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Curated Disruption at a Reasonable Price

The Deepwater Frontier Tech Index (DFTI) informs Innovator’s NYSE-listed LOUP ETF. We aim to power superior long-term returns in frontier technology investing. We are more convinced than ever that our strategy to invest in the themes pushing the frontier of technology while respecting valuation is the superior approach over the next several years as the market exits many thematic bubbles.

Ways to Invest in Disruption

Disruption-focused funds tend to come in three clear flavors in accordance with our four investor archetypes:

  1. Gunslingers: Disruption at any price. These funds represent disruptive technology well, but they ignore rational consideration of generating future cash flows to justify current prices. Instead, gunslinger funds optimize for the most disruptive companies in the most attractive disruption themes. There’s nothing wrong with the gunslinger approach. As we describe in our archetype overview, gunslingers that understand technology and get in early can do quite well if they also accept supply and demand. Eventually, all equity assets need to rationalize on cash flow generation, so the trick for the gunslinger is to get out when demand for the asset is highest. Few time this correctly.
  2. Indexers: Indexing all disruption at any price. Index approaches to disruption come in two types. First, many disruption indices take significant positions in the FAANG (plus MSFT, NVDA, and TSLA) names. While those mega cap tech favorites are driving disruption, nearly every investor already has significant exposure to those names just by owning the QQQ or SPY. Funds that optimize around the inclusion of FAANG names are closet indexing the most popular funds and serve more to increase investors to mega cap tech than expose them to disruptive technologies. The second index approach to disruption is to hold hundreds of companies that fit into the disruptive category without consideration for valuation. These funds offer exposure to disruption, but they don’t optimize for the most attractive companies on a price/technology basis.
  3. Concentrators: Curated disruption at a reasonable price. Valuation-aware disruption investors combine a deep knowledge of emerging technologies with a respect for how much growth is priced into companies pursuing such technologies. This is Deepwater’s approach.

Disruption at a Reasonable Price

The mantra for the Deepwater Frontier Tech Index is to invest in disruption at a reasonable price so we can sleep well at night.

We’ve done internal case studies on the stock performance of several of the most successful tech companies in the world — the ones that now make up a significant part of the S&P 500 and QQQ. Those studies demonstrated that if investors paid prices that accurately reflected the tremendous future growth of such companies throughout history, the returns from those investments would have trailed the broader market despite the disruptive power of those companies.

Paying any price for a company simply because it’s disruptive doesn’t work. If you pay for all the disruptive power of a company upfront, you’re likely to be disappointed by the long-term result.

Investing in disruption helps us sleep well in the midst of a rapidly changing world, but paying any price for disruption makes us sleep poorly. We believe that a company eventually needs to justify its price through future cash flow generation. To be a great investment, an equity asset needs to generate far more in cash flow than is implied in its price. The point of any investment strategy should be to generate attractive returns, not just to bring exposure to a category.

Howard Marks described the investing game better than anyone: To generate extraordinary investment results, you must do something different than everyone else. If you act according to consensus, you’ll get the same result as everyone else — regardless of whether consensus is right or wrong. If you do the non-consensus thing, and you’re wrong, you get terrible results. If you do the non-consensus thing, and you’re right, you achieve the extraordinary.

The most contrarian viewpoint in investing in disruption is to emphasize future cash flows — not technologies, market sizes, or optionality. All the other aspects of disruptive investing only matter to the extent that they generate incremental cash flow above and beyond what’s already priced into a stock.

A respect for valuation is intentionally built into how we construct the Deepwater Frontier Tech Index so that we create exposure to disruption at a price that gives us a chance to generate strong returns.

Variant Perception

There’s a persistent interest in disruptive companies because disruption is exciting. Disruption has the potential to create the next FAANG 10-40x returning stock, the next Tesla, the next Bitcoin. Those returns are intoxicating.

The problem is that most of what’s considered disruption consists of things that are obviously disruptive. Tesla was a great investment when no one believed in electric vehicles. Now everyone sees EVs are the future. Tesla could still generate attractive returns, but it’s mathematically and economically harder for them to do so compared to their valuation many hundreds of billions of dollars ago.

With a market full of investors seeking disruptive tech, there are three contrarian ways to find disruption at a reasonable price:

  1. Be earlier than everyone else.
  2. Understand a much bigger opportunity than everyone else.
  3. Look where others aren’t looking.

Each of these strategies can be effective when applied appropriately, and we use each in our investment approach.
Being early works not only because you benefit from the tailwind of excitement that benefits the gunslinger but also because future cash flows may not be fully priced into emerging disruptive tech.

Understanding an opportunity bigger than everyone else has been the story of global e-commerce for much of the last decade with AMZN, MELI, SHOP, BABA, etc. But the excitement around disruptive tech means that it’s hard to get ahead of a trend for very long, and it’s hard to find opportunities that aren’t fully appreciated.

Looking where others aren’t is the most difficult of the three options. It often requires consideration of companies that appear to be obvious candidates for being disrupted by the disruptors.

We won’t always be right, and we won’t always be different. But when we see an opportunity to be different with good odds of being right, we take it. That’s the only sustainable way to invest in disruption.

Evolving Frontier of Technology

The frontier is ever shifting, as are technologies and the companies that drive innovation on the frontier. As such, the index is dynamic in the themes that it tracks.

Today, we’re witnessing the emergence of AI to power computers and machines to do human tasks. We’re seeing consumers adopt alternative digital assets as we move to a deeply connected metaverse that acts as a strong parallel to the physical world. And we’re seeing a transformation in the way we think about transportation in the physical world.

Timing these waves of innovation is challenging. Even more challenging is identifying the difference between an emerging theme and a true paradigm shift. Focusing on only one domain risks missing another, potentially much larger wave. The Deepwater Frontier Tech Index enables investing in the most promising emerging technologies which helps mitigate risk and improve the odds of participating in the next big wave.

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