Bruno Paulson

At a time of heightened unpredictability in an evolving world order, investors can find an element of consistency by focusing on high quality companies that prioritise sustained innovation, according to portfolio manager for the Morgan Stanley Investment Management’s International Equity team, Bruno Paulson.

“In order to thrive and withstand the current market volatility, even the world’s most enduring franchises must keep evolving.

“Companies that demonstrate innovation through groundbreaking product development or cutting-edge AI applications remain best positioned to navigate market shifts, capture new opportunities and are more inclined to succeed in the long term,” said Mr Paulson.

Innovation extends beyond disruptive or breakthrough inventions. Incremental innovation is a core strategy for maintaining relevance, driving competitive differentiation, and enabling long-term growth.

According to Mr Paulson, companies within mature and well-penetrated industries like consumer staples still need to innovate in order to strengthen their market positions and meet evolving client needs and expectations.

“In an industry like consumer staples, achieving growth and maintaining pricing power requires a steady pipeline of innovations that address consumer needs, supported by sustained marketing investment and best-in-class execution.

Mr Paulson pointed to Procter & Gamble and Coca-Cola as examples of the select consumer staples companies the team chooses to own through its quality portfolios that demonstrate sustained innovation.

“For example, Procter & Gamble (P&G) allocates 14 per cent of its revenue to research and development (R&D) and advertising, ensuring continuous product innovation.

“Most recently the company launched Tide EVO, a water- activated laundry tile incorporating fifty patents. Packaged as a dry tile rather than encased in plastic, the product is targeted at consumers who want to a zero-waste product and can decrease plastic and energy use. The innovation of this product not only addressed the need to adapt swiftly to changing consumer needs but also helped P&G to gain more market share, sustain pricing power and resilient gross margins, after maintaining for the past five decades mid-single digit organic growth in this category,” he said.

In the beverages sector, Coca-Cola, which operates over 500 brands across soft drinks, waters, juices, teas and coffees, continues to expand its functional portfolio through strategic innovation. This year it launched Simply Pop, it first prebiotic soft drink, and the Fairlife brand, which is now a leader in the US protein drink segment.

“Despite currency headwinds and macro-economic turbulence, Coca-Cola continues to grow earnings. This is a testament to its strength and alignment of its global system and continued persistence towards the “Total Beverage Company” strategy. The company continually looks for gaps in the market to expand into and innovates new products to meet those changing consumer needs.

“Coca-Cola also innovates at an operational level. It strategically refranchised it bottling operations by streamlining its structure, reducing capital intensity and directing focus to higher return activities. This has resulted in improved gross and operating margins, as well as higher returns on capital, supporting a more favourable valuation multiple.

“In our view, Coca-Cola’s integrated growth strategy, underpinned by innovation and operational efficiency, positions it well to navigate economic challenges and sustain its market leadership,” said Mr Paulson.

Companies that have mastered the art of recurring revenues and pricing power are often underpinned by strong innovation, which Mr Paulson said is important to weather the turbulence of today’s market.

“In order to thrive, even the world’s most enduring franchises must keep evolving. We continue to deepen our understanding of companies that demonstrate innovation to underpin longevity, whether it be through groundbreaking product development or cutting- edge AI applications, high quality companies that prioritise sustained innovation are on the right track for long-term and sustainable performance,” he said.

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Bruno Paulson

Investing in a portfolio of high-quality compounders – well managed companies with sustainably high returns on operating capital – can result in strong returns and the potential to outperform traditional equity indices, according to Bruno Paulson, managing director of Morgan Stanley Investment Management’s International Equity team.

“We’re well-known advocates for a long-term approach to high quality investing. The secret to compounding is steady growth at sustainably high returns on operating capital over the long term, which can compound shareholder wealth over the long term, something lower quality companies are unable to do,” Mr Paulson said.

The chart below illustrates the power of compounding, comparing an initial investment of $100 receiving 9 per cent simple interest versus 9 per cent compounding interest over 10 years. As the chart demonstrates, compound interest results in the doubling of capital every eight years, with returns growing dramatically over time.

As Mr Paulson explains, the International Equity team looks for the companies in their global portfolios to be able to continue to compound at around 10 per cent. For a typical company in the portfolio this might be achieved by revenues growing reliably at 5 to 6 per cent across the economic cycle, incremental improvements in margins adding another 1 per cent, and with a 4 per cent free cash flow yield, helped by the near 100 per cent free cash flow conversion, completing the picture.

In rough economic conditions, can the market match this compounding ability? The team is not convinced. “That is the worry right now, that after 15 years without a recession, barring the brief interregnum of COVID, trickier times may be on the way, though signs of an imminent US recession are fading” notes Mr Paulson.

While 2023 was the story of the Magnificent Seven in the US, things have moved on in 2024. “We now have talk of the ‘Fabulous Four’, but it is really the ‘Omnivorous One’ – the American graphics processing unit and chip systems company Nvidia, which is up another 150 per cent in the first half of 2024 as reported by Forbes and at a US$3.09 trillion market capitalisation, according to Bloomberg”.

A combination of ebullient and concentrated markets makes for a challenging investment environment, however, the team’s response is to think in absolute terms and look to compound over the long run. “We want to avoid the permanent destruction of capital, which we would argue is just as important to investors as the chance to earn outsized investment returns.”

Ultimately, the team believes long-term investors benefit from investing in high quality equities that can stand the test of time.

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