Big shifts in technology or behaviour don’t only excite culture wars. Investors, too, get giddy at the prospect of catching a wave that will deliver them glory and riches.
You could even classify some investors as big wave surfers. Monster wave surfers scour the world, seeking to catch the improbable and rare 100-footers.
And some investors hunt plays to capitalise on exponential themes in pursuit of the improbable and rare 100-baggers.
Often, we call these thematic investors.
Identify a theme about to crest…and catch the exhilarating ride.
The logic is simple and alluring.
When done well, it’s also almost mythical. A great thematic investor is like a time traveller cashing winning lottery tickets.
But spotting trends forming on the horizon isn’t easy. And the work doesn’t stop once the spotting is done.
Picking winning themes is not the same as picking winners
To be a successful thematic investor requires at least two great skills — foresight and business acumen.
You need to be clairvoyant enough to spot the true societal or technological shifts. But you also need the business sense to figure out who stands to benefit.
And what do I mean by benefit? A business should profit from the tectonic shift in a way that creates vast shareholder value.
Investing is a strange topic.
It lies at the intersection of so many others — business, finance, economics, technology, science, etc. — yet it has its own core, too.
At the end of the day, a successful investor makes money (and doesn’t lose money). That usually means backing companies that make money.
And that boils down to cash flows.
It seems so banal that investing — often exciting and multi-disciplinary — is headquartered in the accountant’s office.
Respected investment strategist Michael Mauboussin summarised investing this way (emphasis added):
‘The founder, buyer, or holder of a business anticipates satisfactory returns based on the company’s distributable cash flows over time. Cash flows are defined as the difference between profits after taxes and the investments required to sustain or grow the business. This is as relevant for a small business in the local community as it is for a company in the S&P 500. When an owner sells a business, the rights to the cash flow and the associated risk and reward are transferred to the new holder.’
That’s why I said thematic investing requires business acumen. Being right about a rising trend is not enough. You must also pick businesses that leverage the trend into profitable enterprises.
The internet is one of the most profound technological advances and societal shifts. But seeing the advent of the internet early was not enough.
Many early internet companies failed. Scores of others took years to turn a profit.
Picking winning themes is not the same as picking winning stocks.
Lessons from thematic funds
You could argue that one way to circumvent the need to pick winners of exponential trends is by buying the lot. That is, by investing in a thematic fund.
For instance, according to Morningstar data, the cybersecurity thematic fund has outperformed the benchmark S&P 500 over the past five years.
But cybersecurity was one of only two thematic funds to outperform the S&P 500 out of the 33 tracked by Morningstar.
In fact, a third of thematic funds launched a decade ago have not survived.
Stuart Kirk — ex-head of thematic research at a global bank — offered a great explanation as to why in a recent Financial Times column (emphasis added):
‘The most common way thematic funds are born is when someone in sales or product development has read about a hot theme in an airline magazine, or someone at golf was banging on about the “circular economy”.
‘Everyone is bullish, and the race is on to bring a product to market. This is fine for everyone but us poor sods who invest at the peak of the theme, just before prices correct.
‘I’ve done a lot of analysis on the money-weighted performance of thematic funds, which weights returns by the date and size of flows into them. Little money is around at the start to enjoy the serious gains. Most rushes in near the top, and then suffers a loss. On this basis, most thematic funds destroy more value than they make.
‘If there is a lesson to take away here, it is the same for all investing. Buy when no one is talking about a theme and sell once everyone is. Easier said than done as most funds are launched only when a theme is exciting enough, and by that time it’s too late.’
Kirk’s lesson is timeless and applies widely. It also echoes Buffett’s motto to be fearful when others are greedy and greedy when others are fearful.
The perils of seeing a trend early
Grasping where the future is headed is not always a boon.
Sometimes, you can see the future too early and wisen waiting for it to arrive.
Famously, that nearly happened to Michael Burry, who was one of the first to see the collapse of the US housing market in 2008 coming.
He positioned to profit from the looming collapse…but his earliness nearly cost him his fund…and the opportunity to make a fortune.
Seeing trends early is especially fraught with danger in the tech sector. I alluded to this in last week’s piece, where I referenced the work of economist Carlota Perez.
Perez has dedicated her career to studying the economics of technological change and paradigm shifts.
She found that there is often a decades-long lag between the arrival of revolutionary technology and its mass adoption.
Perez summarised her findings in Technological Revolutions and Financial Capital (emphasis added):
‘The main contention is that the full fruits of the technological revolutions that occur about every half century are only widely reaped with a time-lag. Two or three decades of turbulent adaptation and assimilation elapse, from the moment when the set of new technologies, products, industries and infrastructures make their first impact to the beginning of a “golden age”’ or “era of good feeling” based on them.
‘For each technological revolution, that time-lag is characterized by strong divergence in the rates of growth of industries, countries and regions as well as a worsening of the trends in income distribution that had previously prevailed. Historically, those decades have brought the greatest excitement in financial markets, where brilliant successes and innovations share the stage with great manias and outrageous swindles. They have also ended with the most virulent crashes, recessions and depressions, later to give way, through the establishment of appropriate institutions, to a period of widespread prosperity, based on the potential of that particular set of technologies.’
Maybe there is a middle way — a Goldilocks zone where trend-spotting and business evaluation come together to form a sound investment approach.
Investment firm Accel may be one firm to operate there.
Historian Sebastian Mallaby’s history of venture capital — The Power Law — tracked the fortunes and methods of the most successful venture firms in the world.
Accel was one of them. Profiling its investment methodology, Mallaby described Accel’s ‘prepared mind’ approach:
‘Accel, the partnership best known for backing Facebook, developed an approach known as “prepared mind.” You study a coming technology shift — for example, the migration of data from customer devices to the cloud. You figure out the implications: new hardware configurations, new software business models, new security vulnerabilities. Then, when you come across a start-up that is poised to surf the new wave profitably, you are primed to react quickly.’
Here’s to being prepared…and profitable!
Is 2023 the year of the ‘Big Loss’?
Here’s an idea not many are contemplating, especially with markets rallying in recent weeks and Bitcoin [BTC] up more than 30% since November 2022.
My colleague Vern Gowdie thinks this optimism is misguided.
For Vern, 2023 could be the year of the ‘Big Loss’. He’s ‘as worried as he’s ever been about the state of the markets.’
But he’s got a plan.
In fact, Vern’s hosting a four-day strategy session outlining his ideas on how investors can protect their capital.
You can reserve your spot here.
Until then,
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Kiryll Prakapenka,
For Money Morning