Keeping Up with Innovation

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Keeping Up with Innovation by Dan Roarty, AllianceBernstein

The pace of innovation is accelerating and equity investors are increasingly at risk of getting left behind. We think that moving away from the benchmark can help portfolios keep up with rapid change across many industries.

As they gain support, insurgent technologies often topple long-dominant regimes. The losers fall further and faster than expected, and the winners come out on top in surprising ways. Mainframes displaced adding machines in the 1950s, only to be uprooted by personal computers (PCs) in the 1980s. Today, PCs are being displaced by services that leverage the wireless Internet and cloud computing, working on a wide range of devices from tablets to TVs (and soon eyeglasses and watches).

Benchmarks tend to miss these revolutions. Since they’re backward looking, indices reflect yesterday’s successes, not tomorrow’s. So benchmark-sensitive or index-tracking approaches will be overly bound to legacy technologies. In contrast, active managers can look forward and capture innovation well before it’s reflected in the benchmark.

Grappling with Creative Insurgency

Technological progress often advances exponentially rather than linearly. It can be hard for people to grasp the power of such rapid change, but we see examples in the world all around us. The number of transistors on a silicon chip, for example, has grown exponentially, while the cost of decoding the human genome has fallen exponentially.

As new technologies are embraced, incumbent players are threatened. This process is happening faster than ever. It took the PC roughly 30 years to achieve 75% penetration of US households. Laptops—introduced about a decade later—achieved that milestone in only 20 years. Today, smartphone penetration has reached nearly 60% in just five years, and the tablet isn’t far behind. The accelerating pace of innovation heightens the risk of being tethered to a benchmark.

Apple Inc. (NASDAQ:AAPL) is a case in point. In 2007, Microsoft was the single largest technology stock in the S&P 500 Index, with a weighting nearly 3.5 times larger than Apple’s. Yet from 2007 to 2013, Apple shares soared 561%, driven by the iPhone and iPad revolution, while Microsoft Corporation (NASDAQ:MSFT) shares rose just 25% (Display). Investors in an index fund would have missed out on much of Apple’s renaissance.

Competitive Challenges Are Accelerating

Traditional barriers to scale are also eroding. The Internet offers unprecedented reach, while the capital and time needed to attract millions of users are declining rapidly. This makes it easier than ever for young companies to threaten dominant players.

Facebook inc (NASDAQ:FB), which recently acquired WhatsApp for US$19 billion, provides an interesting example. With more than a billion users, you’d think Facebook had a high competitive barrier. However, in a very short time, WhatsApp attracted 450 million users of its own—more than half in the nine months preceding the acquisition. WhatsApp posed such a huge potential threat that the incumbent (Facebook) was compelled to pay a hefty sum to buy the innovator.

How to Embrace Innovation

These forces require investors to think differently about creative disruption. Technological innovation is bringing upheaval across many sectors—from retail to financial services, to pharmaceuticals to entertainment. We believe that investors should increasingly embrace creative disruption as a tailwind, rather than a headwind, in their portfolios. That requires keeping up with scientific and technological advances and having the experience and expertise to evaluate their potential.

Of course, buying into future innovation isn’t without risk. Not every scientific breakthrough results in a commercially viable product or service (anyone remember the Apple Newton?). And potentially disruptive companies must grow their profits substantially in order to justify valuations that are often expensive on current earnings. Skeptics warn that these “dream stocks” represent fantasies. We argue that rigorous research can identify companies with a good chance of success and avoid those that may turn into nightmares.

In our view, less-constrained approaches offer the best way to capture the potential of accelerating technological change. Traditional benchmark-sensitive portfolios are often biased toward past successes (legacy technologies) and will give short shrift to the disruptive companies. In contrast, we believe that active portfolios—which can look forward and go beyond conventional sector, geographic or size constructs—have a clear advantage in keeping pace with innovation.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Dan Roarty is Team Leader, Global Growth/Thematic Portfolios at AllianceBernstein Holding LP (NYSE:AB).

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