Investing Reinvented

Capturing Disruption in Companies and Portfolios

28 September 2021

9 min read

Erin Bigley, CFA| Chief Responsibility Officer

Christopher W. Marx| Global Head—Equity Business Development

In a world of pervasive innovation, investors need a new mindset to identify transformational companies and portfolio strategies with true return potential. But reaping the benefits of innovation also requires some old-fashioned fundamental sense.

Do flashy products or services that claim to change the world stand up to traditional business scrutiny? Are innovative funding structures capable of incentivizing good corporate behavior and producing solid returns over time? Will new trading technology create meaningful advantages for investors on the right side of change?

Dazzling investment fads aren’t always supported by strategic rationale. Still, innovation can be harnessed to capture powerful return sources and to create solutions to evolving investing problems. As always in investing, the secret to success is to ask the right questions and to take a sober look behind the hype to gain a comprehensive understanding of the latest developments.

How to Identify Investible Innovation

It’s perfectly natural for investors to get excited about the next big thing. Early investors who backed companies like Apple or Amazon.com and stuck with them enjoyed outstanding returns. Yet identifying successful innovators in hindsight is easy. It’s harder to find the most investible companies today, when countless firms say they are poised to disrupt a wide range of industries. Setting guidelines can help facilitate a successful search for innovation with return potential.

What features point to truly disruptive companies? Lasting innovators introduce features or attributes unquestionably different in a product, service or process. Many innovations offer evolutionary improvements on current products or processes. Breakthrough innovation refers to revolutionary developments like synthetic biology, electric vehicles (EVs), or true artificial intelligence and autonomous driving.

To be a successful investment though, a disruptive company needs a market with robust demand. Highly differentiated product sets add resilience to profitability and create high barriers to entry from new competitors. Companies that benefit from network effects—the tendency to exponentially expand customer reach, which drives future monetization opportunities—are particularly attractive. The sweet spots for successful investments often lie in the steeper portion of the innovation “S-curve,” or the rapid growth phase (Display).

Finding Attractive Investments on the Innovation S-Curve

Schematic graphic and S-shaped curve illustrates different stages of innovation from incubation to rapid growth to maturity.

Source: AllianceBernstein (AB)

For innovators, commercial success also requires exceptional management teams. When creating a new market, management must have vision and focus, always with an eye on competitive threats and a willingness to “self-disrupt” their own processes to stay ahead.

Enablers: Leaders Behind the Scenes

Don’t just be seduced by headline-grabbing products. Instead, look further afield as technology enablers are often a better source of investible innovation in public equity markets. Enablers might not have the sexiest products or services. However, these companies provide the underlying technology to power blockbuster products and burgeoning trends. As a result, they tend to benefit from powerful demand drivers. And because they don’t dominate the headlines or investors’ attention, they often offer much better valuations and long-term return opportunity.

For example, suppliers of car safety systems aren’t household names, but they are almost certain to benefit from steady growth as automatic braking systems and blind-spot detection systems become mainstream in vehicles. Sophisticated sensors are becoming commonplace in a wide range of products, from computers to trains to spacecraft. Companies that make components for the Internet of Things are well positioned to benefit from an increasingly interconnected world.

Platform companies that benefit from network effects are another wellspring of innovative potential. Network effects are the disproportional benefits generated by the addition of new users. Think about companies like PayPal and Salesforce.com; they function as matchmakers, reducing business friction as the number of participant connections grows. That helps grow a company’s total accessible market—and effectively lower transaction costs, which can stabilize revenues.

What’s the secret to success for high-density platforms? Leaders enjoy a protective supply and demand model that often assures consistently high return on invested capital and stable sales growth. Would-be disruptors struggle to cross an ever-widening network-effect moat. For example, in the US, Zillow’s online real estate database controls most of the country’s house listing supply and most of the viewer demand—a high barrier that new entrants can’t seem to clear. And great platform businesses tend to yield strong-performing stocks—not just among the few concentrated at the top but across a broad swath of global companies.

Emerging-Market Innovation: Not Just China

Innovation is no longer just a developed-market story. In emerging markets (EM), too, investors can discover abundant innovation. That’s why technology and internet-centric companies make up about 40% of the MSCI Emerging Markets equity benchmark—up from only 11% in December 2007.

Investors should look beyond the usual suspects for EM innovation. It’s not just about exports and it’s not just in China. The new wave of EM innovation is focused on developing new technologies for domestic use. Local internet companies are growing fast and establishing strong market positions in countries as diverse as India, South Korea or Russia. Poland’s Allegro, for example, is an internet shopping destination with a 33% market share of Polish e-commerce, well ahead of US competitors such as Amazon.

In fintech, India is one of the world’s fastest-growing markets. In 2020, India processed US$25.5 billion in real-time payments, according to ACI Worldwide. Banks in India are leveraging technology and big data to grow their business. For example, HDFC Bank has developed technology to approve personal loans for customers in as little as 10 seconds; its personal loan business grew over 12% year over year in April 2021.

Green Revolution Drives Change

Innovation is not only driven by technological change. Sometimes social change, like increased environmental attention, can drive change. In both emerging and developed markets, growing global efforts to combat climate change are creating fertile ground for innovators. For example, although EVs are still a niche product today, with only 7 million vehicles in the global fleet of 1.6 billion, technological breakthroughs are widely expected to promote a huge increase in adoption. By 2030, we expect 200 million EVs on the road around the world. The beneficiaries of this shift will be not only EV manufacturers, but also auto-parts suppliers, battery-makers and certain semiconductor companies that are enabling the transition.

In the rapidly evolving world of climate solutions, many companies are pioneering completely new industries with rapidly growing demand drivers. Investors can take innovative approaches to find them, for example, by searching for companies with formidable carbon handprints. In contrast to carbon footprints, which measure the negative impact of companies on the environment, companies with carbon handprints are creating positive solutions to global climate challenges. Companies with formidable carbon handprints will be at the forefront of efforts to reduce the world’s carbon intensity. Many offer products and services that will facilitate the transition to a low-carbon economy or help communities become more resilient against the physical effects of climate change. Examples include companies providing decarbonization solutions for clean energy, resource efficiency, transportation and sustainable agriculture, as well as resiliency solutions for water and infrastructure.

Novel Funding Models and Portfolios

Alongside the vibrant innovation driven by companies, the financial sector is rapidly offering new ways for companies to raise money and for investors to back them.

In equity markets, special purpose acquisition companies, known as SPACs, have become wildly popular on Wall Street over the last year as an alternative to initial public offerings (IPOs). In this model, investors fund a “blank check” company with the intention of purchasing a yet-unnamed privately held company and taking it to market. SPACs have helped hundreds of companies find a speedier path to market than traditional IPOs, but they also have a complicated financial structure and present risks to the initial financial backers—who don’t know what the target company will be. Although SPACs have existed for some time, their recent popularity surge demonstrates the market’s growing appetite for innovative funding structures that break through established Wall Street norms. While the SPAC boom is opening up exciting new funding opportunities for innovative companies, investors must approach these deals with caution and be aware of the risks, as they are typically signing a blank check for a target company to be determined later.

Fixed-income investors are also seeing big changes in issuance structures, particularly when it comes to environmental, social and governance (ESG) bonds. While green bonds to finance a specific environmentally focused project or projects have been around since 2007, the concept has been expanded and enhanced in recent years. Today, investors can also buy bonds that are dedicated to social projects—such as new buildings for communal benefit, educational programs for underprivileged demographics and more hospital beds for low-income areas. Green and social bonds offer the ability to marry an investing strategy to a project aligned with a responsible investing agenda (Display).

ESG Structures: The Landscape

Analysis is for illustrative purposes only and is subject to revision.
As of May 17, 2021
KPI denotes key performance indicators; ICMA denotes International Capital Market Association; GBP denotes Green Bond Principles; and SBP denotes Social Bond Principles
Source: AllianceBernstein (AB)

Bonds with key performance indicators (KPIs) were introduced in recent years, which penalize companies for not meeting explicit sustainability goals. These are different from the project-specific green bond format by linking a company’s sustainability goals to its bottom line. For example, in 2020, Italian utility Enel issued a bond that pins the company’s renewable energy goals to its bottom line. If Enel falls short of having 55% of its electricity generation capacity in clean energy by the end of 2021—up from 46%—the bond’s coupon rises by 0.25%.

Innovations in this area could get a boost if companies begin to set ambitious KPIs and convert the majority of their capital structures to such bonds. A components manufacturer recently committed to a sustainability performance target featuring a greater-than-20% reduction in greenhouse gas emissions within 10 years—an ambitious target in the context of its industry peers. Further, the company has committed to future bond issues in the same format as part of its long-term strategic plan.

Companies that fail to achieve the KPI within the specified timeline are penalized with a coupon step-up on the bond. Accordingly, investors must research the company’s overall sustainability strategy and determine whether the KPI aligns with that goal.

For all ESG-related bonds, investors must be vigilant about greenwashing. That means making sure that the issuer’s projects are genuinely environmentally beneficial and not misrepresented. Metrics established for a project’s impact report should be specific, material and credible. This is especially important in KPI-linked structures, where companies have much more flexibility around the use of proceeds. Innovative bond structures cannot deliver returns or ESG results automatically, but rather, require comprehensive due diligence and engagement with management on the part of investors.

Even without a KPI structure, bond investors are finding new ways to align their financial goals with social and environmental initiatives. In the US, some municipal bonds issued by state and local entities are designed with specific impact goals in mind, such as ensuring safe drinking water or helping underserved kids. For example, in 2019, the Essex County Improvement Authority issued $70 million in municipal bonds to mandate the replacement of 18,000 lead water service pipes that risk the health of thousands of Newark residents. So far, nearly 21,000 lines have been swapped out. Last year, the Arizona Autism Charter School in Phoenix issued $9 million in muni bonds to renovate and add facilities.

Keeping Up with Innovation

With so much innovation unfolding across companies, portfolios and asset classes, investors may struggle to keep up with the pace of change. Innovation is indeed everywhere, affecting everything from the company held in your portfolio on the other side of the world to the trading systems that turn over securities every day and the growing range of strategies on offer.

Advanced technology can help bond managers scan the entirety of the bond market in real time, suggest potential trades, build out trades in seconds and invest new portfolios more quickly. Three years ago, it took an average of 35 days to get a new credit or emerging-market debt portfolio 90% invested. Today, that can be accomplished in half the time—if bond managers have mastered the tech revolution. And every extra day those assets are invested amounts to more interest earned. Lastly, cutting-edge tech allows traders to cut through the noise of thousands of bonds trading at any given time to find opportunities and source liquidity. In contrast, bond managers who don’t have the right tech will fall rapidly behind in the post-pandemic world.

Innovation in trading, investing or portfolio structures, however, is only as good as its ability to help meet investment goals. By keeping that principle front and center, we believe investors will be able to distinguish between changes that will end up as footnotes to market history and those that will deliver lasting improvements to long-term performance and the consistent achievement of strategic objectives.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to revision over time.

About the Authors

Erin Bigley, CFA

Erin Bigley is a Senior Vice President, AB’s Chief Responsibility Officer, and a member of the firm’s Operating Committee and Women’s Leadership Council. In this role, she oversees AB’s responsible investing strategy, including integrating material environmental, social and governance considerations throughout the firm’s research, engagement and investment processes. Bigley joined the firm in 1997 and previously served as a portfolio manager and trader for the global and Canadian bond strategies. She spent two years based in London as the global head of Fixed Income Business Development for institutional clients. Bigley served as a fixed-income senior investment strategist for over a decade, and as head of the strategist team from 2018 to 2021. Prior to taking her current role, she served as head of Fixed Income Responsible Investing, overseeing the Fixed Income team’s responsible investing strategy. Bigley holds a BS in civil engineering from Villanova University and an MBA from the Massachusetts Institute of Technology’s Sloan School of Management. She is a CFA charterholder. Location: New York

Christopher W. Marx

Christopher W. Marx is Senior Vice President and Global Head of Equity Business Development. He is responsible for overseeing the firm's team of equity investment strategists and product managers, setting strategic priorities and goals for the global Equities business, developing new products, and engaging with clients to represent market views and investment strategies of the firm. Previously, Marx was a senior investment strategist and a portfolio manager of Equities, and in 2011 he cofounded the Global, International and US Strategic Core Equity portfolios with Kent Hargis. He joined the firm in 1997 as a research analyst covering a variety of industries both domestically and internationally, including chemicals, metals, retail and consumer staples. Marx became part of the portfolio-management team in 2004. Prior to joining the firm, he spent six years as a consultant for Deloitte & Touche and Boston Consulting Group. Marx holds a BA in economics from Harvard University and an MBA from the Stanford Graduate School of Business. Location: New York