Wealth Strategies

Innovation Investing In The New Economic Reality

Mikhail Zverev and Graeme Bencke 26 June 2023

Innovation Investing In The New Economic Reality

A few days ago this publication interviewed Mikhail Zverev and Graeme Bencke, co-managers on the TB Amati Strategic Innovation Fund. In this article, they describe their investment ideas and approach in more detail. The editors are pleased to share these views and invite responses. Jump into the conversation! Email tom.burroughes@wealthbriefing.com

Innovation can be a powerful source of investment returns, but only when grounded in reality.

Innovation creates value and helps build businesses with faster growth and superior profitability. Furthermore, the stock market is inefficient at recognising the impact of innovation on company fundamentals. Complexity, change, and uncertainty of outcome mean that market participants are sometimes ill-equipped or unwilling to adequately price in the value created by innovation. Our own experience, and a growing body of academic evidence, consistently points to such inefficiency. This makes innovation a compelling opportunity for active stock pickers.

However, in the recent near zero interest rate environment, and a benign macro and geopolitical setting, we saw something different. Investors were dazzled by the prospect of exciting new technologies and did not wait for the concept to be proven, or for a profitable business model to be established.

Such a high risk/high reward approach works well in the field of venture capital, where one win in 10 is sufficient to make for an attractive investment return. This is much less appropriate in the world of listed equities.

The wider pool of investors and increased attention tends to lead to higher valuations for unproven concepts – reducing potential upside and heightening the risk of a permanent loss of capital. As the period of 'free money' has ended, many of those listed concept companies have collapsed in price.

In pursuit of high risk/high reward “pioneers” of innovation, investors sometimes overlooked other beneficiaries – “enabling” companies providing the proverbial “picks and shovels” to the innovators, and the fast-following “adopters,” which benefit from innovation without the associated binary outcome risk.

Take genomics as an example. A crop of innovative life sciences tools' companies – from a well-established but expensively valued Illumina to disruptive new entrants such as Pacific Biosciences, Twist Bioscience or Seer – continued to advance the industry’s ability to sequence DNA, analyse proteins in living organisms, and even write DNA code. This raised many exciting possibilities and, in a zero rate environment backed by generous capital markets, these companies achieved peak values.

Subsequent share price corrections were brutal: Illumina is down over 60 per cent since peak, Pacific Bio over 70 per cent, Twist and Seer down over 90 per cent. While Illumina generates profits, Seer, Twist and Pacific Bio do not, and are not expected to for many years. They may need to raise more cash to survive.

Yet in that period the DNA sequencing costs continued to fall, CRISPR gene editing technologies advanced, and researchers gained new techniques to explore the functioning of genes and cells.

The quiet beneficiaries of that innovation were the enablers and the adopters. Qiagen, which makes high throughput diagnostics equipment, benefits from an increasing ‘menu’ of clinically valuable tests developed from these genomic insights that run on their machines. Laboratory Corp, a leading US lab network, benefits when these tests are run in their labs. These companies are profitable, growing, cash generative and valued at reasonable multiples for their growth. They significantly outperformed the “pioneers” of genomics during and after the sell-off in 2021/2022.

Elsewhere there are numerous examples of futuristic technologies which are already making a real difference and helping to sustain profitable business models, often below many investors’ radar and with a lot of growth ahead of them. One such area is digital tools for industrial applications. 

Augmented Reality (AR) has been showcased for consumers in high-end furniture showrooms, Pokemon Go mobile games, and consumer products like Google Glass – with little real effect. We’ll see whether the newly-launched Apple Vision Pro headset will make a difference.

However, in industrial engineering, today companies are using AR technology to assist engineers with servicing equipment or training new workers. Maintenance protocols can be presented to the technician through an AR headset. Remote colleagues can see 'through the eyes' of the engineer and guide them, making highlights directly in their field of vision. Still in its infancy, industrial AR offers many years of growth. 

The ‘metaverse’ remains a loose concept, with unclear consumer implications. There was widespread scepticism and derision regarding the cartoonish avatars in metaverse meetings in the recent Meta (aka Facebook) demonstrations. However, digital representation of physical objects is a proven and profitable technology in the industrial world.

Sophisticated simulation software enables engineers to test the performance of their products in a “multi-physics” environment, simulating electromagnetic, aerodynamic, thermal, and mechanical stresses at the design stage, avoiding costly problems later in the production cycle.

‘Digital twins’ create a “living” digital replica of their physical counterpart. Changes in the physical asset – a bridge, an engine or a production line, are relayed to the cloud-based version via wirelessly connected sensors around the asset. The remote twin then maintains an accurate digital record of behaviours, wear patterns, and possible sources of faults. This helps predictive maintenance and allows engineers to model scenarios in a safe and low-cost digital environment.

Software companies such as Bentley Systems, PTC or Ansys provide these multi-physics simulation, AR and digital twins tools. These tools are “adopted” by managers of the asset or products in question, or “enabled” by engineering consultancy firms such as Jacobs Solutions. Again, these businesses are profitable, cash generative and do not depend on the generosity of capital markets.

A confluence of innovation and change in multiple sectors and regions leads to a tipping point in adoption and the creation of profitable business models that capture these opportunities.

Progress in AR, simulation and digital twins relies on developments in software, high performance computing, sensors, and data storage, combined with machine learning and AI.

Genomics benefits from progress in sequencing, industrialised diagnostic techniques such as digital PCR, and advanced biomanufacturing.

This multi-sector, multi-disciplinary occurrence of innovation has significant implications. It is important to research the whole value chain of innovation – pioneers, enablers, adopters – to understand and validate the opportunity. In addition, this broader approach helps investors to pick the optimal combination of risk/reward within the value chain. This means that the innovation is best pursued through a global multi-sector innovation strategy, rather than a single sector or single geography.

Innovation investing is based on fundamental value creation, combined with persistent market inefficiency. It calls for a pragmatic, long-term approach, designed to capture the opportunity in a normalised market environment, where interest rates are not zero, capital has cost, risks need to be factored in and valuation discipline and profitability matter – as investors are beginning to remember.

Share price performance data as of 8 June 2023

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