Old wine, new cork

Innovation is of keen interest to Invesco Perpetual's European Equities investment team - particularly when it's a new take on an old industry.

May 21, 2017 | Erik Esselink

As investors in European and Global Smaller companies, we often think about innovation as one of the key value drivers of the stocks we own in our portfolios. We see Innovation as a driver of multiple benefits; sustained growth, new market opportunities, strengthening existing market shares, creating efficiencies and margin improvement. Simply put, innovation enhances company returns.

In our minds there are two common misconceptions when it comes to company innovation. The first being that most innovation these days is done by start-ups and that the only way listed companies remain innovative is through, often expensive, acquisitions. The second is that the only truly innovative region is the USA and specifically Silicon Valley. We welcome these misconceptions because it leaves regions of the world where investors are not focused on discriminating between the innovative and less innovative companies and hence leaves us a fertile hunting ground of good investment returns for our funds.

In this short blog we will try to explain why we care about innovation and why these misconceptions are wrong. We’ll conclude with an example of a truly innovative company in perhaps the unlikeliest of industries.

In our investment process we spend a lot of time understanding how management allocates capital between the various uses of capital (maintenance/investment/distribution). We like to see companies where management are able to balance healthy but sustainable shareholder returns and invest in the company’s future growth. It goes without saying we want that investment in growth to be done with a high return on capital, but we also care as much about the balance between internal (R&D and Growth Capex) and external (M&A) allocation. In general, we like companies that have a lot of Intellectual Property (IP) because it acts as a barrier to entry and is intrinsically linked to sustainability. Better still we like companies that have the ability to create new IP through internal R&D or innovation. However, this innovation must not be unfocused or indisciplined; we want companies to stick to their knitting and focus their R&D around their core expertise where they have an edge.

We understand that our companies can not always forecast the future direction of innovation in their industry perfectly. Therefore, from time to time, buying in a competitor to get access to the best available technology or as a catch up, to remain competitive, is the right action to take. We also welcome external investments in adjacent activities which allows our companies to leverage their core technology on a broader or new platform. Even in these cases there’s significant benefit of having a strong internal R&D expertise, because is often these men and women that are the scouts. They are well placed to identify new or emerging innovations in start-ups/universities or other companies with which their management can perhaps acquire or form partnerships.

When looking at innovation in Continental Europe we are encouraged, partly because of what we see in the companies we analyse as part of our process, but also when looking top down. The World Economic Forum produces the annual Competitiveness Report; this sophisticated and globally consistent ranking of Global competitiveness contains a subindex for Innovation (which in it self is build up in a number of criteria such as corporation between universities and business, education level of workforce, number of patents submitted etc). In the Top 7 of this sub index there are 5 Continental European countries (Switzerland, Germany, Sweden, The Netherlands and Finland) alongside the US and Japan. The UK for reference ranks number 9 just ahead of Denmark, Austria, Belgium and France. Of course these rankings are arbitrary (albeit the WEF is the most quantitative method we have seen), but the point for us is that Continental Europe is as good a place as any to search for innovative companies.

As smaller company investors, the “risk” is the innovative companies we hold aren’t so much the hunters but the hunted. Year to date, we’ve had two companies we own in both the Continental European Small Cap and the Global Small Cap Strategy taken over, with premiums to their market prices, by larger peers for access to the innovation and growth.

One of the companies that has proven to us that sustainable investment in innovation pay off over the longer term, is Oeneo from France. Since a strategic review in 2004, this French maker of Wine Barrels and Cork stoppers, founded in 1838 is on an amazing journey driven by innovation. The company illustrates how a 2000 year old product has been transformed by the use of technology and innovation in a series of engaging videos. This innovation has led to higher margins and greater market share for Oeneo and this is possible because the innovation has created a more cost effective solution for their customers, wine growers, and that despite lower cost that it make a better and more consistent quality of wine globally! The company hasn’t stopped innovating there and is now becoming a consultant to the wine industry. The whole wine industry can now benefit from the sustainable investments in innovation the Oeneo is making, this will help vineyards around the world grow better grapes, helps producers of white, red and rose to make better wines, and I am sure you will agree that this is good for everybody.