Innovation is back in vogue

It may seem that innovation was written off by the recession but many companies are finding original ways to extend and promote their products

After dropping down the priority list for many companies during the recession, the push to innovate is now back on the agenda for many UK and US firms. However fund managers say that challenges when it comes to financing research and development may still stand in their way.

For many sectors, the post-credit crunch period proved difficult when it came to innovation. In Britain, the UK Innovation Survey 2011 noted that unfavourable economic conditions from 2008 onwards likely had an impact on the number of businesses starting innovation activities, with only 31 per cent of enterprises classed as being “innovation active” during the 2008 to 2010 period.

Stuart Watson, UK leader for Ernst & Young’s Entrepreneur of the Year program, says between 2008 to 2010 the number of people – whether they be entrepreneurs or large corporations – who were prepared to take a risk on the grounds the market would buy the product or service they were innovating had shrunk significantly.

“There were more sectors that were feeling in the doldrums and the innovation had to achieve a far higher hurdle rate before people would actually have the confidence to go and do it,” he says.

Recently, however, there are signs the tides may be turning as far as corporate commitment to innovation. According to a May 2013 report by global management consultancy Accenture which surveyed 519 UK, US and French companies with revenues greater than $100m, 70 per cent ranked innovation among their top five priorities. Meanwhile some 60 per cent of organisations now have a chief innovation officer – up 6 per cent since 2009.

“There are sectors where the confidence is back and is high and they are having success in the marketplace with the innovations that have come through, and that encourages them to go back and innovate again and put in new product,” explains Watson.

While this may be true in certain sectors, Julian Fosh, co-manager of the Liontrust UK Growth fund, says amongst the companies he looks at, namely those with intangible asset strength, R&research and development activity is not particularly rising because it has never really fallen.

“The companies that we are invested in do not cut R&D spend or innovation when times get tough because they have learned that in the long-run that has not worked,” he says. In essence, he explains, they have to keep spending levels up through downturns, to develop the next generation of products.

In the US, which is estimated will account for more than 28 per cent of global research and development spending this year, R&D spending as a percentage of GDP in 2013 is expected to stay similar to 2012 at just over 2.6% says nonprofit research and development organization Battelle. Industry funding for R&D, which accounts for 62 per cent of total US R&D investment, is projected to increase by 2.3 per cent this year.

Battelle estimates that UK R&D as a percentage of GDP will also remain similar to 2012 this year at 1.84 per cent, up slightly from 2011. The UK Office for National Statistics notes that total business R&D expenditure increased by 8 per cent to £17.4bn in 2011, compared with 2010, with the largest increases in computer programming and information service activities, motor vehicles and parts, and the pharmaceuticals industry.

In the technology and pharmaceuticals industries, where innovation and R&D spending have traditionally been high, managers say activity is on the rise, but perhaps differently than in the past.

John Bowler, manager of the Schroder Global Healthcare fund, says: “This may sound obvious but 10 years ago the strategy was having ‘lots of shots at goal’ – this led to a lot of drugs being pushed into development where the science was not fully developed.

“Large cap companies have improved from a low base – a) because they had to, b) there is better depth of understanding in the science that leads to better informed decisions. There are more small/mid-size companies with innovative drugs in development – during the last biotech bubble in 2000 there were few companies with actual new medicines in development but rather hope value in companies that were either involved in gene sequencing or producers of research tools to exploit the first sequencing of the human genome,” he explains.

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Bowler notes that real innovation is now coming through in the healthcare sector, with more novel drugs getting approved now than in 2008 and 2009 and pipelines looking a lot more interesting.

“Drug choice has become much better informed than before and we are seeing that translate into positive data. My guess is there isa lot more success to come,” he adds.

Underlining its commitment to innovation, AstraZeneca, also recently announced its intention to invest around £330m to establish a new global R&D centre and corporate headquarters in Cambridge by 2016.

On the tech side, while the giants undoubtedly continue their work towards the next big concept, Watson explains the broad innovation trend is not a pure tech play anymore, but rather exploiting what the tech companies have already invented and understanding how to cross it over into another market.

For example, Tom Ewing, manager of the Fidelity UK Growth fund, points to the online retail sector, specifically in the UK, as one area where innovation is rampant.

“I think the pace of change in online retail is very rapid. And I that is an area I’m pretty excited about,” he says. Specifically, he names clothing retailer Asos and grocery site Ocado as examples of UK consumer-facing companies that are successfully innovating online.

Indeed, while managers point to the outsourcing, engineering and chemicals sectors as other strong players when it comes to R&D, it is the consumer-focused sectors in general that are particularly innovation-active at the moment.

James Thomson, manager of the Rathbone Global Opportunities fund, names several successful innovators in the American and British consumer-facing sectors, namely, the US used car retailer CarMax, which he says has changed the way people approach buying used cars through its “no haggle guarantee”.

He also mentions the UK’s Rightmove – which has simplified the property search for consumers by aggregating all property information from estate agents in one place – as a company which has shown exciting innovation but may not seem to on the surface.

Keith Bowman, an equities analyst at Hargreaves Lansdown, notes that companies in the household goods sector have been looking towards innovation as a major theme in recent years.

“Reckitt Benckiser is a company that stands out in particular and they are a company that has been pursuing innovation particularly for packaging and in many different ways with various products, and it does seem to have had some success and with that in mind,” he says.

E&Y’s Watson explains how the innovation priorities of consumer-focused companies have changed over the last few years. He points to the example of a food manufacturer within the entrepreneur of the year contest which, he says, a couple of years ago, was only looking at innovation that would save them money.

“The absolute driver, in a consumer-facing market like that, was ‘can we save a few quid out somehow of this whole supply chain, from one end of the process to the other’,” he says.

Now, he explains, the company’s innovation is aimed at rejuvenating old brands and innovating within the premium, high-profit sector.

But Thomson does not attribute the increased spending on R&D from consumer-focused sectors to an improving economy. Rather, he says, innovation in this sector is happening because of fear.

“I think it is outright fear that a lot of these consumer-facing companies are going to be marginalised or obsolete if they do not spend money in research, development and innovation. And the fear largely comes from Amazon. Amazon is the retail killer,” he says.

“They are racing to try and stay ahead of the innovation curve in order to fend off Amazon and other retailers who are spending more in that area,” he adds.

While the intent is there amongst many US and UK companies to ramp up their innovation spend – the Accenture survey notes that nearly all respondents “continue to regard their company’s long-term success to be dependent on its ability to innovate” – only 18 per cent believe their own innovation strategy is delivering a competitive advantage.

The survey found that between 2009 to 2012, the number of companies that saw their primary goal as “disrupting current markets or introducing entirely new product categories” dropped by one-third.

For some companies, disrupting a current market incumbent through innovation is a needed strategy for success. “The necessity comes from the low sales growth,” explains Alex Hunter, a global equity analyst at Sarasin & Partners. This means, he adds, that if you want to grow, you are going to have to disrupt an incumbent.

Indeed, the team on the Sarasin Global Thematic fund formally changed one of its themes to disruption and innovation in April of this year, which Hunter says is proving to be a useful tool – especially with slowing top lines – to help find interesting stocks and avoid those that could spell trouble.

For Sarasin, examples of disruptive and innovative companies include emerging technologies, current disrupters, companies where the disruption has occurred and is getting mature and sectors people have given up on where there is a resurgence of disruption and innovation happening.

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As opposed to the incremental innovation done by incumbent companies to stay relevant, Hunter says when it comes to disruption, his team generally tries to look for ideas that are revolutionary.

Two obstacles to driving higher returns from innovation, says the Accenture survey, include a “conservative approach” that focuses on line extensions rather than a broader portfolio of bold ideas and an overreliance on the invention process, combined with a lack of ability to bring these ideas to scale, supported by a robust business model.

However, Thomson notes that changing habits or unseating an incumbent technology are a lot more difficult to do than an investor might think.Game-changing innovation, where companies come up with a brand new product or service, may be enticing, but can also be dangerous as an investment, he says.

“It is very often difficult for these game changing innovations to succeed, even though it may be very clear to the investor that they should. But I think the risk is that the investor gets mesmerised by the potential for huge success that could come from this game-changing innovation and if it does not prove to be the case, they will refuse to believe that they are wrong,” he explains.

“For every Apple, there are probably nine other ones that people perhaps thought would replicate that kind of success, that did not. And I just do not want to get involved in those sort of odds,” he adds.

Fosh agrees, saying that he instead looks for companies where innovation or intellectual property is in the DNA of the company itself.

“Often game-changing stuff is very high risk, it either will disrupt and win or else it won’t and the company’s out of business,” he says.

Thomson looks for gentle innovation – subtle improvements or potentially more profitable and predictable business models that may lead to a more sustainable growth profile. Most of this gentle R&D activity, he says, is happening in the mid-cap area, namely companies between $1bn and $5bn in market capitalisation, which he calls the ‘sweet spot’ for innovation.

Possibly resulting from the view that the chance of success from game-changing innovation is low, Thomson is seeing ‘innovation discipline’ setting in from some companies.

“They just want to subtly improve on their business model or product or service that they are providing. So I think the willingness to throw money at every idea is not there anymore, but that is a good thing,” he says.

“I do not want these companies trying to be all things to all men and sort of scatter gun approach, try a bit of everything, see what works. I really want them targeted on what are the most, the greatest chances of success and the best return on investment for that innovation,” he adds.

Thomson points to an example of gentle innovation happening on the retail side of Associated British Foods, namely the Primark brand, given its mantra of high volume and cheap prices.

“I think that sort of innovation in the retail, clothing retail space, has proven a big winner but it did not require NASA trained scientists to come up with it. Its sort of common-sense innovation I think, which is often the most successful in business and you get a much higher success rate, hit rate, as an investor,” he says.

Broadly, however, although confidence amongst some companies and sectors may be on the rise, an aversion to risk in the broader market may still have the ability to hamper an increase in innovation activity.

In a recent report on the relationship between finance and innovation in the UK, the Big Innovation Centre notes that leading up to the financial crisis, investment in innovation was falling in the UK as a proportion of total capital. This ‘disconnect’, says the report, has persisted beyond the recession.

Innovative small firms in particular, says the Big Innovation Centre, are “finding it significantly more difficult than their peers to secure the funding they need to grow”. The report noted that one in three that sought finance between 2010 and 2012 did not obtain any of the funding they needed – nearly triple the rate seen in 2007 and 2008.

Behind the titans in the tech industry, says Ewing, there are small companies coming up with the incremental advances which are important for the innovation to move forward.

In the UK, he says, one particularly worrying trend is the prevalence of venture capital funds who find innovative, young British technology and biotechnology companies and look to list them on the Nasdaq. The view, he says, is that the companies will receive a better reception and valuation in the US than they will in the UK.

“It can be a struggle sometimes because they know that maybe they will be more appreciated, have more access to funding if they go to the US,” says Ewing.

Although US Federal Reserve chairman Ben Bernanke recently told a group of US college graduates that “the incentives to innovate are greater today than at any other time in history,” managers say that for some companies, that incentive is still not back to the levels needed for substantial innovation to come through.

Indeed, Ewing says that while the government and regulators are keen to promote innovation through initiatives such as the Patent Box legislation, for example, investors’ lack of risk appetite is still hampering financing for innovation amongst UK companies in particular.

“Those companies find it difficult to get funding, their share price does not do so well and I guess there is a sort of negative feedback loop in that people are, companies are not incentivised to go out there and innovate and spend money on a new facility or spend money on a new lab or on scientists, because they are not getting appreciated for it,” says Ewing.

In a recent development that might help change that perspective, Fosh explains the US is making changes to its data measurement next month to recognise R&D spending as fixed investment, which will lift its GDP by about 3 per cent.

This change in approach, he says, could help recognition of innovation and appreciation of assets and is set to be followed by a similar change to the calculation of the formation of assets in the European System of Accounts in 2014.

“Intangible assets are of real economic worth to companies but they are not easy to see for investors, but they do nonetheless add value,” he explains.

Another problem for companies focused heavily on R&D, says Ewing, is that investors are favouring companies which are paying out a dividend and away from those which are not holding out the prospect of cash return anytime soon, because they are innovating.

“Companies can either be generating cash, which they are then paying out in dividends to shareholders or they’re generating cash which they’re re-investing in interesting things,” he adds.

For many large companies, however, Thomson does not think there is a direct link between higher dividends and less money being spent trying to innovate.

“I think most companies are pretty sensible, they want to be balanced between keeping their owners, which are the shareholders, happy, not wasting excess capital and paying it back to shareholders, but also not starving their business either,” he says. Investors, he says, know it is a potentially dangerous sign if a company has turned off the taps for R&D and innovation.

“I do not see it as an either/or. I think a lot of companies can pay a modest dividend, as long as they continue their research and development as well,” he says.

Fosh also explains that a great dividend growth record and a record of spending money on R&D are not mutually exclusive.

“Our belief is that in companies that do invest in innovation and R&D, it is an investment and is money well spent. This is because it produces new products and world-leading products that then go on to sell very well and give them the scope to generate free cash flow which they can use to pay above average dividends.”

Ultimately, while there may be several reasons why innovative companies may not be getting the audience they should, says Ewing, one potential deterrent is the fact that genuine innovation does take time and is inherently risky. However while an innovator may be volatile in the interim, he says there is always the prospect of making a good return on genuinely strong innovation if an investor has continued confidence in a company’s competitive advantage and the end market.

“If you are out there and turning over stones and trying to meet new technology companies, every so often, one stands out and you think ‘wow, that could actually work, that could change the world on a long-term view’. But you have to be willing to take a risk and you have got to be willing to take a long-term view,” says Ewing.