This means that if we think of innovation in its aggregate form – lower prices and better quality across the whole economy – it happens to be the exact opposite of stagflation. Indeed, it is the most important driver by far of economic growth, real purchasing power and improvements in living standards.
The founding father of growth economics Robert Solow’s old rule of thumb was that about 7/8ths of economic growth was likely due to innovation. Subsequent research in recent decades says this might have been an understatement. Innovation may ultimately be the only thing that matters.
It is also the most important driver of stock returns. Innovative businesses have historically delivered significantly higher returns to shareholders than the stock market overall.
Academic evidence covering global markets over the past four decades shows that the most innovative quintile of companies (as measured by a simple proxy of R&D/sales) returned more than 15 per cent a year compared with the global market return of around 10 per cent. This is a huge difference. A portfolio compounding at 15 per cent a year becomes a 10-bagger in 16 years compared to the 25 years it would take the market overall.
So how does an innovative individual business such as Costco successfully navigate stagflation?
In Costco’s case it comes down to its bargaining power with suppliers and flexibility with customers. Two of Costco’s key mainstay innovations are its staunch commitment to a fixed markup of 14-15 per cent above costs on everything it sells and its limit on the number of different items it sells to only 3,700 per store on average. This gives it very strong bargaining power with its suppliers, because every product must make sense to Costco and its customers at its fixed markup to stay in the store ahead of the competition on the bench.
Equally, customers understand that the stores chop and change in their best interest based on pricing. So, when particular products become too costly, Costco just sells other products. Meanwhile, as the lowest cost retailer, customers respond to any cost of living squeeze by shopping more at Costco.
Innovation for income
A question we are often asked is: 'How do you invest in innovation for income, surely it is more a driver of capital growth than dividends for shareholders?'
Our answer is that there are two types of innovators, one of which is the perfect type of investment for capital growth and the other for income. We refer to these as 'disruptors' and 'leaders'. Disruptors are innovators with a big growth opportunity ahead of them through taking market share – think of Amazon and retail over the past two decades. Disruptors can be great businesses, but they are not income stocks because they are usually investing heavily in growth and so not paying a dividend.
