10 innovators for your investment portfolio

Over at the Creativity and Innovation Driving Business blog, Sanjay Dalal has been tracking the performance of the Innovation Index, a basket of 20 stocks comprised of innovators such as Google, Apple, Starbucks, Southwest Airlines and Target. As of March 22, the Innovation Index is up 4% for the year, leading every major U.S. index (e.g. S&P 500) during that time period. In fact, the broader market has mostly been drifting sideways or down for most of the year.

In a column for TheStreet.com, MSN Money senior markets editor Jim Jubak comments on a similar type of investment strategy that he started to track way back in April 2004, based on his analysis of R&D activity at America’s leading companies. Over the past three years, the five stocks in his “innovation portfolio” were up an average of 32.4%, eclipsing the 27%

return on the S&P 500 index, the 21% return on the Nasdaq Composite Index and the 20% return on the Dow Jones Industrial Average for the period.

However, this success of the five-stock “innovation portfolio” over the time period 2004 – 2007 does NOT imply that there is a link between R&D performance and stock market performance:

“My mistake — and it’s a pretty common one among investors —

was to believe that there’s a straightforward connection between the

amount of money a company spends on research and development and how

fast it can grow revenue and profit. The logic goes that more money

spent researching and developing new products means more future revenue

from those products and faster earnings growth, since new innovative

products command a higher profit margin from the market.  […]

“There are no significant statistical relationships between

R&D spending and the primary measures of financial or corporate

success: sales and earnings growth, gross and operating profitability,

market capitalization growth and total shareholder returns.”  That’s consulting company Booz Allen Hamilton talking, and I

find its conclusion convincing. It has run the numbers twice now —

once in 2005 and again in 2006 — for a group of companies it calls the

Global Innovation 1000. And it has run them with a rigor that no

individual investor can hope to match, analyzing seven performance

screens from 2000 through 2005.

Each annual study has come to the same conclusion: What counts

isn’t how much a company spends but how it spends it. The companies

that get the biggest bang out of their R&D spending are those that

manage research and development as part of an ongoing process that

includes customer feedback, design, manufacturing, marketing and —

certainly — innovation and commercialization.

The annual study — the most recent version came out in

November 2006 — punches holes in

some basic assumptions about R&D…”

Thus, to create an innovation portfolio for 2007, Jubak did more than just study the R&D spending patterns of companies. He began with a list of Booz-Allen’s 94 “high-leverage innovators.” Then, he combed through that list of 94, looking for certain technical and fundamental factors suggesting the companies might out-perform the market over the next 12 to 18 months. Based on this analysis, he came up with six American companies: Apple

(AAPL), Caterpillar

(CAT), MEMC Electronic Materials

(WFR), Newmont Mining

(NEM), Smith International

(SII)

and Weatherford International

(WFT).

In order to diversify overseas, Jubak then looked for foreign companies in Booz-Allen’s list that had similar types of characteristics as the U.S. innovation winners. He came up with four overseas stocks for the portfolio: Smith & Nephew (SNN), Komatsu, Hon Hai Precision Industry, and Companhia Vale do Rio Doce (RIO).