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UBS research focus

Wealth Management Research November 2010

Pricing the new: how investors should value innovation


Innovation makes the world go round Core investments and innovation Innovation for outperformance

Contents
UBS research focus This report has been prepared by UBS AG. Please see important disclaimer at the end of the document. Past performance is not an indication of future returns. The market prices provided are closing prices on the respective principal stock exchange. Publication UBS AG, Wealth Management Research, P.O. Box, CH-8098 Zurich Editor in Chief Stefan Schneider, Analyst, UBS AG Editor Roy Greenspan Authors Tony Andersson, Analyst, UBS AG Sacha Holderegger, Analyst, UBS AG Thomas Krmmel, Analyst, UBS AG Rudolf Leemann, Analyst, UBS AG Carsten Schlufter, Analyst, UBS AG Stefan Schneider, Analyst, UBS AG Alexander Stiehler, Analyst, UBS AG Editorial deadline 2 November 2010 Project Management Valrie Iserland Desktop Publishing WMR Desktop Translation 24 Translate, St. Gallen, Switzerland; CLS Communication, Basel, Switzerland Pictures www.dreamstime.com Printer Fotorotar, Egg, Switzerland Languages Published in English, German, French, Italian, Spanish and Portuguese Contact ubs-research@ubs.com UBS homepage: www.ubs.com

Editorial ..................................................................................................... 3 Highlights .................................................................................................. 4 Chapter 1 Innovation makes the world go round........................................................ 6 Chapter 2 Innovation and core investments .............................................................. 11 Chapter 3 Innovation for outperformance ................................................................ 16 Bibliography ............................................................................................ 20 Selection of research publications ........................................................... 21

SAP-No. 82092E-1008

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Pricing the new: how investors should value innovation

Editorial
Dear reader, Innovation: The word alone can ignite the imagination of investors. They see visions of new markets and big profits, as a long list of success stories unfurls to the clinking cash registers. Meanwhile, in our world of all-pervasive advertising, viral media and 24/7 broadcasting, we are constantly told that new is better. We are just one short, if cheerless, decade from the end of a golden age of innovation. The bursting of the Tech bubble hurt a lot of investors but the magic promise of innovation survived. After all, that era gave us a raft of corporate giants that are still with us. And, as individuals, we owe our global connectivity to the innovations of the Tech sector, with devices now the size of a deck of playing cards. At least since the Industrial Revolution, innovations in the sciences and technology have triggered vast leaps in social and economic progress. Today, for emerging economies, the transition from innovation followers to leaders is propelling them towards advanced levels of economic development. For the industrialized nations, innovation is an important factor in maintaining competiveness and attracting foreign investment. The Austrian economist Joseph Schumpeter (18831950) was an important theorist on the topic of innovation. He famously explained economic development and social progress as a perpetual process of creative destruction. The old gives way to indeed is overrun by the new. In his view, innovations break up established economic relations and enable a step-change, a sharp shift upwards, in economic development. Innovation enjoys a shining reputation among investors, policy makers and the public at large. But we find this esteem overdone. We think investors need to apply a clearer, less emotional lens to the cash-eating pitfalls of innovation. The key is to see innovation as part of a companys overall business strategy. Only then can its risks and returns be properly assessed. We think private investors need to better understand how a companys innovation strategy can affect its ability to generate cash flows. It is this essential context that we provide in this UBS research focus. Background is only part of what we intend to deliver. We also share our sector-specific findings on which kinds of innovators show a track record of solid investment returns. As with one of the earliest examples of our subject, fire, we must learn to exploit innovation wisely or we will be burned.

Andreas Hfert

Stefan Schneider

Andreas Hfert Global Head Wealth Management Research

Stefan Schneider European Head Equity Research Wealth Management Research

UBS research focus November 2010

Highlights

Pricing the new: how investors should value innovation


We all like innovations, the source of cool gadgets that people talk about even before they hit the market. Innovations make our lives easier and they provide growth to corporations and even countries. Consequently, innovations are good, arent they? But are they as good for investors as they seem to be for consumers? This is the question we explore, and answer, in this UBS research focus: Pricing the new: how investors should value innovation. We think that evaluating a companys innovation strategy and related costs is essential to making a good investment. In this report, we explain why, and we highlight sectors that offer the best returns for the money when innovation is considered as a relevant factor in the investment decision process. Innovation makes the world go round In terms of this report, an innovation is an invention big enough to have an economic impact. An innovation offers advantages over what has been available, making it more attractive in a given market. An innovation is not to be confused with an invention, which is something new but not necessarily marketable. Innovations can be very powerful. They often are door-openers, clearing the way for follow-on innovations. Innovations are rapidly diffused in the marketplace. Only saturation can curb their adoption in the market. Economically, innovations allow the innovator today, often corporations to enjoy a temporary period of monopolistic dominance over competitors allowing for rapid growth and large profits. Competition is the driving force, and this lucrative period of dominance is the incentive for a company to invest in innovation. Naturally, not all companies are exposed to the same competitive environment. This differentiation is also seen at the sector level. Some sectors are plainly more reliant on innovation than others. There is no recipe for a commercially very successful innovation. The pursuit of innovation is risky, costly and time-consuming and results are certainly not guaranteed. We distinguish three types of innovation in this study: product innovation, which usually is the riskiest and costliest; processes innovations that offer efficiency gains in manufacturing, for example; and distribution innovations that improve or expand a companys
4 Pricing the new: how investors should value innovation

reach. Moreover, we also assess the influence governments have on the innovation process. Generally, the more competitive the business environment, the bolder are the investments in innovation. Just think of non-profitable start-up companies that often spend heavily in innovation with no guarantee of success. This means that investors, who are the owners and thus share the companys risk should have a close look at a companys spending on innovation. There is a basic conflict of interest here: while companies need to invest in innovation to secure their future cash flows and competitiveness, investors want an immediate return on their investment. Thus, the use of a companys cash flow needs to be wisely balanced to satisfy both needs. Innovation and core investments We wanted to establish whether it pays for investors to consider innovation as a relevant factor in their core-satellite portfolio investment decision process. First, we tested innovation as an investment factor in the context of the core portfolio that part of a portfolio that should provide stable long-term returns. To do this, we created a qualitative scoring model that defines the innovation intensity for all major industries. We looked at product, process, and distribution innovation and also assessed the influence governments have on the innovation process. In order to identify companies with the most sustainable cash flow generation, we screened average EBIT (Earnings Before Interest and Taxes) margin figures, adjusted for annual volatility. Plotting innovation intensity against the EBIT margin stability of the various sectors gave us the four sectors with both the lowest innovation risk and the most stable EBIT margins: Consumer Staples, Utilities, Telecom and Consumer Discretionary. With backtesting, we found that the companies from these sectors that provide the most stable cash flow actually do provide higher investment returns. Innovation for outperformance We then considered whether innovation would also provide higher investment returns when properly applied in the satellite portfolio the more opportunistic part of the portfolio that is dedicated to pursuing outperformance. We constructed a

Pricing the new: how investors should value innovation

satellite portfolio using the Research and Development-to-sales ratio as a measure for innovation. Although Research and Development (R&D) is an imperfect measure for innovation, we find it a suitable indicator for our purposes. The result of our analysis was impressive, and even a bit surprising. We found that the best-performing investment strategy involved companies with low R&D-to-sales ratios. With R&D as a proxy for risky product innovation, our conclusion is that the market does not reward product innovation risk. There were two exceptions: the Healthcare and IT sectors, where the market actually prefers companies with high R&D-to-sales ratios. Our interpretation is, that as soon as innovation becomes a matter of survival as is the case for these two sectors investors are willing to pay for the

innovation risk with the expectation for higher future returns. Consequently, we think investors in these sectors need to have a deep understanding of how innovation works in these areas. In summary, our findings show that investors are well-advised to consider innovation as a relevant investment factor. And contrary to the perception held by the broad public investors should be rather critical and look for those companies that invest less in innovation. There are only two sectors where investments in high-innovators pay off IT and Healthcare. Here, innovation stands for survival and is also understood as such by investors. As a result, the market favors companies in these sectors that reinvest in innovation rather than paying dividends.

Ability to generate sustainable high free cash ow


High stable EBIT margin and low innovation is crucial for succes in the core portfolio Low 1st quintile UBS WMR equity analysts assessed the various sectors based on four innovation metrics product, process, distribution and regulation by government. Further, we used EBIT margin stability to identify stable earnings generation. We then classified the sectors in five quintiles whereby the first quintile is least affected by innovation and has the highest EBIT margin stability. Plotting innovation intensity against EBIT margin stability of the various sectors gave us the four sectors with both the lowest innovation risk and the most stable EBIT margins. We think companies in these sectors should have the most sustainable cash flow generation throughout business cycles and thus are suitable for the core portfolio in a core-satellite investment strategy. The remaining six sectors are suitable to generate outperformance via the satellite. Only in the IT and Healthcare sectors does the market favor companies that reinvest in innovation rather than paying dividends. Otherwise investors are advised to choose companies that invest belowaverage in innovation.

Materials

Consumer Staples

2nd quintile

Telecom

Utilities

Level of innovation

3rd quintile

Energy

Consumer Discretionary

4th quintile

Financials*

Industrials**

5th quintile

IT

Healthcare

High 5th quintile Low Core Portfolio 4th quintile 3rd quintile 2nd quintile 1st quintile High

EBIT margin stability


Satellite Portfolio

Note: *For Financials an EBIT approximation was used ** For Industrials only Capital Goods was considered Source: UBS WMR

UBS research focus November 2010

Chapter 1

Innovation makes the world go round


Innovation is a motor of economic growth. It can also promise investors a pot of gold at the end of a rainbow. However, given its almost instinctual appeal, investors should assess it critically to ensure higher returns and to better control investment risks. Creation of an idea When James Watt tightened the last bolt on his steam engine in 1776, he could not know that his invention would change the world. Steam-powered engines launched the Industrial Revolution, and they created a new social class, factory laborers, thus triggering nothing less than a social revolution as well. Watts innovation also had profound geopolitical implications, as Britain became the worlds preeminent economic and military power in the late 19th century. Throughout history, inventions, or more broadly speaking, innovations have often been the driving force behind social and economic change. Innovation is central to what we understand by the word progress. Inventions and innovations are inseparable from entrepreneurship. Many of the great inventors were also highly successful entrepreneurs. Think only of Alexander Graham Bells telephone, Karl Benzs motor car, or Thomas Edisons many inventions. Indeed, many if not most inventions have been spurred by a profit motive. Johannes Gutenberg, whose printing press surely must rank among the most revolutionary inventions of all time, had tried his hand in various businesses before making his big breakthrough. Putting ones own resources on the line to create something new, risking total failure, is the essence of entrepreneurship. As the reward, the inventor/entrepreneur earns what is called pure entrepreneurial profit. And even in large corporations, innovation remains essential, at the least to generate profit, or simply to survive in competitive markets. We think innovation has an almost instinctual appeal for investors. After all, we inhabit a world of success stories. The past two decades have seen the emergence of the personal computer, and, more recently, mobile smart phones, and, of course, the Internet, which for many is a daily companion, essential tool, beloved toy and priceless treasure trove. With exceptional innovations
6 Pricing the new: how investors should value innovation

like these, it is no wonder that innovation sends visions of profit dancing through the imaginations of many investors. But the reality is far more nuanced, of course. In this UBS research focus we take a close look at what innovation can and should mean for investors, and how it should be evaluated when making an investment decision. We think readers may be surprised by our findings and our cautionary advice. In this chapter, we explore the broad theme of innovation and show why investors should consider innovation as a relevant investment factor. In the second chapter, we consider the innovation factor in the context of a core-satellite portfolio. Despite the lure of innovation, our analysis shows that long-term investment returns can be enhanced when investments favor less innovation. We also explore which sectors are most suitable for the core allocation in a portfolio. In the third chapter, we explain the most effective ways to benefit from innovation in a portfolios satellite portion.

Innovation makes the world go round

Our perhaps surprising conclusion is that, with two exceptions, the companies that spend less on innovation reward investors better than those that spend more. Thats innovation Be innovative! Use your imagination! Who has not heard this call to action sometime in his or her life? We all think we know exactly what it means. It is about being creative, approaching things differently in order to achieve something exceptional. With this predisposition, ardently reinforced by the all-pervasive noise of advertising where new is always better it is not surprising that being innovative is almost exclusively perceived as something positive. To begin our discussion, we offer a definition of the key term innovation. What we mean by innovation is an invention big enough to have an economic impact. In other words, an innovation offers an advantage over what is currently available, making it more attractive in a given market. Austrian economist Joseph Schumpeter (18831950) was a pioneering thinker on this topic, connecting innovation to business cycles and economic development. An invention is something new, but it may not have any economic impact. Essentially, an innovation is an invention that has been adopted by the market. As an innovation spreads throughout the market and alternatives fade away, it is diffused. It is this diffusion that distinguishes innovations from inventions (see Fig. 1.1).

Often, the very first innovations are door-openers. They pave the way for further innovations that expand acceptance in the market place. With increasing saturation, adoption rates start to slow as the innovation approaches its maximum market potential (see Fig. 1.2). Soon after Karl Benz designed and patented his automobile in 1886, his invention began to diffuse rapidly in the market place. A new industry was born that spread across the world. With increasing adoption, the innovation of motorized transportation gained popularity, which then launched the construction of the modern highway systems. The worlds first limited-access road Italys Milano-Laghi motorway was completed in the 1920s. Karl Benzs innovation was adopted on a global scale, and led to uncountable related innovations. It changed our world as only very few innovations have (see Box: The power of innovation). Competition the fuel for innovation With innovations offering benefits over the currently available products or services in a given market, the innovator can enjoy a period of monopolistic dominance, with high revenues and profits. This period of dominance, whether short or long, is a key incentive for innovation. Competition is the driving force behind most innovative ideas. More competition generates more innovations, uncovering better ways of satisfying consumers, increasing productivity and providing growth.

Fig. 1.1: Invention, innovation and diusion


Activities and results of the process Innovation activities Research & development Results of innovation activities Invention

Fig. 1.2: The industry life cycle model


Innovation adaption follows an S-curve Introduction Level of innovation adoption Growth Maturity Decline

Market roll-out

Innovation

Market penetration

Diusion Time
Source: Institute of Systems, Sciences, Innovations and Sustainability Research; UBS WMR

Source: Institute of Systems, Sciences, Innovations and Sustainability Research; UBS WMR

UBS research focus November 2010

Chapter 1

Unfortunately, despite countless hours spent by many bright people, the recipe for granting success to an innovation has not yet been revealed. The path to that next big thing remains obscure, risky, costly and time-consuming. Depending on the competitive environment, some companies are compelled to spend vast sums of money to keep innovation high and fend off competition, while others only need small investments as competition is more benign and innovation is less imperative. This can be best exemplified by start-up companies that tend to operate in highly innovative environments. They often spend significantly on innovation without making any revenues, yet. This contrasts with mature companies that operate in a more consolidated business environment. Here, investments in innovation usually represent only a fraction of revenues, allowing for more immediate cash-flow generation. In view of this dynamic, where innovators spend their way to hoped-for success and established companies pick their profitable spots judiciously, we identify one group of people who should not automatically favor the innovators. On the contrary, we argue that they should maintain a rather critical stance toward innovation, given its costs and risks. This group can be neatly summarized in one word: investors. Investors often only see the bright side of innovation Investors, like everyone else, have several ways to spend their money. They can consume products, buy gold or real estate, or choose to invest in equities, corporate or government bonds. The route they choose for their money mainly reflects their specific needs and risk-return expectations. Taking a risk-bearing equity position in a company, investors expect an attractive return as compensation. As equity holders ultimately own a company, this creates a conflict of interest. While the companys owners the shareholders expect cash returns, the company itself may prefer to invest any available cash in innovation. The company wants to maintain and potentially expand its competitive position to ensure future cash flows, which again may go to shareholders or be re-invested in innovation. In
8 Pricing the new: how investors should value innovation

The power of innovation


Innovations are powerful engines of economic growth and higher living standards. Many innovations become part of everyday life and interlink with the business cycle. Then there are innovations so revolutionary that they give rise to worldwide K-waves named after Nikolai Kondratieff, the Russian economist who first described them that last some 50 to 60 years. To date, the world has seen five such waves, all based on a revolutionary innovation that led to a profound technological change (see Fig. 1.3). Fig. 1.3: The ve K-waves (Kondratie waves)
K-waves last in average 50 years and are hard to predict steam engine cotton railway steel electrical engineering chemistry petrochemicals automobiles information technology

1. K-wave 1800

2. K-wave 1850

3. K-wave 1900

4. K-wave 1950

5. K-wave 1990

Source: www.Kondratie.net, UBS WMR

other words, cash that is spent today for innovation is sacrificed for the benefit of potentially larger cash-flows in the future. Applying the time-value-of-money concept, todays cash flow is worth more than the same amount some time in the future (see Box: Time value of money). Therefore, the future cash

Time value of money


The time-value-of-money concept dates back at least 500 years to Martn de Azpilcueta (1491-1586) of the School of Salamanca. It assumes that 100 dollars paid today are more worth than 100 dollars in some years time given the interest that would accrue on the money received today. This can be significant over a long period of time, far exceeding the original amount as the interest is compounded, that is, added to the principal.

Innovation makes the world go round

flows have to be much larger than the ones generated today. Since we know how uncertain the returns are that originate from the innovation process only a small fraction of the many innovative ideas ever become successful products it is impossible to specify a given return on an investment in innovation. Consequently, investors take on significant risk when the company they have invested in chooses to invest its cash in innovation. Despite these risks, investors are often susceptible to the positive spin that innovation enjoys. Too often they select companies that spend heavily on innovation putting their own investment

success at unnecessary risk, in our view (see Box: The Tech bubble). Different types of innovation offer different risk profiles When we think of great innovations, we tend to think of product innovations. After all, innovative products are tangible. But other types of innovation are no less important and, for investors, potentially no less rewarding. While Karl Benz invented a product the automobile Henry Ford focused on the process how to manufacture automobiles. He conceived the assembly line, which produced cars much

The Tech bubble


Between 1995 and 2000, a vast and highly speculative bubble formed on global stock markets, inflated by the high levels of innovation in the broad Information Technology (IT) sector (see Fig. 1.4). Excitement approached near-hysteria about the new technologies. They promised vast productivity gains and equally large quality-of-life enhancements. They were seen as the elixir of eternal corporate growth and share price performance. How did this happen? IBM launched their first personal computer in 1981. Growing by some 20% per year during the 1990s, PCs really became mainstream. Nokias first mobile phone that could carry data as well as voice was launched in 1992, and mobile subscriptions grew by over 50% per year by the end of the 1990s. At the same time, data networks were connecting ever-larger areas of the planet. The first web browsers were also launched in the early 1990s, and with an ever-growing base of installed PCs, the Internet began to spread rapidly. In this era of innovation, it is not surprising that stock analysts made optimistic forecasts. Ultimately, they were right: technology works, and it has changed our lives in profound ways. A long list of companies started small and grew into very large corporations while many others disappeared. Google did not even exist before 1998. Microsoft, HP, Cisco, Dell, Apple, and so many other Tech firms became gigantic. As a result, IT companies comprise more than 20% of the equity market today. Investing in technological innovation made many people rich and poor. In, sum, the Tech bubble displayed both the promise and the illusions of innovation for investors.

Fig. 1.4: Crash of the Tech bubble


Dead-Cat-Bounce: A er the Tech bubble burst in 2000, the market bounced briey in 2001 and then collapsed until early 2003 5,000 4,000 3,000 2,000 1,000
Dec 94 Aug 96 Apr 98 Dec 99 Aug 01 Apr 03 Dec 04 Aug 06 Apr 08 Dec 09

Tech bubble crash triggered by unjustied high valuations for IT companies

2,500 2,000 1,500 1,000 500 0

Nasdaq (index points; lhs)


Source: Thomson Reuters, UBS WMR

S&P 500 (index points; rhs)

UBS research focus November 2010

Chapter 1

faster than the prevailing handcrafted methods. Developed between 1908 and 1915, this new production concept was rapidly adopted by rivals around the world. Later in the twentieth century, Japanese made significant refinements to Fords innovation. With their highly efficient just-intime production system, for example, they made spectacular improvements in productivity. By the 1990s, Japanese car makers were offering highquality cars at very competitive prices across the entire global market leaving many European and American car producers struggling for survival.

From an investors perspective, innovations in products, processes and distribution have very different implications. Product innovation follows an expensive trial-and-error approach, with some companies succeeding while others fail. As the focus is on making something new, something that will find acceptance in a market, the risks are very high. This is not only because the innovation process itself is challenging, but also given the additional complication of having to anticipate future market behavior.

According to a 2005 article in the Wall Street Journal, more than 90% of the roughly 30,000 Innovations in distribution can also yield dramatic new consumer products launched each year are doomed to fail. On the other hand, innovations in breakthroughs, as well as market share gains, sales growth and profitability. E-commerce is one processes and distribution are altogether less very instructive example of innovative distribution. costly and risky. Since innovations in these areas focus on productivity improvements and market Sales are no longer linked to stores; consumers expansion, the main risk, in our view, is to ignore can be reached anywhere in the world. In other new technological developments (see Fig. 1.5). words, companies today can tap into markets that previously were too costly to explore. For In the following chapters, we explore how invesexample Tiffany, the jewelers, has said that, tors can successfully integrate the investment through E-commerce, it has been able to open factor innovation in their investment decisions. new markets in regions where a physical store offered an unattractive risk-return profile. Location is no longer the sole determinant of retail success; other values, such as ease of ordering, are decisive for this innovative distribution channel.

Fig. 1.5: Types of innovation


Product, process, and distribution innovation have dierent cost and risk proles High

Rate of innovation

Product innovation

Process & distribution innovation

Low High Cost and Risk Low

Source: Institute of Systems, Sciences, Innovations and Sutainability Research; UBS WMR

10

Pricing the new: how investors should value innovation

Chapter 2

Innovation and core investments


Innovation impacts the performance and volatility of an equity portfolio. In a coresatellite portfolio framework, risk stemming from innovation cannot only be reduced, but, as our analysis shows, overall portfolio performance can be improved. Since the costs are significant and can impact both profits and cash flow, a companys innovation strategy is important. We think that evaluating a companys innovation strategy should be part of an investors investment decision-making process. This chapter discusses how to do this in the framework of a core-satellite portfolio. Our goal is to help investors benefit from innovation while avoiding undue risk. The equity core-satellite approach The core-satellite strategy originated because of the problems experienced in constructing and running traditional portfolios for private investors. Investors tend to give different weights to losses and gains. They also have sometimes contradictory goals and needs: broadly, they must pay taxes, they want to maintain a certain lifestyle and achieve their financial targets, regardless of market conditions (see Fig. 2.1). The core-satellite framework is a way to address these goals. The portfolio comprises a core component a lowturnover and as such cost- and tax-efficient equity portfolio that should provide the investor with broad market exposure, called beta. While the core should provide portfolio stability, the satellite component pursues outperformance, called alpha, and hence takes a much more opportunistic approach. Constructing equity core-satellite portfolios The core portfolio should be a well-diversified group of stocks with exposure to the broad market, encompassing large-, mid-, and small-cap stocks. In order to benefit from international diversification, investors should focus more on a companys underlying business and less on the companys domicile. For example, Nestl may be headquartered in Switzerland, but 98% of its revenues are generated outside of Switzerland. The primary goal in constructing the satellite portfolio is to generate alpha, which means generating excess return against the benchmark. As such,

this component usually has a higher turnover than the core. We see long-term value in an equity satellite portfolio and we reject the notion, heard from some pundits, that stock picking is dead. The passive approach of investing in stock indexes, in our view, actually means running in the same direction as the whole investment community, which is what behavioral finance calls herd behavior. We think there are often attractive investment opportunities elsewhere, where the herd doesnt go.

Fig. 2.1: The journey matters


Private investors oen can only take limited volatility Wealth Target Wealth

Success

Determinis
Starting Wealth Minimum Wealth Success

tic Approac

Failure

Time
Note: While investors have the deterministic approach in mind, reality oen takes dierent routes to reach the target wealth Source: Chhabra, Ashvin, B.; "Beyond Markowitz"; 2005

UBS research focus November 2010

11

Chapter 2

Optimal core allocation The optimal allocation to the core or satellite component of a portfolio is probably more dependent on the investors investment goals, risk appetite and return expectations than on optimizing pure after-tax returns. However, using purely quantitative arguments, the optimal allocation to the core, according to the ample literature on the subject, can range from 60% to 90%. As shown in Fig. 2.2, a simulation by Clifford Quisenberry came to the conclusion that the optimal core portion may be closer to 60%. Considering a slightly more cautious stance on generating alpha from the satellites, as a strategic allocation, we think allocating two-thirds to the equity core is reasonable. Innovation is a relevant investment factor As outlined in chapter 1, there is often a conflict of interest between companies and their shareholders about how to use the cash flow. While shareholders may prefer to see the companys cash flow as return on their investments, the company would rather direct any available cash to innovation in order to maintain competitiveness. The uncertainty associated with the innovation process makes it difficult to optimize the risk-return profile of investments (see Box: When defensive investments hurt, on page 15). We believe that the ability of a company to generate high and sustainable free cash flow is crucial for long-term investment success. As shown in Fig. 2.3, free cash flow stability can be divided into revenue stability, earnings margin stability and the level of capital expenditure (capex). While revenue stability is influenced by the business cycle, both

earnings margin stability and capital expenditure are affected by innovation through expenditures on R&D, fixed and working capital. Thus, in our view, sustainable free cash flow generation can best be achieved if a companys investment strategy balances both risks and costs. In other words, we would expect higher investment returns from an aggregate of companies with below-average overall investments in innovation, a lower percentage of high-risk product innovations and less exposed to the overall business cycle. Considering the risks associated with investing in innovation, and the fact that the market only attributes value to those investments in terms of future cash flow, we urge investors to evaluate the factor of innovation in their investment decisions. We think innovation deserves to be considered along with the more recognized factors that influence a companys performance and an investors returns, like revenues, margins, or earnings per share, for example. Considering innovation yields returns In order to test our thesis that considering innovation should assure higher investment returns, we constructed and tested a core portfolio that generates sustainable high free cash flow. In our model, we used the S&P 500, given its high liquidity. We analyzed the period from 1995 to 2010, in order to account for several business cycles and screened for earnings margin stability and the level of innovation. To determine earnings stability, we screened the reported average EBIT margin figures, adjusted for annual volatility. To analyze the level

Fig. 2.2: Optimal core allocation: Maximizing aer-tax return


60% weight to the core portfolio is the optimum allocation in % 8.6 8.5 8.4 8.3 8.2 8.1 8.0 7.9 7.8 7.7 in % 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0 20 Aer-tax return (lhs)
Source: Cliord Quisenberry, 2006

Fig. 2.3: Free cash ow constituents


Earnings margin stability and capex two variables impacted by innovation
Free Cashow = net revenues * (EBIT margin incl. R&D) Tax + depreciationstock capex (1 depreciationnew)

Revenue stability

Earnings margin stability

Capex

40 60 Weight to core (%) Tracking error (rhs)

80

100

inuenced by the business cycle

inuenced by innovation

Source: UBS WMR

12

Pricing the new: how investors should value innovation

Innovation and core investments

of innovation intensity, we created a qualitative scoring model that defines the innovation intensity for all major industries based on product, process, distribution innovation, and factored in government regulation (see Box: Government regulation). Our analysis reveals that the Materials, Consumer Staples, Telecom, Utilities, Consumer Discretionary and Energy sectors have the relatively lowest levels of innovation of all sectors (see Fig. 2.4; Innovation quintiles 13). We also find that Consumer Staples, Utilities, Consumer Discretionary, Healthcare, Telecom and Industrials score highest on EBIT margin stability (see Fig. 2.4; EBIT margin stability quintile 13). When we combine these results to determine the sectors offering the highest sustainable free cash flow generation throughout business cycles, we identified Consumer Staples, Utilities, Telecom and Consumer Discretionary (see Fig. 2.4; Core Portfolio).

Government regulation
Government regulation is an important factor in assessing innovation as it relates to investing. Governments foster innovation in many ways, for instance, by funding research or sponsoring certain technologies or industries. Without government sponsoring, many alternative energy projects would likely not exist. Governments also influence the innovation process indirectly, by legislation. Banning monopolies that would hamper further innovation is one example. Patents indirectly influence the innovation process, granting the holder a temporary monopolistic advantage. The possibility of gaining such market dominance, even if only briefly, encourages companies to invest in expensive and highly risky innovation projects. The Pharmaceutical industry is a case in point. Developing a new drug can easily cost more than USD 1bn, with the risk that the drug will never make it to the market. Patent protection, if the drug succeeds, allows for a payback for the companys development costs and risks.

Fig. 2.4: Ability to generate sustainable high free cash ow


High stable EBIT margin and low innovation is crucial for success in the core portfolio Low 1st quintile On the search for sustainable free cash flow Measuring a companys innovation is a challenging task due to the often confidential nature of these expenditures. UBS WMR equity analysts assessed the various sectors based on four innovation metrics product, process, distribution and regulation by government using a ranking from zero to 10. Further, we used EBIT margin stability taking the average EBIT margin over 5, 10 and 20 years and dividing it by the annual volatility to identify stable earnings generation. We then classified the sectors in quintiles (five equal-sized groups), whereby the first quintile is least affected by innovation and has the highest EBIT margin stability. Plotting innovation intensity against EBIT margin stability of the various sectors gave us the four sectors with both the lowest innovation risk and the most stable EBIT margins. We think companies in these sectors should have the most sustainable cash flow generation throughout business cycles.

Materials

Consumer Staples

2nd quintile

Telecom

Utilities

Level of innovation

3rd quintile

Energy

Consumer Discretionary

4th quintile

Financials*

Industrials**

5th quintile

IT

Healthcare

High 5th quintile Low Core Portfolio 4th quintile 3rd quintile 2nd quintile 1st quintile High

EBIT margin stability


Satellite Portfolio

Note: *For Financials an EBIT approximation was used ** For Industrials only Capital Goods was considered Source: UBS WMR

UBS research focus November 2010

13

Chapter 2

We are not surprised that three of the four sectors identified Utilities, Telecom and Consumer Staples are so-called defensive sectors meaning they are less influenced by the business cycle, which in turn supports their overall EBIT margin stability. Also unsurprising to us is that the two sectors that invest most in high-risk product innovation IT and Healthcare are absent from this group (also see chapter 3). To confirm innovation as an important investment criterion, we then analyzed whether long-term investments in our selected sectors really would yield a higher investment return. We considered the long-term returns of the 30 stocks with the most stable EBIT margins in the four sectors with the most sustainable free cash flow. They, confirming our thesis, significantly outperformed the S&P 500 over our 15-year time span regardless of whether we used equal weights or marketcapitalization weights (see Fig. 2.5).

We think our findings solidly confirm that innovation is an important factor to consider in the investment process. As we noted in chapter 1, we assume that investors are intuitively aware of the importance of innovation. Our point is that their positive associations with the word innovation can lead them to pick companies that spend heavily on innovation. Our analysis shows that these companies are not the best investment choices to achieve long-term investment success of a core portfolio.

Fig. 2.5: Performance of Core Portfolio against S&P 500, 19952010, rebased at 100
Strong outperformance of the core portfolio based on EBIT margin stability

900 700 Index 500

300
100 1995 1997 1999 2001 2003 Years Equal weighted Change in basket Capitalization weighted S&P 500 2005 2007 2009 2011

Note: The core portfolio is a basket of the 30 companies from the core sectors (Consumer Staples, Utilities, Telecom, Consumer Discretionary) with the highest EBIT margin stability over 20 years. As some of the companies have not been listed from the rst day of the time series, the portfolio was rebalanced at their listing date (change in basket). Source: Thomson Reuters, Citigroup; UBS WMR as of 23.09.2010

14

Pricing the new: how investors should value innovation

Innovation and core investments

When defensive investments hurt


Investors that switch from cyclical to more defensive investments usually do so to reduce business-cycle risk in their portfolios. Contrary to the products of a cyclical companies, those from defensive companies are valued for their independence from the overall course of the global economy. Probably the sector that best exemplifies this independence to the business cycle is Healthcare. After all, we take medicine when we need to, regardless of global growth patterns. However, Healthcare stocks have been performing poorly of late, which has led investors to ask whether the sector really is still defensive. We argue that this is an instance where investors may be confusing defensiveness with innovation. Of course, the sector is still defensive in that it resists cyclical influences. When we assessed the historical performance of sectors and industries in terms of their innovation (R&D) spending patterns, we concluded that the Pharma industry invests disproportionately in high-risk product innovation (see chapter 3). Investors should not assume that the money spent on clinical trials guarantees new drugs and cash flows. Indeed, the R&D productivity for the Pharma industry has been deteriorating for many years (see Fig. 2.6). In our view, this is a classic example of how difficult it is to define the riskreturn profile of investments in companies that rely on innovation for growth. Fig. 2.6: R&D productivity for the Pharma industry has been deteriorating for years
Ever-more investments in R&D do not translate into more new drug approvals 100 80 60 40 20 0 1990 1994 1998 2002 2006 2010 Global R&D spend (USD bn)
Source: www.fda.gov; PhRMA, JPMA, efpia, UBS

No. of new FDA drug approvals

UBS research focus November 2010

15

Chapter 3

Innovation for outperformance


We prefer companies with below-average innovation expenses and high dividends. Only the Healthcare and IT sectors can justify a high-innovation investment strategy, but this requires that an investor has in-depth knowledge of the respective innovation machineries. So far, we have shown that innovation is a factor to consider in the investment decision process. We have also shown that investment returns of the core portfolio can be enhanced with low innovators. We now address how an understanding of innovation can influence the construction of a satellite portfolio. For the purposes of this UBS research focus, we used R&D spending as a measure of innovation. While perhaps not a perfect indicator, R&D data enjoys the advantages of being available, reasonably accurate and applicable to different sectors. The satellite diversifies One important function of the satellite is to enhance a portfolios overall diversification and this also holds true when it comes to innovation. As the core portfolio focuses on investments in established companies in low-competition and low-intensity innovation environments, the portfolio is vulnerable to so-called game-changing events. The term refers to groundbreaking innovations that can topple companies that seem to be highly stable and utterly safe (see Box: The game-changer). Thus, from a risk management perspective, adding innovation diversification to a low-innovation core portfolio is sensible, in our view. R&D an imperfect but usable measure for innovation Although there is a broad understanding of what goes into an innovation namely, ample capital, labor, time and a bit of luck the exact recipe is elusive. Thus, it should not surprise that measuring innovation is also rather inexact. To measure innovation, many kinds of inputs and output variables can be considered. Most can only be estimated subjectively, and some can not be published because they are confidential business matters. R&D spending is often used as a proxy for innovation. It ignores innovation failures and typically only captures product innovations
16 Pricing the new: how investors should value innovation

but not the less risky process or distribution innovations. Moreover, it can fluctuate through the cycle due to capitalization and possible impairments (see Box: R&D activities under IAS 38/36). However, R&D spending data are readily available and, we think, reflect innovation efforts to a reliable degree for our purposes. Low-spending innovators for your satellite with two exceptions To understand the impact of R&D spending on share price performance, we constructed a model that allows us to track the performance of companies with high and low R&D spending levels versus sales. To measure how much companies pay out to shareholders of the money earned through R&D spending, we also considered dividend yield. Either companies use the money to reinvest in innovation, which leads to low dividend payments, or they provide investors with a decent dividend yield through a high payout ratio. The result of our analysis (see Fig. 3.1) was impressive, and even a bit surprising. We found that the best-performing investment strategy over our time frame involved companies with low R&D-tosales ratios. With R&D as a proxy for risky product innovation, our conclusion is that the market generally does not reward product innovation risk. This echoes our findings in chapter 2. There, we

Innovation for outperformance

ran a different analysis, which revealed that low innovation leads to higher investment returns in the context of a core portfolio. Also, as expected from our findings in chapter 2, all four sectors that we identified as suitable for core portfolio construction (Utilities, Consumer Staples, Consumer Discretionary and Telecom) also match the group in this analysis, where the market offers little reward for high innovation activity. We identified two exceptions, the Healthcare and IT sectors, where the market actually prefers companies with high R&D-to-sales ratios. Product innovation is the lifeblood of these two sectors as the continuous flow of new and innovative products to the market is vital. As shown in Fig. 3.2, their R&D levels are by far the highest. In the Healthcare industry, for example, drugs are protected by patents allowing pharma companies to reach a temporary monopolistic position. As patents have finite lifetimes, each new blockbuster drug will be reproduced by the generics industry when its patent expires, and revenues from the drug will fall dramatically. This forces pharma companies to always launch the next innovative drug in time in order to replace those revenues that fall victim to the generics industry. In the industrial sector, for instance, the dynamics are very different. Siemens can sell a wind turbine for many years but needs to continuously improve the product and manufacturing process to remain competitive in the market. Here, the company is

The game-changer
Toward the end of the 19th century, following the innovations of film rolls and inexpensive box cameras, George Eastman had a very good idea: everybody could take pictures, and his company, Kodak, would be the enabler. This business idea proved to be robust the sale of film and the subsequent development of the pictures on Kodak paper provided an ample and continuous cash flow stream. Over the decades, cameras, film and photographic paper were enhanced but not re-invented. The basis of the business was and remained silver bromide. This did not change when Fujifilm entered the competition and grew bigger. Meanwhile, in the early 1970s, a light-sensitive silicon chip was developed in some pioneering laboratories. From crude beginnings, it was continuously improved and around 25 years ago, the first digital camera came on the market. Demand grew as consumers discovered the convenience and efficiencies of this new technology, and market forces came into play. Digital cameras rapidly improved in performance, grew smaller and lighter and cheaper. Diffusion of this innovation gained momentum and digital cameras found their way into most households. Today, color printers have replaced the photo lab and snapshots are shared via mobile phones and the Internet. George Eastmans innovation has virtually vanished in the market. Once a giant, Kodak is only a fraction of its former size. In 2004, after 75 years, the stock was removed from the Dow Jones Industrial index. Kodak suffered much as horse-drawn vehicles when they were overrun, literally and figuratively, by Karl Benzs automobiles 100 years ago. Every now and then, game-changers revolutionary innovations render seemingly dominant technologies superfluous. Game-changers are unpredictable and no industry or company is safe from their potential impact.

Fig. 3.1: Companies with low R&D-to-sales ratios perform best with the exception Healthcare and IT
Investors generally prefer a dividend with the prominent exceptions of Healthcare and IT where investors prefer the dividend to be reinvested R&D-to-sales Low Low Energy Utilities, Consumer Staples Consumer Discretionary Telecommunication Materials Industrials High High Healthcare Information Technology R&D to sales methodology The basis of our model is the MSCI World index. We calculated the median R&D versus sales figure for all our selected companies relative to their subsectors. We then split the set of companies into two groups, those below the median R&D-to-sales and those above. Based on the weight of each company within its group, we calculated the performance for each stock and the total sum of each group to get the above/below median total. We simulated investments in either the high or the low R&D versus sales companies. In the next step, we again used our initial subsector group and split the companies into two groups, one with high dividend yields, above median, and the other with low dividend yields, below median. In the final step, we combined the results from both analyses and derived a two-bytwo matrix. All four portfolios are dynamic, meaning that we applied our company selection process freshly each year. However, in the following year, a company with these characteristics can also move into another group, depending on their R&D spending and dividend yield. Then, we calculated the performance of each group to determine how they performed from 2002 to 2009, when the necessary data was available.

Dividend yield

Dominating investment strategy low R&D-to-sales ratio


Note: Financials were omitted from this analysis as they lack R&D expenses Source: Thomson Reuters, UBS WMR

UBS research focus November 2010

17

Chapter 3

not forced to continuously re-innovate its products. In other words, when innovation is vital for survival, the stock market is willing to pay for investments in it despite the risks associated with it.

R&D activities under IAS 38/36


R&D costs are expensed as incurred and should be differentiated between research and development. While the former cannot be capitalized, and hence, will be shown in the profit & loss statement (P&L), capitalization is possible for the latter if criteria are met such as technical feasibility, the companys intention to complete, and after that, the ability to use or sell the intangible asset. The assessment as to whether the intangible asset will generate future economic benefits is critical for capitalization and impairment of the intangible asset.

Our findings on dividend yield support our analysis of innovation activity. For the Healthcare and IT sectors, the market clearly favors companies that reinvest in innovation rather than paying dividends to shareholders. This confirms our view that investors in these sectors understand the importance of innovation for survival and need to know how the innovation machinery in these sectors works. Investors in the other sectors mostly prefer a higher dividend payout ratio. returns by considering innovation as a relevant investment factor. The core should consist of Conclusions stocks that provide stable and sustainable free Innovation is a strategic response to a companys cash flow. As innovation influences free cash flow competitive environment. It may offer a profitgeneration, we advise making core investments in able, although temporary, monopolistic position companies with low innovation intensity, in parthat ensures a period of robust growth. Innovaticular from the Consumer Staples, Consumer tion is not a straightforward process; rather, it is Discretionary, Telecom and Utilities sectors. Here, costly, risky, and difficult to measure. we think investors should adopt a buy-and-hold strategy. With its great potential to generate cash flow and growth, innovations certainly influences share For the satellite portfolio, investments in the reprices and, in our view, should be explicitly conmaining six sectors should be considered. Of these, sidered by investors. In our experience, investors all but two offer higher investment returns from may think they understand the importance of companies with below-average investments in innovation, but they often do not properly acinnovation. For investments in the Healthcare or count for it in their investment decisions. IT sectors, the winning investment strategy is to identify companies that spend more than their We could show that investors using a core-satelpeers on innovation and make their investment lite portfolio construction approach earn better pay off.

Fig. 3.2: R&D-to-sales ratios for MSCI World sectors


Relative R&D levels are by far the highest for Healthcare and IT R&D-to-sales (%) 12 10 8 6 4 2 0 Healthcare Consumer Discretionary Industrials Consumer Staples Materials Energy Telecom Financials Utilities IT

Note: Our R&D-to-sales gure is a 3-year average, to smoothen the eect of the last downturn Source: Thomson Reuters, Citigroup, UBS WMR

18

Pricing the new: how investors should value innovation

Innovation for outperformance

The next big thing from the past to the future


Knowing that innovation makes the world go round, we all wonder what the next big thing will be. A functioning crystal ball would be a most welcome innovation in this context. All companies need to innovate to one degree or another, and the strategies they employ have a big effect on the returns they generate for investors. Consequently, innovation is a basic factor to consider when investing. Our crystal ball is decidedly in the pre-market prototype phase of development. However, our working assumption is that areas with a high level of product innovation activity could bring about the next revolutionary innovations that can change the game dramatically. Those innovation hotspots can for instance be found in the Pharma and Biotech industries. Nanotechnology, where we would rate the level of innovation as aggressive, also is in the running to make some revolutionary changes. Finally, alternative energies like solar and wind energy may one day threaten the dominance of fossil fuels, and thus are a major innovation playing field. Despite this daring look into the future, we are well aware that one aspect of innovation is that it supplies the unexpected. Who thought the recent innovations in the IT sector were anything but science fiction just a few decades ago?

UBS research focus November 2010

19

Bibliography

Bibliography
Amenc, Nol; Malaise, Philippe and Martellini, Lionel (2004): Revisiting Core-Satellite Investing A Dynamic Model of Relative Risk Management, EDHEC. Das, Sanjiv; Markowitz, Harry; Scheid, Jonathan and Statman, Meir (2010): Portfolio Optimization with Mental Accounts, Journal of Financial and Quantitative Analysis. Evans, George; Honkapohja, Seppo and Romer, Paul (1996): Growth cycles. National Bureau of Economic Research (NBER) Working Paper Series. Freeman, Christopher and Loua, Francisco (2001): As Time Goes By: From the Industrial Revolutions to the Information Revolution, Oxford, Oxford University Press. Heger, Diana (2004): The Link Between Firms Innovation Decision and the Business Cycle: An Empirical Analysis, Zentrum fr Europische Wirtschaftsforschung GmbH. Jennings, William W.; Horan, Stephen M. and Reichenstein, William (2010): Private Wealth Management: A Review, CFA Institute. Korotayev, Andrey V. and Tsirel, Sergey V. (2010): A spectral analysis of world GDP dynamics: Kondratieff Waves, Kuznets Swings, Juglar and Kitchen Cycles in Global Economic Development, and the 20082009 economic crisis. Structure and Dynamics, Volume 4(1). Pompian, Michael M. (2006): Behavioral Finance and Wealth Management, John Wiley & Sons. Quisenberry, Clifford (2006): Core/Satellite Strategies for the High-Net-Worth Investor, CFA pubs. Roger, Everett M. (1995): Diffusion of innovations. Fourth edition. Schumpeter, Joseph A. (1939): Business cycles: A theoretical, historical and statistical analysis of the Capitalist process. Smihula, Daniel (2009): The waves of the technological innovations of the modern age and the present crisis as the end of the wave of the informational technological revolution, Studia Politica Slovaca, 1/2009, pages 3247. Twiss, B. (1995): Managing technological innovation. London. Utterback, James M. and Abernathy, William J. (1975): A dynamic model of process and product innovation. Omega, The Int. Jl of Mgmt Sci., Vol. 3 (No. 6), pages 639656. Welch, Scott (2008): The Hitchhikers Guide to Core/Satellite Investing, The Journal of Wealth Management.

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Pricing the new: how investors should value innovation

Selection of research publications


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Pricing the new: how investors should value innovation

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