Australia’s National Innovation and Science Agenda appears to have sharpened the focus on companies perceived as ‘innovative’ in nature. From an investment perspective, innovation represents opportunity. It also present risks, however, primarily for incumbents whose margins or market shares are threatened by new entrants or more innovative competitors.
By understanding the breadth of opportunities for new entrants in an industry, as well as the threats to incumbents, professional long-short investors are able to profit from opportunities on both sides of the ledger. In this article, we consider what innovation means in the Small Companies sector and how innovation and disruption can drive investment decisions in this often under-researched space.
What does disruption mean for small company investors?
The information technology age in which we live means many people associate innovation with something digital or online. Consider how innovative products like Uber and iTunes have revolutionised the taxi and music businesses. In fact innovation, and therefore disruption, is occurring in all kinds of businesses in Australia, across a wide range of sectors.
From an investment perspective, you need to consider much more than the innovation itself. Many other factors will determine whether an innovative company is a good investment such as the size of the market for the product or service. Then there are questions like:
- are there barriers to entry or lack thereof?
- how many years a product has been in development?
- is it meaningfully different from competitors?
- is it patented?
- how much money has been invested in research and marketing?
- how broad is the distribution footprint?
All of these considerations determine whether a company has competitive advantages and, importantly, the sustainability of those advantages over time.
There are also investment considerations for incumbent operators. Some of these established, listed companies may have been operating successfully in an industry for many years, with earnings streams that were previously deemed defensive and sustainable. For long-short investors, the potential negative effects of disruption can be as appealing as the potential benefits of innovation.
Innovation in established industries
In any industry, there is almost always some level of product development or innovation occurring. The car industry is one of the most established and competitive in the world and there is an astonishing level of innovation underway, including the development of electric motors and the release of prototype driverless vehicles.
For Australian small cap investors, there are exciting earnings opportunities from companies with innovative products and services in rather less futuristic areas.
In the 1970s, owners of 4x4 vehicles relied on homemade or ill-fitting equipment for use in rural or outback regions. At that time, ARB Corporation was established and the company started designing and producing a range of 4x4-related accessories. Following more than 40 years of product development and innovation, the company is a global market leader in the manufacture and supply of bull bars and other accessories. The 4x4 market is growing at a double-digit pace due to the ever-increasing popularity of SUVs and utility vehicles.
ARB currently exports to more than 100 countries, has a vast distribution footprint and owns its own outlets to service the aftermarket for additional, non-standard accessories. The global reach of this business model is not easily replicated. The company is on a strong financial footing, too. ARB is in a net cash position and earnings margins in the 20% range are the envy of companies in many other industry sectors.
Whilst many of ARB’s products are perceived to be innovative, the key appeal for us as investors is the sustainability of the competitive advantages developed over more than four decades.
Innovators completing Initial Public Offerings (IPOs)
Many of the most innovative companies are relatively immature, unlisted companies. Some of these go on to complete IPOs, crystallising gains for founders and seed investors and raising capital to fund future growth. An example in the Australian small cap sector is Reliance Worldwide Corporation, a recent IPO of a company operating in plumbing, an established and ‘old fashioned’ industry.
Among the company’s main products is a ‘push-to-connect’ pipe fitting. The product offers plumbers and DIY users an efficient, less labour-intensive solution to repairs following pipe leaks. While Reliance Worldwide has about 80% share in the push-to-connect market in the US, Canada and Australia, the real attraction is that push-to-connect currently only accounts for about 10% of the plumbing supply market in the US. The growth opportunity is significant and the company is experiencing sales growth of more than 10% per annum.
Reliance Worldwide has been distributing plumbing products into the US for more than 16 years and has market-leading positions in primary locations. Trademark protection of the product provides another important competitive advantage. Market share is protected from imitation products and, importantly, means Reliance Worldwide can maintain decent pricing power with stockists.
Will we continue to see innovative companies in Australia?
Given the National Innovation and Science Agenda of the Federal Government, we expect to see a steady stream of start-up companies threatening incumbent operators in many industries. Some of these companies will have aspirations to list and will go on to complete IPOs.
As pioneers such as REA Group (in real estate digital advertising) and TPG Telecom (in both internet and telephony services) have proved, disruptive companies with innovative products and services – combined with the right focus from a capable management team – can generate handsome returns for investors.
On the other hand, there have been countless examples of companies whose products and services have not lasted the test of time, resulting in a permanent loss of capital for investors. The challenge is to identify the key differences between the two and position your investment portfolio accordingly.
Dawn Kanelleas is Senior Portfolio Manager at Colonial First State Global Asset Management. This article is general information and does not consider the investment needs of any individual.