The Next Big Thing

10530_light_bulb_stock_1Currently, the investment landscape is dominated by low-risk assets, bond yields are at record lows, steady durable growth equities, such as consumer staples, have enjoyed a significant price-earnings ratio (PE) re-rating and low-volatility strategies are gaining in popularity.

Investors have sought out yield, run from risk and embraced reliability. This has created opportunities for investors willing to embrace the risk and rewards of innovation – technology looks especially well priced. For instance, Apple trades on 10x forward earnings and Samsung Electronics on 8x. It is human nature to innovate, but we think this is currently being ignored by the stock market. Now is the time for plan sponsors to test their managers’ appetite to invest in innovation.

To benefit from innovation-based growth, investment managers must take a long-term approach because the companies set to gain the most are focused on multi-year opportunities, not just the next quarter. For example, Amazon frequently states and restates its primary goal: Putting customers first is the only reliable way to create lasting value for shareholders. This commitment means that the company cannot produce reliable short-term profit growth. And this should not be the goal. Instead, Amazon has embraced innovations such as Cloud storage, Kindle and same-day delivery, all of which aim to improve the customer’s experience. This can occasionally depress profits but has produced a 32% compound annual growth rate in revenues since 1998 and the shares have responded accordingly, even though the market worries intermittently about Amazon’s profitability.

The rise of the genome

In January 2013, The Economist posed the question, “Will we ever invent anything this useful again?” Perhaps some of the depressed valuations in innovative companies reflect this fear; however, we believe those fears are unfounded. While the invention of the transistor (1947) and the discovery of the structure of DNA (1953) took place around the same time, the former has revolutionized our world, but the latter has had almost no impact. This is because the incubation period between the initial discovery and the commercialization of a new technology can take years, or even decades.

One company involved in the advancement of work on genomic health is Illumina, which has a dominant market share in gene sequencing technology. The first human gene was sequenced less than 15 years ago, but the cost of this technology has advanced at a scarcely believable rate. According to biostatistician Steven Salzberg of Johns Hopkins University, “In the past 10 years, sequencing has gotten approximately 500,000 times more efficient. Nothing in the history of civilization or technology has ever gotten that much more efficient that fast.” Sequencing the human genome helps us understand diseases better, bringing treatment, or a cure, ever closer. The declining cost of this technology means it can have a hugely beneficial impact on lives and brings the advantages of targeted medicine. For example, it is estimated that $60 billion is wasted each year in the U.S. on cancer drugs with no statistically therapeutic benefit. Innovations such as Illumina’s sequencing technology will not just rock the world but save lives. A real revolution in healthcare is in prospect over the next 20 years.

Innovation is fast and violent, and fortunes are won and lost. While the changes it reaps can feel uncomfortable, they are pervasive. Plan sponsors and their investment managers should not overlook companies that embrace innovation at the expense of reliability. Innovation-based companies represent a great opportunity, but investors must identify genuinely innovative companies, be long term in their approach to investment and look for the revolutions that will truly improve our world.

Right now, one of the most exciting fields is healthcare. If companies such as Illumina are successful, then plan sponsors may once again have to address the longevity challenge in their plans as people live longer, healthier lives.

John Carnegie is director, clients department, Baillie Gifford