Value Managers Can Also Benefit from the Wealth Generated by Innovation
Skilled value investors employing an intrinsic-value approach with a long investment-horizon are uniquely positioned to benefit from the wealth created by disruptive innovations. These investors seek opportunities in durable franchises, run by managements who are constantly cultivating new potential sources of shareholder value. When those efforts are successful, the innovations can create new value-streams that drive significant returns to long-term shareholders.
Disruptive Innovations vs Incremental Improvements
Not all innovations are disruptive. In fact, most innovations are incremental improvements—enhancements to existing products or services designed to better serve a company’s current customers. They include enhancements such as quieter dishwashers, the creation of more comfortable airplane seats, etc. While these and similar product advancements improve user experience, they do not fundamentally alter the dynamics of the markets they inhabit.
Disruptive innovations, on the other hand, introduce entirely new approaches to meeting consumer needs, often creating new markets and upending existing ones. These disruptions can dramatically alter the economics of previously profitable industries, with examples including the iPhone (demolished incumbent mobile phone manufacturers), Netflix’s steaming service (dismantling the cable bundle), and Uber’s ride-sharing service (upended the taxi & private-transportation industries).
An Intrinsic Value Approach Combined with a Long-Term Perspective
Investors who integrate an intrinsic value approach with a long-term mindset must assess several key factors:
1. The durability of a company’s core franchise.
2. Management’s ability to strengthen their core business, while successfully capitalizing on innovative opportunities.
3. The potential value, often underestimated, of those new opportunities.
Over the past decade, some businesses possessing one or more core franchises and a talented management team have brought about new products and/or business models that were highly innovative. These innovations initially met with widespread skepticism, offering an opportunity to skilled long-term investors to benefit from the compounded returns those disruptive innovations generated.
Below are three examples of disruptive innovations from large-cap companies operating in the public equity markets. In each example, those innovations generated enormous shareholder returns.
Eli Lilly
New drug compounds have been improving and extending lives for over a century. And occasionally, a dramatic burst of pharmacological innovation brings with it extraordinary benefits for human health. Eli Lilly has done just that, revolutionizing care for diabetes and obesity with their blockbuster GLP-1 receptor agonists.
In 2016, Eli Lilly was emerging from a wave of patent expirations and was in a period of rebuilding and deep innovation. They still maintained their core insulin franchise, along with some recently launched new compounds. The company had a particularly robust late-stage pipeline (nine molecules were either in Phase III or under regulatory review in early 2016), and it had an early-stage pipeline with two compounds that possessed absolute blockbuster potential. One of these played to the company’s core scientific strengths in metabolic disease and endocrinology.
This backdrop created an enviable set-up for the long-term, intrinsic-value focused investor: a strong core business led by an able management team, which was concurrently pursuing significant emerging opportunities that were being heavily discounted by the market.
Over the next several years, the hit-rate and commercial execution on Eli Lilly’s late-stage pipeline was outstanding. The firm’s new GLP-1 offerings revolutionized the medical industry’s approach to obesity and metabolic disease. In addition, the company’s pipeline of obesity and neurodegenerative compounds holds the potential to forever change the landscape in previously impossible to treat neurodegenerative diseases, such as Alzheimer’s.
These innovations have added hundreds of billions to the company’s market capitalization during the last decade (Exhibit 1).
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Broadcom
Through a combination of both business model and product innovations, Broadcom has created new and captured emergent opportunities to add tremendous value.
Long-time CEO Hock Tan’s first key insight was that the semiconductor industry was littered with highly durable business franchises, but whose steady cash flows were being reinvested into sub-scale opportunities with unappealing return prospects. Hock wrote a new playbook for unlocking shareholder value: 1) roll-up other semiconductor franchises, 2a) reinvest in the franchise while 2b) simultaneously raising prices, and 3) sell or shut down everything “non-core” that was acquired alongside the franchise.
Broadcom applied the same insight and strategy to the software industry, generating tremendous value by acquiring under-managed software franchises. Broadcom’s innovations have not, however, been confined to its business model. The company has also defined and dominated the first stage of the ASIC accelerator market for custom AI workloads. Drawing on its networking semiconductor expertise, the company’s XPU products have dramatically enhanced current results via massive end-market expansion.
The “one-two” punch of Broadcom’s business model innovations and end-market expansions have led to one of the best FCF/share growth profiles within the S&P 500, generating significant returns for shareholders (Exhibit 2).
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Walmart
Innovation doesn’t always come in the form of a novel compound or an algorithmic breakthrough. Sometimes a company carves entirely new paths forward for their business via unconventional and opportunistic decisions, transforming themselves in the process.
Walmart is a quintessential example of such a company. Decades of brilliant execution by founder Sam Walton and his immediate successor had cemented the company’s status as the country’s leading retailer. However, the company’s core franchise, built on a reputation for offering customers Everyday Low Prices, was increasingly challenged by Amazon and other e-commerce retailers. These emergent competitors offered customers greater convenience and selection at competitive prices, increasing the odds that Walmart might become increasingly irrelevant (as K-Mart experienced before it).
Enter new CEO Doug McMillon in 2014, who initiated a significant, multi-year reinvestment cycle focused on optimizing store operations and raising wages and benefits, laying the groundwork for the transformation to come. Walmart‘s 2016 acquisition of Jet.com was a critical part of the company’s omnichannel transition, injecting e-commerce talent, infrastructure, and an ethos that Walmart needed. Building upon that new foundation, the company’s aggressive transition broadened out into related adjacencies that planted the seeds of future growth.
The result? New capabilities and products started to emerge, including Walmart’s Marketplaces, Data Services, Walmart Connect, and Walmart +. And while it took time for these new businesses to gain scale, the incremental profitability once revenue exceeded fixed costs has set the company up for a multi-year run of margin-accretive growth. Simultaneously, and just as importantly, they enhanced the competitive position of Walmart’s core retail franchise.
Walmart’s broad swath of innovations across various dimensions has generated strong absolute and relative returns for shareholders, and left the company superbly positioned for the next wave of AI-enabled retail disruptions (Exhibit 3).
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Value and Innovation
Disruptive innovations are uncommon. It is rare for company management to identify an opportunity and successfully transform a market. However, when they do occur, they can offer significant returns to investors.
Contrary to old stereotypes, value investors can benefit from disruptive innovation, especially managers that combine an intrinsic value approach with a long-term mindset. These investors can find opportunities in durable franchises with management that effectively pursue new potential sources of value. Innovation can create new revenue streams that boost market value and reward shareholders over the long term.
We believe this approach is especially suitable today. Accelerating advances in technology promise to transform the global economy, and the opportunities for skilled active management and their clients can be extraordinary. We believe an intrinsic value approach can help uncover these opportunities and can reward investors for years to come.
