Innovation is Outperforming in this Bear Market: Will it Also Lead the Way Out? | Lord Abbett
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Institutional Perspectives

Investors might want to look to the most innovative U.S. companies as a core holding.

 

In Brief:

  • The bear market is here, with the pandemic causing significant damage to economic activity. Equity investors looking to identify where to invest may want to focus on both innovation and durability in their portfolios.
  • Innovation, in particular, has performed best on a relative basis during the selloff thanks to the secular growth nature of its industries and businesses. Economically sensitive cyclical stocks, on the other hand, have borne the brunt of the downturn.
  • Looking ahead, we believe innovation should be viewed no longer as a “satellite” asset class, but as the new core equity allocation for long-term investors. In this paper, we highlight three areas of focus for the next decade.

 

The pandemic-driven crash in the U.S. equity markets that began February 20 is the steepest bear market in stock market history. To many observers the selling seemed overdone at the outset. But based on economic damage to date and what is forecast in the coming months, the market’s moves appear to be painfully justified. U.S. gross domestic product for the second quarter of 2020 is likely to be a figure our minds could not have comprehended a few weeks ago. In the end the 11-year expansion did not end from old age or excesses, but rather it got sick.

We believe the economic fallout will get worse before it gets better. But like all recessions and bear markets, the equity market will bottom and begin to recover long before the U.S. economy does the same. In that spirit, we are continuously assessing the relative health of equities across industries, sectors, and styles as some investors look to rebalance into them for the next decade.

Our perspective coming into this bear market is that there are two areas that may be most compelling for investors: Innovation and Durability.

  • Innovation as a theme has been flourishing for nearly a decade, though some distrusted it after the fallout from the all-hope and no-earnings dot-com crash. But many of those most innovative industries have rapidly progressed from their infancy to their prime in the past 20 years, and now make up the core of the global economy. We also believe there is an innovation premium in the U.S. equity market, explaining why many stocks in high-growth industries are consistently cheap, even with above-average current valuations.
  • Durability, on the other hand, involves identifying strong, more established companies that we believe demonstrate compelling long-term fundamental strength and mispriced future earnings prospects, while avoiding stocks that had become part of the “bond proxy bubble” that formed over the past decade. That bubble arose out of the 2008-2009 financial crisis, when many higher-yielding stocks became overpriced because they were prized for their low volatility and high yields.

Given today’s market, we reinforce these recommendations for allocating to Innovation and Durability. In our view, both are key long-term, strategic equity themes that should outperform the broader market for client portfolios over the next decade.

Innovation stocks, in particular, may have finally shaken off the stain of the late 1990’s mania and the subsequent 80% NASDAQ crash in 2000-2002, as evidenced by their meaningful outperformance during this pandemic-induced market crash. In Figures 1 and 2, we highlight two compelling ways to look at innovation and stock performance over the past 10 and 15 years:

 

Figure 1: “Most Innovative” Companies with Highest R&D Have Outperformed Over Last Decade

Source: FactSet. Most/least innovative stock excess performance is derived from highest and lowest S&P 1500 quintiles based on R&D as % of sales, normalized for market value, using one month returns for 10 years ended November 30, 2019. Baruch Lev and Suresh Radhakrishnan, “The Stock Market Valuation of R&D Leaders.” The performance data quoted represents past performance, which is not an indication or a guarantee of future results.

 

In Figure 1, we show that companies we classify as “most innovative,” as defined by the top quintile of companies with the largest investment in research and development (R&D) as a percentage of revenues, have delivered massive upside relative to the overall equity market. Those in the bottom quintile have lagged significantly. Note that these high R&D companies include many that are not yet profitable, and may be viewed as expensive by traditional valuation metrics. Yet strong revenue growth has been a far greater predictor of investment performance than more traditional metrics such as price-to-earnings ratios, as seen in Figure 2.

 

Figure 2: Historically, U.S. Growth Companies with the Highest Revenue Have Been Worth Their Premium
Three-year rolling averages (December 31, 2004–December 31, 2018)

Source: FactSet and Lord Abbett Research. Based on annual reported earnings. Most recent data available.
The average top 10% of high-revenue-growth stocks were chosen by screening all companies with a market capitalization greater than $10 billion at the end of each three-year time period and then stacking the companies according to their revenue growth over that three-year time period. The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Due to market volatility, the market may not perform in a similar manner in the future. Past performance is not a reliable indicator or guarantee of future results.

 

Innovation: The “New Core” Asset Class for Equity Investors?
Innovation-oriented stocks have arguably shown the most resilience during this severe bear market, as measured by the relative performance of secular growth industries such as software, internet retail, and biotechnology. By contrast, cyclical industries including leisure, construction, airlines, and automobiles have suffered most severely due to their high economic sensitivity and their potential devastation tied to the pandemic.1 We believe that this relative resilience represents the rapid ascent of innovative industries in the global economy, not only through organic growth, but also through Darwinian destruction of older, less efficient businesses and technologies. In the three areas highlighted in Figure 3, we discuss the disruptive nature of these dominant innovation themes:

 

Figure 3: Megatrends in Innovation: Three themes bringing efficiencies and disruptions.

Source: Lord Abbett. For illustrative purposes only.

 

The Technological Revolution
Technology itself is where the modern innovation “industrial revolution” took root. Starting with the microchip and the personal computer, then the internet, the cloud, and now artificial intelligence, raw computing power and its exponential growth in processing speed has powered the surge in disruptive technologies. Cloud computing is a perfect example of an industry creating new efficiencies and productivity for corporations and individuals. At the same time, cloud computing is crippling outdated server technologies, applications development, and operating platforms along with corporate information technology (IT) infrastructure.

In the figures below, we illustrate the tremendous anticipated growth in both cloud computing and artificial intelligence, and how growth so far is far outpacing estimates. IDC, which forecast in 2016 that cloud spending would grow to $138 billion last year, recently updated that figure to the actual total of $228 billion.

 

Figure 4: Spending Growth in Global Cloud Computing and Global Artificial Intelligence Projected to Soar

Source: Cloud software spending: IDC, 2016; data past 2016 represents projections. Worldwide Spending on Artificial Intelligence: BofA Merrill Lynch Research Estimates, 2017; data past 2017 represents projections. For illustrative purposes only.

 

By our observation, these industries are driving growth at rates far higher than the broader economy. We believe their displacement characteristics, which makes them appealing as technologies that can replace costlier and less efficient businesses, have helped them outperform in a bear market.

Lastly, we would note that crisis is often the mother of innovation. As many office workers pivot to work from home and students adapt to online learning, technologies that facilitate this “virtual empowerment” are new opportunities for tech investors. After the crisis abates, businesses, schools, and individuals may continue using these technologies to make their lives easier and more productive.

Health Care and the Genomics Revolution
Perhaps the most dynamic area in this age of innovation is in health care, where the pace of drug discovery and life-changing therapies is progressing at a rate never seen before, thanks to the genomics revolution. Sparked by the initial de-coding of the human genome in 2000 and completion of the project in 2003, the dawn of a new biotech industry took form late in the last decade. Gene therapy and gene editing became realities, unleashing treatments that can directly target mutated genes in patients to cure or mitigate a growing number of debilitating afflictions. Immunotherapies can provide more targeted therapies for diseases, particularly cancers, by stimulating the body’s natural defenses and immune system to target and destroy cancer cells.

Alongside biotech, we have seen life-changing breakthroughs in medical devices and diagnostics that bring relief to physical and mental pain, ease afflictions such as diabetes, and provide early detection of cancers.

Many investors may view this space as too early or speculative. We disagree. While there will always be companies lacking great science, or which should never have gone public, there are many others that have shown remarkable breakthroughs and asymmetrical upside in their clinical trials.

In Figure 5, we show that even small cap biotech stocks are demonstrating real financial success. The green bars illustrate the average stock’s revenue growth in the Russell 2000 Index of small caps stocks, while the gold bars represent the average revenue growth of biotech stocks in that same index. On a three-year rolling basis, biotech stock revenue growth has seen on average more than 50% revenue growth per year. This is a space that has been demonstrating not just high hopes, but real monetization from an investment standpoint.

 

Figure 5: Not Just Hope? Small and Mid-cap Biotechnology Stocks Have Posted Enormous Revenue Growth
Three-year revenue growth of biotech stocks versus that of the Russell 2000 Index (as of January 31, 2020)

Source: Factset, Lord Abbett. As of January 31, 2020. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

Empowerment of the Consumer and Brands
Finally, we’re seeing an acceleration of the consumer transformation during this crisis.

E-commerce continues to increase market share over physical brick-and-mortar stores, but not just in the light consumables and durables. Internet-based businesses are expanding into markets we assumed would never be part of e-commerce. Consumers are now buying property and houses online, as well as ordering furniture, cars, food delivery, and more. These trends could be accelerated by the current social distancing and might also continue post-crisis. As Figure 6 shows, with only 12% of retail business conducted online, the industry is still young.

 

Figure 6: E-commerce is Still Young, and Expanding Rapidly 

Source: U.S. Census Bureau and Bloomberg. Most recent data available. 1Q18 data are revised estimates. 2Q19 data are preliminary. Estimates are based on data from the Monthly Retail Trade Survey and administrative records. Estimates are adjusted for seasonal variation, but not for price changes. Total sales estimates are also adjusted for trading-day differences and moving holidays. E-commerce sales are sales of goods and services where an order is placed by the buyer or price and terms of sale are negotiated over an Internet, extranet, Electronic Data Interchange (EDI) network, electronic mail, or other online system. Payment may or may not be made online. For illustrative purposes only.

 

The Decade Ahead
In thinking about the next decade rather than the next month, we believe there is an abundance of evidence showing that secular growth themes within innovation are both powerful and resilient, even during crises such as the current pandemic. We believe we will emerge from this and see the overall equity market recover. Still, our view is that long-term investors must re-frame their view of innovation. It is no longer an asset class merely for those who can stomach significant risk, but rather, in our opinion, should be a central component of equity allocation, thanks to the disruptive nature of these industries and the powerful tailwinds of the tech revolution.

To put it into even starker terms: We believe the U.S. economy is evolving into a binary story of two types of companies: Innovators, or companies vulnerable to the disruptive effects of innovation.

 

1 Source: FactSet, Lord Abbett research, industry data performance between the peak of the equity market and the time of writing this paper, 2/20/2020 – 3/21/2020.

 

A Note about Risk: The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future. All investments involve risks, including the loss of principal invested.

This commentary may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

Glossary of Terms

The S&P 1500®, or S&P Composite 1500 Index, is a stock market index of US stocks made by Standard & Poor's. It includes all stocks in the S&P 500, S&P 400, and S&P 600. This index covers approximately 90% of the market capitalization of U.S. stocks.

The Russell 2000® Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index.

The information provided herein is not directed at any investor or category of investors and is provided solely as general information about our products and services and to otherwise provide general investment education. No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action as Lord, Abbett & Co LLC (and its affiliates, “Lord Abbett”) is not undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity with respect to the materials presented herein. If you are an individual retirement investor, contact your financial advisor or other non-Lord Abbett fiduciary about whether any given investment idea, strategy, product, or service described herein may be appropriate for your circumstances.

The opinions in this commentary are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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