Beware of investment themes

Many of you like to invest in themes such as green energy or specific emerging markets. This is dangerous.

The problem with these has been pointed out by Bradford Cornell at UCLA and Aswath Damodaran at New York University. They call it the big market delusion. Investors pay too much for companies which they expect to grab a share of a potentially huge market, be it renewable energy or India.

In the late 1990s, for example, investors correctly foresaw that internet shopping would become huge and paid fortunes for companies they thought would benefit from it. Mostly they were wrong. Similarly, China’s economy has grown enormously since the 1990s, but any investor who held Chinese stocks in the hope of profiting from this has been gravely disappointed for years.

The point generalises. Jay Ritter at the University of Florida has shown that across countries there is actually a negative correlation between economic growth and equity returns. “Countries with high growth potential do not offer good equity investment opportunities unless valuations are low” he concludes. Economists at Morgan Stanley have corroborated this. “Long-run stock price growth has fallen short of GDP growth in many countries” they have found.

A potentially big market does not mean big profits for investors, even if that potential is realised. It is actually very difficult for companies to translate a growing market into what really matters, which is cold hard profit. Investors underestimate these difficulties.

One of the problems is simply that a potentially big market attracts new entrants and therefore more intense competition, which squeezes profit margins. The Nobel laureate William Nordhaus has found that firms have captured only “a minuscule fraction” of the total returns to innovation since 1948. One reason for this is that even with patent protection new products can be emulated: think how many companies produce smartphones or LED TVs.

Also, new technologies – such as the batteries that power electric cars – are often inefficient at first and need big investments to make them better or to produce them at scale. Such huge investments, even if subsidised by governments, are risky.

And then there are the usual problems with growing any company. Managers focused on growth can lose control of costs, under-price their products, take on too much debt or burn through investors’ cash too quickly. Liverpool University’s Charlie Cai has shown that investors have in the past often under-rated these problems and so paid too much for “growth” stocks.

Investment themes and big ideas are therefore dangerous. They distract us from what really matters, which is the nitty-gritty ground truth about specific companies. Does it have an economic moat to fight off competitors? How much can it grow without requiring more capital? Does its technology actually work? Have its managers got pricing, marketing and cost control right? Is the valuation reasonable? A potentially big market and exciting story does not mean you can avoid the grunt work of company analysis.

Such stories can mislead us in another way. They are an example of what Nassim Nicholas Taleb calls the narrative fallacy. In patching together neat narratives from a jumble of facts stories encourage us to see the world as more ordered and predictable than it really is and thus to underestimate uncertainty and randomness. This leads to overconfidence and to taking on too much risk.

And remember: some of the biggest facts about the investment climate today were not widely-told stories before they actually emerged. In the mid-2000s the looming financial crisis, secular stagnation and impending 15-year downtrend in bond yields were not big themes, and nor was the growing monopoly power of big tech firms. All of which reminds us that our future world is likely to centre around big themes which we do not yet know.

None of this, however, means you should shy away from themes and investment fashions. Instead, we should treat them realistically. They are potential bubbles. And we can ride such bubbles as long as we ignore the hype and futurology and instead see them for what they are – waves of sentiment that ebb and flow. To do so requires that you have an exit strategy. And we know that the rule to sell when prices fall below their ten-month (or 200-day) average works reasonably well in sentiment-driven markets – and especially in the important sense of getting us out before the long, big losses that happen when bubbles deflate.

Good investing is not about windy big-think. It’s about detail, rules and discipline.