Watch out for investment themes – Investors’ Chronicle
- Investors must resist the appeal of themes such as renewable energies or emerging markets. Companies rarely convert potential into real profits.
- Themes and stories simplify a complex world and encourage us to take too many risks.
Many of you like to invest in themes such as green energy or specific emerging markets. It’s dangerous.
The problem with these has been pointed out by Braford Cornell at UCLA and Aswath Damodaran at New York University. They call it the big market illusion. Investors are paying too much for companies they expect to take a share of a potentially huge market, be it renewables or India.
In the late 1990s, for example, investors correctly predicted internet shopping would become huge and paid big bucks for the companies they believed could benefit. Most were wrong. Likewise, the Chinese economy has grown tremendously since the 1990s, but any investor who held Chinese stocks in the hope of profiting from them has been sorely disappointed for years.
The subject generalizes. Jay Ritter of the University of Florida has shown that across countries, there is in fact a negative correlation between economic growth and stock returns. “Countries with high growth potential only offer good equity investment opportunities if valuations are low,” he concludes. Morgan Stanley economists have corroborated this. “Long-term stock price growth has been lower than GDP growth in many countries,” they found.
A potentially large market does not mean big profits for investors, even if that potential is realized. 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 large market attracts new entrants and therefore more intense competition, which reduces profit margins. Nobel laureate William Nordhaus found that companies have captured “a tiny fraction” of the total return on innovation since 1948. One reason is that even with patent protection, new products can be imitated: think of the number of companies that produce smartphones or LEDs. televisions.
In addition, new technologies, such as the batteries that power electric cars, are often inefficient at first and require large investments to improve them or produce them on a large scale. Such huge investments, even if they are subsidized by governments, are risky.
And then there are the usual problems with growing any business. Growth-oriented managers can lose control over costs, undervalue their products, take on too much debt, or drain investors’ cash too quickly. Charlie Cai of the University of Liverpool has shown that investors have often underestimated these issues in the past and therefore paid too much for “growth” stocks.
Investment themes and big ideas are therefore dangerous. They distract us from what really matters, which is the truth on the ground about specific companies. Does it have an economic gap to fight its competitors? How much can it grow without requiring more capital? Does its technology really work? How well do its managers understand pricing, marketing and cost control? Is the valuation reasonable? A potentially large market and an exciting history doesn’t mean you can avoid the tedious work of business analysis.
Such stories can mislead us in another way. They are an example of what Nassim Nicholas Taleb calls the narrative fallacy. By assembling neat narratives from a jumble of facts, stories encourage us to see the world as more orderly and predictable than it really is, and thus to underestimate uncertainty and chance. This leads to overconfidence and taking too many risks.
And remember: some of the most important facts about today’s investment climate weren’t widely known until they actually came to light. In the mid-2000s, the looming financial crisis, secular stagnation, and the looming downtrend in 15-year bond yields were not major themes, nor was the growing monopoly power of big tech companies. All of this reminds us that our future world is likely to revolve around major themes that we do not yet know.
However, none of this means you should avoid themes and investing modes. Instead, we should treat them realistically. These 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 feelings that come and go. To do this, you must have an exit strategy. And we know that the rule of selling when prices fall below their ten-month (or 200-day) average works quite well in sentiment-driven markets – and especially in the important sense of getting us out before long ones. and big losses that occur. when the bubbles deflate.
A good investment is not a matter of great windy spirit. It is a matter of detail, rules and discipline.