June 11, 2010

Most investors acknowledge that innovation can be very profitable. Finding innovative companies when they are young allows investors to reap the benefits as new ideas and products conquer markets. If only it were that simple. David Eiswert, manager of the T. Rowe Price Global Technology Fund, cautions that "innovation alone doesn't make money." Even great ideas can flounder if industry trends are unfavorable.

Thomas Rowe Price, Jr., recognized decades ago that change was a constant in the economy. Similarly, Henry Ellenbogen, who recently assumed the role of manager of the firm's New Horizons Fund, believes that the increased flow of information around the world has increased the pace of "paradigm shifts"—major innovations that shake up business models and industries.

Often, the companies that use new technologies are changed more than those that develop them. Jack Laporte, Ellenbogen's predecessor and manager of the New Horizons Fund for 22 years, relates that he has "had more success with innovations in retailing, value-added distribution, and services" than with manufacturers who come up with new products. For this reason, investors should broaden their search for innovation well beyond technology companies. Segmented big-box retailers and online, for-profit education companies are two areas that have grown substantially through innovation in recent years.

Investors also need to broaden their search for innovative companies beyond the shores of the United States. While the U.S. remains the leader in research and development spending, Asia's investment in new technologies is growing faster and rapidly approaching that of our own.

One challenge in investing in innovative companies is finding them before the value of their innovation is reflected in their stock prices. Ken Allen, manager of the Science & Technology Fund, notes that finding innovative advantages before other investors become widely aware of them is typically the only way to make outsized returns.

T. Rowe Price has a large and growing global network of analysts seeking out these innovative companies before their advantages are widely known. The firm's analysts seek to understand not only a company's balance sheet but also the dynamics of its customers, partners, and competitors. Eiswert notes that each "industry has its own subculture in which you need to understand what's important and what's valued." In particular, he looks for innovative companies that are disrupting existing markets or creating entirely new ones.

While product cycles in the technology sector can come and go with astonishing speed, equally vital innovation in the health care sector can take decades. Kris Jenner, manager of the Health Sciences Fund, notes that development costs for new therapies and patient safety concerns mean that new drugs or therapies can take years to develop. Even then, adverse side effects in some patients can derail a promising investment.

Innovation in the energy sector will be vital to deal with declining reserves and rising energy demand in the coming decades. While new alternative energy sources are important, Charles Ober, manager of the New Era Fund, believes that innovations in commercial and industrial energy efficiency may end up being the greatest source of additional energy supply.

For a more detailed discussion, read "Investing in Innovation" in the spring 2010 T. Rowe Price Report.

All funds are subject to market risk, including possible loss of principal. Small companies tend to have less experienced management, unpredictable earnings growth, and limited product lines, which can cause their share prices to fluctuate more than those of larger firms. Technology stocks historically have experienced unusually wide price swings, both up and down. The potential for wide variation in performance reflects the special risks common to companies in the rapidly changing field of technology. Because of the cyclical nature of natural resource companies, their stock prices and rates of earnings growth may follow an irregular path.