[Investors intuitively know we live in an economic environment driven by an accelerating rate of change. What they seek, though, is guidance on how to navigate to the opportunities—the leading innovators—while avoiding getting hurt by this structural change we see across so many industries. Investors increasingly seek to harness the power of innovation to compound their wealth over time within their investment portfolios. This growing interest in innovation investing is driven by the knowledge that innovative businesses have become the primary engine of wealth creation across the economy and the markets.
Perhaps innovation-focused strategies should be a primary allocation within portfolios. If so, the natural question is how do investors—and their investment advisors—gain access to innovation investing?
With all this mind, I was thrilled to be introduced to Tom Ricketts, CFA, president and CIO of Evolutionary Tree Capital Management, an investment manager that specializes in innovation-focused, risk-managed, and concentrated strategies of publicly traded innovators using a long-term approach. In short, this firm is a specialist in innovation investing with a strong track record, and thus a thought leader on this important topic. He has a strong pedigree, having spent 22 years at a leading concentrated growth public equity firm, Sands Capital.
Inspired by nature’s evolutionary process, his new firm uses this powerful metaphor of generational change for understanding how strategic shifts—what they call evolutionary shifts, driven by innovation—can create investment opportunity. By harnessing next-generation innovations through portfolios of quality innovators, they seek to “lean into the future, not the past.”]
Bill Hortz: Let’s learn more about the rising importance of innovation for investors. Why is innovation investing becoming more prominent in the industry?
Tom Ricketts: To understand how innovation investing differs from traditional growth or value investing, it may be helpful to provide some history. The traditional growth and value investing styles were developed during the early and mid-part of the 20th century, with value initially becoming the dominant style starting in the 1920s and 1930s. Think Graham and Dodd style investing. After World War II, the emergence of large-brand growth companies drove greater interest and participation by investors in growth style investing.
Today, however, the economy is profoundly different than that era. We’re living in the digital age—what I refer to as the innovation economy—and it has become increasingly apparent that investment styles developed nearly a century ago may no longer meet investors’ needs or be quite as effective. This makes sense when you consider that innovative businesses, often with tech-enabled business models, are very different in their economics from business models built in the prior era. So, the two dominant styles—value and growth—which were developed to analyze older business models, are in my opinion getting stale, if not outdated.
For example, the economy has seen a massive shift away from tangible assets as the foundation of value—think of assets such as land, buildings, and inventory—over to intangible assets in our more intellectual-capital based economy. Intangible assets, such as intellectual property and patents, research and development investments, and technology and organizational investments, are the new drivers of value. In fact, Ocean Tomo, an IP-focused consultant, conducted a study of the S&P 500 and found that in 1975 the value of intangible assets as a percent of the S&P 500 value was only 17%, while tangible assets made up 83%. With the shift to our innovation-based economy of today, this has flipped. Now those numbers have reversed, as intangibles make up over 84% of the value, while tangibles has reduced to 16%, as of 2015. The intangible tail is now wagging the tangible dog.
The focus on intellectual-capital based investments, such as R&D or technology investments, is the driver behind the accelerating pace of change, generating a constant stream of innovative next-generation products and services. This, in turn, is spurring a desire among investors to tap into and benefit from this type of innovation. We call this focus on innovation-based investment strategies, innovation investing, and it is different than traditional growth investing. We believe innovation investing is emerging as the third style of investing.
Hortz: It would seem that growth investing and innovation investing invest in similar companies, at least to some extent. How is innovation investing different than growth investing, and why do you call it the “third style of investing”?
Ricketts: While many innovation-type businesses are classified as “growth companies,” I believe the traditional growth style of investing is not optimally positioned to benefit from the innovation economy. While it is correlated with innovation, and may overlap at times, a growth orientation is sub-optimally positioned to benefit. Why? Consider, for example, that a key metric many growth managers look for in companies is above-average growth over the past five to ten years. From an innovation investor’s perspective, waiting artificially five years or longer to start your work on a company is just too late in the value-creation process. Given the rapid pace at which new products and innovations are being launched and adopted—compressing adoption curves from decades to years—we seek to identify and invest in leading innovators earlier in their lifecycle. That’s an important differentiator between growth and innovation investing.
By searching for important innovations and the quality innovators developing them, innovation investors can potentially get ahead of traditional growth investors. This is the essence of what we do at Evolutionary Tree.