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Innovation as an Investment Theme

(Guest Commentary by Rick Konrad – February 10, 2011)

Dear Subscribers and Readers,

For those who want to learn more about picking stocks, evaluating companies, industry trends, and other issues related to the stock market, we have brought in Mr. Rick Konrad to pen a guest commentary.  Rick has been a regular guest commentator for several years and offers his unique insights to us twice a month.  We highly appreciate your investment insights and general wisdom, Rick!

In this commentary, Rick follows up discusses the importance of innovation to U.S. economic growth—why it is especially important today and how understanding technological trends can lead to long-term investment outperformance.  Rick also discusses the role of the U.S. government in encouraging innovation.  Without further ado, following is Rick's biography:

Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator on MarketThoughts.com (please see “Food Fight” for his last commentary).  Prior to his founding Value Architects, Rick was a professional portfolio manager for institutional investors for over 25 years.  A more complete profile of Rick is available on his blog.  You can also email Rick at the following address if you have any questions or thoughts after reading his commentary.  Rick is a very genuine teacher of the financial markets and treats it very seriously.  Rick has also run the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had graded CFA examinations.

Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice.  Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.


“The policy of being too cautious is the greatest risk of all” -Nehru

One of the oldest adages in the investment business is that you never fight the Fed. Since the Fed controls the printing press, it can provide as much liquidity as necessary to support economic growth. The Fed can overcome reluctant lending practice by burying banks in cash with its impending quantitative easing policy.

Similarly, important planks in government policy are not to be ignored either. Ignoring these policies can prove to be just as foolhardy.  Years ago when encouragement of more widespread home ownership became a central plank of government policy, I looked for beneficiaries of this policy. It became very clear that mortgages needed to become fungible in order to create mortgage backed securities. This led to looking at title insurance companies which evolved from small local and regional firms to national firms. It led to developers of financial service software and databases that maintained title plant and valuation data. As banks became more aggressive, it became clear that consolidation was going to play a role here as well. A single plank of government policy provided an investment theme that, at least until its ultimate undoing as risks became rampant and leverage became ridiculous, provided a lighthouse beacon for a lot of investment strategy for more than a decade.

Another example was mentioned by Obama in the State of the Union address, the Russian Sputnik satellite. As a young boy, I can recall hearing its beep on a shortwave radio. The USSR's launch of the first satellite prompted President Eisenhower to create ARPA which evolved into DARPA, the Defense Advanced Research Projects Agency, an agency of the government to maintain a technological lead for the military.

DARPA's original mission, established in 1958, was to prevent technological surprise like the launch of Sputnik, which signaled that the Soviets had beaten the U.S. into space. The mission statement has evolved over time. Today, DARPA's mission is still to prevent technological surprise to the US, but also to create technological surprise for its enemies. A few years later, NASA was created and investing in technology became a central theme for the better part of a decade.

The clearest statement of a new policy plank for this government has become innovation. As President Obama has indicated, “We have to realize that in today's global, competitive economy, the best jobs and newest industries will take root in the countries with the most skilled workers, the strongest commitment to research and technology, and the fastest ways to move people, goods, and information. To win the future, America needs to out-educate, out-innovate, and out-build the rest of the world.”

Needless to say, the United States is hardly alone in this pursuit. The encouragement of innovation has become an important policy consideration for governments around the world. As global economies have become more integrated and trade flows have increased, the scope and scale of economic competition has increased. Innovation has become a more central driver of growth and competitiveness. In the last ten years, a large number of countries have come to the realization that spurring innovation must be a central component of economic development. For example, in 2009, the United Kingdom made a conscientious decision to “place innovation at the center of the country's economic growth strategy.”

All told, there are probably more than thirty countries that have implemented innovation strategies to link science, technology, and innovation with economic growth. These countries proactively anticipate and articulate the intersections among policies in science and technology, R&D, education, workforce training, immigration, tax, trade, intellectual property, and digital infrastructure in creating economic and social welfare.

The US is a late arrival to the innovation party, at least as far as governmental policy. Unfortunately, the United States, practically alone among the world's leading economies, conspicuously has lacked a national innovation strategy and a mindset to advance one. Once generally recognized as the world's innovation leader, the United States has begun to slip noticeably in recent years. In February 2009, the Information Technology and Innovation Foundation's (ITIF) Atlantic Century report ranked the United States sixth out of 40 leading industrialized nations in innovation competitiveness. Please see: http://tinyurl.com/5veyzs7

 A March 2009 Boston Consulting Group study ranked the United States eighth out of 110 countries. While those figures superficially are acceptable, it is dangerous to rest on our laurels. ITIF's report examined the rate of change in innovation capacity over the last decade for 40 countries and found the United States ranked dead last in improvements across a range of 16 key metrics in human capital,

Technological change drives long-term economic growth, productivity and improvement in living standards. At the same time, the emergence and diffusion of new ideas, products and production techniques throughout the economy contains the threat of a process of “creative destruction.” New technologies destroy jobs in some industries, especially among the less skilled, while creating jobs which are often in different industries and require higher skill sets.

Despite the creative destruction element of innovation, which may be protested by some, the adoption of innovation is quite critical. Innovation drives long-run economic growth and quality-of-life improvements. The U.S. Department of Commerce has estimated that technological innovation has been responsible for as much as 75 percent of the growth in the American economy since World War II. In fact, up to 90 percent of per capita income growth stems directly from innovation. Innovation achieves this impact by enabling the productivity improvements that lie at the core of economic growth.

Government policy plays an important role in the ways that capital is allocated. According to the Bureau of Economic Analysis, from 1999 to 2009, the real net stock of private fixed assets grew by 26%, the slowest 10-year increase in the post-war period. Housing accounted for the majority, 53%, of the real increase in private fixed assets. By comparison, information technology equipment and software–computers, software, and communications equipment–only accounted for 14% of the increase in productive assets. It is quite clear that government policies encouraging investment in housing played an important role in the boom, the bubble, and ultimately the bust of this sector.

Long term investment themes can lead to many years of investment success if they are correctly embodied in your portfolio. In the early 1980's, you either became a believer in Paul Volcker's strategy to kill inflation and embraced disinflation or you were long a great many dead and dying inflation-hedge stocks. For the most part, that single “beacon” led portfolio strategy for at least 25 years. I believe that innovation in the bio-sciences, information technology, and alternate energy will be central to governments' aim to restore sustainable growth and increase competitiveness. I also believe that this will need to become a central plank in your long term investment thinking. I am not sure that we will get 25 years out of it, but I believe that we will be able to ride this for the next decade.

I look forward to revisiting this theme on a recurring basis for some time. In today's overbought market, we have lots of time to research and think rather than transact. The challenge will be to assess intellectual capital, to examine R&D and to decide what is creating value and what is merely “wasted development expenditure.”  It will be an exciting and challenging time.

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