Getting Back to Basics: A No Frills Review of the State of Corporate Innovation
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.
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.