Why innovation matters to investors

5 November, 2014 / Articles

Innovation has been accelerating since the invention of the steam engine, and the pace is increasing. Consider the telephone: it took 56 years for Alexander Graham Bell’s invention to reach half of US households; by comparison, smartphones took seven years to hit the same adoption rate.

Innovation could be defined as the application of invention (think about the 12-year gap between the accidental discovery of penicillin and the first patient treatment with penicillium). Today’s low-growth disinflationary period mirrors the great deflation of 1873-96, a period of high innovation as entrepreneurs sought to lower costs and widen markets.

Why should investors care about innovation? Technological change is at the intersection of employment, nominal economic growth and inflation risk – the focus areas of global policy makers. Innovation is disinflationary (suppressing wages and prices) but can hurt employment (producing more with fewer people). This helps explain why central banks are prepared to risk falling behind the curve because they see little inflation risk and focus on increasing employment.

Tech optimists argue we are on the cusp of a productivity renaissance. Pessimists counter that the productivity boon from the internet era is waning. We are optimists. The next leg of innovation has far to go: exponential increases in computer power, machine learning and the ability to analyse vast reservoirs of data back this view. Many companies, industries and investors have yet to tap these data riches.

The rapid diffusion of technologies is one reason why it is harder for companies to maintain competitive advantages: just 63 per cent of S&P 500 companies a decade ago are still in the index today, according to Thomson Reuters. It becomes more important to invest in companies that can weather the disruptive effects of innovation and harvest its benefits. It also means that predicting whether a company will be around in a decade is going to become tougher.

On a macro level, innovation can erode an important competitive advantage of emerging markets: cheap labour. Businesses faced with rising wages can automate or move to cheaper locations. Even developed economies can benefit: selected US companies are “reshoring” some production, lured by cheap energy and proximity to end markets. At the same time, Chinese factory wages have risen fourfold since 2002 and are forecast to continue on that trajectory. Yet the substitute for Chinese labour today is not just workers in Vietnam or Bangladesh; it is robots. China is already the second largest importer of robots and will shortly take pole position.

Source