Update & Outlook for Innovation Investing

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During our inaugural Innovation Sessions ZOOM call, Portfolio Manager and CIO Tom Ricketts, CFA of Evolutionary Tree Capital Management shared his perspective on the difficult environment for faster-growing, higher-valuation growth stocks and his outlook for innovation investing in 2022. 

TOP TAKEAWAYS » 

1. Investors remain hyper-focused on the potential risk of higher interest rates and rising inflation and the headwind this has created for growth stocks. Additionally, during the past earnings season investors maintained a high bar and were ruthless to any company that lowered guidance, heavily pressuring their stock prices. Some long-term perspective:

  • While interest rates have walked higher, they have moved from abnormally low levels (as low as 50 basis points during depths of COVID and are back to the low-end of the range over the previous decade (1.40 – 3.00%, w/ 2.07% average). Growth stocks have done well over the last ten years when interest rates were range-bound between 0.5% and 3.0%. At 1.5% on the 10-year treasury, we still have room for rates go higher from here, and the actual impact on growth stocks could be more muted than feared over time.
  • While businesses are facing higher input costs due to supply chain issues, we believe highly innovative businesses are well positioned to handle inflation because they are creating innovative products and services that give them pricing power. We are not seeing a material margin deleverage across the portfolio. In fact, on a weighted-average basis, the portfolio companies showed operating margins increasing approximately 100bps y/y during the most recent quarter.

2. The most important question is: What gives us confidence in our strategies?

The answer is our focus on “Quality Innovators.” While evaluating companies relative to our eight investment criteria is how we define quality, there are three quality metrics that can be measured quantitatively—we focus on asking: 1) Are the companies delivering growth?; 2) Are they showing improving profitability?; and 3) Do they have solid balance sheets?

The answer to these questions across all our strategies is YES. Let’s review the Beagle Leading Innovators (Q3’21 Factsheet) portfolio holdings through the most recent calendar quarter to date:

  • GROWTH: Weighted-average y/y revenue growth of 44%—particularly robust top-line growth against tough comparisons from last year.
  • PROFITABILITY: Weighted-average improvement in operating margins of 93bps, with the average holding showing over 200bps of operating EBITDA margin improvement.
  • BALANCE SHEET STRENGTH: Debt/capital ratios show substantially lower leverage than the average company in the benchmark. We prefer companies with low or no debt and net cash on the balance sheet.

From a quantitative point of view, the combination of strong and sustained top-line growth with financial strength and improving profitability is what drives long-term stock price appreciation.

3. We see potential for improving dynamics in 2022 and beyond for Quality Innovators, as we believe valuations have over-corrected over the past few months, which we believe has created a window of opportunity. In our opinion, Quality Innovators are now on sale. We believe the fundamentals underpinning the portfolio holdings are quite strong in terms of innovation, revenue growth, improving profitability, and financial strength.

Tom also discussed areas of innovation and companies where the investment team is seeing attractive opportunities for long-term investors. Send me a note if you are interested in learning more about Evolutionary Tree’s risk-managed approach to investing in innovation.

Bryan

Evolutionary Tree Capital Management, LLC accepts no liability for any errors or omissions arising as a result of transmission. The information and views expressed herein are provided for informational purposes only and do not constitute investment advice. Past performance does not guarantee future results. Any projections, outlooks, or estimates contained herein are forward looking statements based on specific assumptions that are current as of the date indicated, subject to change without notice, and should not be construed as indicative of any actual events that have occurred or may occur. The inclusion of particular investments is not intended to represent and should not be interpreted to imply a past or current specific recommendation to purchase or sell a security and should be considered in the context of an overall portfolio. Investing in equity securities involves risk and principal loss is possible. Nothing contained herein constitutes investment, legal, tax, or other advice and should not be relied upon in making an investment or other decision. Investors should always obtain and read up-to-date investment services material before deciding whether to appoint an investment advisor.