Innovation Isn't Enough: The Need for Strong Business Models

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0 5 Research Becomes Increasingly Important Nevertheless, investing in businesses with high gross margins and neglecting to assess other factors may result in failing to find companies with the greatest potential to reward investors. In-depth research, we believe, is required to identify which innovative companies with high margins possess the greatest potential for generating rapid sales growth that will lead to attractive earnings. To that end, companies must have strong marketing and sales teams that can overcome challenges associated with new product adoption.We believe research should include conducting meetings with company executives, test-driving products, interviewing competing companies and assessing market opportun­ ities. Research should seek to determine not only the appeal of a business’s innovations, but also the strength of a company’s management team. Examples of Winners and Losers We believe Nevro Corp. is a highly innovative company with talented leadership, high gross margins and a strong business model. Nevro developed and offers the Senza Omnia system, which provides electrical stimulation of the spinal cord to manage debilitating back pain. The technology is a compelling alternative to opioid pain medicine and surgery, and we believe it is best-in-class with features that allow doctors to remotely calibrate the frequencies of electrical currents via the cloud. Having already established itself for back pain management, the company is now pursuing the peripheral diabetic neuropathic market, which more than doubles Nevro’s addressable market.We believe it has potential to generate a compound annual growth rate in the mid-to-high teens in the next few years and that its growth and gross margins illustrate that Nevro has a strong business model. Cloud-networking company GTT Communications is also innovative and its gross margins are reasonably high, but we believe its business model is inadequate. In 2017, GTT acquired Hibernia Networks, which owns a cable system connecting 10 15 20 Figure 3: Innovation Drives Excess Performance Importantly, companies with high gross margins will see more of every incremental dollar in sales contribute to the bottom line. As such, high gross margins can result in stronger profit growth and in turn reward investors. We believe high gross margins often reflect strong business models because they suggest that products or services offer significant value. The past is no guarantee of future results, but companies with high gross margins have historically generated the best returns (see Figure 4). The highest quintile +16.7% CAGR over past 5 years ending Aug 2020 Th lowest quintile +1.8% CAGR over past 5 years ending Aug 2020 Universe is Russell 3000 Adopters” and a larger group, the “Early Majority.” This larger group waits for products to be proven by Early Adopters before accepting new technologies. Eventually, other groups, such as “Late Majority” and “Laggards,” accept the disruptive technology. Many businesses fail to cross the chasm because marketing messages must be customized for each group while other businesses fail to generate the required strong sales momentum among Early Adopters. Drivers of Outperformance We believe strong business models are required for companies to generate earnings growth. When assessing a business model and a company’s potential for generating earnings growth, gross margins and the likelihood of sales acceleration are important. Gross margin measures howmuch gross profit is generated on a percentage basis from revenue after accounting for direct costs.

UNDERSTANDING GROSS MARGIN

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Gross margin is derived from first determining gross profit, which is the difference in a company’s revenues and the costs of the goods or services that it sells. The resulting number is then divided by revenues to determine on a percentage basis the amount of gross profit produced after factoring in costs.

Figure 4: Stocks with the Highest Gross Margin Have Outperformed

Highest Quintile +16.7%

Russell 3000 Universe

Lowest Quintile +1.8%

5-Year Annualized Return

Based on Russell 3000 Index performance for five-year period ended August 30, 2020. Source: FactSet and Alger.