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26 January, 2022updated 27 Jan 2022 14:31

Do innovative companies outperform?

Disruption accelerates innovation, but investors underappreciate its importance.

By Adarsh Jain

No matter where we look, we find evidence of disruption-led innovation trends accelerating over the last decade. Consider the following:

  • Patent applications have accelerated at a rapid pace over the past decade, at 10% compounded growth per annum – 1.5-times higher compared with the past.
  • Company filing documents highlight ‘innovation’ as an important strategic focus area for corporates, with 14% compounded annual growth in ‘innovation’ as a focus area over the past five years.
  • Companies are also walking-the-talk on innovation, as measured by patent filings. On average, during any given month, more than 50% of S&P 500 companies have a patent granted against their name.

Amid the wildly disruptive business landscape, companies are innovating for a more durable source of competitive advantage. As per industry reports, 84% of S&P 500 market capitalisation is composed of intangible assets with intellectual property forming a major chunk.

And yet, there is no meaningful or reliable reporting mechanism under GAAP (Generally Accepted Accounting Principles) to capture the significant chunk of companies’ value tied in intangibles.

Innovation insights enables profitable investing opportunities

The natural question to then ask is: “Are traditional methods of analysing companies using financial statements alone, enough?” We think ignoring the innovation potential of companies fails to ascertain their true value, which means lots of missed investing opportunities.

GlobalData, a leading data and analytics company, uses a patents dataset to uncover the innovative potential of companies to build a portfolio of the most innovative companies, which handily beats the benchmark.

Additionally, such analysis is helpful in debunking common misconceptions that only technology companies are major innovators. GlobalData’s patent analysis reveals companies from other sectors are also highly innovative; consumer staples and industrials, for example.

Tangible benefits of using innovation to build investment portfolios

First, GlobalData’s Innovation Indices generates 38% Annualised Alpha over the S&P 500 over the past six years, with superior Sharpe and Information ratios.

We compute three innovation indexes using patents data:

  1. GD Innovation Momentum Indicator: Volume-based metric measuring the number of patents issued to a company. Captures the momentum/intensity in innovation. The higher the momentum, the higher the innovative potential.
  2. GD Innovation Quality: Global Innovators: Measures how many countries or patenting authorities around the world the patent is registered in. Captures how global or local a company’s innovation is. The broader the geographic coverage, the more lucrative the monetisation potential.
  3. GD Innovation Quality: Diversified Innovators: Measures how broadly the innovation is applicable, i.e. application in diverse areas (broad) or niche/specific areas (narrow). The more broadly applicable, the wider the opportunity set for monetising the innovation.

We measure outperformance in two ways for each indicator.

First, ALL portfolio, as can also been seen in the chart below, is the portfolio of all innovative companies for each indicator, while Top portfolio in the chart below refers to the top half of the ALL portfolio (top 50% of most innovative companies).

Second, GD innovation indices also beats specialist third-party US-based Innovation Indexes such as 1) NYSE R&D Innovation Index and 2) M-CAM Innovation α® US Index.

[Note: ALL in chart above refers to GlobalData’s portfolio of all innovative companies, and Top in chart above refers to Top half of innovative companies from the ALL portfolio].

Compared with M-CAM Innovation α® US Index, GlobalData’s innovation indexes ‘Top’ portfolios (Top half of innovative companies) out-perform by 4–13%, and compared with NYSE R&D Innovation Index, GlobalData’s innovation indexes ‘Top’ portfolios out-perform by 1–2.5%.

Third, the outperformance seen above has a fundamental driver. GlobalData’s innovation indexes provide access to companies that generate structurally higher future earnings predicated on innovation potential, ie. they are fundamentally well set-up to beat the benchmark.

Innovative companies have 2.2-times higher future earning potential as innovation not only differentiates, but provides a competitive edge to companies’ products and services, driving higher their future earnings potential, whereas companies that don’t innovate witness sluggish future earnings growth.

Fourth, innovative companies achieve sustainable and consistent out-performance over longer time periods. Investing in any one, three or five-year period in the last six years in GD innovation indexes resulted in out-performance more than 95% of the time.

In the 77 months from 2015–21, there are 65 12-month periods, and GD Top Innovators Index in the table above outperforms in 62 of the 65 12-month periods, i.e. 95% of the time.

In essence, out-performance from GD Innovation Index is not dependent on when you start to invest. They out-perform almost all the time regardless of the starting time chosen to invest.

This consistency in performance across time periods means they are fundamentally sound and immune to gyrations in the markets.

Finally, thematic tagging of GlobalData’s patents data allows thematic investors to bet on the most innovative companies in particular themes like artificial intelligence (AI), electric vehicles, etc. For example, the GlobalData AI Innovation Index, a selection of companies from the S&P 500 at the forefront of innovation in AI, generates 8.5% annualised alpha over the S&P 500. Such indices are available for 50-plus technology themes.

GlobalData enables Thematic Innovation Indexes for 50-plus technology themes to cater to varied investor interests.

In summary, GlobalData’s industry leading patents dataset should be of value to investors in analysing companies’ intellectual capital and innovation to assess their potential in not just navigating the complex maze of technology-led disruptions but to profit from it.

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