Innovation as an Asset Class

I re-watched Howard Lindzon’s interview on Real Vision with Raoul Pal because I generally learn something when I listen to Howard speak. Howard has been on the “software is eating world” theme, correctly, for a long time. Nice Call! Ten Year Weekly of IGV:

Largely speaking I would argue that Howard is an investor in innovation and a rider of trends in the growth areas of the market. When Raoul pushed back on record high valuations, Howard pointed out his view that there are not as many public companies in the market now as there were 20 years ago and only a small subset of what’s on the market now are worth investing in. The truly good businesses command a premium valuation. This is always the case and we can debate if the current levels are extreme. 

Howard admits that multiple compression is a risk but good luck timing that. I agree here, on both points. Valuation is not a catalyst by itself, especially for a short. Valuation is more like an environment. Are stocks cheap or are they expensive? Rich can stay rich and cheap can stay cheap. There needs to be a catalyst that wakes people up to the environment. COVID should have been the catalyst but stimulus quickly put a pin in that argument. One of the bigger catalysts that I am worried about with my growth ideas is the prospect for higher rates which should have a bigger negative impact on growth names, especially if their profitability and cash flow are on the come.

The conversation made me think of this paper from the team at ARK which argues that innovation should be its own asset class, worthy of an allocation, the way that investors allocate to large caps or small caps or growth or value. They use emerging markets as an example. It highlights the risks to an under allocation to innovation with some interesting points made in the paper. Here is their take, not mine:

• ARK believes that asset allocators do not have enough exposure to innovation in the public equity markets. We estimate that disruptive innovation will add $50 trillion to global equity market capitalizations by 2032.1 Today, these technologies account for less than $6 trillion, suggesting that they will deliver a 21% compound annual rate of return during the next 12 years.

• In the 52 years from 1964 to 2016, the average lifespan of a stock in the S&P 500 dropped roughly 25%, from 33 years to 24, according to Innosight. By 2027, it is likely to drop another 50% to 12 years as transformational technologies disrupt broad-based equity indices, impairing the “old guard”. (Howard alludes to this in the interview when talking about investing in old vs new world stocks).

• Stocks in industries particularly at risk - big pharma, banks and other financial services, fossil fuel-based energy, auto and auto-related manufacturers, telecommunications, transportation, retail - dominate broad-based indices today. In fact, their market capitalization weighted index structure may be exacerbating the risk, reflecting success stories from the past, not the future. (I’ll push back here a bit because the smart companies will adopt the innovative technologies to remain relevant in my view).

The case can be made that sites like Stock Twits (Howard) and Real Vision (Raoul) are an innovation in the way that they have “democratized” finance. They both point out that in 2020, everyone has access to a lot of information. Now, not everyone will know how to use the information properly but that is a different story. Knowing who to follow and why is important. Also, following people who don’t share the same views will be helpful in making decisions. I always want to hear the bear case on an investment that I am making. Being connected the way that we are now and having the ability to share ideas on these platforms is great. Anything that brings new investors to the market is clearly welcome. The drawback is that everyone crowds into the same ideas. These are generally popular growth stocks. Howard points out that, yes, this could lead to more volatility in the market going forward especially when “everyone panics at the same time.” So the behavioral dynamics of risk on / risk off are a fact of the markets that we are going to have to accept.

Other great points in the video:

• Asset Allocation: The 60 / 40 or 70 / 30 portfolio may need to be revisited in a world where the 40 or the 30 does not yield all that much. Howard mentions alts with a reference to Rally Road. I don’t disagree here but would make the case that investors should be giving more consideration to commodities, especially with the prospects for inflation heating up.

• Opportunity to Reboot the World: COVID was / is disruptive, many people lost their businesses. But there is going to be an opportunity to rebuild. A new restaurant that opens now will leverage digital options that an older business may not have used. Think about GRUB, YELP, SQ (I am long) and others.

I generally agree with much of what was said in the interview and in the paper and think it makes sense to always have an eye on the innovative themes in the market. That being said, I know that there is the possibility of big drawdowns along the way. I am not going to sit with these when the tide is going out. I can sell them to manage risk and always get back in. This is also a good reason to keep up with the stories and possibly use a mean reversion strategy to get back into good businesses whose stocks may get dislocated to the downside from time to time.