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European top innovators: R&D intensity drives returns
Peter Garnry
Chief Investment Strategist
Summary: R&D is key for long-term shareholder returns and generally understanding the drivers of increasing returns. One key driver is Wright's Law (cost reduction with cumulative output) and Economies of Scale. High ROIC is a hallmark of competitive edge for generating superior returns and high ROIC often reflects industry or technology shifts. Superstar firms increasingly invest in proprietary software for competitive advantage and are outspending rivals in this area. We are used to successful US based technology companies but in this equity note we focus on Europe’s innovation stars like Novo Nordisk, ABB, and ASML that excel in R&D and innovation across diverse industries.
R&D is an important factor to consider for the long-term investor
In a recent research note Increasing Returns – Identifying Returns and What Drives Them by Michael Mauboussin and Dan Callahan the authors talk about what drives equity returns. The table from their note (see below) shows the five main drivers of increasing returns for companies and their shareholders. It worth reflecting on as an investor as it can help you identify whether a company that you are considering investing in has one of more of these drivers of long-term increasing returns. For Tesla Wright’s Law is at play which is the Learning by Doing factor as cost per unit (EVs) drops by about 20% for every doubling of cumulative output. The force often goes hand in hand with the Economies of Scale factor as increasing cumulative output also increase volume of production up to a certain point.
The hallmark of competitiveness and these increasing returns are a high return on invested capital (ROIC) which reflects that a company has a structure and offers a product that yield a return on capital surpassing the cost of capital. High ROIC figures for an industry are often a sign of significant industry or technology changes. Historical data suggests that abnormal ROIC does tend to revert to the long-term average but that the time period is different across industries and technologies.
One of the findings around companies with increasing returns is that superstar firms substantially outspend their competitors on intangible assets. Increasingly those investments are going into proprietary software and those investments are now growing faster than traditional R&D, acquisitions, advertising, and lobbying. In other words, software is key driver of future moats for many companies. In the old economy advertising was important but today software is more important. High R&D spending is generally associated with companies innovating faster than competitors and winning long-term.
We are used to talk about US exceptionalism because the US won the digitalization with Europe’s technology sector sleeping at the steering wheel. But what about Europe, does the continent offer any superstars when it comes to R&D and innovation? The list below highlights 20 European publicly listed companies. We have filtered on those with a market cap above €10bn, ROIC above 12%, and then selected those companies with the highest R&D spending to revenue. We have also chosen companies across a wide range of industries as the list would otherwise be concentrated too much around pharmaceuticals and semiconductors.
Three European superstars: Novo Nordisk, ABB, and ASML
As we cannot highlight all the companies in the list we have chosen three companies that are innovators in different industries.
Novo Nordisk: Leading the obesity treatment boom
Novo Nordisk is one of the leading insulin manufacturers in the world together with US based Eli Lilly. The Danish pharmaceutical company has recently made key breakthroughs in obesity treatment using the same active ingredient used in its insulin. This has unlocked an almost infinite demand for its obesity drug called Wegovy and catapulted revenue growth to its highest level in the firm’s entire history. The pharmaceutical industry of Europe is significant industry and important value driver of European equity markets as the list also shows.
ABB: Industrial and automation powerhouse
ABB is an industrial giant of Europe and a leader in robotics, automation technology, and power solutions. The new wave of electrification ushering over the world with electrification of transportation, heating, and running data centres for digitalization is benefitting ABB. The company’s largest segment is called Electrification which is engaged in everything related to the electrification from power solution, EV charging networks, grid technology and power generation technologies. This segment has been the key driver of the company’s record margin expansion.
ASML: Monopoly in equipment used for advanced AI chips
The crown jewel of Europe’s technology sector manufacturing advanced lithography machines used for advanced chip production. The most advanced AI chips in the world powering the boom in AI are manufactured using extreme ultraviolet lithography machines (EUV). ASML basically holds a close to monopoly in this industry and EUV accounted for 42% of net system sales in 2023. No matter who wins the chip battle (Nvidia vs AMD vs Intel) or who wins the foundry battle (TSMC vs Intel), the industry must use ASML machines and thus the company is well-positioned for the AI boom and general Internet of Things trend over the coming decades. Recent notes on equities
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