Innovation, Vision, and Stock Prices

Elon Musk Just Hinted At An Incredible Possible New Product"
 ~ A Fortune and Time Magazine Headline.  Aug. 7, 2015​

I'm used to seeing fairly depressing financial headlines fretting about Greek debt and China's slowdown.  But this headline was about potential, which we haven't seen enough of lately.  Granted, it is poorly written, but it does attempt to inspire excitement: "Elon Musk", "hinted", "incredible", "possible", "new".  In a media culture of "if it bleeds, it leads," excitement is a welcome topic.
  
I recently read Ashlee Vance's biography of Elon Musk, which I found truly inspiring.  Musk is involved in many of our world's most exciting innovations.  There seems to be a societal turn towards the future again, led by innovators and inventors such as Musk.  What inspires this psychological shift - towards a greater acceptance of big visions, of testing limits?  And more mundanely, are companies innovating for the future better stocks to own?  

In today's newsletter we examine how innovative stocks outperform others by sizeable margins in both value and momentum investing strategies.  Conversely, a decline in innovative perceptions, as may be happening to Apple, heralds a moderation in stock price.  Then we look at the necessity of a compelling story and a positive vision if we are to keep moving human progress forward.

Possibility:  Ascendant or In Decline?

I cannot help fearing that men may reach a point where they look on every new theory as a danger, every innovation as a toilsome trouble, every social advance as a first step toward revolution, and that they may absolutely refuse to move at all.
~ Alexis de Tocqueville (1840)

The past 10-15 years has seen an explosion in innovations: self-driving vehicles (Google), all-electric vehicles (Tesla), inexpensive space launches (SpaceX), the sharing economy (Uber and AirBnB), genetic technologies and cancer immunotherapy, online education (often free), drones, smart phones (Apple, etc...), 3-D printing, robotics, maker spaces, the internet of things, and machine learning - which is itself opening up entire new fields including robotics and translation - let me catch my breath here.  Regardless of these amazing innovations over the past decade, some experts believe that these are simply enhancements, not game-changing innovations.  They debate whether the economy has reached a plateau of innovation.

Tyler Cowen, a professor of Economics at George Mason University and author of the MarginalRevolution blog, authored "The Great Stagnation: How America Ate All the Low-Hanging Fruit of Modern History, Got Sick, and Will (Eventually) Feel Better," a pamphlet published in 2011. His work argues that the American economy has reached a technological plateau and the factors which drove economic growth for most of America's history are spent. The "low-hanging fruit" from the title include the cultivation of previously untilled land, the spread of transport, refrigeration, electricity, mass communications, and sanitation innovations from 1880-1940, mass education, and potentially cheap fossil fuels and the strength of the American constitution. While those produced extremely large returns, future advances will be much more incremental. In a vivid example, he compares the changes witnessed by his grandmother versus those over his own lifetime, and finds the changes he has witnessed to be incremental rather than world-changing.

Cowen takes a critical and too-narrow view of some recent innovations.  He noted on his blog about the hyperloop, a technology to transport people through pneumatic tube-like systems at around 500mph:  "I cannot speak to the technical issues ... but I wonder where the real gain is....  You can already fly LA to San Francisco in about an hour.  Is saving that time so important, noting that in the best case scenario the hyperloop still takes 35 minutes?"

Cowen's argument neglects that one of the most important aspects of inventiveness and innovation - the DREAM.  People - employees, investors, regulators - are motivated by vision.  If we deconstruct the vision into its parts - what is feasible with current technology and what is not - we will never try.  And even when a new project fails, it often leads to new spin-off technologies and greater wisdom about what works and what doesn't.  Steve Jobs understood this, and so does Musk - as he demonstrates when he requires nay-saying employees to explain the materials chemistry and physics that prevent an idea from being manifested in technology.   Once the physics makes an idea in the realm of possibility, then the emotional inspiration of the vision is the motivation behind its ultimate achievement.

Ashlee Vance notes that Musk has two posters of Mars outside his office at SpaceX.  One is Mars now - red rocks and dust - and one depicts Mars transformed into a viable environment for human life - blue and green and with an atmosphere.  That VISION is tangible and emotionally resonant.  It is a guiding inspiration for his commercial ventures.

We are on the verge - within the next 30 years - of living in a world of Mars colonies, cancer cures, free online education, travel by hyperloop, a world of self-driving vehicles and drones.  Regardless of naysayers, the visions that succeed over the next decades will be those that inspire.  Many innovations are possible but have simply not been dreamed of.  Those that are brought to life will be those that inspire smart people to dedicate their lives.

Is Something Wrong at Apple?

Innovation distinguishes between a leader and a follower.
~ Steve Jobs

Apple (AAPL) is not only the world's most valuable public company, but also the most widely held stock.  The stock declined 12.5% since a high on July 20, 2015, following earnings on July 21st that - per the media - stimulated concerns about weak sales of the Apple Watch and a slowdown in China.

Yet innovation may also revive the stock according to this article:  "Apple Expected to Emerge From Doldrums with Upcoming iPhone Event"  Per the article, "That attention is likely to reach fever pitch as anticipation builds for the next iPhone, which if the company follows its usual pattern, will launch in early September."  Unfortunately for Apple investors, another iPhone simply can't be as inspiring as colonization of Mars.

Given its wide retail ownership, AAPL is often moving in response to investor sentiment (we found that Joy is the primary driver of the stock price since 1998).  According to Jeff Sica of Sica Wealth Management, "Apple's stock has always fluctuated because of the exuberance and attention the company gathers."  We see the same.  Apple's stock price performance has been phenomenal since the late 1990's, and one cause may be the continuous innovations at the company.  

Does that mean investors should seek out and invest in innovative companies?  In a study of our Thomson Reuters
MarketPsych Index (TRMI) called Innovation, we found that the answer is generally "yes."  

Arbitraging Innovation

Because, you know, resilience - if you think of it in terms of the Gold Rush, then you'd be pretty depressed right now because the last nugget of gold would be gone. But the good thing is, with innovation, there isn't a last nugget. Every new thing creates two new questions and two new opportunities.
~ Jeff Bezos

How can we measure innovation perceptions of a company?  We set up our text analysis of news and social media - the Thomson Reuters MarketPsych Indices - to answer such questions.  Simplistically speaking, the Innovation TRMI is a metric of the number of times a company, its management, or its products is described with adjectives such as "innovative" as opposed to "boring."  When we quantify such references and add them up, we can identify a net balance of innovation perceptions expressed about a company in millions of social and news media articles.

Using our TRMI for Innovation, we see results indicating that an arbitrage of Innovation across stock prices gives decent returns.  But those results are volatile.  Here is an example of the predictive power of Innovation in a yearly cross-sectional model.  In this model our Head of Research CJ Liu wrote code that first ranks all U.S. stocks by the amount of Buzz about them over the past 12-months.  In the following example he selected the top 200 by Buzz value from social media over the prior year.  Then he ranked those 200 stocks by their average Innovation (the TRMI value).  Using a quintile model, he bought the top quintile (20% with highest Innovation) and shorted the bottom quintile (20% with lowest Innovation).  He held these positions for 12 months.  The strategy was updated monthly with 1/12 of the portfolio, with a one-year holding period.  The equity curve derived from this long-short arbitrage is below:



This result is 80% return over 15 years, excluding transaction costs.  This is an absolute return model based on arbitraging innovation.  It demonstrates that there is some excess value to be gained by buying innovative companies and avoiding less innovative ones as described in social media (and also true for news), but it is not terribly impressive as a stand-alone strategy, and it is volatile.  Where Innovation becomes much more useful is when it is combined with traditional long-only models, such as value and momentum.

Value and Innovation

Often … Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.
~ Ben Graham, Chapter II, The Investor and Stock-Market Fluctuations, p. 42.

In last month's newsletter we described an extreme value strategy that finds the 5% of companies in the S&P 500 with the highest E/P ratios (deepest value).  Using the constituents of the S&P only, CJ’s model ranked these stocks by their earnings-to-price ratio (E/P).  His long-only strategy bought the 25 stocks (top 5%) with the highest E/P values and held them for one year.  Each month he redeployed 1/12 of the portfolio to new annual positions in a rotational model.  The equity curve from this strategy is below:


Over the period displayed (January 1999 - March 2015), the S&P 500 was up 124% with dividends reinvested, while this strategy earned 1250% (excluding transaction costs). 

Value stocks that were described as innovative in the media tend to outperform other value stocks - and the entire market - substantially over time.  The equity curve below was built from the intersection of the 25 value stocks identified above, and the 25 (out of the top 100 most Buzzed-about) S&P 500 companies with the highest average innovation values over the past 12 months.  This small group of innovative value stocks shows - held for 12 months each - shows an impressive long-only return, as seen in the equity curve below: 

This equity curve shows a 30x return using an enhanced extreme value strategy since 1999.  

Momentum and Innovation

One way to keep momentum going is to have constantly greater goals.
~ Michael Korda

After investigating value, we turned our attention to momentum.  The equity curve below demonstrates the results of an extreme momentum strategy that takes the top 25 momentum stocks (highest past 12 month price returns) in the S&P 500:  
 

The equity curve shows about a 5.5x return since 1999 with 12-month holding periods.

Taking the intersection of the top 25 most Innovative companies (out of the top 100 by Buzz) and the top momentum companies, we see the original momentum plot above improve significantly, although remaining volatile, with 14-fold returns from 1999 through 2014 (below):


The finding that innovation perceptions drive momentum returns was also reflected in the value strategy augmentation results, and it may reflect some of the same high-performing stocks in both models (we haven't decomposed the constituents yet).  Media commentators appear to have fairly accurate estimates of corporate innovation (more so in social than in news media), and those estimates have consistently become evident in stock price outperformance for both value and momentum-based strategies.

The TRMI are largely built on media content from the internet, and internet-saavy investors are likely to be more aware of technological breakthroughs than others.  It would make sense that stocks and companies in the technology sector make up a larger overall proportion of stocks in our momentum model than in the overall stock market.  Additionally, heavier internet users are more likely to deem innovativeness a particularly valuable corporate trait.  Perhaps internet investors have an advance view of what is happening at an innovative company, and they transmit it amongst each other before it spreads into the news media.

We didn't test highly innovative stocks stand-alone in a long-only strategy - we always arbitraged highly innovative versus low innovation companies in our simple models.  It's possible that low-innovation companies are being excessively dismissed, as they themselves might also be outperforming in a contrarian fashion.

Innovative Stocks:  Based on the topic of this month's newsletter, we'll share some of the recent top ranked most innovative stocks in social media over the past month:  ​E I du Pont de Nemours,  Scripps Networks Interactive, Johnson & Johnson, Affiliated Managers Group (AQR Capital, a momentum trading fund, is a subsidiary), and Textron​.

Housekeeping and Closing

Perhaps society has been distracted by concerns (terrorism, peak oil, financial crisis, unsustainable debt) which have engendered a sense of insecurity and gripped collective attention.  Now those concerns seem to be somewhat on the back-burner, and we may be entering an age when our collective vision will turn forward again - to colonizing Mars and jetpacks and a world without cancer and many other examples of the impossible made real.

The key to securing an innovative future is stories.  Anthropologists say that humans are biologically evolved to life in groups of 150 people.  If that is true, then how can we have nations of millions ?  How do we trust strangers and carry on economic activities with people we don't know?  We do this because of stories.  Narratives about what we value - such as freedom, exploration, family, democracy  - connect us with others.  If we are lucky, the most amazing innovations in next decade will not be the things, but rather the narrative of invention, that is restored into our society by Elon Musk, Steve Jobs, Peter Thiel, Larry Page, and the many other inventors and innovators we are lucky to share the earth with.

We love to chat with our readers about their experience with psychology in the markets.  Please send us feedback on what you'd like to hear more about in this area.

Please contact us if you'd like to see into the mind of the market using our Thomson Reuters MarketPsych Indices to monitor real-time market psychology and macroeconomic trends for 30 currencies, 50 commodities, 130 countries, 50 equity sectors and indexes, and 8,000 global equities extracted in real-time from millions of social and news media articles daily.

Keep Inventing!
The MarketPsych Team