Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 165

Innovation offers opportunities for investors

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.

 

RELATED ARTICLES

Thinking small to win big

Bounce back delivers super second-half for IPOs

Unconstrained growth found in fresh places

banner

Most viewed in recent weeks

Vale Graham Hand

It’s with heavy hearts that we announce Firstlinks’ co-founder and former Managing Editor, Graham Hand, has died aged 66. Graham was a legendary figure in the finance industry and here are three tributes to him.

The nuts and bolts of family trusts

There are well over 800,000 family trusts in Australia, controlling more than $3 trillion of assets. Here's a guide on whether a family trust may have a place in your individual investment strategy.

Welcome to Firstlinks Edition 583 with weekend update

Investing guru Howard Marks says he had two epiphanies while visiting Australia recently: the two major asset classes aren’t what you think they are, and one key decision matters above all else when building portfolios.

  • 24 October 2024

Warren Buffett is preparing for a bear market. Should you?

Berkshire Hathaway’s third quarter earnings update reveals Buffett is selling stocks and building record cash reserves. Here’s a look at his track record in calling market tops and whether you should follow his lead and dial down risk.

Preserving wealth through generations is hard

How have so many wealthy families through history managed to squander their fortunes? This looks at the lessons from these families and offers several solutions to making and keeping money over the long-term.

A big win for bank customers against scammers

A recent ruling from The Australian Financial Complaints Authority may herald a new era for financial scams. For the first time, a bank is being forced to reimburse a customer for the amount they were scammed.

Latest Updates

Shares

Looking beyond banks for dividend income

The Big Four banks have had an extraordinary run and it’s left income investors with a conundrum: to stick with them even though they now offer relatively low dividend yields and limited growth prospects or to look elsewhere.

Exchange traded products

AFIC on its record discount, passive investing and pricey stocks

A triple headwind has seen Australia's biggest LIC swing to a 10% discount and scuppered its relative performance. Management was bullish in an interview with Firstlinks, but is the discount ever likely to close?

Superannuation

Hidden fees are a super problem

Most Australians don’t realise they are being charged up to six different types of fees on their superannuation. These fees can be opaque and hard to compare across different funds and investment options.

Shares

ASX large cap outlook for 2025

Economic growth in Australia looks to have bottomed, which means it makes sense to selectively add to cyclical exposures on the ASX in addition to key thematics like decarbonisation and technological change.

Property

Taking advantage of the property cycle

Understanding the property cycle can be a useful tool to make informed decisions and stay focused on long-term goals. This looks at where we are in the commercial property cycle and the potential opportunities for investors.

Investment strategies

Is this bedrock of financial theory a mirage?

The concept of an 'equity risk premium' has driven asset allocation decisions for decades. A revamped study suggests it was a relatively short-lived phenomenon rather than the mainstay many thought.

Vale Graham Hand

It’s with heavy hearts that we announce Firstlinks’ co-founder and former Managing Editor, Graham Hand, has died aged 66. Graham was a legendary figure in the finance industry and here are three tributes to him.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.