By Graeme Bencke
The issue of building a global fund in a turbulent environment is a very real one to us as this is exactly what we have just decided to do. The recently launched Amati Strategic Innovation Fund is a truly global equity portfolio aiming to benefit from the recognised inefficiencies in investing in innovation. Launching an equity fund in any market environment requires a focus on three key areas in our view:
# 1 – Maximise reward while minimising risk
It had been increasingly apparent to us over the last several years that investors had become accustomed to an unusually easy monetary environment with little to no inflation and almost unlimited availability of free capital. This led to an extreme focus of investment on a relatively small segment of the index, that of high growth (particularly) technology or consumer businesses. In an environment of zero inflation the value of money is not being constantly eroded, which means that a dollar in five years’ time is worth the same as a dollar today. Therefore, earnings in the distant future represent an unrealistically high proportion a company’s value when analysts create financial models using these assumptions. Unproven business models with overly hyped expectations can be ascribed sky-high valuations. Equally, however, when inflation assumptions change and interest rates start to rise the impact on valuations can be dramatic; as the recent market experience has shown. So the first point to consider when building a global fund must be to make reasonable assumptions that do not extrapolate extreme market environments into the distant future. In other words, buying companies where we can see strong returns despite making realistic or even somewhat pessimistic assumptions.
#2 - Identify a durable opportunity for outperformance
While valuation is a crucial element of investment timing and stock selection, it cannot be the starting point for deciding where to invest. In any market environment, and particularly one facing the current economic and geopolitical challenges, investors must have a clear understanding of how and why they will outperform and stick ruthlessly to their strategy. If investors simply follow the herd they will never get better than average returns. In our case we believe strongly that better than average returns can be generated by investing appropriately into innovation. Our experience has demonstrated to us that the market is inefficient at pricing the impact of innovation into stock prices. Reassuringly, an increasing body of academic research is reaching the same conclusion, with several studies suggesting that a focus on understanding the complexity of innovation to appropriately value it can lead to persistent positive excess returns.*
The formation of a number of ‘innovation’ funds over the recent past suggests that we are not alone in noting this phenomenon, but beyond the name we share few characteristics with these other funds.
Noting our first point regarding valuation, we are cautious about investing in unproven business models which, while undoubtedly innovative, have yet to prove they can create true economic value. First movers in new, high growth markets are often valued to reflect a dominant market share when the industry matures, yet much can change along that path. Assuming that the current winner in ….. (insert early stage industry here … metaverse, grocery delivery, ride hailing, BNPL etc) will retain dominance is a highly risky bet. There are countless examples of ‘winners’ being overtaken or outcompeted before they achieved real returns on investment. These ‘Pioneers’ can see stratospheric growth for a time, but investors will frequently make overly optimistic assumptions of their chances of ultimate success. However, that doesn’t mean that the innovation opportunity is uninvestable. In many cases the innovation leaders are supported by other companies on the fringes of the limelight. Think of the scooter manufacturers serving the armies of food delivery riders, or the packaging companies facilitating the huge growth in online retail. These ‘Enablers’ do not provide the new paradigm excitement of the companies they serve, but neither do they face the same risks. The supplier of diagnostic equipment and test kits doesn’t care which exciting new compound becomes a successful drug, just as long as the ‘pioneers’ keep researching.
Our approach to innovation encompasses both pioneers and enablers given a sufficiently attractive reward for limited risk, but also includes a third category – ‘Adopters’. These are the fast-following businesses that will adopt new products, services or business models which they see being successful elsewhere. These may have large existing market positions which they are looking to defend or even expand. Apple may not yet have a folding screen phone, but who would be surprised if they follow Samsung if the innovation gains real consumer traction? Tesla may be the poster child of innovation in electric vehicles, but Volkswagen’s CEO recently stated the expectation of becoming the leading supplier of EVs globally within 3 years. (Interestingly VW’s 3.8x price to cash flow compares quite favourably with Tesla’s 110.8x (Bloomberg 30/5/22)).
Unlike many other innovation funds, our approach of investing across pioneers, enablers and adopters provides us with a different mechanism to optimise the balance of risk and reward, as well as the flexibility to adjust our focus depending on the market opportunity.
#3 – Invest in strong companies for the long term
In our view ‘investing’ is a long term business. Frequent buying and selling quickly creates high trading costs and rarely provides time for the real world to catch up with share prices (for good or bad). Investing for extended periods requires a high degree of faith in the invested company and this typically comes from gaining a deep understanding of the business model and competitive environment, as well as clarity regarding the strategy for growth. It is through exploring the complexity of a subject that we unlock the most lucrative insights.
We layer on top of this a preference for higher quality companies, both from a financial perspective (low debt, high free cash flow generation, high returns on capital) as well as a focus on proven management. Our concentrated portfolio approach means we are only looking to hold 30-40 exceptional companies from across the world. Each of these companies stands to be a significant beneficiary from one or more global ‘innovation frontiers’, but that benefit is yet to be fully reflected in the valuation.
Ultimately, building a global fund during a period of turbulence requires the same elements as any other period. Ignore the noise and focus on finding the best investment opportunities, with the most attractive rewards for the risk, and then being patient. Markets are always noisy and complicated, and the best investors have the ability to look beyond the short term and make calm, considered decisions and let their companies succeed.
* David Hirshleifer, Po-Hsuan Hsu, Dongmei Li; The Review of Financial Studies, 2018 ; Kewei Hou, Po-Hsuan Hsu, Shiheng Wang, Akiko Watanabe, Yan Xu, Journal of Financial and Quantitative Analysis (JFQA)
This article is provided for information purposes only and does not represent an offer or solicitation to buy or sell any securities, and nor does it provide all of the facts needed to make an informed decision about the merits or otherwise of investing in any Amati funds or products. Prospective investors should always read the Key Investor Information Document and the Prospectus for the relevant fund or product, which contain full details of the costs and charges as well as specific risk warnings. These documents are available at www.amatiglobal.com.
Past performance is not a reliable guide to future performance. The value of investments and the income from them may go down as well as up and is not guaranteed; investors may not get back the amount they originally invested.
Amati Global Investors is authorised and regulated by the Financial Conduct Authority.