Has Innovation Bottomed? Is It Cheap Yet?September 20, 2022
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 12.58% compound annual rate. This translates into a P/E to earnings growth rate of 1.72x.
Doing the same exercise for the S&P 500 yields a P/E of 17.15x earnings and a 15-year compound growth rate in earnings of 6.82%. So, the P/E to earnings growth rate is 2.51x. Seen through this lens, innovation seems pretty cheap compared to historic earnings growth.
Innovative companies are long duration assets and as interest rates have risen, their performance has suffered. It appears, though, that after 15 months of compressing valuations, the valuation of highly innovative companies has found a low compared to the least innovative companies (think resources).
Why don’t investors seem to recognize the value opportunity in highly innovative companies? It is a behavioral bias that results from the dearth of information about innovative companies. When, in 1974 FASB issued SFAS #2, it basically robbed generations of investors of important information regarding corporate innovation activities. The result is clumsy price discovery by investors. P/E-to-growth rate used to be a common valuation metric but seems to have faded in recent times. Perhaps investors should take another look at highly innovative companies from this perspective because it reveals a group of companies that are selling at a 31% (2.51-1.72/2.51) discount to the S&P 500. Innovation appears to have bottomed and looks cheap.