Innovative and disruptive companies can be a source of durable income
Equity investors have always had a strong affinity with dazzling innovations and are drawn to them like moths to a flame. History is littered with examples of high expectations leading to steep valuations and dashed hopes, from the Railway Mania of the 1840s, to the RKO radio boom of 1928, the Dotcom bubble and, more recently, in the early days of genomics.
A succession of monumental breakthroughs has yielded amazing benefits for society, but most have taken a lot longer to come to fruition than impetuous investors initially suspected. Bill Gates’ observation that we “…always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten…” is oft-repeated. His following words are usually omitted: “Don't let yourself be lulled into inaction.”
After the equity market carnival has moved on, the less glamorous, laborious and time-consuming work of implementing disruptive innovations gets under way. The real long-term benefits of an innovation often accrue to what I call the “quiet disruptors”, companies that put in the leg-work of applying innovation in practical ways that make a real difference. The second mouse gets the cheese.
“Innovative” and "disruptive” are two adjectives that rarely surface in the context of equity income investing. Higher dividend stocks are often assumed to be twilight companies in sunset industries that are seeing out their remaining days in quiet dotage or are likely to find themselves on the wrong side of history as the world moves towards a low-carbon economy.
This is partly due to equity markets’ (and the media’s) bifurcation of companies into opposing camps of predators and prey, old and new economy, disruptors and the disrupted, all of which makes for a dramatic narrative but is usually an oversimplification. In applying our thematic investment process, we have identified a category of companies that are behind-the-scenes, quiet disruptors with established and growing businesses, where investors can be on right side of history and benefit today from healthy cashflows, profits and dividends.
When investors think of innovative disruptors, it is usually long-duration, higher volatility, higher return stocks that spring to mind. These are the “extrovert” disruptors beloved of high conviction growth investors. Some of these companies have produced incredible risk-adjusted returns and become household names in the process, and many more will in future. However, they are not what we are seeking to include in our clients’ equity income portfolios.
Quiet disruptors, by contrast, present a very different risk profile that sits near the opposite end of the equity risk spectrum.
Their lower risk and lower return profile is more typical of mature cyclical or defensive franchise companies. To many investors they do not look like disruptors and the full implications of the innovations that they are applying in their businesses are often missed.
Our experience in running global thematic equity income mandates over the past 15 years has taught us that these less-volatile, quiet disruptors produce superior risk/returns over time, not least because the market underestimates their potential and misprices them accordingly.
Strength in diversity
The quiet disruptors that we identify all tend to provide durable income streams from businesses that can look forward to long-term organic growth but, as a result of our thematic approach to idea generation, they hail from very different industries. This is clearly desirable in ensuring that we are able to provide well-diversified, resilient portfolios.
One example is Air Liquide, the world’s second-largest supplier of industrial gases and part of our Climate Change investment theme. The company doesn’t garner the lofty valuations of a fuel cell start-up company but it is instrumental in expanding the world’s ability to generate clean hydrogen, which will be in increasing demand as an alternative energy source in industry and transportation. In addition to being a central player in a key industry of the future, Air Liquide‘s business has proved to be robustly defensive in economic and market downturns.
Turning to our Ageing investment theme, Medtronic is a US-based company that specialises in minimally invasive surgery, miniaturisation of medical devices and medical robotics. Medtronic’s development of its Hugo device brings welcome competition to robotic surgery. This is raising the pace of innovation and, we believe, will give patients around the globe unprecedented access to surgical skills at relatively low cost.
A third quiet disruptor is DS Smith, the second-largest producer/supplier of corrugated packaging in Europe and a Sarasin portfolio holding under our Evolving Consumption theme. DS Smith’s innovative approach to circular-use packaging is enjoying strong organic growth due to e-commerce and demand for recyclable/reusable packaging. DS Smith is committed to manufacturing 100% recyclable or reusable packaging by 2023 and aims for all its packaging to be recycled or reused by 2030.
Income investors DO have a choice
Most investors want to do the right thing. Anyone who doubts this need look no further than the vast sums that have flowed in recent years into funds that offer an ESG focus. When it comes to equity income investing, however, many fund managers are curiously content to retain exposure to high dividend payers in harmful industries such as traditional energy and tobacco.
Some may believe that they will be able to exit these companies before the music stops – or perhaps they hope that the music will never stop. To our mind, neither of these positions is defensible for any asset manager who is engaged as a long-term steward of their clients’ capital.
Income investors do have an alternative to traditional income stocks, and the long-term performance of funds such as the Sarasin Global Higher Dividend and Global Dividend funds bears testament to this. We passionately believe that income-orientated stocks can be interesting and disruptive. We thoroughly enjoy the challenge of seeking new income ideas for our clients among overlooked quiet disrupters.
If you are a private investor, you should not act or rely on this document but should contact your professional advisor.
Sarasin Global Higher Dividend (Sterling Hedged) merged with Sarasin Global Higher Dividend 23.10.20.
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