Innovation was the market darling thematic for many years leading up to COVID. The pandemic turbo-charged returns for innovation as the stay-at-home beneficiaries did phenomenally well. However, since the first quarter of 2021 innovation has struggled as a thematic strategy. It appears to us that innovation made a low in May and has been slowly regaining some ground.
For this exercise, we’ll use Bloomberg Factors. Within the investment factor group, R&D as a % sales is a great proxy for the most innovative companies. The way Bloomberg calculates performance is by taking a traditional factor approach where they construct their quintile-spreads and measure the performance of being long the first quintile (highest R&D/Sales) and short the lowest quintile (lowest R&D/Sales).
The current reading of the Bloomberg US R&D/Sales Quintile Spread is 6.47%, down 93% from just over 100 in February 2021. The entire outperformance from 2017 to 2021 has been reversed. And the good news is the quintile-spread bottomed on May 11, 2022.
Is valuation a concern here still? Well, we are dealing with high-flying companies with large secular growth rates. So, let’s compare the P/E of the Bloomberg R&D Leaders index to the trailing 15-years earnings growth rate. At 21.5x earnings, valuations seem rich on the surface. But let’s qualify the multiple with the earnings growth trend. Over the last 15-years, earnings have grown at a 29.93% compound annual rate. This translates into a P/E to earnings growth rate of .72x.
