible investment. We know this because the ROIC for Knowledge Leaders is roughly double that of all companies, as shown below.
As highly innovative companies generate superior returns, so to do they generate higher and more staple cash flow margins. Cash flow margins for Knowledge Leaders are usually 2-3 percentage points higher than for all companies.
The obvious corollary to higher returns and operating cash flow margins is cash piling up on the balance sheet and no debt. As the charts below show, Knowledge Leaders have about 3x as much cash on the balance sheet as all companies and have a modicum of the net debt levels.
This brings us to the next aspect of this industrialized innovation process: seeding the next stage. When companies have an excess of cash on hand there are only a few things managements can do with that cash. They can repurchase shares, pay down debt, pay dividends, make acquisitions, grow the organic asset base by investing in new capital stock, or try to jump start the next stage of the innovation life cycle by taking minority interests in companies developing new technologies. The chart below depicts corporate venture capital (CVC) investing from 2000-2016 and clearly shows the promise corporate investors see in this area. We are not at all suggesting that companies are giving up on their organic innovation strategies. After all, in 2016 CVC was less than 10% of total R&D investment and less than 2% of total intangible investment. But, it is clearly an area of growing importance and likely to be a mainstay of corporate innovation strategies as the positive feedback loop continues to play out, helped in part by the very financing of start-up companies.
Innovation Investment from a National Accounts Perspective
Finally, let’s not forget how dramatically the investment mix has changed in this country in the post war period. In 1947 business investment in intellectual property (light blue line) accounted for less than 1% of GDP. Today that number is above 4% of GDP and ever since 1992 business investment in IP has been a larger part of GDP than business investment in structures (red line).
Moreover, we can see just how important business investment in IP has become because it is the only category that seems to be immune from the ups and downs of the business cycle. Indeed, as this last chart shows, IP investment barely turned negative in 2009 and has consistently grown at about a 5% clip – or double the rate of GDP growth – throughout this cycle.
The state of corporate innovation in 2017 is strong, maybe as strong as it’s ever been. The modern day GPT continues to power ahead with exponential scale improvements and that provides the impetus for new and better consumer products and services. The companies providing those unique products and services are clearly enjoying the fruits of competitive advantage and as a result have the financial flexibility to act as sources of capital for early stage companies, in effect planting the seeds for the next phase of growth. From a national accounts perspective, it’s easy to see just how important IP investment has become. Through 2016, IP investment continued to gain share a as a percent of total business investment and for both 2015 and 2016 it was the fastest growing category of business investment. So while it’s uplifting to hear unicorn success stories, the true scale and power of the innovation machine is, like Moores Law, alive and well.