Issue 22: 2012

Investing in Innovation

An investor's guide to sidestepping pitfalls, identifying growth and capitalizing on the next big things.

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Ever since the Internet bubble burst roughly a decade ago, investors searching for hefty returns have tended to turn more to the growth leaders of the emerging markets than to technology's innovators. While such reluctance is perhaps understandable, the fact is that real, return-generating innovations are under way in many sectors ? and often much closer to home. In fact, right here in the United States, promising advances range from major breakthroughs in enterprise software, to the emergence of customized manufacturing technology, the ongoing revolution in personalized medicine driven by genetic testing, and the technology-driven boom in oil and gas fracking.

And the impact of these activities ? and many others ? could have ramifications well beyond individual industries. ?Not only can technological innovation have a significant impact on the fortunes of non-tech industries, but innovation itself is certainly not limited to the tech sector,? says U.S. Trust Chief Investment Officer Chris Hyzy. ?Consider how e-readers have changed the way we read. And think how the driverless car ? a reality much closer than most think ? will change the way we travel.? Wherever it occurs, innovation drives productivity, reinvestment and ultimately profitability. Indeed, innovation may be one of the fundamental reasons for owning equities. The question is how.

The Innovation Investor?s Dilemma

Capitalizing on innovation has always presented challenges for individual investors attracted by the potential rewards of getting in on the ground floor but uncertain how to identify nascent opportunities. ?There isn?t an investor who isn?t looking for the next ?Apple??? says Martin Chanzit, a managing director and senior portfolio manager of U.S. Trust's World Thematic Alpha Portfolio, which attempts to capture innovation and growth around the world. ?But if you?re just hunting for elephants, you?re involved in an exceedingly high-risk endeavor.?

How, then, should investors proceed? The key is knowing where to look.

Investment Themes: Several important investment themes that may interest investors seeking innovation and growth Click to expand

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Venture and Growth Capital

In the popular imagination, a way to reap attractive returns may well be from seeking innovation through venture capital. However, in reality, the best-known venture funds tend to corral some of the most promising startup ideas and companies, and competition is stiff for the limited number of slots available to outside investors. That's why private investors actually tend to have a better shot at gaining access to early-stage innovation opportunities through a type of private equity known as growth equity or growth capital. These funds invest in emerging, pre-IPO companies, providing financial support at slightly later stages than the typical venture capital investment. The competition to participate in these investments is less heated, and unlike most venture funds, they can be accessed via feeder funds or investment pools that collect money from a number of private clients.

Still, growth equity has some of the same drawbacks as venture capital, including high minimum investment requirements and illiquidity because of extended ?lockup? periods during which investors are restricted from selling their shares.

Equities: Focus on Sectors More than companies

Even high-net-worth individuals will generally be gaining most of their access to innovation the same way they do to other major investment themes: through publicly traded companies. So how can you improve your chances of zeroing in on those investments that still have plenty of upside? You can start, says Chanzit, by thinking more in terms of industries and sectors than of individual companies. ?The pipeline is so competitive,? he explains, ?you don?t want to put yourself in the position of trying to predict which one company is going to break through and hold on to its advantage. We find it makes much more sense to spread our risk among multiple companies in the areas known to have the highest concentration of promising activity.?

Says Hyzy: ?Sectors to consider here might include mining, energy, life sciences, robotics and social media ? all innovation-led areas attracting a great deal of investment capital.?

It?s important to remember that not all innovations that pay off for investors are radical breakthroughs.

Another way to refine your search, especially today, is by focusing, ironically enough, on large corporations ? and, more specifically, their cash balances, which remain at record-high levels.1 In many cases still grappling with sluggish organic growth, these deep-pocketed companies may well turn to acquisitions to improve their prospects. Identifying those smaller companies in a hot industry or sector that appear most likely to be acquired is one approach to capturing the trend, but so is focusing on those most likely to acquire them.

Likewise, it's important to remember that not all innovations that pay off for investors are radical, game-changing breakthroughs. Companies can also succeed by producing a steady stream of smaller innovations ? version 1.0 leading to a better 2.0 and an even better and more profitable 3.0 and 3.1 of an operating system is a classic example. But keep in mind that nothing lasts forever.

Innovation is Not Just About Technology

It's important to emphasize that investors focusing on innovation should not be afraid to look beyond the tech sector. ?Technology is an intermediate good,? explains Chanzit. ?A semiconductor, as a standalone device sitting in your palm, has little value, but embedded in a computer or GPS, or a remote-control garage-door opener, it enables the delivery of substantial value. Technology needs vibrant end markets, and those can come in any industry ? even a non-tech industry ? benefiting from the application of innovative technologies.? Advances in industrial robotics, for instance, are having a dramatic impact on the fortunes of a vast number of industries ? including the automotive, electrical, metals, pharmaceutical, chemical, and even the food and beverage industries, just to name a few. New data analytics and business intelligence technologies are improving productivity and enhancing profits for any company that demands sorting, organization, labeling and ultimately extraction of that data into a clean and readable report ? whether it's streams of information from offshore oil rigs, global air traffic control centers, city street CCTV networks or genome sequencing. Advances in computing technology are improving efficiencies in the trucking industry. The list can go on and on, but the point is that in the search for innovation, we can look beyond the technological innovation itself to those industries that will benefit most from its use. We might also look to indirect beneficiaries ? to companies that provide the raw materials or components of these new technologies or even those that help to implement it.

There is no rule that says the innovation that shifts an industry paradigm needs to be technological in nature.

And there is no rule that says the innovation that shifts an industry paradigm needs to be technological in nature. Amazon, for instance, instituted revolutionary business processes ? the company's network of warehouses, effective inventory management methods and signature services such as Amazon Prime. ?Innovation can come in many different forms,? says Chanzit. ?It's not necessarily just a product or a technology. It can be a process, too. It's a way of doing something better than anyone else has been able to that yields a competitive advantage.?

Seek Innovation through Investment Themes

Focusing on powerful secular trends and investment themes can be another effective way to identify innovation ? and growth potential ? that spans multiple industries and sectors. ?Targeting the trend or the need first, and then seeking out the innovative solutions, is a way of ensuring that the innovations you find ? whether high-tech, low-tech or no-tech ? are addressing areas of significant growth potential and unmet need,? says Joe Quinlan, managing director and chief market strategist for U.S. Trust.

Quinlan highlights several important investment themes that may interest investors who are seeking innovation and growth:

Climate change. Global climate change has gone mainstream. The scientific debate continues, but those arguing for greater care of planet Earth have seized the upper hand and the attention of policymakers around the world. New industry standards, government regulations and cross-border initiatives are in the offing, creating opportunities for numerous companies. Interest in renewable energy has intensified, with global investment in wind and solar power surging and governments pledging financial support around the world. ?Opportunities exist for companies that are prepared to meet the world's changing needs with respect to alternative energy,? says Quinlan. For this reason, he would focus on the areas of global infrastructure, materials and industrials. Adds Chanzit: ?Investors might also consider the myriad clean-energy innovations that are springing up in the wake of the game-changing ? if controversial ? drive to recover the United States? enormous reserves of natural gas. Those include distributed energy, biofuels and liquefied natural gas fuels. It's a trend that some say will ultimately result in America's energy independence, bringing tremendous economic benefit to the country.?

Global obesity. The battle of the bulge is becoming a world problem. During the past decade, obesity has rapidly become a serious public health problem in a growing number of nations. In the United States alone, the estimated direct medical cost associated with obese and overweight individuals ranges from $130 billion to $160 billion per year, according to the Centers for Disease Control and Prevention. And this is no longer a problem confined to developed nations. After working overtime to catch up to life in the West, China faces the world's biggest diabetes epidemic. One in 10 Chinese adults has the disease, and another 16% are now on the verge of developing it, according to a 2010 report from the New England Journal of Medicine. According to Quinlan, ?As efforts to fight this epidemic become more prevalent, global healthcare outlays should rise even further, and innovative companies working to tackle this global epidemic stand to benefit.?

The constant need to drive productivity gains is buoying demand for robotics and information technology on a global scale.

Robotics and global information technology. Once the domain of developed nations, the use of technology at home and at work has gone global. The pace and pervasiveness of technological change are accelerating, with the greater use of robots a key part of this dynamic. Record robot sales and demand for automation are being driven by technological advancements, lower robotics prices, aging labor forces and rising wages across emerging economies. The constant need to drive productivity gains is buoying demand for robotics and information technology on a global scale, especially in the emerging markets where the cost of capital and labor is increasing. Says Quinlan: ?The need for technology solutions is nearly everywhere, from consumer staples to automation and infrastructure, and technology is becoming more diffused across sectors and countries ? a bullish prospect for U.S. technology leaders.?

Water. Drought conditions have become more severe in many parts of the world, and the accelerating pace of global urbanization has strained the water infrastructures of many nations to their breaking points. Population growth and urbanization are expected to drive up demand for water by 40% within 20 years, according to the World Bank. Additionally, nearly one in four people lives in an area of water scarcity, and water infrastructure in the United States and overseas is crumbling while demand is rising. Against this backdrop, Quinlan believes capital expenditures on building and improving water filtration, wastewater treatment, desalination, rural water services, water utilities, water utility performance, irrigation systems and a host of related projects are poised to increase sharply during the next decade.

Agricultural commodities. Although there are many transitory reasons for the recent surge in global food prices, the multiyear increase in prices reflects something fundamental and structural, says Quinlan.

In the long term, demand for agricultural commodities should remain strong, given a number of global secular trends, including an ever-expanding global population, rising per capita incomes in the emerging markets ? with the attendant rise in the consumption of meat, vegetables and fruits ? and greater urbanization. ?Innovative companies addressing this need effectively should benefit over the longer term,? Quinlan says.

Womenomics. Greater education, better family planning, more economic empowerment and the shift in the nature of work ? from brawn to brains ? have all converged to encourage greater female participation in both developed and developing nations, says Quinlan. Already women represent 40% of the global workforce and more than half of the world's university students. In the developing world, girls now outnumber boys in secondary schools in 45 countries, and there are more young women than men in universities in 60 countries. In the United States, women account for 83% of all consumer purchases, hold 89% of U.S. bank accounts, and by some estimates generate $5 trillion in consumer spending.2 ?Pick virtually any industry and the wants, needs and desires of women will increasingly dictate its future,? Quinlan says. ?In the end, women matter in economics and are poised to become key economic agents of growth and change. The successful corporation of the future will be well attuned to and focused on women.?

Already women represent 40% of the global workforce and more than half of the world's university students.

Emerging markets middle-class consumer. The penchant to consume is gaining global traction. Says Quinlan: ?An estimated 400 million middle-class consumers in the developing nations are a new source of both supply and demand globally, creating new opportunities for innovative companies that successfully target these new consumers.?3

Africa. Robust economic growth, the spread of democracy and more inward foreign direct investment portend more sustainable growth and development in Africa over the next decade. ?While recognizing many of the risks associated with Africa, we are bullish on the continent and believe the region is on the verge of becoming more globally integrated,? says Quinlan.

Key sectors. Key sectors of opportunity, in our view, pivot around not just oil and gas, but also agriculture, telecommunications, banking, manufacturing, retail and tourism.

Of course, investors might consider investing directly in the stocks of companies. This might mean overweighting the small cap portion of your equity allocation by owning shares in four or five cloud technology companies, for instance, or several promising biotech firms on the verge of commercializing obesity drugs. Even there, though, your advisor may advise balancing out the added risk by making adjustments to other portions of your portfolio ? for example, by taking a ?barbell? approach that builds a corresponding position in utility stocks or non-cyclical blue chips or fixed-income securities.

Given the numerous investment vehicles available, each of which has its advantages and disadvantages depending upon your situation, if you would like to invest in innovation, the best approach is to consult with your U.S. Trust advisor to determine the most appropriate investment vehicle for you.

1 According to U.S. Federal Reserve flow-of-funds data as of November 1, 2012.
2 World Bank, World Development Report 2012: Gender Equality and Development.
3 World Bank, Global Economic Prospects 2007: Managing the Next Wave of Globalization (Latest available data).

IMPORTANT INFORMATION

Projections made may not come to pass due to market conditions and fluctuations. Investing involves risk. There is always the potential of losing money when you invest in securities.

Past performance is no guarantee of future results. Asset allocation, diversification and rebalancing do not assure a profit or protect against loss in declining markets.

Always consult with your independent attorney, tax advisor, investment manager, and insurance agent for final recommendations and before changing or implementing any financial, tax or estate planning strategy.

OTHER IMPORTANT INFORMATION

Equities
Equity securities are subject to stock market fluctuations that occur in response to economic and business developments.

Stocks of small and mid cap companies pose special risks, including possible illiquidity and greater price volatility, than stocks of larger, more established companies.

Fixed Income
Investing in fixed income securities may involve certain risks, including the credit quality of individual issuers, possible prepayments, market or economic developments and yields and share price fluctuations due to changes in interest rates. When interest rates go up, bond prices generally drop and vice versa.

International Investing
International investing involves special risks, including foreign taxation, currency risks, risks associated with possible differences in financial standards, and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility.

Commodities
There are special risks associated with an investment in commodities, including market price fluctuations, regulatory changes, interest-rate changes, credit risk, economic changes, and the impact of adverse political or financial factors. Tangible assets can fluctuate with supply and demand, such as commodities, which are liquid investments unlike most other tangible investments.

Alternative Investments
Alternative investments are intended for qualified and suitable investors only. Alternative investments are speculative and involve a high degree of risk. Alternative investments such as derivatives, hedge funds, private equity funds and funds of funds can result in higher return potential but also higher loss potential. Changes in economic conditions or other circumstances may adversely affect your investments. Before you invest in alternative investments, you should consider your overall financial situation, how much money you have to invest, your need for liquidity and your tolerance for risk.