“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 aninnovation strategy, over time, experience excess stock returns. In other words, companiesemploying an innovation strategy consistently exceed investors’ expectations and this isreflected in the stock price.
- Current accounting standards are an antiquated framework for evaluating highly innovativecompanies. They were developed in an industrial era where companies accumulated capital bybuying it from other people.
- Highly innovative companies build their own capital, and thatactivity is poorly captured in current accounting conventions.
- Since 1974, the governing accounting body (FASB) has mandated that companies expenseknowledge investments. This is ironic given this was 3 years after Intel released the 4004, the firstcommercially available semiconductor, launching us into the digital age.
- Accounting standards are a medium of communication between a company and itsshareholders. When they distort or eliminate information relevant to investors, investors canmake mistakes, resulting in highly innovative companies experiencing a potentially higher costof capital and reduced access to capital.
- Evidence suggests that companies that choose to pursue an innovation strategy—rather than amimicking strategy—experience more rapid sales growth, greater market share growth, lessearnings 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 decisioncompelling companies to expense innovation spending. By 2005, he offered the idea that allinnovation spending wasn’t the same and some companies pursue and innovation strategywhile other follow a mimicking strategy.
- While others may recognize the accounting conflict, we are the only firm that has a proprietarymodel to incorporate corporate knowledge investments into an accounting framework.
- We use this accounting framework and some basic screening criteria to identify the companiesin the global developed and emerging stock market that are successfully employing aninnovation strategy.
What's the time window for this increased performance?
- The academic literature suggests that there is a five year window of time after knowledgeinvestments 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 financialhistory 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 forcompanies that invest at least 5% of sale in intellectual property and where at least 5% of theirassets are represented by intellectual property. We also consider profit margins, profitabilityand 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 andtechnology. 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 KnowledgeLeaders, the generic drug companies—like Mylan—who tend to follow a mimicking strategy, arenot Knowledge Leaders.
What are a fewexamples of companies on their way out of Knoweldge Leader status?
- Some high profile examples of companies that are former Knowledge Leaders are Blackberryand Sony.
- In both instances it wasn’t that the companies stopped investing in intellectual property, ratherthey failed to execute on their innovation strategies. I think both of them intentionally orunintentionally 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 bothcases, 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 nolonger 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 thinkSony is the more likely candidate. They have improved their profitability and gotten back trackfrom an operating standpoint. Now, they need to repair the balance sheet from the yearswhere they tripped up. A little deleveraging and improved capital management, and we expectto see Sony among the ranks of the Knowledge Leaders again soon.
Whatthree 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 activitiesyour highly innovative companies.
- Accounting conventions are a communication medium between your company and itsshareholders. As a manager, you may have a certain perspective on how you are allocatingcapital. You probably believe you are investing in a portfolio of projects, where risks in oneproject are offset to some extent by successes on other projects. Sharing this perspective withyour shareholders may be important. They are used to thinking in terms of diversificationwhere specific risks in individual assets can be diversified successfully by investing incomplimentary 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 informationthat will help your investors understand your portfolio perspective, your vision for the futureand why you’re spending money on various innovation initiatives. In general, more informationis better than less, and the more information investors have about your company, the morelikely your company is to experience excess returns as investors get a more complete picture ofyour 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?? Byaskingyourself…
- 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?
Show Notes:
- If you want to get connected, text the word INNOVATE to 33444 (in the US) or send an email to INNOVATE @KillerInnovations.com
- Download the mobile app
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