Innovation investing: going beyond the value vs growth divide
16 May 2023
Instead of debating value vs. growth investing, investors looking for consistent outperformance should rather focus on innovation.
Is the longstanding debate on growth vs. value relevant?
The debate about what style is better between growth investing and value investing seems never-ending. But history shows that the two styles simply alternate periods of over/underperformance relative to one another, bringing to the fore the risks inherent in timing the market.
There is no universally accepted definition of what constitutes a value stock versus a growth stock, making a proper appreciation of the two strategies quite difficult.
In the absence of a clear winner, the decision to invest in growth or value stocks will depend on an individual's own preferences in terms of investment objectives, risk tolerance, and time horizon.
Creative destruction is the way forward
The Schumpeterian approach of "creative destruction" states that the continuous process of innovation and the destruction of outdated technologies drive economic growth.
Stock performance correlates positively with underlying business dynamics. The key issue becomes to identify the proper metric.
Sales growth is a leading indicator of stock performance. It is influenced by various factors, among which innovation is particularly relevant, as it leads to above-average products and services, creates barriers to entry, and commands pricing power.
Innovation-led disruptions can trigger significant long-term trends, capable of reaching such a scale that they affect even the mix of GDP, as shown by the growing importance of the tech sector in the U.S. GDP.
Focusing on those segments of the economy that are able to provide higher growth rates will also provide the most attractive returns.
The disruptive nature of innovation also means that continuous innovation is required to survive. Deep knowledge of an industry and monitoring of business model execution are crucial components for investment success.
Is the longstanding debate on growth vs. value relevant?
Investors are constantly searching for ways to maximize their returns while minimizing risk. One of the most popular debates in the investing world is whether to follow a growth or value investment strategy. Growth investors focus on companies with strong potential for earnings growth, while value investors search for undervalued companies based on financial metrics (e.g., price-to-earnings). We argue that there is a better, third way.
Investing in growth stocks implies identifying stocks that have a high potential for capital appreciation, driven by strong earnings growth. Growth companies are often newcomers, leveraging better products, services, and technologies that can disrupt existing markets, thus enabling profits. On the risk side, growth stocks tend to be more volatile. They usually are in the early stages of their business cycles, lack a proven business track record, and given the usually higher multiples at which they trade, sensitivity to changes in earnings expectations is high.
On the other end, value investing focuses on companies that are undervalued based on selected financial metrics. The idea is that companies that are undervalued by the market offer the opportunity to investors to buy them at a discount, which will be corrected over time. Also, as value companies are often more established and have a proven track record in generating profits, they usually provide greater stability and provide higher dividend payouts to investors. Nevertheless, value companies may be slower to innovate, resulting in a reduced ability to adapt to changing market conditions and limited growth potential. Finally, undervaluation may be due to structural market inefficiencies, creating challenges for investors to identify correctly undervalued opportunities that will be corrected by market forces.
No consistent outperformance
The ultimate goal of investors is to find companies that will outperform the broader market. And history shows that the two styles alternate periods of over/underperformance relative to one another. There are various variables that drive these cycles (interest rates, economic cycle, investor sentiment, etc.), but as shown in the following chart, the average yearly excess returns obtained by being correctly invested in one or the other style are minimal. Also, the length of the outperformance cycle of each style is highly volatile, spanning from a few quarters to many years. As a result, the correct timing of each switch from one style to another is the only element that would provide consistent outperformance over the broader market. And, as more seasoned investors know, relying on timing the markets is usually a recipe for disaster.
The criteria used to determine whether a stock is to be included in the value or growth camp are highly subjective, both in terms of metrics and thresholds. The primary issue is that there is no universally accepted definition of what constitutes a value stock versus a growth stock. As a result, investors and analysts may use different criteria to classify a stock, and their choices can be influenced by subjective factors, such as personal biases and market conditions.
Another issue is that the metrics used to assess a company's value or growth potential may not capture the full picture of its performance. For example, commonly used value metrics such as price-to-earnings (P/E) and price-to-book (P/B) ratios may not accurately reflect the growth potential of a company that is investing heavily in research and development, or one that operates in a fast-growing industry with high potential for future earnings growth. Similarly, metrics used to evaluate growth stocks, such as revenue growth rate, may not necessarily indicate that a company is undervalued or has strong fundamentals. A company that is experiencing rapid revenue growth may also have a high level of debt, which could make it riskier than a company with slower growth but a healthier balance sheet.
Moreover, setting thresholds for metrics can be difficult, as there is no one-size-fits-all approach. The optimal threshold can vary based on market conditions and industry trends. This makes it quite difficult to properly appreciate and compare the performances of the two strategies, especially when using a statistical model.
A matter of individual preferences
Ultimately, the decision to invest in growth vs. value stocks will depend on an individual's own preferences in terms of investment objectives, risk tolerance, and time horizon. Growth investing offers the potential for high returns but also comes with higher risk. It's important to note that not all growth companies will succeed, and investors may experience significant losses if a company's growth potential is not realized. Value investing, by contrast, offers a more conservative approach with lower risk - and hence lower expected returns.
Creative destruction is the way forward
Even if the growth or value styles don't yield a convincing investing advantage, it is well-known that stock performance correlates positively with underlying business dynamics.
The Schumpeterian approach
Based on the economic theory of Joseph Schumpeter, who believed that capitalism operates in a cyclical pattern of creative destruction, economic growth is driven by the continuous process of innovation and the destruction of outdated technologies, industries, and business models.
In the context of equity markets, such an approach suggests that investors should focus on companies that are at the forefront of innovation and creative destruction. These companies are likely to be disruptors in their industries and have the potential to generate high returns. Investors should not focus solely on a company's current financial performance but should also consider its potential for future growth and innovation. Indeed, most of today's mega caps have been innovators all along their history, be it in terms of products, services, operations, or business models. And to maintain their leadership, they have no other options but to continue being at the forefront of innovation - or they will be replaced.
Identifying the proper metric
To determine a company's performance, many people believe that earnings are the most logical metric to consider. However, the reality is that earnings do not have a strong correlation with stock performance, as demonstrated in this paper by the CFA Institute. In fact, various factors can influence earnings, making them a less reliable measure, not to mention the fact that earnings can be tampered with through accounting gimmicks. Quality of earnings is a hotly debated topic these days. As an alternative, free cash flow (FCF) is considered to be a far superior metric compared to earnings. Nevertheless, companies that are still in their early development phase may not generate significant free cash flow, as they may be reinvesting heavily into their business operations.
A more generally applicable metric is sales growth. It is a rather straightforward and easier-to-monitor metric that can provide a reliable indication of how well a business is doing. Indeed, as illustrated by this short paper by McKinsey & Co, there is generally a positive correlation between a company's stock price and its sales growth over the long term. Several other studies (cfr. sources section) have shown a positive correlation between a company's stock price and its sales growth over the long term. This is because sales growth can lead to higher value creation, and investors tend to value companies with strong sales growth prospects more highly.
The chart above also shows how, even at a broader index level, returns and sales growth follow similar patterns. Nevertheless, actual sales growth is a rather lagging indicator. The market, seen as a discounting mechanism, is driven by expectations. This also explains why, in the chart, returns show higher volatility compared to sales growth.
What generates sales growth?
Sales growth is the result of various factors such as increased consumer demand, market expansion, new product launches, improved marketing strategies, innovative technologies, and operational efficiencies. Companies that can effectively identify and respond to these factors are likely to experience strong sales growth over time. Innovation is a particularly important factor as it can lead to the development of new and better products or services, help build entry barriers, command pricing power and enable expansion into new markets.
The Schumpeterian approach emphasizes the importance of market competition in driving innovation and growth. As new companies enter the market and disrupt existing industries, they create new opportunities for investors to identify attractive stocks with high growth potential. However, the Schumpeterian approach also acknowledges that innovation and creative destruction can be unpredictable and that not all companies will succeed in disrupting their industries. Therefore, investors using this approach must be prepared to accept a higher level of risk and volatility in their investments, and above all, they need to have a profound knowledge of the industries in which they invest in order to identify winners and losers of the innovation cycles. These are the basic tenants that also shape Atonra's investment process.
Innovation's ripple effects
Innovation often refers to new products or services that disrupt existing markets. A typical example is a biotech or MedTech company that introduces a new "product" to better solve an existing problem. A company like Shockwave Medical (part of our Bionics portfolio) has been able to disrupt cardiovascular medicine. Its innovative device simplified treating patients with severe arterial calcification who were previously obliged to face a difficult and risky process that often involved invasive procedures. The stock has obviously reaped the benefits of such a breakthrough, providing stellar returns. Also, the resulting high multiples may also reflect the high barriers to entry that such an innovation enables.
Another example of a company benefiting from disruptive innovation is The Coca-Cola Company. Back in the mid-'80s, Coca-Cola transformed itself from a leading U.S. company into a global giant through disruptive marketing innovation. This resulted in a stronger brand and aggressive market share gains in previously untapped countries. This strategy drove the company's international expansion and generated stunning returns for shareholders spanning over a decade.
But innovation often has ripple effects that extend beyond the industries it initially impacts. Take the industrial gases sector, for example, which may seem dull and uninteresting due to its industrial nature. However, this sector has exhibited high multiples and attractive steady growth rates, thanks to the spill-over from constant innovation in the production processes of tech-related components. Indeed, the more electronic components were reduced in size, the more added-value industrial gases were needed in their production process. This simply demonstrates how innovation can affect industries that may not seem related at first sight.
These examples highlight how a single innovation can create opportunities for companies across different industries, leading to growth and value creation for investors.
Setting trends in motion
Innovation disruptions are powerful forces that can bring about long-lasting changes in the economy, affecting the composition of GDP. As illustrated in the charts presented below, the US economy has undergone a significant transformation in the past five decades, with the manufacturing sector shrinking in favor of the service sectors.
As a result of these shifts, service sectors such as finance, healthcare, and technology have become increasingly dominant in the U.S. economy, while the manufacturing sector has declined. However, the changing landscape of the economy highlights the importance of companies being able to adapt to disruptive innovations and stay ahead of the curve to remain competitive in the long term.
Over the past 50 years, the U.S. economy has undergone significant changes in its composition. And this is the consequence of differing growth rates across the various sectors. However, one sector has stood out as the clear winner: technology. The tech sector has gone from representing merely 0.4% of U.S. GDP back in 1977, to ~12% today. At the peak of 2000, the U.S. tech sector was still only 6.3% of GDP. Over this whole period, it displayed the strongest growth rate thanks to its ability to continually innovate and disrupt existing industries. As long as innovation keeps driving the sector, this trend is bound to continue and IT will become more and more important for the U.S. economy.
Investors who focus on sectors with high growth potential are likely to see attractive returns, as a rising tide tends to lift all boats. However, not all companies within a given sector will benefit equally from disruptive innovation. Therefore, investors must carefully assess the potential of each company to identify the winners and avoid the losers. Additionally, investors should consider the broader economic trends and the impact of disruptive innovation on the overall mix of GDP, as these can provide valuable insights into the long-term outlook for a given sector.
Growth and execution are key
Identifying the sectors that will experience the most attractive growth over the investment horizon is undoubtedly a challenging task. However, by keeping an eye on disruptive innovation, investors can have a better idea of where the growth potential lies. The very nature of disruptive innovation means that not all companies will thrive in the long run. Hence, monitoring the competitive landscape and regularly evaluating the quality of management's business model execution is critical for long-term investment success.
Ultimately, the key to achieving sales growth is to identify and invest in sectors with high growth potential. Stock price growth also depends on the quality of management and their ability to execute the business model effectively. In other words, while identifying the right sectors is crucial, investing in companies with strong management teams that can execute their strategies effectively is equally important for long-term success.
While at Atonra we tend to invest in stocks that show high revenue growth rates, we don't see ourselves solely as growth investors. Instead, we follow the Schumpeterian approach to investing in equity markets and focus on disruptive innovation in specific industries that can lead to consistent returns.
We have been pioneers in thematic investment, and our investment process is oriented towards implementing this approach to the best possible extent. Through our deep understanding of the technological, industrial, regulatory, and competitive aspects of the industries we invest in, we aim to identify potential game-changers. While we acknowledge the inherent risk and volatility associated with innovation and creative destruction, we believe that by staying ahead of the curve, we can generate long-term value for our clients.
Disruptive technologies. Companies that are developing and implementing these technologies can have significant growth potential.
Consumer behavior. Changes in consumer behavior can create new opportunities for companies that can quickly adapt and leverage them. Similarly, innovation and new technologies can spark significant changes in consumer behavior.
Regulatory changes. Policies encourage innovation through direct incentives for R&D activity, but also indirectly by introducing requirements that push for the development of new products or solutions.
Technology adoption curve. Innovative technologies may require a longer than anticipated time to be accepted and widely adopted.
Regulation. Innovation tends to operate in an unregulated environment, especially at its onset. As adoption increases, so does the need for regulation.
Companies mentioned in this article
Shockwave Medical (SWAV); The Coca-Cola Company (KO)
- "Sales Growth and Firm Value: Evidence from a Regression Discontinuity Design" by Prachi Deuskar, Anthony W. Lynch, and Jeffrey A. Pontiff, published in the Journal of Financial Economics in 2017.
- "Sales Growth and Stock Returns: Evidence from a Panel of US Firms" by Yan Zhang and Keith Jakob, published in the Journal of Financial Research in 2018.
- "Sales Growth, Profitability, and Firm Value: Do They Correlate?" by Hyeryeong Kim, Sungjin Lee, and In-Mu Hawng, published in the Journal of Applied Accounting Research in 2019.
- CFA Institute - "Myth busting: earnings don't matter much for stock returns"
- McKinsey & Co: "Which metrics really drive total returns to shareholders"
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