Innovation – our best chance against the rise of the East

The West must use its superior intellectual property reserves to fight the growing global economic dominance of China, writes Paul Hill.

A university student asked me for advice on getting his first job last month. His first question was nothing to do with his CV, or potential earnings, or even where he should look for work experience. What he really wanted to know was this: "What careers are outsourcing-proof?"

It shows just how worried even qualified graduates are about their skills being off-shored to low-cost countries. And they're right to be. Like it or not, globalisation is here to stay. China's gross domestic product (GDP) has grown on average at three times the pace of Britain's over the past 20 years. As well as being the third biggest economy ($4.3trn) behind Japan ($4.9trn) and the US ($14.2trn), it is also the world's largest exporter, car market and consumer of commodities by miles. Both its domestic steel and cement industries are larger than those in the entire European Union, Japan, the US and Russia put together.

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And it's not just manufacturing that is going offshore; the services sector is also taking a hit. Call centre, data entry, IT and more recently high-end research and development (R&D) posts are shifting overseas to nations who can supply smart graduates at bargain prices. R&D salaries in China are one-sixth of those in the US. An electrical engineer with a master's degree and five years' experience earns an average of $18,000 in India, compared to $84,000 in the US. At those prices, you can see why the likes of IBM now employ 100,000 workers in India, Hewlett-Packard 26,000, Microsoft 5,500 and Cisco 5,000.

How the West can compete

So it's little wonder that pundits across the world are declaring that the global balance of power and money is all heading in one direction east. But it's not game over, not by a long chalk. The West is starting to fight back. Not by indulging in protectionism there have been some trade disputes during the recession, but nothing dramatic as yet. Instead, the West's secret weapon is innovation.

Developed nations have one huge advantage over their emerging-market (EM) cousins. They have a treasure chest stuffed with intellectual property (IP), patents, coveted brands and unexploited technology, ownership of which has deliberately been kept under lock and key, deep within their research vaults.

For example, the West still dominates the planet's IP base, with Japan (29.7%), the US (25.4%) and Germany (9.5%) sitting at the top of the patent tree, according to the World Intellectual Property Organisation. The UK takes fifth place on 3.2% (although that's gradually declined from 5.5% in 1985). The likes of China and India don't even feature in the top ten. This horde of knowledge, trade secrets and experience has been created over decades. It can't be replicated overnight just by building a new factory or opening a call centre.

It doesn't stop there. Developed nations also possess the highest literacy/education levels, and house all of the world's top 20 universities (such as Cambridge and Stanford), according to the UN. In turn, they produce most of the scientists who have won Nobel Prizes. In the biotech space too, the US accounts for more than 80% of the world's R&D spending, while Western corporates own 98 of the world's 100 most valuable brands, including household names such as Coke, Nokia, Disney and McDonald's.

The trick is for developed nations to exploit this IP to raise productivity, drive prosperity and create the next generation of corporate titans. This is already happening. Some of the world's most innovative companies are less than 20 years old these include Google, Nokia, Apple, Microsoft, CISCO, SAP, Amazon, eBay, Dell and Intel, to name just a few. The UK isn't bereft of talent either. We've built firms such as Autonomy, O2, ARM, Dyson and Sage from scratch. But now this rate of innovation has to accelerate exponentially, as Asia is fast catching up, registering more patents than ever and sending thousands of students overseas to study at the West's top colleges.

To their credit, most Western governments realise innovation is one of the best ways to stay ahead of the game, and is one of the few hopes they have of dragging themselves out of the current crisis. As a result, they are now throwing serious money into areas that will hopefully deliver millions of new, well-paid, knowledge-based jobs in the future.

Governments are pushing R&D

For instance, in the first quarter of this year, President Barack Obama announced a whopping $158bn injection of new capital into bolstering Uncle Sam's scientific credentials: $16bn was allocated to pure science, $83bn to education and a further $59bn for green technologies.

Next out of the traps came the UK, which is launching a government fund to promote R&D and harness the UK's "world-class technology". This comes on top of R&D tax credits, and extra cash to stimulate innovation across the manufacturing, digital and biotechnology sectors. And let's not forget the £45bn (equivalent to £1,675 per pupil) already ear-marked for Britain's Building Schools for the Future (BSF) programme to raise academic standards, improve computer literacy and upgrade infrastructure.

The French are pitching in, too. President Nicolas Sarkozy has come up with a e34bn package for new investments in France's universities, laboratories and renewable energy. These, he says, "will pay for themselves by lifting the nation's long-term growth rate". And on a broader level, both the European Union and the US are aiming to devote 3% of GDP to science in the long run. This may not sound earth-shattering, but it's a big improvement on existing R&D budgets. It would equate to an extra $300bn a year roughly six times the amount that China and India spend in total.

More research should mean more technological breakthroughs. And that's crucial for economic growth. The link between IT advances, for example, and efficiency has been clear for some time. In the US, the annual rate of productivity growth was a full percentage point higher after 1995 than before, solely because of the surge in computing. Of course no one knows for sure where the next technological breakthrough will occur. But there's no shortage of candidates including personalised medicine, space travel and exploration, climate change, robotics and artificial intelligence.

How to cash in

So how can we profit from this huge investment in the innovation eco-system? There are several approaches, but among the companies that should do well are those involved in the supply of laboratory equipment, say to the healthcare or technical sectors. These are the 'picks and shovels' companies that will provide the new equipment needed to seek out the next big idea. Thermo Fisher Scientific (NYSE: TMO) is the largest and most diversified play, along with Agilent Technologies (NYSE: A), Tecan (Zurich: TECN) and for something more racy, UK-based Genetix (Aim: GTX). Agilent is the world's top provider of measurement and testing products. The other three firms supply state-of-the-art laboratory kits to the pharmaceutical industry. Tecan and Genetix specialise in the rapidly growing area of biologics (drugs made from living organisms rather than chemical compounds) and oncology. These stocks look fully valued for now, but you should put them on your watch list and buy for the long term on any correction.

There are also plenty of stocks well-placed for the education boom. RM Group (LSE: RM) installs IT systems in schools, and has around a 30% share of the £1.1bn UK market. It has secured an estimated 34% of all the BFS contracts tendered more than twice the amount of its nearest rival. It also recently bagged a prestigious £16.5m deal in Hull, and renewed its deal to run the intranet for Scotland's education network. Those with a higher appetite for risk could try small caps such as Findel (LSE: FDL), which supplies everything from white boards to desks, and DRS (Aim: DRS), which marks exam papers. In the US, there are several education providers too, such as Apollo Group (Nasdaq: APOL), Corinthian Colleges (Nasdaq: COCO) and DeVry (NYSE: DV), all of which offer post-secondary degrees and diplomas. Again, keep these on your watch list as they are fully priced for now.

One to buy now

So what does look like good value right now? In terms of the risk/reward outlook, my favourite is Murgitroyd (Aim: MUR), a UK-listed patent lawyer. The company should have a field day as scientists come up with more ideas that have to be protected across numerous jurisdictions. Headquartered in Glasgow, the group employs 227 staff in eight countries, and specialises in filing, defending and renewing patents, trademarks and designs. It also helps customers ranging from multinationals to individual inventors with their general IP management. These services span many industries, including engineering, electronics, chemistry and biotechnology.

This is a growth market, regardless of how government stimulus plans pan out. The industry has doubled in size over the past decade (with an average growth rate of 7% a year), on the back of greater corporate R&D investment, together with a growing number of patent disputes between owners and copycat rivals.

Britain is still Murgitroyd's biggest earner, accounting for 63% of its revenues (£28.9m), followed by the US (14%), France (5%), Japan (4%) and Ireland (3%). The industry is not immune to the recession, yet it has been impressively resilient. Despite the slump, filings at the European Patent Office rose by 1.8% last year. And when the dotcom bubble burst in 2001, Murgitroyd benefited from a deluge of litigation work, as patents were challenged more frequently in the courts. So if history repeats itself, there could be another spike in demand.

Turnover for the year ending May 2010 will come in at £30.4m, with underlying earnings per share (EPS) of 27.9p, rising to £31.2m and 30p respectively in 2011, reckons research group Hardman. On the current share price of 257p, that puts the stock on p/e ratios of 9.2 and 8.6, while paying a 3.5% dividend yield. I would value the group on a ten-times operating profit (Ebita) multiple. After adjusting for the £7m in net debt, that generates an intrinsic worth of more than £3.50 a share 35% above today's level. There are a few risks, of course. It's possible that companies might slash R&D budgets further. But this is unlikely it would amount to commercial suicide. And fees for patent lawyers will remain under pressure from cost-cutting clients. But overall, Murgitroyd should be able to maintain its 14% Ebita margins by keeping a tight rein on overheads. The group has bought five businesses in the past six years, so there could be some residual snags involved in tying these together, but most of the integration has already occurred. Finally, as a net purchaser of euros, the firm could also be hurt by any further slide in the pound. All the same, protecting IP is a vital role in Western economies, so stocks like Murgitroyd should continue to do well.

And one to watch

Another IP-focused company is RWS Holdings (Aim: RWS) Europe's top patents translator. Its clients include 3M, AstraZeneca, France Telecom and Peugeot across Europe, North America and Japan. Its work is very complex: obviously the translation has to be factually correct, but the sense, purpose and tone of a document must also be spot-on. If a patent is poorly drafted and later over-turned, billions could be wiped off company valuations overnight. This need for stringent attention to detail and a reputation for getting it right create substantial barriers to entry. RWS also benefits from the weak pound. Two-thirds of its turnover is denominated in euros, while most of its costs are in sterling.

Profits have been hit this year by a new EU directive (known as the London Agreement). This meant that from May onwards, clients filing a Europe-wide patent did not have to have it translated into all local languages. However, six months on, RWS has successfully traded through this change. What with overall patent business only likely to grow, any fall-off in European translation work should be offset by rising business levels across the globe. RWS's balance sheet is also solid, with £24m in net cash.

However, I wouldn't buy right now. At 317p, the stock has jumped by more than 90% over the past 12 months, and now trades on a 12.5 p/e, which looks about right to me. If you have the stock, hold on to it if you don't then keep an eye on it and wait for the chance to buy in lower.

Of course, while the West tries to maintain its lead in innovation, China is hardly sitting on its hands. For more ways to profit from the education arms race, see below.

Three speculative punts on Chinese education

The West has the edge on innovation, but the Chinese are well-placed to catch up. Because of the one-child policy, parents are able to allocate all of their resources to a single son or daughter indeed, they have little choice. And since most families view education as the ticket to a more prosperous life, this is an area in which they should expand rapidly.

That should be good for New Oriental Education and Technology (NYSE: EDU). This $2.8bn firm offers a wide range of products including exam preparation, online courses and language training for pupils, students and adults in China. However, at $72 apiece, trading on a forward p/e of 34, the shares aren't exactly cheap. Keep them on the radar screen and wait for a better time to buy.

ChinaCast Education (Nasdaq: CAST) may be of more interest to investors right now. This far smaller company (its market cap is $320m) offers degree-accredited courses in Chinese universities. It has around $37m in the bank, and expects 2009 earnings to come in at around $15m. After stripping out the cash pile, that puts the stock on a p/e of 16. That may seem quite dear, but given that its profits are forecast to leap by more than 30% next year, the stock's p/e to growth (PEG) ratio (defined on page 40) falls to around 0.6. If you're willing to take a risk, I'd rate this a speculative buy.

Another stock for the brave is China Education Alliance (Nasdaq: CEU). This niche player offers services such as tutoring, exam preparation and vocational training to all ages. Its market capitalisation is $189m, including net cash of $38m. For the first nine months of 2009, both revenues (at $26.5m) and earnings per share (at 44 cents) jumped by a jaw-dropping 65%. Based on full-year earnings estimates of 57 cents per share, the stock trades on a price/earnings multiple of 11. Another speculative buy.

This article was originally published in MoneyWeek magazine issue number 465 on 11 December 2009, and was available exclusively to magazine subscribers. To read more articles like this, ensure you don't miss a thing, and get instant access to all our premium content, subscribe to MoneyWeek magazine now and get your first three issues free.