Innovation results in a higher stock market valuation | Sifted

There is a persistent myth that innovation projects and stock market-listed companies don’t mix well.

Big stock market-listed companies are often hesitant to innovate believing that big innovation projects simply won’t pay off in a timescale that works for them. New business ideas can lose money for years before they finally come good; while chief executives think in quarters, and often are only in the role for just a few years.

“The main conundrum we face is the short-termism of business.”

This is still true, despite all the recent hype about companies like Tesla.

“The main conundrum we face is the short-termism of business — the bigger the company the more short-termist, especially for stock market-listed ones,” says Julian Ritter, associate partner at Stryber, the innovation consultancy.

“To really make a difference, companies have to spend tens or hundreds of millions scaling up a new business, and that’s the point where executives hesitate. They would rather spend a few million here and there.”

To some extent, Ritter says, they are right. A company like Netflix is admired for diversifying out of its original DVD rental business into streaming, but the truth is that Netflix lost money for years on streaming before the business came good. Tesla was lossmaking for years.

The research: is there really an innovation penalty?

But the Stryber team wanted to dig deeper into the stock market effects of innovation. Was there really a penalty for innovators in terms of share price?

Actually, they found that that stock market rewards companies that are more innovative and — this is the crucial bit — they reward them pretty quickly, even before the diversification efforts are fully realised. In other words, stock markets love innovation.

Stryber analysed 1,838 listed companies in the US and Europe between 2010 and 2019, and looked at how many of them diversified their revenue segments during that time. This is a reasonable proxy for innovation — if you are adding a new revenue stream to the business you are commercialising new business models and serving new customer needs. Amazon adding web service provision to its ecommerce activities is a good example of diversification.

Diversification, by this definition, is quite rare. A majority of companies — 68% — did not diversify during the 10-year period. Just 4% changed so much that more than 50% of their revenues in 2019 came from business segments that didn’t exist in 2010. This is probably not a huge surprise.

But when companies did diversify, the stock markets loved it.

Stryber looked at the total shareholder return for companies — the uplift in their share price plus any dividend payments, divided by the number of shares. Total shareholder returns were 54% higher for companies with the highest level of diversification, compared to those that didn’t diversify at all. Even companies that diversified moderately outperformed those that didn’t diversify at all.

Stryber mentions some obviously innovative companies like Amazon and Netflix, but the diversification rewards apply to less high-profile companies as well, such as Duerr, a German supplier for the automotive industry.

Duerr was originally best-known for making machinery that paints cars for automakers (you can see why it’s not exactly a household name) but it has been relentless in adding other business segments, such as exhaust-air purification systems and acquiring a maker of woodworking machinery.

Some 36% of Duerr’s revenues in 2019 came from business segments it hadn’t had in 2010. In the same period, the company generated total shareholder returns of 26%. To put that into perspective, companies that didn’t diversify at all had total shareholder returns of 7.3% on average for that period.

“Even in the short term, innovation pays off.”

The fact that companies got an uplift over ten years was perhaps not surprising. What was surprising, says Ritter, was that the share prices of companies that diversified rose quickly — within the first three years. This was often before any real effects of the diversification would have become apparent on performance.

“Even in the short term, innovation pays off,” says Ritter.

Of course, it could be something of a trend. Stock market investors do prioritise different corporate behaviours at different times. Sometimes they applaud cost-cutting or takeovers, while right now it is innovation.

But Ritter believes the trend is here to stay. Even during the first wave of the pandemic, investors demonstrated their keenness to invest in more innovative companies — there has been a clear recognition that business is changing and companies must keep up.

“Even if this is a trend, it is accelerating and will be with us for some time,” said Ritter.

Maija Palmer is Sifted’s innovation editor. She covers deeptech and corporate innovation, and tweets from @maijapalmer