C.J. Lawrence Weekly – Innovation on Sale

The recent market sell-off has investors questioning their allocation strategies and the underpinnings of the bull market in stocks.  Year-to-date, the S&P 500 is now down 0.56%, after being up 11.2% at its September peak.  The Technology, Health Care, and Consumer Discretionary sectors were joined by Utilities last week as being the only sectors with positive year-to-date price performance.  The Materials and Financials sectors are the worst performing sectors, year-to-date, with sector index prices down 14.8% and 8.3% respectively.  Thursday’s earnings announcements from Amazon and Alphabet that showed lower-than-expected quarterly top-line results thwarted a rebound in broader index shares that began mid-week.  The top-line misses shook the stocks of the two companies in Friday trading and kicked at the foundation of a market that was already on shaky footing.

Approaching the release of calendar 3Q18 corporate financial results, the high estimate bar raised the risk that companies failing to clear the hurdle would be punished by the market.  But not only have the stocks of those companies been punished, but the stocks of companies that hit most of their marks were sold.   Since the beginning of earnings season, the S&P 500 Index price is down 8.5%, despite 78% of reporting companies delivering positive earnings surprises.  Market sentiment is shifting to a position where the consensus now views 2018 as a peak year in S&P 500 sales and earnings growth.  As that view takes hold, pressure may continue to build on stock valuations, which tend to compress during periods of earnings growth deceleration.  Initially, most stocks feel the weight of multiple compression and trade in unison with the broader market.  But eventually the wheat is separated from the chaff and individual leaders emerge and outperform.

Amazon.com Research and Development Spending

The recent market downdraft may be creating opportunities for active managers and investors to buy industry leaders and innovators at attractive prices.  In April of this year, we authored a note titled Innovation at a Reasonable Price, which highlighted increasing rates of research and development spending (R&D) by the market’s leading change-agents, innovators, and disruptors.  The point remains that companies that lead in this area are creating future value and optionality and should be owned not only for today’s cash flow generation but also for tomorrow’s innovation.  In many cases, R&D spending, and its prospective return on investment, is not reflected in the innovator’s stock price, creating opportunities for investors with longer horizons.  Recent financial results suggest that some leaders are accelerating their research and development efforts.  Amazon.com, for example, leads the R&D list having increased its quarterly spend by 21% from last year’s level.  On a four-quarter trailing basis Amazon’s annual R&D spend has eclipsed $27 billion, up from $22 billion at the beginning of this year.  Alphabet takes the second spot on the list of R&D spenders, having bumped up its investment by 24%, versus last year, and is closing in on $20 billion of annual R&D spending.  Microsoft and Apple are following close behind with annual R&D outlays of $15 billion and $13 billion respectively.  All four companies are massive cash flow generators allowing them to funnel resources into continuous product research and development, helping to widen their competitive moats.  Except for Amazon, they trade at less than 1.5x the market P/E multiple.  In recent weeks these, and other R&D leaders, have not been spared by the market sell-off.  Broad market downdrafts can be opportune times for investors inclined to buy “innovation at a reasonable price” especially when “innovation is on sale.”

Terms and Conditions