BAEP’s Beaumont on understanding the economics of innovation

1515326886990by Julian Beaumont

For all the interest in self-driving vehicles, blockchain, 3D printing and the like, very little time is spent by investors in understanding the economics of new innovation and who might actually benefit.

Most investors in these hot industries can’t fathom anything other than a bright future. With the benefit of hindsight, however, investing in the latest hi-tech industry isn’t necessarily the easy path to riches most might presume.

Looking out from the 1920s when air travel was just taking off and the commercial airline industry was attracting much excitement, few would have been disappointed by its subsequent growth or importance to society. Investors in airlines, however, have been losing money ever since. Indeed, many airlines have gone bankrupt, including Ansett and Compass, and most have at some time required bailouts.

Consumers, however, have benefited, especially through lower flight prices over time. And to prove innovation isn’t the key to success, the supersonic Concorde stopped its super-fast flights in 2003.

Similarly, automobiles, plastics, personal computers and dot-coms were all once new-age industries that have caused carnage for investors. Picking the few winners that will emerge from the hype is often difficult.

From the dot-com bubble, Amazon is obviously one. Other big tech winners, such as Facebook, Google and Netflix, weren’t even listed at the time.

To date at least, Amazon has won with profitless prosperity, with arguably little profits to show for its success. Online retailing has been a tough place to invest.

Here, the value of the innovation accrues to customers rather than shareholders, as those in Surfstitch and Temple & Webster can attest.

Improved range, searchability, price transparency and convenience all clearly benefit the customer, but come at a cost to retailers – particularly due to increased price competition and expensive delivery costs.

Interestingly, it has been bricks-and-mortar retailers like Zara and H&M whose fast fashion and express supply chains have been among the most profitable innovations in retail in recent years.

Right now, investors are enthusiastic about lithium stocks, disruptive tech names, pre-profit concept stocks and bitcoin. Of course, that which is new and lacks much historical track record allows this optimism, with little in the way of disproof.

The key for investors is not to focus exclusively on the importance, societal value or seemingly exponential growth of the innovation, but to understand the economics behind it.

For example, if lithium is ultimately plentiful, it won’t be lithium miners that will prosper from the electric vehicle revolution. Nor will it necessarily be Tesla, as incumbent auto manufacturers can just as easily go electric.

Ultimately, whether any one company truly benefits from innovation comes down to whether they have something unique – a competitive advantage – that limits the extent to which the value of the innovation is competed away or otherwise passed on to the customer.

A common example is where the innovation makes for a unique product or service. Often forgotten as innovators are a number of world class Australian-based healthcare companies that include Cochlear, Resmed, Sirtex and CSL.

They spend big on researching and developing new and better medicines and medical devices.

Their products are protected by intellectual property rights such as product registrations and patents, allowing them to reap the profits of their innovation. Interestingly, investors don’t seem to attribute much value to R&D spend, perhaps because it usually represents an expense and subtracts for profits.

For example, CSL’s pre-tax profits would be almost 40 percent higher but for its R&D investment, which is rarely raised by those focused on its apparently lofty earnings multiple.

Other examples on the ASX include Aristocrat, which is spending more than $300 million annually on developing new market-leading slot machines and online social games; Reliance Worldwide with its Sharkbite push-to-connect plumbing fittings that offer ease and time saving in installation, and which are taking share by disrupting the market; and Costa Group, with its intellectual property in blueberries that improves quality and all-year-round availability.

As these cases attest, seemingly boring innovation can produce exciting profits.

Another less risky way to play innovation is by understanding where it can augment a company’s competitive advantage.

For example, the stock exchange ASX Limited is soon to replace its CHESS settlement system with blockchain technology that is expected to reduce costs and provide added functionality.

Another good example is Domino’s Pizza Enterprises, which operates a franchise of pizza stores. The company has very profitably leveraged new innovation to improve the efficiency of its operations and the cost, convenience and appeal of its customer offer.

For example, new ovens cook pizzas in less than four minutes, its GPS tracker helps speed up deliveries and grows the appeal of using its online ordering app, and DRU (Domino’s Robotics Unit) delivery robots save on costs and are fun for customers.

Of course, it is hard to get ahead using innovation that is readily available – all supermarkets now get the labour savings of self-service checkouts, for example – but Domino’s has been ahead of the curve in integrating new technologies into its customer proposition and thereby advancing its competitive advantages.

There are two takeaways. Firstly, to profitably invest in innovation often means looking beyond the latest sexy sector, including to second derivative beneficiaries. And two, looked at this way, the Australian market is full of innovative companies that are worthy of investment. After all, miners like Rio Tinto have already started using driverless trucks and trains, well ahead of Silicon Valley.

Julian Beaumont is the investment director at Bennelong Australian Equity Partners.

Source: Australian Financial Review


Read more:
http://www.afr.com/markets/baeps-beaumont-on-understanding-the-economics-of-innovation-20180102-h0cdwv#ixzz53eEa52qM
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