When investors think about innovation and disruption, one of the factors that comes to mind is valuation and the right price to pay for businesses taking the lead in their sector.
We have recently been asked our thoughts on innovation and how we factor that into our investments in the fund. Below are three illustrations of how innovation figures into our approach to valuation specifically and our investment process more generally.
LogMeIn vs. Zoom Video
LogMeIn and Zoom Video compete in the collaboration space. We invested in LogMeIn in September 2019 at a valuation of 13.6x 2019 estimated earnings. Zoom Video went public in April 2019 and currently trades at 244.6x 2020 estimated earnings.
Zoom is viewed as a disruptor in the space due to its "video first" offering. Zoom's high quality, easy-to-use video conferencing solution has resulted in significant share gains in the market. LogMeIn offers video collaboration through the GoToMeeting brand. LogMeIn recently re-platformed the GoToMeeting software to achieve performance similar to Zoom's and is aggressively marketing the product today.
Both businesses are driving innovation in the high growth (9% p.a.) Team Collaboration space. We elected to access this growing market via the (dramatically) cheaper alternative. In December, LogMeIn received a buyout offer from Francisco Partners at a price of $86.05/share, a 27% premium to our purchase price.
ConvaTec vs. Coloplast
ConvaTec is a UK-listed medical products company focused on ostomy, wound care, and continence. Carved out of Bristol-Myers Squibb in 2008, the business had private equity owners until its 2016 IPO. For many years the business underinvested in R&D, which troughed at roughly $30M or just 1.7% of revenues in 2014. ConvaTec has not coincidentally underperformed in its end markets, ceding share to key competitor Coloplast, a Danish market darling trading for ~39x FY9/20 earnings. Coloplast has historically invested ~3.5% of sales into R&D, driving a positive feedback loop of market-leading products, share gain, and margin expansion.
ConvaTec announced a Transformation Initiative in Q4 2018 that, likely due to a combination of the amount of spend required, near-term margins impacts and investor fatigue, received a lukewarm reception but struck us as the right decision for the long-term health of the business. Following a disappointing Q1 2019 report, relatively little improvement was priced into the shares and we accumulated a position with an average cost below 150p.
With the appointment of a new, dynamic CEO with a strong R&D background effective Sept 30 2019, we expect the business to narrow the performance gap vs. Coloplast, Smith & Nephew, and other competitors. The shares now trade for over 200p as investors have begun to give the company some credit for current and future initiatives. While some discount is warranted given the uncertainty around execution, the multiple of ~21x forward earnings remains inexpensive relative to peers.
Jost Werke vs. WABCO
Jost Werke and WABCO both provide components to the heavy duty trucking industry. Jost Werke is the global leader in fifth wheels and kingpins, the products used to connect trailers to truck cabs. WABCO is a global leader in brakes, stability control, suspensions, etc. Both companies will actively participate in the shift to autonomous trucking.
WABCO is viewed as an innovator and industry leader in the move to autonomous. We analysed WABCO and agreed on a price we would pay for their shares, but the shares never traded down to this level. WABCO received a buyout offer at ~20x P/E in March 2019. Jost Werke's products connect trucks to trailers. Automating this connection is viewed as a less exciting, "driver-assist" technology, but this task is critical for autonomous trucking. Jost Werke is the logical company to develop this technology as it has >50% market share in the fifth wheel market. In the long term, Jost's technology will be required for any truly autonomous truck.
Jost Werke currently trades at 11.5x P/E. The market clearly views Jost Werke's products as lower value-added than WABCO, and expects Jost to see slower long-term growth. In reality, Jost Werke's products are essential for autonomous trucking and will be some of the first autonomous products adopted by the market.
Conclusion
Innovation is the lifeblood of smaller business whom are continuously seeking to take market share from larger players, or to generate greater earnings from their existing customers. The above three companies provide real world examples of how innovation can be accessed through Global Small Caps, without paying sky high valuations.
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