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Innovators: a catalyst in the making

2024 Outlook

5 December 2023 |
Active ESG
Leading innovators played an outsized role in driving returns in 2023. Will we see more of the same in the coming 12 months?
The Federated Hermes 2024 Outlook

They say innovation thrives in difficult circumstances and that constraints can be the catalyst for problem solving and creative thinking. The dramatic rise in the cost of capital since early 2022, may therefore have accelerated the pace of innovation, rather than slowed it.

Going into 2024, we have rarely been more excited by the transformative innovation across a multitude of sectors. The convergence of generative artificial intelligence (AI) and augmented reality (AR) has the potential to redefine user experiences and drive productivity.

In healthcare, the story of 2023 was GLP-1’s (a class of type 2 diabetes drugs that improve blood sugar control) and anti-obesity medication. In 2024, however, we can look forward to the development of precision medicine and see how advanced data analytics can revolutionise patient care. Customized treatment plans, using individual genetic profiles and real-time health data, will likely become more prevalent, ushering in more personalised healthcare solutions.

The energy sector remains dominated by fossil fuels, but there continues to be innovation in sustainable technology, for instance in next-generation solar panels and energy storage solutions. Advancements in materials science and nanotechnology are also helping to drive the efficiency of renewable energy sources, bringing us closer to achieving a greener and more sustainable future.

Blockchain technology has been forgotten by many, but continues to evolve in applications beyond cryptocurrency. In 2024, we can anticipate the widespread adoption of blockchain in supply chain management, ensuring transparency and traceability across complex global networks. This innovation is set to streamline processes, reduce fraud, and enhance overall efficiency in various industries.

Advancements in 6G technology are set to revolutionize communication networks, enabling faster and more reliable connectivity. The Internet of Things (IoT) will benefit from these developments, leading to smarter and more interconnected cities, homes, and industries.

2024 promises a wave of innovation that could shape the future.

In summary, 2024 promises a wave of innovation that could shape the future. From healthcare to energy, blockchain to 6G, these advancements have the potential to drive meaningful improvement in living standards.

Steve Jobs once said, “innovation distinguishes between a leader and a follower”. There is rarely much reward for the latter in public markets; at the time of writing, Apple remains the world’s most valuable company. Innovation is indeed a crucial capability in the companies we invest in, and with the step changes in technology we are witnessing today, it’s never been more important.

This last year has been a perfect storm for small & mid cap (SMID) stocks, with the market concerned about the effect of rising interest rates and costs, and levels of borrowing. The result has been that performance relative to large caps overall has been the worst since the middle of the last decade, and even longer for small caps in the U.S.

However, looking through the distortions caused by the “Magnificent Seven” at the top end of the market cap range, and the nearly 50% of U.S. small caps that are unprofitable at the bottom end, there are still a great number of small and mid-range companies that are dynamic and forever responding, and adapting to, current markets.

These stocks can provide relatively safe exposure to innovation; SMID cap stocks are, in reality, large corporations in the overall scheme of things (i.e. versus unquoted companies and SMEs) and their new ideas emerge from already well-established businesses; far better, in my view, to have the reassurance of being in a relatively high quality business with some attractive optionality, than to bet the ranch on a set of binary outcomes from early stage ventures. The sort of business in which we invest will typically have high market shares in their particular niche, so that their innovation has not only a sound base, but can also still compete against larger entities.

Sectors where there is considerable innovation comprise over half of the investible universe.

Industrials is the largest sector in the of the Global SMID benchmark and comprises just under a quarter of it, which compares with a low double digit percentage for the whole market. In addition, Materials, Health Care and Information Technology between them average about 10% each of the benchmark. So, in aggregate, sectors where there is considerable innovation comprise over half of the investible universe.

The attraction of small caps is to latch onto their faster growth. Yes, this comes with higher risk, but the extra return can offset the extra risk in the long term and there is great potential for exposure to tomorrow’s products and services.

The United States, and the rest of the world, has been awash in capital over the past decade through monetary and fiscal stimulus. The recession of 2008/2009 followed by the unprecedented global pandemic pushed governments and central banks to respond in ways not seen in modern times. Government stimulus programs ensured that consumers and businesses were able to draw on additional sources of funding to meet payroll and provide tailwinds to consumer spending. After a 40-year absence from the developed economies, inflation returned with a vengeance and has forced governments and central banks to curtail spending and start to remove capital from the global economy.

Technology and innovation will continue to be a major growth engine

Asset classes that came to maturity during this time period were able to draw on rising valuations, readily available credit for debt packages and the funding of cash intensive business models, as well as a consumer that was both willing and able to spend.  The next 10 years will be driven by different tailwinds.  In 2024 and beyond, investment returns will more heavily rely on organic revenue growth and cash flow generation.  Successful investments will be driven by business models that are not only exciting and providing real economic value today, but will also be exciting and valuable in five or 10 years’ time. Technology and innovation will continue to be a major growth engine coupled with healthcare, renewables, and business services.  Cutting edge industries such as blockchain and AI will provide further potential opportunity for investors that are able and willing to participate, but are also able to separate the hype from reality from an investment perspective.

The decrease of available capital within the private equity space will reward investors who have dry powder, have the experience and track record of investing through cycles and have a global reach. This could provide an abundance of potential investment opportunities than can be then applied to rigorous underwriting standards. Global investment engines with the flexibility to navigate an increasingly turbulent geopolitical environment will also be rewarded.

As with any economic environment, there will always be prudent investment opportunities and new tailwinds taking shape that flexible global investment frameworks can take advantage of. 

Venture capital investment into AI since 2011

The Federated Hermes 2024 Outlook

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