One of the great investment successes of recent months has been Games Workshop, which has doubled in price in the last 12 months. One of the great failures has been WeWork, which was valued at $47bn last January, but has since slumped. The contrast between these two companies contains an important lesson.
WeWork was a victim of what New York University’s Aswath Damodaran and UCLA’s Bradford Cornell call the “big market delusion”. The global office rental market is so enormous that WeWork’s backers thought the company could become massive if only it could capture a decent chunk of it. But for this to happen, say Professors Damodaran and Cornell, “a whole host of other pieces have to fall into place”. For example, the company must actually capture market share, which is difficult when it faces lots of competition and few barriers to entry. And it must at least have a plan for becoming profitable sometime, which is tricky when it must invest millions in advertising and marketing in an effort to capture market share; when growing companies often lose control of costs; and when sales often grow slower than assets when a company tries to expand.
WeWork is of course by no means the only victim of big market delusion. So too were internet retail stocks in the late 1990s. The hope of capturing a chunk of the massive retail sector led companies to overinvest with the result that many just saw their cash run out. More recently, the prospect of a legalised cannabis market in the US led to cannabis stocks becoming overpriced; the ETFMG alternative harvest fund, which invests in such stocks, has halved in the last 12 months.
Emerging markets are also prone to the big market delusion. China offers a potentially massive market for many companies. But in the last 10 years Chinese stocks have underperformed those in mature economies such as Japan or Germany. The thing about potential is that it is often unfulfilled.
Our tendency to overvalue companies in potentially big markets is compounded by that most ubiquitous of cognitive biases – overconfidence. Entrepreneurs are overconfident about the quality of their product and so overestimate its chance of winning market share. And investors are overconfident about their ability to spot growth stocks, and so they pay too much for what is in fact only the faint prospect of it.
The big market delusion is the flipside of Warren Buffett’s famous advice to look for companies with “economic moats” – things that give it the power to fend off competitors, such as brand power or barriers to entry. WeWork, like internet stocks in the 1990s, didn’t have a moat and spent millions on advertising in a vain effort to build one.
Which brings us to the contrast with Games Workshop. It is not operating in a large market: demand for war games is limited and unlikely to grow very fast. But it has a big chunk of this market and hence sufficient monopoly power to generate nice profit margins; in the six months to December it made £59.2m of operating profit on just £145.6m of sales. It’s better to have proven monopoly power in a niche market (especially if your product is addictive) than the hope of a share of a growing but competitive market.
There is, though, another difference between Games Workshop and WeWork. War gaming, and hence Games Workshop’s customers, has a stigma: the lazy stereotype is that its players are geeks and nerds. In this sense, it has something in common with another hugely successful stock, Greggs (GRG), whose customers are also sneered at by many who think themselves sophisticated.
Both stocks, have therefore benefited from a longstanding and worldwide bias that investors have – a distaste for dull companies in unattractive markets (serving unattractive customers!) and a preference for exciting glamorous stocks in potentially big markets. This has caused dull companies to be underpriced and glamorous ones to be overpriced with the result that, over the long term, dull stocks have outperformed glamorous ones. In this sense, the big market delusion is also the flipside of the bias that investors have had against dull defensives, which has contributed to the latter outperforming for so long.
But I wonder: is the bias here only in our investing, or is it in our thinking generally? Perhaps we devote too much attention to glamorous 'big picture' stories about long-term growth or secular trends and not enough attention to dull detail. At the macro level, aggregate market returns are better predicted by a few measures of investor sentiment than they are by stories about macroeconomics or geopolitics. And at the micro level a company's fate depends less upon the prospects for the market it is operating in and more upon the mechanics of how it can exclude rivals and how well it can control costs.
In investing – and perhaps not just in investing – the most important questions are not necessarily the most interesting.