Investors intuitively know we live in an economic environment driven by an accelerating rate of change. What they seek, though, is guidance on how to navigate to the opportunities—the leading innovators—while avoiding getting hurt by this structural change we see across so many industries. Investors increasingly seek to harness the power of innovation to compound their wealth over time within their investment portfolios. This growing interest in innovation investing is driven by the knowledge that innovative businesses have become the primary engine of wealth creation across the economy and the markets.
Perhaps innovation-focused strategies should be a primary allocation within portfolios. If so, the natural question is how do investors—and their investment advisors—gain access to innovation investing?
With all this mind, I was thrilled to be introduced to Tom Ricketts, CFA, President & CIO of Evolutionary Tree Capital Management, an investment manager that specializes in innovation-focused, risk-managed, and concentrated strategies of publicly traded innovators using a long-term approach. In short, this firm is a specialist in innovation investing with a strong track record, and thus a thought leader on this important topic. He has a strong pedigree, having spent 22 years at a leading concentrated growth public equity firm, Sands Capital.
Inspired by nature’s evolutionary process, his new firm uses this powerful metaphor of generational change for understanding how strategic shifts—what they call evolutionary shifts, driven by innovation—can create investment opportunity. By harnessing next-generation innovations through portfolios of quality innovators, they seek to “lean into the future, not the past.”
Hortz: Let us learn more about the rising importance of innovation for investors. Why is innovation investing becoming more prominent in the industry?
Ricketts: To understand how innovation investing differs from traditional growth or value investing, it may be helpful to provide some history. The traditional growth and value investing styles were developed during the early and mid-part of the 20th century, with value initially becoming the dominant style starting in the 1920s and 1930s. Think Graham and Dodd style investing. After World War II, the emergence of large-brand growth companies drove greater interest and participation by investors in growth style investing.
Today, however, the economy is profoundly different than that era. We are living in the digital age—what I refer to as the innovation economy—and it has become increasingly apparent that investment styles developed nearly a century ago may no longer meet investors’ needs or be quite as effective. This makes sense when you consider that innovative businesses, often with tech-enabled business models, are very different in their economics from business models built in the prior era. So, the two dominant styles—value and growth—which were developed to analyze older business models, are in my opinion getting stale, if not outdated.
For example, the economy has seen a massive shift away from tangible assets as the foundation of value—think of assets such as land, buildings, and inventory—over to intangible assets in our more intellectual-capital based economy. Intangible assets, such as intellectual property and patents, research and development investments, and technology and organizational investments, are the new drivers of value. In fact, Ocean Tomo, an IP-focused consultant, conducted a study of the S&P 500 and found that in 1975 the value of intangible assets as a percent of the S&P 500 value was only 17%, while tangible assets made up 83%. With the shift to our innovation-based economy of today, this has flipped. Now those numbers have reversed, as intangibles make up over 84% of the value, while tangibles have reduced to 16%, as of 2015. The intangible tail is now wagging the tangible dog.
The focus on intellectual-capital based investments, such as R&D or technology investments, is the driver behind the accelerating pace of change, generating a constant stream of innovative next-generation products and services. This, in turn, is spurring a desire among investors to tap into and benefit from this type of innovation. We call this focus on innovation-based investment strategies, innovation investing, and it is different than traditional growth investing. We believe innovation investing is emerging as the third style of investing.
Hortz: It would seem that growth investing and innovation investing invest in similar companies, at least to some extent. How is innovation investing different than growth investing, and why do you call it the “third style of investing”?
Ricketts: While many innovation-type businesses are classified as “growth companies,” I believe the traditional growth style of investing is not optimally positioned to benefit from the innovation economy. While it is correlated with innovation, and may overlap at times, a growth orientation is sub-optimally positioned to benefit. Why? Consider, for example, that a key metric many growth managers look for in companies is above-average growth over the past five to ten years. From an innovation investor’s perspective, waiting artificially five years or longer to start your work on a company is just too late in the value-creation process. Given the rapid pace at which new products and innovations are being launched and adopted—compressing adoption curves from decades to years—we seek to identify and invest in leading innovators earlier in their lifecycle. That is an important differentiator between growth and innovation investing.
By searching for important innovations and the quality innovators developing them, innovation investors can potentially get ahead of traditional growth investors. This is the essence of what we do at Evolutionary Tree.
Furthermore, not all growth companies are innovators. Many so-called “growth companies” can grow through roll-up strategies and acquisitions, by taking on debt to expand capacity, or grow through unit or geographic expansion. While these growth drivers are not bad, per se, we believe that growing through innovation—the development of next-generation products and services, with tech-enabled business models—creates more defendable businesses with greater differentiation. These elements are critical for reducing competitive risk, as well as providing the fuel for sustainable growth. Innovative businesses are potentially higher quality than mere “growth companies.”
Innovation investing is all about focusing on identifying true innovators and being earlier to spot them, getting ahead of growth investors who are chasing growth in the rearview mirror. Focusing on innovation enables investors to look through the windshield at what is coming down the pike. And, that gives this new third style of investing—innovation investing—a competitive advantage versus growth and value investing.
Hortz: How does your investment process identify important innovative businesses, or as you call them quality innovators?
Ricketts: As we have been discussing, we believe traditional investment processes are inadequate, if not ill-suited, to keep pace with the accelerating change happening across the economy. As a result of this insight, our investment team’s starting point is unconventional by design. It does not rely on traditional growth screens, or Street research, much of which we view as backward-looking or highly short-term oriented.
It is important to remember that investors only get paid on future growth in earnings and cash flow, not past growth. As such, we begin our process by analyzing the root causes of future growth for companies and industries. In our experience, these root drivers are typically a series of new innovations that, in turn, drive industry secular trends and multi-year periods of above-average growth. Types of innovation that the investment team identifies and tracks include: technological innovation, product innovation, service or experience innovation, process or cost innovation, brand innovation, and business model innovation. The great innovators of our time combine multiple types of innovation to create value and competitive advantage. Ultimately, the investment team’s objective is to identify the most important innovations, understand how these cause secular trends, and identify and own the leading innovators at the vanguard.
Every investment is evaluated by our research team based on a disciplined set of eight investment criteria. In my experience, successful investments have a few key ingredients, such as finding an attractive industry, identifying the leader, and getting in early, while paying a fair price. Our eight investment criteria capture these core elements but from an innovation-focused vantage point:
Hortz: We have touched on innovation, but tell us how the evolution piece contributes to your investment approach? It must be important given you named the firm, Evolutionary Tree Capital Management.
Ricketts: Innovation is important, but it is only part of the story. We like to say the “equation” for wealth creation is: Innovation + Evolution = Opportunity.
Innovation—or a series of innovations—is what fundamentally forces change across industries and the whole economy. As these innovations are introduced in different industries, they cause structural change—evolution—that may drive multi-year secular growth. Innovations are the building blocks for next-generation products or services. When successful, they drive a shift from the old generation to the next generation. We call these evolutionary shifts, and they offer both opportunity and risk for investors. Evolutionary shifts are now happening more frequently, especially with the rise of Digital Transformation.
In decades past, innovations arose at a slower pace and were absorbed by incumbents with less disruption. Today, with accelerating change, new innovations can drive profound structural changes within and across industries—creating both long-term growth opportunities for leading innovators and risk to those firms failing to adapt. The days of graceful maturity for incumbents have given way to next-generation products or services displacing less innovative offerings.
Examples of evolutionary shifts can be found in most industries and include the shift from traditional retail to e-commerce, the shift from client-server computing architecture to cloud computing and software-as-a-service, and the shift from traditional media to video streaming.
The never-ending series of new innovations is driving the evolution of business models and industries across the economy, and in the process creating new winners and losers.
Hortz: In building innovation-focused portfolios, what portfolio parameters do you use?
Ricketts: We believe leading innovators are rare, and thus, are best held in focused strategies of concentrated portfolios of thirty-five or fewer holdings. Using our investment criteria and unique investment process we aim to identify and own what we believe are the leading innovators, supporting high-quality portfolios with optimal diversification. In addition to true innovators being rare, empirical data is increasingly supporting the fact that more and more industries are experiencing growing concentration in market share and profit take—the leading innovators are taking more of industry profits now than in the past, further necessitating a concentrated approach to investing in innovators.
We believe leaning into a number of areas of the economy undergoing innovation—with attractive competitive dynamics—is the best way to gain value-added diversification versus blanket ownership of every industry and sector. The fact is, many industries are highly competitive and/or near saturation, with low levels of innovation, all factors that lead us to eliminate these industries from consideration.
We also balance this focus with a reasonable level of industry variety—what we describe as optimal diversification—across different industries and sectors. For example, we may own a variety of technology companies, life science and biopharma companies, digital media and consumer companies, select financial services companies, as well as holdings in other industries experiencing high levels of innovation.
Hortz: How would you recommend that advisors and allocators integrate innovation investing, and how is what you do different than other innovation funds or ETFs in the market?
Ricketts: By now, you probably know I would highly recommend that every investor have an innovation allocation. It is simply the most important driver of wealth creation across our economy. But gaining exposure to innovation is tricky and should be done with care. There are a growing number of strategies with the innovation label or wrapper, but few represent high quality offerings, in my opinion. Most innovation strategies, particularly innovation or thematic ETFs, are often built around broad themes with little real research backing up the portfolio holdings. They are just baskets of companies that fit a theme, with little or no research supporting their inclusion. Frankly, most ETFs in this field are developed by marketing organizations. It is important that investors focus on innovation-focused strategies that are supported by rigorous research and a firm that specializes in innovation investing, such as our firm Evolutionary Tree.
There is also a lot of hype out there, so looking for innovation strategies that are thoughtful about stock selection and risk management is key. While investing always involves risk, we believe our innovation-focused strategy is significantly more risk-managed. How? We focus on quality companies with competitive advantages and strong balance sheets. We also seek to avoid hype by leaning into companies and innovations that have demonstrated technical feasibility with potentially attractive business models—the foundations for being ready for mainstream adoption. Additionally, valuation discipline is an important part of our process and is the final criterion a company must pass before we deem it worthy of inclusion in our portfolios. We build risk-managed portfolios of quality innovators.
The bottom-line: innovation is the new value driver in the markets. Investors are increasingly asking their advisors for more exposure to innovative businesses, and we believe innovation investing is emerging as the solution.