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Innovation should be the engine of equity portfolios, especially in ‘powerhouse’ Australia

As central banks signal that global economies may have reached a tipping point and the inflation cycle may soon retreat, investment teams need to refocus on fundamentals. In 2024, experts say, innovation will be key.

As the inflation boom shows signs of slowing down and two years of economic volatility reaches a tipping point, the fundamental drivers of equity portfolios should once again take prominence for stewards of capital.

According to portfolio managers at Bennelong Australian Equity Partners and First Sentier Investors, this means financial advisers and brokers should refocus on the importance of company innovation when assessing long-term valuations, because history shows that it’s this innovation – especially in Australia – that drives sustained returns.

Rapid inflation, rising interest rates and unheard of movements in the bond markets have largely driven movement in equity markets of since the pandemic, explained Bennelong senior investment analyst Bradley Clibborn (pictured) at The Inside Network’s recent Investment Leader’s Forum in Noosa. These macro themes put some context behind the “pretty significant shock” economies have experienced, he explained, and the effect his has had on markets.

  • But as the US Federal Reserve and central banks around the world, including Australia, indicate an end to the current cycle is near, investment teams return their gaze to firm principles.

    “There’s really this anchoring back to what actually drives equities over the long term,” Clibborn said. “And it’s that growth in the earnings of the underlying businesses that that come into that index, so if we’re building a portfolio we really want to pick those companies that have the ability to compound their earnings over time, and ideally do it at a rate faster than the market.”

    ‘In our view, it’s innovation’

    Clibborn used a handful of Australian companies that have had recent success as an example; Aristocrat, CSL, James Hardie and Breville.

    “Those companies that have the ability to compound their earnings at a higher rate have delivered significantly higher and better results for shareholders. So the key question is what is the common factor that actually differentiates those companies versus the common stock on the ASX? In our view, it’s innovation.

    “These four companies all have a culture of innovation, supported by a consistent discipline of reinvesting into their business by way of research and development. Investing in new products means they’ve become global leaders in their market niches, whether that’s CSL in healthcare, or James Hardy and building products,” he continued.

    “They continue to reinvest in their business, they become those market leaders, which means they grow market share over time. And that grows revenues, which then allows them to reinvest back in the business and grows their investment spending keeps that cycle going.”

    Innovation is often correlated with the technology sector, he noted, but the practice can just as well apply to building products, retail goods, healthcare and gaming. “The key point here is that focus on innovation has translated to significant market share gains.”

    Punching above its weight

    Yet broadening ‘innovation horizon’ outside of technology shouldn’t neglect the importance of tech companies as leaders in innovation. This clearly applies on a global scale, with the so-called ‘magnificent seven’ mega-cap stocks (Apple, Microsoft, NVIDIA, Meta, Alphabet, Amazon, Tesla) propping up the sector.

    But in Australia, argued First Sentier’s head of equities research Christian Guerra, the tech sector itself shouldn’t be discounted.

    “When it comes to technology and software companies, Australia really does punch above its weight,” he said. “Australia continues to be an epicenter of product development and R&D.”

    There are some key principles around investing in technology companies, however, that need to be front of mind.

    “Number one: most tech companies the best tech companies are product cycle stories,” Guerra said. “Number two: you want to buy tech stocks when they’re enjoying positive earnings revisions. And number three: you get those positive earnings revisions when either sales growth or earnings growth is accelerating, or when gross margins and operating margins are rising.”

    And forget about trying to find the undervalued second or third string options in the market, he said.

    “You want the number one player, don’t muck around with number two. Number two is the first loser in tech. The winner takes all, like in many other industries.”

    Staff Writer

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