Innovation Outlook: Where Disruptors Will Make a Difference in 2022

• We believe the most prudent way to invest in innovation is by targeting companies with proven business models that are addressing large and expanding markets and can sustain their investment plans without needing additional capital.
• The adoption of software to enhance digitalization and optimize efficiency had been increasing for years prior to COVID-19 but received a powerful boost during the pandemic as companies were forced to adopt remote or hybrid work models. As a result, software and related services are forecast to see the best spending growth in technology in 2022.
• The most promising areas to access growth through innovation, in our view, are by investing in companies that can elevate efficiency, provide effective cybersecurity, generate data-driven insights and actions, and support frictionless commerce as well as those stocks leveraging these technologies.

After a multiyear run for the valuations of the market’s fastest-growing companies, the prospects of higher interest rates at the end of 2021 sent a shock wave across this cohort of the equity market. While highly profitable mega cap growth stocks continued to thrive late in the year, growth companies down the capitalization spectrum experienced challenging performance. These smaller, rapidly growing companies tend to be less profitable and their valuations are supported by future years’ earnings. As language from the Fed pivoted from an accommodating to a tightening stance, equity values for companies that depend on discounting future years’ cash flows came under substantial pressure.

A rise in valuations for disruptive growth stocks the last few years embedded heightened expectations for the underlying businesses, which many of those businesses were unable to live up to in the second half of the year. While it was particularly apparent in the performance of many businesses that benefited from the pandemic (e.g. video conferencing, at-home exercise equipment, e-commerce), the drawdowns in valuations within this group were most intense for those that missed consensus forecasts and provided disappointing forward guidance.

The new issue market also reflects investors’ consternation over how emerging growth stocks will perform in a tightening Fed environment. Nearly 400 companies came to market through initial public offerings in 2021, the largest deal count since 2000. Add in a flurry of more than 600 SPACs (special purpose acquisition companies) also making their debut and in total more than 1,000 new companies flooded the market. Abundant financing allowed many of these companies to go public with unproven business models, leading to the worst performance for the IPO market in the last five years as the average IPO fell 9.6% while nearly two-thirds finished the year below their deal price.

We believe reduced liquidity will cause the IPO market to slow in 2022 and raise the bar for companies to go public. The same could be said about investing in innovation more broadly, as companies will be forced to execute based on their own merits with less access to financing to underwrite current operations and fund future growth. From a risk standpoint, we believe the most prudent way to invest in innovation through the cycle is by targeting companies that are either cash flow positive or have line of sight to positive earnings and can sustain their investment plans without accessing additional capital raises. We call these companies “self-funded” growth businesses. We gain additional confidence by investing in businesses with proven economic models which showcase that spending to augment product or service innovation and acquire customers has an attractive return profile, supporting plans for aggressive current investment spending.

We further pinpoint disruptors by assessing and focusing on those with large and expanding addressable markets. Conditions we look for include “One of One” companies that are either the leader in a market with no real competitors or targeting a market that can be captured through innovation. Product-fit ensures the company’s goods or services resonate with buyers’ needs and delight end users, delivering continual revenue to support investments in innovation and go-to-market muscle.

Looking ahead to 2022, we believe the most promising areas for growth through innovation will include software and service providers as well as platform companies outside technology supporting four priorities:

• Elevating Efficiency
• Cybersecurity
• Data-Driven Insights and Actions
• Frictionless Commerce

Enterprise software delivered through the cloud has become as critical to running a business as lights and power. Corporate adoption of software to enhance digitalization and optimize efficiency had been increasing for years prior to COVID-19 but received a powerful boost during the pandemic as most companies were forced to adopt remote or hybrid work models. Software and services, which encompasses enablers of innovative tools like website development, are forecast to see the best spending growth in technology (Exhibit 1).

Exhibit 1: Software Spending Should Remain Robust

Source: AlphaWise, Morgan Stanley Research – 3Q21 US CIO Survey.

With record numbers of employees quitting their jobs and payroll growth slowing from its brisk pace earlier in 2021, many enterprises are struggling to hire enough workers. That gap can be bridged, though, with modern hiring tools that more efficiently identify and onboard employees and robotics that automate manual functions. Helping improve the performance and retention of employees and manage wage inflation, software-as-a-service (SaaS) companies are offering more solutions to efficiently address multiple functions of a large enterprise such as human capital management, collaboration as well as project management and workflows.

Cybersecurity is becoming ever more crucial. The surge in hybrid work and the ubiquity of mobile devices have created more endpoints that are susceptible to security breaches and highlighted the need for ever-more sophisticated security solutions. We see a long runway of growth for cybersecurity software providers focused on next-generation endpoint protection that are positioned to take share from legacy players and consolidate even larger portions of the security market.

Greater vulnerability in an increasingly digital world has also led to more spending on tools to ensure a secure environment in which to develop software and other innovative technologies. Verticals such as IT operations now need to incorporate security early on in the process. Software developers are using DevSecOps software to write, package, secure and deploy code while tech support teams are harnessing observability software to manage applications, monitor data as well as maximize efficiency and security.

Meanwhile, actionable, data-driven insights are critical for businesses of all sizes across industries, highlighting the need for data management and analysis software. Companies in this area are providing data-powered, real-time insights through AI and machine learning to a wide range of customers. Such data has a multitude of uses from better targeting sales and marketing to providing real-time analysis to industries as varied as securities trading and sports betting. In fourth-quarter earnings calls, for example, major banks highlighted their robust spending on technology to retain customers, secure sensitive financial data and stay competitive with fintech companies.

E-commerce is not new, but innovation in customer acquisition, payment processing and financing has been democratizing capabilities formerly reserved for the largest players. We have had success in e-commerce by investing in companies providing the picks and shovels to establish a selling presence and process customer transactions, as well as those merchants using those tools and services to gain market share or better compete with larger rivals.

One of the evolutions of the online model we are following is cross-border commerce, focusing on companies that can reduce the frictions caused by taxes, foreign exchange and product returns. E-commerce penetration rates vary widely by geography, with developing markets in Latin America and Asia ex-China among the lowest, representing growth potential for companies that can develop user-friendly solutions.

Existing and emerging e-commerce companies are consolidating business that had previously been handled by multiple players across industries through integrating services across the full lifecycle of a sale within the same product offering. Services critical to the sales journey such as social media marketing, enhanced customer communications and two-way logistics are now available in a single package.

While we believe these four areas will be the vanguard of innovation going forward, identifying potential investments is only the starting point. Disruptors have faced increased scrutiny as rising rates mean the math of discounted cash flow models no longer works in their favor. At the same time, many of these companies have greater scale and improving profitability, creating more attractive valuations that we as active managers can use to our advantage.