The Cerno Global Leaders Programme seeks to identify and invest in a group of companies worldwide which possess leadership attributes with a view to holding them for the long term.

What constitutes leadership capacity?

There are a small group of enterprises within the global equity universe that persistently exhibit above average growth, profitability and investment returns over the long-term. These companies often operate in oligopolistic industries and possess qualities that contribute to their competitive advantage and economic moats, ranging from:-

  • barriers to entry
  • economies of scale
  • differentiated product/service offerings
  • outstanding management teams with good strategy and execution capabilities.

This method of understanding industries has been shaped by the work of Harvard professor Michael Porter. Porter coined five archetypal attributes: pricing power, bargaining power, threat of new entrants and substitutes, and competitive industry structure.

From a quantatively screened universe, the investment group selects stocks based on seven main criteria that were developed from Porter’s five forces:

  1. Strong and defensible competitive position or business franchise
  2. Management with a high level of integrity
  3. Above sector average growth prospects
  4. Cash returns delivered at significant excess to their cost of capital
  5. Operating in multiple markets or in the process of extending a strong domestic position internationally
  6. Companies with a robust balance sheet and low leverage
  7. Quality company at the right price

Complimentary to these, we observe that technological prowess and innovation are relevant factors in the sustenance of positive economic value in many of our candidates. In a world whose trajectory of travel is progressively technologically oriented, the strength of a firm’s intellectual property is crucial to their ability to sustain market leading positions and preserve barriers to entry, thereby protecting higher profits and margins over long time frames.

InfoTech, healthcare and automotive industries are well recognised leaders in innovation. Companies in these sectors regularly post R&D spending in excess of 10% of sales and hold a large portfolio of patents to protect their intellectual property. According to figures from Strategy&, a consultancy under PwC, Volkswagen, Samsung and Intel were the Top 3 investors in R&D worldwide in 2014, spending US$13.5bn, US$13.4bn and US$10.6bn in absolute US dollar terms, respectively. Furthermore, the top 20 R&D spenders illustrated in Exhibit 1 are comprised solely from the three sectors mentioned above.

Exhibit 1: Top 20 firms ranked by R&D expenditure in 2014 (US$ billions)

2014
Rank
2013
Rank
Company Geography Industry R&D
Spend ($Bn)
*
1 1 Volkswagen Germany Automotive 13.5
2 2 Samsung South Korea Computing and electronics 13.4
3 4 Intel United States Computing and electronics 10.6
4 5 Microsoft United States Software and internet 10.4
5 3 Roche Switzerland Healthcare 10.0
6 7 Novartis Switzerland Healthcare 9.9
7 6 Toyota Japan Automotive 9.1
8 10 Johnson & Johnson United States Healthcare 8.2
9 12 Google United States Software and internet 8.0
10 8 Merck United States Healthcare 7.5
11 11 GM United States Automotive 7.2
12 14 Daimler Germany Automotive 7.0
13 9 Pfizer United States Healthcare 6.7
14 N/A Amazon United States Software and internet 6.6
15 N/A Ford United States Automotive 6.4
16 15 Sanofi-Aventis France Healthcare 6.3
17 13 Honda Japan Automotive 6.3
18 16 IBM United States Computing and electronics 6.2
19 17 GlaxoSmithKline United Kingdom Healthcare 6.1
20 N/A Cisco United States Computing and electronics 5.9

* R&D spend data is based on the most recent full-year figures reported prior to July 1st.

Volkswagen has been the largest private sector R&D investor for 3 straight years. The Group employs over 40,000 research personnel working to expand the Group’s model range with a particular focus on the reduction of CO2 emissions. The automotive industry is undergoing a generational transformation, with Tesla leading the way in electronic cars, hybrids increasingly gaining traction, and new players like Google and Apple entering the market with driverless technologies. All of these are highly disruptive for an industry, whose power source has been fundamentally unchanged since the internal combustion engine replaced steam boilers 100 years ago. R&D investments are therefore critical for Volkswagen to sustain an edge over competition and adapt quickly to a changing industry landscape.

In the Tech space, Samsung has more than doubled their R&D spending over the past six years, as illustrated in the chart below. This is not surprising, given the cut-throat competition in two of Samsung’s major revenue generating businesses, smartphones and semiconductors. In the smartphone segment, threats from both established entities (Apple) and new low cost entrants (Lenovo, Huawei, Xiaomi) keep Samsung on its feet as switching costs in handsets is next to zero for its customers. And for semiconductors, competition is also intensifying among the largest manufactures including Intel, TSMC and Qualcomm.

Exhibit 2: Top 3 Enterprise by R&D Expenditure 2009-2014 (US$ Billions)

Top 3 Enterprise by R&D Expenditure 2009-2014 (US$ Billions)

Source: Strategy&

But even companies that are traditionally perceived to be relatively mundane can offer surprisingly innovative initiatives. In a constantly changing macro environment, these companies are either forced to innovate themselves, or alternatively, buy into new technologies to differentiate and gain an edge over their competitors. Research and development is increasingly critical to drive their success. Here we give three examples of such companies, drawn from our approved list and which span across the consumer, industrials and materials sectors.

Givaudan, a leading provider of flavours (for the food and beverage industry) and fragrances (perfumes, personal care, consumer products), at first glance, seems far from technological. The company however, spends 10% of their sales on R&D to develop new molecules (that are patented), proprietary solutions or improve existing formulation that will create value for their customers (e.g. more use of natural ingredients, cost reduction through alternative or substitutes among others). Their products form 3-5% of their customers’ cost base, but taste and smell are highly influential factors when consumers make a decision to purchase an end product. Therefore Givaudan’s customers (for example, Nestle), are less willing to switch to a cheaper provider at risk of reputational damage should the cheaper alternatives not live up to their standard.

Assa Abloy is a leading manufacturer of security locks and automatic doors. In a highly fragmented market, the company must innovate to differentiate themselves from their peers, holding over 500 patents with another 300 applications pending. They have a robust product pipeline, in which new products developed in the last 3 years constitute 32% of sales. What makes them more interesting is their lesser known division that operates in secure solutions, embracing existing technologies including NFC, biometrics and RFID for uses in credential management, secure IDs (i.e. US green card, e-passport, drivers’ licences), asset tracking and logistics, and healthcare (RFID tags).

PPG Industries, a paint manufacturer (a more recognisable subsidiary perhaps being Dulux), also puts substantial efforts into R&D. Their industrial/specialty coatings business, in particular, requires them to adhere to universal or industry specific demands. Depending on circumstances, products must be corrosion proof, weather proof, scratch resistant, insect repellent (architectural), health conscious (for food packaging coatings). They need to think about environmental impacts, adhesion properties (to different surfaces) and application methods (e.g. electro-coat, pre-treatment, powder or liquid). Other innovations are cost or sustainability driven. For example, coatings on aeroplanes needs to be specially designed to achieve cost-savings for the client through reduction in weight/quantity without altering the finish, thereby reducing the fuel cost per flight.

We look for companies that can identify the direction of global industry trends and are flexible enough to take advantage of a changing ecosystem.

Renishaw, a £2 billion market cap, UK industrial company, has a longstanding history of innovation in metrology products with wide applications in many end-markets, including automotive, aerospace, energy, power generation, construction, agriculture, medical and consumer products. The company is a beneficiary of ongoing trends in industrial automation and demands for high precision measurement, calibration, sensory, gauging and probing tools. The company invests heavily in R&D in excess of 15% of sales, which is the highest among peers, and holds a portfolio of 1,500+ patents. More recently, they have added a 3D printing business and a healthcare portfolio leveraging Raman spectroscopy technologies, recognising the wide application potential of the two businesses across multiple industries.

In the Cerno Global Leaders Programme, we place great emphasis on finding companies that can deliver and sustain technological advantage over the long-term, driving a defensible competitive position. R&D activity provides evidence of this commitment. We deploy a wider definition for the term ‘leader’ that also includes the explicitly and implicitly technology inclined companies such as the names mentioned in the examples above.  Exhibit 3 below displays the Top 10 firms in the Global Leaders Programme with the greatest commitment to research and development.

Exhibit 3: Top 10 firms in the Cerno Global Leaders Programme by R&D expenditure (US$ billions)

Company Geography Industry R&D
Spend (US$Bn)
R&D (as % of sales)
Volkswagen Germany Automotive 4.5 6.0%
Samsung South Korea Computing and electronics 8.0 6.9%
Johnson & Johnson United States Healthcare 6.6 11.4%
Novo Nordisk Denmark Healthcare 13.4 15.5%
Nestle Switzerland Consumer Staples 0.2 1.8%
PPG Industries United States Materials 1.7 3.2%
Givaudan Switzerland Materials 4.8 9.2%
Reckitt Benckiser United Kingdom Consumer Staples 10.4 1.6%
Assa Abloy Sweden Industrials 6.2 2.6%
Zimmer Holdings United States Healthcare 2.0 4.0%

Source: Bloomberg

One final point to take note is, however, R&D spending does not automatically translate to innovation. In other words, quantity does not always equate quality. When selecting companies, it is important to understand where their R&D focuses lie, and to assess the impact on the company itself and how influential it is on the industry as a whole. Exhibit 4 below shows the Top 10 most innovative companies globally, and it is clear that the constituents have changed somewhat compared to Exhibit 1. While Apple, Google and Amazon spend less on R&D, what they have achieved is regarded to be more influential across multiple industries that are not restricted to the one they belong to and have wider implications for the global communities.

Exhibit 4: Top 10 most innovative firms of 2014

2014
Rank

2013 Rank

Company Geography Industry

R&D Spend ($Bn)*

R&D Spend (% of sales)

1

1

Apple

United States

Computing and electronics

4.5

3.3%

2

2

Google

United States

Software and internet

8.0

14.9%

3

4

Amazon

United States

Software and internet

6.6

10.4%

4

3

Samsung

South Korea

Computing and electronics

13.4

6.0%

5

9

Tesla Motors

United States

Automotive

0.2

14.5%

6

5

3M

United States

Industrials

1.7

5.6%

7

6

General Electric

United States

Industrials

4.8

3.6%

8

7

Microsoft

United States

Software and internet

10.4

13.1%

9

8

IBM

United States

Computing and electronics

6.2

5.9%

10

N/A

Procter & Gamble

United States

Consumer

2.0

4.8%

* R&D spend data is based on the most recent full-year figures reported prior to July 1st.

Source: Strategy&

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