I’d like to tell you about a special type of UK-listed company. It’s the kind of company that often performs so well, it leaves the FTSE behind.
A group of these stocks outperformed the Blue Chip index by more than four times between 1997 to 2006. A very similar group has beaten the index by 35% between July 2006 and February 2009. And, as I’ll show you, I believe companies from this unique class are set to outperform the FTSE again. Now is a great time for you to own them.
I call them ‘innovator’ stocks. That’s because these companies invest heavily in innovation, even in recession. By doing so they are able to create new products and services and put themselves ahead of their less pioneering competitors.
Investors often confuse these innovators with the ‘dotcoms’ that crashed around the turn of the millennium. But the two classes of company are very different. Let me explain…
A good ‘innovator’ company invests in research and development (R&D) so that customers find its range of products and services to be superior to those of its competitors. It will have a robust business model which generates enough wealth to fund the R&D programme and provide growing sales and double digit profitability.
This is very different from the dotcoms. They had hopeful business plans, meagre sales and frequently no profits. When investors finally worked this out, dotcom shares crashed and burned. Most innovator stocks, however, have survived and prospered.
Take a look at the chart below reproduced from a government publication on research and development. It shows the value of a portfolio of FTSE 100 ‘innovator’ shares compared to the FTSE 100 from 1997 – well before the year 2000 and the dotcom crash – to 2006. The ‘innovator’ portfolio contains all the companies in the FTSE 100 with R&D of more than 4% of sales. No other selection criterion was used to pick them.
Innovator stocks beat the FTSE
As you can see, over the 10-year period 1997 to 2006, the FTSE went up by 16%. Meanwhile, the portfolio of R&D companies rose in value by 73%. In other words, the ‘innovator’ portfolio outperformed by four and a half times.
And what happened after 2006? A similarly selected FTSE 100 ‘innovator’ portfolio rose in value by 7% from July 2006 to February 2009 while the FTSE 100 fell by 28% over the same period. The ‘innovator’ portfolio outperformed by 35%.
The next key question to ask
In practice, an R&D company would never be selected as an investment for an ‘innovator’ portfolio solely on the basis of its R&D to sales ratio. But this ratio – the R&D intensity – is one valuable guide. I always use it as one of my selection criteria for sectors where R&D is a significant competitive factor.
You see, if a company has a high R&D intensity for its sector and has a record of good profitability and cash generation, it probably has a robust business model and an impressive product range. Add a strong balance sheet and you have the makings of a promising investment that could be very good value in a recession.
However, there should also be a clear reason why the business model works. Ask yourself why a growing number of customers will want to buy the company’s product or service and why it will have pricing power.
A good example was Xerox, a company I was fortunate enough to work for just over 30 years ago when it still had a market share of some 90% of the world dry copying market…
There were two keys to Xerox’s success. The first was its patented dry copying technology (xerography). But the second was the novel business idea of renting its machines to customers at low rents and charging them a per copy cost. This proved to be a master stroke because of the pent up demand for good quality copies in offices before personal computers arrived. The copy counter became a cash machine for Xerox. So Xerox became the growth sensation of the 1960’s and early to mid-1970’s.
This combination of a protected and highly effective technology with a novel route to market was unstoppable. Modern examples which have this combination – but not quite the stellar success of Xerox – include Apple’s iPod/iTunes combination.
The message for us as investors is to combine a deep understanding of a company’s business model with an informed analysis of its R&D and financial performance. If you can get that right and find good ‘innovator’ stocks, you could be well on the way to market beating investments.
I’m finding good opportunities in sectors as diverse as pharmaceuticals, health, industrial services and chemicals. These are the sectors to watch right now.
Kind regards,
Dr Michael Tubbs
For The Right Side
Editor’s recommendation: Michael Tubbs is editor of Research Investments. Click here to gain access to his current ‘innovator’ portfolio now.
Past Performance is not a reliable indicator of future results. Your capital is at risk when you invest in shares, never risk more than you can afford to lose.
MARKET NOTES
Why the property market is stuck in a rut
BY SHIVVY ARORA
If you thought the housing market slump was starting to ease, think again. The latest RICS (Royal Institution of Chartered Surveyors) survey shows that estate agents are still selling less than half as many properties as they were last year. And this is despite a 31% jump in buyer enquiries.
RICS has produced a useful housing indicator, shown in today’s chart. The ‘sales to stock ratio’ could show us when house prices will stabilise. It’s calculated by dividing the number of sales by the number of unsold properties. As sales drop, unsold stock goes up and this pushes the ratio down.
The housing market is still in the doldrums, with a low sales-to-stock ratio
Source: RICS
Rather than any specific level, we would want to see this figure rise higher – and sustain that level, before housing looks a safe bet again. You can see that this time last year (red circle) the ratio was just under 40. Since then, the market has been in freefall.
Don’t be fooled by the tiny recent upswing – this is only because the number of unsold properties has fallen harder than sales have. The crunch has been pushing landlords to let their properties rather than struggle to sell. This reduces the ‘stock’ figure, but it still means those properties remain unsold. They’ve just shifted onto the rental market. False sense of security, that…
Look how close the ratio currently is to December’s all-time low of 12.8 (blue circle). Homebuyers aren’t going to return to the market while they’re still unable to get mortgages. And sales will remain dismal until the economy starts to recover.
If the sales-to-stock ratio is anything to go by, the housing market is far from stabilising this year.
There is no Daily Reckoning today as Bill is out of email range in the mountains of South America.
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