[The Institute for Innovation Development recently talked with Steve Scruggs of Bragg Financial Advisors, a family-owned and directed RIA firm and managers of the Queens Road Funds in Charlotte, N.C. While strong proponents of Benjamin Graham and David Dodd security valuation and value investing, they have a keen eye for corporate business innovation and search for investments within a “margin of safety”.]

Hortz: What, if anything, has been written by Graham &Dodd about business innovation management processes in evaluating corporate managements?

Scruggs: Graham and Dodd wrote during an era that was much different than today’s. They were obviously pioneers in securities analysis but they operated in an environment before computers, the internet, Regulation F-D, etc.  During that period industrious analysts could achieve an information advantage by outworking the relatively few number of competing analysts to uncover attractive investment  opportunities.  That’s not the case today.  We think taking their underlying philosophy and applying it to today’s investment world requires not just a backward looking focus on financial statements (which is still very important) but equally a forward looking view that takes into account the increasingly rapid pace of change.  We are certain we can’t predict the future, but we can look at managements and make a judgement on whether or not they are keeping up or falling behind.

Hortz: How do you define and what do you look for in an “innovative” company? 

Scruggs: I think there are two types of innovative companies. The first type is a company that has products or business models that are new or different and potentially disruptive. The second type is a company with traditional products or services, but one that is using innovative ways to become more efficient, more competitive and better able to serve their clients.

The first type of innovative company has untested or novel products or business models that have the opportunity to be disruptive (Biotech, Tesla, Uber).  As value investors, these companies typically don’t have the financial characteristics that we are looking for. They tend to be, by definition, growth companies.  Investors today are banking on these companies growing from innovative ideas into profit producing ones.  From our perspective, there is usually too much hope priced into these companies. 

Our focus is on the second type of company that uses innovative ways to make them even better.  These are companies in more traditional businesses with real revenue and profits, but companies that are embracing technology or improved business models to better compete within their industries. 

An example is Progressive Insurance which competes in the staid business of auto insurance.  But we see them as an innovator.  They were one of the first insurers to embrace using credit scores as a rating factor, a very innovative approach that was responsible for a lot of their profitable growth during the 90s.  The data showed that drivers with higher credit scores generally made more profitable customers.  As one of the first to embrace this in concept and then build out processes that incorporated this seamlessly into their business models they were able to achieve phenomenal profitable growth as other companies played catch up.  Today, we think they are ahead of the curve in Usage Based Insurance.  This is an insurance rating method where they put a device in your car that records your driving habits and provides you with a rate based upon your actual documented driving habits.  Again we think this is going to provide them with a great benefit relative to their competition in the highly competitive auto insurance market.

Hortz: As value managers, how do you translate non-financial business management practices into your investment process and formulation of an “intrinsic value” or buy recommendation on a particular stock? Do you add an innovation premium to companies with systematic and consistent business innovation practices?

Scruggs: The way we view it, non-financial practices must result in financial results to have economic value.  When we are making a qualitative assessment of management’s ability to execute a strategy we look to both a track record of success as well as a current and forward looking view.  Our assessment of the management’s ability to innovate and adapt affects the estimates we use in our valuation models.  In short, we’re willing to value and pay more for a company with a successful track record of being innovative.

Hortz: What are some examples of companies that you feel exemplify a business innovation discipline that attracts stronger valuations and investment interest for you? 

Scruggs: The market clearly puts a price premium on successful managements.  The most successful managements have always been innovative but today’s rapid pace of change has created an increased need to remain on the forefront.  There are no sleepy industries, only sleepy companies within an industry.

Today this is playing out in the retail apparel industry.  When you wanted an article of clothing 25-30 years ago, you went to the local store and picked from what they had.  Companies that are operating with that model today aren’t going to make it. Believe it or not, some companies are not too far from that model.

The buzzword in the industry today is omni-channel marketing.  At its core, it involves capturing customer intent and delivering behavioral based marketing solutions that result in a sales conversion.  It involves capturing information not just on customer  buying habits, patterns and tastes but also behavioral and psychological information that can be better used to make a sale.  Getting the right message to the right consumer in the right way is much more important than just stocking your shelves with an assortment that incorporates the season’s hottest color!

A company we have owned in the past, and is now on our watch list, is Urban Outfitters. They are a great example of a company embracing technology and using it in innovative ways.  Founder and CEO Richard Hayne readily invests in projects on the cutting edge, using stores as laboratories to test new ideas.  They’ve been maintaining a ‘consumer insight database’ for years, capturing as much information as possible on their customers’ purchasing habits.   Also, they were early to embrace point of sale transactions (getting rid of cash registers) and effective social media engagement.  They are a great example of a company embracing innovation and they are smart about it.  Urban Outfitters monitors these pilot projects and continues if they have the potential to bear fruit and changing tack if they don’t.  Innovation for innovation’s sake isn’t good. It has to make economic sense.  We all remember when Coca Cola innovated with New Coke, betting the company on a poorly tested concept that set them back a couple of years.

Hortz: As valuation experts of companies, do you think incorporating business innovation practices into advisors businesses will add to the valuation and potential sale price of their firms? 

Scruggs: Without a doubt.  Being able to do more with less ultimately increases profitability which increases firm value.  Technology that has a high return on investment clearly increases the value of the firm.  Taking that to a second level, by providing clients with something new and engaging, such as real time interactive performance reporting, we increase customer retention and advisories with higher levels of customer retention trade for higher multiples.

As we discuss our business with our peers, there are clear areas where we see some firms embracing business innovation and new technology, while others are not.  From a competitive position as a smaller advisor, as compared with the wirehouses and banks, our ability to analyze new technology, experiment with new business models, and implement them puts us at an advantage over these huge companies with legacy systems and cultures resistant to change. 

Hortz: What best advice would you give advisors about applying business innovation to their business and investment thinking?

Scruggs: As value investors we put a high value on a historical track record of financial success, but this can’t be done without a view of the future. We highly recommend that all advisors, as both investors and business owners, should be aware of and keep learning about how successful companies apply business innovation practices and thinking. We say this as the best investment opportunities we see are companies that exhibit a willingness to move forward and accept the increasing pace of change, but in a measured way.  We love to see companies willing to try something new, even if it doesn’t work out, as long as it’s reasonable, well-thought and honestly communicated.

The Institute for Innovation Development is an educational and business development catalyst for growth-oriented financial advisors and financial services firms determined to lead their businesses in an operating environment of accelerating business and cultural change. We position our members with the necessary ongoing innovation resources and best practices to drive and facilitate their next-generation growth, differentiation and unique community engagement strategies. The institute was launched with the support and foresight of our founding sponsors - Pershing, Voya Financial, Ultimus Fund Solutions, Fidelity, and Charter Financial Publishing (publisher of Financial Advisor and Private Wealth magazines). For more information click here.