Innovation is becoming an increasingly powerful factor in explaining stock performance. That often means technology or biotechnology companies. An examination of various stock indexes shows just how valuable the innovative spirit is.
A central tenet of capitalism is that performance is often derived from innovation, whether it be Henry Ford’s Model T or Steve Jobs’ iPhone. The bigger the innovation, the bigger the investment flows into the stocks that embody it. How much?
To start, let’s compare the Dow Jones Industrial Average with the Standard & Poor’s 500 over the past 10 years. The Dow rose 68% but the S&P was up 71%. That difference seems small, but in investing, even three percentage points makes an appreciable difference.
While the two indexes often track each other fairly closely, the S&P’s slightly higher return largely stems from one thing: It includes a larger number of companies and many more from new economy type industry sectors (e.g., social media, cloud computing, software, networking, etc.), we see the S&P 500 outperformed the DJIA.
The contrast becomes more apparent when we bring in an indexes that specialize in tech businesses. In the chart below, we show the relative performance of the Nasdaq 100 – the highest valued stocks in the tech-dominated Nasdaq Exchange – as embodied by the exchange-traded fund tracking it, the PowerShares QQQ Trust (QQQ) and the First Trust U.S. IPO Index ETF (FPX) to the S&P 500 and the Dow.
FPX is a fund of 100 companies that had initial public offerings within the past four years. Our chart starts from the IPO vehicle’s launch date, Apr. 13, 2006 – some nine years ago.
The chart shows the Nasdaq 100 up 180% and the ETF of IPO companies (FPX) up 190% during that period, as the Dow and S&P advanced 65% and 90%, respectively. Most investors would agree that the amount of new-economy innovation occurring in companies that recently went public and in the Nasdaq 100 is greater on average than the amount found in the S&P and the Dow. Just recently, Facebook (FB) surpassed Wal-Mart Stores (WMT) in market capitalization.
The average market capitalization of the stocks in the Nasdaq 100 is $105 billion. For the FPX, it is $23 billion. While the smaller market-cap group of stocks (FPX) rose more than the giant market-cap group (QQQ), the real difference to be innovation rather than market cap.
Both indexes vastly outperformed groups of stocks with a much lower concentration of innovation. Giant market capitalization companies like Google, Amazon and Apple are keeping pace on the innovation front with newer, smaller companies.
The most concentrated sector of innovation pursuing large market opportunities may be biotechnology. Finding a cure for cancer potentially has a larger financial reward than creating a new way to tweet or stream music over the Internet (although the privately held music streaming company Spotify recently completed a capital raise at an $8.4 billion valuation). Shown below is the chart of the Dow, S&P, QQQ and FPX. But now we add the iShares Nasdaq Biotechnology ETF (IBB). Up 390%, biotech returns dwarf the other investments.
The difficulty of investing in innovation is volatility. A two-thirds Nasdaq drawdown from its peak in late 1999 to its fall 2002 low point is a testament to this. Many innovations suffer unexpected and abrupt ends as either they fail to meet a real market need, fail to perform as expected or some other innovation makes them obsolete.
During boom times, it is easy to fall in love with the next great investment story, which becomes over-hyped and over-valued. Much like a venture capitalist, owning a diversified portfolio of innovative companies should be considered a basic construct of innovation investing. Some cutting-edge investments will work and many will not. Investing in the QQQ, FPX or IBB offers a systematic, periodic rebalancing discipline to cull the portfolio of losers and retain the winners.
Innovation is somewhat of a nebulous term. It is hard to precisely define and measure. If you believe that the pace of innovation is accelerating, so should certain stocks’ outperformance. One might also conclude that innovation may drive better-than-expected economic growth than current consensus expectations.
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Nicholas Atkeson and Andrew Houghton are the founding partners of Delta Investment Management, a registered investment advisory firm in San Francisco, and authors of the new book, Win by Not Losing: A Disciplined Approach To Building And Protecting Your Wealth In The Stock Market By Managing Your Risk. Additional market commentary and investment advice is available via their websites at www.deltaim.com and www.deltawealthaccelerator.com
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