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Can Innovation Overcome Adversity?

Market conditions in 2022 have been difficult for all assets classes, with double-digit declines across the board. It has especially been difficult for the technology sector, as multiples expanded to record highs during the COVID pandemic only to adjust dramatically. The first adjustment was a normalization to prior period levels followed by a decline in keeping with general markets. This performance invokes comparisons to the Dot-com days of the early 2000s and prompts many questions.

November 2022

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Malcolm White

CFA, Portfolio Manager, Global Equity

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We asked tech guru and BMO GAM Portfolio Manager Malcolm White, who was managing money during that period, to provide an overview of the historical parallels. Additionally, he comments why innovation investing is different and how institutions can navigate hype curves.

History never repeats itself, but it often rhymes.

- Mark Twain

Although there were significant differences between the Dot-com era, there was a sense of déjà vu for veteran innovation investors. Notably, easy money from accommodative global central bankers and jubilant capital raising rounds were both similar factors that contributed to multiple expansion of stocks.

Table 1- A Comparison between the Dot-com and COVID Eras

Factor Dot-com Era (1999-2000) COVID Era (2020-2022)
Easy Money Yes – Fed had eased aggressively and was concerned about Y2K Yes – QE compounded by Fed stimulus to counter COVID
Speculation Yes – The technology predicted was a decade away and thus highly speculative. No – The technology from these companies was in widespread commercial use except crypto
Robust Capital Raising Yes – several IPOs a week Yes – several IPOs and even more aggressive funding with SPACs / crypto tokens.
Market Correction Declines were largely tech-centric, value stocks performed much better on a relative basis. All risk assets sold off including bonds, equities and currencies as inflation drove the risk-free rate higher in USD terms.
Valuations Higher, more aggressive, shortly lived and corrected quicker Broader base of mega-cap tech provided a more stable core despite declines in the high-growth segment

Source: BMO Global Asset Management

The underlying investment environments were quite different. The Dot-com era was far more speculative, as the technology upon which it was based was almost ten years away from commercialization. In contrast, the impact of COVID-era innovation (e-commerce, videoconferencing, pervasive device connectivity) was well known and highly welcomed as a means of being productive during the lockdowns. The exception to this was cryptocurrencies, which were not ready for commercial adoption.

Although both eras felt the impact of a market correction, investors in 2000 could easily sidestep the technology sector and create defensive portfolios in other industries using value stocks. In contrast, there was no place to hide in 2022 as out-of-control inflation forced all global central banks to hike risk-free rates as a countermeasure. This put pressure on all assets as valuations reset to reflect a higher interest rate level.

The valuation impact in both eras was also different. As shown in Figure 1, a vast majority of Dot-com companies traded at much higher multiples and nearly 50% were at an unsustainable level. The correction that ensued was sharp and swift. In contrast, COVID-era valuations were more distributed with a smaller percentage trading at high levels. Structurally, today large trillion-dollar mega capitalization entities (e.g., Apple, Microsoft, Alphabet) now anchor the valuation landscape and are less susceptible to dramatic market swings.

Figure 1- Historical Distribution of Technology Valuation Multiples (1970-2022)

Accurate predictions, incorrect timing: Lessons from a lost decade (2001-2011)

Investor appetite for innovation today is also different than during the aftermath of the Dot-com era. This can be explained by what transpired after the Dot-com correction. Although investors had a poor investment experience in 2000 due to high expectations and hype around the potential impact of these nascent technologies, the seemingly outlandish predictions of that period eventually came true. Remember these concepts were all considered moonshots at the time. Today we can do all our shopping online; we can run any application online using cloud computing; we did develop ubiquitous devices and affordable high-speed networks to serve the internet across the globe. Those that bet against innovation were proven wrong and found themselves at odds with the market at the end of lost decade (2011). The market reset coupled with a decade of behind-the-scenes growth in innovation provided a backdrop for attractive investment returns in the following decade.

Investors realized that emotional factors can come into play and expectations around adoption curves are almost always too optimistic. They learned to deconstruct the investment opportunity into a hype cycle, as coined by Gartner, that starts at the earliest awareness of a technological innovation. Although this will ultimately disappoint, leading to substantial investment losses, it is followed by a period where exponential growth of a technology accelerates its commercialization. While it is possible to invest at all stages of the curve, the optimal time for risk-adjusted returns is the intersection of maximum pessimism and early commercialization, as shown in Figure 2. However, this is psychologically difficult, hard to time, and challenges a traditional buy-and-hold approach.

Figure 2- Deconstructing Innovation Investment Cycles

Source: BMO Global Asset Management.

Innovation Investing Requires a Different Lens

The second realization was that traditional approaches did not work well when valuing innovation. This was first realized by NYU Stern Professor Aswath Damodaran during the Dot-com era. He literally wrote the book on how to value companies1 and realized that the traditional valuation framework makes several assumptions that do not hold for emerging businesses. BMO GAM Technology Portfolio Manager Jeremy Yeung was asked to discuss these significant differences, outlined in Table 2, at a CFA Society Conference in 2020.

The conclusion: Professor Damodaran recognized that a different valuation framework was needed2, one that could deal with different growth assumptions such as the sigmoid curves (S-curves) seen in numerous new technological adoption trends over the past century. While this was a powerful new framework, the notion that the “old valuation metrics are not applicable” verges precariously on the erroneous assumption that “valuation need not apply.” Valuation metrics do apply and there are times in the hype cycle where the implied value of the future growth option for the company is trading at an unjustifiable premium and the investment should be sold. However, it is extremely difficult to deduce this without the proper expertise and experience.

Table 2 - Fundamental Differences Investing in Innovation vs Mature Markets

Factor Mature Markets Innovation Investing
Revenue Growth GDP-like growth Hyper to fast growth
Profitability High and predictable Uncertain in size and timing
Total Addressable Market (TAM) Predictable Unknown and disruptive
Competition Known incumbents Early innovators have limited or unknown competitors
Volatility Low High – follows Hype Cycle
Efficient Market Yes No
Valuation Quantifiable Option-based / Uncertain

Source: BMO Global Asset Management.

Adversity Creates Opportunity

The frustrating part of innovation investing during the COVID era was that investors had learned many lessons from the Dot-com days. Innovation was delivering astounding levels of viable, commercial technology in 2020 and 2021. Revenue growth was also at an all-time high during this period. Because of COVID lockdowns, consumers were forced to accelerate their own personal technology adoption curves. Corporations took a leap forward as well. Microsoft CEO Satya Nadella told the investment community that COVID was bringing in “two years of digital transformation in two months.”3

It is no surprise that investors wanted immediate exposure to this dynamic and were willing to pay anything. Early-stage companies were more than eager to come to market early to take advantage of these unsustainable multiples. However, uncontrollable inflation and the subsequent Fed response spoiled the party by taking away all the free money.

As the market closes a tough year, we need to ask question about what the future holds for innovation investing. Are we going to have another lost decade for investors? As a leading sector, technology was the first to witness high inflation caused by supply chain disruptions and elevated wage growth due to talent shortages (War for Talent). This is currently reversing as semiconductor lead times shrink and layoffs occur in previously overheated areas. While seemingly bad news, this may turn out to be good news if it is a precursor to a more dovish approach from global central bankers. This would provide a constructive setup for future investment returns.

We hope that history will rhyme as we look for signposts on the road to recovery. Specifically, we hope that innovation will serve as a bright light and power us through these times as it did post the Dot-com days. Early signs are promising. Last year researchers at DeepMind (acquired by Google) developed an AI-based application that can deduce the incredibly complex structure of 3D proteins. The existing process to do this is prohibitively costly and can take years—the AI application can solve the problem in minutes. This is a revolutionary step towards more health care solutions. Proteins are the key to unlocking vaccines for COVID in addition to several other critical life-sustaining applications. This innovative application has added more than 200 million predictions to a freely available online database, altering the course of biological research and accelerating the timeframe for new medicines.

So even as we dwell in the trough of disillusionment in 2022, innovation reminds us again that its growth is independent of the economy and that fantastic commercial potential still awaits us in the decade ahead. This gives us hope in the midst of adversity.

BMO GAM is fully committed to supporting innovation and has made numerous investments to expand its capabilities. Please contact your BMO Global Asset Management wholesaler to learn more about our innovation initiatives and how our global equity teams can assist you by sharing their extensive sector knowledge, expertise and experience.

BMO Global Innovators Fund - Fund Codes & Fees

Series Fund Code MER*
Advisor FE / US$ FE BMO99164 / BMO79164 (USD) 2.10*
T6 FE BMO34269 2.10*
Series F / US$ BMO95164 / BMO40164 0.99*
Series F6 BMO36164 0.99*

*Management Expense Ration (MER) is estimated as Fund is less than one year old.

1 His textbook “Investment Valuation” has been required reading for the Chartered Financial Analyst designation

2 "The Dark Side of Valuation", Aswath Damodaran




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