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The Secret to Innovation Investing

Technology valuations have compressed sharply this year as central bankers hike rates to curb inflation. Despite macro-related headwinds, the pace of innovation continues to accelerate independent of the economy. BMO Global Innovators Fund portfolio managers Malcolm White and Jeremy Yeung are looking past the volatility of current markets and towards the decade ahead when these emergent technologies will be commercialized in what they describe as the next industrial revolution.

December 2022

Malcolm White

CFA, Portfolio Manager, Global Equity

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Jeremy Yeung

Portfolio Manager, Global Equity

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Key Takeaways

  • The BMO Global Innovators Fund searches the globe to seek leaders in innovative products and services.
  • Innovation is expanding everywhere as more industries undergo a digital transformation accelerated by the pandemic.
  • Volatility within innovation-based portfolios needs to be actively managed and these managers have developed a capital allocation process to target a medium-risk profile.

1. You recently transitioned to BMO Global Asset Management and took on the challenge of creating the new BMO Global Innovators Fund. Can you take us through your investment process and describe what that it has been like?

MW We have been investing in innovation for decades even before the dot-com era. Investors have always told us that they love the underlying theme of innovation, but they wanted a lower risk rating (from high) and found a sector classification restrictive. We listened and so did BMO when we created this product. Innovation is not bound by constraints so why should we be? Every sector and every company is transforming itself to become a digital business and we wanted to capture this with a global equity category classification versus sector. To lower the high-risk rating, we developed proprietary tools that adjust the weights of our best ideas to target a medium risk rating. We feel that this captures the sweet spot for investors.

2. As experienced innovation investors, what do you see as the most important emerging themes over the next 10 years?

MW We used to joke about AI not working for decades (the AI winter). But as we joked, several critical academic and technical breakthroughs occurred in the background. The result today is that AI has achieved mastery of many imaging and language tasks. The decade ahead will be about the commercialization of these breakthroughs. This forms the foundation of what we believe will be the next industrial revolution. This won’t be powered by steam or electricity or industrial robots but instead will be fueled by replacing aspects of human intelligence with AI. We call this cognitive automation.

JY Another area of interest is the next generation of the internet - Web 3.0. To be clear, we’re not excited about speculative cryptocurrencies but rather the evolution of internet services from a Web 2.0 smartphone era. Content creators will be to sell digital products to consumers directly and bypass intermediaries and the app store tax of 30%. It will take time but there are mechanisms emerging for new forms of monetization that can apply to many different products and services beyond movies, music or digital art.

3. You’ve previously said that “innovation is everywhere,” in the sense that it’s not bound to a narrowly defined Technology sector. What is your process for identifying the best investment opportunities?

MW Investment collaboration across industries plays to the strengths of BMO Global Asset Management. A great example of technology impacting other sectors is the product created by DeepMind, an AI-based, protein-folding prediction algorithm. Given a string of amino acid inputs, it figures out what its 3D protein would look like. What previously took years of research and millions of dollars can be done in 10 minutes. Proteins are the action mechanism of the body. While we are the experts on AI, proteins are not our area of expertise. To understand the many ramifications of this discovery and how it can accelerate future drug development efforts, we are fortunate to have fellow BMO GAM PM Dr. Jeff Elliott on our team whose PhD was based on protein engineering. This is a great example of collaboration within our group. Additionally, we have access to many external experts thanks to the global innovation network we have built over the past two decades.

JY We call our investment process ‘Alpha Engines.’ While our day job is to research public companies, our investment pipeline starts by looking at early-stage private companies. We are privy to ‘testing-the-waters’ meetings, engaging with firms right before they are going to go public. That gives us a competitive advantage. And more importantly, we get to understand the trends and business models of these companies at their nascent stage.

4. We’ve seen massive drawdowns in many technology and innovation stocks this year as central bankers, led by Fed Chairman Jay Powell, have lifted interest rates to cool economies. You’ve pointed out that innovation tends to continue independent of the economic backdrop. Can you explain?

MW If you look at transistor growth as a proxy and precursor for innovation, you find that during the global financial crisis or COVID pandemic, the growth of microprocessor transistors continued at a compound rate of 38% in both these periods. This occurred despite enormous macroeconomic pressure, problematic access to capital, and financial institutions going bankrupt. That transistor growth created faster and cheaper chips that industry leaders leveraged to create better smartphones, cloud services and AI applications to further accelerate the innovation cycle. Both periods serve as great examples of how innovation can be independent of economic conditions.

5. Looking at the fundamentals of many high-innovation stocks and their trading levels, are there buying opportunities or are stretched valuations still a concern?

JY With COVID, technology companies benefited from many tailwinds as the world went digital Two years of innovation were essentially pulled forward into two months. Investors paid for growth and multiples expanded to all-time highs. As the Fed started to raise rates last year, we saw those multiples collapse. And we’re now seeing the earnings compression. What is clear is that investors are demanding a focus on unit economics and profitability. That was evident in what we saw from Meta this past quarter. Mark Zuckerberg kept his capital expenditures high and basically said they weren’t going to hire but stopped short of saying they were going to cut jobs. Compare that to Intel, which also missed numbers, but said they were going to trim 20,000 positions and reduce operating expenses by $8 billion. That stock went higher. So, what’s clear now is a focus on sustainable profitability. As we develop our portfolio, we're looking for good stewards of capital that are going to act in our best interests as shareholders.

6. You experienced the bursting of the tech bubble in early 2000 firsthand when firms like Nortel and other dot-coms lost billions. What lessons did you learn from that experience?

MW Nortel significantly impacted all Canadian investors and it is a lesson one cannot forget. While investing in innovation and growth has tremendous merits and potentially high returns, investors may not recover from one very bad experience. So the most important thing we have to do is manage volatility. Yes, we have to capture the upside when market conditions are good but we also must protect against the inevitable downside. Fortunately, this is the twentieth market crisis of my career and the team has learned when to pivot our view. This explains our high turnover as we are not buy-and-hold investors. I stress the “we” as it is a big advantage to have two managers, both with decades of experience in innovation investing, who collaborate well to navigate constantly changing market conditions.

7. There are several macro headwinds that money managers are paying close attention to right now, not the least of which is tightening monetary policy. What are your top concerns at the moment, and how do they influence your asset allocation decisions?

MW Most agree that the global economy cannot handle these interest rate levels. This is the intent of the world’s central bankers – raise rates to trigger an economic downturn that will tame inflation. Looking through this, we have identified the signposts we need to see on the inevitable road to recovery. Firstly, valuations need to reset to lower multiples – this has largely occurred. Next, earnings need to be adjusted downwards to reflect weaker economic activity – this is occurring now. Consumer credit and currency impacts are the next factor to address likely next year. Fortunately, banks are well capitalized in this downturn. These are concerns we need to address before we see the light at the end of this tunnel.

JY One other macro headwind that we're paying a lot of attention to is the U.S.-China tech war. The implications are huge. 20% of tech manufacturing is moving out of China right now, shipping capacity to India, Thailand, Indonesia, Malaysia, Vietnam, and the Philippines. There’s going to be higher costs, and the impact to public companies is on our radar.

8. Lastly, we often ask investment strategists to provide a book or podcast recommendation for our Advisor audience. What have you read or listened to lately that’s informed your worldview?

MW The Man Who Solved the Market: How Jim Simons Launched the Quant Revolution by Gregory Zuckerman. I do a lot of machine learning and AI, and I'm just really impressed by it. Simons’ company is the gold standard for mathematical models and understanding the market.

Please contact your BMO Global Asset Management wholesaler for any support and guidance.

BMO Global Innovators Fund



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