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When does innovation become investable?

If it sounds too good to be true, it probably is.

Today, companies stand on the frontier of enormous technological innovation, but it can be challenging for equity investors to determine which technologies will lead to positive long-term investment returns.

When it comes to evaluating the commercial potential of emerging or evolving technologies such as augmented reality or blockchain, there are a few principles that investors can bear in mind to look beyond the short-term hype.

The first is that it often takes longer for a new technology to make money than is generally expected. This phenomenon is neatly reflected in the Gartner hype cycle, which illustrates how technologies or innovations move from creation, through expectation and disillusionment, to productivity within business over varying timescales which are typically longer than we might expect.

The same can be said of technology companies taking longer than expected to monetise their business models. In February 2018, popular social network Twitter reported its first quarterly profit in 12 years as advertisers have only gradually adopted the platform alongside more established players such as Facebook and Google which account for the bulk of their spending, the Financial Times reports. 

The second principle is that once technology does become commercially viable, it can impact far more customers than initially expected. Collaborative robots, for example, which can work alongside human workers on the factory floor, began life in the automotive industry but are now being rapidly deployed across multiple industries like online retail and logistics.

Similarly, while the commercial potential of 3D printing, for example, has not yet been fully realised, the technology has amazing potential for streamlining manufacturing, logistics and sales industries over the coming decades, as it offers companies unique ways of manufacturing bespoke or low volume, high value things such as prototypes or jet engine components.

Tom Riley, research lead for the Automation theme at AXA Investment Managers, says: “We are enthusiastic about 3D printing as a technology, and the market continues to broaden as new materials become available and new productions technologies improve efficiency and capabilities”.

But this optimism for its future applications must be considered alongside the overall volatility of 3D printing market over the last five years, says Riley:

“The 3D printing market went through a big ‘hype’ stage in 2012-2014, where growth expectations got too far ahead of themselves and share prices of companies using the technology performed strongly. But too much capital was allocated to the sector, however, and performance didn’t match expectation. Over the last 18 months or so, we’ve seen more realistic signs of life as the market has begun to absorb the excess capacity that was created in recent years and sales improve. It’s an exciting area for us, but given its volatility, it is an area we have to be cautious in when investing.”

Separating hype from investment reality

So how can equity investors differentiate short-term hype from long-term reality? For Jeremy Gleeson, AXA IM’s research lead for the Connected Consumer, the understanding that most technology innovation typically takes longer than expected to become commercially adopted means that it is important to be lazer-focused.

“We tend to focus where we see meaningful signs of mainstream adoption and commercial adoption of a new technology – that is when our interest picks up,” he says. In terms of identifying these signs of mainstream adoption, Gleeson explains that there are no short cuts, or easy answers.

“We attend lots of trade shows in each of our investment universes, to see how new technologies are being deployed for the first time by companies. This often gives businesses an opportunity to showcase new developments as they come out of R&D facilities for mainstream commercialisation, but more importantly it can serve as a catalyst for us to make investment decisions by talking first-hand to companies and consumers”.

Paying for potential?

Innovative companies can often seem to attract high valuation multiples in the equity markets. Investors can either view these multiples as an expression of shorter-term hype or as the sage identification of growth prospects, but should ultimately consider this alongside longer-term investment horizons. Multiples naturally matter a lot more if you’re thinking on a one-year view, but over a 10-year timeframe, roughly 70% of returns accumulate from revenue growth, according to a study by BCG.

The key to tapping into viable long-term trends, says Mark Hargraves, Head of Global Strategies at Framlington Equities, is a large supply of prudence and patience.

“To deliver sustainable growth outcomes for investors, we focus on the long-term commercial viability and market share of companies’ products or services, by having the patience to wait for innovations to be reflected in company earnings, and by investing only in listed companies with attractive liquidity profiles.”

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