“You were born to win, but to be a winner, you must plan to win, prepare to win, and expect to win.” ~ Zig Zigler
Some believe that innovation is not something that you can manage much less measure. I don't agree. Over the years, those of us in the innovation space have been looking for ways to understand the impact of our decisions on our respective organizations.
Guest: Steven Vannelli, Managing Director of GaveKal Capital
He oversees index creation. investment strategy, asset allocation, security selection and management of the investment team. His work is the core of GaveKal’s proprietary security selection models and indexes which are based on a novel approach to accounting for intangible capital.
Contact: GaveKal Capital website
Main points …
- There exists anomaly in the stock markets whereby companies successfully implementing an innovation strategy, over time, experience excess stock returns. In other words, companies employing an innovation strategy consistently exceed investors’ expectations and this is reflected in the stock price.
- Current accounting standards are an antiquated framework for evaluating highly innovative companies. They were developed in an industrial era where companies accumulated capital by buying it from other people.
- Highly innovative companies build their own capital, and that activity is poorly captured in current accounting conventions.
- Since 1974, the governing accounting body (FASB) has mandated that companies expense knowledge investments. This is ironic given this was 3 years after Intel released the 4004, the first commercially available semiconductor, launching us into the digital age.
- Accounting standards are a medium of communication between a company and its shareholders. When they distort or eliminate information relevant to investors, investors can make mistakes, resulting in highly innovative companies experiencing a potentially higher cost of capital and reduced access to capital.
- Evidence suggests that companies that choose to pursue an innovation strategy—rather than a mimicking strategy—experience more rapid sales growth, greater market share growth, less earnings variability, less stock price variability and greater long-term capital gains.
What's the history of research in this space?
- Baruch Lev began the body of research in 1993 by questioning the validity of the FASB decision compelling companies to expense innovation spending. By 2005, he offered the idea that all innovation spending wasn’t the same and some companies pursue and innovation strategy while other follow a mimicking strategy.
- While others may recognize the accounting conflict, we are the only firm that has a proprietary model to incorporate corporate knowledge investments into an accounting framework.
- We use this accounting framework and some basic screening criteria to identify the companies in the global developed and emerging stock market that are successfully employing an innovation strategy.
What's the time window for this increased performance?
- The academic literature suggests that there is a five year window of time after knowledge investments are made where companies experience excess returns.
Which companies make the cut and which do not?
- We use our knowledge adjusted framework here. We begin by transforming the financial history of over 3,000 companies into a knowledge-adjusted financial history.
- Next we apply a set of screening criteria focusing on a few types of variables. We are looking for companies that invest at least 5% of sale in intellectual property and where at least 5% of their assets are represented by intellectual property. We also consider profit margins, profitability and financial leverage.
- Companies that exceed all our minimum thresholds are deemed to be Knowledge Leaders.
- Knowledge Leaders tend to be most prevalent in innovation rich sectors like healthcare and technology. For example, most pharmaceutical and biotech companies are Knowledge Leaders.
- At the same time, there are companies in the healthcare sector that do not meet our criteria.
- While the familiar branded drug companies like Eli Lilly and Bristol Myers are Knowledge Leaders, the generic drug companies—like Mylan—who tend to follow a mimicking strategy, are not Knowledge Leaders.
What are a few examples of companies on their way out of Knoweldge Leader status?
- Some high profile examples of companies that are former Knowledge Leaders are Blackberry and Sony.
- In both instances it wasn’t that the companies stopped investing in intellectual property, rather they failed to execute on their innovation strategies. I think both of them intentionally or unintentionally stopped following an innovation strategy and fell into a mimicking strategy.
- So, this showed up as operating metrics that failed to reach our required thresholds. In both cases, operating cash flow margins and return on invested capital fell below our required levels.
- What this told us was that the company was failing to innovate successfully. They were no longer converting innovation into profits… rather they began to convert innovation into losses.
- Whether either company can retain the status of Knowledge Leader is up in the air, but I think Sony is the more likely candidate. They have improved their profitability and gotten back track from an operating standpoint. Now, they need to repair the balance sheet from the years where they tripped up. A little deleveraging and improved capital management, and we expect to see Sony among the ranks of the Knowledge Leaders again soon.
What three things leaders should keep in mind when thinking about innovation investment and stock price?
- The accounting framework is critically important to how an investor will view your company. Because it is rooted in an industrial-era mindset, it does a poor job of capturing the activities your highly innovative companies.
- Accounting conventions are a communication medium between your company and its shareholders. As a manager, you may have a certain perspective on how you are allocating capital. You probably believe you are investing in a portfolio of projects, where risks in one project are offset to some extent by successes on other projects. Sharing this perspective with your shareholders may be important. They are used to thinking in terms of diversification where specific risks in individual assets can be diversified successfully by investing in complimentary assets. Share your portfolio view rather than project view.
- While accounting conventions do not mandate any real disclosures about innovative activities, think about information to convey to your shareholders about your innovative activities. Depending on your industry, competitive dynamics and other factors, think about information that will help your investors understand your portfolio perspective, your vision for the future and why you’re spending money on various innovation initiatives. In general, more information is better than less, and the more information investors have about your company, the more likely your company is to experience excess returns as investors get a more complete picture of your vision.
Killer Question/Mind Hack
What features of my product create unanticipated passion?
What would you have to do to make your company, and its product, so essential to your customer that they would refuse to let your business die? Imagine that kind of passion for what you do. Imagine a customer base so emotionally invested that they will take on the huge technical challenge of keeping your product alive, long after common sense—and your board—declares it should die.
The Impossible Project is currently doing with Polaroid Company’s instant film division. In 2008, two men—one of them a long time Polaroid employee, the other a committed fan of analog photography—hear Polaroid was getting out of instant film. They said “NO” .. so they bought the relevant machinery from Polaroid, leased the plant and rounded up a core group of employees who’d worked in the instant film division. They then set about re-creating the instant film product from scratch.
On a rational level, Polaroid film is an obsolete product that has run its course. But on an emotional level it’s a “warm” product, which means that it is something that a substantial number of fans have a deeply emotional, rather than logical, connection to. Need proof? Just look at your home page on Facebook and see how many digital photo’s re-create the original Polaroid experience.
Corporate reasoning is that they could NOT continue to produce an obsolete product.
The Impossible Project was able to do is isolate the elements of the instant film business that still had value, emphasize them, and promote them to exactly the people who would recognize, appreciate, and pay for those values.
Polaroid’s decision to shutter their instant-film plant may have been the right one for them. However, it’s surprising that Polaroid was unable to understand, or leverage, their customers’ love for their product into
An emotional bond with your customer is essential to creating a “must-have” product. It’s tempting to think that this link only happens organically, but you can forge this connection in a strategic manner.
How?? By asking yourself …
- What are the features that have elicited the strongest emotional response from your customers?
- How do you ensure these are carried forward both in your current and future products?
- How do you avoid killing the passion?
- If you want to get connected, text the word INNOVATE to 33444 (in the US) or send an email to INNOVATE @ KillerInnovations.com
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