David Meier

Portfolio Manager

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The Importance of Innovation

11/05/2018

More and more companies are investing in innovation. And that gives us more opportunity to find them for our funds. I recently sat down with my colleague Matt Trogdon to discuss the many shapes that innovation can take and the innovative trends that excite me most.

Matt: I know that innovation is something you think about a lot in your investing process. Why is it so important in today’s business landscape, and what are some of the trends you are seeing?

Dave: First of all, business is always competitive. That is the way our capital markets work. You try to allocate capital to the best returns. And if you’re not good, you’re not getting capital.

So one of the reasons companies innovate is to generate higher returns for their shareholders, and that’s what attracts capital.

The other thing is, there’s always advancements going on. There’s new science coming out. We have to remember, all innovation means is something new. And so you have new science coming out. You have people developing new technologies. The companies are looking to get better by investing in new products, new services, new ways of doing business. Sometimes you create a brand-new business structure. You’re a disruptive innovator. You want to take on the status quo. Really, everyone should be focused on innovation. Change is always happening, and you have to figure out how to respond to that change in order to get better, in order to get your returns on investment up and get your stock price up.

And those are the types of companies we look for, the ones that are creating new things and have big markets to serve so that they can grow for a long period of time.

Matt: You mentioned disruptive innovation. Are there specific companies that have caught your eye recently, or companies that the team here at MFAM focuses on that are especially disruptive currently?

Dave: Great question. I think the best example of that over the past few years, and probably the few years down the road, is Align Technology. For those who don’t know, Align Technology has created retainer-based orthodontics, as opposed to gluing the pegs on and attaching a metal wire, and tightening the wire, which I know I had to deal with when I was a teenager and it was terrible. So they found a way to create, 3D-print, a retainer you pop in your mouth. And you switch it out as your teeth move. As they move, they take another picture of your teeth, adjust the retainer some more. So if you think about it, it’s just orthodontics when you get a package in the mail for your next retainer, for however long the treatment takes. What we have is a disruption to the status quo. Pretty much everybody does it with braces and wires, and Align said, “No, there’s a better way. Let’s try it this way.”

As they have moved along, the other thing they have had to do is think, “If I’m going to sell millions and millions of retainers to millions and millions of people, and they’re spread all throughout the world, first of all, how am I going to do it efficiently, manufacturally? How do I make sure the science of what they need is correct so I don’t mess up somebody’s oral healthcare by giving them something bad? And the logistics. If Matt is a subscriber to this, how do I make sure Matt gets the right retainer and keep track of it all?”

Not only is it, yes, I have been able to change the way that we’re competing in orthodontics, but there is a massive manufacturing and business operations problem that they’ve had to innovate over the last four or five years to get to scale. They’re making incredible margins off this, so that work is extremely valuable.

What does that do for them going forward? It creates an enormous competitive advantage for them. Because who is going to want to enter the market now? Sure, it’s really not that hard today to make a plastic retainer using 3D technology. Quite honestly, we could probably make something like that with the 3D printers we have upstairs. What you can’t do, though, is it’s very difficult to replicate the customer experience they have: manufacturing them well, getting it there on time, quickly, at a good price. And doing that efficiently across millions and millions and millions of these devices.

So that’s a perfect example of disruptive innovation: “Hey, I’m going to come at the market with a new perspective.” But also, what I like to call incremental innovation: “How do I keep getting a little bit better?” The operations manufacturing. The logistics. They continue to innovate along those lines in order to go after the rest of the market that is still available to them.

Matt: When I think of innovation, I don’t think about companies that provide retainers. I tend to think about more traditional technology, and software types of things. So I’m surprised to hear that story. What are some other surprising innovation stories that people may raise their eyebrows at?

Dave: You’re exactly right. Most of the time we think of high-tech, or venture funding, things more like Silicon Valley. Another innovator is GrubHub. Essentially, GrubHub has developed a platform for any restaurant to join to get food delivery. So they have enabled customers to come to their platform. Make an order. It gets routed to the restaurant. And then they have a network of delivery people that execute the deal.

We may think of that, “How hard can that be?” But actually, it’s very hard. You have to get everything straight. “How do I make sure the customer is up to date with what is actually available on the menu? How do I make sure the payment is taken care of comfortably? How do I route the order to the right carrier to make sure it gets delivered in a respectable time?” Obviously, that’s a huge part of the customer experience. No one wants to order food and have it be 45 minutes late and cold. That doesn’t create a good experience.

They’re doing this across a vast number of restaurants in cities all over the United States. They said, “Yes, there’s an opportunity. We can enter this market.” But it’s taken a lot of work on their end to make sure all their systems are in place, to make sure their relationships are in place to deliver a good customer experience that it’s not really completely in control of. That’s been another fantastic company. What they have done by putting all that that together, they have become the de facto standard. It’s the one people rely on. And as a result, they have been growing fast, and as a result we see a growth runway ahead of them going forward.

Matt: When you are doing your research, are there any innovation trends or themes you focus on?

Dave: My background is in technology, I was an engineer before I was an investor, so that is where I tend to look for things. High-tech. I do look in software. I do look in industrial. What I tend to look for in a bottom-up standpoint is, who’s making good inroads with technology? And then the other thing I look for is, how can that keep going? What is the tailwind that is driving innovation, and how will companies turn that into growth, turn that into sales, cash flow growth, all that?

As an example, we have two companies in our portfolios. One is called IPG Photonics, and one is called nLight. And they make what is called fiber lasers. And essentially, we’ve known about IPG since 1997, and we don’t have to get into the physics of lasers, but what is driving these companies is that both of these companies have figured out how to make high-powered lasers with higher and higher beam quality. The beam works the way people want it to. Whether that is cutting metal, or melting two pieces of metal together, to do whatever it is being asked. And the cost per power level and quality level of the beam goes down.

What that means is more and more traditional manufacturing processes are going to be disrupted. Whereas you used to take a drillbit and drill a hole into a piece of metal, it is now more cost-efficient to use a laser, because drill bits wear out. They need to be replaced. This takes a lot of labor. With a laser, essentially, it doesn’t wear out. It keeps doing what it needs to do, and it does it effectively and it does it efficiently. Not unlike the cost of computing going down and driving new innovation in cloud computing, this same trend is happening in the laser market. And these two companies are harnessing that power and drive that trend with the technology they have and invest in. There are all sorts of market opportunities for them over the next 10, 20 years.

So, in a quick summary, I look for the company that’s “Wow! That’s a cool technology.” And then I think, “What is going to keep driving that trend?” Because you don’t want to invest in technology just because it’s cool. We want to make money for our shareholders. There has to be more than just a cool technology. There has to be a way the total addressable market is going to continue to get bigger, and the company itself has to have ways that it can benefit by taking market share, getting to scale, driving sales growth, profit growth, cash flow growth, things like that, such that shareholders and investors can benefit from it.

Matt: Last question. Innovation, I’m sure, is not just a phenomenon just in the United States. Can you talk about some innovation trends globally that you and the team are seeing?

Dave: The U.S. doesn’t have a lock on the market for innovation. As we know, science and technology happen everywhere. From that standpoint, in our emerging-market fund we have investments in Tencent, which is a Chinese conglomerate, as well as Douzone Bizon, which is a South Korean software maker. Essentially, Douzone Bizon has said, “Businesses in South Korea need software to help them more productive. We are happy to invest in creating more and more products for them to use in order for them to run their business more effectively.”

Tencent actually has a number of different models. Not only do they develop technology and then turn it into business, but they have another model by which they make investments in companies that they think are innovative. It’s like a venture capital or private equity-type fund, where they say, “You know what, we don’t have time or expertise to respond to this technology and innovation, but we want to be a part of it. So let’s invest in it. Let’s help it grow.” As a result of partnerships, they can get learning and feed it back into all the other businesses it has. That’s been a huge driver for Tencent, and we think it gives them a competitive advantage. They’re saying, “Look, we’re a great company, but not all the best ideas are going to come from us. Let’s invest in people who have great ideas, get them out there, have our shareholders benefit from them, too.”

You’re exactly right, though. Innovation does not just happen in Silicon Valley. It happens everywhere. IPG is based just outside of Boston; nLight is in the state of Washington. One of the things we don’t want to get into is the mindset that Silicon Valley is the only place for this. It’s not, and that’s one of the things that we think gives us an advantage. We don’t care where the company is from. We’re just looking for companies that have the ability to create new products and services, have management teams that understand how to drive that within their business, have a good business model such that their business can create a competitive advantage such that they can take market share and as a result grow for five, 10, 20 years, and our shareholders can benefit from that.

Matt: Dave, I said that was the last question. This is really the last question. If you are an on-the-street, mom-and pop investor thinking about innovation and what it means for your portfolio, or if you are a financial advisor thinking about innovation and how to talk to your clients about it and thinking about your client portfolios, what would be the executive summary?

Dave: That’s a great set of questions, Matt. I think the first thing is that I think there is a perception that innovation can be scary, can be risky. Yes, it can be. If it doesn’t work, it tends to fail. But if it does work, and you have a process like we do that tends to ferret out really good businesses that are actually taking advantage of this, it’s not as scary as you might think. So you shouldn’t shy away from these types of investments, either as an individual or if you’re an advisor working with clients. Depending on your risk tolerance, it doesn’t have to be a large part of your portfolio, but, again, like we’ve been saying, innovation is happening all the time. Great businesses are getting better.

Let’s just take Google as an example. Google’s revenue rate since 2016 has moved from 21% to 24%. This is an enormous company that’s doing innovation, and it’s growing faster now. There is reward, and as long as their risk tolerance provides for it — I don’t necessarily think if you’re retired and 80 years old you should put a big allocation to this, but it should be a part of people’s portfolios. It is how the world is working now, with the trends out there. More and more companies are investing in innovation. And that gives us more opportunity to find them for our funds. So far we’ve done a good job, and we think we have a repeatable process such that we can continue it in the future.

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