Drawing Capital Newsletter
September 25, 2020
Over the past 10 years, the S&P 500 Index has delivered above-average returns, and investors in funds indexed to the S&P 500 Index over the long term have been well rewarded. Nonetheless, a wide dispersion in the constituents of the S&P 500 is increasingly present: a handful of growing technology companies and technology-enabled businesses are leading the index, and a group of financially-engineered value traps are negatively detracting from the overall index return. At Drawing Capital, we believe that a significant source of future performance returns in the coming decade will derive from investing in innovation and disruptive technologies.
The paradigm shift has already begun:
In 2018 and 2019, S&P 500 companies spent more money on share buybacks than research and development (R&D) spending, and only about ⅓ of S&P 500 companies have R&D budgets (2,3,4). Less emphasis on R&D spending may curtail future long-term innovation.
In 2019, companies in the NASDAQ-100 Index spent a weighted average of about 12% of their revenues on R&D, while S&P 500 companies that are not in the NASDAQ-100 Index only spent a weighted average 2.8% of their revenues on R&D (5).
In 2019, more than ⅓ of S&P 500 companies posted year-over-year earnings declines, and this occurred even before the COVID-19 outbreak in 2020 (6).
Traditionally-defined value investing works well in a combination of a declining interest rate environment, high capacity of inorganic shareholder return programs (such as dividends, share repurchases, and M&A activity), and when there is an emphasis on seeking value by buying assets at a discount to their present values of future cash flows. One cannot simply extrapolate these characteristics in the future when there are headwinds to the likelihood of the repetition of these characteristics (ie. there is some resistance of nominal interest rates falling below 0 in America, there is increasing scrutiny on consumer M&A activity by Big Tech and share buybacks, and buying discounted assets is more difficult when the S&P 500 P/E multiple is near 22) (7). As a result, it is no longer guaranteed for S&P 500 Index funds to make consistent top decile returns going forward when compared to other public equity funds.
Pioneered by author Clayton Christensen in his book titled, The Innovator’s Dilemma: When New Technologies Cause Great Firms to Fail, the term “disruptive technology” refers to a new company creating something that is faster, cheaper, and more convenient to the consumer compared to the incumbent’s suite of products or services to such as degree that it disrupts the economies of the incumbent. Disruption does not simply indicate something that is new and different. A key component of disruptive technology is the concept of the “innovator’s dilemma”: if an incumbent company ignores a startup, then the startup gains market share over time; if the incumbent company attempts to compete with a disruptive startup, then it may wreck the company’s existing short-term economics and financials, which leads to other issues at the incumbent company.
At Drawing Capital, we share the viewpoint that disruptive innovation fuels future growth opportunities. Stanley Druckenmiller’s “long the disruptors and short the disrupted” phrase and Marc Andreessen’s “software is eating the world” phrase are two of the most powerful phrases that describe the past 10 years in the investing landscape (8,9). Numerically, we see these phrases play out in prime time: over the past 10 years ending September 17, 2020, the iShares Software ETF (ticker: IGV) and the First Trust Dow Jones Internet ETF (ticker: FDN) have compounded at annualized rates of 19.32% and 20.06% respectively (10,11). Meanwhile and over the same time period, the S&P 500 Index ETF (ticker: SPY) and the MSCI International Developed Markets Index ETF (ticker: EFA) have a respectable yet more modest 13.64% and 5.03% compounded annualized return, respectively (12,13). Furthermore, annual changes in the top ten publicly-traded American companies by market cap suggest that incumbents are susceptible to competition, changes in investor sentiment, and changing forces among both customers and competitors. The three charts below assist in highlighting the performance differences in these four funds and the changing ranked annual market caps of publicly-traded American companies since 2014:
Charts from Portfolio Visualizer (14)
We share the viewpoint that this performance alpha from growth investing in disruptive innovators will continue to occur, and COVID-19 has accelerated existing trends in digital adoption. We have identified 12 key trends that will help drive disruptive innovation over the coming decade:
Cybersecurity & Cryptography
Software as a Service (“SaaS”)
Internet of Things
Gene Editing & Health-Tech
Sustainability, Decarbonization & Renewable Energy
Financial Technology (“Fintech”)
Overall, we are attracted to the creativity of new technologies and remain committed to seeking multi-year growth opportunities with a tech-focused lens that enables scalable growth. In this age of hypercapitalism and with a continued low interest rate environment that is supported globally by central banks, well-informed investors will seek investments in growing businesses and disruptive innovation in an effort to generate significant performance alpha in the coming decade.
(1) "MacBook Pro on top of brown table photo – Free ... - Unsplash." https://unsplash.com/photos/1SAnrIxw5OY. Accessed 24 Sep. 2020.
(2) "S&P 500 buybacks up 3.2% in Q4 2019 - PR Newswire." 24 Mar. 2020, https://www.prnewswire.com/news-releases/sp-500-buybacks-up-3-2-in-q4-2019-full-year-2019-down-9-6-from-record-2018--as-companies-brace-for-a-more-volatile-2020--301028874.html. Accessed 18 Sept. 2020.
(3) "Gross Domestic Product: Research and Development - FRED." https://fred.stlouisfed.org/series/Y694RC1A027NBEA. Accessed 18 Sept. 2020.
(4) "The Unusual Ambitions of Chamath Palihapitiya | Institutional ...." 31 May. 2020, https://www.institutionalinvestor.com/article/b1lw211ts92n62/The-Unusual-Ambitions-of-Chamath-Palihapitiya. Accessed 18 Sept. 2020.
(5) "NDX Fundamentals - Nasdaq Global Indexes." https://indexes.nasdaqomx.com/docs/NDX_Fundamentals.pdf. Accessed 18 Sep. 2020.
(6) "A Growing Share of S&P 500 Companies' Earnings Are ...." 4 Dec. 2019, https://www.wsj.com/articles/a-growing-share-of-s-p-500-companies-earnings-are-contracting-11575475559. Accessed 18 Sept. 2020.
(7) "S&P 500 P/E Ratio - YCharts." https://ycharts.com/indicators/sp_500_pe_ratio. Accessed 23 Sep. 2020.
(8) "https://www.bloomberg.com/news/videos/2019-12-23/citi-s ...." https://www.bloomberg.com/feeds/markets/sitemap_video_2019_12.xml. Accessed 18 Sept. 2020.
(9) "Why Software Is Eating the World - Andreessen Horowitz." 20 Aug. 2011, https://a16z.com/2011/08/20/why-software-is-eating-the-world/. Accessed 18 Sept. 2020.
(10) "iShares Expanded Tech-Software Sect ETF (IGV ... - Morningstar." https://www.morningstar.com/etfs/bats/igv/performance. Accessed 18 Sept. 2020.
(11) "First Trust Dow Jones Internet ETF (FDN) Performance ...." https://www.morningstar.com/etfs/arcx/fdn/performance. Accessed 18 Sept. 2020.
(12) "SPDR® S&P 500 ETF Trust (SPY) Performance | Morningstar." https://www.morningstar.com/etfs/arcx/spy/performance. Accessed 18 Sept. 2020.
(13) "iShares MSCI EAFE ETF (EFA) Performance | Morningstar." https://www.morningstar.com/etfs/arcx/efa/performance. Accessed 18 Sept. 2020.
(14) "Fund Performance - Portfolio Visualizer." https://www.portfoliovisualizer.com/fund-performance. Accessed 18 Sept. 2020.
(15) "Historical Market Caps of Largest U.S. Companies | Siblis ...." 7 Jan. 2020, https://siblisresearch.com/data/market-caps-us-companies/. Accessed 18 Sept. 2020.
This letter may not be reproduced in whole or in part without the express consent of Drawing Capital Group, LLC (the “Drawing Capital”).
This letter is not an offer to sell securities of any investment fund or a solicitation of offers to buy any such securities. An investment in any strategy, including the strategy described herein, involves a high degree of risk. Past performance of these strategies is not necessarily indicative of future results. There is the possibility of loss and all investment involves risk including the loss of principal.
The information in this letter was prepared by Drawing Capital and is believed by the Drawing Capital to be reliable and has been obtained from sources believed to be reliable. Drawing Capital makes no representation as to the accuracy or completeness of such information. Opinions, estimates and projections in this letter constitute the current judgment of Drawing Capital and are subject to change without notice.
Any projections, forecasts and estimates contained in this document are necessarily speculative in nature and are based upon certain assumptions. In addition, matters they describe are subject to known (and unknown) risks, uncertainties and other unpredictable factors, many of which are beyond Drawing Capital’s control. No representations or warranties are made as to the accuracy of such forward-looking statements. It can be expected that some or all of such forward-looking assumptions will not materialize or will vary significantly from actual results. Drawing Capital has no obligation to update, modify or amend this letter or to otherwise notify a reader thereof in the event that any matter stated herein, or any opinion, projection, forecast or estimate set forth herein, changes or subsequently becomes inaccurate.